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DEMAND & DETERMINANTS OF DEMAND

DEFINITION OF DEMAND
Demand is different from mere desire. Actually the desire is only

a wish to get things but demand requires willingness to pay as well as ability to pay.
Definition-The demand means a desire backed by willingness

and ability to pay. The demand for any commodity is the quantity of it a consumer decides to buy at a given price and at a given time. For eg a beggar has a desire to own a house but he does not have willingness and ability to pay then that is not called demand. But a business man has desire to own a house. He has willingness as well as ability to pay then that is called as demand.

DETERMINANTS OF DEMAND (CONTINUED)


1.Consumers Income Demand varies proportionately/directly with the income of the consumer.

As the income of a consumer increases his purchasing power increases and hence he can buy more goods and hence demand increases. The goods for which the demand increase with increase in income are called Normal goods or Superior goods. On other hand the goods for which demand decreases with the increase in income are called as inferior goods. This is because as the income of consumer rises the poor quality/inferior goods are substituted by superior or normal goods. One example of an inferior good might be CRT television sets. People buy them only because they cannot afford a LCD/LED television set. As income rises, people buy fewer CRT television sets. Another example of an inferior good might be riding the bus. As income rises, people are less likely to use the bus and more likely to own an automobile. Thus, demand varies directly with the consumers income for superior goods and inversely with the consumers income in the case of inferior goods. The income-demand curve is also known as Engels curve as shown below.

DETERMINANTS OF DEMAND

Income

Demand for Superior/Normal Goods


Engels Curve

Income

Demand for Inferior Goods

DETERMINANTS OF DEMAND (CONTINUED)


2.Price of Related Goods a. Price of same good Normally the demand for a commodity varies inversely with its own price.

Thus, other things remaining constant the demand for a good increases as its price decreases and vice versa. This is also known as law of demand. A graphical representation is shown below-

Price

Demand for Goods

DETERMINANTS OF DEMAND (CONTINUED)


b. Price of Substitute Substitutes are different goods that compete with the one under consideration. A substitute good is one which can be used in place of some other goods. Coca-Cola and Pepsi Cola are substitutes, as are tea and coffee, homes & apartments. What happens to the demand for coffee if the price of tea rises? If the price of tea rises then demand for coffee will rise. It is also likely that the demand for Coca Cola would rise (fall) if the price of Pepsi Cola rises (falls), the demand for apartments would rise (fall) if the price of homes rises (falls), Therefore, our relationship is: as the price of the substitute rises (falls), the demand for the product rises (falls). Thus demand for a product is directly proportional to price of substitute. Price of Substitute Demand for the product

DETERMINANTS OF DEMAND (CONTINUED)


c.Price of Complement A complement is a different good that goes together with the

one under consideration. Homes and interest rates tend to go together. So do bread and butter, tea and sugar, petrol and automobiles. What happens to the demand for new homes if the interest rate rises? The answer, of course, is that it falls. When interest rates rise, people are less likely to borrow. If they do not borrow, they will not buy the homes. It is also likely that the demand for sugar will fall if the price of tea rises, the demand for automobiles will fall if the price of petrol rises, and so on. Therefore, our relationship is: if the price of the complement rises (falls), the demand for the product (homes) falls (rises).

DETERMINANTS OF DEMAND (CONTINUED)


3. Consumers Tastes and Preferences Another determinant of demand is ones taste and preference.

Taste and preference are influenced by culture, religion, social customs, habits of people, lifestyle, age, gender and history. For example eating beef is popular in America but it is a taboo in India. The principle is: the more (less) we like a good or service, the greater (less) is our demand for it. For example if you like ice cream you buy more of it. If consumers taste or preference change for certain goods and services following change in fashion, people switch their consumption pattern from cheaper old fashioned goods over to costlier modern goods.

DETERMINANTS OF DEMAND (CONTINUED)


4. Expectations Expectations affect our demand for many products. For

example, people commonly buy Shares/Land because they expect the prices of the shares or land to rise. The principle here is: if buyers expect the price to rise (fall), the demand rises (falls) today. There are other kinds of expectations one might have that will affect the demand for products. If one expects that the product will soon be unavailable, the demand will rise today. This is the case for petrol/diesel if Oil companies go on strike. Expecting that petrol stations will be closed, buyers rush to stock-up. Also, if one expects that one's income will rise, he will start saving less and spending more.

DETERMINANTS OF DEMAND (CONTINUED)


5. Population/Number of Buyers The market demand is simply the sum of the individual

demands. If the population or number of buyers rises then the market demand is bound to rise. It because of rising population of India and China many MNCs want to enter into Indian & Chinese market. The population of there home country is on decline and so is the demand for their products.
6.Distribution of National income The distribution pattern of national income also affects the

demand for a commodity. If the national income is evenly distributed market demand for normal goods will be highest. If the national income is unevenly distributed i.e. if majority of population belongs to lower income groups, market demand for essential goods (including inferior ones) will be highest.

DETERMINANTS OF DEMAND (CONTINUED)


Demand Function
Dx = f( Px, Pr, I, T, E)

Px- Price of a commodity


Pr-Price of related goods I-Income of the consumer T-Taste of the consumers E-Expectations

Law of Demand
Law of Demand-Other things being equal at any

given time demand for a commodity or service rises with decrease in price and falls with increase in price. Demand Schedule-A table showing different quantities demanded by an individual consumer or number of consumers of a commodity at different prices is known as demand schedule. Demand Schedule for Sugar at different pricesPrice in Rs Demand in Kgs 40 1 35 1.5 30 2 25 3 20 5

Law of Demand (Continued)


Price

Demand for Goods

Exceptions/Limitations of Law of Demand

There are some cases where the demand for a good varies directly

with its own price. These cases are exceptions to law of demand or limitations of law of demand. Giffen Goods /Giffens Paradox Sir Robert Giffen of Ireland first observed that people used to spend more their income on inferior goods like potato and less of their income on meat. But potatoes constitute their staple food. When the price of potato increased, after purchasing potato they did not have so many surpluses to buy meat. So the rise in price of potato compelled people to buy more potato and thus raised the demand for potato. This is against the law of demand. This is also known as Giffen paradox. These goods are inferior goods consumed mostly by poor consumers as essential commodities e.g. bajra. Consumers spend a considerable portion of limited income on these goods. The demand for such goods increases with an increase in price and decreases with decrease in price.

Exceptions/Limitations of Law of Demand


Example Suppose a poor man has a total income of Rs 400 per month and needs

atleast 30 Kg of food grain to survive. Let us assume that price of Bajra is Rs 10 per Kg and price of wheat is Rs 20 per Kg. Bajra is an inferior commodity and wheat is superior commodity. The consumer consumes 20 Kg of Bajra and 10 Kgs of wheat. (Total Income- Rs 400 per month & Minimum quantity to consume for survival is 30 Kg).
Bajra Quantity(Kg) Price (Rs) Amount Spent 20 10 200 Wheat 10 20 200 400 Total 30

Exceptions/Limitations of Law of Demand

If the price of Bajra rises to Rs 12 per Kg while that of

wheat remains the same. (Total Income- Rs 400 per month & Minimum quantity to consume for survival is 30 Kg).
Bajra Quantity(Kg) 25 (20) Price(Rs) Amount Spent 12 (10) 300 Wheat 5(10) 20 (20) 100 400 Total 30

Thus we can see that when price of Bajra rises the

consumer raises the quantity of Bajra from 20 Kg to 25 Kg and reduces the quantity of wheat from 10 Kg to 5 Kg to consume minimum required quantity of 30 Kg for survival with his stipulated income of Rs 400.

