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COM 231
BUSINESS ECONOMICS - I
M. Com (M 17) – Part I
Semester - II
(Compulsory)
YASHWANTRAO CHAVAN MAHARASHTRA OPEN UNIVERSITY
Dnyangangotri, Near Gangapur Dam, Nashik 422 222, Maharashtra
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YASHWANTRAO CHAVAN MAHARASHTRA OPEN UNIVERSITY
Vice-Chancellor : Dr. M. M. Salunkhe
Director (I/C), School of Commerce & Management : Dr. Prakash Deshmukh
State Level Advisory Committee
Dr. Pandit Palande
Hon. Vice Chancellor
Dr. B. R. Ambedkar University
Muaaffarpur, Bihar
Dr. Suhas Mahajan
Ex-Professor
Ness Wadia College of Commerce
Pune
Dr. V. V. Morajkar
Ex-Professor
B.Y.K. College, Nashik
Dr. Mahesh Kulkarni
Ex-Professor
B.Y.K. College, Nashik
Dr. J. F. Patil
Economist Kolhapur
Dr. Ashutosh Raravikar
Director, EDMU,
Ministry of Finance, New Delhi
Dr. A. G. Gosavi
Professor
Modern College, Shivaji Nagar, Pune
Dr. Madhuri Sunil Deshpande
Professor
Swami Ramanand Teerth Marathwada
University, Nanded
Dr. Prakash Deshmukh
Director (I/C)
School of Commerce & Management
Y.C.M.O.U., Nashik
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Dist. AhmedNagar
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Associate Professor and
Associate Dean (Training)(Finance )
Dr. Surendra Patole
Assistant Professor
School of Commerce & Management
N I B M , Pune
Y.C.M.O.U., Nashik
Dr. Latika Ajitkumar Ajbani
Assistant Professor
School of Commerce & Management, Y.C.M.O.U., Nashik
Authors
Dr. J. F. Patil
Dr. R. S. Mhopare
Dr. R. A. Waingade
Dr. S. B. Yadav
Editor
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Dr. Latika Ajitkumar Ajbani
Assistant Professor, School of Commerce & Management
Y.C.M.O.U., Nashik
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Y.C.M. Open University, Nashik - 422 222.
Copyright © Yashwantrao Chavan Maharashtra Open University, Nashik.
(First edition developed under DEC development grant)
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M. Com. ( M 17) Part – I (Business Economics - I)
(Compulsory)
Semester - II
Contents
Pages
Unit 1. Nature, Scope and Definition of Managerial (Business) Economics
7 to 12
Unit 2. Importance, Contribution and Basic Concepts
13 to 16
Unit 3. Concept of Elasticity
17 to 28
Unit 4. Cardinal and Ordinal Utility
29 to 41
Unit 5. Revealed Preference Theory
42 to 50
Unit 6. Demand Forecasting Techniques
51 to 61
Unit 7. Theory of Production – I
62 to 71
Unit 8. Theory of Production – II
72 to 80
Unit 9. Economics and Diseconomies of Scale
81 to 80
Unit 10. Cost Concept
89 to 95
Unit 11. Theories of Costs
96 to 102
Unit 12. Optimum Production in The Short Run
103 to 105
INTRODUCTION
This book of self-instructional material is based on the syllabus for the subject
“Business Economics” - I (Com. 231). In practice sometimes some people
call this paper is Managerial Economics because most of the topics covered
by business economics and concepts, theories and tools developed therein
deal with decision making and practical management in the working of a
business unit, a firm or enterprise.
This book deals with basic concepts in business economics - i.e. - demand,
supply, elasticity, revenue and cost concepts and curves, market structure,
production function, demand projection.
The authors have kept in mind the fact that students here an distant
students, sprend over a large territory, different environment and do not
have regular interaction with feachers. Therefore, if has been our ulmost
effort to simplify, without affecting scientific quality and precision, in
the organization of SIM. Necessary numerical examples and diagrams are
used in explaination.
Comment, and modification and addition if any and welcome.
The editor and authors are grateful to the authorities of the YCMOU for
guidance and co-operation.
Nashik - January, 2016.
J. F. Patil
Editor
Business Economics
NOTES
6 Business Economics - I
UNIT 1 : NATURE, SCOPE AND
DEFINITION OF MANAGERIAL
(BUSINESS) ECONOMICS
Nature, Scope and Definition
of Managerial (Business)
Economics
NOTES
Structure
1.0 Introduction
1.1 Objectives
1.2 Subject Description
1.2.1 Nature and Scope of Business Economics
1.2.2 Scope of Managerial (Business Economics)
1.3 Summary
1.4 Some Important Words and their meaning
1.5 Questions for Self-Study
1.6 Answers to question for self study
1.7 Exercises
1.8 Field Work
1.9 Books for further reading
1.0
INTRODUCTION
The term managerial economics or business economics is of recent origin in
economics literature. We will use the managerial economics as synonymous with
business economics. Managerial Economics became a separate branch of
economics, more particularly after 2nd world was and growth of global business
through corporate organization, larger scale of operations and rapid improvements
and progress in technology vis-à-vis production and distribution. Modern business
– industry and trade, involves large man-power, intensive and extensive division
of labour, large amounts of financial capital and huge infrastructure. Most efficient
use of such large complexes of productive systems requires highly competent
and constantly dynamic management with full and precise understanding of basic
concepts of economics.
1.1
OBJECTIVES OF THE UNIT
The reader, after careful reading the contents of this unit, will be in a position to
understand in an elaborate way –
I. Definition of managerial economics.
II. Meaning of managerial economics.
III. Scope of managerial economics.
It is always essential to understand the basic meaning of study area along with a
proper grasp of scope of the topic and know the exact definition of what we are
studying. In this sub-unit we focus only on meaning, scope and definition of
managerial economics.
Business Economics - I 7
Business Economics
NOTES
1.2
SUBJECT DESCRIPTION
We discuss below some introductory aspects of the subject under study. It is a
simple, as far as possible, non-technical explanation of the content and scope of
the subject, here managerial economics.
1.2.1
DEFINITION OF MANAGERIAL ECONOMICS
The phrases Managerial Economics and Business Economics are broadly used to
mean the same thing. However, business economics is a term used to mean
economics which a business man should understand. Managerial Economics,
however, emphasises managerial functions, attributes and attitudes and abilities
required for carrying out managerial functions in any business manufacturing,
trade, financial services, agriculture and other services. In simple, managerial
economics enables a businessman to make proper economic decisions and
undertake proper timely, precise and effective forward planning.
Managerial economics evolved with the growth of industry and trade – hunting,
pastoral activities, agriculture, primary craft based industry, organised trade and
finance (commerce) and modern manufacturing and services industry. It is the
result of some organisers, businessmen and consultants in the field writing down
their experiences, difficulties and solutions.
We will examine some definitions of managerial economics in order to pinpoint
the exact meaning of managerial economics.
(i) Joel Dean : He defines managerial economics as –
“It is a departure from the main stream of economic writings on the
theory of firm; much of which is too simple in its assumptions and too
complicated in its logical development to be managerially useful”. In
clearer-words, simplification of rigorous economic theory is managerial
economics. Therefore, many experts in the field, believe that managerial
economics is the methodology of economics useful for the analysis of
business situations.
Many believe that managerial economics is the logic of economics as
applied to practical situations.
(ii) Prof. Watson : Let us examine Prof. Watson’s definition of managerial
economics. According Prof. Watson managerial economics is defined
as – “Price theory in the service of business executives.” In other words,
various aspects of price-theory, when made amenable to application
and solution of business problems, constitute managerial economics.
(iii) Prof. W. W. Haynes : He defines managerial economics as “the study
of the allocation of resources available to a firm or other units of
management among activities of that unit.” Each unit of business
organization undertakes activities like collection of raw material,
processing the same; packaging, distributing and advertising and finally
selling the product, storage and inventory, human resource management
etc. where at every step a decision regarding allocation of limited
resources in a productive, efficient manner requires understanding of
basic economics principles.
8 Business Economics - I
(iv) Prof. Gillis : Prof. Gillis maintains that ‘managerial economics deals
almost exclusively with those business situations which can be quantified
and dealt within a model or at least, approximately quantitatively.” In
other words, application of various principles, theories, laws and rules
of economics to business related decision making, is managerial
economics.
(v) Spencer and Siegelman : According to Spencer and Siegelman,
“managerial economics is the integration of economic theory with
business practice to facilitate decision making and forward planning.”
In other words, managerial economics needs proper understanding of
economic theory as also an understanding of planning for future.
Nature, Scope and Definition
of Managerial (Business)
Economics
NOTES
(vi) Eugene and James Papas : For Eugene and James Papas, managerial
economics requires “the application of economic theory and
methodology to business administration practices.”
(vii) McNair and Miriam define managerial economics as the use of
economic modes of thought to analyse business situations.
(viii) McGurial and Moyre make a more direct statement. According to them
“managerial economics is the application of economic theory and
methodology to decision making problems faced by both public and
private institutions.
(ix) Finally, we must note that for Prof. Mansfield managerial economics
is concerned with application of economic concepts and economic
analysis to the problem of formulating rational managerial decisions.
It is thus clear that – managerial economics
l
Uses economics principles.
l
Uses economic theory.
l
Uses economic logic.
l
Uses economic methodology.
to examine –
l
Business situations.
l
Business problems.
l
Allocation of resources.
to arrive at –
l
Rational managerial decisions.
l
Scientific economic decisions.
l
Uses economics knowledge for forward planning.
And –
For –
l
1.2.2
Efficient allocation of resources to maximise economic gain for the
business unit.
MEANING OF MANAGERIAL ECONOMICS
Economics, according to Lord Lionel Robbins is a study of human behaviour as a
relationship between unlimited ends and scarce means which have alternative
uses ‘Economic man aims at, in consumption, maximum utility and in production,
maximization of profits. Management is a way, scientific way of striking a balance
between multiplicity of requirements and scarcity of means with alternative uses.
Managerial economics is therefore a science which deals, more with behaviour
Business Economics - I 9
Business Economics
NOTES
of an entity (individual, partnership, corporate, non-govt. govt. and public,
charitable etc.) in the attempt to allocate and use scarce resources most efficiently
to maximise profits, sales, minimise costs and reach positions of optimization
and equilibrium in its material, economic functioning.
1.2.3
SCOPE OF MANAGERIAL ECONOMICS
The scope of managerial economics is vast and complex. We have already noted
two main functions of managerial economics.
l
Decision making.
l
Forward Planning.
The scope of managerial economics is decided by these two functions. Naturally,
various economic decisions comprise first part of scope of managerial economics.
If we carefully think over, it is realised that there are many major areas in which
businessmen are required to take decisions. These areas are –
(i) Decisions regarding demand condition.
(ii) Decisions regarding supply conditions.
(iii) Decisions regarding cost-conditions.
(iv) Decisions regarding pricing of products in different kinds of marked.
(v) Decisions regarding manpower, recruitment, training, placement,
promotion, termination and other working conditions.
(vi) Decisions regarding profit management.
(vii) Decisions regarding macro-economic conditions.
(viii) Decisions regarding financing and capital.
(ix) Decisions regarding choice of technology.
(x) Decisions about planning and policy.
No business unit wills be successful without a proper assessment of demand for
its product. He, the business owner, has to estimate potential demand, actual
demand, change in demand, tastes and habits behind demand, and factors affecting
demand. He must realise that quantity of his product also determines demand. He
has to understand elasticity of demand w.r.t. charges in income, prices and other
factors. He must also know about cross and substitution classification of demand
for this product.
After ascertaining and estimating demand, the businessman will have to
take decisions regarding production and costs. These decisions include, what to
produce, how much to produce, how to produce (technology); how to procure
raw material, at what prices, in what quantities and level of inventories. The
businessman requires to know about production function, returns to scale, division
of labour, factor substitution, industrial location etc. He must also take decisions
regarding recruitment of man power, distribution channels competing goods and
sales promotion.
10 Business Economics - I
The manager of business firm is continuously faced with various pricing
decisions, under different market conditions. This requires proper market analysis.
The price of the product, prices to be paid for raw materials, labour, capital and
overheads and many other things. The businessman must know various pricing
policies like – average cost pricing, cost plus pricing, discriminatory pricing,
going rate pricing etc.
The scope of managerial economics can be shown with following chart.
Managerial Decision Problem
l
Product price
l
Volume of output
l
Make or Buy
l
Technology
l
Inventory
l
Advertising, media and intensity
l
Labour-hiring, training, placement, pay-benefits (HRM)
l
Investment and financing
Nature, Scope and Definition
of Managerial (Business)
Economics
NOTES
Economic Concepts
l
Framework for division
l
Theory of consumer behaviour
l
Theory of the firm
l
Theory of market structure and pricing
Decision Sciences
l
Tools and Techniques of Analysis
l
Numerical analysis
l
Statistical Estimation
l
Forecasting
l
Game Theory
l
Optimization
Managerial Economics
l
Use of economic concepts and decision sciences
l
Methodology to solve managerial decision problems
l
Optimal solutions to managerial decision problem.
1.3
SUMMARY
l
1.4
Managerial Economics is application of economic logic to solve business
problems and business planning and take business decision.
SOME IMPORTANT WORDS AND THEIR
MEANING
l
Management – Taking decisions and planning.
l
Economics – Science of Choice.
l
l
Managerial Economics – taking economic decisions and organising
future economic behaviour.
Forward planning – planning for future short, medium and long-term.
Business Economics - I 11
Business Economics
1.5
QUESTIONS FOR SELF STUDY
i) What is managerial Economics?
ii) What are different areas of business decision making?
NOTES
1.6
ANSWERS TO QUESTION FOR SELF
STUDY
(i) According to Prof. Watson – “Managerial Economics is price theory in
the service of business executives.
(ii) Following are different avers of business decision making.
1.7
l
Demand conditions
l
Supply conditions
l
Production system
l
Pricing of product and factors of production
l
Profit maximization
l
Macro economic conditions.
EXERCISES
(i) Explain in detail the scope of managerial economics.
(ii) Discuss various decisions making situations in business.
1.8
FIELD WORK
l
1.9
Meet a businessman and discuss with him his business problems. Write
down the gist of your discussion.
BOOKS FOR FURTHER READING
l
‘Managerial Economics – Analysis for Business Decisions’, by Hague
D.C.
r r r
12 Business Economics - I
UNIT 2 : IMPORTANCE, CONTRIBUTION
AND BASIC CONCEPTS
Structure
Importance, contribution
and basic concepts
NOTES
2.0 Introduction
2.1 Objectives of the Unit
2.2 Subject Description
2.3 Summary
2.4 Some Important Words and their meaning
2.5 Questions for Self-Study
2.6 Answers to question for self study
2.7 Exercises
2.8 Field Work
2.9 Books for further reading
2.0
INTRODUCTION
This unit briefs about importance of managerial economics, its contribution and
explains some of the basic concepts.
2.1
OBJECTIVES OF THE UNIT
This unit will enable the reader to understand –
I. Importance of the subject business / managerial economics.
II. Contribution of business economics.
III. Important basic concepts in managerial economics.
2.2
SUBJECT DESCRIPTION
2.2.1
BASIC APPROACH
We all know that every firm ultimately aims at profit maximization-profits basically
depend on the difference between price-received and cost incurred in the
production of the good. In other words, the profits will be decided by the decision
of the businessman, regarding prices of inputs, quantity produced and sold, prices
of output etc. In all these respects, the business man will have to take decisions
with a view to maximising profit.
There are certain factors like changes in govt. policy, change in GDP, change in
bank-rates, CRR, exchange rate, planning which we call as macro-economic
factors. Changes in such macro-economic factors do affect the working and
success of business firms. A businessman, who is not alert to change in macroeconomic factors, may come into trouble any time. Whenever, there are changes
Business Economics - I 13
Business Economics
NOTES
in macro-factors, the businessman with have to revise his decision regarding what
to produce, how to produce, how much to produce and the price at which it is to
be sold.
Regarding the second major function-forward planning, the businessman must be
in a position to take decisions regarding – estimates of future demand, possibilities
of change in tastes and habits, emergence of competing goods, changes in govt.
policy and other macro factors. He has to have access to reliable data in this
respect.
Finally, we can conclude that reliable information and knowledge regarding
demand and supply, cost and revenue, production conditions, pricing, market
conditions macro-factors and various aspects of business environment constitute
the scope of the business economics.
2.2.2
CONTRIBUTION
OF
MANAGERIAL
ECONOMICS TO BUSINESS DECISION MAKING
Managerial economics uses basic economic analysis to take business decisions.
Theory of consumer behaviour, that is demand analysis helps business decision
making regarding size of demand, elasticity of demand, demand forecasting and
decision about changes in product price.
Theory of production (Firm) enables businessmen to decide upon production
technology, scale of production, factor-combination, location of unit and buying
of raw material and other inputs.
Theory of market equips the businessmen with alternative decision pattern in
response to type of market competition he faces, e.g. monopoly, duopoly oligopoly,
monopolistic completion and perfectly competitive market. It is a well-known
economic fact, that with increasing market competition the businessmen loses,
more and more his price making power and has to take prices given by the market.
Economics has developed (in its developed quantitative firm) various techniques
of measurement and fore-cast of demand, supply, elasticity and other economic
variables which make business decision making more and more precise and reliable
with advances in econometrics, the capacity to predict well as to more meaningfully
explore economic causation, has improved, which strengthens capacity of
businessmen to take decisions.
2.3
SUMMARY
Managerial economics helps businessmen in making choices and taking economic
decisions regarding resource allocation, factor & product pricing, technology,
location and profit maximization. It also helps in scientific forward planning in
respect of all the business aspects mentioned above.
2.4
14 Business Economics - I
SOME IMPORTANT WORDS AND THEIR
MEANING
There are a set of basic concepts or postulates in economics which very effectively
can guide a businessmen in taking business decision. These basic concepts or
postulates are briefly explained below –
(i) Choice - a basic economic problem : According to Lord Robbins
economics is fundamentally a science of choice between alternatives
with limited resources. Resources are always limited. They have
alternative uses. Therefore, economics is making a profitable choice.
Businessmen are always confronted with such choices.
Importance, contribution
and basic concepts
NOTES
(ii) The Principle of tradeoff : When our resources are limited and we
have to buy or obtain say both X and Y, then with limited resources, I
can have more of X only when Ireduce use of Y by some units. With
limited resources, I cannot increase consumption of both X and Y at the
same time. This is known as principle of trade of.
(iii) The opportunity cost : The real cost of some thing is something that
we give up to get that thing. Suppose I have only Rs. 100/-. I can use
that amount to buy a ticket to a multiplex and enjoy a cinema. But if buy
a book on economics for Rs. 100/- then I have to forget about cinema.
Therefore, opportunity cost of having a book is giving up enjoying a
cinema.
(iv) Incentives are causes for change in human behaviour : When prices
or attributes of goods change, human demand for those goods also
changes. Law of demand is a very simple but clear example of how
incentives change human behaviour. If you reduce the price of particular
type of Banarash silk sari, many more buyers will buy more units of
that sari. Similarly if you improve quality (in terms of colour, durability,
design) of your product, people will buy more units of your product,
even at the same price.
(v) Margin : It is generally believed that human behaviour is rational. If
you are rational, you consider the effects of your change in behaviour
i.e. marginal benefits and marginal costs – A rational decision is one
where marginal benefits are greater than marginal costs. In case, as the
result of our decision, marginal benefits are exactly equal to marginal
costs, you will not change your earlier economic behaviour.
There are many other basic concepts in economics which need to be grasped –
These are –
(vi) Trade benefits all parties involved (buyer as well seller)
(vii) Free markets organise economic activity efficiently.
(viii) When market is not perfectly competitive, government action may
improve market outcome.
(ix) National income (GDP) which depends on capacity of the economy to
produce goods and services determines a country’s standard of living in
a direct way.
(x) Larger money supply, at least in short period, causes inflation.
(xi) At higher levels of inflation, unemployment is lower, and vice-a-versa.
(xii) Price-mechanism that operates in market, ensures distribution of goods
and services (products and factors) efficiently.
(xiii) Forces of demand and supply give us the basic framework for economic
analysis and decision making.
Business Economics - I 15
Business Economics
2.5
QUESTIONS FOR SELF-STUDY
1. Explain the importance of managerial economics
2. List the contribution of managerial economics.
NOTES
3. List the basic concepts of managerial economics.
2.6
ANSWERS TO QUESTION FOR SELF
STUDY
1. Managerial economics assists business executives to take important
business decisions like, what to produce, how to produce, how much to
produce, pricing the product, factors utilization, sales promotion, and
maximisation profits. It also helps businessmen in forward planning
regarding the aspects mentioned above.
2. Managerial Economics contributes to business management in following
ways –
(a) Allocation of resources.
(b) Factor utilization.
(c) Choice of production techniques
(d) Sourcing raw materials.
(e) Sales promotion.
(f) Price setting.
(g) Identifying markets.
3. Basic concepts in managerial economics are - choice, trade off,
opportunity cost, incentives, margin, market.
2.7
EXERCISES
1. Discuss various economic decisions a businessmen has to take?
2. Explain basic elementary concepts in managerial economics.
2.8
FIELD WORK
l
2.9
Discuss with a small group of shop-keepers their initial and regular
problems while decision making is involved.
BOOKS FOR FURTHER READING
l
‘Managerial Economics – Analysis for Business Decision’, Hague
D. C.
r r r
16 Business Economics - I
UNIT 3 : CONCEPT OF ELASTICITY
Structure
Concept of Elasticity
NOTES
3.0 Introduction
3.1 Objectives
3.2 Subject Description
3.3 Summary
3.4 Important Words and their meaning
3.5 Questions for Self-Study
3.6 Answers to question for Self-Study
3.7 Exercises
3.8 Field Work
3.9 Books for further reading
3.0
INTRODUCTION
Concept of elasticity, regarding demand and supply, more so in regard to demand
is a vital tool of economic analysis and decision making. This unit explain elasticity
concept in all its important aspects.
3.1
OBJECTIVES
The study of this unit will acquaint the reader with –
I. Definition of concept of elasticity.
II. Various types of elasticity of demand.
III. Elasticity of Supply.
and IV. Applications of the concept of elasticity.
3.2
SUBJECT DESCRIPTION
3.2.1
ELASTICITY CONCEPT
In this part we examine- the concepts of elasticity of demand, its different types
and also the concept of elasticity of supply.
The objectives of this sub unit are – to
(i) understand the concept of elasticity with regard to demand and supply.
(ii) evolve and use precise formulae for measuring different types of
elasticity of demand and supply.
and (iii) Solve practical examples of elasticity of demand and supply.
Business Economics - I 17
Business Economics
3.2.2
INTRODUCTION
In economics, the concept of elasticity in regard to demand and supply, constitutes
a basic element of foundation of economic principles and decision making.
