FYBCOM
SEM-I
BUSINESS ECONOMICS-I
KEY NOTES BY DR. ARUN CHANDANE
CHAPTER -I
INTRODUCTION BUSINESS ECONOMICS
Micro and Macro
Business economicsis a field in economics that deals with issues such as business organisation,
management, growth and strategy?
The scope- 1) Market demand and supply
2)Production analysis
3)Cost and profit analysis
4)Market structure
5)Pricing
6) Objectives of the firm
7)Forecasts and business policies
8) Project planning
BASIC CONCEPTS
OPPORTUNITY COST-opportunity cost would be the next best alternative
than you sacrificed e.g. Amitabh Bachhan wants to join Hollywood than
Bollywood.
MARGINALISM: it means addition or extra e.g. any changes increase or
decrease.
MC=∆TC/∆Q
MR=∆TR/∆Q
INCREMENTALISM: It denotes that a small unit change, many a times
changes takes place in CHUNK or BUNCHES or batch of additional units.
For e.g. a firm produce 1000 units, TC is ₹20000 thus AC?
20000/1000=₹20
(AC=₹20)
The firm sell each unit at ₹40, making a profit of ₹20 per unit
The firm decide to produce one more unit of output at a marginal cost of 15.
Now the firm total cost will be ₹20015 and total output will be 1015 now what
is the AC of the firm.
20015/1015 =₹19.72
( AC=₹19.72)
VARIABLES- A variable is a magnitude of interest that can be defined, change
and measure.
They are price, profit, revenue, cost, investment, interest, saving. Types of
variable
1) ENDOGENOUS2) EXOGENOUS-
within a theory
outside the theory
FUCTIONS- A function shows the relationship between two or more variable. It
shows that how the values of one independent/dependent depends on each other.
C = f (Y) and
Q = f (P)
EQUATIONS- an equation specifies the relationship between the dependent and
independent variables. E.g. Q=f (p) in a simple equation Q = −𝑏𝑃
b is constant it has value greater than zero but less than one
e.g. if b is 0.5 then the quantity demanded would fall by 0.5 for every unit rise in
price. The negative sign indicates the inverse relationship between price and
demand.
Alternative equation Q = 𝑎 − 𝑏𝑃
Supply equation 𝑄𝑠𝑥 = −𝑐 + 𝑑𝑃𝑥
Individual demand and Market demand
Increase in demand and decrease in demand by other factors.
Extension in demand and contraction in demand by changes in price.
Equilibrium price by interaction of demand and supply.
Module II
DEMAND ANALYSIS
Demand = desire + ability to pay +willingness to pay for it
Law of demand, Assumption, law, exception.
Determinants. demand equation.
Nature of demand curve under different markets
1) Perfect competition-horizontal straight line
2) Monopoly-downward sloping flat
3) Monopolistic –downward sloping more elastic than monopoly
4) Oligopoly-kinked action and reaction of rival
UNIT-IV
ELASTICITY OF DEMAND
Degree of responsiveness, change in any one factor
Price elasticity of demand 𝐸𝑝 =
1)
2)
3)
4)
5)
𝒑𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒊𝒏 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅
𝒑𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒑𝒓𝒊𝒄𝒆
Ep=∞ Perfectly elastic demand
Ep=o Perfectly inelastic demand
Ep>1 Relatively elastic demand
Ep<1Relatively inelastic demand
Ep=1Unitary elastic demand
Income elasticity oy demand
𝐸𝑦 =
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒
Cross elasticity of demand
𝐸𝑥𝑦 =
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑔𝑜𝑜𝑑𝑠 𝑥
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑦
Promotional elasticity of demand
Ea.=
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑑𝑒𝑚𝑎𝑛𝑑/𝑠𝑎𝑙𝑒𝑠
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑖𝑛 𝑎𝑑𝑣𝑒𝑟𝑡𝑖𝑠𝑒𝑚𝑒𝑛𝑡 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
Factors determining elasticity of demand
1) Nature of commodity
2) Availability of substitute
3) Proportion income spent
4) Consumers habit
5) Number of uses of goods
6) Time
7) Postponement of demand
8) Range of prices
9) Joint demand
10) Income
11) Durables goods
Significance of elasticity of demand
1) Nature of market/structure
2) Types of goods
3) Public utilities
4) Government policy
5)Business decisions
6)Trade unions
7)Advertisements decisions
8)International trade
9)Foreign exchange rate
10)Degree of monopoly power
UNIT V
DEMAND ESTIMATION AND FORECASTING
MEANING
A forecast is a prediction or estimation of future situation. It is an objective
assessment of future course of action. Since future is uncertain, no forecast
can be percent correct. Forecasts can be both physical as well as financial
in nature. The more realistic the forecasts, the more effective decisions can
be taken for tomorrow.