Exceptions/Limitations of Law of Demand

If the price of Bajra falls to Rs 8 per Kg while that of wheat

remains the same. (Total Income- Rs 400 per month & Minimum quantity to consume for survival is 30 Kg)
Bajra Quantity(Kg) 16.7 (20) Price(Rs) Amount Spent 8 (10) 133.6 Wheat 13.3 (10) 20 (20) 266.6 400 Total 30

Thus we can see that when price of Bajra falls then he uses this saving

due to fall in price of Bajra to purchase greater quantity of wheat (10 Kg to 13.3 Kg) and lowers the quantity of Bajra from 20 Kg to 16.7 Kg to consume minimum required quantity of 30 Kg for survival with his stipulated income of Rs 400. Thus in case of Giffens Goods the demand for a commodity increases with the increases in its price and falls with fall in the price.

Costly Luxury goods or Veblen Goods Luxury goods are those that are not essential for the survival of human beings. Thus goods like diamonds, antiques, air conditioners etc are luxury goods. For such goods

Exceptions/Limitations of Law of Demand

the demand increases with an increase in the price and vice versa. This is because rich people attach a lot of value to costly luxury goods that distinguish them from common people. These goods have a prestige value for the upper strata of society. Whenever the price of such goods rises, their prestige value increases and hence the demand for them goes up.

Necessities: Certain things become the necessities of life. So we have to purchase them despite their high price. The demand for Sugar, Wheat etc. has not gone down in spite of the increase in their price. So they are purchased despite their rising price
Emergencies: Emergencies like war, famine etc. negate the operation of the law of

demand. At such times, households behave in an abnormal way. Households accentuate scarcities and induce further price rises by making increased purchases even at higher prices during such periods. During depression, on the other hand, no fall in price is a sufficient inducement for consumers to demand more.

Exceptions/Limitations of Law of Demand

Future changes in prices: Households also act speculators. When the prices are rising

households tend to purchase large quantities of the commodity out of the apprehension that prices may still go up. When prices are expected to fall further, they wait to buy goods in future at still lower prices. So quantity demanded falls when prices are falling. Change in fashion Outdated goods: A change in fashion and tastes affects the market for a commodity. Goods that go out of use due to advancement in technology or change in tastes of consumer are called outdated goods. For example demand for CRT television sets, radio and telephone will fall even if their prices fall. Seasonal Goods Seasonal goods which are not used during the off season will be subject to similar demand behaviour. For example sale of air coolers may go down in winters even if they are sold at reduced prices.

Elasticity Of Demand
Elasticity of Demand- is defined as the ratio of

percentage change in demand to the percentage change in one of the determinants of demand. Elasticity of demand is a measure of the responsiveness of demand to the changes in the variables on which demand depends.
Ed= Percentage change in demand / Percentage

change in determinant of demand.

Income Elasticity of Demand


The income elasticity of demand is the measure of the

percentage change in the demand of a commodity to the percentage change in consumers income ceteris paribus (Other things remaining constant) Ei= Percentage change in demand/Percentage change in income. It is positive when demand has a direct relationship with consumers income in case of normal and superior goods like LCD/LED television

Income Elasticity of Demand

Income

Demand for Goods(Normal or Superior Goods) It is negative when demand has inverse relationship with consumers

income in case of inferior goods lke CRT televisions.


Income

Demand for Inferior Goods

Income Elasticity of Demand


Use of Income Elasticity of Demand

The concept of income elasticity of demand is very useful

in studying the effect of changes in national income on the demand for the firms product. Companies whose product have a high income elasticity will grow faster when the economy expand. Luxury goods such as cars, air conditioners, mobile phones are highly income elastic. Necessity goods like food and cloth are less income elastic.

Price Elasticity of Demand


The ratio of proportionate change in quantity

demanded to proportionate change in price is called elasticity of demand. It measures the responsiveness of demand for a product to the changes in the price of product, when all other variables are constant Price Elasticity of Demand=Ep= Proportionate Change in Quantity Demanded Proportionate Change in Price =Q1- Q2/P1-P2

Price Elasticity of Demand


Perfectly Elasticity of Demand (Infinite)

When negligible fall or rise in price of commodity

leads to great/infinite extension/contraction in demand it is called perfectly elastic demand.

Price

Ep=

Quantity Demanded

Price Elasticity of Demand


Perfectly Inelastic Demand(Zero Elasticty)-

When great rise/fall in price of commodity does not

cause any considerable rise or fall in demand it is called perfectly inelasticity or zero elasticity.For eg Salt and Life Saving drugs.
.

Price

Ep=0

Quantity Demanded

Price Elasticity of Demand


Highly Elastic Demand-

When a small rise/fall in price causes substantial or

considerable contraction/expansion in quantity demanded then that is called highly elastic demand.

Price Ep > 1

Quantity demanded

Price Elasticity of Demand


Less Elastic Demand/Highly Inelastic demand-

When substantial rise/fall in price causes negligible contraction/expansion in quantity demanded then that is called highly inelastic demand.

Price

Ep<1

Quantity demanded

Price Elasticity of Demand


Unitary Price Elasticity of demand- When the

quantity demanded changes exactly equal to change in price of the commodity then it is called as Unitary Price elasticity of demand.

Price

Ep=1

Quantity demanded

Cross Elasticity of Demand


Cross Elasticity of Demand Demand for a product seldom exists in isolation and often price of some related product also causes a variation in the demand for a commodity. Either it can be substitute or complement. A substitute good is one which can be used in place of some other goods. Coca-Cola and Pepsi Cola are substitutes, as are tea and coffee, homes & apartments. A complement is a different good that goes together with the one under consideration. Homes and interest rates tend to go together. So do bread and butter, tea and sugar, petrol and automobiles. It would therefore become important for a manager to develop some sort of relationship between demand for a commodity and price of related goods. This can be done by knowing the cross elasticity of demand. The cross elasticity of demand measures the responsiveness of demand for one product to the changes in price of another. Ec= Percentage change in demand of X/ Percentage change in price of Y where X an Y are either substitutes or complements. The cross elasticity of demand is positive for substitutes and negative for complements. In case of substitutes tea and coffee if the price of tea rises and coffee remains the same, then people will replace tea with coffee and so the demand for coffee will rise. Thus demand for coffee increases with rise in price of substitute tea. Thus the direct relationship makes the cross elasticity positive. In case of complements Cars and interest rates if the interest rates rises then people will postpone their purchases of cars and so demand for cars decreases with rise in complement interest rates. Thus the inverse relationship makes the cross elasticity negative.

