CHAPTER- 01:

ECONOMICS – OVERVIEW
WHAT IS ECONOMICS?
Economics is a social science which deals with economic activities of people. People have
unlimited wants, but the resources required to satisfy these wants are limited. Scarcity of
resources in the presence of unlimited wants gives rise to all economic activities. If the resources
were not scarce, there would not be any economic activity at all. With unlimited resources, a
person could get as much as he would like to have without doing any work. Economics is rightly
called the study of the allocation of resources for satisfying human wants. On other words,
economics is a social science that studies how decision-makers allocate limited resources to
fulfil unlimited wants and needs with maximum satisfaction.
Limited RESOURCES Unlimited WANTs

Maximization of
satisfaction

What Is Main Economic Problem Of A Society?

The main economic problem of a society is how do we get the most satisfaction from our limited
resources.

Scarcity & Choice

The fundamental concepts behind the economic problem is that scarcity of resources forces
people to make choices among available alternatives.

Good and Service: Economic vs Free

The item that satisfies a human want, thereby increasing happiness or satisfaction. It can be a
good or a service. Example, good= clothing, food, Ferrari car; service = haircut, bus ride, etc.
Economic good - Any good that is scarce. A scarce good is a good where the quantity demanded
exceeds the amount available at a zero price.
Positive price for the good ↔ scarce good.
A free good means everyone can enjoy as much as they want at a zero price. Example: Air.

Economic Resources
Anything that can be used to produce an economic good. Resources are also called Inputs or
Factors of Production.
Solve the problem !
Which of the following are economic goods:
Air, Sea water, Sunlight, Paddy, Mineral water, Mango, Sands in the desert.
MICROECONOMICS versus MACROECONOMICS
Microeconomics deals with behavioural patterns of the smallest economic agents which make
their decisions independently. It shows how allocation of resources, production of commodities,
determination of price, etc., are affected by the independent decisions of the consumers,
producers and other economic agents. Microeconomics analyzes the decision-making processes
of different economic agents under different behavioural assumptions
Macroeconomics deals with aggregate variables facing an economy. Gross national product
(GDP), aggregate employment level, the general price level, the growth rate of the economy, etc.,
are few examples of macroeconomic topics.

POSITIVE versus NORMATIVE ECONOMICS

Positive economics is the branch of economics that concerns the description and explanation of
economic phenomena. It focuses on facts and cause-and-effect relationships and includes the
development and testing of economics theories. Earlier, it was called as value-free economics.
Positive economics as science concerns analysis of economic behavior. Positive economics as
such avoids economic value judgements.

On the other hand, normative economics is the branch of economics that incorporates value
judgments (that is, normative judgements) about what the economy ought to be like or what
particular policy actions ought to be recommended to achieve a desirable goal. Normative
economics looks at the desirability of certain aspects of the economy. It underlies expressions of
support for particular economic policies.

Whereas in normative economics it is tried to answer the question "what ought to be" in
economic matters, in positive economics efforts are made to answer the question "what is". An
example of a normative economic statement is as follows: The price of milk should be Tk. 70 a
gallon to give dairy farmers a higher living standard and to save the family farm. This is a
normative statement because it depends on value judgments and cannot be proven true or false by
comparison against real world data. This specific statement makes the judgment that farmers
need a higher living standard and that family farms need to be saved. An example of a positive
economic statement can be as follows: The price of milk has been increased to Tk. 60 a liter.
This is a positive statement because it depends on value judgments and cannot be proven true or
false by comparison against real world data.

BASIC PROBLEMS/ECONOMIC QUESTIONS OF AN ECONOMY

The central problems of an economic society are similar to the individual problems except for the
fact that the problems now relate to the economy as a whole. The main problem is the scarcity of
resources in the face of unlimited wants. The scarce resources have, however, alternative uses.
The problems of an economic society are, symbolically expressed by three question words, viz.,
what to produce?, how to produce? and for whom to produce? The problem of deciding the
level of investment can be added to the above list. We discuss each of these problems
systematically by turns.

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PRODUCTION POSSIBILITY CURVE(PPC) / PRODUCTION POSSIBILITY
FRONTIER (PPF):
Production-possibility curve (PPC) or Production possibility frontier (PPF) or
"transformation curve" is a graph that shows the different combinations of two goods that an
individual or group can efficiently produce with limited productive resources. The PPF shows the
maximum obtainable amount of one commodity for any given amount of another commodity or
composite of all other commodities, given the society's technology and the amount of factors of
production available.

Here is an example using two goods, food and computers. In figure below, the move from point
A to point B indicates an increase in the number of computers produced, but it also indicates a
decrease in the amount of food produced. Assuming that productive resources do not increase,

Food
Outside PPF:
A Impossible points
FA
N
Inside PPF:
Productively
inefficient points On PPF:
Efficient points

M
FB B

0 Computers
CA CB
making more computers requires that resources be redirected from making food to making
computers. If production is efficient, FA of food and CA of computers could be made (as Point A
shows), or FB of food and CB of computers could be made (as Point B shows).

All points on the curve are points of maximum productive efficiency (Point B); all points inside
the frontier are feasible but productively inefficient (Point M); all points outside the curve are
infeasible (Point N) for given resources.

SHIFT FACTORS OF PPF/PPC:

The production possibility frontier will shift when:

a. There are improvements in productivity and efficiency (perhaps because of the

introduction of new technology or advances in the techniques of production)

Page-3
 b. More factor resources are exploited (perhaps due to an increase in the available
workforce or a rise in the amount of capital equipment available for businesses to use)

In the following figure, we see due to the enhancement in the state of technology in producing
computers given the amount of resources allocated to food causes an anticlockwise outward shift
in the PPF (Panel-01). With the same resources allocated to food, a greater output of computer is
possible. The real cost of computer will fall and thence greater output of computer is possible to
get by the same resources allocated to computer. If new resources are discovered an exploited,
then greater production of both food and computer is possible. In that case, the PPF will shift
parallely (Panel-02).

Panel-01 Panel-02
FA
B •N
FB
A A
FA
Food

FB D
B

0 CA CB CD 0 CACB
Computers
Figure: Shift of PPF

Problem 01
In Panel-02 the above figure, what does Point N mean? What steps must be taken to attain the
output combination of Point N?

Problem 02
Suppose, the level of technology has recently been enhanced in Bangladesh. How this increase in
technology will bring changes to the position of PPC?
Problem 03
Suppose, a coal mine has been discovered recently in Bangladesh and coal exploration has
already been started there. How this increase in resources will bring changes to the PPF of
Bangladesh?

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OPPORTUNITY COST

If there is no increase in productive resources, increasing production of a first good has to entail
decreasing production of a second, because resources must be transferred to the first and away
from the second. Points along the curve describe the trade-off between the goods. The sacrifice in
the production of the second good is called the "opportunity cost" (so-called because the
opportunity to increase the first good entails the cost of decreasing the second). In brief,
opportunity cost of getting something is the best alternative forgone. Opportunity cost is
measured in the number of units of the second good that are foregone if an additional unit of the
first good is made. Suppose, you have Tk.30 with you. You bought a cup of coffee by that
money. however, you could have bought a piece of sandwich otherwise. In this example, the
opportunity cost of buying a cup of coffee is the piece of sandwich you just forgone to get the
coffee.
Do All Goods Have Opportunity Cost? What about Free Goods?
Not all goods have an opportunity cost. Free goods are not scarce and no cost is involved when
consuming them.

Air conditioning uses up scarce resources especially during hot weather. Is fresh air an example
of a free good? Usually the answer is yes – yet we know that air can become contaminated by
pollutants. And, in thousands of offices, shops and schools, air-conditioning systems cool the air
before it is “consumed”. With air conditioning, scarce resources are used up in providing the
“product” – for example the capital machinery and technology that goes into manufacturing the
air conditioning equipment; the labour involved in its design, production, distribution and
maintenance and the energy used up in powering the system.

Cool air might appear to be free – but in fact it is often an expensive product to supply!
OPPORTUNITY COST AND PPF:
The idea of opportunity cost can be explained with the help of an opportunity cost curve,
alternatively known as production possibility curve. Suppose, a hypothetical economy can
produce only two commodities - food and computers - by using all of its resources. The
production possibilities of the economy are shown in the following figure. We measure the

Page-5
quantity of food along the vertical axis and the number of computers along the horizontal axis.
Initially, the economy is at point K producing OK (23 units) amount of food and no computers .
Perhaps both the people and the government of the economy express their dissatisfaction in
having no computers and would like to produce FAA aomount of omputers by sacrificing KFA
quantity of food. In other words, the opportunity cost of FAA aomount of omputers is KFA
quantity of food. Some resources previously used in producing food were released and shifted to
the production of computers. Consequently, the production of food fell when the economy stand
to produce a small number of computers.

Food
K
23
FA=20 A

FB=10 B
M

L
0 CA=5 CB=10 13
Computers
Suppose the country needs more guns. The economy moves to A from B gaining MB amount of
computers at the cost of AM amount of food. It can be easily found that the amount of sacrifice
of food for each extra unit of computer tends to fall gradually.

SOLUTIONS OF THE FUNDAMENTAL PROBLEMS UNDER ALTERNATIVE

ECONOMIC SYSTEMS
Socialist and other Centrally Planned Economics
In socialist and other centrally planned economies, the answers to the fundamental questions are
dictated by central authority under the Government. Usually, a planning commission under close
supervision of the Government takes decisions about the nature and production targets of
different commodities and services.
Capitalist Economy
In a capitalist economic system, answers to the fundamental questions are provided through the
operation of the market mechanism in the economy. A market for a commodity is the collection
of consumers and suppliers for that commodity, who interact among themselves for exchanges.

Page-6
Mixed Economy
It should be noted that pure capitalism is rare in real world. In most of the capitalist countries of
the world, governments have means of controlling the markets, though answers to the
fundamental question are sought through market mechanism. Private ownership of some key
sectors of the economy are replaced by state ownership. In USA, anti-trust laws are in vogue to
check and curb the emergence of monopoly powers. Market economies having both private and
public ownerships may be called mixed economic systems. We have a mixed economic system in
Bangladesh where some enterprises are owned and managed by the state.
Islamic Economy
This system is similar to the mixed economic system. However, in this system, all the three basic
economic questions are solved based on the market signals as well as the Islamic Sariah. Here
sariah gets top priority in making the decisions in an Islamic economy. Any business which
includes the elements that are not halal, is strictly prohibited. For example, if a business relies on
interest based financial system, that business is not allowed in an Islamic economy.

THE ROLE OF GOVERNMENT IN ECONOMIC AFFAIRS

The role of government in economic affairs of the state is pervasive in socialist and other
centrally planned economies. The proponents of market economy discourage any intervention in
free functioning of market mechanism. They would like to restrict the role of the state to
maintenance of law and order in society so that economic forces and agents can work
undisturbed. The non-interventionist view of the role of the state is now held in abeyance.
Especially, the theory of demand management put forward by the great economist John Maynard
Keynes brought the government to the forefront as the most important economic institution for
devising and implementing different economic policies. Moreover, the market economy can
achieve the desired goal of efficiency if the market structure is competitive. There are a few cases
where market economy cannot work. The major problem is that market structure is not
competitive for most of the commodities and services. In such a dismal situation about the
efficiency of market economy, the government has a significant role in facilitating and
encouraging unhindered functioning of market economy. The government can use different kinds
of policy tools to correct market failures. Only then the market economy can function properly.
Despite the importance of government interventions, theoretical controversies about the role of
the government in economic affairs are still on. In reality, however, most governments of
capitalist economic systems frame and implement economic policies to achieve economic goals.
Solve the problem !

Which ones are the microeconomic variables:

Price of mango, National income, Profit of a firm, Supply of a commodity.

Page-7
TWO FUNDAMENTAL ASSUMPTIONS
Two Fundamental Assumptions we'll use at all times throughout the course:
Rational Behavior - Individuals are assumed to be rational, i.e., they know what's best for them
and pursue that which is in their best self-interest. Not Selfish!
Consumer Sovereignty - Individuals make their decisions freely, there is no coercion. The
individual is best at determining what is in their best self-interest.

MATHEMATICS REVIEW
Equation, Graph, Slope, Intercept : Linear Forms
Y=2X+10
Y
Equation -01 (Figure-01):
Y = 2X + 10 2
Slope = 2; Y-Intercept = 10;
10
Positively Related
O X
Fig. 01

Y
Equation-01 (Figure-02): 10
Y = -5X + 10
Slope = -5; Y-Intercept = 10; Y=-5X+10
Inversely Related -5

O X
Fig. 02
Slope of a line can be calculated using the following formulae:

Rise ChangeinY <Y

Slope = = =
Run ChangeinX < X

Example:

Y
Equation of the line:
Y=20-4X
20 M
Y=20-4X
Rise OM 20
Slope = = = = −4
Start Run ON − 5
N
X
O 5
Special Slopes: Horizontal and Vertical Lines

Slope=0 Slope = ∞

Page-8
 Slope = 0 Slope = ∞

Equation, Graph, Slope, Intercept : Non-linear Curve

In this case, unlike linear lines, slope is different at different points on a curve.

Point A: Large Negative

A
D Point B: Small Negative
B Point C: Slope = 0
A
Point D: Large Positive

Tangency : A line that "just touches" a curve is A

M N
tangent to the curve at the point where it touches.

At point A, line MN touches the SAC curve. So,

MN is the tangent at point A. Slope of SAC curve S C
at point A is zero.

WHAT IS MANAGERIAL ECONOMICS?

Managerial economics deals with the use of economic analysis to make business decisions
involving the best use (allocation) of an organization’s scarce resources. Actually, there is no
difference managerial economics and regular economics in terms of the theory; rather,
standard economic theory provides the basis for managerial economics. The difference is in
the way the economic theory is applied. In brief, we can define managerial economics as
applied microeconomics (normative microeconomics).

Page-9

SAMPLE QUESTIONS FOR REVIEW!!!!!!
1. What is economics? Who is considered as the father of economics? Why?
2. Distinguish between microeconomics and macroeconomics. Economic goods vs free goods.
Identify which of the following are the economic goods: Rain water, Mango, Air, Gold, Gas,
Sunshine, Park, mineral water.
3. What are the three basic questions to be solved in an economy? What are alternative
economic systems? How the basic economic questions are solved in alternative economic
systems. What kind of economic system exists in Bangladesh?
4. What are the Twin-themes of economics?
5. What are the factors of production? Define wage, rent, interest and profit. Define input and
output.
6. Distinguish between positive and normative economics. Examples of positive and normative
statements.
7. What is Production Possibility Frontier (PPF)? Define the concept of opportunity cost Show
the idea of opportunity cost by PPF. Where we get the efficient output combination on a PPF
space? 3 points around PPF/PPC. Mention the cases when PPF shifts outward and inward.
Suppose, a coal mine has been discovered recently in Bangladesh and coal exploration has
already been started there. How this increase in resources will bring changes to the PPF?
8. With a fixed amount of resources, 20 units of computers or 30 units of food can be produced.
Also, the combinations of computer and food can be produced. Combinations are 25 units of
food and 4 units of computers, 20 units of food and 7 units of computers, 15 units of food
and 10 units of computers, etc. Draw the PPF. If new technology in computer production is
invented and adopted, what will happen to the PPF? Find the opportunity cost of first 4 units
of computer? If the total resources of the country increase, what will happen to the PPF?
9. Why does PPF become a straight line? When it becomes a curve?
10. When the PPF shifts parallelly? When it shifts clockwise or anti-clockwise?
11. Define managerial economics. What are the roles of managerial economics in solving
decision problems? How does the study of managerial economics help a manager?
12. Case study: Related to PPF

Page-10
 CHAPTER- 02:
THEORY OF DEMAND
WANT, NEED, DEMAND

What is Want?
In economics, want is something desired It's said that we have unlimited wants, but limited
supplied resources. Thus, we can't have everything we want and must look for the best
alternatives sometimes that will cost us less. People usually carry the tendency to have a strong
desire to obtain something. This desire, known as "want" has been established since the
beginning of life. The first cavemen wanted to be safe so they developed weapons. Before
cavemen, there were dinosaurs that were hungry and needed to eat. They wanted food so badly
that they would kill other dinosaurs in order to satisfy their want. There is an often stated quote,
"You always want what you can't have." It is meaning that after we have something, it is no
longer a want, so we move onto the next 'want' on our list.

What is Need?
Need is something that is necessary for our survival. Therefore, need are the wants that are
necessary for our survival.

What is Demand?
Demand is the wants that are fulfilled by the consumer. That means, if a person has the want for
a commodity, he/she has the purschasing power to buy it and he/she has the willingness to spend
the money on it, then we can say that the person has the demand for the commodity. For
example, Musad has the demand for a kilo of Mango means the fiollowing conditions are
fulfilled:
1. He has the desire to have a kilo of mango
2. He has the purchasing power to buy that
3. He is willing to spend the money on that.