NOTES
According to law of demand given other things, a change in price of a commodity
causes opposite changes in demand for that commodity at a given time. To be
more elaborate, given other things.
l
l
l
l
3.2.3
A decrease in price of X will increase quantity demanded of X or;
A increase in price of X will decrease quantity demanded of X. In brief,
changes in price of X and quantity demand of X are inversely related.
However, in regard to supply, changes in price of X and quantity supplied
of X, are directly related. i.e. if price of X increase, supply of X will
increase and vice-r-versa.
The concept elasticity is a measure of intensity or degree of response of
demand or supply of a commodity, to a change in the price of a
commodity.
THE CONCEPT OF ELASTICITY
Broadly elasticity is a measure of change in effect due to a change income.
In economic theory, there are certain fundamental laws e.g.
Law of Demand
and
Law of Supply
These are causal relations between price of commodity X and changes in demand
for and supply of such commodity X due to changes in the price.
It is normally accepted that –
P of X and D of X are inversed related.
P of X and S of X are directly related – of course where other things remain
constant.
3.2.4
PRICE ELASTICITY OF DEMAND
The law of demand in economics tells us that other things being constant- a change
in price induces an opposite change in the quantity demanded of the commodity.
But this relationship indicates only the direction of change. If we want to measure
the quantity of change in demand due to a certain quantity of change in price, we
must use the concept of elasticity of demand. In this case, other things which are
supposed to be constant are income, habits and tastes of the consumer and prices
of other close substitutes in the market.
Price Elasticity of Demand is, according to Marshall, the responsiveness of demand
for a commodity X to change in price of that commodity, Price elasticity or as
Boulding calls it relative elasticity, measures the proportionate change in quantity
demanded due to proportionate change in price of the commodity. Let us consider
the following formula.
Epx =
18 Business Economics - I
Relative change in quantity demanded of commodity X
_____________________________________________
Relative change in price of commodity X
Epx
qx
=
=
Where Px
Qx
Qx
Px
px
____ ____
)
qx
px

qx
____
px
V
Concepts of Elasticity
Px
___
qx
NOTES
= Original price of X
= Original quantity of X demanded
= change in quantity demanded
= change in price of X.
Let us explain this formula by a numerical example. Suppose price of sugar is Rs.
30 per kilogram. At this price, demand for sugar of a family, at a given time is 10
Kgs. Suppose price of sugar increases to Rs. 32 per Kg. The demand goes down
by 2 Kg. What is the price elasticity of demand for sugar? Let us calculate.
Px = Rs. 30/- Kg.
Qx = 10 Kgs.
Qx = 10 – 8 Kg. = 2 Kgs.
Px = 32 – 30 = Rs. 2
 2 ___
+2
___
Edp =
V
10
2
__
V
=
2
1
__
V
=
1
............. (Demand falls – ve)
............. (Price increases + ve)
30
30
__
10
3
__
1
= 3
 Elasticity of demand for sugar wrt price is 3, highly elastic. Normally
negative sign is disregarded. Negative sign indicates inverse relation
between price and demand changes.
3.2.5
TYPES OF PRICE ELASTICITY OF DEMAND :-
Price Elasticity of demand for different goods differs – following are different
types of price elasticity of demand.
(a) Perfectly Elastic Demand :In Fig. 1 PD is a demand curve.
OP is price and demand is infinite.
If there is slight change (rise) in
price demand disappears – A slight
fall in price increases demand
infinitely in a fully competitive
market-demand tends to perfectly
elastic demand curve is parallel to
OX axis.
(b) Normal Elastic Demand :This is shown in Fig. 1.2 when price is OP, demand is OD. When price is OP1
demand in OD1. When % change in demand is greater then % change in price,
Business Economics - I 19
Business Economics
NOTES
price-elasticity is greater than 1. The demand curve stopes downward to the left
and is fatter. In fig. 1.2-A we show is a steeper demand curve. Here % change in
price is greater than % change in demand, therefore demand is less elastic.
Therefore price-elasticity is less than one.
In fig. 1.2 & 1.2-B, we show a demand curve with a unitary elastic demand. In
this CRX % change in demand and % change in price are equal. Therefore, price
elasticity of demand is equal to one. It is unitary.
In fig. 1.2-C, we show a demand curve, which is parallel to OY axis (vertical to
OX axis). Such a demand is perfectly inelastic. Any change in price does not
change the quantity demanded.
Normal goods have more or less elastic demand. Goods which are basic necessities
or essential have inelastic demand. Luxury goods have elastic demand.
3.2.6
INCOME ELASTICITY OF DEMAND
Price is not the only factor which influences demand. There are other factors
like changes in income, which affect demand even when price remains
constant.
Respensiveness of demand to change in income measures income elasticity
of demand. The formula for measuring income-elasticity of demand is as
under.
Income Elasticity of Demand =
20 Business Economics - I
% change in demand
___________________
% change in income
Symbolically,
Concepts of Elasticity
Q
___
Eyd =
Y
V
Y
__
Q
NOTES
Where,
Eyd = Income elasticity of demand
Q = Change in quantity demanded
Y = Change in income.
When value of income elasticity is greater than one, proportionate change in
quantity demanded is greater than proportionate change in income. When value
of income elasticity in less than one, proportionate change in demand is less that
proportionate change in income, zero
income elasticity of demand
indicates that change income (+ or
! ) does not affect quantity
demanded. If increased income
reduces quantity demanded or viceversa; income elasticity becomes
negative.
Figure 1.3-A, B, C show different
types of income elasticity in respect
of different kinds of goods.
In Fig. 1.3-A, DD1 is a demand curve
wrt income. It is flatter and rises to
left. With a fall in income from I to
I1 demand falls from Q to Q. (viceversa). It is evident that a small
change in income causes a big
change in demand. Thus here income
elasticity is greater than one,
indicating superior good.
In this figure, we depict the example
of normal goods, where % change in
demand will be less than % change
in income. With a fall in income from
I to I1, demand falls from OQ to OQ1.
% change in demand is less than %
change in income. This is the case of
normal goods.
Fig. 1.3-C shows the example of
inferior goods. In case of such goods,
with a rise in income-demand falls
and vice-versa. In fig. 1.3-C income
falls from I to I1 and demand rises
from Q to Q1.
Curves of the nature of 1.3-A, B & C
are sometimes called as Engel
Curves.
Business Economics - I 21
Business Economics
NOTES
3.2.7
CROSS ELASTICITY OF DEMAND
Just as price of a good affects demand, factors like income and prices of other
commodities also affect demand. In the previous paragraph we examined various
possibilities of income elasticity of demand.
Now we examine the concept of cross-elasticity of demand. Now suppose there
are two goods X and Y. When we examine the responsiveness of demand for X,
(without change in its price) to a change in the price of Y, we measure Cross
Elasticity.
The formula for measuring cross elasticity of demand for X wrt (with respect to)
a change in the price of Y is given under.
X
Py
____ ___
V
PY
X
Exy =
Where,
Exy = Cross Elasticity of demand for X wrt.
To change in price of Y.
X = Change in demand for X good.
Y = Change in price of Y.
Py = Original price of Y.
X = Original demand for X.
When we measure cross elasticity of demand for X wrt Y, we keep price of X
constant and consumer’s income constant.
3.2.8
COMPETITIVE GOODS AND COMPLEMENTARY
GOODS AND CROSS ELASTICITY
It is evident that nature of goods X and
Y will influence value of cross
elasticity.
If X and Y are competitive goods, i.e.
they are substitutes for each other, the
cross elasticity of X wrt Y is positive.
If price of Basamati rise increases, the
demand for Ajara Ghansal also
increases. Similarly when price of
Basamati decreases, the demand for
Ajara Ghansal also decreases. This is
because consumer always tries to
substitute cheaper good for dearer
good. This is shown in figures 1.4-A
and 1.4-B.
Substitute Goods :-
22 Business Economics - I
In this case, demand curve D D1, is
positively sloped, which means if price
of Y increases, demand for X will also
increase. This is the case of substitute
goods like tea and coffee.
Complementary Goods :-
Concepts of Elasticity
In this case, if price of Y falls, demand for X increases and if price of Y increases,
demand for X also decreases. Such relationship is observed for complementary
goods like tea powder and sugar.
3.2.9
NOTES
FACTORS INFLUENCING PRICE - ELASTICITY
OF DEMAND
There are a number of non-price factors which influence price-elasticity of demand.
These include necessities for which Ep is inelastic e.g. foodgrains, salt, milk
edible oil etc. Demand Ep for luxuries like paintings and historical things is elastic.
Ep for durable goods like footwear, clothes etc is elastic. Goods like electricity
which has multiple uses, have elastic demand. Demand for substitute goods is
however elastic but for joint goods inelastic. It is also seen that price electricity
of demand is influenced by share of spending on a commodity in total consumer
spending. Price elasticity or various directly with share of spending on that
commodity in total spending. Finally, very low levels of price initially, do not
create significant changes in demand due to small changes in price. Rising income
level and more equal distribution of incomes increase price elasticity of demand.
In the long run, price elasticity of demand tends to increase. Greater and more
inclusive infrastructure tends to increase price elasticity of demand.
3.2.10 ELASTICITY OF SUPPLY
The responsiveness of supply to changes in price (other things remaining constant)
is elasticity of supply. The formula for measuring price-elasticity of supply is
given below.
S
P
___ __
V
P
S
Es =
As relationship between price and
supply is basically positive, other things
remaining constant, when price
decreases, supply decreases and when
price increases, supply also increases.
Price elasticity of supply is, however
determined in the long run by supply of
raw materials, technology, industrial
peace and govt. policy.
Normally, the supply curve is upward
sloping to the right as given in Fig. 1.5.
SS is a supply curve sloping upwards to the right. When price increases from P to
P1 supply increases from Q to Q1. Threfore, Es is equal to –
%
change in supply
________________
Es =
% change in price
QQ
____1
Es =
 OR
QQ
1
____
Es =
PP 1
PP1
) ___
OP
V
OQ
___
OP
Business Economics - I 23
Business Economics
It is elastic, in this case greater
than one.
Fig. 1.5-A is a case of infinitely
elastic supply which is very rare.
NOTES
Fig. 1.5-B is a case of perfectly
inelastic supply. This may happens in
very short period. But, supply is
normally more or less elastic.
3.2.11 MEASUREMENT
OF ELASTICITY
There are three methods of measuring
price-elasticity of demand; namely
(i) Total outlay Method or
Total Expenditure Method.
(ii) Point Method.
(iii) Arc Method.
We explain these methods in the following paragraphs.
Total Outlay Method :This is also known as Total Expenditure or Total Revenue method. Total revenue
of a firm is price (= AR) of the commodity and quantity of goods sold. Normally,
firms aim at maximising total revenue.
TR = Price X Quantity sold
TR = ARX Quantity sold
Where TR = Total revenue
A AR = Average Revenue. In a competitive
market AR = Price.
Total outlay (= expenditure = Revenue) method of measuring price – elacticity
was developed by Dr. Marshall. A seller will always look to changes in total
revenue as a responce to change in price. Let us take one example.
Table1.1 Demand Schedule
(for Wheat, Salt and Butter)
(Rs.)
Price Quantity
P x Q = TR
Quantity
P x X = TR
Quantity
P x Q = TR
P. demanded Total Revenue demanded Total revenue demanded Total revenue
Rs. /
Wheat
For Wheat
of Salt
for Salt
of butter
for butter
Kg.
Kg.
Rs.
Kg.
Rs.
Kg.
Rs.
Rs.10
200
2000
10
100
20
200
Rs. 8
220
1760
12.5
100
30
240
Rs. 5
300
1500
20
100
50
250
Source : Business Economics – By Dr. J. F. Patil & others,
Phadke Prakashan, Kolhapur-2003, P.64.
24 Business Economics - I
In the case of wheat, we find that, with falling price, total revenue is also falling.
It is clear that price elasticity of demand for wheat is less than one (less elastic).
In the case of salt, although there is fall in price, and quantity demanded increases,
the total revenue is constant. In such a case, price – elasticity of demand is unitary.
In the case of butter however, with fall in price, quantity demand increases
significantly and TR increases. This is an example of more than one elasticity of
demand. We can conclude –
l
l
l
When fall in price leads to decreasing TR, demand is less than unit
elastic.
When fall in price leads to constancy in TR, demand is Unitary elastic.
Concepts of Elasticity
NOTES
When fall in price leads to increasing total revenue TR demand is more
than one elastic.
3.2.12 THE POINT METHOD OF MEASURING PRICE
ELASTICITY OF DEMAND
This method is also known as
geometric method of measuring price
elasticity of demand. This method is
based on demand curve. When we
consider a demand curve (normally a
curve sloping downwards to right), we
take a point on the curve and then
consider a small change in it and
measure elasticity value in a geometric
way, therefore, it is also called as
geometric method of measuring price
– elasticity of demand – Let us now
examine a diagram in this regard and
measure price-elasticity of demand.
According to established analysis –
Point Easticity of Demand =
Lower segment of demand curve
____________________________
Upper segment of demand curve
In this figure, AF is the usual demand curve. OY measure price and DX measures
quantity demanded. A, B, C, D, E are points on the AF demand curve. Now as per
our formula,
Ep at point A =
AF
____
=  = infinite
Zero
Ep at point B =
BF
____
=>1
AB
Ep at point C =
BF
____
= 1 because CF = AC.
AC
Ep at point D =
DF
___
= < 1.
AA
Ep at point F =
Zero
____
= zero.
A
The numerical values of Ep can be found if we practically measure the
distances.
Business Economics - I 25
Business Economics
NOTES
3.2.13 ARC METHOD OF MEASURING ELASTICITY
Point method of measuring elasticity is useful only when demand curve is linear
straight line. However,
demand curves are rarely
straight-line – they are
usually
curvilinear.
Moreover, point method
measures elasticity for
slight changes in price. In
practice, businessmen are
interested to find out
demand response over a
range. In such cases ARC
method is used.
In this diagram, AB is a
demand curve. P and R are
two points on the curve (PR
constitutes the ARC)
According to ARC method, price elasticity of demand is measured by the following
formula.
Ep =
OP + OP1
OQ1 – OQ _________
_________
H
OQ1 + OQ OP – OP1
Where,
OQ = quantity demanded at price OP
OQ1 = quantity demanded at price OP1
OP = original price
OP1 = changed price
We can take a numerical example,
Price of Dawat Rise/Kg.
Quantity Demanded
Rs. 50/-
100 Kg.
Rs. 40/-
150 Kg.
Let us put these values in the above quotation.
100 – 150 ______
5+4
_________
H
100 + 150
5–4
–____
50 __
9
H
=
250
1
– 1 __
9
___
H
=
5
1
Ep =
=–
9
__
5
= – 1.8
26 Business Economics - I
 demand is significantly elastic.
3.2.14 APPLICATION OF THE CONCEPT OF PRICE
ELASTICITY OF DEMAND
The concept of price – elasticity of demand is useful in taking decisions regarding.
l
Product pricing.
l
Pricing of factors of production.
l
Deciding upon export and imports.
l
l
3.3
Concepts of Elasticity
NOTES
Deciding which goods to tax. Normally goods with less elastic demand
are taxed indirectly (Sales tax, excise duties, customs)
Government spending on subsidies.
SUMMARY
Concepts of elasticity wrt demand and supply, with changing prices and incomes,
constitute a basic part of decision making tools to be used by businessmen. More
importantly, elasticity can be measured numerically. It is also a tool of policy
making for consumers, producers and govt.
3.4
IMPORTANT WORDS AND THEIR
MEANING
(i) Elasticity : It means responce of a variable to a change in caused
variable.
(ii) Price Elasticity of demand : It is elasticity of demand due to small
changes in the price of the commodity.
(iii) Income Elasticity of Demand : It is elasticity of demand due to changes
in income of the consumer.
(iv) Cross Elasticity of Demand : It is elasticity of demand due to a change
in the price of a substitute good.
3.5
QUESTIONS FOR SELF-STUDY
1. What is price elasticity of demand?
2. What is income elasticity of demand?
3.6
ANSWERS TO QUESTION FOR SELFSTUDY
1. Price elasticity of demand means degree of responsiveness of demand
to small changes in price of the product, other things remaining constant.
2. Income Elasticity of demand means degree of responsivers of demand
to changes in income of the buyers, other things remaining constant.
Business Economics - I 27
Business Economics
3.7
EXERCISES
l
NOTES
3.8
Explain methods of measuring elasticity of demand wrt price
changes.
FIELD WORK
l
3.9
Collect price and demand data for onions in a market for two days a
fort-night apart and calculate elasticity values.
BOOKS FOR FURTHER READING
l
‘Managerial Economics – Analysis for Business Decisions’, Hogue D.C.
r r r
28 Business Economics - I
UNIT 4 : CARDINALAND ORDINAL
UTILITY
Cardinal and Ordinal Utility
NOTES
Structure
4.0 Introduction
4.1 Unit Objectives
4.2 Subject description
4.2.1 Cardinal and ordinal utility
4.2.2 Cardinal utility approach
4.2.3 Ordinal utility approach
4.3 Summary
4.4 Key terms
4.5 Questions and Exercises
4.6 Further reading and exercises
4.0
INTRODUCTION
Consumption is the beginning of all the productive and economic activities.
Households make demand for goods and services to satisfy their various needs.
Businessess produce or buy and sell various goods and services that are in
demanded. So, demand is the basis of all productive activities. In other words,
demand is the mother of production. The demand theory or the theory of consumer
behaviour seeks to explain the decision making behaviour of the consumer in
demanding a particular commodity. Therefore, it is necessary for business
managers to have a clear understanding of the source of demand, the factors
influencing buyers, decision regarding the quantity of products and the techniques
of market demand forecasting. Knowledge about market demand is vital for the
business managers in creating price, sales and output strategies. In this unit you
will read about neo-classical utility analysis i.e. the theory of consumer demand
as built by Marshall, Pigou and others. The neo-classical utility analysis is based
on the cardinal measurement of utility which assumes that utility is measurable
and additive. This unit will also describe the ordinal utility analysis i.e. the theory
of consumer behaviour as built by Prof. Hicks, a popular alternative theory of
consumer’s demand is the indifference curve analysis.
4.1
UNIT OBJECTIVES
After studying this unit, you should be able to –
l
Understand the cardinal utility approach of consumer behaviour.
l
Understand the ordinal utility approach of consumer behaviour.
l
Show consumer’s equilibrium according to cardinal utility approach.
l
Present and analysis consumer’s equilibrium by ordinal utility approach.
Business Economics - I 29
Business Economics
4.2
SUBJECT DESCRIPTION
4.2.1 CARDINAL AND ORDINAL UTILITY
NOTES
Economists have offered consumer behaviour theories on the basis of the
measurement of utility. There are three approaches to the analysis of consumer
behaviour.
(i) Cardinal Utility Approach : It was developed by the classical
economists, viz. Gossen, William Stanley Jcvons, Leon Walras, Karl
Menger. Neo-classical economist, Alfred Marshall (1890) made
significant improvements in the cardinal utility approach. So, it is called
‘Marshallian Utility Theory’ or Neo-Classical Utility Theory’ of demand.
(ii) Ordinal Utility Approach : It is also known as indifference curve
analysis. The indifference technique was invented and used by Francis
Edge worth (1881), Irving Fisher (1892), Vilfred Pareto (1906), E.E
Slutsky, W.E Johnson and A.L Bowley. However, J.R Hicks and R.G.D
Allen (1934) developed systematically the ordinal utility theory as a
powerful analytical tool of consumer analysis.
(iii) Revealed Preference Approach : Samuelson formulated (1947)
‘revealed preference theory of consumer behaviour. It is a behaviourist
ordinal utility analysis as distinct from the introspective ordinal utility
theory of Hicks and Allen.
The Marshallian cardinal utility approach is based on cardinal measurement of
utility. Neo-classical economists believe that utility is measurable and cardinally
quantifiable. It can be measured like height, weight, length and temperature. They
used a term ‘utile’ as the measure of utility under the assumption that one unit of
money equals one ‘utile’ and they also assumed that marginal utility of money
remains constant.
This method of measuring utility has been rejected by the modern economist. In
practice it is impossible to measure the utility of any commodity in a cardinal
way. Numerous factors affect the consumer’s mood, which are impossible to
determine and quantify. Thus, cardinal utility analysis is defective in several
respects. Indifference curve analysis adopted the more rational assumption of
ordinal measurement of utility. The ordinality implies that the consumer is able to
compare the level of satisfaction from the two goods. It may not be possible for
consumer to tell how much utility a particular combination gives, but it is always
possible to tell which one between any two combinations is preferable to him. An
indifference curve as a locus of points which show equal satisfaction to the
consumer.
4.2.2 CARDINAL UTILITY APPROACH
The Marshallian cardinal approach is based on the following postulates :• Concept of utility and its cardinal,
• The law of diminishing marginal utility, and
• The law of equi-maiginal utility.
30 Business Economics - I
Cardinal approach helps to explain consumer’s equilibrium i.e., how a consunier
can derive maximum utility out of his given limited resources. The capacity of a
commodity to satisfy the human wants is called as its utility. In other words,
utility is the level of satisfaction derived by the consumer from the purchase of a
commodity. Consumers demand goods because of goods utility. The Marshallian
utility analysis try to explain the inverse relationship between the price and quantity
demanded. According to Marshalian analysis, utility is cardinally measurable or
quantitative. It can be measured like height, weight, length. In simple words, the
utility means want satisfying power of a commodity. It is also defined as property
of the commodity which satisfies the wants of the consumers.
Cardinal and Ordinal Utility
NOTES
Total Utility and Marginal Utility :It is important to distinguish between total utility and marginal utility. When the
consumer buys apples he receives them in units, 1, 2, 3, 4, 5 etc. The total utility
of a commodity to a consumer is the sum of utilities which he obtains from
consuming a certain number of units of the commodity, as shown in table 4.1.
Table 4.1 : Total utility and marginal utility
Units of Apple
Total Utility in Units
Marginal utility in Units
0
0
0
1
20
20
2
34
14
3
46
12
4
56
10
5
61
05
6
59
!2
7
54
!5
In the above table, the first apple has 20 utility and it is the best out of the lot
available to him and thus gives consumer the highest satisfaction. When an apple
is taken by the consumer, total utility derived by the person is 20 utils and because
this is the first apple its marginal utility is also 20. The second apple will naturally
be the second best with lesser amount of satisfaction or utility than the first and
has 14 utils. The total utility rises to 34 (20 + 14) but marginal utility falls to 14.
Total utility is the sum total of utilities obtained by the consumer from different
units of a commodity. It will be seen from the above table that as the consumption
of apple increases to 5, marginal utility from the additional apple goes on
diminishing. When the consumer takes 5 apples, his total utility of all the 5 units
goes up to 61 utils. It means that total utility is the function of the quantity of the
commodity consumed.