Promotional/Advertising Elasticity of Demand The promontional elasticity of demand is a measure of the

responsiveness of demand for a commodity to the change in outlay on advertisements and other promotional efforts. Ea= Percentage change in demand/Percentage change in expenditure on advertisements or other promotional efforts. This plays an important role in the marketing decisions of any firm. A low advertising elasticity indicates that demand changes less as compared to changes in advertising expenditure of firm. Thus firm will have to incur relatively much higher expenditure on advertisements.

Determinants of Price Elasticity of Demand


1.Availability of Substitutes The closer the substitute greater is the elasticity of demand for that

commodity. For example tea and coffee are close substitutes. So if price of tea rises and coffee remains the same then demand for tea will fall more than the proportionate increase in price because the consumer have option of switching to cheaper substitutes. 2. Nature of CommodityCommodity can be classified as luxuries, comforts and necessities and nature of commodity affects the price elasticity of demand. Luxuries- Demand for luxuries (luxury cars, decorative items) is more elastic than demand for other goods because consumption of these goods can be postponed if the price of such commodity rises. Necessities- Consumption of necessary goods (eg sugar, clothes, vegetables etc) cannot be postponed and hence their demand is inelastic. Comforts- Demand for comforts ( Air conditioners, Washing machines) is more elastic than necessaries but less elastic than luxuries.

Determinants of Price Elasticity of Demand


3. Proportion of Income spent on a commodity If proportion of income spent on a commodity is very small, its demand

will be less elastic and vice versa. Examples of such commodities are salt, match boxes, books, toothpastes, newspapers etc. which claim a very small proportion of consumers income. Demand for these goods is generally inelastic because increase in the price of such goods does not substantially affect consumers consumption pattern and the total purchasing power. Therefore people continue to purchase the same quantity even when the price increases. 4.Time factor Price elasticity of demand also depends on the time the consumers take to adjust to a new price. Longer the time taken the greater the elasticity. For over a period of time consumers are able to adjust their expenditure pattern to price changes. For example if price of cars decrease demand may not increase in short run and will be less elastic . But in long run people can adjust their expenditure pattern and so demand may increase and will elastic in long run.

Determinants of Price Elasticity of Demand


5. Range of Alternative Uses of a Commodity The wider the range of alternative uses of a product, the

higher the price elasticity of its demand for decrease in price but less elastic for the rise in price. As the price of a multi-use commodity decreases, people extend their consumption to its other uses. Therefore the demand for such a commodity generally increases more than the proportionate decrease in its price. For instance milk can taken as it is, it may be converted into curd, cheese, ghee and butter milk. The demand for milk will be highly elastic for decrease in price but will be in elastic to increase in price.

Point Elasticity & Arc Elasticity


The elasticity of demand is measured either at a finite point or

between any two finite points on the demand curve. Point Elasticity of Demand- It is defined as the proportionate change in quantity demanded in response to a very small proportionate change in price or the elasticity measured on a finite point of a demand curve is called point elasticity. Ep= Q1-Q2/Q1 =Q1-Q2/Q1 x P1/P1-P2 P1-P2/P1 For eg The demand for a product priced between Rs 10/unit and Rs 8/unit is 200 and 400 units. Then Q1= 200 units , Q2=400 units & P1= Rs 10/unit , P2= Rs 8/unit Point elasticity at P1 = 200-400/200 x 10/10-8 =-5 Point elasticity at P2= 200-400/400 x 8/10-8 = -2

Point Elasticity & Arc Elasticity


Arc Elasticity of Demand- It is measure of the average of

responsiveness of the quantity demanded to a substantial change in price or the elasticity measured between any two finite points is called arc elasticity. Ea= Q1-Q2/Q1+Q2/2 P1-P2/P1+P2/2 For eg The demand for a product priced between Rs 10/unit and Rs 8/unit is 200 and 400 units. Then Q1= 200 units , Q2=400 units & P1= Rs 10/unit , P2= Rs 8/unit Arc Elasticity= 200-400/200+400/2 10-8/10+8/2 = -3

Supply & Determinants of Supply


Supply-It is quantity of commodity which is offered

for sale at a particular rate and time. In simple words it means the quantities that a seller is willing and able to sell at different prices. Determinants of Supply/Factors on which Supply depends Price of the Product- The supply of a product depends upon the market price of that product. If the other things are same, a higher price of the product would make its production more profitable. So as the prices rises supply increases and vice versa.

Determinants of Supply

Price

Supply of Goods Objectives of the Firm- The supply of the product also depends upon the objectives of the firm selling the product. If the objective is maximization of sales, the supply would be larger than the supply with the objective of profit maximization.

Determinants of Supply
Factor Prices- Since the prices of the factors of production are

costs from the point of view of the firm, a rise in their prices results in pushing up the costs of production. The profit margin declines and the supply also falls. State of Technology- This also influences the supply of goods. Sometime new technology is developed which lowers the cost of production which in turn increases the supply. Sometimes new products are invented which affect the supply of existing products. For example Chemistry made available to us several varieties of plastic as a result of which the supply of many products like bamboo-baskets has declined. Future Expectations of Price- If the seller expects the price to rise further in the future then he might lower the supply or maintain it at the same level even if the price might have risen. When further heavy fall in price is anticipated the seller may become panicky and sell more at a current lower price.

Law of Supply
As the supply of a product increases with the increase

in its price and decreases with decrease in its price, other things remaining constant.
Price

Quantity Supplied

Exceptions/Limitations of Law of Supply


Other things remaining constant was our assumption. This shows

the following limitations 1.Prices of other products are constant: If the prices of other products change then law of supply would not hold good. For example suppose the price of jowar increases, its supply must increase. But if the price of cotton rises further, the farmers would rather sow cotton than jowar. The supply of jowar would thus fall inspite of a rise in its price. 2. Costs of Production are constant: The law would apply as long as the costs of production are constant. If the price of the product rises but a rise in production results in rise in cost of production offsetting the gain. Thus supply would not rise. Sometimes a rise in production lowers the cost of production due to economies of scale and so supply would rise even without increase in price. 3.State of Technology is constant: Technology brings down the cost of production. In such case even a fall in price might not induce the seller to lower the supplies.

Exceptions/Limitations of Law of Supply


4. Government tax policy is constant: If the Government

lowers the taxes on raw materials or electricity, cost of production would go down and the producers might be encouraged to produce more without any change in the price. 5. Market Control: If the type of market control is monopoly i.e a market with a single seller, is not necessarily inclined to offer a larger quantity supplied even though the price is higher. Market control by the monopoly allows it to set the market price based on demand conditions, without cost constraints imposed from the supply side. 6.Future Expectations of Price- If the seller expects the price to rise further in the future then he might lower the supply or maintain it at the same level even if the price might have risen. When further heavy fall in price is anticipated the seller may become panicky and sell more at a current lower price.

Equilibrium Price
The price at which demand and supply are equal is known as

equilibrium price, since at this price,the force of demand and supply are balanced or are in equilibrium.
Price in Rs Quantity Demanded in Quantity Supplied in Kgs Kgs

50
40 30 20 10

18
20 24 30 50

36
32 24 14 0

In the above table we can see that at price of Rs 30 the demand and

supply are equal i.e 24 Kgs. That point is called equilibrium price

Equilibrium Price

Demand

Supply

Price

Equilibrium Price

Quantity Demanded or Supplied

At equilibrium price P demand and supply curve intersect and are equal.