DEMAND versus QUANTITY DEMANDED

Demand refers to the relationship between price and quantity. When we think about the whole demand
curve (shown in figure 2.1), we think of demand - the relationship between price and quantity - for the
commodity. However, quantity demanded refers to a particular quantity or point on the demand curve.
Thus, when we think of a particular quantity, we can avoid confusion by calling it quantity demanded
rather than demand.

Page-11
DETERMINANTS OF QUANTITY DEMANDED
The amount of any particular commodity or service that consumers plan to buy depends on many factors.
The main ones are:
The commodity's own price: The amount of a commodity the people will be willing to buy depends
mainly on the commodity's own price. If price of the commodity is low, people desire to buy more; if
price is high, then people wish to buy less.
The prices of related goods: The quantity of a commodity that a consumers plan to buy depends in part
on the prices of related goods and services that fall into two categories: substitutes and complements.
A substitute is a good that can be used in place of another good. For example, rice substitutes for wheat,
sugar substitutes for saccharin, beef substitutes for chicken, mustard oil substitutes for soabin oil, etc.
More similarly, burger has many substitutes - hotdog, pizza, sandwich, etc. If the price of one of the
substitutes increases, people economize its use and buy more burger. For example, if the price of hotdog
rises, more burgers are bought - the demand for burger increases.
A complement is a good that is used in conjunction with another good. Some examples of complements
are burger and French fries, snacks and drinks, noodles and sauce, running shoes and jogging pants,
cements and sand, etc. If the price of french fries increases, people will buy fewer burgers. If the price of
cement increases, people will buy less sand. Thus if the price of the complement increases, the demand
for a commodity decreases.
Income: Other things remaining the same, when income increases, consumers buy more of most of the
goods, and when income decreases, they buy less of most of the goods.
Tastes: Tastes are an individual's attitudes towards goods and services. For example, a pop music fanatic
has a much greater taste for tapes than does a tune-deaf workaholic. As a consequence, even if they have
the same incomes, their demand for tapes will be very different.
Population: If the population of the country increases, the quantity demanded of a good increases even
though the price of the commodity remains unchanged.
Other unrelated goods: If price of a good decreases, you will get more money to spend on books or any
other goods or services. On the other hand, if other unrelated goods are not available, then you will have
more money to spend on the commodity.
Expectations : Expectations have influence on consumer decisions. If someone expects that the price of
Sony TV will be decreased within the next few days, she/he will be reluctant to buy a TV set at the
moment. If you think that you are going to get a personal computer with more facilities and the same price
after a few days, would you decide to buy a computer at this moment? Certainly not.
Therefore, due to the expectations about future price, quality, etc. of a product, the demand for the product
varies.
Now, think yourself. What is the most important determinant of quantity demanded? Certainly, own price
of the commodity. Let's know about the relationship between price and demand.

RELATIONSHIP BETWEEN PRICE AND QUANTITY DEMANDED: THE LAW OF DEMAND

You have learnt about the determinant of quantity demanded in the above section. Now, if we like to see
the influence on the quantity demanded of the commodity's own price, how do we do that? The basic
hypothesis is that we have to assume all the determining variables other than commodity's own price are
constant.
A basic economic hypothesis about the relationship between price and quantity demanded is:

Page-12
"Other things remaining the same, the higher the price of a commodity, the smaller the quantity demanded
and the lower the price of a commodity, the higher the quantity demanded." Economists call this
relationship the Law of demand. Here, other things indicate the determining factors of quantity demanded
other than commodity's own price (see in the table below).
Determining factors of quantity demanded
Commodity's own price
Prices of related goods
Average income of the consumers
Tastes
Prices of unrelated goods Other things
Expectations about future price
Population

How Can the Relationship Between Quantity Demanded and Price Be Portrayed?

Three methods are usually used to do that:

First Method: Demand Function

Demand function shows the relationship between quantity demanded and it determinants. We can show
that by the following demand equation:
Q XD = ∫ ( PX , M , PY , T , PZ , A, etc.) = 20 − 5 PX + 4 PY + 0.2 M + 3 A − 2 PZ + 3T .
Here, PX=Price of X, PY=Price of Y (X & Y are substitutes), PZ=Price of Z (X & Z are complementary),
M=Consumer’s Income, A=Advertisement cost, T=Taste.

Now if we like to see the relationship between quantity demanded and the commodity’s own price in
particular, we have to assume all other factors/determinants are given/fixed. We can show this
relationship by the following equation:

Q XD = ∫ ( PX ) = 20 − 5 PX . This equation reflects the theme of the law of demand.

All Other things fixed

Second Method: Demand schedule

This is a numerical tabulation showing the quantity that is demanded at selected prices. Table 2.1 is a
hypothetical demand schedule for biscuits. It lists the quantity of biscuits that would be demanded at
various prices on the assumption that average households income is fixed at Tk. 1000.00, and other
factors like tastes, expectations, prices of other related goods, etc. do not change. The table gives the
quantities demanded for five selected prices, but actually there is a separate quantity that would be
demanded at each possible price.
Table 2.1: Demand schedule for biscuits (hypothetical data)
Price per Kg (Tk.) Quantities demanded
(Kg per week)
Pt Qt
A 10 100
B 15 80
C 20 60
D 30 40
E 60 20

Page-13
In Table 2.1, we see that as the price of biscuit increases, the quantity demanded for biscuits decreases.
That is, there is an inverse relationship between the quantity demanded for biscuit and its own price.
Third Method: Demand curve or willingness and ability to pay curve
The relationship between quantity demanded and price can be shown by drawing a graph. If we
plot the information given in Table 2.1 in a graph, we get demand curve. Figure 2.1 shows a
demand curve which represents the points corresponding to price-quantity pairs of table 2.1.
In Figure 2.1, DD is the demand curve for biscuit. Each point on the DD curve refers to the quantity
demanded for biscuit at a particular price. We see that as price of biscuit rises the quantity demanded for
biscuit decreases along the DD curve.

PROPERTIES OF A DEMAND CURVE

• Demand Curve shows the relationship between quantity demanded of a good and its own price
assuming that other things remain the same.

Pt
D
60 E

50
Price

40 D

30 C
B
20 A
D
10 Qt
20 40 60 80
Quantity
Figure 2.1: Demand Curve for Biscuit
• Normally, demand curves are downward sloping i.e. the relationship between quantity demanded and
price is inverse. The law of demand - people buy more at a low price than at a high price - is reflected
in the downward slope of the demand curve.
• The term demand refers to the entire relationship between price and quantity. However, a single point
on a demand curve refers to the quantity demanded at a particular price. For example, at point C in
Figure 2.1, we see that 60 Kg. of biscuits is demanded at a price of Tk. 20.00 per Kg.
• The slope of the demand curve changes if the pattern of the relationship between price and quantity
demanded changes.
• The position of a demand curve changes if the ceteris paribus assumption is violated, i.e., if other
things such as tastes, income, price of related goods, expectation, etc. change.

Page-14
What is the Advantage of Graphing the Demand Schedule ?
We see both Table 2.1 and Figure 2.1 contain exactly the same data and reflect the same relationship
between price and quantity demanded. However, an added advantage lies with graphing that we can
represent clearly a given relationship - in this case the law of demand - more simply than if we relied on
tabular or verbal presentation. A single curve on a graph, if understood, is simpler to state and manipulate
than tables and lengthy verbal descriptions. Especially, in economic analysis, graphs are invaluable tools.
They permit clear expression and handling of complex relationships.
Change in the Quantity Demanded Vs. Change in Demand
From the above discussion, you have learnt that quantity demanded refers to a particular point on a
demand curve, whereas demand refers to the entire relationship between price and quantity as shown by
the whole demand curve. Therefore, if the own price of a commodity changes (i.e., rises/falls), the
quantity demanded of that commodity changes along the demand curve; the position of the demand curve
does not change. This is called the movement along the demand curve (see Figure 2.3). On the other
hand, if factors other than price (i.e., tastes, income, population, expectation, etc.) change, the demand
changes, which is reflected by the change in the location of the demand curve, i.e., the demand curve
shifts (see Figure 2.2 below). Hence, the determinants other than the commodity's own price are called
demand shifters. The chart below shows the reasons and consequence of the change in the quantity
demanded and the change in demand for a commodity:
Chart 2.1: Consequences of the changes in the determinants of quantity demanded
Consequences
Change in Change in What happens with the demand
Possible causes quantity demand curve?
demanded
Own price Rise Decreases Downward movement along the demand
curve
fall increases Upward movement along the demand curve

Price of Rise Increase Outward shift of the demand curve

substitute fall decrease Inward shift of the demand curve

Price of Rise Decrease Inward shift of the demand curve

complement fall Increase Outward shift of the demand curve

Income Increase Increase Outward shift of the demand curve

decrease decrease Inward shift of the demand curve

Population Increase Increase Outward shift of the demand curve

decrease decrease Inward shift of the demand curve

Expectation Rise Decrease Inward shift of the demand curve

about future fall Increase Outward shift of the demand curve
price
Taste Increase Increase Outward shift of the demand curve

decrease decrease Inward shift of the demand curve

Therefore, if the own price of a commodity changes, the quantity demanded changes but demand doesn't
changes i.e. the demand curves doesn't shift. However, if the factors other than commodity's own price
change, the demand does change and the demand curve shifts. Since the demand curve shifts, at any price
the quantity demanded will also be different from the previous amount. For example, if the average

Page-15
income of the people increases by 10%, price remaining same, the demand for biscuits will be more than
before. Table 2.2 shows the change in demand.
Table 2.2: Changes in Demand (hypothetical data)

Price Quantity demanded Quantity demanded

(Tk. per Kg.) (Kg. per week) (Kg. Per week)
Average Household Average household
income = Tk. 1,000 income = Tk. 1,500
10 100 110
15 80 90
20 60 70
30 40 50
60 20 30

In Column 2 of Table 2.2, the quantity of biscuits demanded at different prices are shown (same as Table
2.1). But in Column-3, the quantity demanded for biscuits is higher than before at each price, though the
prices are the same. What's the reason? Because the average income level has been increased. People are
now willing to buy more of the commodity (since biscuit is a normal good; for detail see Lesson-3 of
Unit-3) because their purchasing power is now higher than before. Graphically, the change in demand is
shown by the outward shift of the demand curve, from DD1 to DD2 in Figure 2.2.

Pt
D
D
60

50
Price

40

30
D2
20
D1
Qt
10
20 40 60 80 100
Quantity
Figure 2.2: Shift of the demand curve
In Figure 2.2, the initial location of the demand curve was DD1. Due to the increase in income, the
demand curve has been shifted to the right, from DD1 to DD2. Conversely, due to a decrease in average
household income, the demand curve shifts to the left from the initial position. Notice that due to change
in income, people now buy more amount of biscuit at the same price. At price of Tk. 30.00, people now
buy 60 Kg. biscuit which is 20 Kg. higher than the initial purchase (40 Kg.).
Similarly, if any other determinant (except the commodity's own price) of demand is changed, the demand
will be changed causing the demand curve to shift. For detail please see Chart 2.1.

Page-16
When the own price of the commodity changes, the quantity demanded of the commodity is changed and
thus a movement along the demand curve occurs. For example, along the demand curve DD1 in Figure
Pt
D
60 E

50
Price

40
D
30 C

20
D1
10 Qt
20 40 60 80
Quantity
Figure 2.3: movement along the demand curve
2.3, a rise in the price of biscuit produces a decrease in the quantity demanded of biscuit and fall in the
price produces an increase in the quantity demanded of biscuit. The arrows on the demand curve represent
the movements along the demand curve. Due to the fall in the price of biscuit from Tk. 60.00 to Tk. 30.00,
the quantity demanded has been increased by 20 Kg., from 40 Kg. to 60 Kg. This situation is shown by
the movement from point E to point D along the DD1 curve. Conversely, in the case of a rise in price, the
consumer moves from point C to point D. In this case, point C is assumed to be the initial point.
Therefore, when any determinant of demand other than commodity's own price changes which increases
the quantity people plan to buy, then demand curve shifts rightward (from DD1 to DD2 in Figure 2.2) and
demand increases. Conversely, if any determinant of demand other than its own price changes that
reduces the quantity people plan to buy, the demand curve shifts leftward and demand decreases. On the
other hand, if the commodity's own price changes, the quantity demanded changes and the consumer
moves from one point to another point along the same demand curve.
Exceptions to the Law of Demand
The law of demand does not apply to the following cases:
• Expectations regarding future prices. When consumers expect a continuous increase in the price of
a durable commodity, they buy more of it despite the increase in its price. They do so with a view to
avoiding the pinch of a still higher price in future. Similarly, when consumers anticipate a
considerable decrease in the price in future, they postpone their purchases and wait for the price to fall
to the expected level rather than buy the commodity when its price initially falls. Such decisions of
the consumers are contrary to the law of demand.
• Prestigious Goods. The law does not apply to the commodities which serve as a status symbol,
enhance social prestige or display wealth and richness, e.g., gold, precious stones, rare paintings and
antiques, etc. Rich people buy such goods mainly because their prices are high.
• Giffen Goods. An exception to this law is also the classic case of Giffen Goods named after Robert
Giffen (1837-1910). A Giffen Good does not mean any specific commodity. It may be any
commodity much cheaper than its substitutes, consumed mostly by the poor households claiming a
large part of their incomes. If price of such a good increases (price of its substitute remaining

Page-17
 constant), its demand increases instead of decreasing. For instance, let us suppose that the monthly
minimum consumption of foodgrains by a poor household includes 20 kg. of wheat (an inferior good)
at the rate of Tk. 10 per kg. and 5 kg. of flour (a superior good) at Tk. 20.00 per kg. It spends a fixed
amount of Tk. 300.00 on these items. Now, if price of wheat increases to Tk 13 per kg., the household
will be forced to reduce the consumption of flour by 3 kg. and increase that of wheat by the same
quantity in order to meet its minimum monthly consumption requirement within Tk. 300.00.
Obviously, the household's demand for wheat increases from 20 to 23 kg. per month despite increase
in its price.
Individual and Market Demand
In the previous sections, we have discussed the things related to the individual demand curve and that
time we have assumed just one consumer. Certainly, the choices by individuals are the basis of the theory
of demand. But the market demand is of primary interest to managers.
Fortunately, the transition from the individual to the market demand schedule is possible. Market demand
curve can easily be derived by summing the quantity demanded by each consumer at various prices. The
aggregation process is not more difficult than simple arithmetic. If there are just three consumers in the
market, it would be easy to determine the total quantities demanded (or market demand) at each price.
This is shown in Table 2.4.
Table 2.4 : Market demand for biscuit, three buyers (hypothetical data)
Quantity demanded Total quantity
Price First buyer Second buyer Third buyer Demanded/ Market
(Tk.. per Kg) ('Kg. per week) (Kg. per week) (Kg. per week) demand (Kg. per week)
10 30 35 35 110
15 25 25 25 75
20 15 20 20 55
30 10 15 15 40
40 5 10 10 25
If we plot the data of Table 2.4 in graph, we get the market demand curve as a horizontal summation of
the individual demand curves. Figure 2.4 shows this.

Pt Pt Pt Pt
Buyer 1 Buyer 2 60 d Buyer 3 60 Market demand
60 60 d
d D
Price

40 40 40 40

20 d1 20 d2 20 d320 D
Qt
0 10 20 0 10 20 0 10 20 30 0 20 40 60 80 100
30 30
Quantity Quantity Quantity Quantity
Figure 2.4: Market demand curve derived from the individual demand curves

In Figure 2.4, market demand curve is drawn from the individual demand curves. In the figure, we see
that at price Tk. 20.00 , the demand for biscuit from Buyer 1, Buyer 2, and Buyer 3 are 15 Kg., 20 Kg.,
and 20 Kg. per week respectively. The market demand at this price is 55 Kg. (=15 + 20 + 20). Similarly,
we can see that at each price, the market demand for biscuit is the summation of the quantity demanded
by individual buyers at that price.

