Download ECONOMIC ANALYSIS FOR BUSINESS UNIT II CONSUMER AND

ECONOMIC ANALYSIS FOR BUSINESS
UNIT II
CONSUMER AND PRODUCER BEHAVIOUR
Market – Demand and Supply – Determinants – Market equilibrium – elasticity of demand
and supply – consumer behaviour – consumer equilibrium – Approaches to consumer
behaviour – Production – Short-run and long-run Production Function – Returns to scale –
economies Vs. diseconomies of scale – Analysis of cost – Short-run and long-run cost
function – Relation between Production and cost function.
Table of Contents
2.1 Definition of Demand ........................................................................................................................ 1
2.1.2 Elasticity of Demand .................................................................................................................. 2
2.1.3 Measurement Of Elasticity Of Demand ................................................................................. 4
2.2SUPPLY ........................................................................................................................................... 10
2.2.2 Law of supply ........................................................................................................................... 12
2.3 Production Function With One Variable Input ................................................................................ 16
2.4 Production Function With Two Variable Inputs ............................................................................. 18
2.5 Production Function With All Variable Inputs ................................................................................ 21
2.6 Cost Concepts .................................................................................................................................. 25
2.6.1 COST DETERMINANTS ........................................................................................................ 27
2.7 LEARNING AND COSTS.............................................................................................................. 33
2.8 ECONOMIES OF SCALE .............................................................................................................. 33
2.9 Diseconomies Of Scale.................................................................................................................... 35
2.10 Cost Control................................................................................................................................... 36
2.11 Utility............................................................................................................................................. 37
2.12 Marginal Utility Analysis .............................................................................................................. 38
2.13Consumers Equilibrium .................................................................................................................. 40
2.1 Definition of Demand
The demand for any commodity at a given price is the quantity of it which will be bought per
unit of time at that price.
2.1.2 Elasticity of Demand
MEANING
The elasticity of demand in a market is a great or small according to the quantity
demanded increases much or little for a given fall in the price and rise in price.
TYPES OF ELASTICITY OF DEMAND
There are three types of elasticity of demand namely
1. Price elasticity of demand
2. Income elasticity of demand
3. Cross elasticity of demand.
1. Price Elasticity of Demand
Price Elasticity of Demand measures the changes in quantity demanded to a change in
price of the product. There are 5 cases of Price Elasticity of Demand.
A) Perfectly Elastic Demand
When a small change in price leads to infinitely large change in quantity
demanded it is called perfectly / infinitely elastic demand. In this case, there is no charge in
price but that is large charges in quantity demanded
Price
Y
D
O Quantity demanded X
B) Perfectly inelastic Demand
D
Price
Y
O Quantity demanded X
In this case, even a large change in price fails to bring about a change in quantity demanded.
When a price increases from OP to OP1, the quantity remains the same and the
elasticity of demand E=0
C) Relatively Elastic Demand
A small change in price leads to a very big change in the quantity demanded.
Price
Y
D
P
P1
D1
X
Q1
Q
Quantity demanded
O
In this case, E> 1 and the demand curve will be flatter.
D) Relatively Inelastic Demand
A large change in price leads to a small change in quantity demanded.
Y
D
Price
P
P1
D1
O
X
Q1
Q
Quantity demanded
When price falls from OP to OP1, the quantity demanded increases from OQ to OQ1 which is
smaller than change in price. Here, E<1 and the demand curve will be steeper.
E) Unit Elasticity of Demand
The change in demand is exactly equal to change in price. When both are equal E = 1 and
Elasticity is said to be unitary.
Y
D
Price
P
P1
D1
O
X
Q1
Q
Quantity demanded
Thus a change in price has resulted an equal change in quantity demanded and E = 1.
2. Income Elasticity Of Demand
The income elasticity of demand is a measure of responsiveness of the quantity of and
lower the income there may be lower the purchasing. It should be calculated by using the
formula as,
E=
Proportionate change in quantity demanded
Proportionate change in income
3. Cross Elasticity Of Demand
A change in the price of the one product leads to change in quantity demanded of another
product. The formula is,
E = Change in Quantity Demanded of x
Change in Price of x
2.1.3 Measurement Of Elasticity Of Demand
It is more useful to the management to find out the extent to which demand is elastic
or inelastic. Generally 4 methods are used to measure the elasticity of demand. They are
1. Percentage method
2. Total outlay method
3. Point / geometric method and
4. Arc method
1. Percentage Method
It measures elasticity of demand by comparing the ratio of percentage of change in the
quantity demanded to the percentage of change in price of the product. The formula for
measuring elasticity of demand is
E= relative change in the quantity demand
Relative change in price
2. Total Outlay Method
The term „outlay‟ is spend the amount expended by the consumer. In this method,
elasticity is measured based upon the total outlay of the consumer. The outlay is illustrated in
the following table.
S.No
1
2
3
4
Price
product
6
5
4
3
of
No. of units bought
4
4
5
8
Total outlay
E=1
24
20
20
24
E<1 Inelastic
E>1 Elastic
In the first two case, there was a fall in the total outlay from Rs.26 to Rs.20. this
indicates that the elasticity is less than unity. But in last 2 case, the outlay is increased from
Rs.20 to Rs.24, this indicates that the elasticity is greater than unity.
3. Geometric Method
The elasticity of demand can also be worked out geometrically. The elasticity of
demand has been considered as unity, less than unity and more than unity. Now, three points
are said to be evident namely E1, E2, and E3 on the demand curve D.
Y
D
E 2=1
.
Price
.
E3<1
.
E1>1
O
X
D1
Quantity demanded
The distance between D1 E2and D E2is equal (i.e.) D1 E2 = DE2. Hence the elasticity of
demand at point E2 is unity [E=1].
The distance between D1 E1 is less than the distance between D E1 (i.e.) D1 E1< DE1.
Hence the elasticity of demand at point E1 is less than unity [E<1].
the distance between D1 E3 is greater than the distance between DE3 (i.e.) D1 E3> DE3.
Hence the elasticity of demand at point E3 is greater than unity [ E >1 ].
4. Arc method
Arc method is used for measuring price elasticity of demand. It is useful only when we have
full information about the changes in price and quantity demanded. The formula is
E= (Q1-Q2/Q1+Q2) / (P1-P2/P1+P2)
where P1 and Q1 are the initial price & quantity
P2 and Q2 are the price and quantity after change.
2.1.4 Applicaions of Elasticity of Demand
The following areas of business administration, the elasticity of demand can be applied
1. Price Fixation
Elasticity helps to the management when price decisions are taken. for example, if the
product have monopoly position, then the elasticity will be inelastic and the firm may fix
high price. On the other hand, if the product have more competitors, then the elasticity will be
elastic and the firm may fix lower price.
2.Sales potential
The elasticity of demand exerts its influence on sales. If the elasticity is highly
inelastic one then the firm can expect more sales. Then if the elasticity is highly elastic, then
the firm can expect low sales of their product.
3. Substitutes
In substitute product, the price of one product increase will automatically make an
increased demand for the substitute product. For example the demand for rain coat get
increase due to the use and increased price of an umbrella.
2.1.5 Demand Analysis
Meaning
A major part of the managerial decision making depends on accurate estimates of
demand and it is termed as demand analysis. Forecasting a future demand for a product can
serve as a guide to management for strengthening market position and enlarging profit.
Determinants / Factors Affecting Demand
The determinants on factors which affect demand are as follows
1. Price
A change in price of a commodity may bring about a change in the quantity
demanded. For example, when the price of the commodity falls, it may lead to rise in demand
and when the price of the product rise, the customer shift to other product or substitute
product therefore the demand may get fall.
2.Population
An increase in population would automatically lead to an increase in the demand and
if population decreases, the demand would automatically decreases.
3. Income
The income of a person raises, he purchases a lot and therefore the demand increases.
On the other hand if the income falls, their consumption comes down and the demand
decreases.
4.Inflation
During inflation, the general price level rises. The real income of the consumer falls.
Therefore, consumer automatically reduce their demand.
5.Climate
Climate has a direct influence on demand. In winter, generally speaking, there is a
great demand for woolen clothes. On the other hand in summer, there is a demand for fans,
coolers etc., demand is thus depend on climatic condition.
6. Taste and Preferences
Fashions changes often. Therefore, when a new fashion comes, there is a great demand
for it.
7. Sales Promotion
If there will be more sales promotion techniques like gifts, price discount etc., of a
product then the demand of the product increases and vice verse.
Demand Distinctions
In some things, the demand will be more and the other things, the demand will be
less. It is necessary to find out those differences among the two and this differences is termed
as “demand distinctions”.
The following are the important demand distinctions
1. Producer goods and consumer goods.
2. Durable goods and non-durable goods
3. Derived demand and autonomous demand
4. Industry demand and company demand
5. Short run demand & long run demand.
6. Total market and market segment
1. Producer goods and consumer goods.
Producers goods are those which are used for the production of other goods. Ex.
machines etc,.
consumer goods are those goods which are used for final consumption ex ready made clothes,
prepared food etc… it may be sub-divided into
Consumer durable→ those goods which can be consumes more than once over a
period of time, Ex., umbrella, refrigerator etc…
Consumer non–durable →those goods which cannot be consumer more than once.
Ex., bread.
For consumer‟ goods, income is the most important determinants of demand while for
producers‟ goods it is the business profit /activity that determines demand.
2. Durable goods and non-durable goods
Durable goods are those goods which can be used repeatedly and their life time is
long.
