Discussion Unit B

1. The Revealed Preference Theory

1. The Marshallian Cardinal approach to Demand Theory: Based on Cardinal

Measurement of utility.
• The Hicksian ordinal approach: Based on relative or ordinal or introspective
measurement of U. But non-observable.
• The RPT of Samuelson: Based on “actual”, behaviour of the consumer
2. The RPT based on the following assumptions
• Rationality: Consumer prefers a large basket of goods to the smaller ones
• Transitivity: A,B,C, alternative basket of goods
APB
BPC
⇒ APC
• Consistency: APB, then B is not preferred to A
⇒ Strong ordering
⇒ Makes definitely one and only choice → Reveals his specific preference
• Effective price inducement: Consumer can be induced to buy a particular
collection by providing him sufficient price incentive.
• Positive income – Elasticity of Demand: Recall: Income – demand function
cases of normal, inferior and neutral good.
⇒ Negative Income Elasticity or Zero Income Elasticity is ruled out
3. Diagrammatic Exposition of RPT:
• Two commodities: X & Y
• Prices of X and Y: Given

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 • Has a given money income
Y
M•
Δ OMN: Comsumer’s choice triangle
•B •D
Units of Com Y

Y1
•A
•C

X1 N
0 • X
Units of Com X
• MN: BL
’ Choice of commodity combination A: oY1 & oX1
⇒ Prefers A to any other feasible combination on MN
⇒ B or any other combination on MN: Not preferred.
⇒ His preference is revealed for A.
’ Any other point:
Point C: Smaller and cheaper basket of X & Y
Point D: Larger and more expensive basket
Hence A is a preferred combination.
4. Derivation of Inverse Relationship between P & Q (Law of Demand) from
RPT:

Comm Y

M1

M2

•C
•A
•B

0 •
X1 X2 X3 N1 N2 N3
Comm X

Fig: SE & IE Effects: Revealed Preference Approach

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 • M1N1 = initial budget
• A = Choice at point A: with Ax1 of Y and 0X1 of X
• Know: All the points on M1N1, feasible combinations of X and Y
• But: Prefers A to all the other feasible bundles.
Let: Px↓, Py M → New B.L , M1 N3.
• But: Shift from A and C due to effects of price change viz income and
substitution effects
• Decompose total effect of price change into substitution and income effects.
• M2 N2 : BL passing through point A.
⇒ Adjustment budget → point A with AX1 of Y and 0X1 of X still available
• Consumer: Not to choose any point between A and M2; because inferior to
bundle represent by Point A.
: Not to choose any other point say B on AN2 segment of the BL
: If continues to buy basket at point A ⇒ S.E is zero
: If chooses point B, SE = X1 X2
⇒D for X ↑ with a Px ↓ → Samuel Son’s Fundamental Demand Theorem.
⇒ Law of D is established
• The income effect: X2 to X3
• The S.E : X1 to X2
• Total effect of price change: X1 X3 = X1 X2 + X2 X3 → Move from point A to
point C
• RPT considers only the case of normal goods.

2. Demand Estimation and Forecasting:

2.1 Methods of Estimating Demand Function:

” Why demand estimation in BM?

• Impact of changes in exercise duty, lower prices, rising GDP etc on
demand for products.

” Consumer interviews (Surveys)

o Interview consumers on their consumption habits
o Census and sample methods

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 o Information on quantities of the concerned good bought at different
periods at various prices of the product, prices of related goods,
income of the consumer and so on.

” Market Experiments Method:

o Actual Experiment:
Record consumer’s reactions in different shop locations with respect to
income, religion, sex, age group etc.

o Market simulation (Consumer clinic or laboratory experiment)

method:
→ Provide token money to a set of consumers.
→ Vary prices of various goods, their quality, packaging etc and
record shopping behaviour of consumers.
→ Too costly and consumer’s may not take the experiment seriously.

o Functional forms for estimation: Simple and Multiple Regression.

” Regression Method:
→ Identify variables which influence demand for a particular commodity
→ Collect data
→ Select appropriate functional form
→ Estimate the function
Ex: Demand Function for Groundnut Oil
Dg = f (Y, Po, Pv, Pg, U)
Where: Dg = demand for groundnut oil
Y = national income
Po = price of groundnut oil
Pv = price of vanaspathi
Pg = price of pure ghee
U = ‘other’ determinants of g.n.o
→ Time series or cross section data.

2.2 Demand Forecasting

” D. Forecasting: An estimate of the future demand, based on laws of

probability.

” Levels of D. F:
o Micro Level: Forecast by an individual business firm.
o Industry Level:
o Macro Level: Ex: Country consumption function.

” Why D. F?
o Production planning
o Sales forecasting
o To control business and inventory
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 o To plan long term growth and investment programmes.
⇒ Demand – led business strategy.

