BUSINESS ECONOMICS BY

DR. B. T. CHAVAN ASSIST. PROFESSOR

DAYANAND COLLEGE OF COMMERCE, LATUR

UNIT: 1

INTRODUCTION TO

BUSINESS ECONOMICS

Economics in the life of Human Being

Children/Farmer/Salaried/House Wife

Bargaining Power

Shortage of Money

Demand & Supply

Inflation/Deflation

Recession

Consumer Behavior

Business Cycle

Product Life Cycle

Definitions

Wealth Definitions

Adam Smith: “Father of Economics” Book: Wealth of Nations written in 1776

“Economics is an enquiry into the nature and causes of the wealth of the nations.”

J.S. Mill:

“Economics is the practical science of the production and distribution of wealth.”

Welfare Definition

Dr. Alfred Marshall:

Book: Principles of Economics written in 1890

“Economics is a study of mankind in the ordinary business of life.”

WHAT IS ECONOMICS

DEFINITIONS

Modern Definition

Lionel Robbins: (1939)

Book: An essay on the nature and significance of economic science

According to him economics is the study of problems of choice which arises due to scarcity of resources in relation to unlimited wants.

He defines economics “As the science which studies human behaviour as a relationship between ends and scares means which have alternative uses.”

WHAT IS BUSINESS ECONOMICS

Evans Douglas:

Book: Managerial Economics, theory, practice and problems.

According to him “Business economics is concerned with the application of economic principles

and methodologies to the decision making process within the firm or organisation under the conditions of uncertainty.”

Dominick Salvatore:

According to him “Business economics refers to the application of economic theory and the tools

of analysis of decision science to examine how an organization can achieve its aims or objectives most efficiently.”

Spencer and Siegelman:

“ Business economics is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management.”

Business Economics seeks to

Establish rules and principles for management

Facilitate the attainment of the desired goals of management

CHARACTERISTICS OF BUSINESS ECONOMICS

1. Study of Micro Economics: “It studies the problem of an individual business unit.”

2. Normative Science: (Establishing norms or standards)

It explains what managers should do under particular circumstances.

It determines the goals of the enterprise.

It develops the ways to achieve the goals.

3. Pragmatic: (Dealing with matters from a practical point of view) It

concentrate on making economic theory more application oriented.

4. Prescriptive: Managerial economics is prescriptive rather than descriptive.

5. Uses Macro Economics: Managerial economics takes the help of macro

economics to understand the external conditions such as business cycle,

national income, economic policies of government etc.

CHARACTERISTICS OF BUSINESS ECONOMICS

6) Uses theory of firm: Managerial economics uses economic concepts and

principles towards solving the business problems. (Profit, Interest, Rent,

Wages, Law of variable proportion, Law of demand & Supply, Indifference

curve, Laws of returns to scale)

7) Management oriented: It helps to the management in taking correct

decisions and preparing plans and policies for future. It also analyses the

problems and give solutions. (Regression, correlation, mean, mode, median,

standard deviation, probability, index numbers, permutation/combination)

8) Multi disciplinary: Managerial economics makes use of most modern tools of

mathematics, statistics and operation research.

9) Art and Science: It establishes relationship between cause and effect by

collecting, classifying and analysing the facts on the basis of certain principles.

It points out to the objectives and also shows the way to attain the said

objective.

SIGNIFICANCE OR SCOPE OF BUSINESS ECONOMICS

1) Demand analysis and Forecasting: Accurate demand analysis helps a firm in minimizing its cost of production and storage. Demand

forecasts serves as a guide to the management for maintaining its

market share in competition.

2) Cost and Production analysis: It helps to the manager in estimating costs of the production by considering variations,

uncertainties, wastages of material and time.

3) Pricing Decisions, Policies and Practices: Firms income and profit

depend mainly on the price decisions. Pricing policies are framed after considering the nature of the market in which the firm operates.

4) Profit Management: Correct estimation of costs and revenues at

different levels of output is possible with the help of economic policies

and theories. It helps in reducing uncertainty which results in higher profits.

5) Capital Management: Capital management requires top level

decisions. It means planning and control of capital expenditure.

It deals with cost of capital, rate of return and selection of

projects.

6) Inventory Management: Business economics helps in

maintaining ideal level of stock which is neither very low nor

very high.

7) Environmental issues: Macro-economic issues like general

business, social and political environment are tackled with the

help of business economics.

8) Business Cycles: Business cycles like depression, recovery,

prosperity, boom, and recession affect business decisions.

Business economics helps to tackle above situations.

SIGNIFICANCE OR SCOPE OF BUSINESS ECONOMICS

OBJECTIVES OF BUSINESS FIRM

Economic Objectives

1) Maximisation of profit: The main measure of business efficiency is the

profit made by it.

2) Satisfactory level of profit: Herbert simson has presented this concept.

According to him firms goals should not be maximisation of profit, but

attaining a certain level of profit, holding a certain level of sales.

Firms should try ‘to satisfy’ rather than ‘to maximise.’

3) Sales Maximisation: Prof. Boumol provides two goals in firms behaviour

first is satisfactory minimum level of profits and second is the highest

possible sales.

4) Maximum Growth Rate: According to Boumol a firm can attain maximum

growth rate with optimal (most favorable) net profits.

5) Desire for liquidity: Firm has to keep adequate amount of cash so that it

can avoid a liquidity crisis.