In the words of Cundiff and Still, “Demand forecasting is an estimate of
sales during a specified future period which is tied to a proposed marketing
plan and which assumes a particular set of uncontrollable and competitive
forces”. Therefore, demand forecasting is a projection of firm’s expected
level of sales based on a chosen marketing plan and environment.
Significances of demands
Production planning
sales target
Inventory planning control
appropriate price policy
Planning resources
budget
Control of business
Growth and long term investment programmes
Economic planning and policy making
stability
Taking management decisions
helping government
Types of demand forecasts
Passive and active forecasts
Passive forecasts- under passive forecast, predictions is based on the
assumption that the firm does not change the course of its actions
Active forecasting- under active forecasts, predictions is done under the
condition of likely future in the actions by the firms
Short term and long term demand forecasting
Different level of forecasting
Micro
Macro
Industry
Steps in demand forecasting
Identification of objectives
Nature of the products
Determinants of demands
Collection of data
Time period
Methods
Estimation and interpretation of result
Measurement of Price Elasticity of Demand:
There are three methods of measuring price elasticity of demand:
(1) Total Expenditure Method.
(2) Geometrical Method or Point Elasticity Method.
(3) Arc Method.
These three methods are now discussed in brief:
(1) Total Expenditure Method/Total Revenue Method:
Definition, Schedule and Diagram:
The price elasticity can be measured by noting the changes in total
expenditure brought about by changes in price and quantity demanded.
(i) When with a percentage fall in price, the quantity demanded
increases so
much that it results in the increase in total expenditure, the demand is
said to be elastic (Ed > 1).
For Example:
Price Per Unit ($)
20
10
Quantity Demanded
10 Pens
30 Pens
Total Expenditure ($)
200.0
300.0
The figure (6.6) shows that at price of $20 per pen, the quantity
demanded is ten pens, the total expenditure OABC ($200). When the
price falls down to $10, the quantity demanded of pens is thirty. The total
expenditure is OEFG ($300).
Since OEFG is greater than OABC, it implies that change in quantity
demanded is proportionately more than the change in price. Hence the
demand is elastic (more than one) Ed > 1.
(ii) When a percentage fall in price raises the quantity demanded so
much as to
leave the total expenditure unchanged, the elasticity of demand is said
to be
unitary (Ed = 1).
For Example:
Price Per Pen ($)
10
5
Quantity Demanded
30
60
Total Expenditure ($)
300
300
The figure (6.7) shows that at price of $10 per pen, the total expenditure
is OABC ($300). At a lower price of $5, the total expenditure is OEFG
($300).
Since OABC = OEFG, it implies that the change in quantity demanded is
proportionately equal to change in price. So the price elasticity of
demand is equal to one, i.e., Ed = 1.
(iii) When a percentage fall in price raises the quantity demanded of a
good so as to cause the total expenditure to decrease, the demand is
said to be inelastic or less than one, i.e., Ed < 1.
For Example:
Price Per Pen ($)
5
2
Quantity Demanded
60
100
Total Expenditure ($)
300
200
In the fig (6.8) at a price of $5 per pen the quantity demanded is 50
pens. The total expenditure is OABC ($300). At a lower price of $2, the
quantity demanded is 100 pens.
The total expenditure is OEFG ($200). Since OEFG is smaller than
OABC, this implies that the change in quantity demanded is
proportionately less than the change in price. Hence price elasticity of
demand is less than one or inelastic.
Note:
As the demand curve slopes downward, therefore, the coefficient of
price elasticity of demand is always negative. The economists for
convenience sake, omit the negative sign and express the price
elasticity of demand by positive number.
(2) Geometric Method/Point Elasticity Method:
"The measurement of elasticity at a point of the demand curve is
called point elasticity".
The point elasticity of demand method is used as a measure of the
change in the quantity demanded in response to a very small changes in
price. The point elasticity of demand is defined as:
"The proportionate change in the quantity demanded resulting from a
very small proportionate change in price".
Measurement of Geometric/Point Elasticity Method:
(i) Measurement of Elasticity on a Linear Demand Curve:
The price elasticity of demand can also be measured at any point on the
demand curve. If the demand curve is linear (straight line), it has a
unitary elasticity at the mid point. The total revenue is maximum at this
point.
Any point above the midpoint has an elasticity greater than 1, (Ed > 1).