Marginal utility is the addition made to total utility by having an additional unit
of the commodity. It means that, it is the extra utility which consumer gets when
he consumes more unit of the commodity. It is clear from the above table. When
the consumer takes two apples instead of one apple, his total utility increases
from 20 to 34 utils. It means that the consumption of the second unit of the
commodity has made addition to the total utility by 14 utils. Here, marginal utility
is equal to 14 utils. Beyond consumption of 5 apples, total utility declines and
therefore, marginal utility becomes negative.
Algebracally, the marginal utility (mu) of N units of a commodity is the total
utility (TU) of N units minus the total utility N – 1, marginal utility can be expressed
as under :-
Business Economics - I 31
MUN = TUN – TU N – 1
Business Economics
In other words,
_____
MUN = TU , where DQ = 1.
Q
NOTES
The Law of Diminishing Marginal Utility :The law states that with successive increase in the consumption commodity, the
marginal utility of a commodity will fall. Marginal utility is the utility derived
from the marginal or the last unit consumed. Total utility may be defined as the
sum of the utility derived from all the units consumed of the commodity. In order
to maximise total utility, a household will not spend all its money income on a
particular commodity but on different commodities. This law applies to household
consumption.
The Law of Equi-marginal Utility :The law states that a household will attain equilibrium when the marginal utilities
of various commodities that it consumes are equal. This law explains consumer’s
equilibrium. Consumer allocates his income in such a way that he could get
maximum satisfaction. This law is also known as law of substitution. It explains
how a consumer allocates his limited income between various goods in order to
get maximise utility.
According to this law, a consumer will be at equilibrium
when,
MUx _____
MUy _____
MUz
_____
=
=
= MU per unit of money income
Px
Py
Pz
i.e. the ratio of marginal utilities and price are equalised in purchasing the various
commodities. In other words, in order to be in equilibrium, the ratio of marginal
utility of good X to its price should be equal to the ratio of marginal utility of
good Y to its price, and so on. In simple words, the consumer gets maximum
satisfaction when the marginal utility of the commodity is equal among various
uses.
Diagrammatic Illustration
The law of equi-marginal utility can be explained with the help of a utility schedule
as follows :Table 4.2 : Marginal Utility Schedule
Quantity
32 Business Economics - I
Goodx
Px = Rs. 6
Good*
Py = Rs. 5
TU
MU
TU
MU
1
60
60
41
41
2
148
48
76
35
3
189
41
106
30
4
224
35
133
27
5
254
30
159
26
6
274
20
184
25
Assume, the consumer has income of Rs. 60. The consumer will allocate his
income between two commodities in such a way that the ratios of marginal utilities
to the respective prices of the two commodities are equal. In order to be in
equilibrium the consumer will buy 5 units of X and 6 units of Y,
Cardinal and Ordinal Utility
NOTES
where,
30
25
___
___
=
=5
6
5
Subject to the budget constraint, where
(6 H 5) + (5 H 6) = Rs.60
The consumer gets total utility equal to (254 + 184) = 438 utils. Any other
combination of X and Y would yield only lesser total utility.
Assumptions of Cardinal utility analysis :Marshallian utility analysis of demand is based upon certain important
assumptions. The basic assumptions of cardinal utility approach are as follows :1. Utility of any commodity can be measured quantitatively or numerically.
The consumer can express how much utility he gets from any commodity.
Thus, a person can say that he derives utility equal to 15 utils from
the consumption of a unit of a commodity and 20 utils from the
consumption of a unit of another commodity. (Here utils is used to
measure the utility.)
2. Utilities are independent. It means that utility of each commodity is
experienced independently in a given bundle of various commodities.
On this hypothesis, the utility which a consumer derived from A good is
the function of the quantity of that good only and not of B and C. It
means that, the utility which a consumer obtains from a good does not
depend upon the quantity consumed of other goods.
3. Utilities are additive. It means the consumer can make the total of the
utilities derived from different units of the commodity.
4. The utility derived from each additional unit in succession tends to be
lesser and lesser in the axiom of the cardinal approach.
5. The marginal utility of any commodity is measured in terms of money
and marginal utility of money to be constant at all levels of income of
the consumer.
6. Marshall adopted the introspective method of analysis to observe the
consumer’s experience about marginal utility. This method uses selfobservation method.
Limitations of the Marshallian Approach
Marshallian cardinal utility approach is criticised on the following grounds :
1. Marshall assumes that utility is measurable cardinally i.e. quantitatively.
However, in practice it is impossible to measure the utility of any
commodity in a cardinal way.
2. Since utility cannot be measured quantitatively, it is wrong to assume
that the utility is additive.
3. Another limitation of Marshallian cardinal utility analysis is that it
assumed utilities are independent. But in actual life, utilities are
Business Economics - I 33
interdependent. The utility of a commodity depends upon the change in
the consumption of its related goods i.e. competitive or complementary
goods.
Business Economics
NOTES
4. The assumption of the constant marginal utility of money is also wrong.
Marginal utility of money is not constant. Hicks argues that money is
also commodity and its marginal utility also diminishes slowly.
5. The utility analysis does not analyse the price effect completely. It fails
to distinguish between the substitution effect and the income effect.
The cardinal utility approach is illogical, illusory and unrealistic. However, it
leads to more scientific, systematic and comprehensive analysis of demand which
is known as indifference curve analysis.
4.2.3
ORDINAL UTILITY APPROACH
Various limitations or defects of cardinal utility analysis resulted in an ordinal
utility approach to demand theory. It is known as indifference curve analysis.
This technique was invented and used by Francis Y. Edgevvorth (1881) to show
the possibility of exchange of commodities between two individuals. This was
also used by Irving Fisher, EdgeWorth, Vilfred Pareto, Eugen E. Slutsky, W.E
Johnson and A.LBowley to explain consumer’s equilibrium. In 1934, J. R Hicks
and R. G. D. Allen developed systematically the ordinal utility theory as a powerful
analytical tool of consumer analysis.
There is fundamental difference between cardinal utility analysis and ordinal
utility analysis. Ordinal utility approach discards the concept of cardinal
measurement of utility. It adopted the more rational assumption of ordinal
measurement of utility. According to ordinalists, all that is required to analyse
consumer’s behaviour is that the consumer should be able to order his preferences.
He is able to differentiate the level of satisfaction qualitatively, but not
quantitatively.
Indifference Curve
Professor Hicks popularised the innovation of the indifference curve approach to
the theory of demand in his ‘Value and Capital’ published in 1939. An indifference
curve is defined as the locus of points, each representing a different combination
of two goods but yielding the same level of satisfaction or utility. Since each
combination of two goods yields the same level of satisfaction, the consumer is
indifferent between any two combinations of goods when it comes to making a
choice between them. At that time, the consumer can rank various combinations
of goods according to their level of satisfaction. After ranking various
combinations, the consumer is able to tell which combination he prefers more or
is indifferent between some combinations. When such combinations are plotted
graphically the resulting curve is known as indifference curve. Indifference curve
is also called equal utility curve.
A rational consumer seeks to maximise his level of satisfaction from the goods
the buys. He gives preference to goods with consideration of their prices. Such
preferring of different goods and their combinations in a set order of preferences
is termed as the scale of preferences.
34 Business Economics - I
An indifference curve is based on an indifference schedule. An indifference
schedule is a list of alternative combinations in the stocks of two goods which
yield equal satisfaction to the consumer. Indifference schedule showing different
combinations of two goods is presented below.
Cardinal and Ordinal Utility
Table 4.3 : Indifference Schedule
Combination
Apple
Bananas
A
1
+
25
B
2
+
20
C
3
+
16
D
4
+
13
E
5
+
11
NOTES
Above indifference schedule indicates various combinations of two goods which
give equal satisfaction to the consumer. The consumer is indifferent to any of
these combinations whether he gets A, B, C, D, or E. He will neither be better off
nor worse off whichever combination he has. The consumer may pick up any one
of the five combinations of apple and bananas. The total satisfaction derived by
the consumer will remain the same irrespective of the combination chosen by
him. He is, therefore, indifferent towards different combinations. The satisfaction
of 1 apple and 25 bananas is equal to 5 apples and 11 bananas.
An indifference curve can be drawn with the help of the indifference schedule. It
is shown in the following figure.
Fig. 4.1 : Indiference Curve
Figure 4.1 shows an indifference curve, drawn by joining combinations A, B, C
and D of apples and bananas. The combinations of the two commodities i.e apple
and banana, given in the indifference schedule or those indicated by the
indifference curve are by no means the only combinations of the two commodities.
Each combination yield the same level of satisfaction. Although, the various
combinations contain different quantities of the apples and bananas, consumer
scale of preference for the different combinations, however, is the same. Another
indifference curves can be drawn above or below the indifference curve given in
Figure 4.1. A set of indifference curves or a family of indifference curves
representing different levels of satisfaction is called an indifference map.
Business Economics - I 35
Business Economics
Assumptions of Ordinal Utility Theory
The indifference curve analysis of consumer’s behaviour is based on the following
assumptions :-
NOTES
1. The consumer is a rational being. He aims at maximising his total
satisfaction, given his income and prices of goods and services he
consumes.
2. Consumer can rank different combinations of two goods in order of
preference.
3. Consumer’s behaviour is consistent. Consistent means that, if consumer
prefers A to B in one period, he will not prefer B to A in another period
or treat them as equal.
4. Non-satiation, i.e. the consumer always prefers more quantities of goods
to lesser quantities.
5. Consumer’s choices arc transitive. It means, when he prefers combination
A in the indifference map to combination B, and B to C, then A must be
preferred to B.
6. The ordinal utility approach assumes diminishing marginal rate of
substitution. The marginal rate of substitution means the rate at which a
consumer is willing to substitute one commodity for another.
Properties of Indifference Curves
The important properties or characteristics of indifference curves are as
follows :1. Indifference curves have a negative slope :It is one of the important features of indifference curves. In the words of Hicks,
“so long as each commodity has a positive marginal utility, the indifference curve
must slope downward to the right”. When the consumer makes sacrifice of some
good, it must be compensated by the gain of the other good. In other words,
consumer will have to curtail the consumption of one commodity if he wants to
consume larger quantity of another commodity to maintain the same level of
satisfaction. It makes the indifference curve slope downwards from left to right.
In figure 4.1 IC is the indifference curve which slopes downward from left to
right.
2. Indifference curves are convex to the origin :Not only is an indifference curve downward sloping, it is also convex to the
origin. It implies that indifference curve is relatively steeper at left hand portion
and flatter to the right hand. Convexity means that the curve is so bent that is
relatively steep towards the Y-axis and relatively flat towards the X-axis. The
indifference curve becomes convex to the origin because the marginal rate of
substitution decreases. As can be seen in figure 4.1, as the consumer moves down
from point A towards point D, the MRS= y/x goes on diminishing. This can be
verified from table 4.2.
3. Indifference curve can neither intersect nor he tangent :-
36 Business Economics - I
This means that there cannot be a common point between the two indifference
curves. This is because each indifference curve represents a specific level of
satisfaction and each point on an indifference curve gives a level of equal
satisfaction.
Cardinal and Ordinal Utility
4. Upper indifference curves represent a higher level of satisfaction :Every indifference curve to the right or at a higher level indicates higher level of
satisfaction.The indifference map represents an ordinal measurement of utility.
Thus, a higher indifference curve represents a higher level of satisfaction of
comparison with a lower indifference curves. It can be explained with the help of
Fig. 4.2.
NOTES
Fig. 4.2 : Upper Indiference Curve
In figure 4.2 IC1, and IC2 and IC3, are three indifference curves. The consumer
gets more units of both goods on IC2 at point B than at point A on the lower
indifference curve. Here, an upper indifference curve contains all along its length
a larger quantity of both the goods than the lower indifference curve. Thus, the
consumer gets more satisfaction when he moves on to a higher level of indifference
curve.
Consumer’s Equilibrium
A rational consumer attains an equilibrium position when his motive of maximizing
satisfaction is realised. So, he always tries to reach the highest possible indifference
curve. But there is a limitation to consumer of money income to spend. When the
consumer gets maximum satisfaction from his limited income he is in equilibrium.
Indifference curve technique helps a consumer to reach equilibrium position.
Consumer’s equilibrium is based upon a number of assumptions which are as
follows :(i) The consumer is rational and wants to maximise his satisfaction.
(ii) The consumer has a fixed amount of money income to spend.
(iii) The consumer has an indifference map which indicates scale of
preferences.
(iv) Prices of two goods do not change.
(v) Goods are homogeneous and divisible.
(vi) Consumer has full knowledge of market conditions.
Business Economics - I 37
Business Economics
Consumer’s Equilibrium is illustrated in Fig 4.3.
NOTES
Figure 4.3 : Consumer’s equilibrium
In Figure 4.3, indifference map along with price line AB is shown. Good X is
measured on OX axis and good Y is measured on OY axis. AB is the price-line
which shows budget constraint of the consumer. IC 1, IC2, and IC3 are the
indifference curves which indicate consumer’s scale of preferences. These three
indifference curves represent different level of satisfaction. Consumer can derive
more satisfaction on IC2 than on IC1.
The consumer can purchase any combination lying on the price line or budget
line AB. In case, he spends all his money income on good Y he can buy OA
quantity, and similarly, if he spends all his money income on commodity X, he
can buy OB quantity. The consumer will try to choose that combination
which lies on the highest indifference curve. But, consumer cannot attain
equilibrium at point K, because it is beyond his budget line. Similarly, the consumer
will reject combination they, E and T, as D yield lesser satisfaction. P point is the
point which lies on the highest possible indifference curve. Consumer attains
equilibrium at this point. At this point, both the conditions of equilibrium arc
satisfied, viz.
(i) The budget line is tangent to the indifference curve.
(ii) The indifference curve must be convex to the origin.
These conditions are fulfilled at point P. So the consumer is in equilibrium at
point P.
Superiority of indifference curve technique :The indifference curve analysis is an improvement over the Marshallian utility
analysis because it is based on fewer and more realistic assumptions.
38 Business Economics - I
1. The Marshalian utility analysis assumes that utility to be cardinally
measurable. In other words, it believes that utility is quantifiable. It is
unrealistic. The indifference curve analysis assumes that utility is merely
orderable and not quantitative. The ordinal method and the assumption
of transitivity make indifference curve technique more realistic.
2. Indifference curve analysis studies combinations of two goods instead
of one good.
3. It provides a better classification of goods into substitutes and
complements. However, Marshallian utility analysis is based upon the
hypothesis of independent utilities.
Cardinal and Ordinal Utility
NOTES
4. Indifference curve analysis of demand is free from the assumption of
constant marginal utility of money. In other words, in indifference curve
analysis, it is not necessary to assume constant marginal utility of money.
5. The superiority of indifference curve analysis lies in the fact that it
discusses the income effect when the consumer’s income changes; the
price effect when the price of a particular good changes. It also explains
the dual effect in the form of the income and substitution effects.
Critique of indifference curve analysis :Indifference curve analysis has come in for criticism on several grounds. The
main points of criticism are as follows :1. Professor D. H. Robertson does not find anything new in the indifference
curve analysis and regards it simply the old wine in a new bottle.
2. For avoiding the difficulty of measuring utility quantitatively, the
indifference curve analysis is toned to make unrealistic assumption that
the consumer possesses complete knowledge if his whole scale of
preference or indifference map.
3. This analysis can demonstrate and analyse consumer’s behaviour
effectively only in simple cases. In other words, the observed market
behaviour of the consumer cannot be explained objectively. Prof. Hicks
also admits this shortcoming of indifference curve analysis.
4. Indifference curve analysis cannot formalise consumer’s behaviour when
uncertainty or risk is present.
5. The indifference curve assumes that the consumer acts rationally. In
fact, consumer is not rational.
Despite these criticisms, the indifference curve analysis is still regarded superior
to the Marshallian utility analysis.
4.3
SUMMARY
In this unit you have learned about neo-classical utility analysis i.e. the theory of
consumer demand as built by neo-classical economist. This analysis is based on
cardinal measurement of utility. There are three approaches to the analysis of
consumer behaviour i.e. cardinal utility approach, ordinal utility approach and
revealed preference approach. Cardinal utility approach has been rejected by
modern economists. Ordinal utility approach adopted the more rational assumption
of ordinal measurement of utility. An indifference curve is a locus of points which
show equal satisfaction to the consumer.
4.4
KEY TERMS
l
Utility : The total satisfaction derived from the consumption of goods
and services.
Business Economics - I 39
Business Economics
l
l
NOTES
l
4.5
Total utility : The total utility of a co mmodity to a consumer is the sum
of utilities which he obtains from consuming a certain number of units
of the commodity.
Marginal utility : Marginal utility is the addition made to total utility
by having an additional unit of the commodity.
Indifference Curve : It is defined as the locus of points, each
representing a different combination of two goods but yielding the same
level of satisfaction or utility.
QUESTIONS AND EXERCISES
1. Distinguish between cardinal and ordinal utility.
2. Explain the law of diminishing marginal utility.
3. State and explain the law of diminishing marginal utility.
4. What is meant by consumer equilibrium? How does a consumer
maximise his satisfaction in cardinal utility analysis?
5. Explain the law of equi-marginal utility. How does it explain consumer
equilibrium?
6. Discuss the main assumptions and defects of utility analysis?
7. On what grounds Marshall’s cardinal utility analysis has been criticised?
8. Distinguish between cardinal utility and ordinal utility which is more
realistic?
9. Explain in detail the properties of indifference curves.
10. What are indifference curves? What are the assumptions on which
indifference curve analysis of demand is based?
11. Explain the concept of ordinal utility. How is the ordinal utility concept
different from cardinal utility concept?
12. What is meant by consumer’s equilibrium? Explain it with indifference
curve approach.
13. Explain consumer’s equilibrium condition with the help of indifference
curve approach.
14. Discuss superiority of indifference curve technique over utility analysis.
15. Explain criticisms of indifference curve analysis.
16. Write short notes :(i) Cardinal utility approach.
(ii) Ordinal utility approach.
(iii) Total utility and marginal utility.
(iv) The law of diminishing marginal utility.
(v) The law of equi-marginal utility.
(vi) Assumptions of cardinal utility analysis.
(vii)Limitations of the cardinal utility analysis.
(viii) Indifference schedule.
40 Business Economics - I
(ix) Indifference curve.
(x) Assumptions of ordinal utility theory.
Cardinal and Ordinal Utility
(xi) Properties of indifference curves.
(xii)Consumers equilibrium.
NOTES
(xiii) Superiority of indifference curve technique.
(xiv) Critique of indifference curve analysis.
4.6
FURTHER READINGS AND REFERENCES
1. Mithani D,M. (2008) : ‘Managerial Economies’, Himalaya publishing
House, Mumbai.
2. Dingra I.C. and V.K. Garg (2005) : ‘Micro Economics and Indian
Economic Environment’, Sultan Chand & Sons, New Delhi.
3. Patil J.F. and others (2004) : ‘Managerial Economies’, Phadke
Prakashan, Kolhapur.
4. Banerjee,AandS,Mukherji(1985): ‘Topics in Managerial Economies’,
New Central Book Agency, Kolkata.
5. Gupta G.S. (1990) : ‘Managerial Economies’ Tata McGraw Hill, New
Delhi.
6. Mehla P.L. (1997) : ‘Managerial Economics Analysis, Problems and
Cases’, Sultan Chand & Sons, New Delhi.
7. Koutsoyiannis A. (1971) : ‘Modern Micro Economies’, Macmillan,
London.
r r r
Business Economics - I 41
Business Economics
NOTES
UNIT 5 : EVEALED PREFERENCE
THEORY
Structure
5.0 Introduction
5.1 Unit Objectives
5.2 Subject description
5.2.1 Choice reveals preference
5.2.2 Assumptions of revealed preference theory
5.2.3 Explanation of revealed preference theory
5.2.4 Critical evaluation of the revealed preference theory
5.2.5 Consumer choice under risk
5.3 Summary
5.4 Key terms
5.5 Questions and Exercises
5.6 Further reading and references
5.0
INTRODUCTION
In the previous unit, you have learned Marshallian cardinal utility analysis, which
assumes that utility is measurable and additive. You have also learned Hicks and
Allen’s ordinal utility approach. In this unit you will read about behaviourist
ordinal utility theory as formulated by Prof. Samuelson in his book “Foundations
of Economic Analysis.”
5.1
UNIT OBJECTIVES
After studying this unit, you should be able to –
l
5.2
42 Business Economics - I
Understand behaviourist ordinal utility theory i.e. revealed preference
theory.
l
Evaluate cardinal utility approach and ordinal utility approach.
l
Analysis superiority of revealed preference theory.
l
Understand different approaches of consumer choice under risk.
SUBJECT DESCRIPTION
In succession to Hicks-Allen ordinal utility approach, Samuelson (1947)
formulated his own ‘Revealed Preference Theory’ of consumer behaviour. This
theory is based on observed consumer behaviour in the market. On the basis of
actual observations, Professor P.A Samuelson realistically examines how a
consumer reacts to changes in price and income. Samuelson adopted a new
approach known as behaviourist approach to explain the consumer choice. So
this theory is called as behaviourist ordinal utility theory.
Samuelson’s approach is objectively based on actual observations. The main
advantage of this theory is that the ‘law of demand’ can be directly derived from
the revealed preference axioms without using indifference curve and most of its
restrictive assumptions.
5.2.1
Revealed Preference Theory
NOTES
CHOICE REVEALS PREFERENCE
Prof. P. A. Samuelson’s theory of demand is based on the revealed preference
axiom which states that choice reveals preference. According to this axiom or
hypothesis, when a consumer buys a combination of two goods out of various
alternative combinations either because he likes this combination in relation to
others or this is cheaper than others. It means that he reveals his preference.
Suppose the consumer buys A combination out of various alternatives i.e. B, C
and lying below the line PL such as D, E and G. It means he considers all other
alternative combinations which he could have purchased to be inferior to A. It
means that he reveals his preference for A combination. In other words, he rejects
all other alternative combinations open to him. Thus, according to Prof. Samuelson,
choice reveals preference. This is explained in figure 5.1.
Y
P
Good Y
B
H
E
D
G
I
A
C
F
O
Good X
L
X
Figure 5.1 : Choice reveals preference
In the above figure, good X is shown on OX axis and good Y is shown on Y axis.
PL is the income of consumer or budget line. The budget line PL represents a
given price-income situation. The triangle OPL is the area of choice for the
consumer which shows the various combinations of X and Y on the given priceincome-situation PL. It means that the consumer can buy or choose any
combination lying within the triangle OPL. A, B, C, D, E, F and G are
the combinations open to him. But combinations H and I are beyond the reach
of the consumer being dearer for him because they lies above his price-income
line PL. The consumer can buy or choose any combination out of A, B and C
on the line PL or D, E, F, G below this line. If he chooses A combination, it is
revealed as preferred to B and C. Combinations below price-income line will be
rejected because they are inferior to A. Therefore, A is revealed as preferred to
other combinations. Consumer can do this for two reasons. First, A combination
may be cheaper than the other combinations on the line and below the line. Second,
A combination may be dearer than others, but he likes this combination in relation
to others.
