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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 Copyright © Yashwantrao Chavan Maharashtra Open University, Nashik. All rights reserved. No part of this publication which is material protected by this copyright notice may be reproduced or transmitted or utilized or stored in any form or by any means now known or hereinafter invented, electronic, digital or mechanical, including photocopying, scanning, recording or by any information storage or retrieval system, without prior written permission from the Publisher. The information contained in this book has been obtained by authors from sources believed to be reliable and are correct to the best of their knowledge. However, the publisher and its authors shall in no event be liable for any errors, omissions or damage arising out of use of this information and specially disclaim any implied warranties or merchantability or fitness for any particular use. 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 Dr. Parag Saraf Chartered Accountant Sangamner Dist. AhmedNagar Dr. S. V. Kuvalekar 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 Dr. J. F. Patil Instructional Technology Editing & Programme Co-ordinator Dr. Latika Ajitkumar Ajbani Assistant Professor, School of Commerce & Management Y.C.M.O.U., Nashik Production Shri. Anand Yadav Manager, Print Production Centre Y.C.M. Open University, Nashik - 422 222. Copyright © Yashwantrao Chavan Maharashtra Open University, Nashik. (First edition developed under DEC development grant) First Publication : September 2015 Type Setting : M/s. Win Printers, Kolhapur. Cover Print : Printed by : Publisher : Dr. Prakash Atkare, Registrar, Y.C.M.Open University, Nashik - 422 222. 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 + bx xy = ax + bx2 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 Business Economics 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 Business Economics 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