Page-18
CONSUMER SURPLUS
Definition: The difference between the value of the commodity and its price is called consumer surplus.
When a person buys any chosen quantity of a commodity at a given price, diminishing marginal utility
guarantees that she/he always attains some consumer surplus. Why? Let's see this.
Calculating consumer surplus: Look at Figure 4.5(A). This figure illustrates the consumer surplus of
an individual consumer. DD' is Modhu's demand curve for chicken Patty when she has Tk.30.00 to spend.

d Consumer
15
surplus

10
Price

E
5 Market price

0 d'
2 1
3 4 5 6
Quantity of Patty
Figure 4.5(A): Consumer surplus of Modhu
If Modhu consumes only one piece of Patty, she would be willing to pay Tk. 10.00 for it. If she consumes
two pieces of Patty, she would be willing to pay Tk.10.00 for the first one and Tk.9.00 for the second one.
Accordingly, she would be willing to pay Tk.6.00 for the third one, Tk.4.00 for the fourth one, and so on.
However, she is lucky enough that the market price of Patty is Tk.4.00 each, i.e., she has to pay only
Tk.4.00 to get a piece of Patty. So, up to the third piece she has to pay less than she would be willing to
pay. For the first four pieces of Patty, Modhu is willing to pay Tk.28 in total (= Tk.10 + Tk.8.00 + Tk.6.00
+ Tk.4.00 ), i.e., the value she places on the Chicken Patty is Tk.28.00. But she actually pays Tk.16.00 (=
Tk.4.00 ✕ 4 ) for buying them. So, the extra value she receives from buying four pieces of Patty is Tk.12
(=Tk.28 - Tk.16). This extra value is Modhu's consumer surplus. From the consumption of four pieces of
Patty she gets Tk. 12 worth of value in excess of what she has to spend to consume them. In Figure
4.5(A), the shaded area under the dd' curve indicates the consumer surplus of Modhu.
Now let's see how the consumer surplus of all the consumers in a market is calculated. Figure 4.5(B)

12

D
10 Consumer
surplus
8
Price

4 Market price

2
D'
0
1 2 3 4 5
Quantity( thousand pie ces)

Figure 4.5(B): Consumer surplus of the entire market Page-19

illustrates the consumer surplus of a market as a whole. Suppose that there are one thousand consumers in
the Patty market. They are similar, but not identical, to Modhu. DD' is the market demand curve for Patty.
The market price of Patty is Tk.4.00 each. The consumer surplus for the market as a whole is
Tk.14,000.00, which is shown by the area of the shaded triangle under the DD' curve. The area of the
shaded triangle is calculated as below:

The base of the triangle = 4 thousands of Patty.

The height of the triangle = Tk.11.00 -Tk.4.00 = Tk.7.00 a piece of Patty

1
Therefore, the area of the triangle is: × base × height
2
1
= × 4000 × 7
2
= Tk .14000.00

SAMPLE QUESTIONS FOR REVIEW!!!!!! !

1. What is demand? How it is different from want and need? Mention the determinants of
demand.
2. Law of demand. Formulate a hypothetical demand schedule. Draw a demand curve based on
the demand schedule.
3. Distinguish between Demand and Quantity demanded. Explain movement along vs. shift of
the demand curve. Show graphically the effect of the following changes on the position of the
demand curve for Pepsi: i) Decrease in the price of Coca-Cola, ii) Increase in the consumer’s
income, iii) Increase in the advertisement cost.
4. What is demand function? Write the demand equation.
5. What is market demand? How the market demand curve is derived?
6. Define consumer surplus? “The more the competition among the sellers, the more the
consumer surplus gained by the consumers” – do you agree with the statement. Justify your
answer. Suppose, a consumer is willing to pay Tk.28/Kg for 10Kg potato and Tk.24/Kg for
15Kg potato. If the market price of potato is Tk.25/Kg, what will be the total consumer
surplus of the consumer if he/she buys 10Kg potato?

Page-20
a.
CHAPTER- 03:
THEORY OF SUPPLY
WHAT IS SUPPLY?
Supply is a schedule which shows the amounts of a product a producer is willing and able to produce and
make available for sale at each price in a series of possible prices during a specified period. The amount
the firms are willing to sell (desired sales) may not be the same as the amount they succeed in selling.
Desired sales many not be equal to the actual sales.
Since desired purchases do not have to equal desired sales, different terms (quantity demanded and
quantity supplied) are needed to describe the two separate amounts. But, as the quantity actually
purchased must be the same amount as the quantity actually sold, both can be described by a single term
quantity exchanged.

Determinants of Quantity Supplied

How much of a commodity will firms be willing to produce and offer for sale?
It depends on a number of factors. The main ones are:
The price of the commodity: If the price of the commodity is higher, firms will produce and sell more
amount of the commodity and vice versa.
The price of other goods produced: The supply of a commodity is influenced by the prices of the other
goods produced. For example, a piece of high land can produce either potato or wheat in winter season.
So, these two commodities are substituted in production. If the price of potato increases, the supply of
wheat will be lower. People will use their land more in producing potatoes. Therefore, an increase in the
price of the substitute in production lowers the supply of the commodity. Commodities can also be
complements in production. Complements in production arise when two things are, of necessity,
produced together. For example, cattle produce beef and cowhide. An increase in the price of anyone of
these by products of cattle increases the supply of the other.
Prices of factors of production: The prices of factors of production used to produce a commodity do
influence its supply. For example, an increase in the prices of the labour and the capital equipment used to
produce audio-cassettes increases the cost of producing audio-cassettes; so the supply of audio-cassettes
decreases.
The goals of the firm: Normally, the firm is assumed to have the single goal of profit maximization.
Firms might, however, have other goals either in addition to or as substitutes for profit maximization. If
the firm worries about risk, it will pursue safer lines of activity even though they promise lower probable
profits. If the firm values size, it may produce and sell more than the profit-maximizing quantities. If it
worries about its image in society, it may avoid highly profitable activities (such as the production of
opium) when there is major public disapproval. However, as long as the firm prefers more profits to less,
it will respond to changes in the possibilities of alternative lines of actions. A change in the emphasis that
firms give to other goals will change the willingness to supply the quantity at given price and hence, the
level of profitability will be changed.
Expected Future Price: Assume that the price of paddy will rise just after 4 months. What will happen
with the supply of paddy presently? Since paddy can be stored for couple of months and the return from
selling paddy will be higher than it is in the present, producers will offer a smaller quantity of paddy for
sale now. So, the current supply of paddy decreases. Here producers substitute over time. Similarly, if the
price of paddy is expected to fall in the future, the return from selling it at present is high relative to what

Page-21
is expected. So, again producers substitute over time. They offer more paddy for sale before its price is
expected to fall, so the current supply of paddy increases.
The state of technology: Invention of new technologies that enable the producers to produce their
commodity at lower cost (use of less factors of production or cheaper factors of production), which
increases their profits at any given price of the commodity, and they increase supply. For example, the
invention of transistors and silicon chips has revolutionized production in television, high-fidelity
equipment, computers, and guidance-control systems.
Number of suppliers: Other things remaining the same, the larger the number of firms supplying a
commodity, the larger the supply of the commodity.
Taxes and subsidies: Producers treat most taxes as costs. Therefore, an increase in sales or property taxes
will increase costs and reduce supply. On the other hand, subsidies are reverse of taxes. If the government
subsidizes the production of a good, it in effect lowers cost and increases supply.
Let's now look at the relationship between commodity's own price and the quantity supplied.

THE RELATIONSHIP BETWEEN PRICE AND QUANTITY SUPPLIED: LAW OF SUPPLY

In the previous section, you have learnt the determinants of quantity supplied. If all other factors remain
constant, there exists a relationship between commodity's own price and quantity supplied. This
relationship is called the law of supply..
The law of supply simply states:
Others things remaining the same, the higher the price of a commodity, the higher the quantity supplied
and vice versa.
Why does the higher price lead to greater quantity supplied?
It is because of increasing opportunity cost. The opportunity cost of the commodity increases as the
quantity produced increases. So, if the price of commodity is high, only then producers are willing to
incur the higher opportunity cost and increase production.
Does supply always increase with the rise in price?
NO. For detail please see price elasticity of supply in Lesson-2 of Unit-3.
How can the relationship between quantity supplied and price be portrayed?
Three methods can be used to do that:

First Method: Supply Function

Supply function shows the relationship between quantity supplied and it determinants. We can show that
by the following supply equation:
Q XS = ∫ ( PX , W , Pinputs , G , P E , etc.) = 10 + 3PX − 2 Pinputs − 0.3W − 3P E + 3G .
Here, QXS = Quantity supplied of commodity X , PX = Price of commodity X, W = Money income of the
consumer, Inputs = Price of inputs, PE = Expected future price, G = Goal of the firm.

Now if we like to see the relationship between quantity upplied and the commodity’s own price in
particular, we have to assume all other factors/determinants are given/fixed. We can show this
relationship by the following equation:

Page-22
 Q XS = ∫ ( PX ) = 10 + 3PX . This equation reflects the theme of the law of supply.
All Other things fixed

Second Method: Supply schedule

This is a numerical tabulation showing the quantity that is supplied at selected prices. Table 2.1 is a
hypothetical supply schedule of biscuits. It lists the quantity of biscuits that would be supplied at various
prices on the assumption that all the factors influencing supply other than price do not change. The table
gives the quantities supplied for five selected prices, but actually there is a separate quantity that would be
supplied at each possible price.
Table 3.1: Supply schedule of biscuits (hypothetical data)
Price per Kg. (Tk.) Quantities supplied
(Kg. per week)
Pt Qt S
A 10 20
B 15 40
C 20 60
D 30 80
E 60 100
In Table 3.1, we see that as the price of biscuit increases, the quantity supplied of biscuits decreases. That
is, there is an inverse relationship between the quantity supplied of biscuits and its own price.
Third Method: Supply curve
The relationship between quantity supplied and price can be shown by drawing a graph. If we plot the
information given in Table 3.1 in a graph, we get the supply curve. Figure 3.1 shows a supply curve
which represents the points corresponding to price-quantity pairs of Table 3.1.
In Figure 3.1, SS is the supply curve of biscuit. Each point on the SS curve refers to the quantity supplied
of biscuit at a particular price. We see that as price of biscuit rises, the quantity supplied of biscuit
decreases along the SS curve.

Pt

60 S
E
50
Price

40 D
C
30
B
A
20 S
QtS
10 20 40 60 80
Quantity supplied
Figure 3.1: Supply curve of biscuit

Page-23
Properties of a Supply Curve
• Supply curve shows the relationship between quantity supplied of a good and its own price assuming
that other things remain the same.
• Normally, supply curves are upward sloping i.e. the relationship between quantity supplied and price
is direct. The law of supply - producers supply more at a high price than at a low price - is reflected in
the upward slope of the supply curve.
• The term supply refers to the entire relationship between price and quantity. However, a single point
on a supply curve refers to the quantity supplied at a particular price. For example, at point C in
Figure 2.6, we see that 60 Kg. of biscuits are supplied at a price of Tk. 20.00 per Kg.
• The slope of the supply curve changes if the pattern of the relationship between price and quantity
supplied changes.
• The position of a supply curve changes if the ceteris paribus assumption is violated, i.e., if other
things such as price of other goods produced, prices of factors of production, the goals of the firm,
expected future price, the state of technology, number of suppliers, taxes and subsidies, etc. change.

Consequences of the changes in the determinants of quantity supplied and supply

Consequences
Change in Change in What happens with the supply curve?
Possible causes quantity supply
supplied
Own price Rise Increases Upward movement along the supply curve
Fall Decreases Downward movement along the supply curve
Price of Rise Decrease Leftward shift of the supply curve
substitute in Fall Increase Rightward shift of the supply curve
production
Price of Rise Increase Rightward shift of the supply curve
complement in Fall Decrease Leftward shift of the supply curve
production
Price of factors Rise Decrease Leftward shift of the supply curve
of production Fall Increase Rightward shift of the supply curve
Expected future Increase Decrease Leftward shift of the supply curve
price Decrease Increase Rightward shift of the supply curve
State of New invention Increase Rightward shift of the demand curve
technology Backward trend Decrease Leftward shift of the demand curve
Taxes Rise Decrease Leftward shift of the supply curve
Fall Increase Rightward shift of the supply curve
Subsidies Increase Increase Rightward shift of the supply curve
Decrease Decrease Leftward shift of the supply curve
Number of Increase Increase Rightward shift of the demand curve
suppliers Decrease decrease Leftward shift of the demand curve
Therefore, if the own price of a commodity changes, the quantity supplied changes but supply doesn't
changes i.e. the supply curve doesn't shift. However, if the factors other than the commodity's own price
changes, then supply does change and the supply curve shifts. Since the supply curve shifts, at any price
the quantity supplied will also be different from the previous amount. For example, if the government
initiates subsidy to biscuit production, price remaining the same, the quantity supplied will be more than
before. Table 3.2 shows the change in supply.

Page-24
Table 3.2: Changes in supply (hypothetical data)
Price Quantity supplied Quantity supplied
(Tk. per Kg.) (Kg. per week) (Kg. per week)
Without subsidy With subsidy of Tk.2 per Kg.
10 20 40
15 40 50
20 60 70
30 80 90
60 100 110

In Column-2 of Table 3.2, the quantity of biscuits supplied at different prices are shown (same as Table
3.1). But in Column-3, the quantity supplied of biscuits is higher than before at each price, through the
prices are the same. What's the reason? As subsidy is provided with biscuit production, it lowers the cost
of producing biscuit. As a result, bakers are now willing to produce more biscuits because producing
biscuit is now more profitable than before. Graphically, the change in supply is shown by the rightward
shift of the supply curve, from SS1 to SS2 in Figure 3.2.

Pt
S3
S1 S2
60

50
Price

40

30

20 S
S S
10 QtS
20 40 60 80 100
Quantity supplied
Figure 3.2: Shift of the supply curve
In Figure 3.2, the initial location of the supply curve was SS1. Due to the initiation of subsidy to biscuit
production, the supply curve has been shifted to the right, from SS1 to SS2. Conversely, due to the
imposition of taxes, the supply curve shifts to the left from the initial position, from SS1 to SS3. Notice
that due to the initiation of subsidy, more biscuits come out in the market at the same price. At price of
Tk. 20.00, bakers now supply 70 Kg. biscuit which is 10 Kg. higher than the initial supply (60 Kg.).
Similarly, if any other determinant (except the commodity's own price) of supply is changed, then supply
will be changed causing the supply curve to shift. For detail please see Chart 3.1.

Page-25
When the own price of the commodity changes, the quantity supplied of the commodity is changed and
thus a movement along the supply curve occurs. For example, along the supply curve SS1 in Figure 3.3, a
rise in the price of biscuit produces an increase in the quantity supplied of biscuit and fall in the price
produces an decrease in the quantity supplied of biscuit. The arrows on the supply curve represent the
movements along the supply curve. Due to the fall in the price of biscuit from Tk. 60.00 to Tk. 30.00, the
Pt
S
60 E
Price

50
D
40
C
B
30 A
S
20 QtS
20 40 60 80
Quantity supplied
Figure 3.3: Movement along the supply curve
quantity supplied has been decreased by 20 Kg., from 100 Kg. to 80 Kg. This situation is shown by the
movement from Point E to Point D along the SS1 curve. Conversely, in the case of rise in price, the
producer moves from Point C to Point D. In this case, Point C is assumed to be the initial point.
Therefore, when any determinant of supply other than commodity's own price changes which increases
the quantity supplied, then supply curve shifts rightward (from SS1 to SS2 in Figure 3.2) supply increases.
Conversely, if any determinant of demand other than its own price changes that reduces the quantity
people plan to buy, the demand curve shifts leftward and demand decreases. On the other hand, if the
commodity's own price changes, the quantity demanded changes and the consumer moves from one point
to another point along the same demand curve.

PRODUCER SURPLUS
Definition: The producer surplus is the amount that producers benefit by selling at a market price
mechanism that is higher than they would be willing to sell for.

Calculating producer surplus: Look at Figure 4.4. This figure illustrates the producer surplus of an
individual producer.

Page-26
 Price

12
D
10 Consumer
surplus Producer S'
surplus
8

6
E
4 Market price

2
D'
S
0
1 2 3 4 5
Quantity of Patty (in Thousands)

ASSUMPTIONS IN DEMAND SUPPLY ANALYSIS

The supply and demand model does not describe all markets--there is too much diversity in the ways
buyers and sellers interact for one simple model to explain everything. When we use the supply and
demand model to explain a market, we are implicitly making a number of assumptions about that market.

Supply and demand analysis assumes competitive markets. For a supply curve to exist, there must be a
large number of sellers in the market; and for a demand curve to exist, there must be many buyers. In both
cases there must be enough so that no one believes that what he does will influence price. In terms that
were first introduced into economics in the 1950s and that have become quite popular, everyone must be a
price taker and no one can be a price searcher. If there is only one seller, that seller can search along the
demand curve to find the most profitable price.1 A price taker cannot influence the price, but must take or
leave it. The ordinary consumer knows the role of price taker well. When he goes to the store, he can buy
one or twenty gallons of milk with no effect on price. The assumption that both buyers and sellers are
price takers is a crucial assumption, and often it is not true with regard to sellers. If it is not true with
regard to sellers, a supply curve will not exist because the amount a seller will want to sell will depend not
on price but on marginal revenue.

Page-27
The model of supply and demand also requires that buyers and sellers be clearly defined groups. Notice
that in the list of factors that affected buyers and sellers, the only common factor was price. Few people
who buy hamburger know or care about the price of cattle feed or the details of cattle breeding. Cattle
raisers do not care what the income of the buyers is or what the prices of related goods are unless they
affect the price of cattle. Thus, when one factor changes, it affects only one curve, not both. When buyers
and sellers cannot be clearly distinguished, as on the New York Stock Exchange, where the people who
are buyers one minute may be sellers the next, one cannot talk about distinct and separate supply and
demand curves.