Here, price reduction leads to an increase in the total revenue
(expenditure). Below the midpoint elasticity is less than 1. (Ed < 1). Price
reduction leads to reduction in the total revenue of the firm.
Graph/Diagram:
The formula applied for measuring the elasticity at any point on the
straight line demand curve is:
Ed
=
%∆q
%∆p
X
p
q
The elasticity at each point on the demand curve can be traced with the
help of point method as:
Ed = Lower Segment
Upper Segment
In the figure (6.9) AG is the linear demand curve (1). Elasticity of
demand at its midpoint D is equal to unity. At any point to the right of D,
the elasticity is less than unity (Ed < 1) and to the left of D, the elasticity
is greater than unity (Ed > 1).
(1) Elasticity of demand at point D = DG = 400 = 1 (Unity).
DA 400
(2) Elasticity of demand at point E = GE = 200 = 0.33 (<1).
EA 600
(3) Elasticity of Demand at point C = GC = 600 = 3 (>1).
CA 200
(4) Elasticity of Demand at point C is infinity.
(5) At point G, the elasticity of demand is zero.
Summing up, the elasticity of demand is different at each point along a
linear demand curve. At high prices, demand is elastic. At low prices, it
is inelastic. At the midpoint, it is unit elastic.
(ii) Measurement of Elasticity on a Non Linear Demand Curve:
If the demand curve is non-linear, then elasticity at a point can be
measured by drawing a tangent at the particular point. This is explained
with the help of a figure given below:
In figure 6.10, the elasticity on DD/ demand curve is measured at point C
by drawing a tangent. At point C:
Ed = BM = BC = 400 = 2 (>1).
MO CA 200
Here elasticity is greater than unity. Point C lies above the midpoint of
the demand curve DD/. In case the demand curve is a rectangular
hyperbola, the change in price will have no effect on the total amount
spent on the product. As such, the demand curve will have a unitary
elasticity at all points.
(3) Arc Elasticity:
Normally the elasticity varies along the length of the demand curve. If we
are to measure elasticity between any two points on the demand curve,
then the Arc Elasticity Method, is used. Arc elasticity is a measure of
average elasticity between any two points on the demand curve. It is
defined as:
"The average elasticity of a range of points on a demand curve".
Formula:
Arc elasticity is calculated by using the following formula:
-
Ed = ∆q X P1 + P2
∆p
q1 + q2
Here:
∆q denotes change in quantity.
∆p denotes change in price.
q1 signifies initial quantity.
q2 denotes new quantity.
P1 stands for initial price.
P2 denotes new price.
Graphic Presentation of Measuring Elasticity Using the Arc Method:
In this fig. (6.11), it is shown that at a price of $10, the quantity of
demanded of apples is 5 kg. per day. When its price falls from $10 to $5,
the quantity demanded increases to 12 Kgs of apples per day. The arc
elasticity of AB part of demand curve DD/ can be calculated as under:
Ed = ∆q X P1 + P2
∆p
q1 + q2
Ed = 7 X 10 + 5 = 7 X 15 = 7 X 15 = 21 = 1.23
5 5 + 12 5 17 5 17 17
The arc elasticity is more than unity.
The more commonly used methods of demand forecasting are
discussed below:
The various methods of demand forecasting can be summarised in the
form of a chart as shown in Table 1.
1. Opinion Polling Method:
In this method, the opinion of the buyers, sales force and experts could be
gathered to determine the emerging trend in the market.
The opinion polling methods of demand forecasting are of three
kinds:
(a) Consumer’s Survey Method or Survey of Buyer’s Intentions:
In this method, the consumers are directly approached to disclose their
future purchase plans. I his is done by interviewing all consumers or a
selected group of consumers out of the relevant population. This is the
direct method of estimating demand in the short run. Here the burden of
forecasting is shifted to the buyer. The firm may go in for complete
enumeration or for sample surveys. If the commodity under consideration is
an intermediate product then the industries using it as an end product are
surveyed.
(i) Complete Enumeration Survey:
Under the Complete Enumeration Survey, the firm has to go for a door to
door survey for the forecast period by contacting all the households in the
area. This method has an advantage of first hand, unbiased information,
yet it has its share of disadvantages also. The major limitation of this
method is that it requires lot of resources, manpower and time.
In this method, consumers may be reluctant to reveal their purchase plans
due to personal privacy or commercial secrecy. Moreover, at times the consumers may not express their opinion properly or may deliberately
misguide the investigators.