Non-durable goods are those which can be used only once and their life time is too
short. Ex., flowers, milk etc…
The demand for durable goods is influenced by expected price, income and change in
technology.
The demand for non- durable goods demands on their current price, income, fashion
etc…
3. Derived Demand and Autonomous Demand
When the demand for a product is tied to a purchase of a parent product, it is called
derived demand. Ex., the demand for cement is derived being related to building activity.
The demand for a product, which arises directly from the biological or physical needs
of human being may be regarded as autonomous demand.
Derived demand is generally supported to have less price elasticity than derived
demand.
4. Industry Demand and Company Demand
Industry means group of firms producing similar products. The term “Industry
Demand” is used to denote the total demand for the product of the particular industry. Ex., the
total demand for steel in the country.
A company demand is the demand for the product of a particular company. Ex.,
demand for steel produced by TATA Iron and Steel Company.
5. Short run Demand & Long run Demand
Short run demand refers to the demand for goods for short-period of time. Ex., goods
if seasonal use, consumer goods etc. It refers to demand with its immediate reaction to price
changes, income fluctuations etc.
The long term demand refers to demand that exists over long period. It takes some
time for reaction to price changes, income fluctuations etc.
For example, if electricity rates are reduced in the short run, existing users of electric
appliances will make greater use of it. But in the long run, more people buy electric
appliances and use which ultimately leading to a still greater demand for electricity
6. Total Market and Market Segment
The market will be divided in to different segments on the basis of geographical areas,
uses of the product etc. total market refers to the total demand for the product. Market
segment refers to a part of total market.
Some problems like sales forecasting have to be analyzed in total market and problems
like pricing, promotion and distribution have to be analyzed in market segment.
2.1.6 Demand Forecasting
Meaning
Forecasting means to know the trend or behavior after a period of time. this trend or
behavior can be increasing or decreasing one. it is an extension of the present demand.
Demand always refers to sales. A demand forecast is a prediction of future sales or it is
an estimate of the future demand of the product. It is essential for the firm to produce the
required quantities at the right time.
Definition
Demand forecasting may be defined as, “objective assessment of the future of
demand”
Methods of Demand Forecasting
Several methods are employed for forecasting demand. All these methods can be
grouped under
1. Survey method and
2. Statistical method
Survey and Statistical methods are further subdivided into different categories
1. Survey method
Under this method, information about the demand forecasted is collected through
interview. The 4 types of survey method are as follows
a) Opinion survey method
Under this method, the company asks its salesmen to submit estimates of future sales
in their areas. These estimates are consolidated by the top executives and make the forecast
realistic one.
b) Expert opinion
Apart from salesman and consumers, distributors or outside experts may also be used
for forecasting firms in advanced countries make use of this method.
c) Delphi method
Under this method, a panel is selected to give suggestions about the demand of the
product. Both internal and external experts can be the member of the panel. Panel member
express their views about the demand of the product and finally one conclusion is taken from
it.
d) Consumers Interview Method
The most direct method of estimating sales in the near future is to ask customers what
they are planning to buy. This method may be undertaken in 3 ways
i) Complete enumeration method → under this method all the consumers of the
product are interviewed
ii) Sampling method - a sample of consumers is selected for interview.
iii ) end- use method →under this method, the demand for the product from different
sector such as industries, consumers, export and import are found out.
2. Statistical methods
Statistical methods is used for long run forecasting. In this method, statistical and
mechanical techniques are used to forecast demand.
a) Trend analysis
An industry which has been existence of accumulated data on sales, production etc.
belong to different time periods. Such data when arranged chronologically form, it is termed
as time series analysis. Based on this, trend we can estimable the demand by the following 2
ways
i) Moving averages→ under this method, the average of past achievements is based
on prediction of future
ii) Exponential smoothing → in this technique of moving average, all time periods
are weighted. But the recent periods are get more weight when compared to older periods.
b) Barometric technique
A barometer is an instrument for measuring change. Under barometric method, present
events are used to predict the direction of change future. This is done with the help of
economic indicators such as gross national income, employment, personal income etc.
c) Correlation and regression analysis
In correlation analysis, the demand function states that relation between sales and
other variables in the economy., and it expressed the nature relationship, between two
variables while in regression, the extent of relationship between two variables are analyzed.
FORECASTING DEMAND FOR NEW PRODUCTS
For forecasting the demand for new product the following 6 approach are followed
1. Evolutionary approach
Under this method, the demand for the new product is estimated on the basis of an
existing old product. This approach is useful only when the new product is closely related to
the old product.
2. Substitute approach
Under this method , the demand for the new product is analyzed as a substitute for
some existing product.
3. Growth curve approach
Estimate the rate of growth and ultimate level of demand for the new product on the
base of the pattern of growth of established produce.
4. Opinion polling approach
Under this approach, the demand for the new product is estimated by enquiring
directly from the sample of consumers.
5. Sales experience approach
Offer the new product for sale in sample market and from this try to estimate the total
segment of the developed market.
6. Vicarious approach
Consumers reactions for a product are found indirectly, with the help of specialised
dealers. These dealers are well informed about the consumers taste and preferences therefore
forecasting the demand is easy.
2.2SUPPLY
MEANING
The supply of a commodity means the amount of that commodity which producers are
able and willing to offer for sale at a given price
Determinants of supply/Factors Influencing supply
The various factors influencing supply are as under:
1.
The supply of a commodity depends upon the goals of firms. If drug companies prefer
to engage in the production of medicines rather than rat poison because it makes them feel
more important in society, we expect more medicines and less rat poison to be produced than
if producers held all commodities in equal regard. If producers of some commodity want to
sell as much as possible, even if it costs them some profit to do so, more will be sold of that
commodity than if they wanted to make maximum profits. If producers are reluctant to take
risks, we would expect smaller production of goods whose production is risky.
2.
The supply of a commodity depends upon the price of that commodity. Ceteris
paribus, the higher the price of the commodity, the more profitable it will be to make that
commodity. One expects, therefore, that the higher the price, the greater will be the supply.
3.
The supply of a commodity depends upon the price of all other commodities.
Generally, an increase in the price of other commodities will make production of the
commodity whose price does not rise relatively less attractive than it was previously. We thus
expect that ceteris paribus, the supply of one commodity would fall as the price of other
commodities rises.
4.
The supply of a commodity depends upon the price of factors of production. A rise in
the price of one factor of production will cause a large increase in the costs of making those
goods which use a great deal of that factor, and only a small increase in the cost of production
those commodities which use a small amount of the factor. For example, a rise in the price of
land will have a large effect on the cost of producing wheat and only a vary small effect on the
costs of producing motor vehicles. Thus, a change in the price of one factor of production will
cause changes in the relative profitability of different lines of production and this will cause
producers to shift from one line to another, and so cause changes in the supplies of different
commodities.
5.
The supply of a commodity depends upon the state of technology. The enormous
increase in production per worker that has been going on in industrial societies for about 200
years, is very largely due to improved method of production. These, in turn, have been heavily
influenced by the advantages of science. But the Industrial Revolution is more than a
historical event; it is a present day reality. Discoveries in chemistry have led to lower costs of
products made of plastics and synthetic fibers. The new electronics industry rests upon
transistors and other tiny devices that are revolutionizing production in television, highfidelity equipment, computers and guidance- control systems. Atomic energy will one day be
used to build canals and to extracts fresh water from the sea. At any time, what is produced
and how it is produced depends upon what is known. Over time, knowledge changes and so
do the supplies of individual commodity.
6.
Time factor can also determine elasticity of supply. Time can be broadly classified
into three categories:
(a) Market period is the one where supply is fixed as no factor of production can be altered.
(b) Short period is the time period when it is possible to adjust supply only by changing the
variable factors like raw-material, labour, etc., and
(c) Long period where supply can be changed at will because all the factors can be changed.
Obviously, in the market period, where the supply is fixed, the elasticity of supply will be
zero. The elasticity will be higher in the long run than in the short run as the possibility of
changing output is limited in the short-run but not in the long run.
7. Supply may be consciously decreased by agreement among the producers, for example,
agreement among oil producing countries to cut back oil output.
8. Supply may also be destroyed to raise price. For example, in Brazil, coffee was thrown
into the sea.
9. Supply may also be affected by taxation on output or imports. Government may also
restrict production of certain commodities on grounds of health (e.g., opium in India).
10. Political disturbances or war may also create scarcity of certain goods.
Some other factors affecting supply are given below:
1. Expectations about the future level of prices may affect the willingness of the suppliers to
sell the stocks or withhold them.
2. Natural factors such as failure of monsoons, floods, plant disease or pests, which are likely
to affect production, may also influence the decision of stockholders.
3. Government procurement or other Government controls may also influence supply.
4. The supply of some commodities depends on the price at sometime in the past rather than
on the current price. For example, in India, jute acreage and production has been found to
depend on jute/rice price parity in the preceding year.
5. When the trader wants to finish the old stock before having new stock, he will sell more
commodities by reducing price.
6. When a particular trader is interested in changing place or trade, he sells more of the
commodity by lowering the price so that he frees himself at an early date.
7. Sometimes, the goal of the firm is not to maximize profits but maximize sales. In that
case, the quantity supplied may be increased even by lowering the price.
8. At a time when price of a commodity in international market are falling faster than in the
domestic market, sales in domestic market will grow despite price fall. This happened in case
of coffee sales growing in the Indian retail market with international coffee prices dropping
faster.