The model of supply and demand also assumes that both buyers and sellers have good information about
the product's qualities and availability. If information is not good, the same product may sell for a variety
of prices. Often, however, what seems to be the same product at different prices can be considered a
variety of products. A pound of hamburger for which one has to wait 15 minutes in a check-out line can
be considered a different product from identical meat that one can buy without waiting.

Finally, for some uses the supply and demand model needs well-defined private-property rights.
Elsewhere, we discussed how private-property rights and markets provide one way of coordinating
decisions. When property rights are not clearly defined, the seller may be able to ignore some of the costs
of production, which will then be imposed on others. Alternatively, buyers may not get all the benefits
from purchasing a product; others may get some of the benefits without payment.

SAMPLE QUESTIONS FOR REVIEW!!!!!

1. What is supply? Describe the determinants of supply. “The amount of a commodity produced
may not be equal to the quantity supplied of the commodity” – do you agree with the
statement. Justify your answer.
2. Explain the law of supply. Formulate a hypothetical supply schedule. Draw a supply curve
based on the supply schedule.
3. Distinguish between Supply and Quantity supplied.
4. Distinguish between the movement along the supply curve and shift of the curve. What will
happen to the supply curve of potato if: (i) The price of potato increases (ii) Weather during
the winter season goes very bad and (iii) Price of the inputs has been lowered.
5. What is supply function? Write down the supply equation.
6. What is market supply? How the market supply curve is derived?
7. What is producer surplus? “The more the competition among the sellers, the less the producer
surplus enjoyed by the producers” – do you agree with the statement. Justify your answer.
Suppose, a producer is willing to sell 50Kg potato at price Tk.18/Kg. If the market price of
potato is Tk.24/Kg, what will be the total producer surplus of the producer if he/she sells
50Kg potato?

Page-28
 CHAPTER- 04:
ELASTICITIES – DEMAND and supply

What Is Elasticity?
Elasticity is the ratio which measures the responsiveness or sensitiveness of a dependent variable to the
changes in any of the independent variables. Specifically, the term elasticity refers to the percentage
change in dependent variable divided by the percentage change in independent variable. That is,

Percentage change in dependent variable

Elasticity =
Percentage change in the independent variable

If Y = f (X), i.e., Y depends on X, then the elasticity of Y with respect to X is as follows:

Percentage change in Y % ∆Y
Elasticity of Y = =
Percentage change in X % ∆X

If Y = f (X1, X2, .........., Xn), then we can calculate elasticity of Y with respect all X's, which is called total
elasticity, as follows:

Percentage change in Y % ∆Y % ∆Y % ∆Y
Elasticity of Y = = + + .............. +
Percentage change in X % ∆X 1 % ∆X 2 % ∆X n

or we can calculate the elasticity of Y with respect to each of the X's, which is called partial elasticity, as
follows:

Percentage change in Y % ∆Y
Elasticity of Y with respect to X n = =
Percentage change in X n % ∆X n

ELASTICITY OF DEMAND
Definition
The elasticity of demand is the measure of responsiveness of demand for a commodity to the changes in

Percentage change in Y % ∆Y
Elasticity of Y with respect to X 1 = =
Percentage change in X 1 % ∆X 1
any of its determinants. We studied in the previous lessons that the determinants of demand are the
commodity's own price, income, price of related goods (substitutes and complements), and consumers
expectations regarding future price, i.e.,

Q XD = f ( P X , M , P y , Pz , etc. )

Page-29
Here, QXD = Quantity demanded of commodity X
PX = Price of commodity X
M = Money income of the consumer
PY = Price of the substitute, X and Y are substitutes to each other
PZ = Price of the complement, X and Z are complements to each other
Therefore, we can calculate the elasticity of demand with respect to each of the determinants. When we
calculate the responsiveness of demand to the change in commodity's own price, then we call it price
elasticity of demand. If we calculate the elasticity of demand with respect to the change in consumer's
money income, we call it income elasticity of demand. If we calculate the elasticity of demand with
respect to the change in the price of any related goods (substitutes or complements), we call it cross
elasticity of demand.
Now let's start with price elasticity of demand.
PRICE ELASTICITY OF DEMAND
If the price of a commodity changes, then do consumers change their attitude in buying that commodity?
The answer may be one of the following three:
• They do not change their attitude;
• They slightly change their attitude;
• They change their attitude drastically.
How much consumers respond to the price changes is measured by price elasticity of demand. In other
words, the response of consumers to a change in price is measured by the price elasticity of demand.
Specifically, the price elasticity of demand refers to the percentage change in quantity
demanded divided by the percentage change in price. That is, the price elasticity of demand,

percentage change in quantity demanded of X % ∆Q XD

E PD = =
percentage change in price of X % ∆PX

Here, QX = Quantity demanded for commodity X

PX = Price of commodity X
%∆ PX denotes percentage change in price which is calculated by dividing the change in price by the
original price and %∆QXD denotes percentage change in quantity demanded which is calculated by
dividing the change in quantity by the original quantity. That is:

% ∆ PX = ∆POX × 100, where PXO = Original Price

PX

and % ∆ QX = ∆QOX × 100, where Q OX = Original Quantity

D
QX

Thus, our formula restated :

As we know from the demand law that one of the changes (∆QX or ∆Px ) in the elasticity formula will be
∆Q X / Q XO ∆Q X PXO
E PD = = .
∆PX / PXO ∆PX Q XO

Page-30
 negative. As a result, the sign of the elasticity coefficient will be negative. For convenience, we ignore
the sign of the elasticity formula.
Explanation of different elasticity coefficients and shape of the demand curve
The explanation of different elasticity coefficients and the shape of the corresponding demand curves are
presented as below:

Elasticity Explanation Shape of the demand curve

coefficients

EP = 0 Demand is perfectly inelastic Vertical (Figure 3.4)

EP =1 Demand is unitary elastic Rectangular hyperbolic (Figure 3.5)

E P⇒ α Demand is perfectly elastic Horizontal (Figure 3.6)

0 < EP < 1 Demand is inelastic

1 < EP < α Demand is elastic

PX PX PX
D
Price
Price
Price

D
0 QX 0 EP = 1 0 EP = ∝
EP = 0
Quantity Quantity Quantity

Figure 3.4 Figure 3.5 Figure 3.6

Relationship Between Price Elasticity and Marginal Revenue

The marginal revenue is related to the price of demand with the formula
 
MR = P  1 − 1 
 
 ep 

This is a crucial relationship for the theory of pricing.

Proof:
We know, total revenue TR = P.Q

Page-31
By differentiating TR = P.Q with respect to P, marginal revenue (MR) can be obtained as presented
below:

∂
MR = (P.Q )
∂Q
∂Q ∂P
=P +Q
∂Q ∂Q
∂P
=P+Q
∂Q

 Q ∂P 
∴ MR = P 1 + .
 P ∂Q 

 
 1 
= P1+ 
 P . ∂Q 
 Q ∂P 

Since − P . ∂Q = e , we get by substituting

Q ∂P

= P 1 − 1 
 e

 1
∴ MR = P 1 − ........................... (4)
 e 
From this relationship, it can be concluded that:
If demand is unitary elastic (EP = 1), the marginal revenue is zero, i.e., the total revenue-curve reaches its
maximum point.
If demand is elastic (EP>1), marginal revenue is positive, i.e., total-revenue is increasing, and has not
reached its maximum.
If demand is inelastic (EP<1), marginal revenue is negative, i.e., total-revenue is decreasing.

➦ EP>1
Price

•➦ EP=1
➦ EP<1

AR

0 Q
Quantity Page-32
MR
Figure 3.10: Price elasticity and marginal revenue
In Figure 3.10, it is shown that the point of unitary elasticity corresponds to the point where the marginal
revenue curve crosses the quantity axis. That is, marginal revenue is zero where demand is unitary
elastic.The figure also shows that marginal revenue is positive where demand is elastic, and negative
where demand is inelastic.
In the previous paragraphs, we learnt about price elasticity of demand. However, we know there are some
other factors which influence our buying plans. Among the other factors, the prices of other goods and
income are important. We can calculate an elasticity of demand for each of these other factors as well as
for own price. Let's now know the elasticities of demand with respect to income, which is called income
elasticity, and with respect to the prices of related goods, which is called cross elasticity of demand.
Tables below summarize some estimated price elasticities of demand based on empirical
estimates of demand equations (US economy).
Estimated Price Elasticities of demand:
Food Products Estimated Price Elasticity
Beef -0.65
Pork -0.45
Peas (Fresh) -1.8
Peas (Canned) -1.6
Potatoes -0.3
Beer -0.9
Non-food Items and Processed Meals
Restaurant meals -1.63
Glassware -1.34
Taxi service -1.24
Radio, TV service -1.19
Furniture -1.01
Housing -1
Movies - 0.89 (-3.60 in long run)
Air travel (Domestic) -1.4 (Long run)
Air travel (International) -0.77
Shoes -0.70
Legal services -0.61
Medical insurance -0.31
Natural gas -0.35
Telephone -0.25
Gasoline and oil -0.15 (0.78 long run)
Electricity -0.13 (1.89 long run)

INCOME ELASTICITY OF DEMAND

We knew before that there is influence of income changes on demand for a good. Now we will know how
the demand for particular good changes as income grows? The answer depends on the income elasticity of
demand for the good. The income elasticity of demand is a measure of the responsiveness of demand to a
change in income, other things remaining the same. It is calculated by using the following formula:

Percentage change in quantity demanded

Income elasticity of demand =
Percentage change in income

Page-33
Mathematically, the formula stands for:
dQX . Y
EY =
dY QX

Income Elasticity Co-efficient and the Nature of the Commodity

Income elasticity of demand can be positive or negative and falls into the following interesting ranges:

Absolute value Nature of the

of elasticity commodity
coefficient Terminology Description Example

Greater than 1 Elastic Quantity demanded changes by a larger Luxury/ International

demand percentage than does income travel, jewelry,
(EY>1) superior
works of arts,
etc.

Between zero Inelastic Quantity demanded changes by a Normal Food, clothing,

and 1 smaller percentage than does income furniture,
demand
newspaper, and
(0<EY<1)
magazines

Less than 0 Inelastic Quantity demanded changes in opposite Inferior Potatoes, rice,
demand direction of the income change etc.
(EY<0)

The three cases cited above can be illustrated by diagrams. Figure 3.11 does it.
Part (a) shows an income elasticity that is greater than 1, i.e., as income increases, quantity demanded
increases, but the quantity demanded increases faster than income.

Positive
Income Income Income
elastic inelastic elasticity
Quantity demanded

Negative
Income
elasticity

0
0 Income 0 Income 0 m Income
(a) EY >1
(b) 0<EY<1 (c) EY <0
Figure 3.11: Income elasticity of demand
Part (b) shows an income elasticity of demand that is between zero and 1. In this case, the quantity
demanded increases as income increases, but income increases faster than the quantity demanded.

Page-34
Part (c) shows an income elasticity of demand that eventually becomes negative. In this case, the quantity
demanded increases as income increases until it reaches a maximum at income m. After that point, as
income continues to increase, the quantity demanded declines. Up to the income m, the income elasticity
of demand is positive but less than 1. After income m, the income elasticity of demand in negative.
The low-income people normally buys bicycles, potatoes, and rice. Up to a level of income, they increase
buying of these commodities as income increases. But as income goes above the Point m, consumers
replace these good with superior alternatives. For example, a motorcycle replaces bicycle; fruit,
vegetables and meat begin to appear in a diet that was heavy in rice or potato.
Tables below summarize some estimated income elasticities of demand based on empirical
estimates of demand equations (US economy).

Estimated Income Elasticities of Demand

Food Products Estimated Income Elasticity
Beef 1.05
Chicken 0.14
Pork 0.28
Tomatoes 0.24
Peas 1.05
Potatoes 0.15
Beer 0.93
Coffee 0
Non-food Items
Gasoline 1.08
Clothing 1.03
Whole Life Insurance 1.09
Electricity (Residential) 0.20
Natural Gas (Residential) 0.027
Housing (rooms) 0.063-0.184
Furniture 1.48
Books 1.44
Private Education 1.48

Engel's Law
Ernst Engel, a German statistician, proposed this law in the nineteenth century.
Main theme of the Law: The percentage of income spent on food decreases as incomes increases, i.e., the
income elasticity of demand for food is less than unity and greater than zero (0<EY < 1).
To conclude this expenditure pattern, Engel studied the consumption patterns of a large number of
households. Later, many other researchers has been confirmed his findings repeatedly.
Implication of Engel's Law: During the period of economic prosperity, farmers may not prosper as much
as people in other occupations. The reason is that if expenditures on food do not keep pace with increase
in gross domestic product, farm incomes may not increase as rapidly as incomes in general. However, this
tendency has partially offset by the rapid increase in farm productivity in the recent years.

Page-35
CROSS ELASTICITY OF DEMAND
We already talked about the response of demand for a commodity to its own price and also to consumers
income. Now, we will discuss the responsiveness of quantity demanded for a commodity to the prices of
related commodities (substitutes and complement).
When we measure the responsiveness of demand of a commodity to the price of its substitutes or
complements, then we call it cross elasticity of demand. Symbolically, we have
dQ x dPy dQ x Py
E xy = = .
Qx Py dPy Q x

Here X and Y are related goods.

If X and Y are complementary goods, the sign of the cross-elasticity is negative. If X and Y are
substitutes, the sign is positive. The higher the value of the cross-elasticity the stronger will be the degree
of substitutability or complimentarity of X and Y.
Tables below summarize some estimated cross elasticities of demand based on empirical
estimates of demand equations (US economy).
Estimated Cross Price Elasticities of Demand, Exy=%∆QX/%∆PY
Good X Good Y Elasticity
Electricity Natural Gas 0.20
California Oranges Florida Oranges 0.14
Butter Margarine 0.67
Pork Beef 0.14

Elasticity of Demand: Mathematical Derivation

Problem 01
(a) Suppose the demand function for rice is:
Q XD = ∫ ( PX , M , PY , T , PZ , A, P E etc.) = 20 − 5 PX + 4 PY + 0.2 M + 3 A − 2 PZ + 3T + 0.4 P E .
Here, QXD = Quantity demanded of commodity X
PX = Price of commodity X
M = Money income of the consumer
PY = Price of the substitute, X and Y are substitutes to each other
PE = Expected future price
PZ = Price of the complement, X and Z are complements to each other
A = Advertisement cost
T=Taste
1. If X sells for Tk.20 per unit, the price of Y is Tk.30 per unit, average consumer income is Tk. 25000,
and the advertising budget is 40 units, calculate- i) Price elasticity of demand, ii) Income Elasticity of
demand and identify the nature of the commodity, iii) Cross Elasticity of demand and identify the
nature of the commodity, and iv) Advertisement elasticity of demand.
2. Do you think the firm producing X good should go for advertisement to increase its sale revenue?
Problem 02

Page-36
a. Suppose, the price elasticity of demand for beef be ED = -1.5. (i) If a 10% increase in the price of
steaks occurs, what will happen to the demand for beef? (ii) If a 20% decrease in the price of beef
occurs, what will happen to the demand for beef?
b. Suppose, at a price of Tk. 200, 100 pieces of T-shirt are sold. If the price increases to Tk. 250, what
will the change in demand (sales) for T-shirt be?
c. Suppose the price elasticity of demand for milk is -.50. What impact would a 25% increase in price of
milk have on the demand for it?
Problem 03
If the MC of seating for a theatregoer is Tk. 6 and the elasticity of demand is ‘- 4’, what will be the profit
maximising price?
Problem 04
Suppose, the cross price elasticity of demand of applesauce with respect to the price of pork is -.25. Then
what will happen to demand for applesauce if the price of pork is increased by 10%?

ELASTICITY OF SUPPLY
Definition
The elasticity of supply is the measure of responsiveness of the supply of a commodity to the changes in
any of its determinants. We studied in the previous lessons that the determinants of supply are the
commodity's own price, weather, price of inputs, goals of a firm, advertisement, consumers expectations
regarding future price, etc. The relationship between supply and its determinants can be written as
follows-

QXS = ∫ ( PX ,W , Pinput , P E , G , etc.)

Here, QXS = Quantity supplied of commodity X

PX = Price of commodity X
W = Money income of the consumer
Inputs = Price of inputs
PE = Expected future price
G = Goal of the firm
Therefore, we can calculate the elasticity of supply with respect to each of the determinants. When we
measure the responsiveness of supply to the change in commodity's own price, then we call it price
elasticity of supply. If we measure the responsiveness of supply with respect to the change in weather, we
call it weather elasticity of supply. If we calculate the elasticity of supply with respect to the change in the
goal, we find goal elasticity of supply.
Let us know how price elasticity of supply of a commodity is measured.
PRICE ELASTICITY OF SUPPLY
The price elasticity of supply measures the responsiveness of the quantity supplied of a commodity to a
change in its price. The formula used to calculate the price elasticity of supply is:

Page-37
 Percentage change in quantity supplied % ∆Q XS
E PS = =
Percentage change in price % ∆PX
∆Q XS / Q Xave ∆Q XS PXave
= = ⋅
∆PX / PXave ∆PX Q Xave
Note that the formula for measuring price elasticity of supply is similar to the formula used in measuring
price elasticity of demand. In this formula, the only alternation is the substitution of percentage change in
quantity supplied for percentage change in quantity demanded. As in the elasticity of demand formula,
the mid-point of the changes in quantity supplied and price are used in calculation. The sign of the
coefficient of the elasticity of supply is always positive because the supply curves are positively sloped -
that is, direct relation exists between price and quantity supplied.