(ii) Sample Survey and Test Marketing:
Under this method some representative households are selected on
random basis as samples and their opinion is taken as the generalised
opinion. This method is based on the basic assumption that the sample
truly represents the population. If the sample is the true representative,
there is likely to be no significant difference in the results obtained by the
survey. Apart from that, this method is less tedious and less costly.
A variant of sample survey technique is test marketing. Product testing
essentially involves placing the product with a number of users for a set
period. Their reactions to the product are noted after a period of time and
an estimate of likely demand is made from the result. These are suitable for
new products or for radically modified old products for which no prior data
exists. It is a more scientific method of estimating likely demand because it
stimulates a national launch in a closely defined geographical area.
(iii) End Use Method or Input-Output Method:
This method is quite useful for industries which are mainly producer’s
goods. In this method, the sale of the product under consideration is
projected as the basis of demand survey of the industries using this product
as an intermediate product, that is, the demand for the final product is the
end user demand of the intermediate product used in the production of this
final product.
The end user demand estimation of an intermediate product may involve
many final good industries using this product at home and abroad. It helps
us to understand inter-industry’ relations. In input-output accounting two
matrices used are the transaction matrix and the input co-efficient matrix.
The major efforts required by this type are not in its operation but in the
collection and presentation of data.
(b) Sales Force Opinion Method:
This is also known as collective opinion method. In this method, instead of
consumers, the opinion of the salesmen is sought. It is sometimes referred
as the “grass roots approach” as it is a bottom-up method that requires
each sales person in the company to make an individual forecast for his or
her particular sales territory.
These individual forecasts are discussed and agreed with the sales
manager. The composite of all forecasts then constitutes the sales forecast
for the organisation. The advantages of this method are that it is easy and
cheap. It does not involve any elaborate statistical treatment. The main
merit of this method lies in the collective wisdom of salesmen. This method
is more useful in forecasting sales of new products.
(c) Experts Opinion Method:
This method is also known as “Delphi Technique” of investigation. The
Delphi method requires a panel of experts, who are interrogated through a
sequence of questionnaires in which the responses to one questionnaire
are used to produce the next questionnaire. Thus any information available
to some experts and not to others is passed on, enabling all the experts to
have access to all the information for forecasting.
The method is used for long term forecasting to estimate potential sales for
new products. This method presumes two conditions: Firstly, the panellists
must be rich in their expertise, possess wide range of knowledge and
experience. Secondly, its conductors are objective in their job. This method
has some exclusive advantages of saving time and other resources.
2. Statistical Method:
Statistical methods have proved to be immensely useful in demand
forecasting. In order to maintain objectivity, that is, by consideration of all
implications and viewing the problem from an external point of view, the
statistical methods are used.
The important statistical methods are:
(i) Trend Projection Method:
A firm existing for a long time will have its own data regarding sales for past
years. Such data when arranged chronologically yield what is referred to as
‘time series’. Time series shows the past sales with effective demand for a
particular product under normal conditions. Such data can be given in a
tabular or graphic form for further analysis. This is the most popular method
among business firms, partly because it is simple and inexpensive and
partly because time series data often exhibit a persistent growth trend.
Time series has got four types of components namely, Secular Trend (T),
Secular Variation (S), Cyclical Element (C), and an Irregular or Random
Variation (I). These elements are expressed by the equation O = TSCI.
Secular trend refers to the long run changes that occur as a result of
general tendency.
Seasonal variations refer to changes in the short run weather pattern or
social habits. Cyclical variations refer to the changes that occur in industry
during depression and boom. Random variation refers to the factors which
are generally able such as wars, strikes, flood, famine and so on.
When a forecast is made the seasonal, cyclical and random variations are
removed from the observed data. Thus only the secular trend is left. This
trend is then projected. Trend projection fits a trend line to a mathematical
equation.
The trend can be estimated by using any one of the following
methods:
(a) The Graphical Method,
(b) The Least Square Method.
a) Graphical Method:
This is the simplest technique to determine the trend. All values of output or
sale for different years are plotted on a graph and a smooth free hand
curve is drawn passing through as many points as possible. The direction
of this free hand curve—upward or downward— shows the trend. A simple
illustration of this method is given in Table 2.
Table 2: Sales of Firm
Sales (Rs.)
Year
Crore)
1995
40
1996
50
1997
44
1998
60
1999
54
2000
62
In Fig. 1, AB is the trend line which has been drawn as free hand curve
passing through the various points representing actual sale values.
(iii) Regression Analysis:
It attempts to assess the relationship between at least two variables (one or
more independent and one dependent), the purpose being to predict the
value of the dependent variable from the specific value of the independent
variable. The basis of this prediction generally is historical data. This
method starts from the assumption that a basic relationship exists between
two variables. An interactive statistical analysis computer package is used
to formulate the mathematical relationship which exists.