OBJECTIVES OF BUSINESS FIRM

Non Economic Objectives

1) Survival: Profit is necessary for the survival in the market for this firm

should earn goodwill in the society.

2) Securing public support: Firm can win public support by providing high

quality goods with low prices.

3) Welfare of labour and society: workers can be taken care by providing

good working conditions, fair wages and other benefits. By undertaking

charitable works a firm can contribute in the social development.

4) Business Ethics: A firm must adopt sound business practices like issuing

price lists, replacements or refund for defective products.

5) Progressive management: For achieving this objective, policies like

participation of workers in management, training programmes for workers

etc. should be implemented.

Micro Economics is the branch of economics that analyses the market

behavior of individual consumers and firms in an attempt to

understand the decision making process of firms and households.

According to Prof. K. E. Boulding, "Micro Economics is the study of

particular firm, particular household, individual prices, wages,

incomes, individual industries and particular commodities."

Macro Economics studies the behavior and performance of an economy

as a whole. It focuses on aggregate changes in the economy such as

unemployment, growth rate, GDP, inflation and income.

According to Prof. K.E. Boulding, “Macroeconomics deals not with

individual quantities as such, but with aggregates of these quantities,

not with individual income but with national income, not with

individual price but with price level, not with individual output but

with national output”.

MICRO AND MACRO ECONOMICS

Micro Economics: (Study of a single tree in a forest)

Study of small parts like households, firms and

industries or group of industries.

Determination of price, employment and consumer

equilibrium.

Studies Behaviour of Individual Unit.

Macro Economics: (Study of the whole forest)

Study of whole economy.

Study of changes in employment, income level and

general prices.

It deals with the whole economy like savings,

national income, economic growth, trade cycle etc.

1. Nature of Analysis: In micro economics, the behavior of individual

consumers and producers in detail is analysed. It is study of subject

matter from particular to general.

2. Slicing Method: Micro economics divides the economy into various

small units and every unit is analysed in detail. It is a slicing method.

3. Scope: Micro economic analysis involves product pricing, factor pricing

and theory of welfare.

4. Application: Both theoretically and practically, micro economics is

useful in formulating various policies, resource allocation, public finance,

international trade, etc.

5. Nature of Assumptions: Assumption of Ceteris Paribus (other things

being equal) is always made in every micro economic theory. It means

theory is applicable only when 'other things being same'.

CHARACTERISTICS OF MICRO ECONOMICS

1. Aggregate: Macro-Economics deals with the study of Economy as a whole. It is

concerned with the aggregate concepts such as National Income, National

Output, National Employment, General level of Prices, Business cycle etc.

2. National income and employment: Macroeconomics studies the concept of

national income, its different elements, methods of measurement and social

accounting.

3. Lumping Method: In slicing method we are concerned with small individual

Slices of the entire object where as Lumping method concerned with the object as

a whole.

4. A Bird’s eye view of the Economy: Macro Economy gives an overall view of

the economy. It summaries & connects various aggregates so as to show the

interrelationship between them.

5. General price level: Determination of and changes in general price level and

what is the importance of various factors which influence general price level is

studied.

CHARACTERISTICS OF MACRO ECONOMICS

Unit: 2

Demand Analysis

DEMAND ANALYSIS

Concept of Demand: Demand in economics is defined as consumers'

willingness and ability to consume a given good. The inverse relationship between price and quantity demanded of a good is known

as the law of demand and is typically represented by a downward

sloping line known as the demand curve.

Demand Curve:

The law of demand states that quantity purchased varies

inversely with price. In other words, the higher the price, the lower the

quantity demanded. This occurs because of diminishing marginal

utility. That is, consumers use the first units of an economic good they

purchase to serve their most urgent needs first, and use each additional

unit of the good to serve successively lower valued ends.

The law of demand is a fundamental principle of economics which states that at a

higher price consumers will demand a lower quantity of a good.

Demand is derived from the law of diminishing marginal utility, the fact that

consumers use economic goods to satisfy their most urgent needs first.

A market demand curve expresses the sum of quantity demanded at each price

across all consumers in the market.

Changes in price can be reflected in movement along a demand curve, but do not

by themselves increase or decrease demand.

The shape and magnitude of demand shifts in response to changes in consumer

preferences, incomes, or related economic goods, NOT to changes in price.

LAW OF DEMAND

UNDERSTANDING THE LAW OF DEMAND

UNDERSTANDING THE LAW OF DEMAND

Factors Affecting Demand

Rising income

Availability of close substitutes

Availability of complementary goods

Future expectations

CONCEPT OF ELASTICITY

Concept: Elasticity is a measure of a variable's sensitivity to a change in

another variable. In business and economics, elasticity refers the degree to which

individuals, consumers or producers change their demand or the amount supplied in

response to price or income changes.

Elasticity of Demand is calculated as the percent change in the

quantity demanded divided by a percent change in another economic

variable. A higher demand elasticity for an economic variable means

that consumers are more responsive to changes in this variable.

When price of a good falls, the demand for it expands.

And when price rises, the demand for it contracts.

Examples: 1) Salt: demand will not affect much

2) LCD: Demand will affect if prices fall or rise.

This expansion and contraction of demand for goods after the change in

prices is known as price elasticity of demand.

DEFINITIONS

Dr. Alfred Marshall: “The elasticity of demand in a

market is great or small according as the amount demanded

increases much or little for a given fall in price, and

diminishes much or little for a given rise in price.”