Magnitude of the Price Elasticity of Supply

There are two extreme cases of price elasticity of supply:
• If the quantity supplied is fixed regardless of the price, the supply curve is vertical and the elasticity
of supply is zero. Supply is perfectly inelastic. This would be the case, for example, if suppliers
produce a given quantity and dump it on the market for whatever it would bring.
• If there is a price at which suppliers are willing to sell any quantity demanded, the supply curve is
horizontal and the elasticity of supply is infinite. Supply is perfectly elastic.
• If the percentage increase in quantity supplied exceeds the percentage increase in the price, the
elasticity of supply is greater than 1 but less than infinity. Supply is elastic.
• If the percentage increase in the quantity supplied is less than the percentage increase in the price the
elasticity of supply is less than 1 but greater then zero. Supply is inelastic.
Note that the formula for measuring price elasticity of supply is similar to the formula used in measuring
price elasticity of demand. In this formula, the only alternation is the substitution of percentage change in
quantity supplied for percentage change in quantity demanded. As in the elasticity of demand formula,
the mid-point of the changes in quantity supplied and price are used in calculation. The sign of the
coefficient of the elasticity of supply is always positive because the supply curves are positively sloped -
that is, direct relation exists between price and quantity supplied.

We can calculate the magnitudes of elasticity of supply with respect to goal of the firm using the similar
formula. For example,
Goal elasticity of supply is:

S Percentage Change in Quantity Supplied %∆Q S (Q2S − Q1S ) / Q1S ∗ 100

Eadv = = =
Percenatge Chnage in Goal of the Firm %∆G (G2 − G1 ) / G1 ∗ 100

S Percentage Change in Quantity Supplied (Q2S − Q1S ) /[(Q1S + Q2S ) / 2] ∗ 100

or , E adv = =
Percenatge Chnage in Goal of the Firm (G 2 − G1 ) /[(G1 + G 2 ) / 2] ∗ 100
∆Q S / Q ave ∆Q S G ave
= = •
∆G / G Ave ∆G Q Ave
Here ave means average.

Page-38

SAMPLE QUESTIONS FOR REVIEW !!!! !
1. What is elasticity? Define price elasticity of demand for a commodity, income elasticity of
demand, cross elasticity of demand. Mathematical derivation of elasticity coefficient: mid-
point method vs Change method.
2. Determinants of price elasticity of demand.
3. Price, elasticity and revenue. What happens to total revenue if i) demand elastic, price
decrease, ii) demand inelastic, price decrease, iii) demand elastic, price increase, iv) demand
inelastic, price increase.
4. Identify whether the demand for the following commodities are price elastic or inelastic:
Rice, Electricity, Education, sugar, Econo ballpoint pen, Vegetable, apple, Gas, Lux soap.
5. Define price elasticity of supply of a commodity and its determinants. Identify whether the
supply of the following commodities are price elastic or inelastic: Rice, Vegetable, apple,
Tomato, T-shirt, Singara, Cauliflower.
6. Suppose, at a price of Tk. 200, 100 pieces of T-shirt are sold. If the price increases to Tk.
250, what will be the change in demand (sales) for T-shirt be? The price elasticity of demand
for T-shirt is -0.8.

Page-39
a.
CHAPTER- 05:
PRICE DETERMINATION: MARKET EQUILIBRIUM

PRICE DETERMINATION
In a free market, where no outside forces other than commodity's own price are considered to influence
supply decisions and buying decisions, adjustments in price coordinate the devices of buyers and sellers.
Here price is treated as a regulator. The price of a good regulates the quantities demanded and supplied. If
the price is too high, the quantity supplied exceeds the quantity demanded. If the price is too low, the
quantity demanded exceeds the quantity supplied. There is one price, and only one price, at which the
quantity demanded equals the quantity supplied - that price is called equilibrium price (or market price)
WHAT IS "EQUILIBRIUM"? HOW EQUILIBRIUM PRICE AND QUANTITY
DETERMINED?
Equilibrium is a situation in which the opposing forces are in balance. So, equilibrium in market occurs
when the price is such that the opposing forces of the plans of buyers and sellers balance each other, e.g.,
in equilibrium situation, the price is such that the quantity demanded equals quantity supplied - there is no
surplus or shortage. That's why, the equilibrium price is called the market-clearing price.
Now, let's see graphically, how the market-clearing price or equilibrium price is established. Figure 4.1
shows the equilibrium that occurs at the intersection of market demand and market supply curves. In the
figure, Point E is the equilibrium point. The equilibrium price is Tk. 20.00 and the equilibrium quantity is
6,000 Kg. of biscuits.
At point E, the market demand curve intersects market supply curve. Hence, there is no surplus or
Pt
D
60 S1
50

40 Surplus
Price

30 E

20 S D1
Shortage
10 QtD,QtS
2 4 6 8
Quantity ('000 Kg.)
Figure 4.1: Equilibrium in market
shortage at this point. At any price level other than Tk. 20.00, the market is in disequilibrium. We see that
at the price of Tk. 30.00, market supply of biscuit exceeds market demand by 4,000 Kg. - there is an
excess supply or surplus in the market. Similarly, at price of Tk. 10.00, market demand for biscuit exceeds
market supply by 4,000 Kg. - there is an excess demand or shortage in the market. But the disequilibrium
situations are not long-lived. They disappear through market mechanism. In the case of excess demand,

Page-40
the producers want to supply less than the buyers' desire. The tendency for buyers to offer, and sellers to
ask for, higher prices crates upward pressure on price. Price rises till the equilibrium occurs again.
Similarly, in the case of excess supply in market, e.g., the producers wants to supply more than the
consumers' or buyers' desire, the tendency for buyers to offer, and sellers to ask for, lower prices creates a
downward pressure on price. Price falls till the equilibrium occurs again. Table 4.1 below summarizes
these events:
Table 4.1: Equilibrium in the market
Quantity supplied Quantity demanded
Price ('000 Kg. Per week) ('000 Kg. Per week)
( Tk. per Qt S Qt D
Kg.)
10 2 Excess demand/market 10
shortage (QtS< QtD)
15 4 8
20 6 Equilibrium(QtS = QtD) 6
30 8 Excess supply/market 4
surplus (Qt > QtD)
S
60 10 2

MATHEMETICAL DERIVATION OF EQUILIBRIUM PRICE AND QUNTITY

Suppose, the demand equation and supply equations are as follows:

Demand: Q XD = 50 − 5 PX ............................(1)
Supply: Q XS = 10 + 3PX ............................(2)
Equilibrium condition: Q XD = Q XS ..............................(3)

Now, using the information of equation-3, we get the right sides of equations 1 & 2 are equal. So, we can
write,
50-5PX = 10 + 3PX
or, 5PX +3PX = 50 – 10
or, 8PX = 40
or, PX = 40/8 = 5
Now putting PX=5 in either in equation-1 or equation-2, we get, QX = 50 - 5PX = 50 – 5.5 = 50-25 = 25

Therefore, the equilibrium price of X is Tk.5 and the quantity is 25 units.

Problem 01
Suppose, demand function for Singara is QD = 40 – 2P and supply function is QS= 20 + 3P. Find
out -
(i) The equilibrium price and quantity of Singara.
(ii) If the supply increases to QS = 10+3P, what will happen to the equilibrium price and
quantity?

Page-41
Market Price, Demand Price and Supply Price
The price at which demand equals supply is called market price. On the other hand, the price consumers
are willing to pay for a specific amount of commodity is called demand price. Similarly, the price
suppliers are willing to charge for supplying a specific amount of commodity is called supply price. In
Figure 4.1, at the 4000th Kg. of the commodity, the demand price is Tk. 30 per Kg. and the supply price is
Tk. 15 per Kg. Only at the equilibrium point, demand price equals supply price (Tk. 20 per Kg.).
What Happens With the Equilibrium Situation When Supply or Demand Changes?
We learnt from the previous lessons that when the determinants of quantity supplied other than
commodity's own price change, then supply curve shifts, and when the determinants of quantity
demanded other than commodity's own price change, the demand curve shifts. Let's first consider the
effect of a change in demand on the equilibrium position. Figure 4.2 shows the effects of a change in
demand on the equilibrium price and quantity. The figure shows that the original equilibrium price is Tk.
Pt
D
D
60 S1
Price (Tk. Per Kg.)

50

40 E2

30 E1
D2
20 S D1
10 QtD,QtS
2 4 6 8
Quantity ('000 Kg)
Figure 4.2: The effects of a change in Demand
20.00 per Kg. of biscuit, and the quantity is 6,000 Kg. biscuit a week. When demand increases, the
demand curve shifts rightwards, from DD1 to DD2 in Figure 4.2. The equilibrium price rises to Tk.30.00 a
Kg. of biscuit and the equilibrium quantity increases to 8,000 Kg. of biscuit, which corresponds to the
new equilibrium Point E2. The effects will be reverse if demand decreases, i.e., the demand curve shifts
leftward.
On the other hand, if the supply curve shifts rightward, then equilibrium price of the commodity decreases
and the equilibrium quantity increases as in Figure 4.3. The effect will be reverse if the supply curve
shifts leftward.

In Figure 4.3, we see that due to the rightward shift of the supply curve, new equilibrium position has
been established at Point E2. At E2, the price of the commodity is lower and the quantity exchanged is
higher than those at the initial equilibrium point E1.

Page-42
 Pt
D
60 S1
S2
50
Price

40

30 E1
E2
20
S D1
S
10 QtD,QtS
2 4 6 8
Quantity ('000 Kg)
Figure 4.3: Effect of a change in supply on equilibrium position

In the cases described by Figure 4.2 and Figure 4.3, only demand curve or supply curve was assumed to
be shifted. There we haven't explained the case where both supply and demand curves shifts
simultaneously.

What Will Happen If Both Demand Curve and Supply Curve Shift?
If they shift in the same direction and same extent, the equilibrium price will not be changed, but the
equilibrium quantity will be changed as in Panel A of Figure 4.4. In Figure 4.4, we see that the supply
curve has been shifted rightward from SS1 to SS2 and at the same time, the demand curve has been shifted
outward from DD1 to DD2. The extent of change in both demand and supply is the same. We see that at
the new equilibrium point E2, the equilibrium price is the same as that at the initial equilibrium Point E1,
but the quantity exchanged has been increased.
Pt Panel A Pt
60 D 60 Panel B
D D D
S1 S1
50 S2 50
S2
Price

40 40

30 E1 E2 30 E1 E2
D2
D2
20 S D1 20 S
D1
S S
10 10 QtD,QtS
2 4 6 8 10 2 4 6 8 10
Quantity ('000 Kg) Quantity ('000 Kg)
Figure 4.4: Effect of a change in both supply and demand

If the extent of change in both demand and supply is not the same, both equilibrium price and quantity
exchanged are changed. Panel B of Figure 4.4 shows that.

Page-43
Similarly, we can see what happens to the equilibrium price and quantity when supply and demand
change in opposite directions.

What are effects of Price Floor, Subsidy, Taxes and Export Quota?

SAMPLE QUESTIONS FOR REVIEW!!1!! !

1. What is equilibrium? How equilibrium quantity and price are determined? Show graphically
and mathematically. Define demand price, supply price and market price/market clearing
price/equilibrium price.
2. Show graphically the effect of the following changes on the equilibrium price and quantity of
a commodity (For example, potato): a) Price of the commodity has been reduced, b) Weather
got worse, c) Level of technology has been enhanced, d) Increase in the prices of inputs, e)
Expected future price is high, f) Price of the commodity, g) Increase in the population size.

3. Suppose, the market demand and market supply function of rice are QD = 30 – 3P and QS= 20
+ 2P respectively. Find out – i) Market price and quantity of rice. ii) If due to the increase in
the increase in the income of the consumers, the demand increases to QD= 40 - 3P, what will
happen to the market price of potato? iii) If the consumers expect that in near future the price
of rice will be decreased, how it will affect the current market price of rice? Use graph if
required. iv) If the rice farmers of Dinajour send most of their rice to Dhaka City for higher
price, what may happen to the market price of rice in Dinajpur? Use graphs. v) If the price
becomes Tk. 4, what will happen to the market? vi) If the price becomes Tk. 2, what will
happen to the market?

4. If the aged people of the country increase, what will happen to the equilibrium price and
quantity of the commodity? Compare with the effects of other changes like Population
increase, bad weather, Price increase, etc
5. What is the effects of the following factors on equilibrium price and quantity: (a) price
ceiling, (b) price floor, (c) subsidy, (d) taxes, (e) Export quota
6. What is market equilibrium? Suppose, due to the recent flight of the price of sugar,
government is thinking to impose binding price ceiling on sugar. What may be the impact of
this decision on: i) sugar market, ii) sugar production, and iii) quality of sugar.

Page-44
 CHAPTER- 05:
CONSUMER BEHAVIOUR

What Is Meant by Consumer Behaviour?

As a consumer, we have to take several decisions on the goods and services we consume in our daily life.
For example, we have to decide: whether we should take tea or coffee in the morning, whether we should
carry lunch packet or eat in the office canteen, whether we should buy or rent a house, etc. The way a
consumer takes decisions on such problems is called consumer's decision-making behaviour or, in brief,
consumer behaviour.
Economists constructed a theory of consumer behaviour based on the hypothesis that how each consumer
spends her/his income between the goods depends on her/his likes or dislikes - her/his preferences.
Consumers are willing to pay more for the good that is expected to give them additional satisfaction or
pleasure. If the oral sensation of mango juice at the cricket matches really turns you on, you are likely to
be willing to pay more prices for it. If you don't have great taste or desire for mango juice, you are not
likely to pay more money for it. Consumers always want to allocate their spending among the goods and
services in the way that yields the greatest amount of satisfaction, or pleasure. Economists use the term
utility to refer the expected pleasure, or satisfaction, obtained from the goods and services.

WHAT IS UTILITY?
The notion of utility was first introduced to social thought by the British philosopher, Jeremy Bentham, in
the 18th century. Later William Stanly Jevons introduced it to Economics in the 19th century.
In its economic meaning, the term utility refers to the benefit or satisfaction or pleasure a person gets from
the consumption of a commodity or service. In abstract sense, utility is the power of a commodity to
satisfy human want, i.e. utility is want-satisfying power. A commodity is likely to have utility if it can
satisfy a want. For example, rice has the power to satisfy hunger; water quenches our thirst; books fulfil
our desire for having knowledge, and so on.

Characteristics of Utility
The following characteristics of the concept of utility must be emphasized:
Utility and usefulness are not synonymous: Usefulness is not necessary for a commodity to satisfy one's
want. An useless commodity may yield substantial utility. For example, Paintings by Picasso may be
useless in a functional sense and yet be of tremendous utility to art connoisseurs.
Utility is a subjective notion: The utility of a specific product varies widely from person to person. All
persons need not derive utility from all commodities. For example, non-drinkers do not derive any utility
from wine, but alcoholic people derive great utility from wine; non-smokers do not get utility from
cigarettes, but smokers derive utility from smoking; strict vegetarians do not derive any utility from beef
and chicken, but non-vegetarians get utility from beef and chicken; eyeglasses have no utility to a person
having 20-20 vision, but great utility to someone who is extremely far- or near-sighted; and so on.
Utility is ethically neutral: Utility is neutral between good and bad and between useful and harmful. For
example, opium is bad and harmful, but it yields utility to the people who takes it. Utility is free from
moral values. It is not subject to social desirability of consuming a good.

Page-45
Measurability of Utility
As you have learnt at the beginning of this lesson, the consumer is a rational being. Given her/his income
and the market prices of the various commodities, he plans her/his income so as to attain the highest
possible satisfaction or utility - this is the axiom of utility maximization. In order to attain this objective

Cardinalist approach
Measurability of

Ordinalist approach:
utility

-indifference-curves approach
-revealed preference hypothesis
•
the consumer must be able to compare the utility of the various baskets of goods which he can buy with
her/his income. To compare utilities we need to know whether utility can be measured or not. Economists
have different views on this point. There are two basic approaches to the problem: the cardinalist
approach and the ordinalist approach:

The cadinalist school held the views that utility can be measured. But how can it be measured? What units
can it be measured in? Various suggestions have been made for the measurement of the utility. Some
economists have suggested that utility can be measured in monetary units while others suggested the
measurement of utility in subjective units, called utils.

On the contrary, the ordinalist school postulated that utility is not measurable, but is an ordinal magnitude.
The consumer need not know the units of utility he gets from the commodities to make her/his choice. It
is sufficient for him if he is able to rank the various baskets of goods according to the satisfaction that
each bundle gives him.