Utility & Types of Utility


Types of Utility Marginal Utility-It is amount of satisfaction obtained by

consuming last unit of commodity or by consuming a little bit more of it. The addition to total utility caused by an addition of one unit of a commodity to the stock of it is known as Marginal Utility. Total Utility-The sum total of utilities of all the units of commodity consumed at particular time is known as total utility. Zero Utility-When the consumption of commodity results in no addition to the total utility then that point is called is zero utility. Negative Utility-When the consumption of the last unit of commodity results in dissatisfaction instead of satisfaction then that point is called is negative utility.

Law of Diminishing Marginal Utility


Law of Diminishing Marginal Utility-Dr Marshall states

that other things being equal the additional benefit which a person derives from a given increase of his stock of anything diminishes with the growth of the stock he has. In simple words-Other things being equal as we go on consuming a commodity, the satisfaction derived from its successive units goes on decreasing. For eg A man who is hungry wants to eat chapatis. When he ate 1st chapati that gave him maximum satisfaction(utility).But as he ate additional chapattis the additional satisfaction, benefit or utility goes on decreasing. As he continues to eat further at a certain point the additional chapatti instead of giving satisfaction, it caused dissatisfaction or negative utility. This is expressed in table and graphical form

Law of Diminishing Marginal Utility


Chapatis 0 1 2 3 4 5 6 7 8 Marginal Utility 0 30 25 15 10 0 -5 -15 -25 Total Utility 0 30 55 70 80 80 75 60 45

Law of Diminishing Marginal Utility


Marginal Utility

Zero Utility Negative Utility No of Chapatis

Law of Diminishing Marginal Utility

Total Utility

No of Chapatis

Determinants of Law of Diminishing Marginal Utility


1.Each unit of commodity should be homogenous i.e. all the units of the commodity must be exactly alike in respect of taste, quality, size, packing and so

on. A change in any of these would make it a different commodity. The law has to be applied to one particular commodity. 2.Time- Units of the commodity should be consumed successively, one after another. Because wants are recurrent, the same wants may appear after a lapse of time and can give the same satisfaction. If you eat a pizza today and tomorrow you may get the same satisfaction . So successive consumption is necessary. 3.Tendency of people/ Taste of Consumer- During the entire period of testing the law, the tastes of consumer must remain constant. For eg if you see a movie and then you read a review of the film in newspaper and again see the film. In this case you might enjoy the film more than the first time. Because your taste has been influenced. 4.Price of Commodity- The price of commodity should remain constant. For example if you purchase a white shirt of some brand at Rs 1000/- and if the price of the second shirt is lowered to Rs 800/- then you might get more utility 5.The units of the commodity selected for consumption should be of a minimum workable size or quantum. Thus if you go on giving one grape at a time to a hungry man or a spoon of water to a thirsty man, the utility may at first go on increasing, though in the end utility may start diminishing after a certain minimum amount is consumed.

Consumer Surplus
The idea of Consumer Surplus was understood by a French engineer

economist , Arsene Jules Dupuit in 1844. But his explanation lacked scientific touch. Dr Alfred Marshall developed it further in his Principles of Economics and named it as Consumer Surplus. There are several things in our daily expenditure we find that the price we pay for a commodity is usually less than satisfaction (utility) which we obtain from that commodity. For example a packet of salt, a match box, a post card, a newspaper etc. These things have a high utility but are cheap and we are prepared to pay much more for them than what we are actually paying, if need arises. Thus Consumer Surplus may be defined as the excess of utility (or satisfaction) obtained by the consumer. It is measured by the difference between what we are prepared to pay and what we actually pay. Consumer Surplus= What one is prepared to pay- What one actually pays. Consumer Surplus= Total Utility obtained- Total amount spent. In Dr Marshalls words The excess of the price which a consumer would be willing to pay rather than go without the thing, over that which he actually does pay

Consumer Surplus
= Area PMB M Price

Q Quantity Consumer Surplus

Consumer Surplus= Total utility-Total price paid =Area OMBQ- Area OPBQ = Area PMB

Consumer Surplus
Assumptions Market price is given and market is perfectly competitive so that neither buyers nor sellers can affect the price. Utility is cardinally measurable. Marginal Utility of consumers money income remains constant. Utility of each commodity is independent of other goods and services consumed by consumer. There is no close substitute of the commodity in question and all the substitutes are grouped as one commodity. Importance/Application of Consumer Surplus. 1.Public finances- The knowledge of those commodities in which buyer enjoys much surplus is of great value to Finance Minister while imposing taxes and fixing the tax rates. Such taxes based on the concept of Consumer Surplus will bring in more revenue to the state and less hardships on weaker sections of the society 2. This concept is useful in pricing policy of monopoly where a discriminatory pricing is feasible and desirable, 3. The concept of consumer surplus is also used in social cost benefit analysis of both private and public sector projects e.g. dams, bridges, roads, flyovers parks etc. 4. The concept of consumer surplus is also used in estimating the gains from the international trade. i.e. the exchange of goods between the countries.

Consumer Surplus
Criticism/Limitations Hypothetical-The concept of consumer surplus is not real but imaginary. Difficult to measure utility- Since utility is in the mind of the consumer, it is difficult measure consumer surplus. Very few consumer can tell us what exactly they are prepared to pay. Again different individual will be ready to different prices for the same commodity. Utilities are interdependent- The assumption that utility of a commodity depends upon the quantity of commodity alone has been severally criticized,

Because for example the utility of coffee not only depends on quantity of coffee but also on supply and demand of its related goods like tea. Difficult to group substitutes- Critics point out that there is hardly any commodity which has no substitute of it. And it is not possible to group the various substitutes as one. The concept of consumer surplus cannot be applied to essential and may prestigious goods. For example an affluent person dying of hunger may be willing to pay Rs 10000 for a piece of bread while he may be required to pay only Rs 10. As such, his consumers surplus will be equal to Rs 9990 which seems ridiculous. In case of prestigious goods e.g. rare paintings , diamonds etc what a buyer is generally willing to pay equals what he actually pays. It means there is no consumer surplus. The concept of consumer surplus is thus illusory in some cases

Indifference Curve
Indifference Curve- It is locus of points each representing a

different combination of 2 substitute goods, which yield the same utility or level of satisfaction to the customer. It is also called as Iso utility curve or Equal Utility curve. Since each combination of 2 goods yields the same level of utility, the consumer is indifferent between any two combinations of goods when it comes to making a choice between them. A consumer consumes a large number of goods and services and often he finds one commodity serves as a substitute for another. It gives him an opportunity to substitute one commodity for other and to make combinations of 2 substitute goods. It may not be possible for him to tell how much utility a particular combination gives but it is always possible to tell which combination is better than or equal to other . If a consumer is faced with combinations which give him equal utility he will be indifferent to between such combinations. When such combinations are plotted graphically the resulting curve is indifference curve.