Albert Meyers: “The elasticity of demand is a measure of

relative change in the quantity purchased in response to

relative change in the price on a given demand curve.”

Prof. K. E. Boulding: “Elasticity of demand measures the

responsiveness of the quantity demanded to changes in the

price.”

ELASTICITY GRAPHS

UNITARY LESS THAN

UNITARY

MORE THAN

UNITARY

PERFECTLY

INELASTIC

PERFECTLY

ELASTIC

MEASUREMENT OF ELASTICITY OF DEMAND

Percentage Method

Percentage change in Demand

E p =

Percentage change in Price

15%

1) E p = = 1.5 (Elasticity is more than Unity) E>1

10%

10%

2) E p = = 1 (Elasticity is equal to unity) E=1

10%

PERCENTAGE METHOD

8%

3) E p = = 0.8 (Elasticity is less than Unity)E<1

10%

100%

4) E p = = Infinite (Perfectly Elastic)

0%

0%

5) E p = = 0 (Perfectly Inelastic)

100%

1) Elasticity of Demand is equal to unity:

2) Elasticity of Demand is Greater than Unity:

Price Quantity Demanded

Total Outlay

Rs. 5 100 Kgs. Rs. 500

Rs. 4 125 Kgs. Rs. 500

Rs. 10 50 Kgs. Rs. 500

Price Quantity Demanded

Total Outlay

Rs. 5 100 Kgs. Rs. 500

Rs. 4 200 Kgs. Rs. 800

Rs. 2 500 Kgs. Rs. 1000

Total Outlay Method

3) Elasticity of Demand is less than unity:

Price Quantity Demanded

Total Outlay

Rs. 6 100 Kgs. Rs. 600

Rs. 2 200 Kgs. Rs. 400

Rs. 1 200 Kgs. Rs. 200

Total Outlay Method

Revenue Method

Average Revenue

Average Revenue-Marginal Revenue Ed=

Y

M E=Infinite

P2 E>1

Price

P E=1

P1 E<1

E=0

0 Quantity D X

Point Method or Geometric Method

This is possible when there

is small change in price and quantity demanded

MD= 6 Inches

P is at mid point of MD

Lower Segment Upper Segment

Ed=

Original Quantity - New Quantity

Original Quantity + New Quantity

E of D =

Original Price - New Price

Original Price + New Price

Q1= Original Q

Q2= New Q

P1= Original Price

P2= New Price

ARC method: (Curve)

Q1 – Q2 P1 - P2 Q1 + Q2 P1 + P2

÷ Price=

This is relevant where change in price and

resulting change in demand is large

Ignore

negativ

e sign in

answer

DETERMINANTS OF ELASTICITY OF DEMAND

1) Nature of the commodity

a) Necessary commodities (Inelastic demand) LPG Gas

b) Comfort goods (Unitary elastic demand) Special food items,

Seasonal Fruits

c) Luxurious goods (Elastic demand) Fridge, Washing Machine

2) Availability of substitutes

a) If substitute available (Demand will be elastic)

b) If substitute not available (Demand will be inelastic)

3) Various uses of the commodity

a) If price rises (buy for only most important uses)

b) If price falls (buy for many uses) e. g. Electricity

4) Importance of commodity in consumers budget

(If consumer spend very less on a commodity then utility of such

commodity will be very less.)

5) Possibilities of postponing the consumption

Salt, Medicine, Food grains (Demand will be inelastic or less elastic)

DETERMINANTS OF ELASTICITY OF DEMAND

6) Joint demand:

a) Ink and Pen

b) Electricity and Fridge

7) Time for Adjustment in purchases

a) Long period (More elastic)

b) Short period (Less elastic)

8) Fashion, tastes and preferences of consumers:

a) If very much fond of (Not much elastic on price rise)

e. g. Garment in vogue (relatively inelastic demand on price rise)

9) Distribution of income:

If wealth is evenly distributed (demand will be elastic)

10) Recurrence of demand: (Sugar, Calendar)

Recurring nature demand (Higher elasticity) Sugar

11) Range of prices: Either expensive or cheap (Demand will be inelastic)

12) Income

13) Durability of commodity

14) Industrial Products

PRICE ELASTICITY

The price elasticity measures how much the quantity demanded for a commodity responds to a change in its price.

Relative change in demand to the relative change in price.

% change in quantity demanded

Ed =

% change in price

Price and quantity demanded is inversely related, so price elasticity is negative. We consider only numerical value of the elasticity

INCOME ELASTICITY

The relationship between consumer’s income and

quantity demanded is positive.

% change in the quantity demanded

E i =

% change in the income

a) Normal goods (Positive elasticity of demand)

b) Inferior goods (Negative elasticity of demand)

CROSS ELASTICITY

It measures the % change in the quantity of ‘X’ in

response to a given change in the price of some other

good ‘Y’.

% Change in the demand of ‘X’ E c =

% Change in the price of ‘Y’

a) If goods are substitute (Positive cross elasticity)

b) If goods are complementary (Negative cross elasticity)

c) If goods are independent (Zero cross elasticity)

IMPORTANCE OF ELASTICITY OF DEMAND

1) To Businessman:

a) Price elasticity

b) Income elasticity

c) Cross elasticity

2) To the Govt. and Finance Minister

a) Fiscal policy

b) Deciding taxation

3) In International Trade

Formulation of import and export policies as per commodity

4) To policy makers – Farmers income in the situation of bumper crop

5) To trade Unions (wage bargaining)

If products are elastic in nature union leader can ask to cut prices and increase sales and wages of the workers.