In this lesson, we are not going to discuss the approaches to the analysis of consumer behaviour, i.e., the
cardinalist approach and the ordinalist approach, in detail. We will thoroughly examine them in the
following lessons.

CARDINALIST APPROACH: UTILITY IS MEASURABLE!

How Can We Measure Utility?
Utility is an abstract concept. It cannot be observed or touched anyway. That's why, the measuring units
of this entity are arbitrary. Just like temperature, utility can be measured in arbitrary units. Let's know how
temperature is measured, that will help us understand how the measurability of utility in arbitrary units is
justifiable:

Temperature is an abstract concept. We cannot observe it - only we can feel it. However, we can observe water
turning to steam if it is hot enough or turning to ice if it is cold enough. And we can construct an instrument, called
thermometer, that can help us predict when such changes will occur. The scale on the thermometer is what we call
temperature. But the units in which we measure temperature are arbitrary. For example, we can accurately predict
that when a Celsius thermometer shows a temperature of 0, water will turn to ice. But the units of measurement do
not matter because this same event also occurs when a Fahrenheit thermometer shows a temperature of 320.

In the above example, we have seen that temperature helps us to make predictions about physical
phenomena. In the same way utility helps us make predictions about consumption choices. However,
utility theory is not as precise as the theory that helps us to predict when water will turn to ice or steam.

Page-46
From the above discussion, one thing is now clear to us that utility is measurable, though it is not so
precise as other measurements. But it is still unclear how to measure utility, i.e. in what units we can
measure the utility we get from the consumption of a commodity?
About a hundred years ago, economists thought utility as an indicator of the pleasure a person gets from
the consumption of some set of goods, and they thought that utility could be measured directly in some
psychological units called utils, after somehow reading the consumer's mind. But it was an impossible
task to guess the satisfaction one gets from consuming a commodity. Can you say how many utils did you
get from the last cricket match you saw at the Bangabandhu National Stadium? Probably your answer is
NO, because you have no idea what util is. The same thing would happen to anyone else.

But if you are asked: how many Shingara would you give up to get the ticket to watch that cricket match?
Now you can answer this question confidently - for example, five Shingaras. Remember that still you
don't know how many utils you got from watching the cricket match. But you do know that your
satisfaction from the cricket match is more than the satisfaction from a piece of Shingara. In this case,
Shingaras, rather than utils, become the unit of measurement. We can say that the utility you derived from
the cricket match is five Singagas. Actually, this indirect way of measuring utility is the basis of the
cardinalist theory of consumer behaviour. In the early twentieth century, economists used this indirect
way of measuring utility to analyze the consumer behaviour.

We can measure utility derived from a commodity (like a ticket for watching cricket match) in terms of
any other commodity (such as Shingara, Samucha, money, etc.) we are willing to give up for it. In our
discussion, we will use the commodity which is the simplest and commonly used as a medium of
exchange- that is, MONEY- to measure utility.

Thus we can define the utility of a commodity to a consumer as the amount of money she/he is willing to
give up for it. For example, suppose Modhu decides to buy one Chicken Patty by Tk. 10.00, she will not
buy any Chicken Patty if the price is higher than 10.00 taka. Then the utility of one piece of Chicken Patty
is Tk. 10.00 - the maximum amount of money she is willing to pay to have it. If she wants to buy five
pieces of Chicken Patty and is willing to pay Tk.30.00 at a maximum, then the total utility of five pieces
of Chicken Patty to her is Tk. 30.00. Here one thing is noticeable that though Modhu is willing to pay Tk.
10.00 for one piece of Chicken Patty, she is willing to spend Tk. 30.00 only - not Tk. 50.00 = 5 @Tk.
10.00 - for five pieces of Chicken Patty. This happens because she is willing to pay less for each
additional piece of Chicken Patty, which indicates that she gets lower utility from additional unit. The
utility derived from an additional piece of Chicken Patty is called marginal utility. Marginal utility and
Toa utility are two related concepts. Let's now see how these concepts are related.

TOTAL AND MARGINAL UTILITY

Total utility refers to the amount of satisfaction from consumer's entire consumption of a commodity. In
the example cited earlier, the utilities Modhu derives from the 1st, 2nd, 3rd, 4th and 5th pieces of Chicken
Patty are Tk. 10.00, Tk. 9.00, Tk. 7.00, Tk. 4.00 and Tk. 0.00 respectively. Therefore, the total utility
derived from five pieces of Chicken Patty is Tk.30.00 = Tk. 10.00 + Tk. 9.00 + Tk. 7.00 + Tk. 4.00 + Tk.
0.00.

On the contrary, marginal utility is the amount of utility a consumer derives from consuming the last, i.e.
marginal, unit of a commodity. In other words, marginal utility can be defined as the amount of utility a
consumer derives from the consumption of an additional unit of the commodity. Marginal utility can also
be defined as the change in the total utility resulting from the change in the consumption - that is:

Page-47
 MR = ∆TU/∆C

Here, MR = marginal utility, ∆TU = change in total utility and ∆C = change in consumption.
Recall our example of Chicken Patty consumption. Modhu gets the utility of Tk.10.00 from the first piece
of Chicken Patty. When she takes the second one, she gets the utility of Tk. 9.00. This additional utility is
called marginal utility. When she takes the third one, her marginal utility becomes Tk. 7.00. For the fifth
one, she is not willing to pay any money, i.e., the marginal utility is zero.

Table 4.1 helps clarify the distinction between marginal and total utility and shows how the two are
related. First two columns show how much total utility Modhu derives from various quantities of Chicken
Patty. For example, one Chicken Patty is worth Tk.10.00 to her, two Chicken Patties are worth Tk.19.00,
in total, to her and so on.

Table 4.1: Total and Marginal Utility

Quantity of Total Utility (TU) Marginal Utility (MU)
Chicken Patties ( in taka) ( in taka)
0 00
1 15 15 (=15-00)
2 24 09 (=24-15)
3 29 05 (=29-24)
4 31 02 (=31-29)
5 31 00 (=31-31)
The marginal utility is the difference between any two successive total utility figures, which is shown in
the third column of the Table 4.1. For example, if Modhu already consumed three pieces of Chicken Patty
which are worth Tk.26.00 to her, consumption of an extra piece of Chicken Patty makes her total utility
Tk.30.00. Thus her marginal utility is the difference between the two, i.e., Tk.4.00 (= Tk. 30.00 - Tk.
26.00). If we plot the data of Table 4.1 into the graph, we get total and marginal utility curves. Figure 3.1
portrayed the total utility and the marginal utility curves in the same plot area.
In Figure 4.1, the TU curve indicates the total utility Modhu derives from Chicken Patties at different
consumption levels. We see that the total utility curve is upward up to a level of consumption (Point M),

M
TU
30
Total and Marginal utility

20

10

MU
0
2 3 4 15
Quantity of Patty
Figure 4.1: Total and marginal utility curves
which means that the more patties Modhu consumes, the more total utility she gets up to a certain level of

Page-48
consumption. Notice that the total utility curve is rising but at a diminishing rate (Why?- see the law of
diminishing marginal utility). We see the MU (Marginal Utility) curve lying just under the TU curve in
the same plot area. The downward sloping MU curve tells us that as she incases her consumption, the
amount of utility Modhu gets from each extra piece of Patty decreases.

Therefore, if we summarize the message given in Figure 4.1, we get the following characteristics of total
and marginal utility, which tells us how total and marginal utility are related:

Up to a certain level of consumption, total utility increases as the consumption increases.

Marginal utility is decreasing with the increase in consumption.

Total utility increases till marginal utility is positive, but at a diminishing rate.

When marginal utility becomes zero, then total utility is the maximum.

Total utility decreases if marginal utility becomes negative.

The area under the marginal utility curve indicates the total utility derived from various pieces of
Patty.

In the previous discussion, we have learnt that marginal utility diminishes as the consumer increases her
consumption of Chicken Patty - this very nature of marginal utility is described by the law of diminishing
marginal utility. Let's know the law in detail.

THE LAW OF DIMINISHING MARGINAL UTILITY

This law is the main instrument used in the cardinal utility analysis of the consumer behaviour. It explains
why the demand curve of a specific commodity is downward sloping? It also explains the elasticity of
demand for a product. Except these, there are many other applications of this law in our everyday life.

Main theme of the law

The additional units of a specific commodity are worth less and less to a consumer as more of the
commodity she/he consumes. In other words, marginal utility of a specific commodity declines as more of
it is consumed.

Assumptions
The assumptions upon which this law is based are as follows:

Given time period: Units of the commodity are consumed in a given time period. The time period must
be appropriate. If you drink ten cans of cold drinks during the whole day, the idea of diminishing marginal
utility will not hold. However, if you are asked to drink all of the cans in two hours of time, then the idea
of diminishing marginal utility makes sense.

Continual consumption: The units of the commodity are consumed continually, but the time interval
between the consumption of two units of the commodity must be appropriately short.

Normal behaviour of the consumer: The mental condition of the consumer remains normal during the
period of consumption of the commodity. She/he has a hierarchy of uses to which she/he will put a
particular commodity. All of these uses are valuable, but some are more valuable than others.

Standard units of the commodity: The units of the commodity must be standard, i.e., a can of cold
drinks, a glass of juice, a cone of ice-cream, a cup of tea, a pair of shoes, etc. If the units are excessively
small or large, the law may not hold.

Page-49
Consumption of other commodities is given: During the consumption of the commodity, the
consumption of all other commodities remains constant.

Logic behind the law

Our wants are unlimited. However, the want for a specific commodity is not unlimited - we can meet it.
How? Simply think of your personal desire to have a specific commodity. Do you want more and more of
a specific commodity? Are you willing to spend the same amount of money for each unit of it? Will you
Consume endless quantities of the commodity if you can afford it? The answer to all of the questions is
NO, because, the thrill diminishes with the consumption of each unit of the commodity. Even people who
love sea-fish (for example, Rupchanda or pomfret), i.e. get great utility from it, and can afford it, don't eat
endless quantities of it, presumably because, satisfaction from each piece of fish diminishes as the
consumption increases. The first piece of fish may bring sensual gratification, but the second or third
piece is likely to bring a stomach ache. If we express this change in perceptions in terms of utility, we find
that the marginal utility derived from the first piece of Rupchanda (pomfret) fish is higher than the
marginal utility derived from the second piece, i.e. the marginal utility from each extra piece of
Rupchanda fish diminishes as the consumption of it increases.

The behaviour of the sea-fish connoisseurs is not abnormal. Generally speaking, as we consume more and
more of a commodity, even the most favorite one, we become bored with it and our satisfaction from
additional units of it diminishes. Indeed, this phenomenon of diminishing is so nearly universal that
economists have fashioned a law around it which is called the law of diminishing utility.

Note that this law does not say that we won't like the third or fourth piece of a commodity; it just says we
won't like them as much as the ones we have already consumed.

Numerical and graphical illustration of the law

Recall the hypothetical data in Table 4.1. In the table, we see that as the consumption of Chicken Patty
increases, the total utility increases, but at a decreasing rate, which indicates that the additional or
marginal utility derived from each extra piece of Chicken Patty diminishes with the increase in
consumption. This is shown in the third column of the table.

Graphically, the law of diminishing marginal utility has been illustrated in Figure 3.1. The downward
sloping MU curve in the figure indicates that the marginal utility derived from each extra piece of Chicken
Patty diminishes as the consumption of it increases.

Exceptions of the law

The law of diminishing marginal utility is plausible for most consumers and for most commodities.
However, like most laws, it has some exceptions. There are some commodities particularly significant to
some people. The more of those commodities they get, the more they want. For example, the need for
second glass of alcohol is higher than the need for the first glass to an alcoholic, the need for additional
stamps do not diminish to a stamp collector, the desire to have more rare paintings doesn't diminish to a
painting connoisseur, the need for more gold doesn't dwindle to women, and the want for money doesn't
diminish to anybody. In these cases, the marginal utility increases rather than decreases. Economists,
however, generally treat such cases of increasing marginal utility as anomalies. For most goods and most
people, marginal utility probably diminishes as consumption increases.

Page-50
CONSUMER EQUILIBRIUM: UTILITY-MAXIMIZING RULE
We have learnt from the previous discussion that as we consume more and more of a commodity the total
utility increases at a decreasing rate, which implies that the marginal utility is diminishing with the
increase in consumption. There we didn't consider any constraints which prohibit us from having the
quantity of the commodity as much as we like. Now, ask yourself whether you are actually free to
consume any amount of the commodity you like. Undoubtedly, your answer is NO. Then try to guess what
the constraints are. You will easily find that the two main constraints are: our INCOME, which is limited
and the price of the commodity. So, how much of a commodity we can buy depends on our income and
the price of the commodity.

Now, let's think about utility-maximization. What rule should be followed to identify the amount of a
commodity or a combination of different commodities which yields maximum total utility to the
consumer? The answer to this question depends upon the factors we will consider in the process. If we
don't consider any constraint, such as income and price of the commodity, then the process of utility
maximization is called free maximization of utility. If we consider the constraints, then the process is
called constrained maximization of utility.

Process of utility maximization

Free Constrained
maximization maximization
of utility of utility

We will confine ourselves to constrained maximization of utility which corresponds to the concept of
consumer's equilibrium.

CONSUMER SURPLUS
Definition: The difference between the value of the commodity and its price is called consumer surplus.
When a person buys any chosen quantity of a commodity at a given price, diminishing marginal utility
guarantees that she/he always attains some consumer surplus. Why? Let's see this.
Calculating consumer surplus: Look at Figure 4.5(A). This figure illustrates the consumer surplus of an
individual consumer. DD' is Modhu's demand curve for chicken Patty when she has Tk.30.00 to spend.

d Consumer
15
surplus

10
Price

E
5 Market price

0 d'
2 1 3 4 5 6
Quantity of Patty
Figure 4.5(A): Consumer surplus of Modhu
Page-51
If Modhu consumes only one piece of Patty, she would be willing to pay Tk. 10.00 for it. If she consumes
two pieces of Patty, she would be willing to pay Tk.10.00 for the first one and Tk.9.00 for the second one.
Accordingly, she would be willing to pay Tk.6.00 for the third one, Tk.4.00 for the fourth one, and so on.
However, she is lucky enough that the market price of Patty is Tk.4.00 each, i.e., she has to pay only
Tk.4.00 to get a piece of Patty. So, up to the third piece she has to pay less than she would be willing to
pay. For the first four pieces of Patty, Modhu is willing to pay Tk.28 in total (= Tk.10 + Tk.8.00 + Tk.6.00
+ Tk.4.00 ), i.e., the value she places on the Chicken Patty is Tk.28.00. But she actually pays Tk.16.00 (=
Tk.4.00 ✕ 4 ) for buying them. So, the extra value she receives from buying four pieces of Patty is Tk.12
(=Tk.28 - Tk.16). This extra value is Modhu's consumer surplus. From the consumption of four pieces of
Patty she gets Tk. 12 worth of value in excess of what she has to spend to consume them. In Figure
4.5(A), the shaded area under the dd' curve indicates the consumer surplus of Modhu.

Now let's see how the consumer surplus of all the consumers in a market is calculated. Figure 4.5(B)
illustrates the consumer surplus of a market as a whole. Suppose that there are one thousand consumers in
the Patty market. They are similar, but not identical, to Modhu. DD' is the market demand curve for Patty.
The market price of Patty is Tk.4.00 each. The consumer surplus for the market as a whole is
Tk.14,000.00, which is shown by the area of the shaded triangle under the DD' curve. The area of the

12

D
10 Consumer
surplus
8
Price

4 Market price

2 D'

0
1 2 3 4 5
Quantity( thousand pieces)

Figure 4.5(B): Consumer surplus of the entire market

shaded triangle is calculated as below:

The base of the triangle = 4 thousands of Patty.

The height of the triangle = Tk.11.00 -Tk.4.00 = Tk.7.00 a piece of Patty

Therefore, the area of the triangle is:

1
× base × height
2
1
= × 4000 × 7
2
= Tk .14000.00

Page-52
THE PARADOX OF VALUE: WATER - DIAMOND PARADOX
The early economists, including Adam Smith, have been puzzled by a paradox that the market often
valued necessary commodities such as water, which is essential to life itself, much lower than it valued
such luxuries as diamonds which are merely decorative and have little practical value compared to water.
This is called Water - Diamond paradox. In the paradox, we see that market prices apparently cannot
reflect or measure the usefulness of commodities. How can this paradox be resolved?

Adam Smith tried to solve this paradox. But he failed. Until the theory of marginal utility had been
developed no one could give a satisfactory answer.

We can solve this puzzle simply by considering two things: First, the supplies of the commodities. It will
help us identify the distinction between total and marginal utility of the commodities and know about
their prices. Second, the utility-maximizing rule of the consumer. It will help us understand that total
utility is not relevant to price of the commodity, rather marginal utility is relevant to price of the
commodity.