Indifference Curve
Combination A B C D E Mango (Y) 25 15 10 6 4 Orange (X) 5 7 12 20 30 Marginal Rate or Substitution (MRS) 0 25-15/5-7 = -5.0 15-10/7-12= -1.0 10-6/12-20= -0.5 6-4/20-30= -0.2

Indifference Schedule- This is a schedule of various combinations of two

commodities Mango & Oranges. The consumer will find all combinations equally satisfying. In the above example in combination A the consumer has 25 mangoes and 5 oranges. In the combination B he substitutes 10 mangoes with 2 oranges and so his Marginal rate of substitution is -5.0 In the combination C he substitutes 5 mangoes with 5 oranges S0 MRS is -1.0. In the combination D he substitutes 4 mangoes with 8 oranges . So MRS is -0.5. In the combination E he substitutes 2 mangoes with 10 oranges. So MRS is -0.2. Thus the consumer is willing to forgo less and less of Mangoes for obtaining more of oranges to keep his satisfaction same.

Consumer Surplus

Mangoes

Oranges Indifference Curve

Indifference Curve
Marginal Rate of Substitution- The rate at which a

consumer is willing to exchange successive units of a commodity with another will be marginal rate of substitution. It can be expressed as follows MRS= Y/X = MUx/MUy= Slope of Indifference Curve. One of the important condition for Indifference Curve is MRS diminishes. i.e. The consumer is willing to forgo less and less of one commodity for obtaining more of other to keep his satisfaction same,

Characteristics of Indifference Curve


1.The Indifference curves always slopes negatively or downwards from

left to right. The following indifference curves in which the slope is positive or constant is not possible

Mangoes

Mangoes

Mangoes

Oranges

Oranges

Oranges

Characteristics of Indifference Curve


2. The indifference curve are convex to the origin of axes. The following indifference curve in which it concave to the origin is not possible.

Oranges

Mangoes

Characteristics of Indifference Curves

Mangoes

Oranges Indifference Curve 3.No Indifference Curves can intersect each other. This above figure is not possible

Characteristics of Indifference Curves

Mangoes

IC1

IC2

IC3

Oranges Indifference Curve 4. Upper indifference curve indicate a higher level of satisfaction than lower level.

Exceptions of Indifference Curve


1.Perfect Substitutes- In case of perfect substitutes the indifference

curve will be straight line with negative slope. In case of perfect substitutes like tea and coffee one cup for tea will be substitute for one cup of coffee and 5 cups of tea will be substitute for 5 cups of tea. So MRS will not be diminishing and in fact it will be equal.

Tea

Coffee

Characteristics of Indifference Curve


2. Complementary Commodity When 2 commodities are complementary to each other for example the

right and left shoes or gloves a person cannot get satisfaction if he gets more of one unit of such commodities. He will not give up one unit of commodity to get one more unit of other commodity. Therefore Marginal Rate of Substitution will be zero and the indifference curve will be 2 straight lines each running parallel to one of the axes and meet each other vertically.

Shoe of Right Leg

Shoe of Left Leg

Budget Line
No of Mangoes(Y) 50 40 30 20 10 0 No of Oranges (X) 0 20 40 60 80 100 Price of Mangoes 400 320 240 160 80 0 Price of Oranges 0 80 160 240 320 400 Total PrIce 400 400 400 400 400 400

Suppose a consumer has Rs 400 and cost of each

mango is Rs 8 and cost of each orange is Rs 4 he can buy above combinations of mangoes and oranges.

Budget Line
With the help of the indifference curve analysis we can explain the various combination of the 2 commodities a consumer can have which yield him equal satisfaction. But a consumer has limited income and this is crucial in deciding the actual combination he can afford.


Mangoes

Budget Line for Income Rs 400 Budget Line for Income 600

Budget Line for Income Rs 300

Oranges

Budget Line
A consumers income decides the position of the budget line or price line. If the consumer can spent higher income than Rs 400 the budget line will shift upwards and if the consumers income lowers then the budget line will shift downwards. The prices of the commodities in this case the price of mangoes and oranges decide the slope of Price Line or Budget line. Slope of Budget Line= Price of Mangoes (Y)/ Price of Oranges (X) Thus the price line or Budget line shows the various opportunities open to the consumer in the market with his income and the prices of two commodities.

Consumer Equilibrium

The indifference map represents the possible combinations of 2

substitute commodities which give him equal satisfaction. The budget line or price line represents the possible combinations of 2 substitute commodities a consumer can have within his limited income. Thus consumers equilibrium can be revealed by using indifference map and budget line. This can be explained in following manner. Suppose following is the indifference map of a consumer consisting of indifference curves IC1, IC2, IC3 & IC4 for 2 commodities mangoes and oranges. Suppose consumer has Rs 400 as his income which he can spent on mangoes and oranges and cost of each mango is Rs 8 and Rs 4. AB is the price line or budget line indicates the combinations of mangoes and oranges he can have with this income of Rs 400 .

Consumer Equilibrium

A Mangoes U

P Q IC2

S IC3 IC4

IC1

R (Point of Equilibrium)

Z Oranges

Consumer Equilibrium

Now we can find out the consumer equilibrium i.e. the

specific combination of mangoes and oranges which will give him maximum satisfaction with his income of Rs 400.He can choose any combination on Budget Line AB. But he will select only point R at which Budget line is tangent to Indifference curve IC3. as this point yield him maximum satisfaction. Both budget line and IC3 have equal slope at this point R. At this point he can have OV mangoes and OZ oranges. This is his point of maximum satisfaction within his budget. This point R is his point of equilibrium. He will not choose any point on IC1 & IC2 as they yield him less satisfaction. Even point S on IC3 or any point on IC4 will not chosen as this is beyond his budget or income.

Production Concepts
Input- An input is a good or service that is used into

process of production. Thus an input is anything which the firm buys for use in its production or other process. For e.g. Labor, Capital, Land, raw materials and time. Types of Input Fixed Input- A fixed input is one whose quantity remains fixed or constant for a certain level of output. It remains fixed or inelastic in short run. For e.g. plant, building and machinery. Variable Input- A variable input is one whose quantity changes with output. It is variable or elastic in short run. For e.g. labor and raw materials. Output- An output is any good or service that comes out of production process

Production Function
A production function is the technological

relationship between the output and its inputs. The inputs are also known as the factors of production . For any production process the factors of production determine the output. Land, labor, capital, management and technology are 5 determinants of any output. The dependent variable output is positive is a positive function of independent variables i.e. the factors of production.

Production Function

Q= F(Ld, L, K, M, T) Q- Output Ld- Land employed in production K-Capital employed in production (Machines, tools, raw materials, fuel and consumables, money) M- Management employed in production T-Technology employed in production. An increase in any of these factors of production when the other factors are constant will lead to increase in output. Generally the output of any commodity is related to inputs. Though the determinants may be almost the same, their relative importance varies from commodity to commodity. For eg Production of mobile phones requires larger capital and technology plays more crucial role in it than compared to a ball point pen. Similarly a diamond polishing process may require larger capital but smaller land as compared to a marble plishing process.