6) To determine Foreign Exchange rates

(Effects of evaluation and devaluation of local currency)

Unit: 3 Theory of Consumer Behavior

Utility Analysis

A subset of consumer demand theory that

analyses consumer behavior and market demand

using total utility and marginal utility. The key

principle of utility analysis is the law of

diminishing marginal utility, which offers an

explanation for the law of demand and the

negative slope of the demand curve.

Utility and Satisfaction

The primary focus of utility analysis is on the

satisfaction of wants and needs obtained by the

consumption of goods. This is technically termed

utility. The utility generated from consumption

affects the decision to purchase and consume a

good.

The Law of Diminishing Marginal Utility

The law of diminishing marginal utility states that

marginal utility, or the extra utility obtained from consuming a

good, decreases as the quantity consumed increases. In essence,

each additional good consumed is less satisfying than the

previous one.

If each additional unit of a good is less satisfying, then a

buyer is willing to pay less. As such, the demand price declines.

This universal law of demand relation between price and

quantity demanded is a direct implication of the law of

diminishing marginal utility.

Dr. Marshall states the law

“The additional benefit which a person derives from a given increase of his stock of anything diminishes with the growth of the stock that he has.” In this statement of the law, the word “Additional” is very important. It is only additional (marginal) benefit which decrease and not the total benefit as we shall see in the following table.

Marginal Utility is the utility at the point where the consumer stops further consumption of a commodity.

Assumptions • The consumer who is consuming the goods should be logical and

knowledgeable to consume every unit of goods. • The goods which are to be consumed should be equal in size and

shape.

• Consumer should consume the goods without time gap.

• The consumer’s income, preference, taste and fashion should not be changed while consuming the goods.

• To hold the law good, utility should be measured in countable units or cardinal numbers. The utility obtained from those goods is measured in ‘utils’ unit.

• As we know that money is the measuring rod of utility, being so, marginal utility of money should remain constant during consumption of the goods.

No. of Rasgullas Marginal Utility Total Utility

1 15 15

2 13 28

3 10 38

4 8 46

5 4 50

6 2 52

7 0 52

8 -2 50

9 -5 45

Consumer consuming ‘rasgullas’ illustrates the law:

As the consumer goes on eating ‘rasgullas’, the additional or marginal

utility goes on decreasing. The 7th ‘rasgulla’ yields no additional satisfaction

and the 8th and 9th have a negative utility (see column 2). Their consumption,

instead of giving satisfaction or pleasure, causes dissatisfaction.

If you look at column 3, you will find that the total utility goes on

increasing up to a point. It also seems reasonable that the utility of two

‘rasgullas” should be more than that of one, and the total utility of three more

than that of two, and so on. But if you look at it more carefully, you will notice

that although the total utility does increase, it increases only at a diminishing

rate.

For example, when our friend consumes the second ‘rasgulla’, the

increase in utility is 13; and when he-consumes the third, the total utility

increases by 10 only. Column 2 shows the rate at which utility increases. We

can see that it increases at a diminishing rate In other words, the marginal

utility decreases.

Limitations or Exceptions Importance

Dissimilar Units (second ‘rasgulla’ is much larger than the first-one)

In Taxation (The principle of

progressive taxation is based on this law.)

Very Small Units (If we are given water by the

Spoonful when we are very thirsty, each successive

spoonful will give us more satisfaction.)

In Determining Prices

Too Long an Interval (Continuous

consumption) In Determining Prices

Rare Collections (If a person has a hobby of

collecting rare coins, the larger the number he collects

the greater will be his happiness)

In Support of Socialism (Beyond a

certain point, wealth will have less utility

for a rich man)

Abnormal Persons (The more money a miser has,

the greater is the satisfaction that he derives)

prestigious goods (gold, cash)

In Household Expenditure (stop

purchasing a commodity at a point where

the utility of money spent is equal to the

utility of the last unit of the commodity purchased)

Change in another Person’s Stock (Suppose,

there are two persons collecting stamps in a town and

both are rivals)

Basis of Some of Economic Laws (Several very important laws and

concepts of Economics arc based on the

law of diminishing marginal utility)

Changes in Income, Habits and Tastes

Marginal Utility and Price: Price measures marginal utility.

When we pay a certain price for a commodity, it can be taken for

granted that we think that the satisfaction is at least equal to the

price paid. Hence we say that price measures the marginal utility

or that marginal utility indicates the price.

Total and Marginal utility:

• As the total utility rises, the marginal utility diminishes • When the total utility is maximum, the marginal utility is zero.

• As the total utility starts diminishing, the marginal utility becomes negative.

Conclusion: However, in spite of the above limitations or

exceptions, the law has universal application. This is so because it

expresses a basic principle of human behaviour.

Law of Equi-marginal Utility

• This law is also known as the Law of substitution or the Law

of Maximum Satisfaction.

• We know that human wants are unlimited whereas the means

to satisfy these wants are strictly limited. It, therefore’

becomes necessary to pick up the most urgent wants that can

be satisfied with the money that a consumer has. Of the things

that he decides to buy he must buy just the right quantity.

Every prudent consumer will try to make the best use of the

money at his disposal and derive the maximum satisfaction.