” Demand Forecasting Methods:

o Consumers’ survey

o Experts’ opinion
→ Simple expert opinion poll
→ Delphi Method: An extension of the simple expert opinion poll
→ Use Delphi Method (DM) to consolidate the divergent expert
opinion and to arrive at a compromise estimate of future demand.
→ Under DM: Collect opinions from experts. Instead of taking
averages, try to match the opinions by bringing experts to-gether
and to arrive at a consensus.

• Statistical Methods:

” Trend method to extrapolate

Dg = f (T)
Where: Dg = demand for groundnut oil
T = Time (Years)

” Barometric Method of Forecasting

o Meteorologists use the barometer to forecast weather conditions on the
basis of movements of mercury in the barometer.
o So use relevant economic indicators such as GDP, prices, lending rate
for loans.

” Econometric Method: Regression Method

o Simple or Bivariate Regression Technique:

Y = f (X)
Y = Sugar consumed
Y = Population

o Multivariate Regression
Dx = f (Px, Ps, M, A)
Where: Dx = Quantity of x demanded
Px = Price of X
Ps = Price of substitutes
M = Consumer’s income
A = Advertisement expenditure

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3. Returns to Scale:

• To explain the behaviour of output in response to proportionate and

simultaneous changes in input use ⇒ Expansion/Contraction in the scale of
production.

• Technical possibilities of proportionate and simultaneous increase in the use

of both L & K:

o Y (output) increases more than proportionately ⇒ IRS

o Y increases proportionately ⇒ CRS

o Y increases less than proportionately ⇒ DRS

o Y = ƒ (L, K)
o Firm uses L units of Labour in combination with K units of capital to
obtain an output of Y: L + K → Y

o Let us change both L and K by a proportion, call it λ.

9 By how much Y increases?

9 Let output increase by b:

λL + λK → bY bY
b = λ ⇒ CRS
b > λ ⇒ IRS
b < λ ⇒ DRS

9 Diagram:

IRS (Increasing Slope Curve)

Total output

CRS (Constant Slope Curve)

DRS (Decreasing Slope Curve)

Units of L & K

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 9 Why IRS?: Due to specialization – use of specialized labour and
machinery (Details later under Economies of Scale).

9 Why DRS?: With increased scale of operation, increased

problems of co-ordination (Details later under Economies of
Scale).

• Output elasticity and R to S:

α = % change in output (Y)
% change in all inputs (L & K)
α = ∆Y . IO
∆I YO
Case1: α > 1 ⇒ % change in Y >% change in inputs
⇒ IRS
Case2: α = 1 ⇒ % change in Y = % change in inputs
⇒ CRS
Case3: α < 1 ⇒ % change in Y < % change in inputs
⇒ DRS

• R to S In Iso – Quant Framework:

K
3L + 3K → Y1 = 100
6 B 6L + 6K → Y2 = 200
A Y2 = 200 ⇒CRS
3
Y1 = 100
O L
3 6

K
⇒?
6 C
A Y2 = 300
3
Y1 = 100
O L
3 6

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 K
⇒?
6 D
A Y2 = 1500
3
Y1 = 100
O L
3 6

4. Technology and P.F:

• Technical Change: Economic Interpretation

Y↑, I
Y, I↓

• Technical change for facing global competiveness.

• Labour – intensive technology: L ratio ↑

K

• Capital – intensive technology: L ratio ↓

K

• Neutral technology: L ratio remains constant.

K

• Impact of technology change on TP, MP and AP: TP↑ with same amount of
input. MP↑ and AP↑ with same amount of input.

• Upward shifts in product curves & shifts in iso-quant.

• Embodied technology change & P.F shift: Embodied in inputs (say a new and
more efficient machine).

• Disembodied technology change: P.F shifts due to improved efficiency in

input-combination, and improved managerial efficiency etc. Do you contest
this difference?

5. Economics and Diseconomics of Scale: Real and Pecuniary Economics.

o Economics of Scale: Decreasing segment of LRAC curve.

o Diseconomics of Scale: Increasing segment of LRAC curve.

” Economics of Scale:

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 o Internal (internal to the firm) Economies:
9 Economies of Production: Technological advantages and
advantages of division of labour and specialization.
9 Economies in Marketing: Large scale purchase of inputs and sale of
output.
9 Managerial Economies: Specialised management in production,
HRD, Marketing, Finance etc.
9 Economies in Transport and Storage: Fuller utilization of transport
and storage facilities.
o External or Pecuniary Economies of Scale:
9 Large scale purchase of inputs: Concessions and discounts.
9 Large scale acquisition of external finance.
9 Massive advertisement campaigns.

⇒ Declining portion of LRAC due to economies of scale due to output

expansion.