Production Function
The concept of production function can be better

understood by considering 2 inputs for an output. Hey Although any 2 inputs can be considered we take labor and capital since they are most important variables of all. Q= F( L, K)

Production Function
Short run refers to period of time in which supply of certain inputs (plant, buildings and machines etc) is fixed or inelastic. In short run the production of commodity can be increased by increasing the use of variable inputs like

labor and raw materials. It is worth noting that short run does not refer to any fixed time period. While in some industries it may be matter of weeks or a few months, in some others (eg electric and power industry) it may be 3 or more years. Long run refers to a period of time in which the supply of all inputs whether fixed or variable can be increased to increase the production. Here only technology will not change. Thus in the short run the firm can increase its production by increasing only labor since supply of capital is fixed. In the long run the firm can employ more of both labor and capital. Accordingly the firm will have 2 types of production functions. The Short run production function or single variable production function given by Q= f(L) In the Long run production function both Capital & Labor are included and it is denoted by Q =f(K, L)

Law of Return to Variable Proportions- Production with one variable input/ Law of Diminishing returns. In short run the firms can employ only a limited or fixed quantity of fixed factors and an unlimited quantity of variable factor. It means that firm can employ in short run, varying quantities of variable inputs against a given quantity of fixed factors. This kind of change in input proportions leads to variation in factor proportions. The laws which bring out the relationship between varying factor proportions and output are known as law of variable proportions or Law of Diminishing returns or Law of returns to factor.

Law of Return to Variable Proportions- Production with one variable input/ Law of Diminishing returns.
The law of Diminishing Returns states that if more and more units of a variable input are applied to a given quantity of fixed inputs, the total output may initially increase at an increasing rate, but beyond a certain level, output increases at diminishing rate. This means that marginal increase in total output or marginal output decreases when additional units of variable factors are applied to a given quantity of the fixed factors. The main reason behind the operation of this law is the decreasing labor-capital ratio. Given the quantity of fixed factor (capital) with increasing variable input (labor) capital-labor ratio goes on decreasing. Thus each additional worker has less tools and equipments to work. Consequently productivity of marginal worker eventually decreases. As a result output increases but at a diminishing rates and beyond a point it will come down.

Law of Return to Variable Proportions- Production with one variable input/ Law of Diminishing returns. There are 3 types of factors productivities and they are as follows Total Product (TP) of factor of production is defined as the total production of output obtained by employing different quantities of that factor input while other factors are constant. Average Product (AP)- It is the total production of output obtained divided by the quantity of that factor employed while other factors are constant. Marginal Product(MP)- It is the change in total product obtained due to the use of additional unit of that factor input while other inputs are constant.

Law of Return to Variable Proportions- Production with one variable input/ Law of Diminishing returns.
In the example below the capital (K) is held constant at 10 units and labor (L) is increased from 1 to 10 units, the output increases from 30 to 130 units at increasing rate for increase of labor from 1 to 3 then output increases from 185 to 300 for increase in labor from 4 to 9 at diminishing rate and when labor is increased to 10 units the output falls down from 300 units to 280 units instead of rising.

Labor

Output

Total Product (TP) 30 70 130 185 225 260

Marginal Product (MP) 0 40 60 55 40 35

Average Product 30 35 43.33 46.25 45 43.33

Stage

1 2 3 4 5 6

30 70 130 185 225 260

285

285

25

40.71

Law of Return to Variable Proportions- Production with one variable input/ Law of Diminishing returns.

TP/MP/AP

TP

AP Labor MP

Return to Scale
In the last topic we studied what happens to output

when only one input factor is changed and all other inputs are constant or what happens in short run . Now we will see what will happen to output if all the input factors are changed in the same proportion and in same direction . This can be done in long run. In long run all the input factors whether fixed or variable can be changed. This relation between the output and variation in all the inputs taken together is known as returns to scale. In this both the inputs labor and capital will be increased.

Return to Scale
Returns of Scale can be of 3 types Increasing Returns to Scale- Returns to scale are said to

be increasing if there is more than proportionate increase in output when compared to increase in inputs. For eg if by employing 1 unit of labor and 1 unit of capital you were getting 1 unit of out put and now if you increase labor to 2 units and capital to 2 units and if you get more than 2 units of output then this is increasing returns to scale. If you increase labor and capital by 20 % and the output increases by more than 20 % then this is called as increasing returns to scale. This happens as the internal and external economies are more than internal and external diseconomies.

Return to Scale
Returns of Scale can be of 3 types Constant Returns to Scale- Returns to scale are said to be

constant if the output increases in same proportion as the increase in inputs. For eg if by employing 1 unit of labor and 1 unit of capital you were getting 1 unit of out put and now if you increase labor to 2 units and capital to 2 units and you get exactly 2 units of output then this is constant returns to scale. If you increase labor and capital by 20 % and the output increases by eaxctly 20 % then this is called as constant returns to scale. This happens due to balancing of internal and external economies and internal and external diseconomies.

Return to Scale
Returns of Scale can be of 3 types Decreasing Returns to Scale- Returns to scale are said to

be decreasing if the output increases in smaller proportion than the increase in inputs. For eg if by employing 1 unit of labor and 1 unit of capital you were getting 1 unit of out put and now if you increase labor to 2 units and capital to 2 units and if you get less than 2 units of output then this is decreasing returns to scale. If you increase labor and capital by 20 % and the output increases by less than 20 % then this is called as decreasing returns to scale. This happens as the internal and external economies are less than the internal and external diseconomies.

Law of Return to Scale


If we increase the inputs by same proportion then output increases at

increasing rate i.e. increasing returns to scale, if we further increase the input then the output increases at constant rate or same rate i.e. constant returns to scale and if we increase it further then output increases at decreasing rate i.e. decreasing returns to scale and ultimately it declines. Thus marginal output 1st increases, then becomes constant and finally declines.

Marginal Output

Scale of Production

Economies of Scale

They are classified as Internal or real economies of scale. External or pecuniary economies of scale. Internal or real economies of scaleThese are those which arise from expansion of the plant size of the firm. The economies are internal in the sense that economies are internalized to the expanding firms and not available to non expanding firms. Internal economies can be classified under following categories Economies in production/ Technical Economies. Economies in marketing Managerial Economies Financial Economies Managerial Economies Economies in transport and storage. Risk bearing economies

Economies of Scale
Economies in production/ Technical EconomiesThese economies are the result of using better techniques of production facilitated by growth of firm. They are of 4 types Economies of Increased dimension- These are economies of large size of a machine or plant or any other form of capital asset. For eg it is less costly to use a double decker bus than to use to 2 buses. Also when dimensions of a rectangular water tank are doubled i.e. length, breadth and depth its capacity to hold water increases 8 times. One operator can run a small machine as well large machine so large machine would reduce per unit labor cost. Economies of Linking processes- Production involves several processes and linking these processes the firm can achieve cost reduction. For eg production of cloth in textile mill may comprise such plants as 1. Spinning 2. Weaving 3. Printing and Pressing 4. Packing. Under the small scale of production the firm may not find economical to have all the plants. Economies of Superior techniques- Large scale production make it possible for a firm to use advanced and more sophisticated machines. A large farm can use tractor instead of wooden plough. Economies of Specialization and Division of Labor-Difficult or risky operations can be mechanized and those operations requiring individual care can be left to manual work. Every job can be spilt in parts for division of labor and jobs can be assigned as per required skills. This saves unnecessary wastes of time and energy. This increases efficiency and lowers cost

Economies of Scale
Managerial Economies- For a large scale firm it becomes possible for

the management to divide itself into specialized departments under specialized personnel such as production manager, sales manager, personnel manager labor officers. This increases the efficiency of management at all levels because of decentralization of decision making. Routine matters can be delegated to subordinates and manager can concentrate on more important matters Economies in Marketing- Sales and purchases on large scale have several advantages. The large scale firms normally make bulk purchases of the input which entitle them to higher discounts and more bargaining power which is not available to small firms. They also get preferential treatment. There are economies in advertising cost. With the expansion of firm the total production increases but the expenditure does not increase proportionately. There are economies in large scale distribution through wholesalers. Selling through the wholesale dealers reduce the cost on distribution of the firms production. The firm also gains on large scale distribution through better utilization of sales force and distribution of samples.

