Economic for Managers E-book

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Economics

for

Managers

Amity Directorate of

Distance & Online

Education

Economics is essentially the study of logic, tools and techniques of

making optimum use of the available resources to achieve the ends.

Economics thus provides analytical tools and techniques that managers

need to achieve the goals of the organization they manage. Therefore, a

working knowledge of economics, not necessarily a formal degree, is

essential for mangers. Managers are essentially practicing economists.

MBA 2yrs

Semester -I

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C O N T EN T S

Module 1: Introduction To Economic Analysis

1.1. Objectives 1.2. Introduction

1.3. Nature and scope of and its relationship with other disciplines 1.4. Scarcity and Efficiency

1.5. Basic Concepts and Principles of Micro-economic analysis 1.5.1. Marginalism

1.5.2. Opportunity Cost

1.5.3. Discounting Time Perspective 1.5.4. Risk and Uncertainty

1.6. Summary

1.7. Check Your Progress 1.8. Questions and Exercises 1.9. Further Readings Module 2: 2.1. Objectives 2.2. Introduction 2.3. Demand Function 2.4. Determinants of demand 2.5. Law of Demand

2.6. Exceptions to the Law of Demand

2.7. Shift of Demand v/s Expansion or Contraction of Demand 2.8. Demand Elasticity

2.9. Types of Elasticity

2.10. Methods of measuring elasticity and its significance 2.11. Demand Forecasting

2.12. Supply Function

2.13. Factors affecting Supply 2.14. Elasticity of Supply 2.15. Budget Constraint

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2.16. Indifference Curves Analysis

2.17. Consumer Equilibrium and Consumer Surplus 2.18. Summary

2.19. Check Your Progress 2.20. Questions and Exercises 2.21. Further Readings

Module 3: Cost and Production Analysis

3.3. Production Functions

3.4. Law of Variable Proportion or Law of Diminishing Returns to Factors. 3.5. Difference between Returns to a Factor and Returns to Scale 3.6. Isoquants

3.7. Isocost Line or Equal Cost Line 3.8. Marginal Rate of Technical Substitution

3.9. Choices of Input Combination (Optimal Input combination) 3.10. Theory of Cost

3.11. Cost Functions 3.12. Various types of Costs

3.13. Relationship between AC and MC 3.14. Long and Short Run Cost Curves

3.15. Cost and Output Relationship (Cost Function) 3.16. Short Run and Long Run

3.17. Economies / Dis-economies of Scale

3.18. The Theory of firm (Profit Maximization Model) 3.19. Break-even and Shut-down Point

3.20. Managerial Theories of the Firm 3.21. Baumol’s Model

3.22. Marris Model. 3.23. Summary

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3.25. Questions and Exercises 3.26. Further Readings

Module 4: Market Structure Analysis

4.1. Objectives

4.2. Introduction: - Perfect Competition

4.2.1. Assumptions of perfect competition: 4.2.2. Short run equilibrium

4.2.3. Long Run Equilibrium 4.3. Monopoly: – Price Discrimination

4.3.1. Monopoly

4.3.2. Price and Quantity Determination in Short Run 4.3.2.1. Supernormal Profit

4.3.2.2. Normal Profit

4.3.2.3. Subnormal Profit or Loss

4.3.3. Price and Quantity Determination in Long Run 4.3.4. Price Discrimination

4.4. Monopolistic Competition

4.5. Oligopoly-Mutual Interdependence 4.5.1. Non-collusive Oligopoly

4.5.2. Sweezy’s Model of Kinked Demand Curve 4.5.3. Collusive Oligopoly

4.5.4. Price Leadership 4.6. Prisoner’s Dilemma 4.7. Summary

Module 5: Capital Budgeting and Risk and Uncertainty Analysis

5.1 Objectives 5.2 Introduction

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5.3.1 Project valuation

Managerial Economics

NOTES

5.3.2 Capital Budgeting Techniques

5.4 Risk and Investment Analysis- Decision Tree Analysis 5.5 Concept of Behavioral Economics

5.6 Summary

5.7 Check Your Progress 5.8 Questions and Exercises 5.9 Further Readings

Module 6: Macro-economics Analysis

6.1. Objectives 6.2 Introduction

6.3. Basic Concept – Circular Flow of Income and Money 6.4. National Income and Keynesian Model

6.5. Saving and Consumption Function 6.6. Investment Multiplier

6.7. Inflation

6.8. Monetary and Fiscal Policies

6.9. International Economics – Fixed and Flexible Exchange Rates 6.10. Spot and forward Exchange Rates

6.11. Current and Capital Account Convertibility – a case study of India. 6.12. Summary

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UNIT 1 Introduction To

Economic Analysis

STRUCTURE

1.3. Nature and scope of and its relationship with other disciplines 1.4. Scarcity and Efficiency

1.5. Basic Concepts and Principles of Micro-economic analysis 1.5.1. Marginalism

1.5.2. Opportunity Cost

1.5.3. Discounting Time Perspective 1.5.4. Risk and Uncertainty

1.6. Summary

NOTES

1.1 OBJECTIVES

The primary purpose of this chapter is to define and explain the scope of economics and the methodology economists’ use in solving problems. A unique feature of this chapter is that it explains the economic way of thinking and shows the student how to apply the tools of economic thinking to everyday decisions. Graphs are used consistently in this module, so the student will need a good knowledge of how a graph is constructed and how to interpret its lines. It would be best to follow the examples in the appendix so that the student has both the text and class notes to review. Stress that the concept of scarcity is a key element in all economic analysis and a link to the rest of the course.

Key Terms

Scarcity, resources, land, labor, capital, opportunity costs, marginalism, risk and uncertainty, discounting time perspective

1.2 INTRODUCTION

Economics is essentially the study of logic, tools and techniques of making optimum use of the available resources to achieve the ends. Economics thus provides analytical tools and techniques that managers need to achieve the goals of the organization they manage. Therefore, a working knowledge of economics, not necessarily a formal degree, is essential for mangers. Managers are essentially practicing economists.

In performing his functions, a manager has to take a number of decisions in conformity with the goals of the firm. Many business decisions are taken under the condition of uncertainty and risk. Uncertainty and risk arise mainly due to uncertain behavior of the market forces, changing business environment, emergence of complexity of the modern business world and social and political, external influence on the domestic market and

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social and political changes in the country. The complexity of the modern business world

NOTES

adds complexity to business decision-making. However, the degree of uncertainty and risk can be greatly reduced if market conditions are predicted with a high degree of reality. The prediction of the future course of business environment alone is not sufficient. It is important equally to take appropriate business decisions and to formulate a business strategy in conformity with the goals of the firm.

1.3. NATURE AND SCOPE OF AND ITS RELATIONSHIP WITH

OTHER DISCIPLINES

Taking appropriate business decisions requires a clear understanding of the technical and environmental conditions under which business decisions are taken. Application of economic theories to explain and analyze the technical conditions and the business environment contributes a good deal to the rational decision-making process. Economic theories have, therefore, gained a wide range of application in the analysis of practical problems of business. With the growing complexity of business environment, the usefulness of economic theory as a tool of analysis and its contribution to the process of decision- making has been widely recognized.