For example, one may build up the sales model as:
Quantum of Sales = a. price + b. advertising + c. price of the rival products
+ d. personal disposable income +u
Where a, b, c, d are the constants which show the effect of corresponding
variables as sales. The constant u represents the effect of all the variables
which have been left out in the equation but having effect on sales. In the
above equation, quantum of sales is the dependent variable and the
variables on the right hand side of the equation are independent variables.
If the expected values of the independent variables are substituted in the
equation, the quantum of sales will then be forecasted.
The regression equation can also be written in a multiplicative form
as given below:
Quantum of Sales = (Price)a + (Advertising)b+ (Price of the rival
products) c + (Personal disposable income Y + u
In the above case, the exponent of each variable indicates the elasticities
of the corresponding variable. Stating the independent variables in terms of
notation, the equation form is QS = P°8. Ao42 . R°.83. Y2°.68. 40
Then we can say that 1 per cent increase in price leads to 0.8 per cent
change in quantum of sales and so on.
If we take logarithmic form of the multiple equation, we can write the
equation in an additive form as follows:
log QS = a log P + b log A + с log R + d log Yd + log u
In the above equation, the coefficients a, b, c, and d represent the elasticities of
variables P, A, R and Yd respectively.
The co-efficient in the logarithmic regression equation are very useful in policy
decision making by the management.
UNIT-III
SUPPLY AND PRODUCTION DECISION
Concept of productiontransformation of resources-creation of utility-in-output-physical relationship
between input and output.
𝐼𝑛𝑝𝑢𝑡𝑠 =
𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑝𝑟𝑜𝑐𝑒𝑠𝑠
= 𝑜𝑢𝑡𝑝𝑢𝑡𝑠
𝑡𝑟𝑎𝑛𝑠𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛 𝑝𝑟𝑜𝑐𝑒𝑠𝑠
Q = f (l, L, K, O, T) land, labour, capital, organisation T is constant bar (-)
Types of production function
Fixed Production Function-where all inputs remain fixed with given level of
output-zero substitution of factors of production.
Variable Proportion Production Function- inputs are not fixed substitutability of inputs can be done
SHORT RUN AND LONG PRODUCTION FUNCTION
CONCEPTS OF TP, AP, MP.
TP=f (QVP)
AP=
(quantity of variable factor)
𝑇𝑃
𝑄𝑉𝐹
MP=TPn-TPn-1
LABOUR
TP
MP
AP
(TPn-TPn-1)
(TP÷L)
0
0
0
0
1
12
12-0=12
12
2
26
26-12=14
13
3
42
42-26=16
14
4
52
52-42=10
13
5
60
60-52=8
12
6
60
60-60=0
10
7
55
55-60= -5
7.85
LAW OF VARIABLE PROPORTION
Definitions:
“As the proportion of the factor in a combination of factors is
increased after a point, first the marginal and then the average
product of that factor will diminish.” Benham
“An increase in some inputs relative to other fixed inputs will in a
given state of technology cause output to increase, but after a point
the extra output resulting from the same additions of extra inputs
will become less and less.” Samuelson
“The law of variable proportion states that if the inputs of one
resource is increased by equal increment per unit of time while the
inputs of other resources are held constant, total output will
increase, but beyond some point the resulting output increases will
become smaller and smaller.” Leftwitch
Assumptions:
(i) Constant Technology:
(ii) Factor Proportions are Variable:
(iii) Homogeneous Factor Units:
(iv) Short-Run:
By keeping land as a fixed factor, the production of variable factor
i.e., labour can be shown with the help of the following table:
From the table 1 it is clear that there are three stages of the law of
variable proportion. In the first stage average production increases
as there are more and more doses of labour and capital employed
with fixed factors (land). We see that total product, average product,
and marginal product increases but average product and marginal
product increases up to 40 units. Later on, both start decreasing
because proportion of workers to land was sufficient and land is not
properly used. This is the end of the first stage.
The second stage starts from where the first stage ends or where
AP=MP. In this stage, average product and marginal product start
falling. We should note that marginal product falls at a faster rate
than the average product. Here, total product increases at a
diminishing rate. It is also maximum at 70 units of labour where
marginal product becomes zero while average product is never zero
or negative.
The third stage begins where second stage ends. This starts from
8th unit. Here, marginal product is negative and total product falls
but average product is still positive. At this stage, any additional
dose leads to positive nuisance because additional dose leads to
negative marginal product.
