Beruflich Dokumente
Kultur Dokumente
UNIT II
Table of Contents
2.1 Definition of Demand ........................................................................................................................ 1
2.1.2 Elasticity of Demand .................................................................................................................. 2
2.1.3 Measurement Of Elasticity Of Demand ................................................................................. 4
2.2SUPPLY ........................................................................................................................................... 10
2.2.2 Law of supply ........................................................................................................................... 12
2.3 Production Function With One Variable Input ................................................................................ 16
2.4 Production Function With Two Variable Inputs ............................................................................. 18
2.5 Production Function With All Variable Inputs ................................................................................ 21
2.6 Cost Concepts .................................................................................................................................. 25
2.6.1 COST DETERMINANTS ........................................................................................................ 27
2.7 LEARNING AND COSTS.............................................................................................................. 33
2.8 ECONOMIES OF SCALE .............................................................................................................. 33
2.9 Diseconomies Of Scale.................................................................................................................... 35
2.10 Cost Control................................................................................................................................... 36
2.11 Utility............................................................................................................................................. 37
2.12 Marginal Utility Analysis .............................................................................................................. 38
2.13Consumers Equilibrium .................................................................................................................. 40
O Quantity demanded X
Y D
Price
O Quantity demanded X
In this case, even a large change in price fails to bring about a change in quantity demanded.
When a price increases from OP to OP1, the quantity remains the same and the
elasticity of demand E=0
D
P
P1
D1
O Q Q1 X
Quantity demanded
P1
D1
O Q Q1 X
Quantity demanded
When price falls from OP to OP1, the quantity demanded increases from OQ to OQ1 which is
smaller than change in price. Here, E<1 and the demand curve will be steeper.
E) Unit Elasticity of Demand
The change in demand is exactly equal to change in price. When both are equal E = 1 and
Elasticity is said to be unitary.
Y
D
P
Price
P1
D1
O Q Q1 X
Quantity demanded
Thus a change in price has resulted an equal change in quantity demanded and E = 1.
2. Income Elasticity Of Demand
The income elasticity of demand is a measure of responsiveness of the quantity of and
lower the income there may be lower the purchasing. It should be calculated by using the
formula as,
Price of
S.No No. of units bought Total outlay
product
1 6 4 24
E<1 Inelastic
2 5 4 20
E=1
3 4 5 20
E>1 Elastic
4 3 8 24
In the first two case, there was a fall in the total outlay from Rs.26 to Rs.20. this
indicates that the elasticity is less than unity. But in last 2 case, the outlay is increased from
Rs.20 to Rs.24, this indicates that the elasticity is greater than unity.
3. Geometric Method
The elasticity of demand can also be worked out geometrically. The elasticity of
demand has been considered as unity, less than unity and more than unity. Now, three points
are said to be evident namely E1, E2, and E3 on the demand curve D.
Y
D
E3<1
.
Price
E 2=1
.
E1>1
.
O D1 X
Quantity demanded
The distance between D1 E2and D E2is equal (i.e.) D1 E2 = DE2. Hence the elasticity of
demand at point E2 is unity [E=1].
The distance between D1 E1 is less than the distance between D E1 (i.e.) D1 E1< DE1.
Hence the elasticity of demand at point E1 is less than unity [E<1].
the distance between D1 E3 is greater than the distance between DE3 (i.e.) D1 E3> DE3.
Hence the elasticity of demand at point E3 is greater than unity [ E >1 ].
4. Arc method
Arc method is used for measuring price elasticity of demand. It is useful only when we have
full information about the changes in price and quantity demanded. The formula is
E= (Q1-Q2/Q1+Q2) / (P1-P2/P1+P2)
1. Price Fixation
Elasticity helps to the management when price decisions are taken. for example, if the
product have monopoly position, then the elasticity will be inelastic and the firm may fix
high price. On the other hand, if the product have more competitors, then the elasticity will be
elastic and the firm may fix lower price.
2.Sales potential
The elasticity of demand exerts its influence on sales. If the elasticity is highly
inelastic one then the firm can expect more sales. Then if the elasticity is highly elastic, then
the firm can expect low sales of their product.
3. Substitutes
In substitute product, the price of one product increase will automatically make an
increased demand for the substitute product. For example the demand for rain coat get
increase due to the use and increased price of an umbrella.
2.1.5 Demand Analysis
Meaning
A major part of the managerial decision making depends on accurate estimates of
demand and it is termed as demand analysis. Forecasting a future demand for a product can
serve as a guide to management for strengthening market position and enlarging profit.
1. Price
A change in price of a commodity may bring about a change in the quantity
demanded. For example, when the price of the commodity falls, it may lead to rise in demand
and when the price of the product rise, the customer shift to other product or substitute
product therefore the demand may get fall.
2.Population
An increase in population would automatically lead to an increase in the demand and
if population decreases, the demand would automatically decreases.
3. Income
The income of a person raises, he purchases a lot and therefore the demand increases.
On the other hand if the income falls, their consumption comes down and the demand
decreases.
4.Inflation
During inflation, the general price level rises. The real income of the consumer falls.