Baumol has pointed out three main contributions of economic theory to business economics. First, ‘one of the most important things which the economic (theories) can contribute to the management science’ is building analytical models, which help to recognize the structure of managerial problems, eliminate the minor details, which might obstruct decision- making and help to concentrate on the main issue. Secondly, economic theory contributes to the business analysis ‘a set of analytical methods’ which may not be applied directly to specific business problems, but they do enhance the analytical capabilities of the business analyst. Thirdly, economic theories offer clarity to the various concepts used in business analysis, which enables the managers to avoid conceptual pitfalls.

Scope of

The problems in business decision-making and forward planning can be grouped into four categories as follows:

z Problems of Resource Allocation: Source resources are to be used with utmost

efficiency to get the optimal results. These include production programming and problems of transportation, etc.

z Inventory and Queuing Problems: Inventory problems involve decisions about holding

of optimal levels of stocks of raw materials and finished goods over a period. These decisions have to be taken by considering demand and supply conditions. Queuing problems involve decisions about installation of additional machines or not hiring labor, against the cost of such machines or labor.

z Pricing Problems: Fixing prices for the products of the firm are important decision-

making problems. Pricing problems involve decisions regarding various methods of pricing to be followed.

z Investment Problems: It is related of allocating resources over time. These normally

relate to: investing new plants, how much to invest, expansion programs for the future, sources of funds, etc.

(ME) seeks solutions to these problems. So, there is a wide spectrum of topics that fall under ME and they are as follows:

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1. Profit Analysis. 2. Cost Analysis

3. Production Possibility Chart 4. Pricing theory and policies 5. Demand Analysis 6. Market penetration studies 7. Economic Forecasting 8. Sales Forecasting

9. Marginal analysis 10. Break-even analysis 11. Competitive market studies 12. Anti-Trust issues

13. Plant location studies 14. Mergers and Acquisitions 15. Labor cost studies 16. Inventory problem

17. Investment analysis 18. Capital Budgeting 19. Cost of Capital 20. Government regulations

NOTES

Out of the above lists, there are some major areas, which are very much important for management, they are as follows:

z Demand analysis and forecasting, z Production and cost,

z Competition,

z Pricing and output, and

z Investment and capital budgeting.

1.4. SCARCITY AND EFFICIENCY

Economics is the study of how economic agents or societies choose to use scarce productive resources that have alternative uses to satisfy wants which are unlimited and of varying degrees of importance. The main concern of economics is economic problem: its identification, description, explanation and solution. The source of any economic problem is scarcity. Scarcity of resources forces economic agents to choose among alternatives. Therefore, economic problem can be said to be a problem of choice and valuation of alternatives. The problem of choice arises because limited resources with alternative uses are to be utilized to satisfy unlimited wants, which are of varying degrees of importance. Scarcity is a relative concept. It can be define as excess demand, i.e., demand more than the supply. For example, unemployment is essentially the scarcity of jobs. Inflation is essentially scarcity of goods.

The job of any efficient manager is of economic one. Decision-making is the main job of management. Decision-making involves evaluating various alternatives and choosing the best among them. For example, a marketing manager is to allocate his / her advertising budget among various media in such a way so as to maximize the reach.

1.5. BASIC CONCEPTS AND PRINCIPLES OF MICRO-ECONOMIC

ANALYSIS

deals with firms, more especially with the environment in which firms operate, the decisions they take and the effects of such decisions on themselves and their stakeholders like customers, competitors, employees and the society in which they operate. The key economic concepts and principles that constitute the broad framework of are explained here.

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NOTES

1.5.1. Marginalism

The root cause of all economic problems is scarcity. So, all should be careful about the utilization of each and every additional unit of resources. In order to decide whether to use an additional unit of resource you need to know the additional output expected there from. Economists use the term marginal for such additional magnitude of output. Marginalism concept will help to know the additional output expected from an additional unit of resource. Therefore, marginal output of labour is the output produced by the last unit of labour.

1.5.2. Opportunity Cost

Economic decision is choosing the best alternative among available alternatives. Before choosing best alternative you rank them all based on their priority and probable return. This choice implies sacrificing the other alternatives. The cost of this choice can be evaluated in terms of the sacrificed alternatives. If the best alternative was not chosen then you could have chosen the second best alternative. So, the cost of this particular best choice is the benefit of the next best alternative foregone. This is called Opportunity Cost.

1.5.3. Discounting Time Perspective

Discounting principle refers to time value of money, i.e., the fact that the value of money depreciates with time. The core discounting principle is that a rupee in hand today is worth more than a rupee received tomorrow. One rationale of discounting is uncertainty about tomorrow, i.e., future. Even if there is no uncertainty, it is necessary to discount future rupee to make it equivalent to current day rupee. In business situations, most of the decisions relate to outflow and inflow of money and resources that take place at different point of time. Most outflows normally occur in the current period, whereas inflows occur only in future, therefore, in order to take the right decision it is necessary to “discount” future inflows to their present value level. The simple formula for discounting is:

PVF = 1 / (1+rn₎

Where PVF = present value of fund, n= period (year, etc.) and r = rate of discount.

1.5.4. Risk and Uncertainty

The uncertainty is due to unpredictable changes in the business cycle, structure of the economy and government policies. This means that the management must assume the risk of making decisions for their organizations in uncertain and unknown economic conditions in the future. Firms may be uncertain about production, market-prices, strategies of rivals, etc. Under uncertain situation, the consequences of an action are not known immediately for certain. Economic theory generally assumes that the firm has perfect knowledge of its costs and demand relationships and its environment. Uncertainty is not allowed to affect the decisions. Uncertainty arises because producers simply cannot foresee the dynamic changes in the economy and hence, cost and revenue data of their firms with reasonable accuracy. Dynamic changes are external to the firm and they are beyond the control of the firm. The result is that the risk from unexpected changes in a firm’s cost and revenue cannot be estimated and therefore the risk from such changes cannot be insured. The managerial economists have tried to take account of uncertainty with the help of subjective probability. The probabilistic treatment of uncertainty requires formulation of definite subjective expectations about cost, revenue and the environment.

1.6. SUMMARY

The can be viewed as an application of that part of microeconomics that focuses on such topics as risk, demand, production, cost, pricing and market structure.

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Understanding these principles will help to develop a rational decision-making perspective and will sharpen the analytical framework that the managers must bring to bear on managerial decisions.

CHECK YOUR PROGRESS

1. Uncertainty and risk arise mainly due to (a) Uncertain behavior of the market forces, (b) Changing business environment,

(c) Emergence of complexity of the modern business world and social and political, external influence on the domestic market and social and political changes in the country,

(d) All above

2. Source resources are to be used with utmost efficiency to get

NOTES

3.