Up to point ‘H’ marginal product increases. At point ‘H’, i.e., when 3
units of labourers are employed, it is maximum. After that,
marginal product begins to decrease. Before point ‘I’ marginal
product becomes zero at point C and it turns negative. AP curve
represents average product. Before point ‘I’, average product is less
than marginal product. At point ‘I’ average product is maximum. Up
to point T, average product increases but after that it starts to
diminish.
ISO-QUANT
Meaning
An isoquant is a firm’s counterpart of the consumer’s indifference curve.
An isoquant is a curve that shows all the combinations of inputs that
yield the same level of output. ‘Iso’ means equal and ‘quant’ means
quantity. Therefore, an isoquant represents a constant quantity of
output. The isoquant curve is also known as an “Equal Product Curve” or
“Production Indifference Curve” or Iso-Product Curve.”
The concept of isoquants can be easily explained with the help of the
table given below:
Table 1: An Isoquant Schedule
Combinations of Units of Labor Units of Capital Output of Cloth
Labor and Capital
(L)
(K)
(meters)
A
5
9
100
B
10
6
100
C
15
4
100
D
20
3
100
The above table is based on the assumption that only two factors of
production, namely, Labor and Capital are used for producing 100
meters of cloth.
Combination A = 5L + 9K = 100 meters of cloth
Combination B = 10L + 6K = 100 meters of cloth
Combination C = 15L + 4K = 100 meters of cloth
Combination D = 20L + 3K = 100 meters of cloth
The combinations A, B, C and D show the possibility of producing 100
meters of cloth by applying various combinations of labor and capital.
Thus, an isoquant schedule is a schedule of different combinations of
factors of production yielding the same quantity of output.
An iso-product curve is the graphic representation of an iso-product
schedule.
Thus, an isoquant is a curve showing all combinations of labor and
capital that can be used to produce a given quantity of output.
Isoquant Map
An isoquant map is a set of isoquants that shows the maximum
attainable output from any given combination inputs.
Properties of Isoquants
1. An isoquant lying above and to the right of another isoquant
represents a higher level of output.
2. Two isoquants cannot cut each other
In figure 4, the isoquant IQ1 shows 100 units of output produced by
various combinations of labor and capital and the curve IQ2 shows 200
units of output,
On IQ1, we have A = C, because they are on the same isoquant.
On IQ2, we have A = B
Therefore B = C
This is however inconsistent since C = 100 and B = 200. Therefore,
isoquants cannot intersect.
3. Isoquants are convex to the origin
In figure 5, as the producer moves from point A to B, from B to C and C
to D along an isoquant, the marginal rate of technical substitution
(MRTS) of labor for capital diminishes. The MRTS diminishes because
the two factors are not perfect substitutes. In figure 5, for every increase
in labor units by (ΔL) there is a corresponding decrease in the units of
capital (ΔK).
Since MRTS must diminish, the isoquants must be convex to the origin.
4. No isoquant can touch either axis
If an isoquant touches the X-axis it would mean that the commodity can
be produced with OL units of labor and without any unit of capital.
Point K on the Y-axis implies that the commodity can be produced with
OK units of capital and without any unit of labor. However, this is wrong
because the firm cannot produce a commodity with one factor alone.
5. Isoquants are negatively sloped
An isoquant slopes downwards from left to right. The logic behind this is
the principle of diminishing marginal rate of technical substitution. In
order to maintai a given output, a reduction in the use of one input must
be offset by an increase in the use of another input.
.
Consider figure 9(B)
At point A, we have OL units of labor and OK units of capital. At point B,
we have OL units of labor and OK1 units of capital.
Since B is having KK1 more units of capital it is wrong to assume that
both A and B will yield the same level of output. The conclusion is that
the isoquant cannot be a vertical straight line.
Similarly at point B in figure 9(C), we have LL1 units of more labor and
KK1 units of more capital. As compared to point A, both the inputs are
higher at point B. Therefore, it is absurd to assume that both the
combinations A and B will give the same level of output.
6. Isoquants need not be parallel
The shape of an isoquant depends upon the marginal rate of technical
substitution. Since the rate of substitution between two factors need not
necessarily be the same in all the isoquant schedules, they need not be
parallel.
7. Each isoquant is oval-shaped
An important feature of an isoquant is that it enables the firm to identify
the efficient range of production consider figure 11.
Positively sloped isoquants imply that an increase in the use of labor
would require an increase in the use of capital to keep production
constant.