Therefore, consumer automatically reduce their demand.
5.Climate
Climate has a direct influence on demand. In winter, generally speaking, there is a
great demand for woolen clothes. On the other hand in summer, there is a demand for fans,
coolers etc., demand is thus depend on climatic condition.
7. Sales Promotion
If there will be more sales promotion techniques like gifts, price discount etc., of a
product then the demand of the product increases and vice verse.
Demand Distinctions
In some things, the demand will be more and the other things, the demand will be
less. It is necessary to find out those differences among the two and this differences is termed
as demand distinctions.
The following are the important demand distinctions
consumer goods are those goods which are used for final consumption ex ready made clothes,
prepared food etc it may be sub-divided into
Consumer durable those goods which can be consumes more than once over a
period of time, Ex., umbrella, refrigerator etc
Consumer nondurable those goods which cannot be consumer more than once.
Ex., bread.
For consumer goods, income is the most important determinants of demand while for
producers goods it is the business profit /activity that determines demand.
The demand for durable goods is influenced by expected price, income and change in
technology.
The demand for non- durable goods demands on their current price, income, fashion
etc
Forecasting means to know the trend or behavior after a period of time. this trend or
behavior can be increasing or decreasing one. it is an extension of the present demand.
Demand always refers to sales. A demand forecast is a prediction of future sales or it is
an estimate of the future demand of the product. It is essential for the firm to produce the
required quantities at the right time.
Definition
Several methods are employed for forecasting demand. All these methods can be
grouped under
1. Survey method
Under this method, information about the demand forecasted is collected through
interview. The 4 types of survey method are as follows
a) Opinion survey method
Under this method, the company asks its salesmen to submit estimates of future sales
in their areas. These estimates are consolidated by the top executives and make the forecast
realistic one.
b) Expert opinion
Apart from salesman and consumers, distributors or outside experts may also be used
for forecasting firms in advanced countries make use of this method.
c) Delphi method
Under this method, a panel is selected to give suggestions about the demand of the
product. Both internal and external experts can be the member of the panel. Panel member
express their views about the demand of the product and finally one conclusion is taken from
it.
d) Consumers Interview Method
The most direct method of estimating sales in the near future is to ask customers what
they are planning to buy. This method may be undertaken in 3 ways
i) Complete enumeration method under this method all the consumers of the
product are interviewed
iii ) end- use method under this method, the demand for the product from different
sector such as industries, consumers, export and import are found out.
2. Statistical methods
Statistical methods is used for long run forecasting. In this method, statistical and
mechanical techniques are used to forecast demand.
a) Trend analysis
An industry which has been existence of accumulated data on sales, production etc.
belong to different time periods. Such data when arranged chronologically form, it is termed
as time series analysis. Based on this, trend we can estimable the demand by the following 2
ways
i) Moving averages under this method, the average of past achievements is based
on prediction of future
ii) Exponential smoothing in this technique of moving average, all time periods
are weighted. But the recent periods are get more weight when compared to older periods.
b) Barometric technique
A barometer is an instrument for measuring change. Under barometric method, present
events are used to predict the direction of change future. This is done with the help of
economic indicators such as gross national income, employment, personal income etc.
c) Correlation and regression analysis
In correlation analysis, the demand function states that relation between sales and
other variables in the economy., and it expressed the nature relationship, between two
variables while in regression, the extent of relationship between two variables are analyzed.
2.2SUPPLY
MEANING
The supply of a commodity means the amount of that commodity which producers are
able and willing to offer for sale at a given price
1. The supply of a commodity depends upon the goals of firms. If drug companies prefer
to engage in the production of medicines rather than rat poison because it makes them feel
more important in society, we expect more medicines and less rat poison to be produced than
if producers held all commodities in equal regard. If producers of some commodity want to
sell as much as possible, even if it costs them some profit to do so, more will be sold of that
commodity than if they wanted to make maximum profits. If producers are reluctant to take
risks, we would expect smaller production of goods whose production is risky.
2. The supply of a commodity depends upon the price of that commodity. Ceteris
paribus, the higher the price of the commodity, the more profitable it will be to make that
commodity. One expects, therefore, that the higher the price, the greater will be the supply.
3. The supply of a commodity depends upon the price of all other commodities.
Generally, an increase in the price of other commodities will make production of the
commodity whose price does not rise relatively less attractive than it was previously. We thus
expect that ceteris paribus, the supply of one commodity would fall as the price of other
commodities rises.
4. The supply of a commodity depends upon the price of factors of production. A rise in
the price of one factor of production will cause a large increase in the costs of making those
goods which use a great deal of that factor, and only a small increase in the cost of production
those commodities which use a small amount of the factor. For example, a rise in the price of
land will have a large effect on the cost of producing wheat and only a vary small effect on the
costs of producing motor vehicles. Thus, a change in the price of one factor of production will
cause changes in the relative profitability of different lines of production and this will cause
producers to shift from one line to another, and so cause changes in the supplies of different
commodities.