(a) The optimal results, (c) The Normal results,

The root cause of all economic problems is

(b) (d)

The Sub-optimal results, All the above.

4.

(a) Over-population, (c) Capital

Discounting principle refers to

(b) (d)

Scarcity,

Poor management

(a) Time value of interest, (c) Time value of investment,

(b) (d)

Time value of money, Time value of capital.

Questions and Exercises

1.1. “ is an integration of economic theory, decision science and business management.” Comment.

1.2. “Economics is a science of choice when faced with unlimited ends and scarce resources having alternative uses.” Comment.

1.3. “ uses the theories of economics and the methodologies of the decision sciences for managerial decision-making.” Elaborate.

1.4. Discuss the salient features and significance of .

1.5. Highlight the role and responsibilities of a business / managerial economist. 1.6. Write short notes on the followings:

1.6.1. The Nature of .

1.6.2. Functions of Managerial Economist. 1.6.3. Decision Making under Uncertainty. 1.6.4. Opportunity Cost.

1.6.5. Marginal Analysis. 1.6.6. Discounting Principles

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NOTES

Fundamental Questions

1. What is economics? 2. What are opportunity costs?

3. How are specialization and opportunity costs related? 4. What is Marginalism?

5. What is Risk and Uncertainty?

6. What is Discounting Time Perspective? Skill Development

i) Prepare a mini case study of a business expansion strategy of a Laptop dealer in your area.

ii) Prepare a hypothetical case study for an automobile firm in India to deal with would be problem of launching of small cars like NANO.

UNIT 2 Consumer Behavior

STRUCTURE

2.1. Objectives 2.2. Introduction 2.3. Demand Function 2.4. Determinants of demand 2.5. Law of Demand

2.6. Exceptions to the Law of Demand

2.7. Shift of Demand v/s Expansion or Contraction of Demand 2.8. Demand Elasticity

2.9. Types of Elasticity

2.10. Methods of measuring elasticity and its significance 2.11. Demand Forecasting

2.12. Supply Function

2.13. Factors affecting Supply 2.14. Elasticity of Supply 2.15. Budget Constraint

2.16. Indifference Curves Analysis

2.17. Consumer Equilibrium and Consumer Surplus 2.18. Summary

NOTES

2.1. OBJECTIVES

The objective of this chapter is to define and analysis of . The chapter also focuses on the Demand Function, Determinant of Demand, Law of Demand and Exceptions, Elasticities of Demand and their Measurements, Demand Forecasting Methods, Supply Function, Elasticities of Supply, Indifference Curve Analysis, Consumer Equilibrium and Consumer Surplus. Graphs are used consistently in this chapter for understanding the subject matter easily.

Key Terms

Demand, Demand Function, Determinant of Demand, Law of Demand, Elasticity, Demand Forecasting Methods, Supply, Supply Function, Indifference Curve, Consumer Equilibrium and Consumer Surplus.

2.2. INTRODUCTION

The amount of good that a consumer is willing to buy and able to purchase over a period of time, at a certain price is known as the quantity demanded of that good. The quantity desired to be purchased may be different from the quantity of good actually bought by the consumer. Quantity demanded is a flow concept, so the relevant time dimension has to be mentioned which will indicate the quantity demanded per unit of time.

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2.3. DEMAND FUNCTION

Demand is a relationship between the price and the quantity demanded, other things remaining the same. If X denotes the quantity demanded and P its price per unit of the

NOTES

good, then other things remaining constant, the demand function is; X = f (P ),

Which shows that quantity demanded depends on the price. This means that any change in price will result in a corresponding change in the quantity demanded.

2.4. DETERMINANTS OF DEMAND

The determinants of demand for a product and the nature of relationship between demand and its determinants are very important factors for analyzing and estimating demand for the product. The most important determinants are as follows:

1. Price of the product.

2. Price of the related goods Complements and Supplements. 3. Level of consumers’ income.

4. Customers’ taste and preference. 5. Advertisement of the product.

6. Consumers’ expectations about future price and Supply position. 7. Demonstration effect and ‘Band-Wagon’ effect.

8. Consumer-credit facility.

9. Population of the country (Goods for mass consumption). 10. Distribution pattern of the National Income.

2.5. LAW OF DEMAND

The law of demand states that other things being constant, price and quantity demanded have an inverse relationship; i.e. as price of a product increases quantity demanded decreases and vice versa. This law states that there is an inverse relationship between price and quantity demanded, as price increases, quantity demanded will decrease. The law of demand can be explained in terms of substitution and income effects resulting from price changes. The substitution effect reflects changing opportunity costs. When price of good increases, its opportunity cost in terms of other goods is also increases. Consequently, consumers may substitute other goods for the good that has become more expensive.

2.6. EXCEPTIONS TO THE LAW OF DEMAND

Though normally law of demand applies to all situations, but there are few cases where the law does not hold goods, therefore these are regarded as exceptions to the law. These are the goods which are demanded less at low price and more at high price. Let us discuss some such exceptions here.

Giffen goods: the case of Giffen Goods needs a little bit of story telling! In early Ireland it was observed that the poor population consumed two goods: meat (which was costly) and bread (which was cheap). A very strange phenomenon was observed when the price of the bread was increased, it made a large drain on the resources of the poor people and raised their marginal utility of money to such an extent that they were forced to curtail

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there consumption of meat and buy more of bread, which was still the cheapest food. This implied that quantity demand of bread (an inferior good) increased with the increase in its price. Sir Robert Giffin, an economist, was the first to give an explanation to this situation. Hence such goods which display direct price demand relationship are called Giffin Goods. These goods are considered inferior by the consumer, but they occupy a significant place in the individual’s consumption basket. It so happens that people in this case, with the rise of price of this good (say rice), are forced to reduce their purchase of other expensive goods (say, chicken) and increase the purchase of that good (rice) in larger quantity to supplement the reduction in luxury food item (chicken). These goods categorically are those on which major portion of consumer’s income is spent, hence they are termed as inferior.

Snob Appeal: opposite to Giffen Goods, there are certain goods which have snob value, for which the consumer measures the satisfaction derived from there commodities not by their utility value, but by their social status. The consumer of this particular commodity wants to show it off to others, and as a result they buy less of it at lower prices and more at higher prices. Thus in this case, price and quantity move in the same direction. Diamond or antique works of art, latest model of mobile phones, sports cars, and designer clothes are example of such goods. Higher is the price of diamond, higher is the snob value attached to it and higher is its demand. These goods are sometimes also known as Vevlen Goods after the economist Thorstein Vevlen.

NOTES

2.7. SHIFT OF DEMAND V/S EXPANSION OR CONTRACTION OF

DEMAND

Demand curve shows the relationship between price of a commodity and demand at that price, ceteris paribus. If the price changes, the demand will also change along the same demand curve. Thus movement along the same demand curve is known as a contraction or expansion in quantity demanded, which occurs due to rise or fall in price of the commodity.