The supplies of the two commodities are very much different. Water is plentiful. As a consequence its
price is very low, and we, therefore, consume large quantities of it. We use so much water that the utility
from the last unit of water - water's marginal utility - is very low. For example, by water we wash our
clothes, wash our dishes, bathe ourselves, make ice cubes, and irrigate our gardens. However, total utility
we get from water is enormous. On the other hand, diamonds have a small total utility relative to water.
But they are rare and costly to mine, cut, and polish. That's why, their supply is restricted and they are
available only at a high price. People buy , therefore, only a few diamonds, which make the marginal
utility of diamond very large.

Utility-maximizing rule states that a consumer should purchase any commodity until the ratio of its
marginal utility to price is the same as that for all other commodities. That is, the consumer will get
maximum total utility if she/he allocates her/his income among the different commodities such as X, Y,
…….., N in a way that satisfies the following condition:

MU X MU Y MU N
= = LL =
PX PY PN

This equality of marginal utilities per dollar spent holds true for water and diamonds: Water has a low
price and a low marginal utility. Diamonds have a high price and a high marginal utility. When a high
marginal utility of diamonds is divided by the high price of diamonds, the result is a number that equals
the low marginal utility of water divided by the low price of water. The marginal utility per dollar spent is
the same for diamonds as for water.

Therefore, the total utility that we derive from water is very much higher than that we derive from
diamond, but it doesn't have relevance to the price, rather marginal utility is relevant to price of a
commodity. Society would gladly give up all of the diamonds in the world if that would be necessary to
obtain all of the water in the world. But society would rather have an additional diamond than an
additional gallon of water, given the abundant stock of water available.

Page-53
ORDINALIST APPROACH - INDIFFERENCE CURVES

The Concept of Ordinal Utility

The word ordinal is synonymous to the word rank. We know that rank is not a quantity, rather it
indicates the position of something in a group in terms of magnitude or satisfaction or any other attributes.
For example, if you are asked to express your preference among three commodities such as Patty,
Shingara and Orange, you may express your best favour to Orange , less favour to Shingara and very low
favour to Patty, i.e., the ranking of your preference according to the satisfaction of each commodity is:

Commodities Ranks
Patty 3
Shingara 2
Orange 1
Therefore, the ordinal utility is the expression of the consumer's preference for one commodity over
another or one basket of goods over another, but not a numerical figure of utility derived from different
commodities or baskets. In this case, it is assumed that the utility derived from the consumption of various
commodities cannot be measured in quantities, but the consumer can rank her/his preferences according to
the satisfaction of each commodity or basket. For example, you can say that you prefer Orange to
Shingara, but it is extremely doubtful if you say that the utility you will receive from Orange and Shingara
is Tk.10.00 and Tk.5.00 respectively.
So ordinal utility analysis is a more advanced explanation of consumer behaviour than cardinal utility
analysis.

INDIFFERENCE CURVE ANALYSIS

Two geometric devices are used in this analysis: indifference curves and budget lines. Both of them are
the locus of various combinations of two commodities. However, the first one is concerned with those
combinations from which the consumer gets same satisfaction or she/he is indifferent among them, while
the second one is concerned with such combinations or bundles which she/he can afford by spending the
same amount of money.
indifference curve analysis

Indifference
curves
Devices used in

Budget lines

Let's first discuss the assumptions underlying the indifference curve analysis. Later, we will discuss
indifference curves and budget lines in detail.

Page-54
Indifference schedule
Let us assume that a consumer named Modhu is indifferent between the various combinations of orange
and Patty. In Table 4.4, some combinations of Orange and Patty are presented. These combinations yield
her equal satisfaction. Table 4.4 is, thus, called an indifference schedule.

Table 4.4: Indifference schedule (hypothetical data)

Combinations Units of Orange Units of Patty

a 12 2
b 7 4
c 4 6
d 2 8
e 1 10

In Table 4.4, five combinations of Orange and Patty have been shown. Combination-a contains 12 pieces
of Orange and 2 pieces of Patty, combination-b contains 7 pieces of Orange and 4 pieces of Patty,
combinaton-c contains 4 pieces of Orange and 6 pieces of Patty, and so on. We see that the quantity
figures are not the same in all the combinations. If a combination contains more Oranges, it has to contain
less Patty. This is necessary, because all the combinations should yield the consumer the same
satisfaction. Note that as the combinations include more of Patty, the quantity of Oranges in the
combinations becomes lower. That means, the consumer has to give up Oranges for getting more Patties
to keep her satisfaction same. So, there is a substitution between the two commodities. But what is about
the rate of substitution? Does she always give up or substitute the same amount of Oranges for every extra
piece of Patty? Look at Table 4.4. When Modhu moves from combination-a to combination-b, she
substitutes 2 pieces of Patty for 5 pieces of Orange; if she moves further, i.e., from combination-b to
combination-c, she substitutes same amount of Patty (2 pieces of Patty) for 3 pieces of Orange; and so on.
Therefore, the rate of substitution of each extra piece of Patty ( marginal rate of substitution) diminishes.
This is shown in Table 4.5.

Table 4.5: Marginal rate of substitution (hypothetical data)

Units of Change in the Units of Change in the Marginal rate of

Orange quantity of Patty quantity of Patty substitution
Combinations

Orange (∆QPatty) ∆Qorange ÷ ∆QPatty

(∆Qorange)

A 12 2
B 7 5 (=12-7) 4 2 (= 4-2) 2.5
C 4 3 (= 7-4) 6 2 (= 6-4) 1.5
D 2 2 (= 4-2) 8 2 (= 8-6) 1.0
E 1 1 (= 2-1) 10 2 (= 10-8) 0.5

In Table 4.5, it is shown that for every extra 2 pieces of Patty the consumer is not willing to give up the
same quantity of Oranges - her willingness to giving up Oranges becomes lower as she gets more of Patty.
This means, her attraction toward Patty reduces as she gets more of it. Column-6 of the table shows the
diminishing marginal rate of substitution of Patty for Orange.

Page-55
Indifference curve
Plotting the data given in Table 4.4 we get the indifferent curve of the consumer. Figure 4.6 shows it.
In the above figure, IC indicates the indifference curve. Any point on the indifference curve indicates a
combination of two commodities - Orange and Patty. At all the points the consumer is indifferent, i.e.,
throughout this curve the consumer's utility or satisfaction is the same. That's why, indifference curve is
also called Iso-utility or Equal-utility curve.

14
a
12
Quantity of Orange

10

8
b
6
c
4
d
2 e
IC
0
2 4 6 8 10
Quantity of Patty
Figure 4.6: Indifference curve of Modhu

Indifference map
An indifference map is the collection of all indifference curves which rank the preferences of the
consumer. As we move out from the origin each successive indifference curve entails a higher level of
utility. That means, combinations of goods lying on a higher indifference curve yield higher level of
satisfaction and are preferred. Figure 4.2 shows an indifference map.
Quantity of Orange

IC3

IC2
IC1
0
Quantity of Patty
Figure 4.7: Indifference map

Page-56
Figure 4.7 depicts a partial indifference map, because only three indifference curves are shown here. Like
IC1, IC2 and IC3 there may be many other indifference curves in the indifference plane. The area between
the two axes is called indifference plane.

Properties of the indifference curves

The indifference curves have the following basic properties:
Downwardsloping: The indifference curve is downward sloping, which implies that: the two
commodities can be substituted for each other; and if quantity of one commodity decreases, quantity of
the other commodity must increase if the consumer has to stay at the same level of satisfaction.
Technically, the slope of the indifference curve is called the Marginal Rate of Substitution (MRS),
because it shows the rate, at the margin, at which the consumer will substitute one good for the other to
remain equally satisfied.
Convex to the origin: Downward slope is the necessary, not sufficient, property of the indifference
curve. As viewed from the origin, a downward sloping curve can be concave (bowed outward) or convex
(bowed inward). The indifference curve is convex to the origin, which means that slope of the
indifference curve, the marginal rate of substitution, diminishes as we move down the curve. The
diminishing slope of the indifference curve means the willingness to substitute one commodity (orange)
for the other (Patty) diminishes as one moves down the curve.
Indifference curves do not intersect nor be tangent to one another: By definition, we know that along
an indifference curve the consumer's satisfaction remains the same. If indifference curves intersect, the
point of their intersection would imply two different levels of satisfaction, which is impossible.
Upper indifference curves represent higher level of satisfaction than the lower ones: The further
away from the origin an indifference curve lies, the higher the level of utility it denotes. Bundles of
commodities on an upper indifference contain a larger quantity of one or both of the commodities than
the lower indifference curve. Thus bundles of commodities on a higher indifference curve are more
preferred by the rational consumer.

Budget Line: What the Consumer Can Afford?

In the previous section, we learnt that an indifference curve shows such combinations of commodities
from which the consumer gets the same level of satisfaction. In that case, we haven't considered any
constraint. Is the consumer able to consume any combination she/he prefers? Certainly the answer is NO.
Why? Because her/his income is limited. Thus which bundle or combination of the commodities the
consumer can afford depends on her/his income and the prices of the commodities.
A budget line shows such combinations of two commodities which the consumer can afford, given her/his
money income and prices of the commodities. Table 4.6 shows the combinations of Orange and Patty
which the consumer can purchase when her/his money income is Tk.36.00, price of Orange is Tk.3.00
and price of Patty is Tk.4.00.
Table 4.6: Combinations of Orange and Patty attainable with an income of Tk.36.00 (hypothetical
data)
Quantity of Quantity of Expenditure on Expenditure Total
Orange Patty Orange on Patty Expenditure
Combinations

(price = (price = (in taka) (in taka) (in taka)

Tk.3.00) Tk.4.00)

a 12 0 3 × 12 = 36 4×0=0 36 + 0 = 36
b 8 3 3 × 8 = 24 4 × 3 = 12 24 + 12 = 36
c 4 6 3 × 4 = 12 4 × 6 = 24 12 + 48 = 36
d 0 9 3×0=0 4 × 9 = 36 0 + 36 = 36

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In the table above, four combinations are shown such as combination-a{12 pieces of Orange and 0 piece
of Patty}, combination-b{ 8 pieces of Orange and 3 pieces of Patty}, combination-c{ 4 pieces of Orange
and 6 pieces of Patty} and combination-d{0 piece of Orange and 9 pieces of Patty}. Each of the
combinations can be purchased with Tk.36.00 of money income.
Algebraically, we can write the income constraint, in the case of two commodities, as follows:

Por × Qor + Ppa × Q pa = M .................................( 4.1)

Here, Por = Price of Orange; Qor = Quantity of Orange; Ppa = price of Patty; Qpa = Quantity of Orange; and
M = Money income.

Solving the above equation (4.1) for Qpa, we derive:

1 P
Q pa = M − or Qor .......................( 4.2)
Ppa Ppa

Equation (4.2) is called budget equation.

Assigning successive values to Qor ( M, Por and Ppa remain the same), we may find the corresponding
values of Qpa . Thus, if Qor = 0 (that is, if the consumer spends all her/his income on Patty), then the
consumer can buy M/Ppa units of Patty. Similarly, if Qpa = 0 ( that is, if the consumer spends all her/his
income on Orange), then the consumer can buy M/Por units of Orange. These results are shown in Figure
4.8 by Points A and B. If we join these points with a line, we obtain the budget line. Budget line is also
called as price line. In the above figure, AB is the budget line. Any point on or under the budget line
indicates the combination of Orange and Patty which is affordable to the consumer, but the points on the
north-east area of the budget line indicate such combinations which are out of the purchasing capacity of
the consumer. Thus the south-west area of the budget line is feasibility area and the north-east area of the
budget line is non-feasibility area. We can geometrically calculate the slope of the budget line as follows:

Point A: M/Por=12
12
Quantity of Orange

Budget line
9

3 Point B: M/Por=9

0 3 6 9 12
Quantity of Patty
Figure 4.8: Budget line (representing the data in table 4.1)

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So, we can draw the budget line easily if we know the prices of the commodities and the money income of
the consumer. Let's consider the prices and money income assumed in Table 4.6. We find:

Por = price of Orange = Tk.3.00

Ppa = price of Patty = Tk.4.00

M = Money income of the consumer = Tk.36.00

Therefore, M/Por = 36/3 = 12 units of Orange

M/Ppa = 36/4 = 9 units of Patty

These two results are shown in Figure 4.8 by Points A and B. If we join these points with a line, we obtain
the budget line, AB. Points on the budget line represents the combinations of Orange and Patty which can
be purchased with Tk.36.00. All the combinations in Table 4.6 fall on the budget line. Thus, without
plotting the data in Table 4.6 budget line can be derived if we have the information about the prices of the
OA M / Por Ppa
= =
OB M / Ppa Por
commodities and the money income of the consumer.

Properties of budget line

Budget line have the following basic properties:

Downsloping: Budget line is downward sloping, which implies that: the two commodities can be
substituted for each other; and if quantity of one commodity decreases, quantity of other commodity must
increase if the consumer has to spend all of her/his money income. Technically, the slope of the budget
line is the ratio of the prices of the commodities: Ppa /Por.

M
Por
Quantity of Orange

Budget line

M
Ppa
0 B
Quantity of Patty
Figure 4.9: Slope of the budget line: Ppa /Por< 0

Position of the budget line: Position of the budget line is determined by two types of data: the prices of
the commodities and consumer's disposable income.

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Income change: If the income of the consumer increases, the budget line shifts outward parallely. The
reason is simply that a, say, 33 per cent increase in available income, if entirely spent on two goods in
question, would permit the consumer to purchase exactly 33 per cent more of either commodities.
Conversely, if the income decreases by 33 per cent, then the consumer's purchase of either goods is
decreased by 33 per cent. In this case, the budget line shifts inward parallely. Figure 4.10 shows both the
cases.
Price change: If the price of one or both of the commodities is changed, the budget line will swing. To

16
14
Quantity of Orange

12
10
Income = Tk.48.00
8
6
Income = Tk.36.00
4
2 Income = Tk.24.00
0
3 6 9 12
Quantity of Pattis
Figure 4.10: The effect of income changes on the budget line
explain the nature of the swing we can consider the following cases:
Case-1: Price of only one commodity changes. If the price of only one commodity changes, one end of
the budget line swings away from the initial position. For example, in Figure 4.11(A), the initial position
of the budget line is indicated by the bold line. The initial prices of Orange and Patty are Tk.3.00 and
Tk.4.00 respectively. Now, if the price of Patty rises to Tk.4.00 while the price of Orange remains fixed,
the end of the budget line on the Patty axis (i.e., horizontal axis) swings toward the origin. This is shown

16 PPatty changes; POrange constant

Quantity of Orange

14
12
10
8 Price of Patty = Tk.3.00
6 Price of Patty = Tk.4.00
4
2 Price of Patty = Tk.6.00
0 3 6 9 12 15
Quantity of Patty
Figure 4.11(A): The effect of price changes on the budget line.
by the dotted line in Figure 4.11(A). But in the case of fall in the price of Patty (from Tk.4.00 to Tk.3.00),
the effect will be reverse. The right most budget line in Figure 4.11(A) shows that. Similarly, we can see
the effect of the changes in the price of Orange assuming that the price of Patty is fixed. Figure 4.11(A)
shows that.

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In Figure 4.11(B), The bold line indicates the initial position of the budget line, when the prices of Orange
and Patty are Tk.3.00 and Tk.4.00 respectively. If the price of Orange rises, the price of Patty remaining

18
16 POrange changes; PPatty constant
Quantity of Orange

14
12
10 Price of Orange = Tk.2.00
8
6 Price of Orange = Tk.3.00
4 Price of Orange = Tk.6.00
2
0 3 6 9 12 15
Quantity of Patty
Figure 4.11(B): The effect of price changes on the budget line
the same, the end of the budget line on the Orange axis (vertical axis) swings inward, which is shown by
the dotted line in Figure 4.11(B). But in the case of a fall in the price of Orange, the effect will be reverse,
i.e., the upper end of the budget line swings outward, which is shown by the right most line in Figure
4.11(B).
In conclusion, we can say that if the price of a particular commodity changes, the respective end of the
budget line swings. If price falls, it swings outward and if price rises, it swings outward.

Case-2: Price of both commodities change. If the prices of both commodities are changed
simultaneously, then it becomes more complex to discuss their effect on budget line. However, keeping
the effect of individual price changes on the budget line in mind, we can see how the budget line shifts or
rotates. If the prices change in opposite direction, the budget line rotate as in Figure 4.11(C). For example,
if the price of Orange falls and the price of Patty rises simultaneously, the budget line will rotate

18 Prices change in opposite direction

16
Quantity of Orange

14 Price of Orange = Tk.2.00

Price of Patty = Tk.6.00
12
10 Price of Orange = Tk.3.00
Price of Patty = Tk.4.00
8
6 Price of Orange = Tk.6.00
4 Price of Patty = Tk.3.00
2
0 3 6 9 12 15
Quantity of Patty
Figure 4.11(C): The effect of price changes on the budget line
clockwise, which is shown by the steepest line in Figure 4.11(C). On the other hand, if the price of Orange
rises and the price of Patty falls, then the budget line rotate anti-clockwise, which is shown by the dotted
line in Figure 4.11(C). The bold line in the figure indicates the initial position of the budget line.