5. The supply of a commodity depends upon the state of technology. The enormous
increase in production per worker that has been going on in industrial societies for about 200
years, is very largely due to improved method of production. These, in turn, have been heavily
influenced by the advantages of science. But the Industrial Revolution is more than a
historical event; it is a present day reality. Discoveries in chemistry have led to lower costs of
products made of plastics and synthetic fibers. The new electronics industry rests upon
transistors and other tiny devices that are revolutionizing production in television, high-
fidelity equipment, computers and guidance- control systems. Atomic energy will one day be
used to build canals and to extracts fresh water from the sea. At any time, what is produced
and how it is produced depends upon what is known. Over time, knowledge changes and so
do the supplies of individual commodity.
6. Time factor can also determine elasticity of supply. Time can be broadly classified
into three categories:
(a) Market period is the one where supply is fixed as no factor of production can be altered.
(b) Short period is the time period when it is possible to adjust supply only by changing the
variable factors like raw-material, labour, etc., and
(c) Long period where supply can be changed at will because all the factors can be changed.
Obviously, in the market period, where the supply is fixed, the elasticity of supply will be
zero. The elasticity will be higher in the long run than in the short run as the possibility of
changing output is limited in the short-run but not in the long run.
7. Supply may be consciously decreased by agreement among the producers, for example,
agreement among oil producing countries to cut back oil output.
8. Supply may also be destroyed to raise price. For example, in Brazil, coffee was thrown
into the sea.
9. Supply may also be affected by taxation on output or imports. Government may also
restrict production of certain commodities on grounds of health (e.g., opium in India).
10. Political disturbances or war may also create scarcity of certain goods.
O Quantity X
This can be explained by two reasons: (i) An increase in price generally implies higher profits
leading producers to offer increased quantities, and (ii) in the long run due to higher
profitability, new producers may enter the field of production leading to an increase in output.
Elasticity of supply
Elasticity of supply can be defined as the degree of responsiveness of supply to a
given change in price. The formula to find out the elasticity of supply is:
Q
Es= Q or
Q
P
proportionatechangeinquantitysup plied
Pr oportionatechangeinprice
Illustration
Firm A supplied 300 units of its output at price of Rs.4. when price increases to Rs.8,
the quantity supplied increases to 500 unit. Find the elasticity of supply.
Elasticity of supply= Es= Q .
p1
P Q1
200 4
=
4 300
200
= =0.67
300
The following figure illustrates five cases of supply elasticity. The cases of zero
elasticity is one in which the quantity supplied does not change as price changes. This would
be the case, for example, if suppliers persisted in producing a given quantity Oa in fig(i) and
dumping it on the market for whatever it would fetch. Infinite elasticity is illustrated in Fig.
(ii). The supply elasticity is infinite at the price Ob because nothing at all is supplied at lower
prices but a small increase in price to Ob causes supply to rise from zero to an indefinitely
large amount, indicating that producers will supply any amount demanded at that price. The
case of unit elasticity of supply is illustrated in Fig. (iii). Any straight line supply curve drawn
through the origin has unit elasticity.
When the supply curve cuts the vertical axis, it is relatively elastic supply fig.(iv).
When the supply curve cuts the horizontal axis, it is relatively inelastic supply [fig. (v)]
Y s Y
Price
Price
s
b
a
O Quantity X
O Quantity X
(i) A supply curve of (ii) A supply curve of
Zero elasticity Infinite elasticity.
Y Y
s1 s1
Price
Price
s2
a
s1
O Quantity X
O Quantity X
Y
s1
Price
O s1 Quantity X
Supply elasticity is a useful concept but not quite so useful a concept as demand
elasticity for the reason that elasticity of demand has the major additional function of telling
us what is happening to total revenue. There is, however, an important fact that supply
elasticity can describe. A given change in price will tent to have greater and greater effects on
the amount supplied as one moves from momentary situation to a short-run period and on to
the long-run period. Elasticity of supply tends to be greater in the long run when adjustments
to the higher price have been made than in the shorter periods of time.
Cross Elasticity of supply
Three economists, vis., F. gruen, L. Ward and A. Powell have introduced this new
concept of elasticity of supply while estimating elasticities of supply for Australian
agricultural products.
The cross (price) elasticity of supply, however, measures change in quantity supplied
of one commodity (say, wheat) When the price of another commodity (say, paddy) changes. It
can be expressed as:
Here, Esc is the elasticity co-efficient. It is always negative indicating that a rise a rise
in the price of one good will lead to a fall in the quantity supplied of alternative good. For
instance, a rise in the price of paddy by 1 per cent may reduce the quantity supplied of wheat
by 0.22 per cent.
In real life, the concept of cross elasticity of supply is quite important. The concept
finds its application significantly in case of agricultural commodities. Since land is a scarce
factor, farmers have to be careful about its use. For example, if price of paddy goes up, land
will be diverted from wheat production causing fall in quantity of wheat supplied.
Increase and Decrease in supply
Increase and Decrease in supply would mean a change in quantity supplied without
any change in price. This, therefore, implies a shift in supply schedule to the right implying
increase in supply and to the left implying decrease in supply.