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NOTES

When price of a good remain the same but any one of the other determinants changed then we will get a new demand curve. So, when demand increases without any change in price of that good, the demand curve will shift to the right and with a reduction in demand, the demand curve will shift to the left.

2.8 DEMAND ELASTICITY

Law of demand gives us the direction of change in demand if the price of the product changes. But this information is not of much practical use since we know only the direction of change in the demand for a given change in the price. For decision making, we need the magnitude of this demand and elasticity of demand can gives this changes. The elasticity of demand helps to understand the extent to which the quantity demanded will rise (fall) due to fall (rise) in the price of the same good or a related good or due to rise (fall) in the income of the consumer. This involves an analysis of demand sensitivity with respect to prices of goods and income which helps the business to forecast market trends for the future.

2.9 TYPES OF ELASTICITY

There are many types of elasticity but the main and important types are as follows. i) Price elasticity of demand ii) Income Elasticity of Demand iii) The Cross-price Elasticity of demand iv) Advertising Elasticity of Demand

2.10METHODS OF MEASURING ELASTICITY AND ITS

SIGNIFICANCE

There are many types of elasticity of demand like determinants. But here we will discuss the most important three elasticity a) Price Elasticity of Demand, b) Income Elasticity of Demand, c) Cross-price Elasticity of Demand d) Advertising Elasticity of Demand.

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Price elasticity of demand (ep)

ep = percentage change in quantity demanded resulting from one percent change in the price of the good, other things remaining constant.

ep =

percentage change in quantity demanded percentage change in price

NOTES

Percentage change in quantity demanded = [change in quantity demanded / original quantity demanded] * 100

Percentage change in price = [change in price / original price] *100 Combining the above two, we have,

ep =

change in quantity demanded/original quantity demanded change in price/original price

= [

œ

Q /

œ

P] * [P / Q], Where,

œ

Q = Infinitesimal change in quantity,

œ

P = Infinitesimal change in price,

P = original price and Q = original quantity demanded of the good.

Some important concepts

z Perfectly elastic demand: A very small amount of change in the price will result in a

change in the quantity demanded to the extent of infinity. Ep = •

z Perfectly inelastic demand: A change in price, however large it may be, causes no

change in quantity demanded. Ep = 0.

z Unit elasticity of demand: When a given change in the price causes an equally pro-

portionate change in the quantity demanded the value of price elasticity of demand id unitary. Ep = 1.

z Relatively elastic demand: Here a change in the price results in more than proportion-

ate change in the quantity demanded. Ep > 1.

z Relatively inelastic demand: Here a change in the price results in less than propor-

tionate change in the quantity demanded. Ep < 1.

Unitary Elastic % ÄQ = % ÄP Ep = 1.

Relatively Elastic % ÄQ > % ÄP Ep > 1.

Perfectly Elastic % ÄP = 0 Ep = “.

Relatively Elastic % ÄQ < % ÄP Ep < 1.

Perfectly Inelastic % ÄQ = 0 Ep = 0.

Income Elasticity of Demand

It is defined as the proportionate change in the quantity demanded resulting from a proportionate change in income.

Ey = [œQ / Q] / [œY / Y] = [œQ / œY] * [Y / Q]

It is clear that the sign of the elasticity depends on the sign of the derivative KQ / KY as both of the expressions Q and Y are positive, i.e., Q>0 & Y>0. The income elasticity is

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NOTES

positive for normal goods. A commodity is considered to be a ‘luxury’ if its income elasticity is greater than unity. A commodity is considered to be a ‘necessity’ if its income elasticity is less than unity.

The main determinants of income elasticity are:

1. The nature of the need that the commodity covers: the percentage of income spent on food declines as income increases.

2. The initial level of income of a country: for example, a TV set is a ‘luxury’ in an underdeveloped and poor country, while it is a ‘necessity’ in a country with high per- capita income.

3. The time period: consumption patterns adjust with a time lag to changes in income.

The Cross-price Elasticity of demand

The cross-price elasticity of demand is defined as the proportionate change in the quantity demanded of product i resulting from a proportionate change in the price of the product j. Symbolically the cross-price elasticity is:

Ecij = [Percentage change in the quantity demanded of the ith good / Percentage change in the price of the jth good]

= [(œQi / Qi)*100] / [(œPj / Pj)*100] = [œQi / œPj] * [Pj / Qi],

As price and quantity values cannot be negative terms, the sign of the cross price elasticity is determined by the sign of the derivative œQi / œPj.

The sign of cross price elasticity is negative if i and j are complementary goods, and is positive if i and j are substitute goods. The higher the value of the cross-price elasticity the stronger will be the degree of substitutability or complementarities of i and j. The main determinant of the cross elasticity is the nature of the commodities relative to their uses. If two commodities can satisfy equally well the same need, the cross elasticity is high and vice versa.

Advertising Elasticity of Demand

It is defined as the rate of change in the quantity demanded of a good due to change in the advertisement expenditure of the product.

Ey = [œQ/Q] / [œADexp/ADexp] = [œQ/KADexp] * [ADexp/Q]

It measures the response of quantity demanded to change in the expenditure on advertisement. It has been seen that some goods are more responsive to advertising, i.e., cosmetics.

2.11. DEMAND FORECASTING

There are so many methods for forecasting demand. Here we will discuss the main methods. Broadly they are divided into two groups:

1. Survey Methods. 2. Statistical Methods.

1. Survey Methods.

Survey methods are generally used where the purpose is to make short-run forecast of demand. Under the survey methods there are two types of survey: I) Consumer Survey Methods – Direct Interviews, and ii) Opinion Poll Methods

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i) Consumer Survey Methods – Direct Interviews

The customer survey method of demand forecasting involves of the potential consumers. It may be in the form of:

a) Complete enumeration, b) Sample survey,

c) End-use method.

a) Complete enumeration method

By this method, almost all potential users of the product are contacted and are asked about their plan of purchasing the product in question. The quantities indicated by the consumers are added together to obtain the probable demand for the product. The main limitation of this method is that it can be used successfully only in case of those products whose consumers are concentrated in a certain region or locality.

b) Sample survey

In this method, only a few potential consumers and users selected from the relevant market through a sampling method are surveyed. Method of survey may be direct interview or mailed questionnaire to the sample-consumers. This method is generally used to estimate short-term demand from business firm, government department and agencies and also by the households who plan their future purchases.

c) End-use method

This method of demand forecasting has a considerable theoretical and practical value, especially in forecasting demand for inputs. This method requires building up a schedule of probable aggregate future demand for inputs by consuming industries and various other sectors. This method has two exclusive advantages. First, it is possible to work out the future demand for an industrial product in considerable details by types and size. Second, in forecasting demand by this method, it is possible to trace and pinpoint at any time in future as to where and why the actual consumption has deviated from the estimated demand.

ii) Opinion Poll Methods

The opinion poll methods aim at collecting opinions of those who are suppose to possess knowledge of the market, i.e., sales representatives, professional marketing experts and consultants. This method includes;

a) Expert-opinion method. b) Delphi Method.

c) Market studies and experiments. a) Expert-opinion method

The estimates of demand can obtain from different regions are added up to get the overall probable demand for a product. The firms are not having this facility; gather similar information about the demand for their products through the professional markets experts or consultants, who can, through their experience and expertise, predict the future demand. This is called opinion poll method.

b) Delphi Method

This method of demand forecasting is an extension of the simple expert opinion poll method. Under this method, the experts are provided information on estimates of forecasts of their experts along with the underlying assumptions. The experts may revise their own estimates in the light of forecasts constitutes the final forecast.