• In order to get maximum satisfaction out of the funds we have, we carefully weigh the satisfaction obtained from

each rupee ‘had we spend If we find that a rupee spent in one direction has greater utility than in another, we shall

go on spending money on the former commodity, till the satisfaction derived from the last rupee spent in the two cases is equal.

• It other words, we substitute some units of the

commodity of greater utility tor some units of the commodity of less utility. The result of this substitution will be that the marginal utility of the former will fall and

that of the latter will rise, till the two marginal utilities are equalized. That is why the law is also called the Law

of Substitution or the Law of equimarginal Utility.

• Suppose apples and oranges are the two commodities to be purchased. Suppose further that we have got seven rupees to spend. Let us spend three rupees on oranges and four rupees on apples. What is the result? The utility of the 3rd unit of oranges is 6 and that of the 4th unit of apples is 2. As the marginal utility of oranges is higher, we should buy more of oranges and less of apples. Let us substitute one orange for one apple so that we buy four oranges and three apples.

• Now the marginal utility of both oranges and apples is the same, i.e., 4. This arrangement yields maximum satisfaction. The total utility of 4 oranges would be 10 + 8 + 6 + 4 = 28 and of three apples 8 + 6 + 4= 18 which gives us a total utility of 46. The satisfaction given by 4 oranges and 3 apples at one rupee each is greater than could be obtained by any other combination of apples and oranges. In no other case does this utility amount to 46. We may take some other combinations and see.

• We thus come to the conclusion that we obtain maximum satisfaction when we equalize marginal utilities by substituting some units of the more useful for the less useful commodity. We can illustrate this principle with the help of a diagram.

Diagrammatic presentation

Limitations Importance

Ignorance (If the consumer is ignorant or blindly follows custom or fashion, he will make a wrong use of money.)

Consumption (A wise consumer consciously acts on this law while arranging his expenditure.)

Inefficient Organization (an incompetent organiser of business will fail to achieve the best results from the units of land, labour and capital that he employs.)

Production (Substitute one factor for another so as to have the most economical combination)

Unlimited Resources (free gifts of nature)

Exchange (By selling sugar, we get money, we buy another commodity, say, wheat. So we substituted sugar for wheat)

Hold of Custom and Fashion (A consumer may be in the strong clutches of custom, or is inclined to be a slave of fashion)

Distribution (substituting one factor for another) Public Finance (The public revenues are so spent as to secure maximum welfare for me community.)

Frequent Changes in Prices (Frequent changes in prices of different goods render the observance of the law very difficult.)

Influences Prices (When a commodity becomes scarce and its price soars high, we substitute for it things which are less scarce. Its price, therefore, comes down)

indifference curve analysis

• The concept of indifference curve analysis was first propounded by British economist Francis Ysidro Edgeworth and was put into use by Italian economist Vilfredo Pareto during the early 20th century. However, it was brought into extensive use by economists J.R. Hicks and R.G.D Allen.

• Hicks and Allen criticized Marshallian cardinal approach of utility and developed indifference curve theory of consumer’s demand. Thus, this theory is also known as ordinal approach.

• An indifference curve is a locus ( of all combinations of two goods which yield the same level of satisfaction (utility) to the consumers.

• Since any combination of the two goods on an indifference curve gives equal level of satisfaction, the consumer is indifferent to any combination he consumes. Thus, an indifference curve is also known as ‘equal satisfaction curve’ or ‘iso-utility curve’.

Assumptions • Two commodities: It is assumed that the consumer has fixed amount

of money, all of which is to be spent only on two goods. It is also assumed that prices of both the commodities are constant.

• Non satiety: Satiety means saturation, It implies that the consumer still has the willingness to consume more of both the goods.

• Ordinal utility: The theory assumes that a consumer can express utility in terms of rank.

• Diminishing marginal rate of substitution: Marginal rate of substitution may be defined as the amount of a commodity that a consumer is willing to trade off for another commodity and, diminishing marginal rate of substitution states that the rate by which a person substitutes X for Y diminishes more and more with each successive substitution of X for Y.

• Rational consumers: consumer always behaves in a rational manner, i.e. a consumer always aims to maximize his total satisfaction or total utility.

Indifference schedule

Combination Mangoes Oranges

A 1 14

B 2 9

C 3 6

D 4 4

E 5 2.5

As indifference curve theory is based on the concept of diminishing marginal rate of substitution, an indifference curve is convex to the origin.

Properties of indifference curve

1. Indifference curve slope downwards to right: An indifference curve can neither be horizontal line nor an upward sloping curve. This is an important feature of an indifference curve. When a consumer wants to have more of a commodity, he/she will have to give up some of the other commodity, given that the consumer remains on the same level of utility at constant income. As a result, the indifference curve slopes downward from left to right.

In the above diagram, IC is an indifference curve, and A and B are two points which represent combination of goods yielding same level of satisfaction

We can see that when X1 amount of commodity X was consumed, Y1 amount of commodity Y was also consumed. When the consumer increased the consumption of commodity X to X2, the amount of commodity Y fell to Y2. And, thus the curve is sloping downward from left to right.

2. Indifference curve is convex to the origin: Two goods can never perfectly substitute each other. Therefore, the rate of decrease in a commodity cannot be equal to the rate of increase in another commodity.

Properties of indifference curve

We can clearly see that the rate of decrease in consumption of coffee is not the same as rate of increase in consumption of cigarette. Similarly, rate of decrease in consumption of coffee has gradually decreased even with constant increase in consumption of cigarette.