In the long run, supply is affected by cost of production. If costs are rising, some of the
existing producers may withdraw from the field and new entrepreneurs may be scared of
entering the field.
2.2.2 Law of supply
“Other things remaining the same, as the price of a commodity rises, its supply
increases; and as the price falls, its supply declines.” Thus the quantity offered for sale varies
directly with price, i.e., the higher the price, the larger is the supply, and vice-versa.
Y
Price
s
s
O
Quantity
X
This can be explained by two reasons: (i) An increase in price generally implies higher profits
leading producers to offer increased quantities, and (ii) in the long run due to higher
profitability, new producers may enter the field of production leading to an increase in output.
Limitations of Law of supply
The law of supply has several limitations:
(1)Future prices
When the price rises and the seller expects the future price to rise further, Supply will
decline as the seller will be induced to withhold supplies so as to sell later and earn larger
profits then. Likewise, when the price falls and seller fears that the price is going to fall
further, the supply will rise as he will be ready to sell more of the commodity in anticipation
of future price fall.
(2) Agricultural output
Law of supply may not apply in case of agricultural commodities as their production
cannot be increased at once following price increase.
(3) Subsistence farmers
In underdeveloped countries where agriculture is characterized with subsistence
farmers, law of supply may not apply. Here, as food grains prices rise, marketable surplus of
food grains falls rather than rise; this is because, with rise in the prices of food grains, farmers
can get the required amount of income by selling less and keep the remaining output for their
own consumption.
(4) Factors other than price not remaining constant
The law of supply is stated on the assumption that factors other than the price of the
commodity remain constant. Hence the law of supply will not apply in the following cases:
(a)
If prices of other commodities show a rising trend, the quantity supplied of a
commodity may fall at a given price.
(b) The change in the state of technology can bring about a change in the quantity supplied
even if the price of that commodity does not undergo a change.
Elasticity of supply
Elasticity of supply can be defined as the “degree of responsiveness of supply to a
given change in price”. The formula to find out the elasticity of supply is:
Q
Q
Es=
or
Q
P
proportionatechangeinquantitysup plied
Pr oportionatechangeinprice
Illustration
Firm A supplied 300 units of its output at price of Rs.4. when price increases to Rs.8,
the quantity supplied increases to 500 unit. Find the elasticity of supply.
p1
Elasticity of supply= Es= Q .
P Q1
200 4
=

4 300
200
=0.67
300
The following figure illustrates five cases of supply elasticity. The cases of zero
elasticity is one in which the quantity supplied does not change as price changes. This would
be the case, for example, if suppliers persisted in producing a given quantity Oa in fig(i) and
dumping it on the market for whatever it would fetch. Infinite elasticity is illustrated in Fig.
(ii). The supply elasticity is infinite at the price Ob because nothing at all is supplied at lower
prices but a small increase in price to Ob causes supply to rise from zero to an indefinitely
large amount, indicating that producers will supply any amount demanded at that price. The
case of unit elasticity of supply is illustrated in Fig. (iii). Any straight line supply curve drawn
through the origin has unit elasticity.
=
When the supply curve cuts the vertical axis, it is relatively elastic supply fig.(iv).
When the supply curve cuts the horizontal axis, it is relatively inelastic supply [fig. (v)]
Y
Y
Price
Price
s
a
Quantity
O
(i) A supply curve of
Zero elasticity
O
X
Y
s1
Price
Price
s1
s2
a
s1
X
Quantity
O
(iii) A supply curve of
unit elasticity
O
X
Quantity
(iv A supply curve of
relatively elasticity.
s1
Price
Y
X
Quantity
(ii) A supply curve of
Infinite elasticity.
Y
O
s
b
(v) Relatively inelastic supply
curve
s1 Quantity
X
Types of supply Elasticity
The different types of supply elasticity are summarized in the following Table
When Elasticity of supply is
It is Known as
(i) Equal to zero
(ii) Equal to Infinity
(iii) Equal to one
(iv) More than one but not Infinity
(v) Less than one but zero
Perfectly inelastic supply
Perfectly elastic supply
Unitary elastic supply
Relatively elastic supply
Relatively inelastic supply
Supply elasticity is a useful concept but not quite so useful a concept as demand
elasticity for the reason that elasticity of demand has the major additional function of telling
us what is happening to total revenue. There is, however, an important fact that supply
elasticity can describe. A given change in price will tent to have greater and greater effects on
the amount supplied as one moves from momentary situation to a short-run period and on to
the long-run period. Elasticity of supply tends to be greater in the long run when adjustments
to the higher price have been made than in the shorter periods of time.
Cross Elasticity of supply
Three economists, vis., F. gruen, L. Ward and A. Powell have introduced this new
concept of elasticity of supply while estimating elasticities of supply for Australian
agricultural products.
The cross (price) elasticity of supply, however, measures change in quantity supplied
of one commodity (say, wheat) When the price of another commodity (say, paddy) changes. It
can be expressed as:
Esc=
Pr oportionate( percentage)changeinqunatity sup pliedofwheat
proportionate( percentage)changeinpriceofpaddy
Here, Esc is the elasticity co-efficient. It is always negative indicating that a rise a rise
in the price of one good will lead to a fall in the quantity supplied of alternative good. For
instance, a rise in the price of paddy by 1 per cent may reduce the quantity supplied of wheat
by 0.22 per cent.
In real life, the concept of cross elasticity of supply is quite important. The concept
finds its application significantly in case of agricultural commodities. Since land is a scarce
factor, farmers have to be careful about its use. For example, if price of paddy goes up, land
will be diverted from wheat production causing fall in quantity of wheat supplied.
Increase and Decrease in supply
„Increase‟ and „Decrease‟ in supply would mean a change in quantity supplied without
any change in price. This, therefore, implies a shift in supply schedule to the right implying
increase in supply and to the left implying decrease in supply.
An increase in supply involving willingness to make and sell more at each price may
be caused by (i) improvements in technology, (ii) decrease in the prices of other commodities,
or (iii) decrease in the prices of factors of production used in making the commodity
concerned. A decrease in supply involving reluctance on the part of sellers to sell as much as
before at each price may be due to (i) increases in the prices of other commodities, or (ii)
increases in the prices of factors of production used in making the commodity concerned.
Y
Price
s1
P1 P2
H
s1
O
s2
s2 s3
P3
s3
Quantity
X
Increase and Decrease in supply
The following figure shows that SS is the supply curve before the change. S` S` shows
a decrease in supply because at the same price pm, less is offered for sale, i.e., OM` instead of
OM. (The new price now would be P` M`.).S`` S`` shows an increase in supply because at the
same price pm, more is offered for sale, i.e., OM" instead of OM. (The new price now would
be p” m”.)
One must clearly distinguish between the Increase in quantity supplied and increase In
supply. Increase in supply means that the entire supply curve has shifted to a new Position to
the right. It is a new curve Altogether whereas increase in the quantity
Supplied means that more is being affered at a higher price. The supply curve is the
same. A movement along the same supply curve simply indicates changes in quantities
offered as a result of a change in price. It does not represent any change in the supply
schedule.
A particularly notable feature of market economies is the effect of the price mechanism on
demand and supply. The price mechanism determines the equilibrium in the market and
consists of the interplay of the forces of supply and demand in determining the prices at which
commodities will be bought and sold in the market. Market equilibrium is the situation, where
at a certain price level, the quantity supplied and the quantity demanded of a particular
commodity are equal. Thus,the market can clear, with no excess supply or demand, and there
is no tendency to change in either price or quantity.Diagrammatically, market equilibrium
occurs where the demand and supply curves intersect, at the point where the quantity
demanded is exactly equal to the quantity demanded. Let us first consider the case where there
is excess demand, where the current price is below that of equilibrium, as shown in Figure
2.3 Production Function With One Variable Input
Law of variable proportions
In Economics, the Production function with one variable input is illustrated with the
well-known Law of variable proportion. The law of variable proportion is one of the
fundamental laws of economics. It has also been called as the Law of Diminishing marginal
Returns (also sometimes known as Law of Diminishing Productivity).
One Factor Fixed and Others Variable
Law of variable Proportion shows the input-output relationship or production function
with one factor variable while other factors of production are kept constant.
Suppose a farmer has 20 acres of land to cultivate. The land has some fixed
investment, i.e., capital on it: a tube well, a farm house and farm machinery. The amount of
land capital is supposed as fixed factor of production. The farmer can, however, vary the
number of men to be employed on its cultivation. Labour is thus the variable factor. The
change in the number of men will change the output.
Law of Eventually Diminishing Returns, i.e.,
Marginal Returns only Eventually Declining
The point worth nothing is that the law dose not state each and every increase in the
amount of the variable factor employed in the production process will yield diminishing
marginal returns. It is possible that initial increase in the amount of variable factor employed
in the production process may yield increasing marginal returns. However, in increasing the
amount of the variable factor employed, a point will be reached where the marginal increasing
in total output will begin declining or marginal return will begin declining.
Three Stages of Production
The total, marginal and average product curves in the following figure demonstrate
the law of variable Proportions. The figure also shows three stages of production associated
with Law of Variable Proportions.
Q3
Output Q
Stage
I
Increasing
Returns
Ep<0
0<Ep<1
Ep<1
Stage
II
Decreasing
Returns
Ep=0
TP
Stage
III
Negative
returns
AP
O
X1
Input X
X2
X3
MP
The total product curve is divided into three segments popularly known as three
stages of production as under:
Stage I
1.
Stage I is the segment from the origin to point X2.
2.