An increase in supply involving willingness to make and sell more at each price may
be caused by (i) improvements in technology, (ii) decrease in the prices of other commodities,
or (iii) decrease in the prices of factors of production used in making the commodity
concerned. A decrease in supply involving reluctance on the part of sellers to sell as much as
before at each price may be due to (i) increases in the prices of other commodities, or (ii)
increases in the prices of factors of production used in making the commodity concerned.
Y s1 s2 s3
Price
P1 P2 P3
H
s1
s2
s3
O Quantity X
Increase and Decrease in supply
The following figure shows that SS is the supply curve before the change. S` S` shows
a decrease in supply because at the same price pm, less is offered for sale, i.e., OM` instead of
OM. (The new price now would be P` M`.).S`` S`` shows an increase in supply because at the
same price pm, more is offered for sale, i.e., OM" instead of OM. (The new price now would
be p m.)
One must clearly distinguish between the Increase in quantity supplied and increase In
supply. Increase in supply means that the entire supply curve has shifted to a new Position to
the right. It is a new curve Altogether whereas increase in the quantity
Supplied means that more is being affered at a higher price. The supply curve is the
same. A movement along the same supply curve simply indicates changes in quantities
offered as a result of a change in price. It does not represent any change in the supply
schedule.
A particularly notable feature of market economies is the effect of the price mechanism on
demand and supply. The price mechanism determines the equilibrium in the market and
consists of the interplay of the forces of supply and demand in determining the prices at which
commodities will be bought and sold in the market. Market equilibrium is the situation, where
at a certain price level, the quantity supplied and the quantity demanded of a particular
commodity are equal. Thus,the market can clear, with no excess supply or demand, and there
is no tendency to change in either price or quantity.Diagrammatically, market equilibrium
occurs where the demand and supply curves intersect, at the point where the quantity
demanded is exactly equal to the quantity demanded. Let us first consider the case where there
is excess demand, where the current price is below that of equilibrium, as shown in Figure
II III
Increasing Decreasing Negative
Returns Returns returns
AP
O X1 X2 X3
Input X MP
The total product curve is divided into three segments popularly known as three
stages of production as under:
Stage I
Stage II
The second stage lies in the range from X2 to X3. In other words, Stage II begins
where the average product of the variable factor is maximized and continues to the point at
which total product is maximized and marginal product is zero. This stage is characterized by
diminishing returns to the variable input over its entire range. That is, although total product is
increasing in this range, it dose so at a continuously decreasing rate.
Stage III
Finally, we have Stage III, the area beyond X3 where the total product curve starts
decreasing. In this range, the marginal product of the variable factor is negative.
The following Table sums up the three stages of law of variable proportions:
Stage II is Rational
Only stage II is rational which means relevant range for a rational firm to operate. For
no firm will choose to operate either in Stage I or Stage III; in Stage I, it is profitable for the
firm to keep on increasing the use of labour and in Stage III, MP is negative and hence it is
inadvisable to use additional labour. The firm, therefore, has a strong incentive to expand
through Stage I into Stag II.
Isoquants
To understand a production function with two variable inputs, it is necessary to
explain what an isoquant is. An isoquant is also known as Iso- product curve, Equal product
curve or a production indifference curve. These curves show the various combinations of two
variable inputs resulting in the same level of output. Table 3 shows how different pairs of
labour and capital result in the same output.
Table 3: Labour & capital Inputs in Relation to Output
q=
30
q=
00
Machinery
20
q=
00
16
q=
00
10
q=
00
60
0
X
Labour
Thus, by graphing a production function with two variable inputs, one can derive the
isoquant tracing all the combinations of the two factors of production that yield the same
output. An isoquant is defined as the curve passing through the plotted points representing all
the combinations of the two factor of production which will produce a given output. The
above figure shows a typical Isoquant diagram levels of outputs are obtained, using larger
quantities of output.
For each level of output there will be a different isoquant. When the whole array of
isoquants are represented on a graph, it is called an Isoquant map.
Substitutability of Inputs
An important assumption in the Isoquant Digram is that the inputs can be substituted
for each other. Let us take a particular combination of X and Y resulting in an output q600
units. By moving along the isoquant q600, one finds other quantities of the inputs resulting in
the same output. Let us suppose that X represents labour and Y, machinery. If the quantity of
the labour (X) is reduced, the quantity of machinery (Y) must be increased in order to produce
the same output.
MRTS
The slope of the isoquant has a technical name: marginal rate of technical substitution
(MRTS), or sometimes, the marginal rate of substitution in production. Thus in terms of
inputs of capital services K and L.
MRTS=dK/dL
(MRTS is similar to MRS, i.e., marginal Rate of Substitution, which is the slope of an
indifference curve.)
Types of Isoquants
Isoquants assume different shapes depending upon the degree of substitutability of
inputs under consideration.