Business Economics - I 43
Business Economics
NOTES
5.2.2
ASSUMPTIONS OF REVEALED PREFERENCE
THEORY
This theory is based on the following straightforward assumptions.
1. The consumer is assumed to be a rational being. Rationality implies
that he prefers a combination of larger stock of the two goods to a smaller
one.
2. It is assumed that the choice of the consumer is always consistent and
not contradictory to earlier choice. It means if he chooses combination
A to B, he will not choose B to A under the same conditions.
3. An important feature of Samuelson’s theory is that it is based on strong
ordering. It means consumer reveals his positive and definite preference
for a particular combination of the two goods against all other
possibilities rejected by him under the given price-income situation.
4. The revealed preference approach is based on positive income elasticity
assumption. It means when his income increases, the consumer always
tends to buy more of the given commodity.
5. This theory is fundamentally based on ‘axioms of preference’, where
the axioms are expressed not in terms of what a consumer prefers but
what he chooses. It means consumer’s choice for a particular combination
of the two goods within his budget reveals his definite preference.
5.2.3
EXPLANATION OF REVEALED PREFERENCE
THEORY
The revealed preference theory can be explained by using following Figure no.
5.2. There are two commodities X and Y Prices of X and Y are given and consumer
has a given money income. According to this theory, “Given the budgetary
constraint and alternative combinations of goods having the same price, if a
consumer chooses a particular combination, he reveals his preference for the
combination.
44 Business Economics - I
Fig. 5.2 : Revealed Preference Theory
In the above figure, the initial price line is AC. It means consumer’s budgetary
constraint has been shown by his budget line AC. If consumer chooses a particular
combination of X and Y (OL of X good and OK of Y good) represented by
point T on the budget line, it implies that he prefers point T to any other point on
the budget line. Any point below the budget line and above the budget line will
not be prefered by the consumer because it will be smaller and cheaper
combination of two goods and larger and more expensive combination of two
goods respectively.
Revealed Preference Theory
NOTES
Let us now suppose that the price of X increases, price of Y remaining the same.
So that budget line AC shifts to AB. It means due to increase in price of X
the consumer has to buy smaller quantities of X. This shift in budget line
resulted in two effects viz. income and substitution effect. The increase in price
of x good has reduced the real income of the consumer and it has changed
the relative prices of X and Y good also. Let us now decompose the income
and substitution effects of the price effect by using the Slutskian method.
We increase the income of the consumer to such an extent that he can buy the
earlier combination of goods. This has been done by drawing a budget line DE
through point T. Since the budget line passes through point T, it implies that the
combination of X and Ygoods indicated by T are still available to the consumer.
Therefore, the consumer will not choose any other combination of X and Ygood.
Thus, demand forX decreases as a result of increase in the price of X. This
establishes the law of demand.
Superiority of revealed preference theory :Samuelson’s revealed preference theory is superior to the Marshallian cardinal
utility theory and Hicks Allen’s ordinal utility theory of demand.
1. Samuelson’s revealed preference theory is the first theory to apply
behaviourist method to derive demand theorem from observed
consumer behaviour.
2. Utility and indifference curve approach focuses on continuity
assumption. However, revealed preference theory believes that there is
discontinuity because the consumer can have only one combination.
3. Revealed preference theory provides the basic for welfare economics
in terms of observable behaviour based on consistent choice.
5.2.4
CRITICAL EVALUATION OF THE REVEALED
PREFERENCE THEORY
The revealed preference approach is superior in many respects compared to earlier
approaches. The theory is a major advancement to the theory of demand. It can be
explained as under.
1. Marshallian and Hicksian approaches are introspective and provide
psychological explanations of consumer behaviour. On the other hand,
revealed preference theory is based on observed behaviour of the
consumer. The behaviouristic approach is more scientific and practical
one..
2. Prof. Samuelson has used the principle of consistency insteal of
maximization. This is less restrictive assumption.
Business Economics - I 45
Business Economics
NOTES
3. The indifference curve approach required continuity assumption. The
revealed preference hypothesis does not assume continuity. It assumes
consistency.
4. The revealed preference theory provides a basis for constructing the
index number of Cost of living.
5. The revealed preference theory does not require the use of the concept
of utility to derive the demand curve.
Prof. Samuelson’s revealed preference theory suffers from certain drawbacks. It
is not a general theory of demand. It has bias towards strong ordering. It has a
limited scope of applicability and it over-stresses the consistency condition of
rationality. However, its superiority over earlier approach cannot be denied. This
approach has laid a foundation of pragmatic approach to demand.
5.2.5
CONSUMER CHOICE UNDER RISK
Cardinal utility approach and ordinal utility approach ignore the possibility of
uncertainty and risk involved in consumer’s alternative choices. The recent
developments in demand theory analyses the consumer’s behaviour where he has
to choose between risky and uncertain alternatives. Famous mathematician John
von Neumann and a well known economist Oskar Morgenstern in their famous
book ‘Theory of Games and Economic Behaviour’ have gone, without disputing
the ordinal utility approach, one step forward to suggest a measure of utility where
risk is involved in choice-making. Friedman, Savage and Markowitz have also
tried to explain the consumer’s choice under risk.
The consumer may face different types of uncertainties or risks while making his
decision. The consumer may face following different types of uncertainties.
(i) Uncertainty regarding prices of the goods.
(ii) Uncertainty regarding income of the consumer.
(iii) Uncertainty regarding availability of goods.
Out of three uncertainties, the uncertainty regarding income of the consumer is
the major one. In practical life some food items like and fruits, cloths may create
risk to life and health. When someone takes insurance, then he is also making
choice when uncertainty is involved. It means that a consumer has to make a
choice of the goods and services under the condition of risk.
Daniel Bernoulli explanation :The Swiss mathematician Daniel Bernoulli made his first attempt to formulate
the consumer’s behaviour under uncertainty in 18th century. He tried to resolve
St. Petersburg Paradox.
46 Business Economics - I
St. Petersburg Paradox states that a rational consumer will not accept the risky
choice even though there is a possibility of winning the option. In other words,
people are not willing to bet at better than 50 percent of winning money in
particular kind of gamble are greater that the money they bet. This paradox was
resolved by Daniel Bernoulli. He adopted utility analysis to explain it. He focuses
on marginal utility of money. According to him, in that case, consumer can measure
the marginal utility of money and the marginal utility of money diminishes as
income increases. Daniel Bernoulli’s explanation can be explained by using
following diagram.
Y
Revealed Preference Theory
NOTES
F
C
B
MU
Loss
Gain
O
E
D
A
X
Figure 5.3 : Daniel Bernoulli’s explanation
In the above figure, income is shown on the OX axis and expected utility is shown
on the OY axis. MU curve shows the expected marginal utility of income.
Consumer compares the possibility of losing the bet and consequent loss in
expected income and marginal utility and similarly, he considers the marginal
utility of the expected income which he can get if he wins the bet. From the above
diagram, it is clear that he gets marginal utility of ABCD (shaded area) from
additional income, when he has a chance of winning the bet. But, if he loses the
bet he finds that the reduction in marginal utility is to the tune of CDEF. Here,
expected loss of income by losing the bet is larger than the expected addition in
marginal utility from additional income by winning the bet. So, he will not bet as
he is rational.
Neumann – Morgenstern explanation :When the consumer faces situation of making choice under uncertainty, he has
to consider the expected utility. In this regard Neumann and Morgenstem
provide a measure (or an index) of utility in terms of N-M index. The prime
objective of N-M index is to show that marginal utility of money decreases. N-M
index helps to make a choice for uncertain or risk alternatives. The N-M hypothesis
suggests that if an individual behaves consistently, it is possible to construct his
‘utility index’ and express his preferences numerically. It does not measure the
intensity of introspective satisfaction or pleasure nor is it the N-M purpose of
measuring ‘cardinal’ utility. This index serves a useful purpose by providing a
basis for rational thinking and prediction, particularly where uncertainty and risk
are involved.
Friedman – Savage approach
Nobel prize winner Milton Freidman and L.J Savage extended the NeumannMorgenstern approach and addressed a question, ‘does marginal utility of money
always diminish?’ This approach tried to explain why the same group of people
buy insurance and also engage in gambling. In this respect, Friedman-Savage put
forward an important hypothess that as income of the consumers increases, its
marginal utility first decreases over certain level of income, and then increases
over certain level of income, and ultimately it decreases as income of the consumers
tendes to increase, In this range they are not willing to take risk.
Business Economics - I 47
Business Economics
NOTES
5.3
SUMMARY
In this unit you have learned about behaviourist ordinal utility approach. In the
succession of Hicks-Allen ordinal utility approach. Prof. Samuelson formulated
his own Revealed Preference Theory of consumer behaviour. The main advantage
of this theory is that the law of demand can be directly derived from the revealed
preference axioms without using indifference curve and most of its restrictive
assumptions. This theory is the first theory to apply behaviourist method to desire
or demand thereon from observed consumers behaviour. Prof. Samuelson’s theory
is superior to the Marshallian cardinal utility theory and Hicks Allen’s ordinal
utility theory of demand.
5.4
KEY TERMS
l
l
l
l
5.5
Rationality : The consumer prefers more units of goods within the given
level of income is the meaning of rationality.
Strong ordering : When consumer selects any combination of goods,
he selects that by rejecting the other alternative combinations. It means
he has certain strong preferences.
Risk : In financial economics, refers to the variability of the returns on
an inverstment.
Budget Line : A line indicating the combination of commodities that a
consumer can buy with a given income at a given set of prices.
QUESTIONS AND EXERCISES
1. Choice revels preference elucidate.
2. Crtically examine the revealed preference theory of demand.
3. What is meant by revealed preference hypothesis’ ? Explain Samuelson’s
revealed preference theory of demand based on it.
4. ‘Choice reveals preference.’ Explain this statement critically.
5. State the assumptions of the revealed preference theory of demand.
6. Discuss the distinguishing features of the Revealed Preference
Hypothesis in the theory of consumer’s behaviour.
7. Revealed preference theory makes a major advancement in the theory
of demand. Discuss.
8. What are the limitations of the indifference curve analysis as an analytical
instrument? How far is the theory of revealed preference an improvement
in this respect?
9. Critically examine revealed preference theory of consumer’s behaviour.
Is it superior to indifference curve theory of consumer’s behaviour?
10. How does consumer make his choice under uncertainty?
48 Business Economics - I
11. How is consumer choice finalised under conditions of risk? Explain
different approaches.
12. Write Short notes –
Revealed Preference Theory
(i) Choice reveals preference.
(ii) Assumptions of revealed preference theory.
(iii) Superiority of revealed preference theory.
NOTES
(iv) Criticism of the revealed preference theory.
(v) Consumer choice under risk.
(vi) Daniel Bernoulli’s explanation of utility.
(vii)Different approaches of consumer choice under risk.
5.6
FURTHER READING AND REFERENCES
1. Koutsoyiannis A. (1971) : ‘Modern Micro Economics’, MacMillan,
London.
2. Samuelson Paul A and William D. Nordhaus (2010) : ‘Economics’, Tata
McGraw Hill Education Private Ltd., New Delhi.
3. Kreps Daud M. (1990) : ‘A Cource in Microeconomic Theory’, Princeton
University Press, Princeton.
4. Layard P. R. G. and A. W. Alters (1978) : ‘Microeconomic Theory’,
McGraw Hill, New Delhi.
5. Sen A. (1999) : ‘Microeconomics : Theory and Applications’, Oxford
University Press, New Delhi.
6. Stigler G. (1996) : ‘Theory of Price’, 4th edition, Princeton Hall of India,
New Delhi.
7. Varian H. (2000) : ‘Microeconomic Analysis’, W. W. Norton, New York.
8. Hirshleifer J. and A. Glazer (1997) : ‘Price Theory and Applications’,
Prentice Hall of India, New Delhi.
9. Green H. A. G. (1971) : ‘Consumer Theory’, Penguin Harmondsworth.
10. Mithani D. M. (2008) : ‘Managerial Economics’, Himalaya Publishing
House, Mumbai.
11. Dingra I. C. And V. K. Garg (2005) : ‘Microeconomics and Indian
Economic Environment’, Sultan Chand & Sons, New Delhi.
12. Henderson J. M. And R. E. Quant (1980) : ‘Microeconomic Theory : A
Mathematical Approach’, McGraw Hill, New Delhi.
13. Green H. And V. Walch (1975) : ‘Classical and Neo-Classical Theories
of General Equilibrium’, Oxford University Press, London.
14. Borch K. H. (1968) : ‘The Economics of Uncertainty’, Princeton
University Press, Princeton.
15. Diamond and Rothschild (Eds.) (1978) : ‘Uncertainty in Economics’,
Academic Press, New Delhi.
16. Samuelson P. A. (1947) : ‘Foundations of Economic Analysis’.
Business Economics - I 49
Business Economics
NOTES
17. Patil J. F. and Others (2014) : ‘Managerial Economics’, Phadke
Prakashan, Kolhapur.
18. Banerjee A. And S. Mukherjee (1985) : ‘Topics in Managerial
Economics’, New Central Book Agency, Kolkatta.
19. Gupta G. S. (1990) : ‘Managerial Economics’, Tata McGraw Hill, New
Delhi.
20. Mehta P. L. (1997) : ‘Managerial Economics Analysis, Problems and
Cases’, Sultan Chand, New Delhi.
r r r
50 Business Economics - I
UNIT 6 : DEMAND FORECASTING
TECHNIQUES
Demand Forecasting
Techniques
NOTES
Structure
6.0 Introduction
6.1 Unit Objectives
6.2 Subject description
6.2.1 Estimation of demand for consumer durables and non-durables
6.2.2 Need for demand forecasting
6.2.3 Methods of demand forecasting
6.3 Summary
6.4 Key terms
6.5 Questions and Exercises
6.6 Further reading and References
6.0
INTRODUCTION
The demand theory seeks to explain the decision making behaviour of the consumer
in demanding a particular commodity. In the previous unit, you have learned
about the demand theory or the theory of consumer behaviour. After studying the
theory of consumer behaviour, it is necessary for business managers to have a
clear understanding of the estimation of demand for consumer durables and nondurables or methods of demand forecasting. Knowledge about market demand is
vital for the business manager in creating price, sales and output strategies against
dynamic changes in the economy or particularly in the determinants of demand.
In this situation, forecasting of demand becomes an important function of the
managerial economist under the conditions of uncertainty. In this unit you will
read about estimation of demand for consumer durables and non-durables. This
unit will also describe the need of demand forecasting and methods of demand
forecasting.
6.1
UNIT OBJECTIVES
After studying this unit, you should be able to –
6.2
l
Explain estimation of demand for consumer durables.
l
Explain estimation of demand for consumer non-durables.
l
Understand need for demand forecasting.
l
Understand various methods of demand forecasting.
SUBJECT DESCRIPTION
In modern business, production is often made in anticipation of demand, and
anticipation of demand implies forecasting of demand.
Business Economics - I 51
Business Economics
NOTES
6.2.1
ESTIMATION OF DEMAND FOR CONSUMER
DURABLES AND NON-DURABLES
For all practical purpose, a business firm may seek to estimate the demand function
for its product. Forecasting of demand is an estimate of future demand for a given
commodity or sale of a firm. The demand estimation is a first step to a demand
forecasting. Demand estimation can be useful in certain business decision making.
For examples; A wine manufacturer may be interested in knowing the impact of
increase in excise duties on wine on its sales. A firm would like to know how
much is the demand for its products. An automobile manufacturer wants to know
how much increase in his sales of cars is possible by advertising more or to spend
more on advertising.
There are some important steps in estimating demand for a product. Initial step is
to identify the demand determinants and to specify the demand function for the
product. Other steps are choice of statistical technique, data collection, empirical
process, result reporting, interpretation and evaluation. Here, we shall discuss
durable and non-durable consumer goods and specify the demand functions for
the two categories of consumer goods.
Estimating Demand for Consumer Durables
These goods can be consumed a number of times or repeatedly used without
much toss to their utilily. These goods include residential buildings, cloths,
households gadgets (TV microwave ovens, refrigerators, air conditioners),
computers, laptops etc. In estimating demand for consumer durables, the first
step is to identify and specify the determinants of demand. The demand for
consumer durables is also known as long-term demand. The major determinants
of demand for consumer durables are as follows.:(i) Price of the commodity (PN)
(ii) Income of the consumer (Y)
(iii) Prices of related commodities (PR)
(iv) Taste of the household (T)
(v) Availability of credit facilities to buy commodities (c)
(vi) Other factors (U) like distribution of income, size of population,
composition of population, sociological factors etc.
The general form of the demand function can be expressed as follows.
D = F(PN,Y, PR,T, C, U)
Once the nature of demand function is specified, the second step is the choice of
statistical technique and then follow other steps for estimating demand for
consumer durables. Demand estimation of these goods is not an easy task.
Estimating Demand for Consumer Non-Durables
52 Business Economics - I
These goods include all those goods and services which can be used only once.
These goods are also known as ‘single - use consumer goods’ or ‘perishable
consumer goods.’ ‘Single goods are those goods which get destroyed as soon as
they are consumed e.g. food, coal, cold and hot drinks, etc. Demand for these
goods depends upon household’s disposal income, price of the commodity and its
related goods and population and its characteristics. The demand function for
consumer non-durables is expressed as –
DN
where, DN
= F (Y, S, P)
= Demand for commodity N,
Y
= Household’s disposable income
S
= Population
P
= Price of the commodity N and its related goods.
Demand Forecasting
Techniques
NOTES
There rest of the process of estimating demand for consumer non-durables is the
same as the one used for estimating the demand for consumer durables.
6.2.2
NEED FOR DEMAND FORECASTING
In modern business, production is often made in anticipation of demand.
Anticipation of demand implies demand forecasting. Demand forecasting means
predicting the future demand for a product. It also means expectations about the
future course of development. We know the future is not certain. But not entirely
so. Hence, one can hopefully predict the future and reasonable gain. Demand
forecasting is very necessary or essential in the course of business decision making.
Its need may be traced as under :1. Demand forecasting is very important in preparing production plans by
the firm. It means expansion or reduction of output should be based on
the estimates of likely demand. In order to avoid over stock or under
stock of finished goods or raw material, a reliable estimate of the future
demand would be a must.
2. Sales forecasting is based on the demand forecasting. If short term
demand forecast is available, suitable sales policy can be formulated by
the firm. Short term demand forecasting is also useful for setting sales
targets and giving incentives to the distributors and buyers.
3. Business decisions related with forward planning (future planning)
become important in the long period. Long term demand forecasting
would help to plan, expand and diversify the firm. It is also important
for developing and introducing new products in the market.
4. Demand forecasting is necessary for determining the growth rate of the
firm and its lont-term investment programmes, It is useful in investment
decisions.
5. With the help of demand forecasting, the firm may ascertain the financial
requirements and long term funds may be arranged.
6. Demand forecasting is essential for planning and scheduling production,
purchase of raw materials, spare parts, acquistion of finance and
advertising.
7. Demand forecasting is also important in identifying and entering the
new market.
6.2.3
METHODS OF DEMAND FORECASTING
There are various methods of demand forecasting. But there is no unique method
of demand forecasting which always guarantees the best result. The choice of the
method depends upon objective of demand forecasting, availability of required
data, cost of forecasting etc. In demand forecasting a judicious mixture of statistical
skill and rational judgement is needed. With the help of statistical techniques,
data can be collected, classified, tabulated, analysed and interpreted. On the other
Business Economics - I 53
Business Economics
NOTES
hand, sound judgement is a prime requisite for good demand forecasting. An
efficient demand forecasting should strike a balance between statistical techniques
and sound judgement.
Following is the chart of forecasting of demand techniques.
Chart 6.1 : Demand forecasting techniques
for Established Products
for New Products
Opinion poll method
Statistical methods
Consumer’s
Survey
Method
Expert’s
Opinion
Method
Collective
Opinion
Method
Trend
Projection
Method
Barometric
technique
Evolutionary
Method
Regression
method
Substitute
Method
Growth
Curve
Method
Opinion
Sales
Poll
Experience
Method
Method
Following are the important methods of demand forecasting.
I. Opinion poll methods
1. Consumer’s survey method.
2. Collective opinion method.
3. Expert’s opinion method.
II. Statistical methods
1. Trend projection method
2. Barometric technique
3. Regression method
I. Opinion Poll Method :-
54 Business Economics - I
These methods are generally used where the purpose is to make short-run forecast
of demand. In this method, the survey of opinions of the people is undertaken.
The consumer survey method of demand forecasting involves direct interview of
the potential consumers. The success of this method depends on there liablity of
the sample and skill of the interviewer in getting current information. In this
method, the firm may go in for complete enumeration or sample surveys. In the
case of complete enumeration, the firm has to go for a door-to-door survey
contacting all the customers in the region. Under the sample survey method, some
representative customers are selected on a random basis as samples.
Opinion poll method is also known as ‘sales force opinion method.’ This method
aims at collecting the opinions of those who are supposed to possess knowledge
of the market, e.g. sales representatives, and consultants. The firm collects
information from these representatives and on the basis of their response it forecasts
demand. Instead of depending upon the opinion poll of customers, firm can obtain
views of the experts.
Demand Forecasting
Techniques
NOTES
This method is used to consolidate the divergent experts opinions and to arrive at
a compromise estimate of future demand. This is also known as ‘Delphi Technique’
of investigation. This technique is simple. This method is best suited in situations
where intractable changes are occuring.
II. Statistical Method
Statistical techniques have proved to be very useful in demand forecasting.
They are to be used in combination for accuracy and cross-checking
purposes. The important statistical methods used in the demand forecasting are
as follows :Long run tendency of a time-series to increase or decrease over a period of time is
known as trend. Time scries analysis relates to the determination of a change in a
variable in relation to time. As earlier said, a trend is a long-term increase or
decrease in the variable. For example, the time series of population in India exhibits
on upward trend while the trend for tiger is downward. Graphic method and least
square method are most important methods of measuring trend. In a graphic
method, all values for different years are plotted on a graph and a smooth freehand
curve is drawn passing through as many points a possible. In this graph, the
direction of free-hand curve-upward or downward - shows the trend.
It can be explained with the help of following data.
Table 6.1 : Sales of Company
Year
Sales (Rs. Crore)
2007
05
2008
10
2009
15
2010
05
2011
15
2012
30
2013
30
2014
35
With the help of above data, the direction of the free-hand curve can be drawn. It
shows the trend.