At this point (X2), the marginal product of X equals its average product.
3.
X2 is, of course, also the point at which the average product is maximized.
4.
In this stage, the production function is characterized first by increasing marginal
returns to the variable factor from the origin to point X1 and then by diminishing marginal
returns, from x1 to x2.
5.
In stage I, it is not correct to understand that only increasing diminishing returns take
place. For upto a point, increasing returns and thereafter diminishing returns take place. Stage
I should not, therefore, be identified with increasing marginal returns only.
Stage II
The second stage lies in the range from X2 to X3. In other words, Stage II begins
where the average product of the variable factor is maximized and continues to the point at
which total product is maximized and marginal product is zero. This stage is characterized by
diminishing returns to the variable input over its entire range. That is, although total product is
increasing in this range, it dose so at a continuously decreasing rate.
Stage III
Finally, we have Stage III, the area beyond X3 where the total product curve starts
decreasing. In this range, the marginal product of the variable factor is negative.
The following Table sums up the three stages of law of variable proportions:
Behaviour of TPP, MPP and APP during three stages of production
Average
physical
Total physical product (TPP) Marginal physical product (MPP)
product(APP)
Increases, reaches its maximum & Increases & reaches its
STAGE I
Increases at an increasing then declines till MR=AP
maximum
rate
Is diminishing and becomes equal Starts diminishing
STAGE II
Increases at a diminishing to zero
rate till it reaches maximum
STAGE III
Starts declining
Becomes negative
Continues to decline
Stage II is Rational
Only stage II is rational which means relevant range for a rational firm to operate. For
no firm will choose to operate either in Stage I or Stage III; in Stage I, it is profitable for the
firm to keep on increasing the use of labour and in Stage III, MP is negative and hence it is
inadvisable to use additional labour. The firm, therefore, has a strong incentive to expand
through Stage I into Stag II.
Stages I and III are Irrational
Stage I and III are described as irrational in the management if it is to maximize profits
will never knowingly the variable to the fixed factors in any combination which will yield a
total product falling in either of these two stages.
Assumptions
1. Constant Technology. If technology changes, marginal and average product may rise
instead of diminishing.
2. Short Run. The law operates in the short run because it is here that some factors are fixed
and others are variable. In the long run, all factors are variable.
3. Homogeneous Input. The variable input as applied unit by unit is homogeneous or identical
in amount and quality.
4. It is possible to use various amounts of variables of factor on the fixed factors of
production.
2.4 Production Function With Two Variable Inputs
Isoquants
To understand a production function with two variable inputs, it is necessary to
explain what an isoquant is. An isoquant is also known as Iso- product curve, Equal product
curve or a production indifference curve. These curves show the various combinations of two
variable inputs resulting in the same level of output. Table 3 shows how different pairs of
labour and capital result in the same output.
Table 3: Labour & capital Inputs in Relation to Output
Labour (units)
Capital (units)
Output (units)
1
2
3
4
5
5
3
2
1
0
10
10
10
10
10
It will be seen that output is the same either by employing 4 L+1C or by 5L+0C (and so
on).this relationship, when shown graphically, results in an isoquant.
Y
0
30
0
00
20
00
16
00
10
0
60
Machinery
q=
q=
q=
q=
q=
X
Labour
Thus, by graphing a production function with two variable inputs, one can derive the
isoquant tracing all the combinations of the two factors of production that yield the same
output. An isoquant is defined as the curve passing through the plotted points representing all
the combinations of the two factor of production which will produce a given output. The
above figure shows a typical Isoquant diagram levels of outputs are obtained, using larger
quantities of output.
For each level of output there will be a different isoquant. When the whole array of
isoquants are represented on a graph, it is called an Isoquant map.
Substitutability of Inputs
An important assumption in the Isoquant Digram is that the inputs can be substituted
for each other. Let us take a particular combination of X and Y resulting in an output q600
units. By moving along the isoquant q600, one finds other quantities of the inputs resulting in
the same output. Let us suppose that X represents labour and Y, machinery. If the quantity of
the labour (X) is reduced, the quantity of machinery (Y) must be increased in order to produce
the same output.
MRTS
The slope of the isoquant has a technical name: marginal rate of technical substitution
(MRTS), or sometimes, the marginal rate of substitution in production. Thus in terms of
inputs of capital services K and L.
MRTS=dK/dL
(MRTS is similar to MRS, i.e., marginal Rate of Substitution, which is the slope of an
indifference curve.)
Types of Isoquants
Isoquants assume different shapes depending upon the degree of substitutability of
inputs under consideration.
(1)
Linear Isoquants
Here, there is perfect substitutability of inputs. For example, a given output say 100
unit can be produced by using only capital or only labour or by a number of combinations of
labour and capital, say 1 unit of labour and 5 unit of capital, or 2 units of labour and 3 units of
capital, and so on. Likewise, given a power plant equipped to burn either oil or gas, various
amounts of electric power can be produced by burning gas only, oil only or varying amounts
of each. Gas and oil are perfect substitutes here. Hence, the isoquants are straight lines
Oil
Q1
Q2
Q3
Q4
Q5
X
Gas
(2)
Right-angle Isoquant
Here, there is complete non-substitutability between the inputs (or strict
complimentarily). For example, exactly two wheels and one frame are required to produce a
bicycle and in no way can wheels be substituted for frames or vice-versa. Likewise, two
wheels and one chassis are required for a scooter. This is also known as Leontief Isoquant or
Input-output isoquant.
Chassis
Q3 = 3 Scooters
Q2 = 3 Scooters
Q1 = 3 Scooters
2
4
6 Wheels
(3) Convex Isoquant
This form assumes substitutability of inputs but the substitutability is not perfect. For
example, a shirt can be made with relatively small amount of labour (L1) and a large amount
of cloth (c1). The same shirt can be as well made with less cloth (C2), if more labour (L2) is
used because the tailor will have to cut the cloth more carefully and reduce wastage. Finally,
the shirt can be made with still less cloth (C3) but the tailor must take extreme pains so that
labour input requirement increases to L3. So, while a relatively small addition of labour from
L1 to L2 allows the input of cloth to be reduced from C1 to C2, a very large increase in labour
from L2 to L3 is needed to obtain a small reduction in cloth from C2 to C3. Thus the
substitutability of labour for cloth diminishes from L1 to L2 to L3.
cloth
C1
C2
Q2
C3
Q1
L 1 L2
Labour
L3
Main Properties of Isoquants
1.
An isoquant is downward sloping to the right, i.e., negatively inclined. This implies
that for the same level of output, the quantity of one variable will have to be reduced in order
to increase the quantity of other variable.
2.
A higher isoquant represents larger output. That is, with the same quantity of one input
and larger quantity of the other input, larger output will be produced.
3.
No two isoquants intersect or touch each other. If two isoquants intersect or touch each
other, this would mean that there will be a common point on the two curves; and this would
imply that the same amount of two inputs can produce two different levels of output (i.e., 400
and 500 units) which is absurd.
4.
Isoquant is convex to the origin. This means that its slope declines from left to right
along the curve. In other words, when we go on increasing the quantity of one input say
labour by reducing the quantity of other input say capital, we see that less units of capital are
sacrificed for the additional units of labour.
2.5 Production Function With All Variable Inputs
A closely related question in production economics is how a proportionate increase in
all the input factor will affect total production. This is the question of returns to scale and one
can think of three possible situations:
1.
If the proportional increase in all inputs is equal to the proportional increase in output,
returns to scale are constant. For instance, if a simultaneous doubling of all inputs results in a
doubling of production, then returns to scale are constant
Q
X,Y
Constant returns to scale
2. If the proportional increase in output is larger than that of the inputs, then we have
increasing returns to scale.
Q
X,Y
Increasing returns to scale
3. If output increases less than proportionally with input increases, we have decreasing returns
to scale.
Q
X,Y
Decreasing returns to scale
The most typical situation is for a production function to have first increasing then decreasing
returns to scale as shown in figure.
Q
X,Y
Variable returns to scale
The increasing returns to scale are attributable to specialization. As output increases,
specialized labour can be used and efficient, large-scale machinery can be employed in the
production process. However, beyond some scale of operations not only are further gains from
specialization limited, but also coordination problems may begin to increase costs
substantially. When coordination costs more than offset additional benefits of specialization,
decreasing returns to scale begin.
Returns to Scale and Elasticity Concept
There is an elasticity concept which is related to the returns to scale concept. This is
known as All Input-Elasticity of Output. The formula is:
eQ.I =
Percent change in output
Percent change in all outputs
=
 Q  I 

  for discrete function
 I  Q 
 Q  I 

  for continuous function
 I  Q 
Where
Q = Output, I = All Inputs
eQ.I = All Input Elasticity of Output
If eQ.I> I, there are increasing returns to scale
If eQ.I = I, there are constant returns to scale
If eQ.I< I, there are decreasing returns to scale
=
Returns to Scale and Returns to an Input
Two features of production functions that it is important to grasp are returns to scale
and returns to an input.
Returns to scale
Returns to scale describe what happens to the output rate when each input rate is
increased by the same proportion. If output increases by a larger percentage than the increase
in each input then there are increasing returns to scale; if it increases by a smaller percentage
there are diminishing returns to scale; if it increases by the same proportion there are constant
returns to scale.
Returns to an Input
Returns to an input describe what happens to output as only one input is varied,
holding all others constant. Again, these returns may be increasing, diminishing or constant.