(1) Linear Isoquants
Here, there is perfect substitutability of inputs. For example, a given output say 100
unit can be produced by using only capital or only labour or by a number of combinations of
labour and capital, say 1 unit of labour and 5 unit of capital, or 2 units of labour and 3 units of
capital, and so on. Likewise, given a power plant equipped to burn either oil or gas, various
amounts of electric power can be produced by burning gas only, oil only or varying amounts
of each. Gas and oil are perfect substitutes here. Hence, the isoquants are straight lines
Oil
Q1 Q2 Q3 Q4 Q5
X
Gas
(2) Right-angle Isoquant
Here, there is complete non-substitutability between the inputs (or strict
complimentarily). For example, exactly two wheels and one frame are required to produce a
bicycle and in no way can wheels be substituted for frames or vice-versa. Likewise, two
wheels and one chassis are required for a scooter. This is also known as Leontief Isoquant or
Input-output isoquant.
Chassis
Q3 = 3 Scooters
Q2 = 3 Scooters
Q1 = 3 Scooters
2 4 6 Wheels
(3) Convex Isoquant
This form assumes substitutability of inputs but the substitutability is not perfect. For
example, a shirt can be made with relatively small amount of labour (L1) and a large amount
of cloth (c1). The same shirt can be as well made with less cloth (C2), if more labour (L2) is
used because the tailor will have to cut the cloth more carefully and reduce wastage. Finally,
the shirt can be made with still less cloth (C3) but the tailor must take extreme pains so that
labour input requirement increases to L3. So, while a relatively small addition of labour from
L1 to L2 allows the input of cloth to be reduced from C1 to C2, a very large increase in labour
from L2 to L3 is needed to obtain a small reduction in cloth from C2 to C3. Thus the
substitutability of labour for cloth diminishes from L1 to L2 to L3.
cloth
C1
C2
Q2
C3 Q1
L 1 L2 L3
Labour
Main Properties of Isoquants
1. An isoquant is downward sloping to the right, i.e., negatively inclined. This implies
that for the same level of output, the quantity of one variable will have to be reduced in order
to increase the quantity of other variable.
2. A higher isoquant represents larger output. That is, with the same quantity of one input
and larger quantity of the other input, larger output will be produced.
3. No two isoquants intersect or touch each other. If two isoquants intersect or touch each
other, this would mean that there will be a common point on the two curves; and this would
imply that the same amount of two inputs can produce two different levels of output (i.e., 400
and 500 units) which is absurd.
4. Isoquant is convex to the origin. This means that its slope declines from left to right
along the curve. In other words, when we go on increasing the quantity of one input say
labour by reducing the quantity of other input say capital, we see that less units of capital are
sacrificed for the additional units of labour.
X,Y
Constant returns to scale
2. If the proportional increase in output is larger than that of the inputs, then we have
increasing returns to scale.
Q
X,Y
Increasing returns to scale
3. If output increases less than proportionally with input increases, we have decreasing returns
to scale.
Q
X,Y
Decreasing returns to scale
The most typical situation is for a production function to have first increasing then decreasing
returns to scale as shown in figure.
Q
X,Y
Variable returns to scale
The increasing returns to scale are attributable to specialization. As output increases,
specialized labour can be used and efficient, large-scale machinery can be employed in the
production process. However, beyond some scale of operations not only are further gains from
specialization limited, but also coordination problems may begin to increase costs
substantially. When coordination costs more than offset additional benefits of specialization,
decreasing returns to scale begin.
Q I
= for discrete function
I Q
Q I
= for continuous function
I Q
Where Q = Output, I = All Inputs
eQ.I = All Input Elasticity of Output
If eQ.I> I, there are increasing returns to scale
If eQ.I = I, there are constant returns to scale
If eQ.I< I, there are decreasing returns to scale
Returns to Scale and Returns to an Input
Two features of production functions that it is important to grasp are returns to scale
and returns to an input.
Returns to scale
Returns to scale describe what happens to the output rate when each input rate is
increased by the same proportion. If output increases by a larger percentage than the increase
in each input then there are increasing returns to scale; if it increases by a smaller percentage
there are diminishing returns to scale; if it increases by the same proportion there are constant
returns to scale.
Returns to an Input
Returns to an input describe what happens to output as only one input is varied,
holding all others constant. Again, these returns may be increasing, diminishing or constant.
Importance of Returns to Scale Concept
The returns to scale concept is quite important in the theory of production. If an
industry is characterized by increasing returns to scale, there will be a tendency for expanding
the size of the firm, and thus the industry will be dominated by large firms. The opposite will
be true in industries where decreasing returns to scale prevail. In case of industries
characterized by constant returns to scale, firms of all sizes would survive equally well.
EXPANSION PATH
The line representing least cost combination for different levels of output is called
firms expansion path or the scale line, e.g., the line ABC in the following figure,
Y
K3
Machinery
L
K2
Expansion path
C
K1 P3
B
P2
A
P1 X
L1 L2 L3
Labour
Measurement of Production Function
Several types of mathematical functions are commonly employed in the measurement
of production function but in applied research, four types have had the widest use. These are
linear functions, power functions, quadratic functions and cubic functions.
(1) Linear Function
A linear production function would take the form:
(Y/X )=(A/X) +b
The equation for the marginal product will be:
y
b
x
(2) Power Function
A power function expresses output, Y, as a function of input X in the form:
Y=aXb
Some important special properties of such power functions are:
(i) The exponents are the elasticities of production. Thus, in the above function, the
exponent b represents the elasticity of production.