RIDGE LINE
In figure 12, the segment P1S1 is the economically feasible portion of the
isoquant for IQ. If we consider such feasible portions for all the
isoquants, then the region comprising of these portions is called the
economic region of production. A producer will operate in this region. It
is shown in figure 12. The lines OP1P2 and OS1S2 are called ridge lines.
Ridge lines may be defined as lines separating the downward sloping
portions of a series of isoquants from the upward sloping portions. They
give the boundary of the economic region of production.
ISO-QUANT IS PARALLEL TO EACH OTHER
ISO-COST LINE/PRICE LINE
Iso cost curves:
Isocost curve is the locus traced out by various combinations of L and K,
each of which costs the producer the same amount of money (C )
Differentiating equation with respect to L, we have dK/dL = -w/r This
gives the slope of the producer’s budget line (isocost curve). Iso cost line
shows various combinations of labour and capital that the firm can buy
for a given factor prices. The slope of iso cost line = PL/Pk. In this
equation , PL is the price of labour and Pk is the price of capital. The
slope of iso cost line indicates the ratio of the factor prices. A set of
isocost lines can be drawn for different levels of factor prices, or different
sums of money. The iso cost line will shift to the right when money spent
on factors increases or firm could buy more as the factor prices are
given.
Slope of iso cost line
With the change in the factor prices the slope of iso cost lien will change.
If the price of labour falls the firm could buy more of labour and the line
will shift away from the origin. The slope depends on the prices of
factors of production and the amount of money which the firm spends on
the factors. When the amount of money spent by the firm changes, the
isocost line may shift but its slope remains the same. A change in factor
price makes changes in the slope of isocost lines as shown in the figure.
Least Cost Factor Combination or Producer’s
Equilibrium or Optimal Combination of Inputs
The firm can achieve maximum profits by choosing that combination of
factors which will cost it the least. The least cost factor combination can
be determined by imposing the isoquant map on isocost line. The point
of tangency between the isocost and an isoquant is an important but not
a necessary condition for producer’s equilibrium. The essential condition
is that the slope of the isocost line must equal the slope of the isoquant.
Thus at a point of equilibrium marginal physical productivities of the two
factors must be equal the ratio of their prices. The marginal physical
product per rupee of one factor must be equal to tht of the other factor.
And isoquant must be convex to the origin. The marginal rate of
technical substitution of labour for capital must be diminishing at the
point of equilibrium.
Law of Returns to Scale:
The degree of change in output varies with change in the amount of
inputs. For example, an output may change by a large proportion,
same proportion, or small proportion with respect to change in
input.
It explains the production behavior of the firm with one factor variable
while other factors are kept constant. Whereas the law of returns to
scale operates in the long period. It explains the production behavior of
the firm with all variable factors.
(1) Increasing Returns to Scale:
If the output of a firm increases more than in proportion to an equal
percentage increase in all inputs, the production is said to exhibit
increasing returns to scale.
For example, if the amount of inputs are doubled and the output
increases by more than double, it is said to be an increasing returns
returns to scale. When there is an increase in the scale of production, it
leads to lower average cost per unit produced as the firm enjoys
economies of scale.
(2) Constant Returns to Scale:
When all inputs are increased by a certain percentage, the output
increases by the same percentage, the production function is said to
exhibit constant returns to scale.
For example, if a firm doubles inputs, it doubles output. In case, it triples
output. The constant scale of production has no effect on average cost
per unit produced.
(3) Diminishing Returns to Scale:
The term 'diminishing' returns to scale refers to scale where output
increases in a smaller proportion than the increase in all inputs.
For example, if a firm increases inputs by 100% but the output
decreases by less than 100%, the firm is said to exhibit decreasing
returns to scale. In case of decreasing returns to scale, the firm faces
diseconomies of scale. The firm's scale of production leads to higher
average cost per unit produced.
Graph/Diagram:
The three laws of returns to scale are now explained with the help of a
graph below:
The figure shows that when a firm uses one unit of labor and one unit of
capital, point a, it produces 1 unit of quantity as is shown on the q = 1
isoquant. When the firm doubles its outputs by using 2 units of labor and
2 units of capital, it produces more than double from
q = 1 to q = 3.
So the production function has increasing returns to scale in this range.
Another output from quantity 3 to quantity 6. At the last doubling point c
to point d, the production function has decreasing returns to scale. The
doubling of output from 4 units of input, causes output to increase from 6
to 8 units increases of two units only.
ECONOMIES OF SCALE
Scale economies have brought down the unit costs of production and
have fed through to lower prices for consumers.