Under the least squares method, a trend line is fitted to the time series sales data
with the aid of statistical techniques. This technique is used to find a trend line
which ‘best fits’ the available data. Fitting trend equation is a formal technique of
projecting the trend in demand. It is a mathematical procedure. When a time
series data reveals a rising trend in sales, then a straight-line trend equation of the
following form is fitted;
Business Economics - I 55
Y = a + bx
Business Economics
NOTES
where Y represents sales, a and b are the values that are to be estimated from the
past data of sales. Here, a and b are constant. X is the year number for which the
forecast is to be made.
Y
Actual Values
35
30
Trend line
25
20
Sales
(Rs. Crores)
15
10
5
O
2007
2008
2009
2010
2011
2012
2013
X
2014
Years
Figure 6.1 : Trend of Sales of Company
Illustration : Calculate trend values from the following data using the least squares
method and estimate sales for the year 2014, 2015 and 2016.
Year
Sales(Rs.Lakh)
:
:
2008
83
2009
92
2010
71
2011
90
2012
169
2013
200
Solution :
In order to estimate the linear trend of sales the following general equation is
used :y = a + bx
In order to solve the above equation we have to make use of the following normal
equations :
y = na + bx
xy = ax + bx2
These values can be calculated as shown in the following table.
56 Business Economics - I
Year
Year No
(x)
Sales(Y)
(Rs. Lakh)
x2
xy
2008
1
83
1
83
2009
2
92
4
184
2010
3
71
9
213
2011
4
90
16
360
2012
5
169
25
845
2013
6
200
36
1200
n=6
x=21
y=705
x2=91
xy=2885
Substituting the above values in the two normal equations :705 = 6a + 21b
....................... (1)
2885 = 21a + 91b
....................... (2)
Demand Forecasting
Techniques
NOTES
Multiplying equation (l) by 7 and equation (2) by 2
4935 = 42a + 147b
....................... (3)
5770 = 42a + 182b
....................... (4)
Subtracting equation (4) from equation (3)
! 835 = !35b
or 35b = 835
835
____
 b =
= 23.85
35
Substituting the value of b in equation (1)
705 = 6a + 500.99
6a = 204.01
 a = 34
Thus, a = 34 and b = 23.85
Trend values of sales for different years can be calculated as follows :Year number of 2008 or x = I, y = 34 + 23.85 H (1) = 57.85 lakh
Year number of 2009 or x = 2, y = 34 + 23.85 H (2) = 8 ] .7 lakh
Year number of 2010 or x = 3, y = 34 + 23.85 H (3)= J05.55 lakh
Year number of 2011 or x = 4, y = 34 + 23.85 H (4) = 129.4 lakh
Year number of 2012 or x = 5, y = 34 + 23.85 H (5) = 153.25 lakh
Year number of 2013 or x = 6, y = 34 + 23.85 H (6) = 177.1 lakh
For 2014, 2015 and 2016, the trend value of sale will be as follows :When x = 7, y = 34 + 23.85 H (7) = 200.95 lakh
When x = 8, y = 34 + 23.85 H (8) = 224.8 lakh
When x = 9, y = 34 + 23.85 H (9) = 248.65 lakh
Alternative Method
Problem given above could be solved by an alternative method as follows :Year
x = 2 years
(1982.5)
Sales (Y)
Rs. Lakh
x2
xy
Trend
values
2008
!5
85
25
!415
2009
!3
92
9
!276
2010
!1
71
1
!71
2011
1
90
1
90
2012
3
169
9
507
2013
5
200
25
1000
= 70
xy = 835
n=6
y = 705
x2
Business Economics - I 57
Business Economics
NOTES
Since the number of years is even (n = 6), origin is taken as 1982.5
a=
y ___
705
___
=
= 11.92
N
6
b=
xy
_______
= 835 = 11.92
H2.70
Trend values of sales for different years can be calculated as follows : Using the
general equation y = a + bx
When x = !5, y = 117.5 + 11.92 (!5) = 57.4 lakh.
Whenx = !3, y = 117.5 + 11.92 (!3) = 81.24 lakh.
When x = !I, y = 117.5 + 11.92 (!1) = 105.08 lakh.
When x = 1, y = 11.75 + 11.92 (1) = 128.92 lakh.
When x = 3, y = 11.7.5 + 11.92 (3) = 152.76 lakh.
When x = 5, y = 11.7.5 + 11.92 (5) = 176.6 lakh.
For 2014, 2015 and 2016 the trend value of sales will be as follow;
When x = 7, y = 117.5 + 11.92(7) = 200.94 lakh.
When x = 9, y = 117.5 + 11.92(9) = 224.78 lakh.
When x = 11, y = 117.5 + 11.92(11) = 248.62 lakh.
Another important statistical technique of demand forecasting is barometric
technique. It is based on the assumption that the future can be predicted from
certain events occuring in the present. Different economic indicators i.e. income,
saving, expenditure, investment, etc. can be used to predict the market trend. In
this method, it is not needed to depend upon the past data for demand forecasting.
Most commonly for demand forecasting purposes, the parameters of the demand
function are estimated with regression analysis. In regression, a quantitative
relationship is established between demand which is a dependent variable and
the independent variables, i.e., determinants of demand such as income of the
consumer, prices of related goods, price of the commodity, advertisement cost,
etc.
Criteria of a good demand forecasting :Various methods of demand forecasting differ in terms of scope, cost, flexibility
and the necessary skill and sophistication. It is becoming increasingly difficult
for the firms to keep pace with frequent changes in demand. Following are the
criteria of a good demand forecasting, which can be used for choosing the suitable
method of forecasting.
(i) Accuracy : Forecast should be accurate as for as possible. The degree
of accuracy may differ according to the objectives of the forecast.
Accuracy must be judged by examining the past forecasts in the light of
the present situation.
(ii) Durability : Durability implies for what period the forecasting power
remains useful. It has an important bearing on the allowable cost of the
forecast.
58 Business Economics - I
(iii) Simplicity : There are various methods of demand forecasting. Some
mathematical techniques can also be used for demand forecasting.
However, it is not possible to all producers to make use of intricate
techniques. Therefore, a simple method is always more comprehensive
than a complicated one.
(iv) Economy : The firm is surely interested in getting accurate forecasts,
but forecasting should have lesser costs as for as possible. It should be
composed of the costs of forecasting and benefits from increased
accuracy.
Demand Forecasting
Techniques
NOTES
(v) Timelines : There is always a time gap between the occurrence of an
event or change in the determinants of demand and its forecasts.
Therefore, the job of the demand forecasting should be done in time or
as early as possible. Because, a time consuming method may delay the
decision making process.
(vi) Flexibility : The demand forecasting should be amenable to adjustment
with the changing conditions. The forecast should be maintained up to
date and changes should be incorporated in forecast procedure, time to
time.
.
6.3
SUMMARY
In this unit you have learned about estimation of demand and demand forecasting.
To reduce uncertainty in planning for future production levels demand forecasting
is essential. Good forecasting of future demand is important for calculating rate
of return on capital investment. Demand forecasting is essential for planning and
scheduling production, purchase of raw materials, spare parts, acquition of finance
and advertising. It is clear that it is necessary for business managers to have a
clear understanding of the estimation of demand for consumer durables and nondurables and also demand forecasting.
6.4
KEY TERMS
l
l
l
l
6.5
Forecasting of demand : It is an estimate of future demand for a given
commodity or sale of a firm.
Short term forecasting : It relates to a period not exceeding a year.
Long term forecasting : It refers to the forecasts prepared for long
period during which the firm’s scale of operations or the production
capacity may be expanded or reduced.
Trend : Long term tendency of a time-series to increase or decrease
over a period of time is known as trend.
QUESTIONS AND EXERCISES
1. What is demand forecasting?
2. Give demand function for non-durable goods.
3. Give demand function for durable goods.
4. Explain estimation of demand for consumer durables and non-durables.
5. What is the significance of demand forecasting in business decisions?
Business Economics - I 59
6. Explain the significance of statistical methods of demand forecasting?
Business Economics
7. What is meant by trend?
8. Distinguish between consumer’s survey method and sales force opinion
method.
NOTES
9. State four criteria of good demand forecasting?
10. What is demand forecasting? What are the methods of demand
forecasting?
11. What is demand forecasting? What is its utility?
12. Explain various methods of demand forecasting.
13. What is meant by demand forecasting? Why is it so important for the
management of business firms?
14. Write short notes –
(i) Estimating demand for consumer durables.
(ii) Estimating demand for consumer non-durables.
(iii) Demand forecasting.
(iv) Need for demand forecasting.
(v) Methods of demand forecasting.
(vi) Opinion poll method of demand forecasting.
(vii)Statistical methods of demand forecasting.
(viii) Least squares method.
(ix) Criteria of a good demand forecasting.
15. The annual sales of a company are given as follows :Year
:
Sales (Rs. In thousands) :
2009
2010
2011
2012
2013
45
56
58
46
75
Using the method of least squares, estimate the sales for 2014.
(Answer : Rs. 80,000)
6.6
FURTHER READING AND REFERENCES
1. Koutsoyiannis A. (1971) : ‘Modern Micro Economics’, MacMillan,
London.
2. Samuelson Paul A and William D. Nordhaus (2010) : ‘Economics’, Tata
McGraw Hill Education Private Ltd., New Delhi.
3. Kreps Daud M. (1990) : ‘A Cource in Microeconomic Theory’, Princeton
University Press, Princeton.
4. Samuelson P. A. (1947) : ‘Foundations of Economic Analysis’.
5. Diamond and Rothschild (Eds.) (1978) : ‘Uncertainty in Economics’,
Academic Press, New Delhi.
60 Business Economics - I
6. Layard P. R. G. and A. W. Alters (1978) : ‘Microeconomic Theory’,
McGraw Hill, New Delhi.
7. Sen A. (1999) : ‘Microeconomics : Theory and Applications’, Oxford
University Press, New Delhi.
8. Borch K. H. (1968) : ‘The Economics of Uncertainty’, Princeton
University Press, Princeton.
Demand Forecasting
Techniques
NOTES
9. Green H. and V. Walch (1975) : ‘Classical and Neo-Classical Theories
of General Equilibrium’, Oxford University Press, London.
10. Stigler G. (1996) : ‘Theory of Price’, 4th edition, Princeton Hall of India,
New Delhi.
11. Varian H. (2000) : ‘Microeconomic Analysis’, W. W. Norton, New York.
12. Hirshleifer J. and A. Glazer (1997) : ‘Price Theory and Applications’,
Prentice Hall of India, New Delhi.
13. Henderson J. M. and R. E. Quant (1980) : ‘Microeconomic Theory : A
Mathematical Approach’, McGraw Hill, New Delhi.
14. Green H. A. G. (1971) : ‘Consumer Theory’, Penguin Harmondsworth.
15. Mithani D. M. (2008) : ‘Managerial Economics’, Himalaya Publishing
House, Mumbai.
16. Dingra I. C. and V. K. Garg (2005) : ‘Microeconomics and Indian
Economic Environment’, Sultan Chand & Sons, New Delhi.
17. Patil J. F. and Others (2014) : ‘Managerial Economics’, Phadke
Prakashan, Kolhapur.
18. Banerjee A. and S. Mukherjee (1985) : ‘Topics in Managerial
Economics’, New Central Book Agency, Kolkatta.
19. Mehta P. L. (1997) : ‘Managerial Economics Analysis, Problems and
Cases’, Sultan Chand, New Delhi.
20. Gupta G. S. (1990) : ‘Managerial Economics’, Tata McGraw Hill, New
Delhi.
r r r
Business Economics - I 61
Business Economics
NOTES
UNIT 7 : THEORY OF PRODUCTION – I
Structure
7.0 Introduction
7.1 Unit Objectives
7.2 Subject Description
7.2.1 Production function
7.2.2 Production with one variable input-Law of diminishing returns
7.2.3 Assumptions of the Law
7.2.4 Diagrammatic presentation
7.2.5 Significance of the Law
7.3 Summary
7.4 Key Terms
7.5 Questions and Exercises
7.6 Further Reading and References
7.0
INTRODUCTION
Production is a continuous process. This process involves the transformation of
inputs into output. The inputs could be land, labour, capital, entrepreneurship etc.
and output could be goods and services. Goods and services are produced by a
firm. The production process involves various costs and they vary differently at
different levels of output. Achieving optimum efficiency in production or
minimizing cost for a given production is the important objective of the business
managers. In a competitive market, survival of a firm depends on their ability to
produce more goods and services at a competitive cost. Therefore, business
managers endeavour to maximize output from a given quantity of inputs or
minimize the production cost. In this case, business managers have to face some
fundamental questions.
(i) Whether to produce or not?
(ii) What input combination to use for optimum production?
(iii) How does output change when quantity of inputs is increased?
(iv) What type of technology to use in reducing the cost of production.
62 Business Economics - I
This unit ‘Theory of Production’ provides a theoretical answer to these questions
through economic models. Theory of production provides tools and techniques to
analyse the input output relationships. In this unit you will learn the production
theory and different concepts of production.
7.1
UNIT OBJECTIVES
Theory of Production – I
After studying this unit, you should be able –
l
To introduce and illustrate production function.
l
To explain the laws of production with one variable input.
l
To understand significance of Law of variable proportions.
7.2
SUBJECT DESCRIPTION
7.2.1
PRODUCTION FUNCTION
NOTES
The production function expresses a functional relationship between quantities
of inputs and outputs. In other words, a production function refers to a functional
relationship, under the given technology, between physical rates of input and
output of a firm, per unit of time. It shows the maximum output which can be
obtained for a given combination of inputs. Basically, production function is an
engineering concept, but it is widely used in business economics for studying
production behaviour. In the words of Stigler, “The production function is the
name given to the relationship between rates of input of productive services and
the rate of output of product. It is the economist’s summary of technological
knowledge.” In a general mathematical form the production function is –
Q = f (L, M, N, K, T)
Where,
Q = Maximum quantity of output
f = Functional relationship
L = Labour input
M = Management (efficiency parameters)
N = Land (natural resources)
K = Capital
T = Technology
This production function is called as general production function because it
explains the functional relationship between input and output. But it cannot
explain exact quantities of inputs and outputs. All above variables enter the
actual production function of a firm However, for the sake of convenience and
simplicity in the analysis of input-output relations, economists use a two- input
production function, viz., capital (K) and labour (L). We write the production
function as :Q = f (L, K)
Where,
Q = Quantity of output produced per time unit
f = Functional relationship’
L = Labour
K = Capital
This function defines the maximum rate of output obtainable for a given rate
of capital and labour input. The production function can be expressed in terms
of geometric curves specifying the maximum output that can be obtained for
Business Economics - I 63
Business Economics
the given combination of factor inputs. Such a production function is shown in
figure 7.1.
NOTES
Fig. 7.1 : Production with one variable input-Law of diminishing returns
This production function implies the maximum quantity of product that can be
produced (Q) given the total volume of capital (K) and the total number of labours
(L). Increasing production will require increase in labour and capital. Whether
the firm can increase both labour and capital depends on the time period. The
functional relationship between changes in inputs and consequent changes in output
depends on the time element i.e. short run and long run time periods.
Short run refers to a period during which supply of certain factors of production
(viz. land and capital) is supposed to be inelastic. In this case, the inputs of some
factors of production cannot be varied. However, in the short run, in order to have
more output it is possible to increase the quantities of one input while keeping the
quantities of other inputs constant. It means that, in the short period, some factors
are fixed and some are variable. A fixed factor is one whose quantity cannot be
varied during the time under consideration. On the other hand, variable factor is
one whose amount can be changed during the relevant period. Short run production
function implies a restricted set of choices open to the firm on account of
inelasticity of fixed factors. This aspect of the production function is known as
the law of variable proportions.
However, in the long run, the firm can employ more of both labour and capital.
There is no constraint on production. The production can be adjusted by changing
both the inputs i.e. fixed and variable. In other words, the longer the length of the
time period under consideration, the more likely it is that the input will be variable
and not fixed. Thus, in the long run, there is a full scope for adjustment between
factors in the production process. This is known as returns to scale.
It means that the firm would have two types of production functions. These are
(i) Short run production function; and
(ii) Long run production function.
In the short run, the firm can adjust the variable input like labour. So, this function
is called as single variable production function, which can be expressed as
Q = f (L)
On the other hand, in the long run, the firm can adjust all the inputs like labour
and capital. So this function is called as two variable production function, which
can be expressed as
64 Business Economics - I
Q = f (L, K)
7.2.2
PRODUCTION WITH ONE VARIABLE INPUT
LAW OF DIMINISHING RETURNS
The production function has been explained by different economists in different
ways to formulate laws relating to the relationship between inputs and outputs.
Output can be produced by keeping one factor or some factors fixed while other
factors are varied. The law of diminishing marginal returns is based upon this
type of production function. First, it was explained by Thomas Malthus, David
Ricardo and J. S. Mill. It was elaborated and refined by the Prof. Alfred Marshall.
His approach considers three different stages of the operation of the laws of
returns. If the number of units of a variable factor is increased, keeping other
factors constant, how output changes is the concern of this law. While keeping
one factor (capital) constant as the quantities of other input (labour) are changed
the output will change. In this case, in the beginning total product increases at an
increasing rate, then at a constant rate and finally at a diminishing rate. The law
of variable proportions depicts this type of relationship between input and output
in the short run.
Theory of Production – I
NOTES
The Law of Diminishing Returns
It was originally explained by the classical economists with reference to agriculture
In agriculture, it was observed that as the units of one input (labour) are increased
by keeping other input (land) fixed, the total production does not increase in the
same proportion. The classical economist stated this law as the law of diminishing
returns. Marshall stated this law as under:
“An increase in capital and labour applied in the cultivation of land causes in
general a less than proportionate increase in amount of produce raised, unless it
happens to coincide with an improvement in the arts of agriculture.”
This law was originally explained in connection with land and agriculture.
However, it is applicable in all fields of production like industry, mining, fishing,
house construction along with agriculture.
The Law of Variable Proportions
This is the modem version of the law of diminishing marginal returns. Modern
economists explained the law of variable proportions. This law illustrates three
stages of production that show the relationship between average product and
marginal product. Under this law it is assumed that only one factor of production
is variable while other factors are fixed. Various economists stated this law in the
following manner,
(i) Prof. Leftwitch : “The law of variable proportions states that if a variable
quantity of one resource is applied to a fixed amount of other input,
output per unit of variable input will increase but beyond some point
the resulting increases will be less and less, with total output reaching a
maximum before it finally begins to decline.”
(ii) George Stigler : “As equal increments of one input are added, the inputs
of other productive services being held constant, beyond a certain point
the resulting increments of product will decrease i.e. the marginal
products will diminish.”
(iii) Prof. F. Benham : “As the proportion of one factor in a combination of
factors is increased, after a point first the marginal and then the average
product of the factor will diminish.”
Business Economics - I 65
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NOTES
It is evident from the above definitions that as we increase units of one factor by
keeping other factor constant, initially the total output increases but finally after
a point, it tends to decline.
7.2.3
ASSUMPTIONS OF THE LAW
The law of variable proportions is based on following assumptions.
(i) Only one factor is variable while others are held constant.
(ii) All units of the variable factor are homogeneous.
(iii) The technique of production does not change.
(iv) It is possible to change the proportions in which the various factors
(inputs) are combined.
(v) It is applicable in the short run.
Under such circumstances, the physical relationship between input (variable factor
proportions) and output is described by the law of variable factor proportion. It is
also known as the ‘Law of non-proportional returns.’
To clarify the relationship further, we may adopt the following concepts of product
viz., total product, average product and marginal product.
(i) Total Product (TP) : It refers to the total volume of goods produced
during a specified period of time. In the short run, the total product
increases with an increase in the variable factor input.
(ii) Marginal Product (MP) : The rate at which total product increases is
known as marginal product, In other words, marginal product means
the addition to the total product resulting from a unit increase in the
quantity of the variable factor.
(iii) Average Product (AP) : It refers to the total product per unit of a given
variable factor. It can be known by dividing total product by the total
number of units of the variable factor.
To illustrate the working of this law, let us take a hypothetical production schedule
of a firm as given in table 7.1.
Table 7.l : Production Schedule
66 Business Economics - I
Fixed
Factor
Variable
Factor
(Labour)
Total
Average Marginal
Product Product Product
(TP)
(AP)
(MP)
10
1
10
10
10
Stage I
10
2
24
12
14
(Increasing Returns)
10
3
42
14
18
10
4
56
14
14
10
5
60
12
04
Stage II
10
6
60
10
0
(Diminishing Returns)
10
7
56
8
!4
Stage HI
10
8
40
5
!16
(Negative Returns)
Stage
We can make following conclusion on the basis of the production schedule
given above.
(i) The law of diminishing marginal returns becomes evident in the marginal
product column. In the first stage, the total output increases at an
increasing rate till third unit of variable factor. Then it increases at a
decreasing rate. Average product also rises. This is analytically described
as the stage of increasing returns. In this stage, marginal product is greater
than zero, average product rising and marginal product is greater than
average product.
Theory of Production – I
NOTES
(ii) The second stage starts with decline in average product. Reaching the
certain point the marginal product begins to diminish. In this stage both
average and marginal product decline but the fall in marginal product is
higher. The rate of increase in total product slows down. Total product
reaches its maximum as the marginal product reaches to zero. This is
the stage of diminishing returns.
(iii) The third stage starts as the marginal product turns to be negative. When
the marginal product becomes zero, the total product is maximum. The
average product declines. Further, when the marginal product becomes
negative, the total product begins to decline in the same proportion.
This is the stage of negative returns.
7.2.4
DIAGRAMMATIC PRESENTATION
Total, Average and Marginal Product
The law of variable proportions can be explained by using following diagram :-
Fig. 7.2 : Three Stages of Production
In the above diagram, the X-axis measures the units of a variable factor employed
i.e. labour, the Y-axis measures the total product, average product and marginal
Business Economics - I 67
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NOTES
product. The TP curve shows the total product, AP curve shows average product
and MP curve represents marginal product.
The first stage goes from the origin to the point where the average product is the
maximum. The total product curve has an upward slope up to point W, and then it
moves downward. In the first stage, the marginal product increases, i.e. the total
product increases at an increasing rate. Thus, this stage relates to increasing average
returns. In this situation, the law of increasing returns is said to operate. The main
reason for increasing returns in this stage is that in the beginning the fixed factor
is large in quantity than the variable factor.
The second stage goes from the point where the average product is maximum to
the point where the marginal product is zero. In this stage both average and marginal
product decline but the fall in marginal product is higher. In this stage, total product
increases at a diminishing rate. This is the crucial stage for the firm, because it is
within this stage that the firm determines its level of the actual operation. The
marginal product decreases because a given quantity of fixed factors, is combined
with larger and larger amounts of variable factors.