(ii) The equation is linear in the logarithms, that is, it can be written
log Y=log a+b log X
When the power function is expressed in logarithmic form as above, the coefficient b
represents the elasticity of production.
(iii) If one input is increased while all others are held constant, marginal product will
decline.
1. It includes only two hector inputs- land and capital, but other sectors are equally important
in production process.
2. Labour input may be measured in number of man hours. but it is very difficult to measure
capital input due to depreciation over time.
3. It assumes constant technology.
4. It assumes there is a perfect competition the market.
5. It assumes that all labour units are homogeneous.
Meaning
Cost means the actual expenditure incurred for producing a product or service
Cost Concepts and Classifications
The kind of cost concept to be used in a particular situation depends upon the business
decisions to be made. Cost considerations enter into almost every business decision, and it is
important, though sometimes difficult, to use the right kind of cost. Hence an understanding of
the meaning of various concepts is essential for clear business thinking. Defining and
distinguishing cost concepts are necessary to emphasize: (i) that cost estimates produced by
conventional financial accounting are not appropriate for all managerial uses, and (ii) that
different business problems call for different kinds of costs. Different combinations of cost
ingredients are appropriate for various kinds of management problems.
1. A firm produces a single homogeneous goods with the help of certain factors of production
some of the factors are fixed and some other are variable and the prices of these factors are
fixed based on the marketing conditions.
2. The technology (t) which is used in the production are also fixed. Thus the total cost
function is expressed as
C=F (Q)
which means that total cost is a function (F) of output (Q) assuming all other are constant.
The cost function is shown diagrammatically.
In the above diagram, the total cost (TC) curve increases due to increase in the output.
But any changes in the fixed factors then the total cost curve are also changed. For example if
any changes in the technology ie., the technology of production increased then the total cost of
the product come down and it is shown in the diagram the TC curve falls to TC1 curve. Due to
reduction in technology the cost get increased and the cure raised to TC2.
The cost function is observed both in short run and long run. in short run some of the
factors are fixed and the firm may have both fixed and variable cost. But in long run, all
factors are variable and the firm may have only variable cost.
Cost-Output Relationship
The study of cost-output relationship has two aspects:
1. cost-output relationship in the short run, and
2. Cost output relationship in the long run.
The short run is a period which does not permit alterations in the fixed equipment
(machinery, buildings, etc.) and in the size of the organization. As such, if any increase in
output is desired, it is possible within the range permitted by the existing fixed factors of
production.
The long run is a period in which there is sufficient time to alter the equipment
(machinery, buildings, land, etc.) and the size of organization. As such, in the long run, output
can be increased without any limits being placed by the fixed factors of production as they
themselves are capable of being changed.
COST-OUTPUT RELATIONSHIP IN THE SHORT RUN
In economic theory, the cost-output relationship in the short run may be studied in
terms of (1) average fixed cost, (2) average variable cost, and (3) average total cost as follows:
1. Average Fixed Cost and Output
The greater the output, the lower the fixed cost per unit, i.e., the average fixed cost.
The reason is that total fixed costs remain the same and do not change with a change in
output. The relationship between output and fixed cost is a universal one for all types of
business. Average fixed cost falls continuously as output rises. The reason why total fixed
costs remain the same and the average fixed cost falls is that certain factors are indivisible.
Indivisibility means that if a smaller output is to be produced, the factor cannot be used in a
smaller quantity. It is to be used as a whole.
2. Average Variable Cost and output
The average variable costs will first fall and then rise as more and more units are
produced in a given plant. This is so because as we add more units of variable factors in a
fixed plant, the efficiency of the inputs first increases and then decreases. In fact, the variable
factors tend to produce somewhat more efficiently near a firms optimum output than at very
low levels of output. But once the optimum capacity is reached, any further increase in output
will undoubtedly increase average variable cost quite sharply. Greater output can be obtained
but at much greater average variable cost. For example, if more and more workers are
appointed, it may ultimately lead to overcrowding and bad organization. Moreover, workers
may have to be paid higher wages for overtime work.
3. Average Total Cost and Output
Average total costs, more commonly known as average costs, would decline first and
then rise upwards. The significant point to note here is that the turning point in the case of
average cost would come a little later than in the case of average variable cost.
Average cost consists of average fixed cost plus average variable cost. As we have
seen, average fixed cost continues to fall with an increase in output while average variable
cost first declines and then rises. So long as average variable cost decline the average total
cost will also decline. But after a point, the average variable cost will rise. Here, if the rise in
variable cost is less than the drop in fixed cost, the average total cost will still continue to
decline. It is only when the rise in average variable cost is more than the drop in average fixed
cost that the average total cost will show a rise. Thus, there will be a stage where the average
variable cost may have started rising yet the average total cost is still declining because the
rise in average variable cost less than the drop in average fixed cost, the net effect being a
decline in average cost. And it is clear that the turning point in the case of average cost is at a
point later than that in the case of average variable cost.