Importance of Returns to Scale Concept
The returns to scale concept is quite important in the theory of production. If an
industry is characterized by increasing returns to scale, there will be a tendency for expanding
the size of the firm, and thus the industry will be dominated by large firms. The opposite will
be true in industries where decreasing returns to scale prevail. In case of industries
characterized by constant returns to scale, firms of all sizes would survive equally well.
EXPANSION PATH
The line representing least cost combination for different levels of output is called
firm‟s expansion path or the scale line, e.g., the line ABC in the following figure,
Y
Machinery
K3
L
K2
Expansion path
C
K1
P3
B
P2
A
X
P1
L1
L2
L3
Labour
Measurement of Production Function
Several types of mathematical functions are commonly employed in the measurement
of production function but in applied research, four types have had the widest use. These are
linear functions, power functions, quadratic functions and cubic functions.
(1) Linear Function
A linear production function would take the form:
Total product: Y=a+bX
From this function, equation for average product will be:
(Y/X )=(A/X) +b
The equation for the marginal product will be:
 y 
 b
 x 
(2) Power Function
A power function expresses output, Y, as a function of input X in the form:
Y=aXb
Some important special properties of such power functions are:
(i) The exponents are the elasticities of production. Thus, in the above function, the
exponent b represents the elasticity of production.
(ii) The equation is linear in the logarithms, that is, it can be written
log Y=log a+b log X
When the power function is expressed in logarithmic form as above, the coefficient b
represents the elasticity of production.
(iii) If one input is increased while all others are held constant, marginal product will
decline.
(3) Quadratic Production Function
The production function may be quadratic, taking the following from:
Y=a+bX-cX2
Where the dependent variable, Y, represents total output and the independent variable,
X, denotes input. The small letters are parameters; their probable values, of course, are
determined by a statistical analysis of the data.
The special properties of the quadratic production function are as under:
(i) The minus sign in the last term denotes diminishing marginal returns.
(ii) The equation allows for decreased marginal product but not for both increasing and
decreasing marginal products.
(iii) The elasticity of production is not constant at all points along the curve as in a
power function, but declines with input magnitude.
(iv) The equation never allows for an increasing marginal product.
(v) When X=0, Y=a. this means that there is some output even when no variable input
is applied.
(vi)The quadratic equation has only one bend as compared with a linear equation
which has no bends.
(4) Cubic Production Function
The cubic production function takes the following form:
Y=a+bX=cX2-dX3
Some important special properties of a cubic production function are:
(i) It allows for both increasing and decreasing marginal productivity.
(ii) The elasticity of production varies at each point along the curve.
(iii) Marginal productivity decreases at an increasing at an increasing rate in the later
stages.
COBB-DOUGLAS PRODCTION FUNCTION
The Cobb-Douglas production function is based on the empirical study of the
American manufacturing industry made by senator Paul H.Douglas and C.W.Cobb. The
general form of C-D production function is Q= ALα Kβ
L→ labour input
K→ capital input
A→ constant or efficiency parameter
α & β→ positive constants
The effect of a change in the scale of input correspond to change in output it is known
as returns to scale. If increase in the input correspond to increase in output it is termed as
increasing returns of scale. If by increase in the input correspond to small increase in output it
is termed as diminishing returns of scale.
The sum of the components (α + β ) represents returns to scale.
 if α + β =1, the firm would be operating under the constant return to scale.
 if α +β < 1, it will have diminishing returns to scales.
 if α + β > 1, it will have increasing returns.
Properties of C-D Production Function
1. The elasticity of substitution is equal to l
2. It‟s iso- quant is downward sloping
3. α and β are partial elasticity of output with respect to labour and capital respectively
4. Expansion path generated by its liner.
5. If one input is Zero, output will also be zero.
Criticisms
The following are the criticisms of the C-D function
1. It includes only two hector inputs- land and capital, but other sectors are equally important
in production process.
2. Labour input may be measured in number of man hours. but it is very difficult to measure
capital input due to depreciation over time.
3. It assumes constant technology.
4. It assumes there is a perfect competition the market.
5. It assumes that all labour units are homogeneous.
Uses of Production Function
There are many use of production function which are as follows
1.
It can be used to compute the least cost input combinations for a given output.
2.
A knowledge of production function is useful in deciding on the value of employing a
variable input factor on in the production process.
3.
Production function also aims at long – run decision making. If the return to scale are
increasing there will be increase production and there is enough market for the product.
2.6 Cost Concepts
Meaning
Cost means the actual expenditure incurred for producing a product or service
Cost Concepts and Classifications
The kind of cost concept to be used in a particular situation depends upon the business
decisions to be made. Cost considerations enter into almost every business decision, and it is
important, though sometimes difficult, to use the right kind of cost. Hence an understanding of
the meaning of various concepts is essential for clear business thinking. Defining and
distinguishing cost concepts are necessary to emphasize: (i) that cost estimates produced by
conventional financial accounting are not appropriate for all managerial uses, and (ii) that
different business problems call for different kinds of costs. Different combinations of cost
ingredients are appropriate for various kinds of management problems.
Actual Cost and Opportunity Cost
Actual cost mean the actual expenditure incurred for acquiring or producing a good or
service. Opportunity cost can be defined as the revenue forgone by not making the best
alternative use.
Incremental Costs (Differential costs) and Sunk Costs
Incremental cost is the additional cost due to a change in the level or nature of
business activity. Sunk cost is one which is not affected or altered by a change in the level or
nature of business activity.
Past Costs and Future Costs
Past costs are actual costs incurred in the past ant are generally contained in the
financial accounts Future costs are costs that are reasonably expected to be incurred in some
future period or periods.
Short-run and Long-run Costs
Short-run costs are costs that vary with output when fixed plant and capital equipment
remain the same. Long-run costs are those which vary with output when all input factors
including plant and equipment vary.
Fixed and Variable Costs
Total costs could be divided into two components: fixed costs and variable costs.
Fixed costs remain constant in total regardless of changes in volume up to a certain level of
output. Thus total fixed costs do not change with a change in volume but vary per unit of
volume inversely with volume. Total variable costs vary in direct proportion to changes in
volume. A decrease in volume results in a proportionate decline in the total variable costs.
There is a linear relationship between volume and total variables costs, but variable costs are
constant per unit.
Direct and Indirect Costs (Traceable and Common Costs)
A direct or traceable cost is one which can be identified easily and indisputably with a
unit of operation (costing unit/costs centre) common or indirect costs are those that are not
traceable to any plant, department or operation, or to any individual final product.
Shutdown and Abandonment costs
Shutdown costs may be defined as those costs which would be incurred in the event of
suspension of the plant operation and which would be saved if the operations are continued.
Abandonment costs are the costs of retiring altogether a plant from service.
Urgent and Postponable costs
Those costs which must be incurred in order to continue operations of the firm are
urgent costs; Costs which can be postponed at least for some time, are known as postponable
costs.
Out-of-Pocked and Book Costs
Out-of-pocked costs refer to costs that involve current cash payments to outsiders.
Book costs such as depreciation do not require current cash payments. In concept, this
distinction is quite different from traceability and also from variability with output.
Escapable Costs
Escapable costs refer to costs which can be reduced due to a contraction in the actives
of a business enterprise.
Replacement and Historical Costs
Historical cost means the cost of a plant at a price originally paid for it. Replacement
cost means the price that would have to be paid currently the same plant.
Controllable and Non-Controllable Costs
A controllable cost may be defined as one which is reasonably subject to regulation by
the executive with whose responsibility that is reasonably subject to regulation by the
executive with whose responsibility that cost is being identified. Non controllable costs are
beyond the control of management.
Average Cost, Marginal Cost and Total Cost
Average cost is the total cost divided by the total quantity produced. Marginal cost is
the extra cost of producing one additional unit. Total cost infers to all cash payment.2.6.1 COST DETERMINANTS
The cost of production of goods and services depends on a number of factors; these
factors may differ from firm to firm within an industry and from one industry to another. The
important cost determinants are as under:
(i) Level of Output
The larger the output, the greater will be the production cost. For there will be larger
use of various factors of production who shall get larger payments. Thus, total cost varies
directly with output.
(ii) Prices of Input Factors
A rise in factor price also increases total production cost. The various factors of
production, viz., land, labour, capital and organization get rent, wages, interest and salary
respectively as their reward. Obviously larger payments will have to be made to the factors of
production when their prices go up. Thus, the cost of production varies directly with the price
of factors of production.
(iii) Productivities of Factors of Production
Productivity of a factor of production refers to the output per unit of that factor. The
higher the productivity of a factor of production, the lower the cost per unit of the input factor.
Thus, an increase in factor productivities would reduce the total production cost for producing
a given output.
Productivity and efficiency are synonymous. Factor efficiency can increase in several
ways such as increasing the machine speed, raising the number of hours per day and/or month
the machine is operated, and so on. Given a certain output, an increase in efficiency brings
down the total production costs.
(iv) Size of Plant
Plant size is yet another important cost determinant. Production costs are generally
lower in case of bigger plants than in smaller plants. This is so because of economies of large
scale production. Notably, with a bigger size, although initial fixed costs are high variable
costs tend to be low compared with a small with sized plant.
(v) Output Stability
Stability of output also leads to savings in various kinds of hidden costs of interruption
and learning. Overall costs are generally lower where output is stable ant constant over a
period of time. Production by sudden breaks and disruption is bound to be costly.