In the third stage, total product starts declining and the marginal product becomes
negative. This stage is the stage of negative returns, when the input of a variable
factor is much excessive in relation to the fixed components in the production
function. Excess quantity of variable factors causes, negative returns. Production
will not take place in this stage.
7.2.5
SIGNIFICANCE OF THE LAW
The law of variable proportions has a great significance both from theoretical
and practical points of view. Marshall applied the operation of this law to
agriculture, fisheries, mining, forests and the building industries. This law is useful
to businessmen in their short run production planning at the micro level. The law
shows the appropriate stage of production. The output will not be taken in the last
stage when the returns are negative. In the words of Wicksteed, the law of
diminishing returns, “is as universal as the law of life itself.” Ricardo also based
his theory of rent on this principle. The Malthusian theory of population is also
based on this principle. According to this theory, food supply does not increase
faster than the growth in population because of the operation of the law of
diminishing returns in agriculture.
7.3
68 Business Economics - I
SUMMARY
In this unit you have learned about production function and production with one
variable input i.e. law of variable proportions. The production function expresses
a functional relationship between quantities of inputs and outputs. In other words,
the technological – physical relationship between inputs and outputs is referred
to as the production function. Production function can be classified into two types
i.e. short-run production function and long run production function. In the short
run, the firm cannot change all the inputs to adjust the output. However, the firm
can adjust the variable input like labour. When the quantity of one factor is varied
(labour) keeping the quantities of other factors constant (land, capital etc.) the
output will change. The law of variable proportions depicts this relationship
between input and output in the short run. It occupies an important place in
economic theory.
7.4
Theory of Production – I
KEY TERMS
l
l
l
l
l
Production Function : It refers to the functional relationship, under
the given technology, between physical rates of input and output of a
firm, per unit of time.
The Short Run : It is defined as a period of time over which the inputs
of some factors of production cannnot be varied.
The Long Run : It is defined as a period of time long enough to permit
variations in the inputs of all factors of production employed by a firm.
Total Product : Total product of a factor is the amount of total output
produced by a given amount of the factor, other factors held constant.
Average Product : Average product of a factor is the total output
produced per unit of a factor employed. Symbolically,
Average Product =
l
NOTES
Total Product
_______________________________
Number of units of a factor employed
Marginal Product : Marginal product of a factor is the addition to the
total production by the employment of an extra unit of a factor
mathematically,
Q
____
MPL =
L
Or
Marginal product of Labour =
l
7.5
Change in total product
_______________________
Change in units of Labour
The Law of variable proportions : As the proportion of one factor in
a combination of factors is increased after a point, the average and
marginal production of the factor will diminish.
QUESTIONS AND EXERCISES
1. What is a production function?
2. State and explain the law of variable proportions. Which is the best
stage in this law and why?
3. Explain the law of diminishing returns. Does it equally apply to industry
and agriculture?
4. What is production function? Explain its main features.
5. Discuss the short-run production function.
6. Explain the law of variable proportions.
7. “As the proportion of one factor in a combination of factors is incresed,
after a point, the marginal and average product of that factor will
diminish.” Discuss the statement.
Business Economics - I 69
8. Explain the Law of variable proportions. Why does this law operate?
Business Economics
9. Is it true to say that the law of diminishing returns is universal?
10. What are the three stages of short run production function? Why does it
not make any economic sense to produce in stage 1 or 3 ?
NOTES
11. State and illustrate with the help of a schedule and diagram the law of
increasing returns.
12. State and illustrate with the help of a schedule the law of diminishing
returns.
13. Fill in the blanks in the following table :Number of variable
Input (Labour)
total
Product
Average
Product
Marginal
Product
1
2
3
4
5
6
7
8
9
10
2
—
—
—
—
150
153
—
—
—
—
25
—
—
—
—
—
—
—
—
—
—
40
30
20
—
—
0
!4
!5
14. Write Short Notes :(i) Production function.
(ii) Types of production function.
(iii) Production with one variable input.
(iv) Law of variable proportions
(v) The Law of diminishing returns.
(vi) Concepts of product.
(vii)Significance of the Law of variable propertions.
7.6
FURTHER READING AND REFERENCES
1. Samuelson Paul A and William D. Nordhaus (2010) : ‘Economics’, Tata
McGraw Hill Education Private Ltd., New Delhi.
2. Samuelson P. A. (1947) : ‘Foundations of Economic Analysis’.
3. Koutsoyiannis A. (1971) : ‘Modern Micro Economics’, MacMillan,
London.
4. Kreps Daud M. (1990) : ‘A Cource in Microeconomic Theory’, Princeton
University Press, Princeton.
70 Business Economics - I
5. Diamond and RothSchild (Eds.) (1978) : ‘Uncertainty in Economics’,
Academic Press, New Delhi.
6. Layard P. R. G. and A. W. Alters (1978) : ‘Microeconomic Theory’,
McGraw Hill, New Delhi.
7. Sen A. (1999) : ‘Microeconomics : Theory and Applications’, Oxford
University Press, New Delhi.
Theory of Production – I
NOTES
8. Green H. And V. Walch (1975) : ‘Classical and Neo-Classical Theories
of General Equilibrium’, Oxford University Press, London.
9. Borch K. H. (1968) : ‘The Economics of Uncertainty’, Princeton
University Press, Princeton.
10. Stigler G. (1996) : ‘Theory of Price’, 4th edition, Princeton Hall of India,
New Delhi.
11. Gupta G. S. (1990) : ‘Managerial Economics’, Tata McGraw Hill, New
Delhi.
12. Mehta P. L. (1997) : ‘Managerial Economics Analysis, Problems and
Cases’, Sultan Chand, New Delhi.
13. Banerjee A. and S. Mukherjee (1985) : ‘Topics in Managerial
Economics’, New Central Book Agency, Kolkatta.
14. Varian H. (2000) : ‘Microeconomic Analysis’, W.W. Norton, New York.
15. Hirshleifer J. and A. Glazer (1997) : ‘Price Theory and Applications’,
Prentice Hall of India, New Delhi.
16. Henderson J. M. and R. E. Quant (1980) : ‘Microeconomic Theory : A
Mathematical Approach’, McGraw Hill, New Delhi.
17. Dingra I. C. And V. K. Garg (2005) : ‘Microeconomics and Indian
Economic Environment’, Sultan Chand & Sons, New Delhi.
18. Patil J. F. and Others (2014) : ‘Managerial Economics’, Phadke
Prakashan, Kolhapur.
19. Green H. A. G. (1971) : ‘Consumer Theory’, Penguin Harmonds worth.
20. Mithani D. M. (2008) : ‘Managerial Economics’, Himalaya Publishing
House, Mumbai.
r r r
Business Economics - I 71
Business Economics
NOTES
UNIT 8 : THEORY OF PRODUCTION – II
Structure
8.0 Introduction
8.1 Unit Objectives
8.2 Subject Description
8.2.1 Production with two variable inputs : Law of Returns to Scale
8.2.2 Assumptions of the Law
8.2.3 Diagrammatic Presentation
8.2.4 Estimation of production function
8.3 Summary
8.4 Key Terms
8.5 Questions and Exercises
8.6 Further Reading and References
8.0
INTRODUCTION
In the previous unit, you have learned about meaning of production function,
production function with one variable input i.e. law of variable proportions or
law of diminishing returns. In it we have discussed that a firm can change its level
of production by changing the quantity of the variable factors i.e. labour in the
short run. In the long run, all factors become variable. When a firm changes the
quantity of both the factors i.e. fixed factors and variable factors (plant, equipment,
building, labour) in the long run, it changes its scale of production. In this unit
you will learn the production function with two variable inputs i.e. law of returns
to scale you will also learn the estimation of production function.
8.1
UNIT OBJECTIVES
After studying this unit, you should be able –
l
l
72 Business Economics - I
To understnad the production function with two variable inputs i.e. law
of returns to scale.
To understand estimation of production function.
8.2
SUBJECT DESCRIPTION
8.2.1
PRODUCTION WITH TWO VARIABLE INPUTS :
LAW OF RETURNS TO SCALE
In the long run there is no constraint on production. The production can be adjusted
by changing both the inputs i.e. fixed and variable. In fact, all factors become
variable in the long run. That means, in the long run, the size of a firm can be
expanded as the scale of production is enhanced. Firm can change production by
changing all the factors of production. If we increase all the factors of production
in the same proportion, how the production will change will be explained by the
long-run production function. Long run production function is also known as law
of returns to scale.
Theory of Production – II
NOTES
The law of returns to scale describes the relationship between outputs and scale
of inputs in the long run. It assumes that there is possibility of changing all the
inputs simultaneously and in the same, proportion. According to Roger Mikee,
the law of returns to scale refers, “to the relationship between changes in output
and proportionate changes in all factors of production.” It explains how a
simultaneous and proportionate increase in both labour (L) and capital (K) affects
the total output at various levels of input combination.
8.2.2
ASSUMPTIONS OF THE LAW
The law of returns to scale is based on following assumptions :(i) All factors are variable but enterprise is fixed.
(ii) All units of factors are homogeneous.
(iii) Technique of production is unchanged.
(iv) There is perfect competition.
(v) Returns are measured in physical terms.
Explanation
What happens when a producer changes his scale of production? This is explained
by the law of returns to scale, There are three phases of returns in the long run,
viz. (i) increasing returns to scale, (ii) constant returns to scale; and (iii) decreasing
returns to scale. If increase in output is greater than proportional increase in the
inputs, it means increasing returns to scale. Returns to scale become constant as
the increase in total product is in exact proportion to the increase in inputs, it
means constant returns to scale. If increase in output is less than proportional to
the increase in inputs, it means decreasing returns to scale. This principle of returns
to scale is explained with the help of following table.
Table No. 8.1 : Returns to scale in physical units
Labour
Capital
Total
Product
Marginal
Product
Production
Function
1
2
10
10
Increasing
2
4
23
13
returns
3
6
39
16
4
8
58
19
Constant
5
10
77
19
returns
6
12
94
17
Decreasing
7
14
109
15
returns
8
16
120
11
This table reveals that in the beginning with the scale of production of (1 labour
+ 2 capital), total output is 10. To increase output when the scale of production is
Business Economics - I 73
Business Economics
NOTES
doubled, total returns are more than doubled. The total output is increasing at an
increasing rate. It shows increasing returns to scale. In the second stage, if the
scale of production is increased, total output will increase in such a way that the
marginal returns become constant. The marginal product remains constant. This
is the stage of constant returns. Finally, the same addition in the scale of production
has resulted in output to increase at a decreasing rate. This is the stage of decreasing
returns.
8.2.3
DIAGRAMATIC PRESENTATION
The law of returns to scale can be shown diagram at ically in the following
way.
Fig. 8.1 : Scale of Production
In figure 8.1, AD is the returns to scale curve where from A to B returns are
increasing, from B to C, they are constant and from C onwards they are decreasing.
Economists make use of isoquants to explain the operation of the returns to scale.
The term ‘isoquant’ has been derived from iso meaning ‘equal’ and quant meaning
quantity. Therefore, isoquant is also known as equal-product curve or production
indifference curve. An isoquant joins all those combinations of factor inputs which
yield the same level of output. In other words, an isoquant curve is a locus of
points representing the various combinations of two inputs-labour and capitalyielding the same output. Returns to scale could be explained using isoquants
representing different levels of output.
(i) Increasing returns to scale
If a proportionate change in both the inputs, labour and capital, leads to more
than proportionate change in output, it exhibits increasing returns to scale,
digramatically, increasing returns to scale may be represented as in Fig. 8.2.
74 Business Economics - I
Fig. 8.2 : Increasing returns to Scale
In figure 8.2, IQ1, IQ2 and IQ3 are isoquants which represent output of 50, 100
and 150 units respectively. The increasing returns to scale is illustrated in this
figure. In this figure, the distance between two isoquants becomes less and less
i.e. in order to double output from 50 to 100, input increase is less than double. In
other words, the cost on labour and capital increases, but it is less than the
proportionate increase in output. Here, OA > AB > BC.
Theory of Production – II
NOTES
Returns to scale increase because of the invisibility of the factors of production.
Indivisibility means that certain inputs like capital equipments and managerial
skills cannot be divided into a smaller size to suit a smaller scale of production.
When a business expands, the returns to scale increase because the productivity
of indivisible factors increases exponentially. Another factor causing increasing
returns to scale is higher degree of specialization of both machinery and labour.
With specialization, efficiency of inputs increases and increasing returns to scale
follow. Another factor causing increasing returns to scale is internal economies
of production.
(ii) Constant returns to scale
When a proportionate change in output equals the proportional change in inputs,
it exhibits constant returns to scale. Diagrammatically, constant returns to scale
may be represented as in figure 8.3.
Fig. 8.3 : Constant returns to scale
In figure 8.3, IQ1, IQ2 and IQ3 are isoquants which represent output of 50, 100
and 150 units respectively. The constant return to scale is illustrated in this figure.
In the figure, successive isoquants are equidistant from one another along the ray
OP. In order to get an equal increase in output, the factor proportion required to
raise the output rises in an equal proportion. Constant returns to scale operate
when he total output increases exactly in the same proportion as an increase in
the quantity of factor inputs. Here, OA = AB = BC.
Increasing returns to scale do not continue indefinitely. When economies of scale
disappear and diseconomies are yet to begin, the returns to scale become constant.
Further, when factors of production are perfectly divisible and homogeneous
returns to scale are constant.
(iii) Decreasing returns to scale
If a proportionate change in both the inputs, labour and capital, leads to less than
Business Economics - I 75
Business Economics
NOTES
proportionate change in output, it exhibits decreasing returns to scale. When
powerful diseconomies are met by feeble economies of certain factors, decreasing
returns to scale set in. When inputs arc doubled, output is less than doubled and
so on. Diagrammatically, decreasing returns to scale may be represented as in
figure 8.4.
Fig. 8.4 : Decreasing returns to Scale
In figure 8.4, IQ1, IQ2 and IQ3 are isoquants which represent output of 50, 100
and 150 units respectively. The decreasing returns to scale is illustrated in this
figure. It implies that for a given increase in output, a more than proportionate
increase in the quantities of factor inputs are required. Here, OA < AB < BC. If
there are decreasing returns to scale, the distance between a pair of isoquants
would become longer on the expansion path.
Indivisible factors may become inefficient and less productive as the industrycontinues to expand after a certain limit. Large management creates difficulties
of control. The problem of supervision and coordination becomes complex and
intractable in a large scale of production. To these internal diseconomies are added
external diseconomies of scale. These arise from diminishing productivities of
the factors. All these factors tend to raise costs and the expansion of the firms
leads to diminishing returns to scale.
8.2.4
ESTIMATION OF PRODUCTION FUNCTION
In the process of decision making, a manager should understand clearly the
relationship between the inputs and outputs. A production function refers to the
functional relationship, under the given technology, between physical rates of
input and output of a firm, per unit of time. It is the mathematical form. There are
many inputs used in the production function. However, economists present a simple
production function, assuming a two factor model viz, labour and capital.
On operational basis, there are two types of production functions :
(i) Short run production function, and
76 Business Economics - I
(ii) Long run production function.
In the short run, the firm cannot change all the inputs to adjust output. The firm
cannot change fixed input like capital, i.e. supply of capital (K) is taken to be
constant. However, the firm can adjust the variable input like labour (L). It means
production can be increased only by increasing the units of labour. So short run
production function will be Q
= f (L)
Q
= Total production
f
= function of
L
= Labour quantity
Theory of Production – II
NOTES
Where,
However, in the long run, the production can be adjusted by changing both the
inputs i.e. fixed and variable. In fact, all the inputs become variable inputs in the
long run. It means production can be increased by increasing the units of labour
and capital. So, long run production function will be
Q
= f (L, K)
Therefore, the first step in estimating the production is to decide whether the
purpose is to estimate short run production function or long run production
function. Second step in the estimation of production function is to collect the
data on inputs used and production. After deciding nature of production function,
the estimator is required to find the empirical form of production function to be
estimated. For empirical measurement various mathematical relationships
such as linear, quadratic, cubic and power are used. Following are the five
types of linear and non-linear models of production functions applied in empirical
studies :(i) Linear production function.
(ii) Quadratic production function.
(iii) Cubic production function.
(iv) Power production function.
(v) Cobb-Douglas production function.
The linear production function represents straight line for the production curve,
when the production function is plotted on a graph. The quadratic production
function is useful to know the quantum of diminishing returns. The cubic
production function highlights the operation of the law of non-proportional returns
to the variable factors. When estimated value is presented graphically, initially
marginal product curve is rising and then falling. The power function is expressed
in logarithmic terms. All these production functions consider single variable factor
at a time. However, Cobb-Douglas production function considers two variable
factor inputs. The logarithmic form of Cobb-Douglas production functions can
be estimated by using least-square regression technique.
Time series analysis, cross section analysis and engineering analysis are the three
types of statistical analyses used for estimation of a production function. Time
series analysis is appropriate for a single firm that has not undergone significant
changes in technology during the time span analysed. In the cross-section analysis,
we may use regression techniques to estimate the relationship between the amounts
of the inputs and the resulting output. In engineering analysis we use technical
information supplied by the engineer. The data in this analysis is collected from
experience with day-to-day working of the technical process.
Business Economics - I 77
Business Economics
NOTES
8.3
SUMMARY
In this unit you have learned about production function in the long run or production
with two variable factors i.e. law of returns to scale. For the analysis of production
function with two variable factors we made use of the concept called isoquants.
These iso-quants are also called the iso-product or equal product curves which
are similar to indifference curves of the theory of consumption. The nature of
returns to scale is very important for a firm. Because its effect on cost of production
influences the firm’s ability to compete with other firms of various sizes in the
same industry. It occupies an important place in economic theory.
8.4
KEY TERMS
l
l
l
l
l
8.5
Isoquant : An isoquant joins all those combinations of factor inputs
which yield the same level of output.
Constant returns to Scale : If we increase all factors (i.e. scale) in a
given proportion and the output increases in the same proportion, returns
to scale are said to be constant.
Increasing returns to Scale : It occurs when the total output increases
in a larger proportion than the proportionate increase in the factor input
along a given scale.
Diminishing returns to Scale : It implies that for a given increase in
output, a more than proportionate increase in the quantities of factor
inputs is required.
Laws of returns to Scale : An increase in all the factor inputs in the
same proportion by the firm results in increase in total output in a larger
proportion than the proportionate increase in the factor inputs initially.
Then total output increases at the same rate as the factor inputs are
increased, but finally, the increase in total output is less than the increase
in the rate of factor inputs.
QUESTIONS AND EXERCISES
1. Explain the laws of returns to scale.
2. Explain the laws of retruns to scale using the isoquants.
3. What is a production function? How does a long run production function
differ from a short run production function?
4. What is meant by linear homogeneous production function?
5. What is meant by constant returns to scale? Represent it by an isoquant
map.
6. What is meant by increasing returns to scale? Explain the factors that
cause increasing returns to scale.
7. Discuss the long run production function.
78 Business Economics - I
8. What do you understand by the law of constant returns? Explain with
the help of a diagram.
9. What do you understand by returns to scale?
Theory of Production – II
10. Explain the difference between short run and long run production
function. Cite one example of this difference in a business situation.
11. State and explain the law of returns to scale.
NOTES
12. Write Short Notes :(i) Production function.
(ii) Assumptions of the returns to scale.
(iii) Increasing returns to scale.
(iv) Constant returns to scale.
(v) Diminishing returns to scale.
(vi) Isoquants.
(vii)Estimation of production function.
8.6
FURTHER READING AND REFERENCES
1. Samuelson Paul A and William D. Nordhaus (2010) : ‘Economics’, Tata
McGraw Hill Education Private Ltd., New Delhi.
2. Samuelson P. A. (1947) : ‘Foundations of Economic Analysis’.
3. Borch K. H. (1968) : ‘The Economics of Uncertainty’, Princeton
University Press, Princeton.
4. Green H. and V. Walch (1975) : ‘Classical and Neo-Classical Theories
of General Equilibrium’, Oxford University Press, London.
5. Koutsoyiannis A. (1971) : ‘Modern Micro Economics’, MacMillan,
London.
6. Kreps Daud M. (1990) : ‘A Cource in Microeconomic Theory’, Princeton
University Press, Princeton.
7. Diamond and Roth Schild (Eds.) (1978) : ‘Uncertainty in Economics’,
Academic Press, New Delhi.
8. Sen A. (1999) : ‘Microeconomics : Theory and Applications’, Oxford
University Press, New Delhi.
9. Layard P. R. G. and A. W. Alters (1978) : ‘Microeconomic Theory’,
McGraw Hill, New Delhi.
10. Mithani D. M. (2008) : ‘Managerial Economics’, Himalaya Publishing
House, Mumbai.
11. Green H. A. G. (1971) : ‘Consumer Theory’, Penguin Harmondsworth.
12. Dingra I. C. and V. K. Garg (2005) : ‘Microeconomics and Indian
Economic Environment’, Sultan Chand & Sons, New Delhi.
13. Patil J. F. and Others (2014) : ‘Managerial Economics’, Phadke
Prakashan, Kolhapur.
Business Economics - I 79
Business Economics
14. Varian H. (2000) : ‘Microeconomic Analysis’, W.W. Norton, New York.
15. Hirshleifer J. and A. Glazer (1997) : ‘Price Theory and Applications’,
Prentice Hall of India, New Delhi.
NOTES
16. Henderson J. M. and R. E. Quant (1980) : ‘Microeconomic Theory : A
Mathematical Approach’, McGraw Hill, New Delhi.
17. Stigler G. (1996) : ‘Theory of Price’, 4th edition, Princeton Hall of India,
New Delhi.
18. Gupta G. S. (1990) : ‘Managerial Economics’, Tata McGraw Hill, New
Delhi.
19. Mehta P. L. (1997) : ‘Managerial Economics Analysis, Problems and
Cases’, Sultan Chand, New Delhi.
20. Banerjee A. and S. Mukherjee (1985) : ‘Topics in Managerial
Economics’, New Central Book Agency, Kolkatta.
r r r
80 Business Economics - I
UNIT 9 : ECONOMIES & DISECONOMIES
OF SCALE
Economies & Diseconomies
of Scale
NOTES
Structure
9.0 Introduction
9.1 Unit Objectives
9.2 Subject Description
9.2.1 Economies and Diseconomies of Scale
9.2.2 Forms of Internal Economies
9.2.3 Forms of External Economies
9.2.4 Diseconomies of Scale
9.3 Summary
9.4 Key terms
9.5 Questions and Exercises
9.6 Further Reading and Exercises
9.0
INTRODUCTION
In the previous unit, you have learned about production function with two variable
inputs; law of returns to scale. In it you have learned about increasing returns to
scale, constant returns to scale and diminishing returns to scale, three different
levels of output. The growing large scale production in the modern business is
due to the expansion of large firms producing commodities. Large scale production
is economical in the sense that the cost of production is low, which implies the
benefits derived by a producer by expanding its scale of production. The low cost
is a result of what is called ‘economies of scale’. In this unit you will learn the
meaning of economies of scale, forms of internal and external economies, and
diseconomies of scale.