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NOTES

c) Market studies and experiments

It is an alternative method of collecting necessary information regarding demand is to carry out market studies and experiments on consumer’s behavior under actual, though controlled, market conditions. This method is known in common parlance as market experiment method.

2. Statistical Methods

This method is utilizes historical (time-series) and data for estimating long-term demand. This method is considered superior techniques of demand forecasting for the following reasons:

z In this method, the elements of subjectivity are minimum. z Method of estimation is scientific.

z Estimates are relatively more reliable. z It involves smaller cost.

Statistical methods of demand projection include the following techniques; 1. Trend Projection Methods.

2. Barometric Methods. 3. Econometric Method.

2.12. SUPPLY FUNCTION

Supply of a good refers to the various quantities of the good which a seller is willing and able to sell at different prices in a given market, at a particular point of time, other things remaining the same. Supply is related to scarcity. It is only the scarce goods which have a supply price. On the other hand, goods which are available freely have no supply price, i.e., air is available freely and hence does not have supply price. The law of supply states that other things remaining the same, more of a good are supplied at a higher price and less of it is supplied at a lower price.

The law of supply takes into account only the most important determinant of supply, viz., the price of the good. So, the supply function is;

Sx = f(Px), other things remaining the same, where,

Sx = Amount of good X supplied, Px = Price of good X.

2.13. FACTORS AFFECTING SUPPLY

The followings are the major factors affecting the supply of the good;

i) Price of the Good. ii) Prices of other goods. iii) Prices of factors of Production. iv) State of Technology.

2.14. ELASTICITY OF SUPPLY

Price Elasticity of Supply refers to the percentage change in quantity supplied due to one percentage change in the price of that good.

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X, Y. X

= [œQs/Qs] / [œP/P] = [œQs/”P] * [P/Qs] Where,

Qs = Original quantity supplied, P = Original price, œQs = Change in quantity supplied,

œP = Change in price.

2.15. BUDGET CONSTRAINT

The consumer has a given income which sets limits to his maximizing behaviour. Income acts as a constraint in the attempt for maximizing utility. The income constraint, in the case of two commodities, may be as:

Y = P_XQ_X+ P_YQ_Y

The income constraint graphically present by the budget line, whose equation is derived as,

NOTES

1 PX

QY- Y- QX

-P Y P Y

Assigning successive values of Q we may find the corresponding values of Q Thus, if Q = 0 the consumer can buy Y/ P units of good y. Similarly, if Q_, _Y _Y= 0, the consumer can buy Y/ P_Xunits of good x.

2.16. INDIFFERENCE CURVES ANALYSIS

The consumer behaviour analysis was expanded to new horizons with the introduction of indifference curve analysis by J.R. Hicks and R.G.D. Allen. In this analysis, the utility is ordinally measurable. If we plot the quantities of two commodities on the two axes, then we get a set of points that would present alternative combination of the two commodities, between which the consumer would be indifferent. The curve joining such points is known as an indifference curve. So, indifference curve is the locus of points which show the different combinations of two commodities a consumer is indifferent about the points A or B or C or D.

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NOTES

2.17. CONSUMER EQUILIBRIUM AND CONSUMER SURPLUS

The consumer is in equilibrium when he maximizes his utility, given his income and market prices. Two conditions must be fulfilled for the consumer to be in equilibrium. The first condition is that the marginal rate of substitution be equal to the ratio of commodity prices

MUx Px

MRSx,y- =

MUy P y

This is a necessary but not sufficient condition for equilibrium. The second condition is that the indifference curves be convex to the origin. This condition is fulfilled by the axiom of diminishing MRS_x,y, which states that the slope of the indifference curve decreases as we move along the curve from left to right.

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1 1 1, 1 1.

At the point of tangency the slopes of the budget line and of the indifference curve are equal:

MUx Px

= MUy P y

Thus the first-order condition is denoted graphically by the point of tangency of the two relevant curves. The second-order condition is implied by the convex shape of the indifference curve. The consumer maximizes his utility by buying Xe and Ye amount of the two commodities.

The concept of consumer surplus was first introduced by Marshal. Consumer surplus is the difference between the price consumers are willing to pay and what they actually pay. The amount that the consumer is willing to pay for the first unit of good he buys is termed as consumers’ marginal value. The marginal value decreases as more and more units are bought. A consumer who maximizes marginal value will buy to that extent where marginal value equals price. A graphically presentation of consumer surplus is given below.

NOTES

AB is the demand curve of a consumer. The consumer is willing to pay a price of q p_{1 1}for q units of goods. For q units of goods he will be willing to pay q p₁ ₂ _{2 2.}And for Q, he will be willing to pay QN and so on. Now, suppose that the market price is OP, which the consumer can decide about the quantity of good he would like to demand. With the demand curve AB, he will demand OQ. Here, the consumer actually pays OP per unit of the good, but he was willing to pay more than OP for any unit to the left of Q. For the quantity q , the consumer is willing to pay q p but he actually pays q r Hence, the consumer surplus is (q p q r_{1 1 -} _{1 1) = 1 1.}r p In the same way for q_2,the consumer surplus is r p and for Q, it is zero. If_{2 2} the quantities are finally divisible, the total amount that the consumer is willing to pay is the area OANQ, whereas what he actually pays is the area OPNQ and the consumer’s surplus is the area APN.

2.18. SUMMARY

Demand refers to the number of units of a good or service that consumers are willing and able to buy at each price during a specified interval of time. Changes in demand can be caused by changes in tastes and preferences, income and prices of other goods and services also. Marginal revenue is the change in total revenue per unit change in demand.

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NOTES

Total revenue is increasing when marginal revenue is positive. Marginal revenue is zero at the maximum point of total revenue and total revenue is declining when marginal revenue is negative. Elasticity measures the responsiveness of demand to various factors. Price elasticity of demand is defined as the percentage change in quantity demanded per 1 percent change in price.

CHECK YOUR PROGRESS

1. Which of the following statements is true?

(a) When the supply increases, both the price and the quantity will increase, (b) When the supply increases, the supply curve shifts towards the left, (c) A shift in the supply curve towards the right results in a fall in the price, (d) A decrease in the quantity supplied results in shifting of the supply curve

towards the left.