(vi) Lot Size
Lot size also affects production costs. Lot size here means the size of a single
production job. In cases where the installation costs of machinery are considerable, the
economy of large lots is significant. Moreover, it is possible to process a bigger lot at one
time, the total cost of operation and thereby the unit cost will be lower compared with a
process in which only smaller lot sizes are produced.
(vii) Laws of Returns
In case the law of diminishing returns is operating, the cost will show a tendency to
rise. The reverse will be the case when the law of increasing returns operates.
(viii) Level of Capacity Utilization
In the short run, level of capacity utilization determines the cost. This especially affect
the per unit fixed cost. Thus, with higher capacity utilization. Fixed cost per unit of output is
bound to be low.
(ix) Period under Consideration
If one considers the short period, the cost curve will rise steeply. However, in case of
long period, cost would not increase that steeply.
(x) Technology
Technology is an important cost determinant. Technological progress or improvement
leads to an increase in the efficiency or productivity of factors of production. This in turn
leads to a reduction in the cost of production. In other words cost varies inversely with
technological progress. Also, most technological innovations aim at reducing costs.
A knowledge of the relationship between cost and technological progress is essential
to forecast the cost the change in technology generally change the equipment, the size of the
plant and the plant flexibility to output changes.
A forecast of technology is also essential for the purpose of tackling the problem of
equipment replacement. Here one has to determine the degree of obsolescence of the old
machine to be replaced.
(xi) Learning Effect
Learning effect means that in many activities costs decline as the activity is repeated
an increasing number of times. Asworkers and management become more familiar with a
production process or a particular product, there will be cost reductions. If there are
substantial learning effects, there will be first-mover advantages by virtue of being the first to
undertake an activity as against late-comers.
(xii) Breadth of product Range
Costs are determined by the breadth of product range. Such cost advantages can occur
when the processing of different goods can share inputs or where distribution and promotion
can take place jointly.
(xiii) Degree of Vertical Integration
Cost advantages can be had by increasing the degree of vertical integration within the
firm, moving closer to the final customer (forward vertical integration) or to sources of supply
(backward vertical integration).
(xiv) Geographical Location
Costs may be affected by geographical location when factor prices, tax regimes and
government incentives vary from place to place.
(xv) Institutional Factors
Institution factors like unionization, local content/indigenization rules and tariffs also
affect costs.
(xvi) Firm’s Discretionary Policies
Costs also depend upon a wide range of firm‟s discretionary policies. The examples
are:
(i) Nature and design of the product being manufactured;
(ii) Level of service provided to customers;
(iii) Package of human resources policies adopted regarding pay, incentive schemes,
employee benefits,training, etc.
COST FUNCTION
The cost function express a functional relationship between total cost (C) and factors
that determine it (ie) the output (Q) the level of technology (T) the prices of the factor (P) and
fixed factors (F). Symbolically the cost function becomes,
C=F(Q,T,PF,F)
In order to simplify the cost analysis, certain assumption are made
1. A firm produces a single homogeneous goods with the help of certain factors of production
some of the factors are fixed and some other are variable and the prices of these factors are
fixed based on the marketing conditions.
2. The technology (t) which is used in the production are also fixed. Thus the total cost
function is expressed as
C=F (Q)
which means that total cost is a function (F) of output (Q) assuming all other are constant.
The cost function is shown diagrammatically.
In the above diagram, the total cost (TC) curve increases due to increase in the output.
But any changes in the fixed factors then the total cost curve are also changed. For example if
any changes in the technology ie., the technology of production increased then the total cost of
the product come down and it is shown in the diagram the TC curve falls to TC1 curve. Due to
reduction in technology the cost get increased and the cure raised to TC2.
The cost function is observed both in short run and long run. in short run some of the
factors are fixed and the firm may have both fixed and variable cost. But in long run, all
factors are variable and the firm may have only variable cost.
Cost-Output Relationship
The study of cost-output relationship has two aspects:
1. cost-output relationship in the short run, and
2. Cost –output relationship in the long run.
The short run is a period which does not permit alterations in the fixed equipment
(machinery, buildings, etc.) and in the size of the organization. As such, if any increase in
output is desired, it is possible within the range permitted by the existing fixed factors of
production.
The long run is a period in which there is sufficient time to alter the equipment
(machinery, buildings, land, etc.) and the size of organization. As such, in the long run, output
can be increased without any limits being placed by the fixed factors of production as they
themselves are capable of being changed.
COST-OUTPUT RELATIONSHIP IN THE SHORT RUN
In economic theory, the cost-output relationship in the short run may be studied in
terms of (1) average fixed cost, (2) average variable cost, and (3) average total cost as follows:
1. Average Fixed Cost and Output
The greater the output, the lower the fixed cost per unit, i.e., the average fixed cost.
The reason is that total fixed costs remain the same and do not change with a change in
output. The relationship between output and fixed cost is a universal one for all types of
business. Average fixed cost falls continuously as output rises. The reason why total fixed
costs remain the same and the average fixed cost falls is that certain factors are indivisible.
Indivisibility means that if a smaller output is to be produced, the factor cannot be used in a
smaller quantity. It is to be used as a whole.
2. Average Variable Cost and output
The average variable costs will first fall and then rise as more and more units are
produced in a given plant. This is so because as we add more units of variable factors in a
fixed plant, the efficiency of the inputs first increases and then decreases. In fact, the variable
factors tend to produce somewhat more efficiently near a firm‟s optimum output than at very
low levels of output. But once the optimum capacity is reached, any further increase in output
will undoubtedly increase average variable cost quite sharply. Greater output can be obtained
but at much greater average variable cost. For example, if more and more workers are
appointed, it may ultimately lead to overcrowding and bad organization. Moreover, workers
may have to be paid higher wages for overtime work.
3. Average Total Cost and Output
Average total costs, more commonly known as average costs, would decline first and
then rise upwards. The significant point to note here is that the turning point in the case of
average cost would come a little later than in the case of average variable cost.
Average cost consists of average fixed cost plus average variable cost. As we have
seen, average fixed cost continues to fall with an increase in output while average variable
cost first declines and then rises. So long as average variable cost decline the average total
cost will also decline. But after a point, the average variable cost will rise. Here, if the rise in
variable cost is less than the drop in fixed cost, the average total cost will still continue to
decline. It is only when the rise in average variable cost is more than the drop in average fixed
cost that the average total cost will show a rise. Thus, there will be a stage where the average
variable cost may have started rising yet the average total cost is still declining because the
rise in average variable cost less than the drop in average fixed cost, the net effect being a
decline in average cost. And it is clear that the turning point in the case of average cost is at a
point later than that in the case of average variable cost.
The least cost-output level is the level where the average where the average total cost
is the minimum and not the average variable cost. In fact, at the least cost-output level, the
average variable cost will be more than its minimum (average variable cost). The least costoutput level is also the optimum output level. It may not be the maximum output level. A firm
may decide to produce more than the least cost-output level.
Short-run Output Cost Curves
The cost-output relationships can also be shown through the use of graphs. It will be
seen that the average fixed cost curve (AFC curve) falls as output rises from lower levels to
higher levels. The shape of the average fixed cost curve, therefore, is a rectangular hyperbola.
The average variable cost curve (AVC curve) first falls and then rises. So also the average
total cost curve (AVC curve). However, the AVC curve starts rising earlier than the ATC
curve. Further, the least cost level of output corresponds to the point LT on the ATC curve and
not to the point LV which lies on the AVC curve.
Another important point to be noted is that in the given figure the marginal cost curve
(MC curve) intersects both the AVC curve and ATC curve at their minimum points. This is
very simple to explain. If marginal cost (MC) is less than the average cost (AC), it will pull
AC down. If the MC is greater than AC it will pull AC up.If the MC is equal to AC, it will
neither pull AC up nor down. Hence MC curve tends to intersect the AC curve at its lowest
point. Similar is the position about the average variable cost curve. It will not make any
difference whether MC is going up or down.
The rate of change in MC is greater than that in AVC and hence the minimum MC is
at an output lower than the output at which the AVC is the minimum. The ATC is at a larger
output than the minimum AVC.
The inter-relationships between AVC, ATC and AFC can be summed up as follows:
1. If both AFC and AVC fall, ATC will fall.
2. If AFC falls but AVC rises:
(a) ATC will fall where the drop in AFC is more than the rise in AVC.
(b) ATC will not fall where the drop in AFC is equal to the rise in AVC.
(c) ATC will rise where the drop in AFC is less than the rise in AVC.
COST-OUTPUT RELATIONSHIP IN THE LONG-RUN
Long-run Costs
In order to study the cost-output relationship in the long- run, it would be necessary to
explain the concept of long-run costs.
The long-run, as we have already seen earlier, is a period long enough to make all
costs variable including such costs as are fixed in the short- run. In the short-run variations in
output are possible only within the range permitted by the existing fixed plant and equipment.
But in the long run, the entrepreneur has before him a number of alternatives which include
the construction of various kinds and sizes of plants. Thus there are no fixed costs since the
firm has sufficient time to fully adapt its plant. And all costs become variable. In view of this,
the long-run costs would refer to the costs of producing different levels of output by changes
in the size of plant or scale of production. The long-run cost-output relationship is shown
graphically by the long-run cost curve-a curve showing how costs would change when the
scale of production is changed.
The concept of long-run costs can be further explained with the help of an illustration.
Suppose that at a particular time, a firm operates under average total cost curve U2 and
produces OM. Now it is desired to produce ON. If the firm continues under the old scale, its
average cost will be NT. If the scale of the firm is altered, the new cost curve would be U 3.