9.1
UNIT OBJECTIVES
After studying this unit, you should be able –
l
To understand internal economies of scale.
l
To understand external economies of scale.
l
To understand diseconomies of scale.
9.2
SUBJECT DESCRIPTION
9.2.1
ECONOMIES AND DISECONOMIES OF SCALE
The scale of production means the size of the production unit of a firm. As
production increases with the increase in quantities of labour, land and capital,
the scale of production expands. The scale of production varies with the size of
Business Economics - I 81
Business Economics
NOTES
the firm. The large scale production has a definite advantage over small scale
production. These advantages, in technical language are referred to as economies
of scale.
Economies of Scale
Economies of scale imply the benefits derived by a producer by expanding its
scale of production. In other words, economies of scale means anything which
serves to minimize average cost of production in the long run as the scale of
output increases. Marshall classified economies of large scale production into
internal economies and external economies. (Diagram 9.1)
Diagram 9.1 : Economies of Scale
Internal economies
Technical Managerial
Economies Economies
External economies
Marketing
Economies
(1) Economies (1) Delegation
of superior
of detail
Techniques
Financial
Economies
Risk minimizing
Economies
(1) Economies in
cost of obtaining
credit
(2) Economies (2) Functional
of increased
specialisation
Dimensions
(1) Diversification
of output
(3) Economies of
linked process
(1) Economies
in the purchase
of raw materials
(2) Diversification
of market
(2) Economies in
the sales of
produced goods
(3) Diversification
of sources
of supply
(4) Economies
of use of
by-products
(5) Economies of increased
specialisation
Economies
of concentration
Economies
of Information
Economies
of Specialisation
Internal Economies
Internal economies are internal to a firm when its costs of production are reduced
and output increases. These economies are not enjoyed by other firms operating
in the industry. In other words, internal economies accrue to a firm largely because
of its own efforts. It means that internal economies are exclusively available to
the expanding firm. These economies are the function of the size of the firm.
External Economies
82 Business Economics - I
External economies are those economies which arc shared by all the firms in an
industry when its size expands. They are available to all the firms of an industry
- they are not specific to any one particular firm. Thus they are the function of the
size of the industry.
In short, internal economies are specific to only one expanding firm, while the
external economies are common to all firms in an industry. In other words,
economies of size of a firm are ‘internal economies’ and those of the size of industry
are ‘external economies’.
9.2.2
FORMS OF INTERNAL ECONOMIES
Economies & Diseconomies
of Scale
NOTES
The internal economies of scale can be broadly classified under five heads as
follows:
1. Technical economies.
2. Managerial economies.
3. Marketing economies.
4. Financial economies.
5. Risk-minimising economies.
1. Technical Economies
Technical economies are those which arise to a firm from the use of better machines
and techniques of production. Use of better machines and techniques of production
leads to arise in the level of output and reduction in the average cost of production
and there by create technical economies. Technical economies can be classified
into five kinds:
(i) Economies of superior techniques : As a firm expands, it can use
superior techniques and high-qualiy machines. It raises the operational
efficiency of the firm and enables it to produce more at a lower cost.
(ii) Economies of increased dimensions : Certain technical economies may
become available just on account of increased dimensions. For example,
the cost of manufacturing a double-decker bus is lower as compared to
the cost of two ordinary buses.
(iii) Economies of linked process : A large firm is able to reduce its per unit
cost of production by linking the various processes of production. For
example, large sugar manufacturing firm or composite dairy unit.
(iv) Economies of use of by-products : A large firm is able to utilise its
waste material as a by-product. Cane pulp and molasses of big sugar
factories can be effectively used by the paper industry and liquor
distilleries.
(v) Economies of increased specialisation : A large firm is able to reap
economies by dividing its production process into sub-processes. It leads
to increased specialization, enhanced productivity and reduced cost of
production.
2. Managerial Economies
With the increasing scale of output, greater managerial economies are reaped by
an expanding firm. Managerial economies arise from specialization in management
and mechanization of managerial functions. For example, a large firm can hire
good manager by paying a handsome salary, so its overall administration will be
more efficient as well as economical. Functional specialization can be introduced
by setting up specialized departments under specialized personnel, There may be
a separate head for manufacturing, assembling, packing, marketing, general
administration, etc. Besides, large firms can afford to adopt the advanced techniques
Business Economics - I 83
Business Economics
of communications. This leads to functional specialization which increases the
productive efficiency of the firm.
3. Marketing Economies
NOTES
Marketing economies are referred as economies of buying (of raw materials,
inputs) and selling (goods produced). Large establishments have a strong
bargaining power and get a preferential treatment from the firms they deal with.
They buy their requirements of various inputs in bulk and more cheaply than a
small one. They can afford to advertise on television screens, in magazines and
newspapers. Thus a large firm is able to reap the economies of marketing.
4. Financial Economies
Large establishments can procure cheap and timely finance from the banks and
financial institutions and market also because it possesses large assets and good
reputation. The large firms can also easily raise fresh capital by issue of shares
and debentures because big firms are usually regarded less risky by investors.
Investors may be willing to lend capital to such firms even at a lower rate of
interest than to small firms.
5. Risk-Minimising Economies
Business enterprises have to face several risks. However, a large firm by producing
a wide range of products is in a position to minimise or eliminate business risks
by spreading them over. The spreading of risk can be done by a large firm in the
following ways.
(i) Diversification of output : The large firm is able to reduce risks by
counter-balancing the loss of one product by the gain from other products.
(ii) Diversification of market : The large firm is able to reduce risks by
counter-balancing the fall in demand in one market by the increased
demand in other markets. Diversification of market takes care of the
risks which arise on account of fluctuations in demand.
(iii) Diversification of sources of supply : In large establishments, there
are less chances of disruption of output as a result of scarcity of raw
materials.
9.2.3
FORMS OF EXTERNAL ECONOMIES
External economies are those economies which are shared by all firms in an
industry. These economies (advantages) benefit all firms within the industry as
the size of the industry expands. The external economies can be classified as
under:
1. Economies of concentration.
2. Economies of information.
3. Economies of specialization.
1. Economies of concentration
84 Business Economics - I
When an industry is concentrated in a particular area, all the member firms derive
mutual advantages through the training of skilled labour, provision of better
transport facilities, stimulation of improvements, etc. In other words, availability
of skilled labour, improved means of transport and communication, offices of
banks, insurance companies and other financial institutions, cheap and better power
resources, all these facilities tend to lower the unit cost of production of all the
firms in the industry.
2. Economies of information
Economies & Diseconomies
of Scale
NOTES
When a number of firms are located in one place, many associations and forams
are formed as trade associations, chambers of commerce etc. These institutions
enable the firms to interact on a common platform, tackle common problems and
voice their grievances. Besides, an industry is in a better position to set up research
laboratories than a large firm because it is able to pool larger resources. Statistical,
technical and other market information becomes more rapidly available to all
firms in a growing industry.
3. Economies of specialization
When an industry expands in size, firms start specializing in different processes
and the industry benefits on the whole. New subsidiary industries may grow up to
serve the needs of the main industry. For example, in the cotton textile industry
some firms may specialize in ginning, spinning, weaving, dyeing and bleaching.
This type of specialization benefits the entire industry by way of a rise in efficiency
and a fall in the unit cost of production.
9.2.4
DISECONOMIES OF SCALE
Beyond a particular limit, certain disadvantages of large scale production emerge.
Internal and external diseconomies are the limits to large scale production. In
other words, diseconomies of scale are disadvantages that arise due to the
expansion of the production scale and lead to a rise in the cost of production.
Generally, the following factors of diseconomies of scale limit the size of the
firm.
1. Financial diseconomies : A big firm needs huge capital. However,
capital or finance may not be easily available in the required amount at
the appropriate time and at reasonable cost.
2. Managerial diseconomies : Diseconomies begin to appear first at the
management level. There is a limit beyond which a firm becomes
unwieldy and hence unmanageable. Because as firm expands,
complexities and problems of management increase.
3. Diseconomies of risk-taking : As the scale of production increases
risks also increase with it. The larger the output, obviously the greater
will be the loss. An error of judgment may adversely affect sales or
production which may lead to great loss.
4. Marketing diseconomies : The expansion of a firm beyond a certain
limit may also involve marketing problems. Firms under monopolistic
competition will have to undertake extensive advertising and sales
promotion efforts and expenditure which ultimately lead to higher costs.
5. Labour diseconomies : Overcrowding of labour leads to a loss of control
over labour productivity and there are more chances of occurrence of
grievances and industrial disputes which prove to be costly to the large
firm.
Business Economics - I 85
Business Economics
NOTES
9.3
SUMMARY
In this unit you have learned about economies and diseconomies of scale. The
economies of scale may be classified as (i) internal economies, and (ii) external
economies. Internal economies are those economies which are open to an
individual firm, when its size expands. External economies implies gains accruing
to all the firms in an industry from the growth of that industry. Indivisibilities and
the specialisation are the two main factors that give rise to internal economies.
Increase in the scale, beyond the optimum level, results in diseconomies of scale.
Beyond a particular limit, certain disadvantages of large scale production emerge.
9.4
KEY TERMS
l
l
l
l
9.5
Economies of Scale : Imply the benefits derived by a producer by
expanding its scale of production.
Large scale production : It refers to the production of a commodity on
a large scale, with a large plant size firm.
Internal economies : The economic advantages which accrue to the
firms and industry with the expansion of the scale of production are
referred to as the economies of scale.
External economies : These are those economies or advantages which
are shared by all the firms in an industry or in a group of industries
when their size expands.
QUESTIONS AND EXERCISES
1. Distinguish between internal and external economies. Give an account
of internal economies.
2. What are the types of internal economies?
3. What are the major types of external economies?
4. Discuss the various economies of large scale production.
5. What are the major types of diseconomies?
6. Discuss the economies of scale of an expanding software firm in
Bangalore.
7. What is meant by ‘economies of scale?’ Explain the important internal
and external economies of scale.
8. What are the internal economies of scale? Explain the main internal
economies.
9. What are external economies of scale? Explain the main external
economies.
10. Write short notes –
(i) Economies of scale.
86 Business Economics - I
(ii) Internal economies.
(iii) External economies.
(iv) Technical economies.
Economies & Diseconomies
of Scale
(v) Managerial economies.
(vi) Marketing economies.
NOTES
(vii)Financial economies.
(viii) Risk-minimising economies.
(ix) Economies of concentration.
(x) Economies of information.
(xi) Economies of specialization.
(xii)Diseconomies of scale.
9.6
FURTHER READING AND EXERCISES
1. Koutsoyiannis A. (1971) : ‘Modern Micro Economics’, MacMillan,
London.
2. Samuelson P. A. (1947) : ‘Foundations of Economic Analysis’.
3. Samuelson Paul A. and William D. Nordhaus (2010) : ‘Economics’,
Tata McGraw Hill Education Private Ltd., New Delhi.
4. Borch K. H. (1968) : ‘The Economics of Uncertainty’, Princeton
University Press, Princeton.
5. Green H. and V. Walch (1975) : ‘Classical and Neo-Classical Theories
of General Equilibrium’, Oxford University Press, London.
6. Mithani D. M. (2008) : ‘Managerial Economics’, Himalaya Publishing
House, Mumbai.
7. Green H. A. G. (1971) : ‘Consumer Theory’, Penguin Harmondsworth.
8. Dingra I. C. and V. K. Garg (2005) : ‘Microeconomics and Indian
Economic Environment’, Sultan Chand & Sons, New Delhi.
9. Sen A. (1999) : ‘Microeconomics : Theory and Applications’, Oxford
University Press, New Delhi.
10. Layard P. R. G. and A. W. Alters (1978) : ‘Microeconomic Theory’,
McGraw Hill, New Delhi.
11. Kreps Daud M. (1990) : ‘A Cource in Microeconomic Theory’, Princeton
University Press, Princeton.
12. Diamond and Roth Schild (Eds.) (1978) : ‘Uncertainty in Economics’,
Academic Press, New Delhi.
13. Banerjee A. and S. Mukherjee (1985) : ‘Topics in Managerial
Economics’, New Central Book Agency, Kolkatta.
14. Mehta P. L. (1997) : ‘Managerial Economics Analysis, Problems and
Cases’, Sultan Chand, New Delhi.
Business Economics - I 87
Business Economics
NOTES
15. Patil J. F. and Others (2014) : ‘Managerial Economics’, Phadke
Prakashan, Kolhapur.
16. Gupta G. S. (1990) : ‘Managerial Economics’, Tata McGraw Hill, New
Delhi.
17. Stigler G. (1996) : ‘Theory of Price’, 4th edition, Princeton Hall of India,
New Delhi.
18. Varian H. (2000) : ‘Microeconomic Analysis’, W. W. Norton, New York.
19. Henderson J. M. and R. E. Quant (1980) : ‘Microeconomic Theory : A
Mathematical Approach’, McGraw Hill, New Delhi.
20. Hirshleifer J. and A. Glazer (1997) : ‘Price Theory and Applications’,
Prentice Hall of India, New Delhi.
r r r
88 Business Economics - I
UNIT 10 : COST CONCEPT
Structure
Cost Concept
NOTES
10.0 Introduction
10.1 Unit Objectives
10.2 Cost Concepts
10.2.1 Accounting Cost Concepts
10.2.2 Analytical Cost Concepts
10.3 Summary
10.4 Key terms
10.5 Questions and Exercises
10.6 Books for Further Reading
10.0 INTRODUCTION
The production cost is an important aspect of all business analysis and decisions.
In other words we can say that the cost of production is the soul of any industry or
business. The knowledge of cost concepts is very much useful for taking business
decisions like minimizing the cost, search the weak points in production
management, determining of price and dealers margin, finding the optimum level
of output and estimating the cost of business operations etc. This unit provides
information related to different cost concepts.
10.1 UNIT OBJECTIVES
After studying this unit, you should be able —
l
To understand accounting cost concepts.
l
To understand analytical cost concepts.
10.2 COST CONCEPTS
According to Hanson, the cost of production of a commodity is “the sum of all
the payments to the factors of production engaged in the production of that
commodity.” Cost of production includes different cost concepts like money cost,
real cost, opportunity cost, actual cost etc. These concepts can be devided into
two groups on the basis of their nature and purpose.
10.2.1 ACCOUNTING COST CONCEPTS
A. Money Cost
For producing any commodity a firm requires various inputs like labour, raw
material, power etc. Firms monetary expenditure of all these inputs is called as
Business Economics - I 89
Business Economics
NOTES
money cost. In short, the monetary expenditure of a firm on all the required inputs
to produce a given volume of output is called money cost.
Accountant and economists use the term money cost in different ways. From the
accountant’s point of view, money costs include only those costs, for which are
accounted for by the firm or for which cash is paid by the firm. It includes wages
and salaries, rent of land and building, cost of raw material, power charges, interest
payments, direct - indirect taxes and other expenses like selling cost, transport
cost etc. If, we take all these items together it is called as Explicit Cost of
production. In other words, explicit cost means all those payments made in terms
of money by a firm to others for the involvement of services of factors required in
the process of production. It is also called Expenditure costs.
Economist use the term money cost in wider sense. It includes all above items of
explicit costs plus values of those inputs which are owned by the enterpreneur
himself called as implicit cost.
E.g. In the process of production the enterpreneure may have supplied his own
capital in production, for which no interest amount is paid. But, if the enterpreneur
invests his capital elsewhere than his business, he will earn some interest.
Therefore, such interest is to be inputed and taken as implicit cost. It includes,
rent of enterpreneur’s own factory premises, wages for the enterpreneur’s own
labour return on enterpreneur’s own capital and normal profits to the enterpreneur
for his managerial functions. There are also called Non-expenditure costs because
these items do not involve actual payments.
B. Real Cost
It is purely a subjective concept. Real cost refers to all types of exertions and
sacrifices of the factors of production in the process of, a commodity production.
e.g. To produce any commodity, the capitalist has to sacrifice and wait, in the
sense that, he has to abstain from current consumption so as to save, invest and
wait for the returns as well as the workers have to exert, toil and put in efforts.
According to Marshall, “Real cost means the exertions of all different kinds of
labour that are directly or indirectly involved in making it; together with the
abstinence or rather the waitings required for saving the capital used in making it.
In short, real cost is a purely subjective concept and it is highly relevant to our
whole society.
C. Opportunity Cost or Alternative Cost
In modern economic analysis the concept of opportunity cost occupies an important
place. We know that the productive resources are scarce and have alternative
uses. Because of scarce resources the production of one commodity can only be
done at the cost of some other commodity. According to Benham ‘’the opportunity
cost of anything is the next best alternative that could be produced instead by the
same factors or by an equivalent group of factors costing the same amount of
money.”
90 Business Economics - I
This concept can be made more clear with the help of an example. There are
some factors which are used for the manufacture of a railway engine which may
also be used for the production of an equipment for the farm. Therefore, the
alternative cost of the production of a railway engine is the output of the farm
equipment sacrificed, which could have been produced with the same amount of
factors that have gone into the making of a railway engine. It should be noted
that, the resources available to the producer are limited, obviously, he can not use
them for producing railway engine and farm equipments simultaneously. His
decision to build railway engine implies the loss of opportunity to make farm
equipments. Shortly, it means the sacrifice of the alternative use of the resources
i.e. for making farm equipments.
D. Business Costs and Full Cost
Cost Concept
NOTES
There are some expenses which are incurred in carrying out a business. Such type
of all expenses are included in business cost. This concept is similar to real or
actual cost. Business cost includes all the payments as well as firm’s contractual
obligations together with the book cost of depreciation on plant and equipment. It
is used for accounting business profits and losses, filling income-tax returns and
for other legal purposes.
Business costs, normal profit and the opportunity cost together constitute
the concept of full cost. We have already discussed about business cost and
opportunity cost. Normal profit is the essential minimum earning in addition to
the alternative or opportunity cost, which a firm must receive to remain in its
present occupation.
10.2.2 ANALYTICAL COST CONCEPTS
A. Fixed Costs And Variable Cost
Fixed costs are those costs which do not change with changes in the volume of
output in the short run. Shortly, costs that do not vary for a certain level of output
are known as fixed costs. It is also called overhead costs because there costs are
common to all the units of the commodity produced by a firm. Fixed costs are
also called supplementary or indirect costs as well as unavoidable contractual
costs. The fixed costs include interest on capital, insurance premium, property
and business taxes, annual license fees, rent of the factory premises, salary
payments of permanent staff, depreciation and maintenance costs etc.
Variable costs are those costs which vary with changes in the level of output in
the short run. Shortly, when output increase these costs increse and when output
falls variable costs decrease. Therefore, when output is nill, no variable cost has
to be incurred. Variable costs are also known as direct costs, prime costs as well
as avoidable costs.
The variable cost includes wages of labour, transport costs, sales tax and excise
duty, cost of raw material, cost of fuel and power, advertisement expenses etc.
One thing should be noted here that, in the long run, nothing remains fixed and all
factors become variable. Therefore, the distinction between fixed and variable
costs is valid only in a short-run period. In the short run some factors remain
constant and others change with the level of output.
B. Total Costs (TC)
Total costs is the total of all types of expenditures incurred by a firm for producing
a given output. Briefly, it is the aggregate of the costs of all the inputs used by a
firm to produce a given output. In the short run period a firm has to incur fixed
and variable costs to produce a given output. Thus, the total costs of production is
the sum of total fixed costs and total variable costs.
TC = TFC + TVC
Business Economics - I 91
Business Economics
NOTES
(i) Total Fixed Cost (TFC)
The aggregate cost of all the fixed inputs used by a firm in the short run denotes
the term total fixed costs. It is also known as overhead costs/supplementary costs/
indirect costs. TFC remains constant at all levels of output in the short run.
(ii) Total Variable Cost (TVC)
The aggregate cost of all the variable inputs used by the firm at each level of
production denotes the total variable cost (TVC). It is also known as prime costs
or direct cost.TVC vary with change in the level of output.
C. Average Fixed Cost (AFC)
If we divide the total fixed cost (TFC) by the total number of units produced (Q),
we obtain average fixed cost (AFC).
Therefore, AFC =
TFC
_____
Q
e. g. During a particular period of time the total fixed cost (TFC) of a firm
is Rs. 10,000. When the number of units produced Q is 100 units the AFC will
_
be
When Q is 100 units, the AFC will be
10000
______
= Rs. = 100
100
_
When Q is 200 units, the AFC will be
Rs. =
Rs. =
10000
______
= Rs. = 50
200
Since the total fixed cost (TFC) remains constant at all levels of output, the
AFC falls as output (Q) increases. Thus, per unit of output AFC is variable.
D. Average Variable Cost (AVC)
If the total variable cost (TVC) is divided by the number of units produced
(Q), we obtain average variable cost (AVC). Therefore,
AVC =
TVC
_____
Q
E.g. The total variable cost (TVC) of a firm is Rs. 500 and output Q is 50
units, the AVC will be Rs 500/50 = Rs. 10. Since the TVC of a firm vary with
level of output, the AVC also varies with output.
E. Average Total Cost (ATC)
If the total cost is divided by the number of units produced, we obtain
average total cost (ATC). Therefore,
AVC =
92 Business Economics - I
TC
____
.Q
In the short run, since the total cost (TC) is the sum of total variable cost
(TVC) and total fixed cost (TFC) similarly the average cost (AC) is also sum of
average variable cost (AVC) and average Fixed cost (AFC).
Thus, AVC =
Cost Concept
. TC
____
.Q
Since, TC = TVC + TFC
TVC + TFC
___________
Therefore, AC =
Q
Since,
NOTES
TVC
TFC
____
____
= AVC and
= AFC
Q
Q
Therefore, AC = AVC + AFC
e.g. If, the total cost (TC) of a firm producing 200 units of output (Q) is
Rs. 10,000 the average cost (AC) will be Rs.
10000
_____
= Rs.50
200
Since the AC can also be obtained by adding AVC and AFC at each level of
output, let us further suppose the firm producing 200 units of output (Q) incurs
TVC of Rs. 2000 and TFC of Rs. 8000. In such a case the AVC will be
2000
8000
_____
_____
= Rs. 10 and AFC of the firm will be
= Rs. 40.
100
200
Therefore, the AC = Rs. 10 (AVC) + Rs.40 (AFC) = Rs. 50.
Average cost is cost per unit of output produced. Therefore, it is also referred
to as unit cost.
F. Marginal Cost (MC)
Marginal cost is defined as the addition made to the total cost when one more unit
is produced. Briefly marginal cost is the extra cost of producing one extra unit of
_
_
output. Marginal cost is calculated as TCn TCn 1 where n is the number of
units produced. E.g. The TC of producing 200 units is Rs. 10000 and that for
_
producing 201 units is Rs. 10080, the MC will be Rs. 80 (Rs. 10080 10000).