Economies of Scale Financial Economies- Large firms can raise share capital in large quantities because they can have a reputation, the shares listed on major stock exchanges and a wide market for their shares, bonds and debentures. They also enjoy better credit facilities from banks and preferential treatment. Risk bearing economies- Production involves certain risks which are not insurable. A big firm can minimize these risks in a number of ways. Firstly they can diversify i.e. produce various commodities satisfying different wants of people. Such a diversification protects the firm from crisis in some fields. For e.g. ITC produces FMCG products, Cigarettes, Paper, Notebooks etc. So if heavy taxes are levied on tobacco products it will not suffer a set back.

Economies of Scale

Economies in transport and storage- It arises from

fuller utilization of transport and storage facilities. Transportation costs and storage costs are incurred on both raw materials and finished products . The large firms can own their own fleet of vehicles and build their own storage facilities. This reduces both transport and storage costs. Besides own transport facilities prevent the delays in transporting goods. Some large scale firms like Bombay Port Trust have their own railway track from nearest railway point to the factory or oil companies have their own fleet of tankers.

Economies of Scale

External Economies- Industrial development

involves two distinct aspects one growth of each individual firm and two industrialization of selected areas, regions or belts through concentration of different types of industries. The term external economies was generally used to describe those economies which accrue to each member firm when whole industry expands. But in modern times this is applicable to firms belonging to different industries but geographically located together. They are called external because they do not flow from within the firm but from outside.

Economies of Scale
They are of following types Economies of Concentration- When several firms of same industry or

different industries get localized at a place several advantages like skilled workers, facilities for transport, banks, hospitals for workers, schools for their children, technical training institute for workers, roads and water supply get available. For eg textile mills have concentrated in cities like Mumbai, Ahmedabad, Surat, Solapur. Diamond cutting and polishing industry has flourished in Surat, a huge industrial belt has developed in Ankleshwar, Pimpri Chinchwad. Economies of Information- Publications like trade and research journals, central research institutes, seminars and training programmes and such activities which are beyond the capacity of a single firm can be undertaken jointly. Many such activities are possible with the help of the Government institutions like universities and research laboratories. Economies of Disintegration- When an industry grows in an area around a city some of the work or process can split up and handed over or outsourced to specialized industries, institutions and agencies. When a large number of book publishers exist in an area specialized services of related experts like artist, designers, proof readers and printers become available to all publishers.

Diseconomies of Scale
Large scale may encounter certain diseconomies and disadvantages.

They are of 2 types. Internal Diseconomies- They are internalized and they may be due to following reasonsManagerial Inefficiency- With fast expansion of the production scale, personal contacts and communication between owners and managers and managers and labor get rapidly reduced. Close control and supervision is replaced by remote control. With increase in number of personnel decision making is complex , delayed and there are coordination problems. Labor inefficiency- Increase in number of workers encourages unionization of labor and these results in strikes and lock outs. This cause stoppage of work and loss of output. No direct contact with customers is possible. So tastes of consumers are ignored. Products are standardized and no specialized services to consumers are possible. Large Scale production may cause over production and this may result in losses.

Diseconomies of Scale
External Diseconomies- These are the disadvantages which originate from outside the firm. Expansion of a particular industry causes certain diseconomies like competition among firms to secure raw materials and other resources for itself causes prices to rise. Also with increase in demand for resources additional resources which are available are naturally of lower quality as compared to those already employed. For eg the best workers are selected first and if ore workers are required a firm has to appoint whosoever are available rather than who are suited for the work. Thus not only wage rate increases but productivity also goes down. Similar diseconomies flow from concentration of industries in certain localities. Overcrowding of cities, traffic congestion, pollution of air and water, strain on civic amenities like drinking water, public health, sanitation and problems of housing, education, medical care and law and order are some of the consequences. These affect efficiency of labor, availability of quick transport, timely deliveries of finished products and overall strain on whole industrial system.

Isocost , Isoquant and Minimization of Cost


Isoquant: In the long run both labor (L) and Capital(K) can be increased to increase the output (Q).

Isoquants represents the various combinations of capital and labor that can be used to produce a same level of output. For example, in the table below, 50 units of output can be produced with 1 unit of capital and 8 units of labor, or with 8 units of capital and 1 unit of labor. The two resources can be substituted for each other. We can do a similar analysis for 100 and 150 units of output. The rate at which the labor is substituted by Capital is called Marginal rate of substitution and it goes on decreasing

Isocost , Isoquant and Minimization of Cost

Isoquant ,Isocost ,and Minimization of Cost


Marginal Rate of Substitution: The rate at which the labor is

substituted by Capital is called Marginal rate of substitution and it goes on decreasing, This is the slope of the Isoquant and it is ratio of Marginal product of Labor and Marginal Product of Capital .

Isocost , Isoquant and Minimization of Cost


Characteristics of Isoquants-

1.The Isoquant curves always slopes negatively or downwards from left to right. 2. The Isoquants are always convex to the origin of axes. 3. No 2 Isoquant curves intersect each other. 4.Upper Isoquant curve represent a higher level of production or output than lower Isoquant curve.

Isocost , Isoquant and Minimization of Cost


Isocost Line-Firms need to know what it costs them to produce a level

of output. The isocost line allows us to represent the quantities of labor and capital that can be purchased at given input prices, given an amount of total cost or firms budget. For eg If the budget of the firm towards total cost is Rs 400 and the cost of Capital is Rs 8 and cost of Labor is Rs 4 then various combinations of Labor and Capital are possible within the total cost of Rs 400.
Units of Capital 50 40 30 20 10 0 Units of Labor 0 20 40 60 80 100 Cost of Capital 400 320 240 160 80 0 Cost of Labor 0 80 160 240 320 400 Total Cost 400 400 400 400 400 400

Isocost , Isoquant and Minimization of Cost

Capital

Iso Cost Line for Total Cost=400 Rs

Labor Slope of Isocost Line= Price of Capital/Price of Labor

Isocost , Isoquant and Minimization of Cost


A firms total cost or budget decides the position of the Isocost line. If the firm can spent higher total cost than Rs 400 then Isocost line will shift upwards and if the firms budget/total cost lowers then the Isocost line will shift downwards. The ratio of prices of the inputs in this case the price of capital and price of labor decide the slope of Isocost line. Slope of Isocost Line= Price of Capital (Y)/ Price of Labor (X) Thus the Isocost line shows the various opportunities open to the producer in the market with his total cost/budget and the prices of two inputs i.e. labor and Capital.