The average cost of producing ON would then be NA. NA is less then NT. so the new scale is
preferable to the old one and should be adopted. In the long run, the average cost of producing
ON output is NA. This may be called as the long-run cost of producing ON output. It may be
noted here that we shall call NA as the long-run cost only so long as the U3 scale is in the
Planning stage and has not actually been adopted. The moment the scale is installed, the NA
cost would be the short-run cost of producing ON output.
To draw a long-run cost curve, we have to start with a number of short-run average
cost curve (SAC curves), each such curve representing a particular scale or size of the plant,
including the optimum scale. One can now draw the long-run cost curve which would be
tangential to the entire family of SAC curves. That is, it would touch each SAC curve at one
point. In this connection the following points are to be noted:
1. The LAC curve is tangential to the various SAC curves. It is said to envelop them
and is after called as the “Envelope Curve” since no point on an SAC curve can ever be below
the LAC curve.
2. The LAC curve is U-shaped or like a „dish‟. The U-shape of the LAC curve implies
lower and lower average cost in the beginning until the optimum scale of the enterprise is
reached, and successively higher average costs thereafter, i.e., with plants larger than that of
the optimum scale.
The tendency for the long-run average costs to fall as the firm expands its scale of
operations is a reflection of cost economies available with the increase in size, while the
ultimate rise in the long-run cost curve is due largely to the eventual setting in of
diseconomies of scale.
The SAC curve also has a U-shape but the difference is that LAC curve is flatter, that
is, U-shape of the LAC curve will be less pronounced. This is because in the long run, such
economies are possible as cannot be had in the short run. Likewise, some of the diseconomies,
which are faced in the short run, may not be faced in the long run.
3. The long-run average cost curve can never cut short-run average cost curve (though
they are tangential to each other). This implies that for any given output, average cost cannot
be higher in the long run than in the short run. This is because any adjustment which will
reduce costs and which it is possible to make in the short run, can also be made in the long
run. On the other hand, it is not always possible in the short run to produce a given output in
the cheapest possible way.
4. LAC curve will touch the „optimum scale‟ curve at the latter‟s least-cost point, i.e.,
N1.
5. LAC curve will touch SAC curve laying to the left of the optimum scale curve at the
left of their least-cost points
6. LAC curve will touch SAC curve laying to the right of the optimum scale curve at
the right of their least-cost points
Thus it will be seen that LAC curve is tangential to the minimum cost point in the case
of the optimum scale SAC and not in the case of other SAC curve.
2.7 LEARNING AND COSTS
Business economists now emphasize another factor why, over a period of time average
costs fall. This factor is known as ‘Learning’.
The idea behind „learning‟ is that practice makes a man perfect. In the beginning,
workers on any job are slow and clumsy but with passage of time, they become more and
more skilful. Whenever product is made over and over aging, it is produced with more and
more efficiency and the average costs fall lower and gains become harder. This elementary
relationship between experience and productivity or inversely costs has far-reaching
implications because not only the workers but the managers also „learn‟.
Actually the effect of learning on production comes through several kinds of
improvements such as the following:
1. Job familiarization and less time to instruct workers,
2. More skilful movements of workers,
3. Better operation sequences, machine-feeds and speeds,
4. Improvements in machines and tooling,
5. Manufacturing lots are larger, cutting down the set-up time proportion, and
6. Improved coordination and management controls.
2.8 ECONOMIES OF SCALE
Marshall classified the economies of large-scale production into two types:
1. External Economies, and
2. Internal Economies.
External Economies
External Economies are those which are available to all the firms in an industry e.g.,
the construction of a railway line in a certain region which would reduce transport cost for all
the firms, the discovery of a new machine which can be purchased by all the firm, the
emergence of repair industries, rise of industries utilizing by-products, and the establishment
of special technical schools for training skilled labour and research institutes, etc. these
economies arise from the expansion in the size of an industry- involving an increase in the
number and size of the firm engaged in it.
The external economies occur when an industry is heavily concentrated in a particular
area. When this concentration happens, special facilities are attracted to the area. For example,
special technical schools are set up and equipment manufacturers build their plants in the area.
In addition, there is usually a pool of technically and professionally skilled labour available.
Interchange of technical information and ideas occurs through formal channels (e.g.,
professional societies) and informal channels (clubs, get-togethers, etc.)
Internal Economies
Internal economies are the economies which are available to a particular firm and give
it an advantage over other firms engaged in the industry. Internal economies arise from the
expansion of the size of a particular firm. From the managerial point of view, internal
economies are more important as they can be effected by managerial decisions of an
individual firm to change its size or scale or otherwise.
To distinguish between internal and external economies, one can say that the former
result due to the firm‟s own expansion while the latter arise not due to its own expansion but
due to expansion of some other firms/industry.
Types of Internal Economies
(a) Labour Economies
If a firm decides to expand its scale of output, it will be possible for it to reduce the
labour costs per unit by practicing division of labour.
Economies of division of labour arise because of (i) an increase in the skill of workers,
and (ii) the saving of time involved in changing from one operation to the other. Again, in
many cases, a large firm may find it economical to have a number of operations performed
mechanically rather than manually. These economies will be the greatest in firm where the
product is complex and the manufacturing processes are capable of being sub-divided.
(b) Technical Economies
There are economies derived from the use of sub-size machines and such scientific
processes as can be carried out in large production units. A small establishment cannot afford
to use intensively. On the other hand, their use will be quite uneconomical if they were to life
idle over a considerable part of the time. For example, a large electroplating plant costs a great
deal to keep deal to keep it in operation. Therefore, the cost per unit will greater the output is
large. Similarly, a machine pressing out the side of a motor car will take a week or more to be
put ready for operation to produce a particular design. The greater the output of cost this
particular design, the lower the cost per unit of getting the machine ready for operation.
Likewise, if a die is made to produce a particular model of cars, the cost of die per unit of cars
will depend upon the output of the cars. Very often large firms may find it economical to
produce or manufacture parts example. Hind Cycle, unlike small manufacturers, produced
parts and components themselves. Again, large firms may find it profitable to utilize their byproducts and waste naphthalene, etc. a small firm„s output of smoke would not be large
enough to justify setting up equipment necessary to do so.
(c) Managerial Economies
When the size of the firm increases, the efficiency of management usually increases
because there can be greater specialization in managerial staff. In a large firm, experts can be
appointed to look after the various sections or divisions of the business, such as purchasing,
sales, production, financing, personnel, etc. But a small firm cannot provide full-time
employment to these experts. Naturally, the various necessarily be experts. Moreover, a large
firm can afford to set up data processing and mechanized accounting, etc… whereas small
firms cannot afford to do so.
(d) Marketing Economies
A large firm can secure economies in its purchasing and sales. It can purchase its
requirements in bulk and thereby get better terms. It usually receives prompt deliveries,
careful attention and special facilities from its supplies. This is sometimes due to the fact that
a large buyer can exert more pressure, at times concessions from transport agencies.
Moreover, it can appoint expert buyers and expert salesmen. Finally, a large firm can spread
its advertising cost over bigger output because advertising costs do not rise in proportion to a
rise in sales.
(e) Economies of vertical integration
A large firm may decide to have vertical integration. This integration has the
advantage that the flow of goods through various stages in production processes is more
readily controlled. Steady supplies of raw materials, on the one hand, and steady outlets for
these raw materials, on the other, make changes. Vertical integration may also facilitate cost
for the enterprise. Transport costs may also be reduced by so planning transportation that
cross – hauling is reduced to the minimum.
(f) Financial Economies
A large firm can offer better security and is, therefore, in a position to secure better
and easier credit facilities both from its suppliers and its bankers. Due to a better image, it
enjoys easier access to the capital market.
(g) Economies of Risk- spreading
The larger the size of the business, the greater is the scope for spreading of risks
through diversification. Diversification is possible on two lines:
(i) Diversification of output. If there are many products, the loss in the sale of the
product may be called putting „all eggs in the same basket‟. Vickers Ltd., for example,
instruments and a wide range of other products. Many of the larger firms have taken to
diversification. ITC diversified to include marine products and hotel business in its operations.
(ii) Diversification of Markets. The larger producer is generally in a position to sell his
goods in many different and even far-off places. By depending upon one market, he runs the
risk of heavy loss if sales in that market decline for one reason or the other.
2.9 Diseconomies Of Scale
But economies of increasing size do not continue indefinitely. After a certain point,
any further expansion of size leads to diseconomies of scale. For example, after the division of
labour has reached its most efficient point, further increases in the number of workers will
lead to a duplication of workers. There will be too many workers per machine for really
efficient production. Moreover, the problem of coordination of different processes may
become difficult. There may be divergence of views concerning to arrive. Decision-making
process becomes slow resulting in missed opportunities.
There may be too much of red-tapes, too many individuals between the managers in
the executive office and workers in the factory and supervision may become difficult. The
management problems thus get out of hand with consequent adverse effects on managerial
efficiency.
The limit of scale economies is also often explained in terms of the possible loss of
control and consequent inefficiency. With the growth in the size of the organization, the
control by those at the top becomes weaker. Adding one more hierarchical level removes the
superior further away from the subordinates. Again, as the firm expands, the incidence of
wrong judgments increases and errors in judgment become costly. Finally, the larger the plant,
the larger is the attendant risks of loss from technological changes as technologies are
changing fast in modern times.
2.10 Cost Control
Meaning
Cost control means achieving the firms objectives at minimum cost. It means
reduction in the percentage of cost and in turn an increase in the percentage of profit.