The least cost-output level is the level where the average where the average total cost
is the minimum and not the average variable cost. In fact, at the least cost-output level, the
average variable cost will be more than its minimum (average variable cost). The least cost-
output level is also the optimum output level. It may not be the maximum output level. A firm
may decide to produce more than the least cost-output level.
Short-run Output Cost Curves
The cost-output relationships can also be shown through the use of graphs. It will be
seen that the average fixed cost curve (AFC curve) falls as output rises from lower levels to
higher levels. The shape of the average fixed cost curve, therefore, is a rectangular hyperbola.
The average variable cost curve (AVC curve) first falls and then rises. So also the average
total cost curve (AVC curve). However, the AVC curve starts rising earlier than the ATC
curve. Further, the least cost level of output corresponds to the point LT on the ATC curve and
not to the point LV which lies on the AVC curve.
Another important point to be noted is that in the given figure the marginal cost curve
(MC curve) intersects both the AVC curve and ATC curve at their minimum points. This is
very simple to explain. If marginal cost (MC) is less than the average cost (AC), it will pull
AC down. If the MC is greater than AC it will pull AC up.If the MC is equal to AC, it will
neither pull AC up nor down. Hence MC curve tends to intersect the AC curve at its lowest
point. Similar is the position about the average variable cost curve. It will not make any
difference whether MC is going up or down.
The rate of change in MC is greater than that in AVC and hence the minimum MC is
at an output lower than the output at which the AVC is the minimum. The ATC is at a larger
output than the minimum AVC.
The inter-relationships between AVC, ATC and AFC can be summed up as follows:
1. If both AFC and AVC fall, ATC will fall.
2. If AFC falls but AVC rises:
(a) ATC will fall where the drop in AFC is more than the rise in AVC.
(b) ATC will not fall where the drop in AFC is equal to the rise in AVC.
(c) ATC will rise where the drop in AFC is less than the rise in AVC.
To draw a long-run cost curve, we have to start with a number of short-run average
cost curve (SAC curves), each such curve representing a particular scale or size of the plant,
including the optimum scale. One can now draw the long-run cost curve which would be
tangential to the entire family of SAC curves. That is, it would touch each SAC curve at one
point. In this connection the following points are to be noted:
1. The LAC curve is tangential to the various SAC curves. It is said to envelop them
and is after called as the Envelope Curve since no point on an SAC curve can ever be below
the LAC curve.
2. The LAC curve is U-shaped or like a dish. The U-shape of the LAC curve implies
lower and lower average cost in the beginning until the optimum scale of the enterprise is
reached, and successively higher average costs thereafter, i.e., with plants larger than that of
the optimum scale.
The tendency for the long-run average costs to fall as the firm expands its scale of
operations is a reflection of cost economies available with the increase in size, while the
ultimate rise in the long-run cost curve is due largely to the eventual setting in of
diseconomies of scale.
The SAC curve also has a U-shape but the difference is that LAC curve is flatter, that
is, U-shape of the LAC curve will be less pronounced. This is because in the long run, such
economies are possible as cannot be had in the short run. Likewise, some of the diseconomies,
which are faced in the short run, may not be faced in the long run.
3. The long-run average cost curve can never cut short-run average cost curve (though
they are tangential to each other). This implies that for any given output, average cost cannot
be higher in the long run than in the short run. This is because any adjustment which will
reduce costs and which it is possible to make in the short run, can also be made in the long
run. On the other hand, it is not always possible in the short run to produce a given output in
the cheapest possible way.
4. LAC curve will touch the optimum scale curve at the latters least-cost point, i.e.,
N1.
5. LAC curve will touch SAC curve laying to the left of the optimum scale curve at the
left of their least-cost points
6. LAC curve will touch SAC curve laying to the right of the optimum scale curve at
the right of their least-cost points
Thus it will be seen that LAC curve is tangential to the minimum cost point in the case
of the optimum scale SAC and not in the case of other SAC curve.
External Economies
External Economies are those which are available to all the firms in an industry e.g.,
the construction of a railway line in a certain region which would reduce transport cost for all
the firms, the discovery of a new machine which can be purchased by all the firm, the
emergence of repair industries, rise of industries utilizing by-products, and the establishment
of special technical schools for training skilled labour and research institutes, etc. these
economies arise from the expansion in the size of an industry- involving an increase in the
number and size of the firm engaged in it.
The external economies occur when an industry is heavily concentrated in a particular
area. When this concentration happens, special facilities are attracted to the area. For example,
special technical schools are set up and equipment manufacturers build their plants in the area.
In addition, there is usually a pool of technically and professionally skilled labour available.
Interchange of technical information and ideas occurs through formal channels (e.g.,
professional societies) and informal channels (clubs, get-togethers, etc.)
Internal Economies
Internal economies are the economies which are available to a particular firm and give
it an advantage over other firms engaged in the industry. Internal economies arise from the
expansion of the size of a particular firm. From the managerial point of view, internal
economies are more important as they can be effected by managerial decisions of an
individual firm to change its size or scale or otherwise.