3. Indifference curve cannot intersect each other: Each indifference curve is a representation of particular level of satisfaction. The level of satisfaction of consumer for any given combination of two commodities is same for a consumer throughout the curve. Thus, indifference curves cannot intersect each other.

Properties of indifference curve

According to indifference curve theory, satisfaction at point C = satisfaction at point A Also, satisfaction at point C = satisfaction at point B But, satisfaction at point B ≠ satisfaction at point A. Therefore, two indifference curves cannot intersect. Yet, two indifference curves need not be parallel to each other.

• Higher indifference curve represents higher level of satisfaction: Higher the indifference curves, higher will be the level of satisfaction. This means, any combination of two goods on the higher curve give higher level of satisfaction to the consumer than the combination of goods on the lower curve.

Properties of indifference curve

Combination at point Q contains more of both the goods (X and Y) than that of the combination at point S. We know that total utility of commodity tends to increase with increase in stock of the commodity. Thus, utility at point Q is greater than utility at point S, i.e. satisfaction yielded from higher curve is greater than satisfaction yielded from lower curve.

UNIT: 4

THEORY OF

PRODUCTION

“The relationship between inputs and outputs is known as production function.”

“The technical law which expresses the relationship between factor input and output is termed as production function.”

Input is any good or service that goes into production and output is any good or service that comes out of production process.

Production of wheat: Input-Land, water, fertilizer, workers and machinery. Output-wheat.

There is only one maximum output obtained from given combination.

In short period factors such as plant, machinery etc can not be changed.

In long period all factors can be changed

Returns of scales 1) Increasing Return, 2) Constant Return, 3) Diminishing Return

Concept of production function

LAW OF VARIABLE PROPORTION

The law of variable proportion is the modern version of

the law of diminishing returns.

The law states how the amount of output changes as the

amount of one of the inputs is varied, keeping other

inputs as fixed.

This law states a technical relationship between the

fixed and variable factors of production in the short run.

It is assumed that only one factor of production is

variable factor while other factors are assumed to

remain fixed.

ASSUMPTIONS OF THE LAW

The rate of technology remains constant

Only one factor of input is variable and other factors

are kept constant

All units of the variable factors are homogeneous

It is possible to change the proportion of the factors

of production

The law assumes a short run situation

The product is measured in physical units

ILLUSTRATION

Amt. of land (in

Units)

Amt. of labour

Total Production

Average Production

Marginal Production

5 1 20 20 20

5 2 60 30 40

5 3 120 40 60

5 4 160 40 40

5 5 190 38 30

5 6 216 36 26

5 7 224 32 8

5 8 224 28 0

5 9 216 24 -8

RESULT OF APPLICATION OF LAW

The marginal product is greater than average product when average product is rising.

Marginal product equals average product when average product is at maximum

Marginal product is less than average product when average product is falling

When marginal product is zero, the total product is highest

Only when the marginal product becomes negative, the total output begins negative, the total output begins to fall

LAW OF VARIABLE PROPORTION-STAGES

B C

A

D TPC

E

APC

M N MPC

Stage II

Prod

ucts

Units of variable Inputs

Three Stages

Stage I: Increasing

Stage II: Diminishing

Stage III: Negative

First Stage

• Total production rises from zero at an increasing rate up to point ‘A’ • Beyond ‘A’ total product continues to rise but at a decreasing rate

• Marginal production falls beyond ‘A’ but still it is positive at this point marginal

production is at maximum

• The maximum point of the average product curve is ‘E’ at this point the marginal

productivity curve intersects the average productivity curve

• The first stage of the law is up to the point ‘A’ • Stage first refers as increasing stage where the total product, average product and

marginal product are increasing

Second Stage

• In this stage the total product continues to increase but at a diminishing rate

until it reaches the highest point ‘C’ • Here second stage ends because total products will not increase further

• In this stage average product and marginal product are decreasing but both

are positive

• When total product achieves its highest level at ‘C’, marginal product falls at

zero.

Second Stage

• In this stage total product declines and therefore, the TP curve slopes downward

• The average product decreases still further

• Marginal product falls faster than average product

• The marginal product becomes negative going down the ‘X’ axis.

Importance of the law

• Industries • Agriculture

• Relative prices paid to the factors of production

• Nature and methods of production

• Analysis of situation of underdeveloped countries

• Adoption of labour intensive or capital intensive technology • Suggest best technology for developed as well as under developed

countries

LAWS OF RETURN TO SCALE

In the long run all factors of production are variable.

No factor is fixed. Accordingly, the scale of

production can be changed by changing the quantity

of all factors of production.

“Returns to scale relates to the behaviour of total

output as all inputs are varied and is a long run

concept”

Increasing Return: In the long run, output can be

increased by increasing all factors in the same

proportion. Generally, laws of returns to scale refer

to an increase in output due to increase in all factors

in the same proportion. Such an increase is called

increasing returns to scale

Increasing returns to scale or diminishing cost refers to a situation

when all factors of production are

increased, output increases at a

higher rate. It means if all inputs

are doubled, output will also increase at the faster rate than

double. Hence, it is said to be

increasing returns to scale. This

increase is due to many reasons like

division external economies of scale.

Diminishing Return:

Diminishing returns or increasing

costs refer to that production

situation, where if all the factors of

production are increased in a given

proportion, output increases in a

smaller proportion. It means, if

inputs are doubled, output will be

less than doubled. If 20 percent

increase in labour and capital is

followed by 10 percent increase in

output, then it is an instance of

diminishing returns to scale.