Techniques of cost control
There are 2 techniques of cost control namely,
1.Budgetary control and
2.Standard costing
Budgetary control
1. Budgeting translates long term plans of the firm ie., reading the cost into deleted
short- term.
2. Budget usually starts with forecasting of sales in the future period and it termed as sale
budget.
3. Based on the sales budget, the production of the coming year are prepared and it is
beamed as production budget.
4. Depend upon the production budget the overhead expenses, Selling and distribution
expenses production cost are prepared .
5. Among all these, the cash budget and capital expenditure budget are prepared
6. All the department budgets are combined together and prepare master budget. Based
on the master budget the planned profit and loss a/c and balance sheet are prepared
which are the long term goals of the firm.
7. once the period of the budget starts, the actual cast are collected and compared it with
budgeted cost are and if any deviation the steps should be taken to rectify it.
Standard costing
In standard costing at first the standard cost are established. Standard cost is an
estimation of the total cost of the product.
1. After fixing the standard cost, the actual cost are collected and compared it, with
standard cost.
2. If the actual cost is high, then steps should be taken to rectify it.
3. If the actual cost is low, when compared to standard cost, then the standard cost should
be revised.
Cost Reduction
Meaning
Cost reduction is the achievement of real and permanent reduction in the unit cost of
goods, without reducing the quality of goods or usefulness of the products.
Cost Control and Cost Reduction
According to the Institute of cost and Works Accountants, London, cost control, as
generally practiced, lacks the dynamic approach to many of the factors affecting costs which
planned cost reduction demands. For example, under cost control, the tendency is to accept
standards once they have been fixed and leave them unchallenged over a period. In cost
reduction, no the other hand, standards must be constantly challenged for improvement. And
there is no phase of business which is exempt from cost reduction. Products, procedures and
personnel are subject to continuous scrutiny to see where and how they can be reduced in cost.
To achieve success in cost reduction, the management must be convinced of the need
for cost reduction. The formulation of a detailed and coordinated plan of cost institution of a
cost Reduction Committee consisting of all departments heads to review progress and assign
responsibilities to appropriate personnel. Every business operation should be approached in
the belief that each is a potential source of economy and may benefit from a completely new
appraisal. Often, it may be possible to dispense entirely with routines which, by tradition,
have come to be regarded as a permanent feature of the concern. Cost reduction is just as
much concerned with the stoppage of unnecessary activity as with the curtailing of
expenditure on that which is essential.
It is imperative that the cost of administering any scheme of cost reduction must be
kept within reasonable limits. What is reasonable must be determined in all cases from the
relationship between the expenditure and the savings which result from it.
2.11 Utility
Utility is the capacity of a commodity to satisfy human wants. It is defined as a
"want satisfying power of a commodity". It is a subjective concept and has no
material existence. It is not inherent in a commodity but depends upon the
mental make up of the consumer. The same commodity may have different
degrees of utility for different persons. Utility cannot be equated with usefulness.
A commodity may not be useful, yet it may have utility for a particular person.
Features of Utility :
(i) Utility is subjective in nature
(ii) Utility is relative and variable
(iii) Utility is not measurable
(iv) Utility, usefulness and pleasure
(v) Utility is Abstract
There are two approaches for measurement of utility :
(i) Measurement of utility in terms of money is called Cardinal UtilityApproach. The
amount of money which a consumer is prepared to pay fora commodity in the indirect
measurement of its utility.
(ii) Measurement of utility in term of ordinal numbers like I, II, III and so on it is Ordinal
Approach. In ordinal approach we may say that I is preferable to II etc.
Types of Cardinal Utility : Utility is of two types :(i) Total Utility : It is the amount of utility derived from the consumption of all the units
taken together at a time.
(ii) Marginal Utility : It is the additional utility derived from additional unit of a commodity.
The total utility and marginal utility are closely related with each other. Their relationship can
be illustrated as below:Relationship between Total Utility and Marginal Utility
Number Total
of Apples Utility
Marginal
Utility
1
30
30
2
55
25
3
75
20
4
90
15
5
100
10
6
105
5
7
105
0
8
100
-5
9
90
-10
10
75
-15
The above table reveals the following :(a) The marginal utility, before the point of satiety, is always positive, but with the
consumption of every additional unit of a commodity, it goes on diminishing.
(b) The marginal utility accruing from the consumption of the various units of a commodity,
no doubt, goes on diminishing, but the total utility accruing to the consumer goes on
increasing at a diminishing rate.
(c) The marginal utility falls to zero at the point of satiety, but the total utility remains
constants and stops increasing further from this point onward.
Thus, we can say that the total utility becomes maximum when the marginal utility falls to
zero.
(d) If the consumption of the commodity continues even beyond the point of satiety, then the
marginal utility accruing from the various units becomes negative, and the total utility starts
diminishing. Thus, we conclude that the total utility is maximum when the marginal utility
falls to zero and when the marginal utility becomes negative, the total utility also starts
diminishing.
2.12 Marginal Utility Analysis
This theory was propounded by Prof. Alfred Marshall, Through this theory he explained how
a consumer spends his income on different commodities so as to attain maximum satisfaction.
The theory is based on certain assumptions which
are as follows :(1) The Cardinal Measurability of Utility
(2) Constancy of the Marginal Utility of Money
(3) The Hypothesis of Independent Utility
(4) Rationality
Law of Diminishing Marginal Utility
The law in based on an important fact that although total wants are unlimited,
each single want is individually satiable. It means that since each want is satiable, the intensity
of want goes on diminishing as the consumer goes on increasing the units of consumption.
This law is in also known as ‘Gossen’s First law.’ To put it on Marshal‟s Word, “The
additional benefit which a person derives from a given increase of his stock of thing
diminishes with every increase in the stock that he already has.”
Units
1
2
3
4
5
6
7
8
Total
Utility
12
20
26
30
32
32
30
26
Marginal
Utility
12
8
6
4
2
0
-2
-4
} Positive Utility
Zero Utility
} Negative Utility
The above table shows the total and marginal utilities derived by a consumer on
consumption of a certain good. When the 1st unit is taken, total utility, is 12 units
and marginal utility is also 12 units. Further, as he goes on 5th unit, the total utility increases,
but at a diminishing rate, i.e. 20, 30, 32……….. but marginal utility falls with every
successive unit of consumption i.e. 8,6,4,2 when 6th unit in taken no addition is made to total
utility and marginal utility falls to zero. Further, when units taken are increased to 7th and 8th
units, total utility falls and marginal utility turns negative. This means that now at this stage
the consumer may also derive dissatisfaction instead of satisfaction. Hence, the consumer
would restrict his consumption to 6th unit.
It can be seen from the given figure that the marginal utility curve goes on
declining continuously, the law of diminishing marginal utility applies almost to
all commodities. However, few exceptions are there as pointed out by some
economists.
Exception to the Law :
(i) Rare Commodities (ii) Alcohol (iii) Music (iv) Miser Man (v) Complementary Goods
Limitations of the law : The law of diminishing marginal utility is applicable
only if the following hold good :(i) The different units consumed should be identical in all aspects.
(ii) The law may not apply to articles like gold, cash etc.
(iii) The presence or absence of complementary or substitutes may affect the
utility.
(iv) The commodity should be consumed in standard units e.g. if first unit of water is given to
a thirsty person by spoon, the second unit should be also given in spoon.
(v) There should be continues consumption i.e. there should be no time gap or interval
between the consumption of one unit and the other unit.
2.13Consumers Equilibrium:
A consumer is said to be in equilibrium when he is deriving maximum possible
satisfaction from the given commodities and is not in a position to rearrange his purchases of
goods, say x and y.
Assumptions in Consumers Equilibrium :
(i) The consumer has an indifference map, which depicts his scale or order of preference for
various combinations of two goods, say x and y.
(ii) He has fixed income to spend on x and y completely.
(iii) Prices of goods x and y are given and do not change.
Consumers equilibrium is illustrated in the figure given below :-
In order to determine consumer‟s point of equilibrium we make use of
indifference map and budget line together.
In the given figure :(a) AB is the budget line of the consumer.
(b) IC1, IC2 and IC3 are different indifference curves, showing different levels
of satisfaction.
In case he spends all his income on commodity x, he can buy OB quantity and
similarly, if he spends his entire income on Y he can purchase OA quantity of it.
However, if he wants to consume both the goods together he will try to reach a
situation of equilibrium where sacrifice made by him equals the satisfaction
derived.
Again, a rational consumer will try to reach the highest possible indifference
curve while staying in his budget line or affording capacity.
As shown is the figure, the consumer has at his options combinations D, C and E, but he
would option for combination at C because it will provide higher satisfaction in comparison to
point. D and E since both these points are lying on the lower indifference curve i.e. IC1,
further, points D and E are part of IC, the lower indifference curve and as known higher the
IC, higher is the level of satisfaction.
It can also be seen the point M is another level on the further higher. But it is beyond the
buying capacity of the consumer as can be seen. Hence, the consumers points of equilibrium
is determined at point C where he will consume OQ units of goods x and of units of goods Y.
At point C,Slope of Indifference Curve = Slope of Budget Line
i.e.
For every act of consumer there will be a separate equilibrium position of the
consumer. The condition that must be fulfilled by a consumer to be in
equilibrium are :(i)
(ii) Diminishing MRS
Hence, conclusively it can be said that given the indifference map and his budget
line, the equilibrium is defined by the point of tengency of the budget line with
the highest possible indifferent curve.