To distinguish between internal and external economies, one can say that the former
result due to the firms own expansion while the latter arise not due to its own expansion but
due to expansion of some other firms/industry.
2.11 Utility
Utility is the capacity of a commodity to satisfy human wants. It is defined as a
"want satisfying power of a commodity". It is a subjective concept and has no
material existence. It is not inherent in a commodity but depends upon the
mental make up of the consumer. The same commodity may have different
degrees of utility for different persons. Utility cannot be equated with usefulness.
A commodity may not be useful, yet it may have utility for a particular person.
Features of Utility :
(i) Utility is subjective in nature
(ii) Utility is relative and variable
(iii) Utility is not measurable
(iv) Utility, usefulness and pleasure
(v) Utility is Abstract
There are two approaches for measurement of utility :
(i) Measurement of utility in terms of money is called Cardinal UtilityApproach. The
amount of money which a consumer is prepared to pay fora commodity in the indirect
measurement of its utility.
(ii) Measurement of utility in term of ordinal numbers like I, II, III and so on it is Ordinal
Approach. In ordinal approach we may say that I is preferable to II etc.
1 30 30
2 55 25
3 75 20
4 90 15
5 100 10
6 105 5
7 105 0
8 100 -5
9 90 -10
10 75 -15
This theory was propounded by Prof. Alfred Marshall, Through this theory he explained how
a consumer spends his income on different commodities so as to attain maximum satisfaction.
The theory is based on certain assumptions which
are as follows :-
(1) The Cardinal Measurability of Utility
(2) Constancy of the Marginal Utility of Money
(3) The Hypothesis of Independent Utility
(4) Rationality
Law of Diminishing Marginal Utility
The law in based on an important fact that although total wants are unlimited,
each single want is individually satiable. It means that since each want is satiable, the intensity
of want goes on diminishing as the consumer goes on increasing the units of consumption.
This law is in also known as Gossens First law. To put it on Marshals Word, The
additional benefit which a person derives from a given increase of his stock of thing
diminishes with every increase in the stock that he already has.
Total Marginal
Units Utility Utility
1 12 12
2 20 8 } Positive Utility
3 26 6
4 30 4
5 32 2
6 32 0 Zero Utility
7 30 -2 } Negative Utility
8 26 -4
The above table shows the total and marginal utilities derived by a consumer on
consumption of a certain good. When the 1st unit is taken, total utility, is 12 units
and marginal utility is also 12 units. Further, as he goes on 5th unit, the total utility increases,
but at a diminishing rate, i.e. 20, 30, 32.. but marginal utility falls with every
successive unit of consumption i.e. 8,6,4,2 when 6th unit in taken no addition is made to total
utility and marginal utility falls to zero. Further, when units taken are increased to 7th and 8th
units, total utility falls and marginal utility turns negative. This means that now at this stage
the consumer may also derive dissatisfaction instead of satisfaction. Hence, the consumer
would restrict his consumption to 6th unit.
It can be seen from the given figure that the marginal utility curve goes on
declining continuously, the law of diminishing marginal utility applies almost to
all commodities. However, few exceptions are there as pointed out by some
economists.
Exception to the Law :
(i) Rare Commodities (ii) Alcohol (iii) Music (iv) Miser Man (v) Complementary Goods
2.13Consumers Equilibrium:
A consumer is said to be in equilibrium when he is deriving maximum possible
satisfaction from the given commodities and is not in a position to rearrange his purchases of
goods, say x and y.
(i) The consumer has an indifference map, which depicts his scale or order of preference for
various combinations of two goods, say x and y.
(ii) He has fixed income to spend on x and y completely.
(iii) Prices of goods x and y are given and do not change.
Consumers equilibrium is illustrated in the figure given below :-
In order to determine consumers point of equilibrium we make use of
indifference map and budget line together.
In the given figure :-
(a) AB is the budget line of the consumer.
(b) IC1, IC2 and IC3 are different indifference curves, showing different levels
of satisfaction.
In case he spends all his income on commodity x, he can buy OB quantity and
similarly, if he spends his entire income on Y he can purchase OA quantity of it.
However, if he wants to consume both the goods together he will try to reach a
situation of equilibrium where sacrifice made by him equals the satisfaction
derived.
Again, a rational consumer will try to reach the highest possible indifference
curve while staying in his budget line or affording capacity.
As shown is the figure, the consumer has at his options combinations D, C and E, but he
would option for combination at C because it will provide higher satisfaction in comparison to
point. D and E since both these points are lying on the lower indifference curve i.e. IC1,
further, points D and E are part of IC, the lower indifference curve and as known higher the
IC, higher is the level of satisfaction.
It can also be seen the point M is another level on the further higher. But it is beyond the
buying capacity of the consumer as can be seen. Hence, the consumers points of equilibrium
is determined at point C where he will consume OQ units of goods x and of units of goods Y.
At point C,Slope of Indifference Curve = Slope of Budget Line
i.e.
For every act of consumer there will be a separate equilibrium position of the
consumer. The condition that must be fulfilled by a consumer to be in
equilibrium are :-