The main cause of the operation of

diminishing returns to scale is that

internal and external economies are

less than internal and external

diseconomies.

Constant Return:

Constant returns to scale or constant

cost refers to the production

situation in which output increases

exactly in the same proportion in

which factors of production are

increased. In simple terms, if factors

of production are doubled output will

also be doubled.

In this case internal and external

economies are exactly equal to

internal and external diseconomies.

This situation arises when after

reaching a certain level of

production, economies of scale are

balanced by diseconomies of scale.

ISO-QUANTS CURVE

Meaning of Iso-quant: Iso means equal and quant means quantity. So iso-quant means equal quantity. So iso-quant represents constant quantity of output.

A given quantity of output may be produced with different combinations of factors. Iso-quant curves are also known as Equal-product or Iso-product or Production Indifference curves. Since it is an extension of Indifference curve analysis from the theory of consumption to the theory of production.

“An Iso-quant curve may be defined as a curve showing the possible combinations of two variable factors that can be used to produce the same total product.” Peterson

Assumptions of the Iso-quant:

• There are only two factors of production i.e. labour and capital

• The two factors can be substitute to each other upto a certain limit

• The shape of the Iso-quants curve depends upon the extent of substitutability of the two inputs

• The technology is gives over a period should be constant

• Divisible Factor: Factors of production can be divided into small parts.

• Efficient Combinations: Under the given technique, factors of production can be used with maximum efficiency.

ISO-QUANTS CURVE: GRAPHICAL PRESENTATION

PROPERTIES OF ISO-QUANTS CURVE

1. Iso-Quants Curves Slope Downward from Left to Right:

This curve slope downward because

MRTS of labour for capital

diminishes. When we increase

labour, we have to decrease capital to produce a given level of output.

2. Iso-Quants are Convex to the Origin: Like indifference curves,

iso-quants are convex to the origin.

In order to understand this fact, we

have to understand the concept of

diminishing marginal rate of technical substitution (MRTS),

because convexity of an isoquant

implies that the MRTS diminishes

along the isoquant.

3. Two Iso-Product Curves Never Cut Each Other: As two indifference

curves cannot cut each other, two iso-

product curves cannot cut each other. In

Fig. 6, two Iso-product curves intersect

each other. Both curves IQ1 and IQ2 represent two levels of output. But they

intersect each other at point A. Then

combination A = B and combination A=

C. Therefore B must be equal to C. This

is absurd. B and C lie on two different iso-product curves. Therefore two curves

which represent two levels of output

cannot intersect each other.

4. Higher Iso-Product Curves Represent Higher Level of Output:

Units of labour have been taken on OX

axis while on OY, units of capital.

IQ1 represents an output level of 100

units whereas IQ2 represents 200 units of output.

5. Isoquants Need Not be Parallel to Each Other: It so happens because the

rate of substitution in different isoquant

schedules need not be necessarily equal.

Usually they are found different and,

therefore, isoquants may not be parallel as shown in Fig. 8. We may note that the

isoquants Iq1 and Iq2 are parallel but the

isoquants Iq3 and Iq4 are not parallel to

each other.

6. No Isoquant can Touch Either Axis: If an isoquant touches X-axis, it

would mean that the product is being

produced with the help of labour alone

without using capital at all. These

logical absurdities for OL units of labour alone are unable to produce anything.

Similarly, OC units of capital alone

cannot produce anything without the

use of labour. Therefore as seen in

figure 9, IQ and IQ1 cannot be isoquants.

7. Each Isoquant is Oval-Shaped: It

means that at some point it begins to

recede from each axis. This shape is a

consequence of the fact that if a producer

uses more of capital or more of labour or

more of both than is necessary, the total

product will eventually decline. The firm

will produce only in those segments of

the isoquants which are convex to the

origin and lie between the ridge lines.

This is the economic region of production. In Figure 10, oval shaped isoquants are

shown.

Principle of Marginal Rate of Technical Substitution: The principle of marginal rate of

technical substitution (MRTS or MRS) is based on

the production function where two factors can be

substituted in variable proportions in such a way

as to produce a constant level of output.

Difference between Indifference Curve and Iso-Quant Curve:

1. Iso-quant curve expresses the quantity of output. Each curve refers to

given quantity of output while an indifference curve to the quantity of

satisfaction. It simply tells that the combinations on a given

indifference curve yield more satisfaction than the combination on a lower indifference curve of production.

2. Iso-quant curve represents the combinations of the factors whereas

indifference curve represents the combinations of the goods.

3. Iso-quant curve gives information regarding the economic and

uneconomic region of production. Indifference curve provides no

information regarding the economic and uneconomic region of

consumption.

4. Slope of an iso-quant curve is influenced by the technical possibility of

substitution between factors of production. It depends on marginal

rate of technical substitution (MRTS) whereas slope of an indifference

curve depends on marginal rate of substitution (MRS) between two

commodities consumed by the consumer.

Unit: 5 Theory of Costs

Introduction

Decision of production depends on:

Demand for goods

Cost of production (If the prices of input are known, cost of production can be

calculated)

Relationship Between cost and output is known as cost function.

Cost functions are derived from production functions.