2. Which of the following statements is false?

(a) An increase in tax will affect the customers more than the producers if the supply schedule is inelastic,

(b) An increase in tax will affect the customers more than the producers if the demand schedule is inelastic,

(c) Both (a) and (d) above,

(d) An increase in tax will affect the customers less than the producers if the demand schedule is inelastic.

3. For complementary goods, the cross elasticity of demand will be (a) Zero, (b) Infinity, (c) Positive but less than one, (d) Negative.

4. When the income elasticity of demand for a good is negative, the good is (a) Normal good, (b) Luxury good, (c) Inferior good, (d) Giffen good.

5. If both income and substitution-effects are strong, this region of the demand curve must be

(a) Relatively price elastic, (b) Relatively price inelastic, (c) Unit-elastic, (d) Perfectly inelastic.

Questions and Exercises

1. Explain the utility analysis for understanding consumer behaviour and demand. 2. What is the Law of Diminishing Marginal Utility? Explain law with empirical example. 3. State and explain the properties of Indifference Curve.

4. Explain the Law of Diminishing Marginal Rate of Substitutions. 5. State the law of demand with some exceptions.

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s d

6. “The law of demand is always applicable to marginal buyers and is usually applicable to intra-marginal buyers.” Comment.

7. Distinguished between substitutes and complements with examples. How does this distinction of goods help in business decision making?

8. If price of milk increases, what do you think will happen to the demand for cornflakes? 9. What are the factors that cause the demand curve to shift?

10. If the demand is fixed but supply of a product increases, what happens to equilibrium price and quantity?

NOTES

11. If the market demand curve is given by Q = 15 – 8P and the market supply curve Q = 2P, find the equilibrium price and quantity graphically and mathematically. 12. Why is it said that the market equilibrium is a highly unstable one?

13. Given the following demand and supply functions, find the equilibrium price and quantity in the market: Demand Q = 100 – P and Supply P = 10 + 2Q_d _s.

14. Differentiate between the following on the basis of elasticity of demand. i) Superior Goods and Inferior Goods.

ii) Complements and substitutes. Fundamental Questions

1. What is demand?

2. What are determinants of demand?

3. What are the different elasticities of demand?

4. What are the different measures of demand forecasting? 5. What is supply?

6. How do we measure supply elasticity?

7. How do you apply indifference curve analysis in analysis? 8. What is consumer surplus?

Skill Development

i) In the context of demand analysis, review the air-fare season wise of Indigo Airlines and Kingfisher Airline.

ii) Choose a branded cosmetic product (Shampoo, Hair Dye, Talcum Power etc.), col- lect monthly price-demand (sales) / advertising expenditure – sales revenue data on an average over a period of six months and measure the point and arc price and promotional elasticity of demand.

NOTES

z Varshney,R.Land Maheshwari, 1994 Manageriaql; Economics, S Chand and Co. z Koutsoyiannis,A. Modern Economics, Third Edition.

z Chandra, P.2006, Project: Preparation Appraisal Selection Implementation and Re-

view, 6th _{Edition, Tata McGraw Hill.}

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UNIT 3 COST AND PRODUCTION

ANALYSIS

STRUCTURE

3.1. Objectives 3.2. Introduction 3.3. Production Functions

3.4. Law of Variable Proportion or Law of Diminishing Returns to Factors. 3.5. Difference between Returns to a Factor and Returns to Scale 3.6. Isoquants

3.7. Isocost Line or Equal Cost Line 3.8. Marginal Rate of Technical Substitution

3.9. Choices of Input Combination (Optimal Input combination) 3.10. Theory of Cost

3.11. Cost Functions 3.12. Various types of Costs

3.13. Relationship between AC and MC 3.14. Long and Short Run Cost Curves

3.15. Cost and Output Relationship (Cost Function) 3.16. Short Run and Long Run

3.17. Economies / Dis-economies of Scale

3.18. The Theory of firm (Profit Maximization Model) 3.19. Break-even and Shut-down Point

3.20. Managerial Theories of the Firm 3.21. Baumol’s Model

3.22. Marris Model. 3.23. Summary

Cost And Production Analysis

NOTES

3.1. OBJECTIVES

The objective of this chapter is to define and application of the production and cost. The chapter also focuses on the Production Function, Total Product, Average Product, Marginal Product; Law of Variable Proportion or Law of Diminishing Returns to Factors, Returns to a Factor and Returns to Scale, Isocost and Isoquant, Marginal Rate of Technical Substitution (MRTS), Model of Profit Maximization, Sales Revenue Maximisation Model by Baumol, Managerial Utility Models, Growth Maximisation Models, Total Cost (TC), Total Fixed Cost (TFC), Total Variable Cost (TVC), Average Fixed Cost (AFC), Average Variable Cost (AVC), Average Total Cost (ATC) and Marginal Cost (MC), Long and Short Run Cost Curves, Cost and Output Relationship, Economies / Dis-economies of Scale, Break-even and Shut-down Point, Baumol’s Model and Marris Model. Graphs are used consistently for understanding the subject matter easily.

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1 x

NOTES

Key Terms

Production, Production Function, Total Product, Average Product, Marginal Product, Law of Diminishing Returns to Factors, Returns to a Factor, Returns to Scale, Isocost, Isoquant, Marginal Rate of Technical Substitution (MRTS), Total Cost (TC), Total Fixed Cost (TFC), Total Variable Cost (TVC), Average Fixed Cost (AFC), Average Variable Cost (AVC), Average Total Cost (ATC), Marginal Cost (MC), Long and Short Run Cost Curves, Cost and Output Relationship, Economies / Dis-economies of Scale, Break-even and Shut-down Point.

3.2. INTRODUCTION

Production is basically an activity of transformation which transfers inputs into outputs. Firms use land, labour, seeds and small amount of capital as inputs to produce output like corn. Similarly, a flour mill uses inputs like wheat, labour, capital for machinery, factory building to produce output like wheat flour. So, an input is the goods or services which produce an output. The firm generally uses many inputs to produce an output. Output of any firm may be the inputs of other firms, e.g., steel is an output of the steel producer, but this steel is also an input of automobile or rail coach manufacturing or refrigeration manufacturing or air-condition manufacturing industries. The transforming process of inputs into output can be three types: i) change in form (output should be new form compared to inputs, for example cloth as output and thread as input) ii) change in space (transportation) and iii) change in time (storage). The transformation process or production increases the consumer usability of goods and services.

3.3. PRODUCTION FUNCTIONS

A production function is the technical relationship between inputs and outputs. A commodity may be produced by various methods using different combinations of inputs with given state of technology. Take the e.g. of cloth, it may be produced using cotton or silk or polymer as raw materials with handloom, power loom or computerized machines. You can see various types of raw materials and technology options will create several possible ways of producing the same product. Hence there can be several technically efficient methods of production. Production function includes all such technically efficient methods. It can be said that production function is purely a technological relationship between physical inputs and physical outputs over a given period of time; production is a function of inputs, their quality and quantity and interrelation, i.e., complementarities and substitutability. Hence it can be said that production function is:

z Always related to a given time period

z Always related to a certain level of technology z Depends upon relation between inputs

Production function shows the maximum quantity of the commodity that can be produced per unit of time for each set of alternatives inputs, and with a given level of production technology. A given amount of output can be produced by different combinations of inputs and each of these combinations may be technically efficient. Technical efficiency is defined as a situation when using more of one input with either the same amount or more of the other input must increase output.