” Diseconomics of Scale: Rising portion of LRAC curve:

o Overcrowding of labour
o Managerial inefficiencies
o With full in demand for the product, underutilization of capacity.

” Impact of Technological Change on LRAC Curve.

5.1 Economies of Scope: Multi-Product Firm

o Not the same as economies of scale.

o Many times, companies/firms produce more than one product to

lower the cost of each operation alone.
Ex1: Automobile companies producing cars and trucks ⇒ product
diversification.
Ex2: A smaller commuter airline providing cargo services.
Ex3: Use the byproducts arising from the production of the first
product – sugar industry.

o Economies of Scope: Total of point production of cars and trucks <

Total cost of producing cars and trucks independently by different
firms.
TC(C,T) < TC(C) + TC(T) ⇒ Less expensive to produce jointly.

o Diseconomies of Scope: TC(CT) > TC(C) + TC(T) ⇒ Less expensive to

produce independently
o Degree of Economies of Scope:
DES= TC(An)+TC(Bn)-TC(An+Bn)
TC(An+Bn)
Where
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 3 DES: Degree of Economies of Scope
3 TC(An): Total cost of producing An units of product A separately
3 TC(Bn): Total cost of producing Bn units of product B separately
3 TC(An+Bn): Total cost of producing products A and B jointly i.e
producing An units of A and Bn units of B together.

6. Learning Curves (Experience Curves).

• Decline in AC of inputs with rising cumulative output over time.

• Take 1,000 hours to assemble the 100th aircraft, but only 700 hours to assemble
200th aircraft workers and managers become more efficient with passage of
time.

AC

F
h

G
h
Learning Curve

O Cumulative
Qt 2Qt Total Output

o Otth output (like 100th aircraft)

o 2Qtth output (like 200th aircraft)

• Economies of Scale: Declining AC of input due to output expansion.

• But Learning Curve: Cumulative experience and decling AC of input for
different units of output.
• Learning Curve: Experienced in manufacturing airplanes, appliances, ship
building, refined petroleum products and operation of power plants.
• Learning Curve: Used to forecast the requirement of personnel, machinery
and raw materials and scheduling product and determining the price at
which to sell output.
Ex: Texas instruments has followed an aggressive price policy for computer
chips, based on the learning curve.
” Comparison of E of S and Learning Curve:
Know:
o Technical Progress: Downward shift in LRAC Curve.
o Managers and workers gaining experience: Downward shift in LRAC
Curve.

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 LRAC

A LRACt
LRACt+1

O Output
Qt Qt+1

” Observations:
o Two periods: t and t+1
o Qt and Qt+1 levels of output during t and t+1
o LRAC at t: OC for Qt level of output
o LRAC at t+1: OB
⇒ Lower LRAC during t+1 period
⇒ BC = Unit cost saving.
o Expand output from Qt to Qt+1
⇒ Economics of Scale:
LRAC at Qt+1: OA
OA < OB < OC
o Learning Curve Effect: BC
o E of Scale Effect: AB
o Downward shift due to learning and movement along a given LRAC
curve due to E of scale
o Remember: Downward shift in LRAC curve (AC reductions) may be
due to Learning Experience, Economies of Scale, technology and input
price decline.

” Hold other things constant to sort out net effect of L.C (Previous Diagram)

7. X – Efficiency:

• Efficiency in production ⇒ Cost Economy

• Any improvement in efficiency → downward shift in cost functions
• Cost reduction: Possible through minimizing wastage of resources
• X-efficiency: Firm’s ability to monitor and control production unit to
minimize the wastage of resources
• X-efficiency: A function of management to minimize the wastage of
resources
• New Managerial Approaches: Six-Sigma Methodology (Adopted by
Motorola, GE and others) to achieve X-efficiency so as to minimize waste
and to attain zero defect level of the business firm.
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8. Cost – Volume – Profit Analysis: Break – Even Point and Operating Leverage.

• Examine the relationship among TR, TC and total profit at various levels of
output (Q).

• C – V – P analysis or B – E – A: used by business executives to determine

volume of sale required for the firm to break even and the total profits and
losses at other sales levels. At what output level B – E, Losses and Profits?

• Use C – V – P or B – E Analyse.

• B – E Analysis: Linear Cost and Revenue Function

CF: TC = 100 + 10 Q
RF: TR = 15 Q.
→ 100 = TFC
V.C varies with output (Q) and varies at a constant rate of 10 per unit.
→ Sale Price = 15

” Algebraic Calculation of B – E – P:
→ TR = TC
→ 15Q = 100 + 10Q
→ Q = 20 ⇒ 20 is the B – E output
→ Beyond 20: operating profit
→ Below 20: operating loss.