CHECK YOUR
PROGRESS
1. Explain the
analytical cost
concepts.
Marginal cost is also denoted as.
MC =
TC
_____
Q
or
MC =
change in total cost
_________________
change in output
Where,  denotes change in total cost and change in output.
10.3 SUMMARY
The cost of production of a commodity is “the sum of all the payments to the
factors of production engaged in the production of that commodity”. Cost of
production includes different cost concepts like money cost, real cost, opportunity
cost, actual cost etc. These concepts can be devided in two groups on the basis of
their nature and purpose i.e. (a) Accounting Cost Concepts and (b) Analytical
Cost Concepts.
Business Economics - I 93
Business Economics
NOTES
Accounting cost concepts include, money cost, real cost, opportunity or alternative
cost as well as business and full cost.
For producing any commodity a firm requires various inputs like labour, raw
material, power etc. firms monetary expenditure of all these inputs is called as
money cost. Implicit cost includes, rent of entrepreneur’s own factory premises,
wages for the entrepreneur’s own labour return on entrepreneur’s own capital
and normal profits to the entrepreneur for his managerial functions. Real cost
refers to all types of exertions and sacrifices of the factors of production in the
process of a commodity production. According to Benham, “the opportunity cost
of anything is the next best alternative that could be produced instead by the same
factors or by an equivalent group of factors costing the same amount of money”.
Business costs, normal profit and the opportunity cost together constitute the
concept of full cost. There are some expenses which are incurred in carrying out
a business such type of all expenses are included in business cost.
Analytical cost concepts includes, fixed cost and variable cost, total cost, average
variable cost, average total cost and marginal cost etc.
Fixed costs are those costs which do not change with changes in the volume of
output in the short run, variable costs are those costs which vary with changes
in the level of output in the short run. Total costs is the total of all type of
expenditures incurred by a firm for producing a given output. TFC remains constant
at all levels of output in the short run. TVC vary with change in the level of
output. If we divide the TFC by the total number of units produced, we obtain
AFC. If the TVC is divided by the number of units produced, we obtain AVC. If
the total cost is divided by the number of units produced, we obtain ATC. Marginal
cost is defined as the addition made to the total cost when one more unit is
produced.
10.4 KEY TERMS
l
l
l
l
Fixed Costs : Costs, which do not vary with output change in shortrun.
Variable Costs : Costs, which changes in the same direction as the
output changes.
Opportunity Cost : Is output of Y good lost by producing a certain
good X.
Total Costs : Sum of all fixed and variable costs.
10.5 QUESTIONS AND EXERCISES
1. Explain the following cost concepts in brief.
(a) Money Cost.
(b) Real Cost.
(c) Opportunity Cost.
(d) Business and full cost.
94 Business Economics - I
2. Explain with illustration the distinction between the following.
Cost Concept
(a) Fixed cost (F. C.) and variable cost (V. C.)
(b) Average variable cost (AVC) and Average total cost (A.T.C.)
NOTES
(c) Fixed cost (F.C.) and Marginal Cost (M.C.).
10.6 BOOKS FOR FURTHER READING
1. Ahuja H. L. : ‘Advanced Economic Theory’, S. Chand and Co., New
Delhi.
2. Appannaiah H. R., Reddy D. N. and Shanthi S. : ‘Economics for
Business’, Himalaya Publishin House, Mumbai, 2005.
3. Chaturvedi D. D., Gupta S. L. and Pal Sumitra : ‘Business Economics
Text and Cases’, Galgotia Publishing Company, New Delhi, 2006.
4. Dwivedi D. M. : ‘Managerial Economics-Theory and Application’,
Himalaya Publishing House, Mumbai, 2006.
5. Hizshleifer J. and A. Glazer (1997) : ‘Price Theory and Applications’,
Prentice Hall of India, New Delhi.
6. Jeffrey M. Perlof : ‘Micro Economics’ (IInd Ed.), Tata Pearson Education
Asia, 2001.
7. Lipsey R. G. : ‘Introduction to Positive Economics’, Oxford University
Press, New Delhi.
8. Misra S. K. and Puri V. K.: ‘Economics for Managerial Text and Cases’,
Himalaya Publishing House, Mumbai, 2006.
9. Mithani D. M. (2008) : ‘Managerial Economics’, Himalaya Publishing
House, Mumbai.
10. N. Gregozy Mankiw : ‘Principles of Economics’, (IInd Ed.), ThomsonSouth-Western, 2001.
11. Patil J. F. and Others (2014) : ‘Managerial Economics’, (IIIrd Edition),
Phadke Prakashan, Kolhapur.
12. Samuelson Paul A. and William D. Nordhaus (2010) : ‘Economics’,
(16th Edition), Tata McGrow Hill Education Private Ltd., New Delhi,
1998.
r r r
Business Economics - I 95
Business Economics
NOTES
UNIT 11 : THEORIES OF COSTS
Structure
11.0 Introduction
11.1 Unit Objectives
11.2 Theories of Costs
11.2.1 Short Run Cost Curves
11.2.2 Long Run Cost Curves
11.3 Summary
11.4 Key terms
11.5 Questions and Exercises
11.6 Books for Further Reading
11.0 INTRODUCTION
The cost of production is the soul of any industry or business. Shortly, the cost of
production is an important aspect of all business analysis and decisions. In the
previous unit (No. 10) we have discussed the cost concepts in detail. As already
mentioned the knowledge of cost concepts and its theories are very much useful
for taking business decisions like minimizing the cost, search the weak points in
production management, determining of price and dealers margin, finding the
optimum level of output and estimating the cost of business operations etc. This
unit provides information related to theories of costs.
11.1 UNIT OBJECTIVES
After studying the unit, you should be able –
l
To analyse the short run costs curves.
l
To analyse the long run costs curves.
11.2 THEORIES OF COSTS
The cost curves of a firm can be divided in to two heads i.e. short run cost curves
and long run cost curves.
11.2.1 SHORT RUN COST CURVES
Short run means a period-of time in which a firm can decrease or increase its
level of output by changing only its variable factors and not the fixed
factors.Therefore, in short run period some factors are fixed and some are variable.
The costs related to fixed and variable factors are called fixed and variable costs
respectively. We have already seen that, TC = TFC + TVC.
96 Business Economics - I
It can be made more explicit with the help of the following cost schedule. This
schedule also provides the per unit or average cost of a firm in the short run.
Theories of Costs
Table No. 1: Short term cost schedule
Units Total
Total
Total Average Average Average Marginal
output Fixed Variable Cost Fixed variable
Total
Cost
(Q)
Cost
Cost
(TC)
Cost
Cost
Cost
(MC)
(TFC)
(TVC)
(AFC)
(AVC)
(ATC/AC)
0
50
0
50
0
0
0
-
1
50
20
70
50
20
70
20
2
50
35
85
25
17.5
42.5
15
3
50
60
110
16.66
20
36.66
25
4
50
100
150
12.5
25
37.5
40
5
50
145
195
10
29
39
45
6
50
190
240
8.33
31.66
40
45
7
50
237
287
7.11
33.85
40.96
47
8
50
284
334
6.25
35.5
41.75
47
NOTES
The following major observations can be made from the cost schedule in
the above table.
(1) AFC is continuously falling because TFC is constant for all units of
output and this fixed amount is distributed among more and more units
as output rises.
(2) AVC declines in primary stage but later starts increasing with a rise in
output.
(3) The summation of AFC and AVC is the AC.
(4) The addition made to total cost (TC) when one more unit is produced as
stated earlier is MC.It also shows a similar trend as the AC.
(A)
(B)
Fig. 11.1 : Short-run total cost curves
In Fig. l1.1 (A) OX axis shows output and OY axis shows cost.Total fixed cost
(TFC) is parallel to the ox axis, because it is constant for all units of output. OP is
the fixed cost of a firm , even when output is zero. Therefore TFC curve starts
from point P on OY axis. The total variable cost curve (TVC) starts from the
origin which means that variable costs are zero when output is zero.Total variable
cost (TVC) curve rises in upward direction indicating that it increases along with
an increase in output. Total cost (TC) is the sum of TFC and TVC.
In Fig. 11.1 (B), The continuously falling curve from left to right towards the ox
axis is AFC curve.The AFC can never touch or cross the ox axis.
Business Economics - I 97
Business Economics
NOTES
The slightly U shaped curve is average variable cost (AVC) At first AVC falls
with a rise in output because of the increasing returns experienced by a firm, but
after a certain point, AVC will rise steeply left to right due to diminishing returns
to scale.
The sum of AFC and AVC is the average cost (AC) curve, As shown in the figure
AC is U shaped curve. In primary stage with the rise in output the average cost
declines and after a certain point it starts rising.
Marginal cost curve is the MC. At first, it falls, when it reaches a minimum point
thereafter rises steeply with rise in output. At the minimum point of AC and AVC,
curves the MC curve intersects them, from below as shown in the fig.
Relationship Between MC and AC
A. In primary stage, AC is greater than MC (AC > MC).
B. AC becomes constant at the 6th unit of output (Schedule no. 1) and MC
and AC both are rising but MC starts rising earlier than AC.
C. When MC decreases it pulls AC down and when MC increases , it pushes
AC up. Therefore ,MC intersects AC at its minimum.
CHECK YOUR
PROGRESS
1. Explain the short
run cost curves with
the help of cost
schedule.
2. Diagr amati call y
explain the relationship between MC
and AC.
Fig. 11.2 : Relationship between MC and AC
In Fig 11.2, OX axis shows, output and OY axis sbows cost. MC and AC are short
run marginal and average cost curves. Up to OQ units of output the average cost
(AC) is greater than the marginal cost (MC) At point A (OQ output), the average
cost (AC) curve is at its minimum level and at this point the marginal cost (MC)
curve intersects the average cost (AC) curve from below. Beyond OQ output
both AC and MC curves are moving left to right upwards, but MC curves is above
AC curve because now the marginal cost (MC) is greater than the average cost
(MC > AC).
11.2.2 LONG RUN COST ANALYSIS
As we know, a long run is period of time in which all factors become variable and
a firm can increase its level of output through enlarging its scale of operations. ln
the long run, not a single factor is fixed and all can be varied to expand output.
Therefore, no fixed factors and the firm has no fixed costs in the long run. Therefore
in the long run there will be only two cost curves i.e. a long run, average cost
(LAC) curve and long run marginal cost (LMC) curve.
(A) Long Run Average Cost Curve (LAC)
98 Business Economics - I
Some economists called the LAC as the planning curve Because a firm plans to
produce output in the long run only by choosing a plant on the long run average
cost curve (LAC) corresponding to the given output. The LAC is also called
‘envelope curve’, since it envelopes a family of short run average cost curves
from below, Another important thing is that there are infinite number of short run
average cost curves included in LAC.
Theories of Costs
NOTES
Fig. 11.3 : Long-run Average Cost Curve
In Fig. 11.3, OX axis shows output and OY axis shows average cost. LAC is the
long run average cost curve and SAC1, SAC2 and SAC3 are the short run average
cost curves, the firm has a series of SAC each having a minimum point showing
the minimum average cost, when the firm has only one plant, BQ is the minimum
SAC. The SAC decreases to B1 Q1 because of economies of scale when the second
plant is added, but after the inclusion of the third plant the SAC rises to B2 Q2. AS
shown in the fig. we can draw the long run average cost curve LAC by joining the
bottom of SAC1, SAC2 and SAC3 to LAC.
(B) Long Run Marginal Cost Curve (LMC)
It is usefull to know how the long run marginal cost curve LMC is derived. The
LMC curve can be derived from the LAC curve, because LMC is related to LAC
in the same way as the short run marginal cost curve (SMC) is related to short run
average cost curve (SAC) In Fig 11.4. We see how the LMC is derived.
Fig. 11.4 : Derivation of LMC
In Fig 11.4, OX axis shows output and OY axis shows cost of the firm. SAC1,
SAC2, SAC3 are the short run average cost curves and LAC is the long run average
cost curve. For deriving the LMC, the tangency points between SAC1, SAC2,
Business Economics - I 99
Business Economics
NOTES
CHECK YOUR
PROGRESS
1. Diagr amati call y
explain the LAC.
2. Diagr amati call y
explain the LMC.
SAC3 and the LAC (i.e. J, K, L) should be considered. These points determine the
output levels in the long run production planning e.g. If we draw perpendiculars
from point J, K, L and to OX axis ,the corresponding output levels will be OQ,
OQ1, and OQ2, At point T,the perpendiculars JQ intersects the SMC1. It means
that at output OQ, LMC is TQ If output increases from OQ to OQ1, marginal cost
(MC) will be KQ1 likewise, if perpendicular LQ2 is extended upward at point V,
it intersects SMC3 and VQ2 measures the LMC at output OQ2. If we join the
points T, K and V through a line, we get long run marginal cost curve LMC.
which will represent the behavior of marginal cost in the long run.
Long run average cost curve LAC like the short run AC curve is U shaped. But it
is less pronounced and flatter than the short run average cost curve SAC. This
will happen because, there is sufficient time for a firm to make all adjustments
and operate efficiently thereby reducing the AC, besides ,in short run the variable
costs do not rise as sharply Thus, the long run average cost curve LAC is flatter
than the short run average cost curve SAC. Like short run, the long run marginal
cost curve LMC intersects the long run average cost curve LAC at its minimum
point.
It is shown in the Fig. 11.5.
Fig. 11.5 : Long-run Cost Curves
11.3 SUMMARY
The cost curves of a firm can be divided into two heads i.e. short run cost curves
and long run cost curves.
Short run means a period of time in which a firm can decrease or increase its level
of output by changing only its variable factors and not the fixed factors. Therefore,
in short run period some factors are fixed and some are variable. The costs related
to fixed and variable factors are called fixed and variable costs respectively.
TC = TFC + TVC
AFC is continuously falling because TFC is constant for all units of output and
this fixed amount is distributed among more and more units as output rises. AVC
declines in primary stage but later starts increasing with rise in output. The
summation of AFC and AVC is the AC. The addition made to total cost (TC)
when one more unit is produced as stated earlier is MC. It also shows a similar
trend as the AC.
100 Business Economics - I
Long run is period of time in which all factors become variable and a firm can
increase its level of output through enlarging its scale of operations. In the long
run, not a single factor is fixed and all can be varied to expand output. Therefore,
no fixed factors and the firm has no fixed costs in the long run. Therefore, in the
long run there will be only two cost curves i.e. a long run average cost (LAC)
curves and long run marginal cost (LMC) curve.
The LAC is also called ‘envelope curve : Another important thing is that there are
infinite number of short run average cost curves included LAC. The LMC curve
can be derived from the LAC curve, because LMC is related to LAC in the same
way as the short run marginal cost curve (SMC) is related to short run average
cost curve (SAC).
Theories of Costs
NOTES
11.4 KEY TERMS
l
l
l
Fixed Costs : Costs, which do not vary with output change in shortrun.
Variable Costs : Costs, which changes in the same direction as the
output changes.
Total Costs : Sum of all fixed and variable costs.
11.5 QUESTIONS AND EXERCISES
1. Explain the relationship between short run average cost (SAC) curves
and short run marginal cost (SMC) curves.
2. Discuss the short run cost curves with cost schedule.
3. Explain the relationship between marginal cost (MC) and average cost
(AC).
4. Diagrammatically analyse the long run cost curve LAC and LMC.
11.6 BOOKS FOR FURTHER READING
1. Ahuja H. L. : ‘Advanced Economic Theory’, S. Chand and Co., New
Delhi.
2. Appannaiah H. R., Reddy D. N. and Shanthi S. : ‘Economics for
Business’, Himalaya Publishin House, Mumbai, 2005.
3. Chaturvedi D. D., Gupta S. L. and Pal Sumitra : ‘Business Economics
Text and Cases’, Galgotia Publishing Company, New Delhi, 2006.
4. Dwivedi D. M. : ‘Managerial Economics-Theory and Application’,
Himalaya Publishing House, Mumbai, 2006.
5. Hizshleifer J. and A. Glazer (1997) : ‘Price Theory and Applications’,
Prentice Hall of India, New Delhi.
6. Jeffrey M. Perlof : ‘Micro Economics’ (IInd Ed.), Tata Pearson Education
Asia, 2001.
7. Lipsey R. G. : ‘Introduction to Positive Economics’, Oxford University
Press, New Delhi.
8. Misra S. K. and Puri V. K.: ‘Economics for Managerial Text and Cases’,
Himalaya Publishing House, Mumbai, 2006.
Business Economics - I 101
Business Economics
NOTES
9. Mithani D. M. (2008) : ‘Managerial Economics’, Himalaya Publishing
House, Mumbai.
10. N. Gregozy Mankiw : ‘Principles of Economics’, (IInd Ed.), ThomsonSouth-Western, 2001.
11. Patil J. F. and Others (2014) : ‘Managerial Economics’, (IIIrd Edition),
Phadke Prakashan, Kolhapur.
12. Samuelson Paul A. and William D. Nordhaus (2010) : ‘Economics’,
(16th Edition), Tata McGrow Hill Education Private Ltd., New Delhi,
1998.
r r r
102 Business Economics - I
UNIT 12 : OPTIMUM PRODUCTION IN THE
SHORT RUN
Theories of Costs
NOTES
Structure
12.0 Introduction
12.1 Unit Objectives
12.2 Optimum Production in the Short Run
12.3 Summary
12.4 Key terms
12.5 Questions and Exercises
12.6 Books for Further Reading
12.0 INTRODUCTION
We have already studied the cost concepts and theories of costs in previous two
units. In this unit we will study the optimum production in the short run as well as
the behaviour of the short run average total cost (SATC) curve.
12.1 UNIT OBJECTIVES
After studying the unit, you should be able –
l
l
To explain the optimum production in the short run.
To understand the behaviour of the short run average total cost curve
(SATC).
12.2 OPTIMUM PRODUCTION IN THE SHORT
RUN
Short run refers to a period of time in which adjustments are not possible in the
context of production function, it implies a period of time in which some factors
of production are fixed while others are variable. Increasing production in the
short run is therefore possible only with the help of variable factors like labour.
The law of variable proportions is the law which explains behavior of production
when variable factors are changed along
with a given quantity of fix factor. The
law exhibits three stages of production in
which production first increases at
increasing rate then at decreasing rate and
finally at negative rate.
The law of variable proportions, which
reflects the behavior of production in short
run, gives rise to a short run average total
cost curve of U shape as shown in the
above Fig. 12.1.
Fig. 12.1 : Optimum production
in the short run
Business Economics - I 103
Business Economics
Average Total Cost
NOTES
As can be seen from the above Fig. 12.1, the average total cost in the short run
and the output will shape the relationship as represented by the SATC (short run
average total cost) curve. With the increase in output average cost will first fall,
then reach the minimum level and finally start going up. This shape of the short
run average total cost curve is the result of input output relationship in the short
run. As stated above, in the short run
increasing quantities of variable factors
Y
are applied to the given quantity of
fixed factors. In order to increase the
output initially the fixed factor are
relatively more and therefore when
SATC
increasing quantities of a variable
factors are applied, fixed factors start
getting fully utilized, this results into
increase in output and decrease in cost.
This happens because of the benefits
X
associated with division of work which O
Output
become available as more and more
variable factors are applied to a given
Fig. 12.2 : Flatter shape of SATC
quantity of fixed factors.
With the increase in the quantities of
variable factors the given quantity of
fixed factors starts getting over
exploited, resulting into decrease in
production and increase in cost. This
happens because the scope for division
of work and specialization becomes
almost zero.
Y
SATC
Average Total Cost
SATC can take a flatter shape (as shown
in Fig. no. 12.2) or it can become
steeper as indicated below in Fig. no.
12.3. This depends mainly on the
technology being used.
O
Output
X
Fig. 12.3 : Steeper shape of SATC
So, in the short run, the average total cost curve first falls up to a point due to the
benefits resulting from division of work and specialization and then goes up as
the scope for division of work ceases to exist. Therefore, in the short run it makes
perfect sense to increase the production until the benefits associated with division
of work and specialization are fully reaped. After this, increasing production
becomes uneconomical. The bottom point of SATC curve (P) is the point where
the average cost is minimum on account of the full utilization of the fixed factors
through division of work and therefore, the output corresponding to this minimum
point is the optimum output in the short run.
12.3 SUMMARY
l
l
104 Business Economics - I
Short run refers to a period of time in which adjustments are not
possible in the context of production function, it implies a period of
time in which some factors of production are fixed while others are
variable.
The law of variable proportions, which reflects the behaviour of
production in short run, gives rise to a short run average total cost curve
of U shape.
l
l
SATC can take a flatter shape or it can become steeper. This depends
mainly on the technology being used.
The optimum output in the short run is given by the minimum point of
the SATC curve.
Theories of Costs
NOTES
12.4 KEY TERMS
l
SATC
12.5 QUESTIONS AND EXERCISES
1. Explain the optimum production in the short run.
2. Diagrammatically explain the different shapes of short-run average total
cost (SATC) curve.
12.6 BOOKS FOR FURTHER READING
1. Ahuja H. L. : ‘Advanced Economic Theory’, S. Chand and Co., New
Delhi.
2. Appannaiah H. R., Reddy D. N. and Shanthi S. : ‘Economics for
Business’, Himalaya Publishin House, Mumbai, 2005.
3. Chaturvedi D. D., Gupta S. L. and Pal Sumitra : ‘Business Economics
Text and Cases’, Galgotia Publishing Company, New Delhi, 2006.
4. Dwivedi D. M. : ‘Managerial Economics-Theory and Application’,
Himalaya Publishing House, Mumbai, 2006.
5. Hizshleifer J. and A. Glazer (1997) : ‘Price Theory and Applications’,
Prentice Hall of India, New Delhi.
6. Jeffrey M. Perlof : ‘Micro Economics’ (IInd Ed.), Tata Pearson Education
Asia, 2001.
7. Lipsey R. G. : ‘Introduction to Positive Economics’, Oxford University
Press, New Delhi.
8. Misra S. K. and Puri V. K.: ‘Economics for Managerial Text and Cases’,
Himalaya Publishing House, Mumbai, 2006.
9. Mithani D. M. (2008) : ‘Managerial Economics’, Himalaya Publishing
House, Mumbai.
10. N. Gregozy Mankiw : ‘Principles of Economics’, (IInd Ed.), ThomsonSouth-Western, 2001.
11. Patil J. F. and Others (2014) : ‘Managerial Economics’, (IIIrd Edition),
Phadke Prakashan, Kolhapur.
12. Samuelson Paul A. and William D. Nordhaus (2010) : ‘Economics’,
(16th Edition), Tata McGrow Hill Education Private Ltd., New Delhi,
1998.
r r r
Business Economics - I 105