Normally a production function is written as;

Q = f (x , x _{1 2,}……… x ) ………..…………(i)_n

Where, Q is maximum quantity of output of a good being produced, and x , x _{2,………. n}are the quantities of various inputs used in production. If we replace x , x₁ _{2,……… n}x in (i) by the factors of production discussed above, the production function may be;

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L

Where,

Q = f (L, K, I, R, E) ……….. (ii) Cost And Production Analysis

Q =output and the inputs are L, K, I, R, E; L= labour,

K = capital, I =land,

R =raw material

E = efficiency parameter

In short run, some inputs like plant, size, and machine equipments cannot be changed, so a producer trying to increase output in the short run will have to do so by increasing only the variable inputs. On the contrary in the long run input options are very wide. On the basis of such characteristics of inputs, production functions are normally divided into two broad categories :( i) with one variable input or variable proportion production function (ii) with two variable inputs or constant proportion production function

Production Function with One Variable Input: In short run producers have to optimize with only one variable input. Let us consider a situation in which there are two inputs, capital and labour, capital is fixed and labour is variable input. You will notice as the amount of capital is kept constant and labour is increased to increase output, the ratio in which these two inputs are used will also change. Therefore any change in output can be manifested only through a change in labour input only.

Such a production function is also termed as variable proportion production function; it’s essentially a short term production function in which production is planned with variable input. The short run production function shows the maximum output a firm can produce when only one of its inputs can be varied, other inputs remaining fixed. It can be written as:

NOTES

Q = f (L, K0_{)………..………(iii)}

Where, Q is output, L is labour and K0 _{denotes the fixed capital. This also implies that it}

is possible to substitute some of the capital by labour. It is easy to understand that as units of the variable input are increased, the proportion of use between fixed input and variable input also changes. Therefore short run production function is governed by law of variable proportions. To explain the concepts of average and marginal products of factor inputs consider the production function given in equation (iii), Assuming capital to be constant and labour to be variable, total product is a function of labour and is given as:

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K L L K L K

If instead labour is fixed in the short run, the total product of the capital function can be similarly expressed as:

TP = f (L0_{, K) ……….(v)}

NOTES

Average Product (AP) is total product per unit of variable input; therefore it can be expressed as:

AP = TP/L………..(vi)

If instead labour is fixed in the short run, average product of the capital function(AP )can be similarly expressed as:

AP = TP / K……….……….(vii)

Marginal Product (MP) is defined as addition in total output per unit change in variable input. Thus marginal product of labour (MP ) would be:

MP = œTP / œL ………...………….……(viii)

Production Function with Two Variable Inputs: Most simplistic form of production function with two variable inputs, labour (L) and capital (K), and a single output, Q, is as follows;

Q = f (L, K) ……….………(ix)

This production function is constructed based on the assumption that the state of the technology is given and output can be increased by increasing inputs. When the state of technology changes, the production function itself changes. Further, it is assumed that the inputs are utilized in the best possible way, i.e., optimum utilization of inputs. The best utilization of any particular input combination is a technical, not an economic problem. Selection of best input combination for the production of a particular output level depends upon the input and output prices and is subject of economic analysis.

3.4. LAW OF VARIABLE PROPORTION OR LAW OF DIMINISHING

RETURNS TO FACTORS.

The slope of the total product curve is determined from the law of diminishing returns. The law of diminishing returns, being empirical in nature, states that with a given state of technology if the quantity of one factor input increased, by equal increments, the quantities of other factor inputs remaining fixed, the resulting increment of total product will first increase and then decrease after a particular point.

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L

L L L

The law is also known as diminishing returns to factors. It states that as more and more one factor of production is employed, other factor remaining the same, its marginal productivity will diminishing after some time. For example, if we increase labour input and capital input remaining the same, then the marginal productivity of labour first increased, reaches maximum and then decreases. The law of diminishing returns to factors is depending on three assumptions.

i) It is assumed that the state of technology is given.

ii) It is assumed that one factor of production must always be kept constant at certain level.

iii) This law is not applicable when two inputs are used in a fixed proportion and the law is applicable only to varying ratios between the two inputs.

NOTES

3.5. DIFFERENCE BETWEEN RETURNS TO A FACTOR AND

RETURNS TO SCALE

The law of diminishing returns factors states that as more and more one factor of production is employed, other factor remaining the same, its marginal productivity will start diminishing after some time, e.g., if we increase one factor of production i.e., labour and other factor of production i.e., capital remaining the same, then the marginal productivity of labour first increased, reaches maximum and then decreases. So, returns to a factor (variable factor) of production is first increasing in the initial level of production and then decreasing if we increase the amount of that variable factor of production. But, if we increase more and more of that variable factor then the returns to the variable factor is negative.

In the very first stage of production, if additional units of labour are employed, the total output increases more than proportionately; so marginal product rises. In the following figure, stage I would begin from the origin and continue to a point where AP attains its maximum value. In this stage, MP

returns to the variable factor.

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L L L 0 0, 1, L.

In the second stage, the total product increases but less than proportionate to increase in labour. In this stage, marginal product of labour falls and this stage is called as diminishing returns to variable factors. Here, MP > 0 and MP < AP

NOTES

The stage three is a technically inefficient stage of production and a rational producer will never produce in this stage. Here, MP < 0 and total product is decreasing.

The law of returns to scale refers to the long run analysis of production. It refers to the effects of scale relationships which implies that in the long run output can be increased by changing all factors by the same proportion, or by different proportions. If the production function is Q = f (K, L) and we increase all the factors of production by the same proportion p. So, the new production function is Q* = f (p.K, p.L).

If Q* increases in the same proportion as the factors of production, p, then we can say there are Constant Returns to Scale (CRS).

If Q* increases less than proportionately with an increase in the factors of production, p, then we can say there are Decreasing Returns to Scale (DRS).

If Q* increases more than proportionately with an increase in the factors of production, p, then we can say there are Increasing Returns to Scale (IRS).

)

3.6. ISOQUANTS

An isoquant is the firm’s counterpart of the consumer’s indifference curve. It is a curve representing the various combinations of two inputs that produce the same amount of output. It is also known as iso-product curve or equal product curve or production indifferent curve. It is the collection of inputs in the form of factors of production labour (L) and capital (K), which yield the same output. For a definite level of output, i.e., for Q say 1000 units of output or for Q say 2000 units of output, the equation of production function is

Q = f (L, K) or Q₀ ₁= f (L , K )₁ ₁ Where, Q and Q are parameters.₀ ₁

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NOTES

The locus of all the combinations of L and K which satisfy the above equation forms an isoquant.