” Diagrammatic Representation:
Costs
Revenue TR
Operating Π
700 Π>0 TC
600 TVC
500
400 Operating h
300 loss B
200
100 Π<0 TFC

O Q (output)
10 20 30 40

o TFC = 100
o TVC: Variable Cost
o TC = TC function i.e TFC + TVC
o TR = Total Revenue: P.Q
o Point B: Point of intersection between TR & TC lines Q=20, B.E level of
output
o Thus Point B: B – E – Point
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 o Below Q=20, TC > TR ⇒ operating loss
o Above Q=20, TR > TC ⇒ operating profit
o B.E.P: TR=TC ⇒ Π=0 ⇒ losses cease to ever and profits yet to begin.

” Limitation of L – C and L – R functions

o C and Revenue functions may be non – linear: Because AVC and price
of output vary at different rates with variations is output.
o Under non – linear conditions, there might be two B – E points, instead
of one.

• B – E – Analysis: Non – Linear Cost and Revenue Functions.

Costs
and
Revenue
TC

B2
h
B1 TR
h
A TFC

O Q (output)
Q1 Q2
o TFC = Total Fixed Cost (OA)
o TVC = TC – TFC = The vertical distance between TC and TFC
o TC = Total Cost = TFC + TVC
o B1 & B2: Points of intersection between TR & TC ⇒ TR = TC
o B1: Lower B – E point at Q1 output level
B2: Upper B – E point of Q2 output level
⇒ Firm, producing more than OQ1 and less than OQ2 will make profit
⇒ Profitable range of output:
More than OQ1
Less than OQ2.
⇒ Producing less than OQ1
more than OQ2
→ losses.
o Contribution Analysis:
Recall: IC = Incremental Cost of a business decision
IR = Incremental Revenue from a business decision.
Ä “Contribution”: TR – TVC, TFC not considered
Ä At B – E Point
“Contribution” = Fixed Costs.

• Uses of B – E Analysis:

o To Know: Level of sales required to cover all costs

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 o To Know: What happens to overall profitability, when the company
incurs higher or lower fixed or variable costs
o To Know: Between two alternative investments, which one offers the
greater margin of profit
o To Know: What happens to overall profitability when a new product is
introduced
o To forecast Π, when revenue and cost estimates are available.
o To Know: Margin of safety
o Useful for production planning
o Useful for deciding when to start paying dividend to its share holders.

9. Degree of operating leverage:

” Percentage change in profits that results from percentage change in

number of units sold i.e elasticity of profit with respect to output sold.

∆Π
DOL = %∆Π = Πo = ∆Π . Qo
%∆Q ∆Q ∆Q Πo
Qo

10. Estimation of Cost Function:

” Forward Planning: Basis for decision – making.

” SR Cost Function: Necessary for the firm determing the optimum level of
output and the price to charge.

” LRC Function: Essential in planning for the optimal scale of plant for the
firm.

” Methods for obtaining appropriate information of its future cost – output

relationship.

o Engineering Method:
J Based directly on the production function, input prices and the
optimum input combination for producing a given quantity of
output.
J Using this information, engineers provide least – cost estimates.
J Based on given technology and input prices.
J When technology and input prices are changing, difficult to obtain
accurate estimates.

• Survivorship Method (Survival Technique)

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 ” Classify various firms of an industry into size groups: small, medium and
large

” Most efficient size group: share in the industry in creases

” Least efficient size group: share in the industry decreases

Industry Share (%)

” Site group Base Year Current Year
S 10 12
M 30 50
L 60 38

⇒ M – Size group: Most efficient

L – Size group: Most inefficient
⇒ Competition will eliminates inefficient firms
⇒ Firms with lower average cost will survive.

” Limitation: The method does not yield the cost function. Does not allow
the measurement of degree of economies and diseconomies of scale.

• Statistical Method: Regression Method

” Short Run Cost Function:

C = TC = f (Q)
C = total cost = TFC + TVC
Q = output

J Linear Cost Function:

TC = a + b Q
TC = 100 + 0.5 Q
∴ TFC = 100
TVC = 0.5 Q
Let Q = 10
TVC = (0.5) (10) = 5
TC = 100 + 5 = 105
AC = -----------------
MC = ----------------

J Quadratic Cost Function:

TC = a + b Q + CQ2
TC = 100 + 60Q + 3Q2, TFC = 100

J Cubic Cost Function:

TC = a + b Q – CQ2 + dQ3
TC = 100 + 60Q – 5Q2 + 0.7 Q3, TFC = 100

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” Long Run Cost Functions:
o To determine the “best” scale of plant for the firm to build in order to
minimize the cost of producing the anticipated level of output in the
long run.
o Can use either time series data or cross section data.
o Can estimate L – R Cost Functions with engineering and survival
techniques.

” Managerial Uses of Estimated Cost Functions:

o To determine the optimum scale or size of the fixed plant and
equipment.
o To determine the optimum output for a given plant size.
o To determine the supply schedule/curve.

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