Kinds of Production Cost

1) Money cost: Money spent on production (Raw material, wages, machinery, depreciation, interest, advertisement, insurance, taxes, profit to owner)

2) Real Cost: The pains and sacrifices involved in producing a commodity

3) Explicit Cost: Costs which are actually paid by the firm (Money cost)

4) Implicit Cost: Value of entrepreneurs own resources (his labour, building and money)

5) Opportunity cost: Factors of production are scares and have alternative uses. So using factors of production in best alternative is known as opportunity cost.

Importance of Opportunity Cost

Determination of relative prices of different goods

To fix the price of a factor (i.e. Retaining Labour)

Useful in allocating the resources effectively.

(i.e. One person can produce one table or three chairs in a

day. Cost of table is 400 and Chair is 200)

Limitations of opportunity cost

1) If not possible to put in alternative uses

2) Factor may be reluctant to move to alternative occupation

3) Assumption of perfect competition

4) Alternatives are not clearly known

Fixed Cost

Fixed cost includes

Salaries and other expenses of permanent office staff Salaries of permanent staff of production department Standard depreciation Rent and maintenance of land and building Charges of fixed capital

Variable Cost

Variable cost includes

Cost incurred on the variable factors are called variable costs. Out put and total variable costs move in the same direction Raw material cost Cost of direct labour Other direct expenses such as on fuel, carraige of raw materials

Total Cost = Total Fixed Cost + Total Variable Cost

Total Cost

Average Cost

The Average Cost is the per unit cost of production obtained by dividing

the total cost (TC) by the total output (Q). By per unit cost of production,

we mean that all the fixed and variable cost is taken into the

consideration for calculating the average cost. Thus, it is also called

as Per Unit Total Cost.

The marginal cost of production is the change in total cost that

comes from making or producing one additional item.

Marginal Cost

Short Run Cost Curves

Output (In Units) TFC (Rs) TVC (Rs.) TC (Rs.)

0 3000 0 3000

1 3000 3000 6000

2 3000 4000 7000

3 3000 4500 7500

4 3000 4800 7800

5 3000 5000 8000

Total cost and variable cost changes directly with the change in output

Short Run Average Cost Curves

Output TFC TVC TC MC AFC AVC ATC

0 3000 0 3000 0 0 0 0

1 3000 3000 6000 3000 3000 3000 6000

2 3000 4000 7000 1000 1500 2000 3500

3 3000 4500 7500 500 1000 1500 2500

4 3000 4800 7800 300 750 1200 1950

5 3000 5000 8000 200 600 1000 1600

6 3000 6000 9000 1000 500 1000 1500

7 3000 7350 10350 1350 430 1050 1480

Short Run Cost Curves

Inverse ‘S’ shape

TC

TFC TVC

TVC

TFC

(A) (B) (C)

Co

st

Out Put Out Put

(A) TFC is

independent of the level of output

(B) Initially TVC increases at

diminishing rate but beyond a certain point it increases at increasing rate

(C) By adding TFC & TVC, the TC

curve is obtained. The vertical distance between TVC & TC curve is constant through

(D) The vertical distance

between TFC & TC represents

the TVC which increases with

an increase in out put

Average Fixed Cost Curve

AFC = TFC / Total Output

AFC

Co

st

Out Put

AFC slopes downward

Because total output increases

but total fixed cost remain stable

AFC will never touch OX axis as

AFC can never be zero

Average Variable Cost Curve

AVC = TVC / Total Output

AVC

Co

st

Out Put

AVC first declines and

afterwards rises

This is due to the operation of

the law of variable proportions

Average Total Cost Curve

ATC = TC / Total Output M

Co

st

Out Put

ATC declines over the range of output

for which both AEC & AVC declines

At point M, the ATC is at its minimum

and afterwards begins to increase

The level of output after which ATC

begins to rise is referred to as

capacity level of output

Y

X

Marginal Cost Curve

Marginal Cost Curve

M

ATC

Co

st

Out Put

Marginal Cost is additional cost incurred in producing an additional unit When firm increases its output, marginal cost will also be increased Marginal cost equals AVC at AVC’s Minimum point Marginal cost is independent of output MC= Change in total cost / Change in output

Long Run Cost Curves

LAC

SAC1 SAC3

E1 SAC2 E3

E2

0 M1 M2 M3

Co

st

Out Put

1) In the long run, all costs can vary

2) There are no fixed costs in the long run

3) LAC is envelope of various short run average cost curves

4) SAC1-Initial stage-High average cost

5) SAC2-Second stage-Average cost reduced

6) SAC3-Last stage-average cost increased

Long Run Marginal Cost Curves

SMC1 SMC3 LMC

A1 SMC2

A3

E1 A2 E3

E2

0 M1 M2 M3

Co

st

Out Put

1) In the long run, all

costs can vary

2) There are no fixed

costs in the long run

3) LMC is envelope of various short run

marginal cost curves

4) SMC1-Initial stage-

High average cost 5) SMC2-Second stage-

Average cost reduced

6) SMC3-Last stage-

average cost

increased

Long Run Marginal Cost Curves

SMC1 SMC3 LMC

A1 SMC2 LAC

SAC1 A3 SAC3

SAC2

E1 A2 E3

E2

0 M1 M2 M3

Co

st

Out Put

1) In the long run, all costs can vary

2) There are no fixed costs in the long run

3) LMC is envelope of various short run marginal cost curves

4) SMC1-Initial stage-High average cost

5) SMC2-Second stage-Average cost reduced

6) SMC3-Last stage-average cost increased