Since the production function is continuous, an indefinite number of input combinations will lie

on each and every isoquant. The two factors of production are substitutable and can employ

more of one input and less of another input to get the same level of output. A higher level of

output is represented by a higher isoquant. If we assume that that the marginal productivities of

both the factors of production are positive and decreasing as more of them are used, the

isoquant will be downward sloping and convex to the origin.

Types of Isoquant: Isoquants are various shapes depending on the degree or elasticity of

substitutability of inputs. These are as follows;

i) Linear Isoquant: This type assume perfect substitutability between factors of pro- duction, i.e., a given output can be produced by using only capital or only labor or by a large number of combinations of capital or labor.

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NOTES

ii) Input-Output Isoquant: It assume strict complementary or zero substitutability between the factors of production, we get input-output isoquant.

iii) Kinked Isoquant: This assume limited substitutability of capital and labor. Since there are only a few processes available for producing any commodity, substitutability of factors is possible only at kinks. This form is also called activity analysis isoquant or linear programming isoquant.

iv) Smooth Convex Isoquant: This form assumes continuous substitutability of capital and labor only over a certain range, beyond which factors can not be substituted for each other. Such an isoquant appears as a smooth curve convex to the origin.

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NOTES

An isoquant is a curve showing all combinations of inputs that can be used to produce a given output. The characteristics of isoquant are as follows.

Isoquants are Downward Sloping: Technological efficiency connotes that an isoquant must slope downwards from left to right, which implies that using more of one input to produce the same level of output must imply using less of the other input. Thus if more of labour is used in the production process, then less of capital must be used to produce the same level of output. Slope of the isoquant is equal to: K/L, ratio of capital and labour.

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2 2 1 2 1 1

NOTES

A higher Isoquant represents a higher output: In the panel I of above figure, if we consider point A on the curve Q and the point C on Q , it can follow that C has more of both labour and capital as compared to A. Thus as per given technology, more of both factors should produce greater output. However you should learn that it is not necessary than on a higher isoquant a point will have greater quantity of at least one of the two inputs as in case of A and B. Hence a greater quantity of any one of the two inputs will render a higher level of output. In short, using more of both inputs and more of either of the inputs must increase output given the state of technology. Hence a higher isoquant Q would represent a higher output than isoquant Q .

Isoquants do not intersect each other: An isoquant represents the same level of outputs with different units of two inputs: intersection of two isoquants would signify single input combinations producing two levels of output. This is explained by Panel II of above figure. Let A and B be two different points on Q₁and Q₂respectively. Suppose two isoquants Q₁ and Q interested each other at point C. At point B and C of isoquant Q the firm produces the same level output Q . Again points A and C of isoquant Q₁ ₂denote the same level of output Q₂any the firm. Thus it follows that at points A and B, the same level of output should be produced. But from the fig it is clear that point A denotes a higher level of output than B; this is contradictory, and hence we conclude that isoquants cannot intersect each other.

Convex to the origin: Given substitutability between factor inputs, as the firm continues to employ more of one input say labour and less of other say capital, a situation comes when it becomes difficult to substitute labour for capital. Since labour and capital are not perfect substitutes, therefore as capital (K) is kept fixed to produce additional units of outputs only by increasing laour (L), it would require successively increasing units of labour. This is better understood with the help of the law of the marginal technical substitution (MRTS). The absolute slope of the isoquant falls as we move down the isoquant and the declining MRTSlk determining the convexity of an isoquant.

3.7. ISOCOST LINE OR EQUAL COST LINE

The cost equation of the firm is Co = w.L + r.K, where w is the cost of labour, i.e., wages and r is the cost of another input capital, i.e., rate of interest. This equation will be satisfied by different combinations of L and K. the locus of all such combinations is called the equal cost line or isocost line.

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0 0 1 LK 0 LK ) KL

NOTES

In the above figure, if the firm spend entire amount of money i.e., C in hiring lanour, the firm will get OB units of labour which is equal to C₀/ w. On the other hand, if the firm spends the entire money in purchasing capital, the firm will get OA units of K which is equal to C / r. By joining the two points A and B we get the isocost line C . With the given cost C₀the firm can purchase any combination of labour and / or capital on the line AB.

3.8. MARGINAL RATE OF TECHNICAL SUBSTITUTION

Marginal Rate of Technical Substitution (MRTS) measures the reduction in per unit of one input, due to unit increase in the other input that is just sufficient to maintain the same level of output. Thus for the same quantity of output, marginal rate of technical substitution of labour (L) for capital (K) (MRTS ) would be willing to give up for an additional unit of labour. Similarly, marginal rate of technical substitution of capital for labour (MRTS would be the amount of labour that firm would be willing to give up for an additional unit of capital.

Consider the isoquant Q of above figure, MRTS would measure the downward vertical distance (representing the amount of capital that the producer is willing to sacrifice) per

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LK K K L L K

unit of the horizontal distance (representing additional units of labour).In other words, MRTS is expressed as the ratio between rates of change in L and K, down the isoquant. Thus: MRTS = –

'.

'L

NOTES

MRTS of labour for capital is equal to the slope of the isoquants, it is also equal to the ratio of the marginal product of one input to the marginal product of other input. Since output along an isoquant is constant, if 'K units of labour are substituted for 'K units of capital, then the increase in output due to increase in , i.e (x ) should match with the decrease in output due to decrease in i.e., (-x MP ). In other words:

'L x MP = -'Kx MP Or,

MP / MP = 'K- / 'L

'.

L K

'L

A change in the level of output can be expressed as change in total output (Q) equals to

the sum of change in labour input ('L) times MP of labour and change in capital input ('K) times MP of capital.

In other words:

'Q = MP x + MP_L _Kx 'K

However, along a given isoquant, output remains unchanged, ie. 'Q = 0. Hence we have

MP x + MP_L _Kx 'K= 0 Or,

MP / MP = - / 'K- / 'L => MRTS_LK= MP / MP_L _K

So, the marginal rate of technical substitution between two inputs is equal to the ratio of the marginal physical products of the inputs.

3.9. CHOICES OF INPUT COMBIN ATION (OPTIMAL INPUT

COMBINATION)

Maximization of Output Subject to the Cost Constraint:

Let us suppose that the production function of the firm is given as Q = f(L,K), given the factor prices w and r for labor and capital, respectively. The firm is in equilibrium when it maximizes its output given its total cost outlay. Suppose that the firm decides on a given cost level Co. With this cost the firm can purchase different combinations of the two factors of production. All these combinations will lie on the isocost line AB in following figure. The objective of the firm is to maximize the level of output while remaining on the given isocost line.

In the figure we see that the firm remains on the isocost line AB and purchase any combination of the two inputs lying on the line AB. All the points on the isocost line AB represent equally costly combinations. When the firm is moving from E3 to E1, it can increase its output, since E1 is on a higher isoquant compared to E3. Similarly, by moving from E1 to E, the firm can again increase the level of its output further. E is also