Most firms find that, as their production output increases, they can
achieve lower costs per unit. This can be illustrated as follows:
Economies of Scale
In the diagram above, you can see that unit costs fall from AC1 to AC2
when output increases from Q1 to Q2. That illustrates the effect
of economies of scale – so what are they?
Economies of scale are the cost advantages that a business can
exploit by expanding their scale of production. The effect of
economies of scale is to reduce the average (unit) costs of production.
There are many different types of economy of scale and depending
on the particular characteristics of an industry, some are more
important than others.
Internal economies of scale
Internal economies of scale arise from the growth of the business itself.
Examples include:
Technical economies of scale:
Large-scale businesses can afford to invest in expensive and specialist
capital machinery. For example, a supermarket chain such as Tesco or
Sainsbury's can invest in technology that improves stock control. It might
not, however, be viable or cost-efficient for a small corner shop to buy
this technology.
Specialisation of the workforce
Larger businesses split complex production processes into separate
tasks to boost productivity. By specialising in certain tasks or processes,
the workforce is able to produce more output in the same time.
Marketing economies of scale
A large firm can spread its advertising and marketing budget over a
large output and it can purchase its inputs in bulk at negotiated
discounted prices if it has sufficient negotiation power in the market. A
good example would be the ability of the electricity generators to
negotiate lower prices when negotiating coal and gas supply contracts.
The major food retailers also have buying power when purchasing
supplies from farmers and other suppliers.
Managerial economies of scale
This is a form of division of labour. Large-scale manufacturers employ
specialists to supervise production systems, manage marketing systems
and oversee human resources.
Financial economies of scale
Larger firms are usually rated by the financial markets to be more 'credit
worthy' and have access to credit facilities, with favourable rates of
borrowing. In contrast, smaller firms often face higher rates of interest on
overdrafts and loans. Businesses quoted on the stock market can
normally raise fresh money (i.e. extra financial capital) more cheaply
through the issue of shares. They are also likely to pay a lower rate of
interest on new company bonds issued through the capital markets.
Network economies of scale
Network economies are best explained by saying that the extra cost of
adding one more user to the network is close to zero, but the resulting
benefits may be huge because each new user to the network can then
interact, trade with all of the existing members or parts of the network.
The expansion of e-commerce is a great example of network economies
of scale – it doesn't cost Amazon.co.uk much (if anything) to add another
10,000 customers to its systems, but the revenue and profit effect can
be significant.
External economies of scale
External economies of scale occur within an industry. Examples of
external economies of scale include:



Development of research and development facilities in local
universities that several businesses in an area can benefit from
Spending by a local authority on improving the transport network
for a local town or city
Relocation of component suppliers and other support
businesses close to the main centre of manufacturing are also an
external cost saving
Diseconomies of scale
Economic theory predicts that a firm may become less efficient if it becomes
too large. The additional costs of becoming too large are called diseconomies of
scale.
Diseconomies of scale result in rising long run average costs which are
experienced when a firm expands beyond its optimum scale, at Q.
Examples of diseconomies include:
1. Larger firms often suffer poor communication because they find it
difficult to maintain an effective flow of information between
departments, divisions or between head office and subsidiaries. Time lags
in the flow of information can also create problems in terms of the speed
of response to changing market conditions. For example, a large
supermarket chain may be less responsive to changing tastes and fashions
than a much smaller, ‘local’ retailer.
2. Co-ordination problems also affect large firms with many departments
and divisions, and may find it much harder to co-ordinate its operations
than a smaller firm. For example, a small manufacturer can more easily
co-ordinate the activities of its small number of staff than a large
manufacturer employing tens of thousands.
3. ‘X’ inefficiency is the loss of management efficiency that occurs when
firms become large and operate in uncompetitive markets. Such loses of
efficiency include over paying for resources, such as paying managers
salaries higher than needed to secure their services, and excessive waste of
resources. ‘X’ inefficiency means that average costs are higher than would
be experienced by firms in more competitive markets.
4. Low motivation of workers in large firms is a potential diseconomy of
scale that results in lower productivity, as measured by output per worker.
5. Large firms may experience inefficiencies related to the principalagent problem. This problem is caused because the size and complexity
of most large firms means that their owners often have to delegate
decision making to appointed managers, which can lead to
inefficiencies. For example, the owners of a large chain of clothes
retailers will have to employ managers for each store, and delegate some
of the jobs to managers but they may not necessarily make decisions in
the best interest of the owners. For example, a store manager may employ
the most attractive sales assistant rather than the most productive one.
UNIT-IV
COST ANALYSIS
CONCEPTS OF COST
EXPLICIT AND IMPLICIT COST