Cost Minimization using Isoquant and Isocost

The Isoquants represents the possible combinations of 2 inputs

i.e. Labor and Capital which give a producer or manufacturer equal output. The Isocost line represents the possible combinations of 2 inputs i.e. labor and Capital a producer can have for a particular total cost/budget he is willing to spent . Thus cost minimization or least can be revealed by using Isoquant and Isocost line. This can be explained in following manner. Suppose IQ1 is the Isoquant curve of a producer for producing 100 units of a product. AB, CD, EF are various Isocost lines for various budget/total cost of the producer i.e. 500 Rs, 400 Rs and 300 Rs respectively. A higher Isocost line indicates higher total cost budget than lower Isocost line. Now which will be the point (Combination of Labor and Capital) of least total cost if producer wants to produce 100 units of the product.

Cost Minimization using Isoquant and Isocost

Now we can find out the least cost i.e. the specific

combination of inputs labor and Capital which will give him total output of 100 units.The producer will not choose any point on Isocost Line AB as there is no common point between Isocost Line AB and Isoquant IQ1. Isocost CD intersects Isoquants IQ1 at point P & Q and Isocost EF touches or is tangent to Isoquant IQ1 at point R. Now producer can select either point P, Q and R as all this points are common to both the curves.But he will select only point R at which Isocost line EF is tangent to Isoquant curve IQ3. as this point yield him least cost of all 3 points. Both Isocost line EF and Isoquant IQ1 have equal slope at this point R. The combination of Capital and Labor corresponding to point R will be used to minimize the cost

Cost Minimization using Isoquant and Isocost

A
Isocost for Budget-500 Rs C Capital E p IQ1 for 100 units of production or output

Isocost for Budget-400 Rs


R Q F D B Labor Isocost Budget-300 Rs Least Cost /Cost Minimization

Theory of Production Costs


Cost Concepts Actual Costs- It refers to the cost actually incurred in

money terms. Such costs are recorded in the books of account of the firm. Eg Cost incurred by the firm in payment for labor, material, plant, building, machinery, equipments, travelling and transport. Opportunity Costs- It is second best use of resources which is foregone for availing the gains from the best use of resources. For eg A businessman with his limited resources can start either a business of printing or a lathe workshop. The expected income from printing is Rs 20000 and lathe workshop is Rs 15000. Obviously he will do printing business as the expected income is more in printing than lathe. In this case he has foregone the opportunity of next best business i.e. lathe workshop. Thus Rs 15000 is the opportunity cost in this case.

Theory of Production Costs


Fixed Costs- are those which remain fixed in volume for a

certain given output. They do not vary with variation in output between zero and certain level of output. For eg in case of textile plants producing 10 lakh metres of cloth per year the costs on account of plant and machinery, building will remain constant at all level of output from 1 metre to 1 lakh metres. This costs are called as fixed costs. Variable Costs- Variable costs are those which vary more or less proportionately with the output are known as variable cost. In the above example costs of raw materials, labor, electric power, running cost of fixed capital such as fuel, ordinary repairs, maintenance are variable costs.

Theory of Production Costs


Short run costs- It can be defined as costs which vary

with variation of output for certain level of output. Thus short run costs are same as variable costs. Long run costs- These are the costs which are incurred on the fixed assets like plant, building machinery, land and are not used in single batch of production but are used over entire period of time. They are by implication same as fixed costs.

Theory of Production Costs


Cost Function- It is the relationship between Cost

and its determinants and is represented as followsC=f(Q, T, Pf, K) C-Total Cost Q-Quantity produced Pf- factor price K-Capital fixed factor. Short Run Cost Function- In the short run all the determinants of cost other than output Q are constant. So the cost function function will bE C=f(Q).

Theory of Production Costs


Relationship between Cost and Output in the Short Run: Total Cost(TC)- It is defined as the total cost incurred to produce a given quantity of output. In short run total cost is composed of 2 major elements i.e. Total Fixed Cost (TFC) & Total Variable Cost(TVC). TC= TFC + TVC TFC remains fixed in short run for a certain level of output and TVC varies with variation in the output. Average Total Cost- It is obtained by dividing total cost (TC) by the quantity of output produced (Q). ATC=TC/Q Similarly AVC= TVC/Q AFC=TFC/Q Marginal Cost(MC)- It is the addition to the total cost on account of producing one additional unit of product or it is cost of marginal units produced. MC=TC/Q

Since TC=TFC+TVC In short run TFC=0 Therefore TC=0+TVC TC=TVC MC= TVC/Q

Theory of Production Costs


Example:
0 10 20 30 40 Q (units) TFC 140 140 140 140 140 TVC 70 110 180 280 TC 140 210 250 320 420 AFC 14.0 7.0 4.7 3.5 AVC 7.0 5.5 6.0 7.0 ATC 21.0 12.5 10.7 10.5 7 4 7 10 MC -

50
60 70 80

140
140 140 140

450
720 1120 1680

590
860 1260 1820

2.8
2.3 2.0 1.8

9.0
12.0 16.0 21.0

11.8
14.3 18.0 22.8

17
27 40 56

Theory of Production Costs


1.Average fixed cost (AFC) : . AFC decreases throughout the output (Q) range.

b. If we extend the output range further to the right, AFC


moves closer and closer to the horizontal axis (Q - axis). c. WHY? AFC = TC / Q and AFC decreases as Q increases 2. Average variable costs (AVC) : a. The average variable cost curve is U - shaped. b. AVC first decreases, reaches a minimum, and the increases. c. WHY? Something you learned a little earlier known as the LAW OF DIMINISHING RETURNS and the LAW OF INCREASING COSTS

Theory of Production Costs


3. Average total costs (ATC) : a. ATC has similar shape of AVC. However, it falls

faster than AVC in the beginning and rises slower after reaching its minimum point. b. WHY? ATC = AFC + AVC AFC and AVC both fall in the beginning, at some point however, AVC begins to rise while AFC continues to fall. When the increase in AVC OUTWEIGHS the decrease in AFC, the ATC will begin to increase forming the familiar U - shaped curve

Theory of Production Costs


4. Marginal cost (MC) : a. This curve also decreases at first, reaches a

minimum, then increases. b. Relationship between MC and Average costs : When MC < AVC AVC are decreasing When MC > AVC AVC are increasing c. MC intersects AVC and ATC at their minimum and this level of output at which the TC will be mminimum.

Theory of Production Costs


Long Run Cost Curves 1.In the long run all costs are variable. Therefore, this

curve is actually a long run average variable cost curve, but since we know all costs are variable in the long run, we just call it the LAC. 2. The LAC is constructed form a series of short run average total cost curves associated with a series of different output levels (Q). 3. The LAC is the points which are tangent to the minimums of the short run average total cost (SAC) curves associated with each output level.

Theory of Production Costs