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If the prices change in the same direction, the budget line shifts. Figure 4.11(D) shows it. For example, if

18 Prices change in opposite direction

16
Quantity of Orange

14 Price of Orange = Tk.2.00

Price of Patty = Tk.3.00
12
10 Price of Orange = Tk.3.00
8 Price of Patty = Tk.4.00
6 Price of Orange = Tk.6.00
4 Price of Patty = Tk.6.00
2
0 3 6 9 12 15
Quantity of Patty
Figure 4.11(D): The effect of price changes on the budget line
both prices fall, the budget line shifts outward (steepest line in the figure), while the rise in both prices
cause the budget line shift inward entirely (dotted line in the figure).
EQUILIBRIUM OF THE CONSUMER: BEST AFFORDABLE COMBINATION
We have learnt about indifference curves and the budget line in the previous sections. Now we will try to
discover the combination which lies on both the budget line and the highest attainable indifference curve.
To do this, we have to bring the budget line and the indifference curves together as in Figure 4.6.
In Figure 4.12, the budget line intersects the IC1 curve at Points M and N. It also touches the IC2 curve at

Ppa
12 = MRS pa ,or
Quantity of Orange

Por
M
9

6
4 E IC3
3 IC2
N
IC1
0 3 6 9 12 15
Quantity of Patty
Figure 4.12: Consumer's equilibrium: Best affordable combination
Point E. At all these three points, the consumer on her/his budget line, i.e., she/he can buy any of the
combinations indicated by these points. But what is the best affordable combination - the combination
which yields the consumer maximum satisfaction? Look at the Figure 4.12. Points M and N are on IC1
curve which indicates lower satisfaction, whereas Point E lies on IC2 which is the highest attainable
indifference curve. Thus, E is best affordable point to the consumer, i.e., E is the equilibrium point of the
consumer and the equilibrium combination of Orange and Patty is {4 units of Orange and 6 units of
Patty}. Therefore, the equilibrium of the consumer is achieved at the point where the budget line touches
an indifference curve, i.e., at the equilibrium point the slope of the budget line equals the slope of the
indifference curve. Any other points may be affordable to the consumer, but they lie on lower indifference
curves.

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SAMPLE QUESTIONS FOR REVIEW!!1!! !
1. What do you mean by consumer? What qualities/qualifications a consumer must have in
economics?
2. What is utility? What characteristics the term utility must have? What are the major approaches
in terms of the measurability of utility – Cardinal vs Ordinal utility?
3. Define Total Utility (TU) and Marginal Utility (MU). Explain their relationship. use graphs
and tables to explain the relationship/characteristics of TU and MU?.
4. Describe the law of diminishing marginal utility with its exceptions and assumptions. Identify
in the cases of which commodities the law of diminishing marginal utility works: Egg, Mango,
Ornaments, Money, juice, sweets, rice, Stamp.
5. What is the utility maximisation condition: ONE commodity case vs TWO commodity case?
6. What is consumer surplus? Explain with graphs.
7. Explain the paradox of value: Water-Diamond paradox. How the paradox can be solved?
8. What is a budget line? Suppose, a consumer wants to use Tk.1000 to consumer X and Y. If
PX=Tk. 10 and PY=Tk. 15, what will be the budget equation. Draw the budget line using these
information.
9. What is indifference curve? What is indifference map? Show in graphs.
10. How a consumer reaches his/her equilibrium in ordinal utility analysis. Use graphs.
11. Explain the price effect, substitution effcet and income effect of a change in the price of a
commodity.

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 12.

CHAPTER- 06(A):
Production
What do We Mean by Production?
In popular language, the term production is used to mean creation of a new commodity or a service. In
Economics, production means creation of new utility. The law of indestructibility of matters in physics
states that human beings cannot create or destroy matters. She/he can only change the shape of matters so
that these transformed matters satisfy human wants. In other words, a human being creates new utility by
rendering her/his services. Suppose a person gets a piece of wood, free of cost, from her/his friend. As
long as the piece of wood lies unused in his courtyard, it will not be a production activity. The person
hires a carpenter who puts her/his services on the piece of wood to change it to an item of furniture.
The carpenter creates new utility by changing the piece of the wood to the shape of a furniture item. Thus,
the carpenter produces a commodity which satisfies human wants. There are four factors of production -
land, labour, capital, and entrepreneur. The owners of land, labour, and capital and the entrepreneur get
rent, wages, interest income and profit respectively as their remunerations. The entrepreneur organizes the
production activities. She/he buys a piece of land, hires the workers and borrow the necessary capital from
the financial institutions for investing in her/his production firm. Her/his ultimate objective is to maximize
her/his profit which can be defined as the difference between total revenue and total cost. A production
firm generally consists of a few production plants; each production plant in turn consists of one
production unit with one big furnace, machinery and equipments. The collection of all firms producing
one commodity is called an industry. For example, the sugar industry in Bangladesh consists of all
production firms engaged in producing sugar.

What is Production Function?

A production function is a technical relationship between the inputs of production and output of the firm;
the relationship is such that the level of output depends on the levels of inputs used, not vice versa. A
production function is traditionally expressed by the following equation:
Q = f(K,L)
where,
Q = the level of output
f = the symbol of relationship, which is determined by the production engineers.
K = the amount of capital
L = the amount of labour

Types of Production Function

A production function may be a short run or a long run production function depending on the period of
time.
♦ Short-run Production Function
In a short run production function, at least one input of production cannot be changed. Short run
does not specify a specific period of time; it depends on the nature of the commodity in question. It
may be six months for one commodity and one year for another commodity, etc. The inputs of
production consist of raw materials that a particular firm buys to use in the production process and

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 the inputs may be the commodities produced by other firms. Mathematically, we can write the
short-run production function as follows:
(i) Q=AK0L0.8, (iv) Q=50L0.5, (v) Q=10L0.7, etc.
♦ Long-run Production Function
In a long run production function, all inputs of production can be changed. Mathematically, we can
write the short-run production function as follows:
(i) Q=AK0.5L, (ii) Q=AK0.6L0.4, (iii) Q=AKL0.7, etc.

THE SHORT-RUN PRODUCTION FUNCTION

In the case of short run production function, at least one input cannot be changed. For example, the firm
owner increases her/his production level by hiring more labour and by buying more raw materials if the
demand for her/his commodity increases in the short run. She/he cannot add a new production plant in the
short run, because it takes some time to erect a new building, to buy machinery and other fixed inputs in
the short run. Even if she/he can add another production unit, she/he would not do so, because the increase
in the demand for his commodity may be very much transitory. Whatever be the cause, some factors of
production would remain fixed in the short run. Symbolically, a short run production function can be
expressed as follows:
Q = f (K0, L). Where, K0 means fixed level of capital.
Suppose there are two factors of production, capital (K) and labour (L). Also assume that capital is fixed
in the short run. We are interested to examine how total, average, and marginal product curves would be
affected if we keep increasing the level of labour input. The following diagram shows the behaviour of
total, average, and marginal product curves in the short run.

A3
TPL
MPL A2
APL TPL
A1

APL
O L
L1 L2 L3
MPL
Figure 5.1: Total, average and marginal product curve in the short-run

In Figure 5.1, we measure productivity along the vertical axis, and quantity of labour along the horizontal
axis. The TP curve in the diagram shows how total product behaves if we increase the quantity of labour
keeping the quantity of other factors fixed in the short run. It is evident that total product increases at an
increasing rate initially. It starts increasing at a decreasing rate after point L1 along the horizontal axis and
after A1 along the TP curve. Total product becomes the maximum when OL3 amount of labour is used.
Then it starts diminishing. Marginal product increases as long as total product increases at an increasing
rate. Marginal product becomes the maximum at the inflection point where total product starts increasing

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at a decreasing rate. Marginal product becomes zero when total product is the maximum. Marginal
product remains negative as long as total product diminishes. Average product increases initially upto
point L2 along the horizontal axis and upto point A2 along the TP curve. It begins to fall after OL2 amount
of labour. It should be noted that average product can never be zero or negative.

Law of Variable Proportions

Depending on the nature of various product curves, the economists have divided the diagram in Figure 5.1
into three parts on the basis of quantity of labour used in the production process. These three regions are
O- L2, L2- L3, L3 - infinite. The first region is called the region of increasing returns, because marginal
productivity of the variable input increases here. The producer will not stop here. The second region, L2-
L3, is known as the region of diminishing returns, because marginal productivity diminishes in this
region. The entrepreneurs find that increased doses of labour applied to a fixed quantity of other inputs
result in decreasing amount of marginal products. Diminishing returns are frequently found in agricultural
production functions. The second stage is also called the economic stage, because the entrepreneur
produces at some point in this stage. The point of production, of course, depends on the prices of the two
inputs, the variable input and the fixed input. For example, the producer will produce at OL2 if the fixed
input is free but the variable input is not free. Similarly, the producer will produce at OL3 if the variable
input is free but the fixed input is not free. She/he will produce at some point in the second stage if both
the inputs are not free. The third stage is called the stage of negative returns. The producer will not
produce in this stage, because the marginal product of the variable input is negative here. In this case, the
producer can increase her/his total product by withdrawing labour from production process. Some
economists call this the stage of disguised unemployment. Labour used at this stage seems to be employed
but their employment decreases total output rather than increasing it. Total product in the short run is also
called returns to variable proportions. The ratio of variable input to fixed inputs changes when quantity of
variable input increases with the quantity of other factors remaining the same.

THE LONG RUN PRODUCTION FUNCTION

In a long run production function, all factors are variable. The factors, however, can be varied in two
ways. We can vary all factors of production proportionately so that the initial ratio of the two inputs
remains constant. Alternatively, the two inputs can be varied by changing the initial ratio between them.
Let us examine how total product changes when we increase all factors of production at the same rate.
Total product and the inputs may increase at the same rate. This is the case of constant returns to scale.
Total product may increase at a rate higher than the rate at which the inputs increase. This is the case of
increasing returns to scale. Finally, the rate of increment of total output may be less than the rate of
increment of inputs. That is the case of decreasing returns to scale. The following table illustrates the three
cases of returns to scale clearly.
Capital Labour Capital-labour ratio
Step K L K/L Total output
1 10 20 10/20 = ½ 100
2 20 40 20/40 = ½ 300
3 40 80 40/80 = ½ 600
4 80 160 80/160 = ½ 1000

It is evident from the table that we change all factors of production keeping the ratio of capital (K) to
labour (L) always equal to half. From step 1 to step 2, we double both the factors, capital and labour.
Total product however, becomes more than double. It is a case of increasing returns to scale. From step 2
to step 3, total output and the two inputs increase at the same rate - all double in step 3. We have constant
returns to scale here. From step 3 to step 4, total product becomes less than double though the inputs
double in step 4. The final case shows decreasing returns to scale. It should be noted that production
functions showing any kind of returns to scale are known as homogeneous production functions. We must

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use equal product curves in order to show returns to scale diagrammatically. At the end of this lesson
returns to scale will be shown by equal product curves.

Equal Product Curves and Budget Lines

Equal Product Curve
An equal product curve is the locus of different combinations of two inputs that can produce a give level
of output. It should be noted that an equal product curve is very much similar to an indifference curve. An
indifference curve consists of different combinations of two commodities. An indifference curve
represents the same level of satisfaction at all points on it; an equal product curve shows the same level of
output at all points on it. There is one difference between two: The given level of satisfaction cannot be
quantified in the case of indifference curve whereas the given level of output can be quantified in the case
of an equal product curve. The following figure shows an equal product curve.
In Figure 5.2, we measure quantity of capital (K) along the vertical axis and the quantity of labour (L)
along the horizontal axis. Q = 20 is an equal product curve showing the different combinations of two

K
Capital

K1 A1
K2 A2
EQ = 20
0 L1 L2 L
Labour
Figure 5.2: Equal product curve
inputs capable of producing 20 units of output. For example, both combination A1 with OK1 units of
capital and OL1 units of labour and combination A2 with OK2 units of capital and OL2 units of labour can
produce 20 units of output. The other points on Q = 20 are also capable of producing 20 units of output.
Characteristics of Equal Product Curve
Equal product curves possess characteristics similar to those of indifference curves. These are cited
below:
 Equal product curves are downward sloping;
 Equal product curves are convex to the origin;
 Two equal product curves cannot intersect each other; and
 A higher level of equal product curve indicates higher level of output.
Let's now discuss the concept of budget line in production analysis.

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Budget Line or Iso-Cost Line
A budget line in production analysis shows the different combinations of two inputs that a firm owner can
buy with a given amount of money and given prices of two inputs. Figure 5.3 shows a budget line with
capital measured along the vertical axis and labour along the horizontal axis.
The combination C with OK1 of capital of OL1 of labour costs as much as the combination D with OK2 of

K
Capital

K1 C

K2
D

0 L1 L2 L
Labour
Figure 5.3: Budget line or Iso-Cost Line
capital and OL2 of labour. All other points on the budget line cause the firm owner to spend the same
amount of money.

Least Cost Combination of Factors

The ultimate objective of a firm owner is to maximize her/his profit. This can be done in two steps. First,
the entrepreneur minimizes the cost of producing a given level of output. Second, she/he maximizes the
total revenue by selling her/his product. The following analysis explains how a producer minimizes the
cost of producing a given level of output when the prices of two inputs are given. Figure 5.4 illustrates the
minimization problem.
The producer wants to minimize the costs of prducing 20 units of output shown by the equal product
curve Q = 20. The producer can obtain 20 units of output by producing at points M,N, P and Q, because
these points are located on her/his equal product curve Q = 20. The producer, however, will not produce at
M, N, P and Q, because these points lie on higher budget lines. A higher budget line means higher level of
cost. Her/his cost of producing 20 units of output will be minimum at point E at which the budget line is
tangent with the equal product curve. At point E the entrepreneur uses the least cost

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 K
Capital

C M
A
N

K* E
Q
P EQ = 20
O L* B D L
Labour

Figure 5.4: Least-cost combination of factors

combination of K* units of capital and L* units of labour. Her/his minimum cost is given by the budget
line CD. She/he would like to go to budget line AB, but she/he cannot produce 20 units of output by going
to budget line AB. Thus, geometric condition for minimum cost is that at the least cost combination, the
equal product curve must be tangent with the budget line. We can formalize the necessary and sufficient
conditions for cost minimization as follows:
Necessary Condition:
PL/PK = MPL/MPK
Where,
PL = Price of labour input
PK = Price of capital input
MPL = Marginal productivity of labour
MPK = Marginal productivity of capital

Sufficient Condition:
At the least cost combination, the equal product curve must be convex to the origin.

Equal Product Curves and Returns to Scale

We can illustrate the concepts of returns to scale with the help of least cost combinations of factors.
Figure 5.5 explains three kinds of returns to scale.

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 We measure capital along the vertical axis and labour, along the horizontal axis. In Figure 5.5, we have
K

A4

A3
T

K4 A2 E4
Capital

Q4 =100

K3 E3
Q3 =75
A1
K2 E2
Q2 =50

K1 E1
Q1 =20
B1 B2 B3 B4
L
O L1 L2 L3 L4
Labour
Figure 5.5: Returns to scale
four budget lines A1B1, A2B2, A3B3 and A4B4 which result from increased budgets of the entrepreneur
with prices of two inputs remaining the same. We also notice four least cost combinations of factors in the
diagram. These are E1, E2, E3 and E4. By joining the least cost combinations, we get a curve like OT in
Figure 5.5. This curve is called the expansion path, because it shows the inputs utilization levels when an
entrepreneur wants to expand its production levels keeping the inputs ratio the same. It should be noted
that the expansion path is a straight line in the case of a homogeneous production function. It is evident
from Figure 5.5 that the following distances have the same length in the diagram.
OE1 = E1E2 = E2E3 = E3E4
This implies that if the producer doubles both the inputs, she/he comes to the least cost combination E2
from the earlier least cost combination E1. The level of output, however, more than doubles at E2 because
E2 is on the equal product curve Q2 showing 50 units of output. At E1, the producer used to produce 20
units of output. In other words, the movement from E1 to E2 shows increasing returns to scale if the two
inputs are doubled and as a result the increase in output is the same as the initial output, the situation is
called constant returns to scale. In Figure 5.5, movement form E2 to E3 indicates constant returns to scale
to the producer. Similarly, if the inputs are doubled and as a result the increase in total output is 1.5 times
of the initial output, the situation is called decreasing returns to scale, the movement from E3 to E4 in
Figure 5.5 indicated decreasing returns to scale.

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Laws of Returns
In the previous sections, we discussed the basic concepts and tools of analysis used in the exposition of
production theory. There we briefly explained the returns to variable proportions and the returns to scale.
The laws related to the returns to variable proportions and the returns to scale are called the laws of
returns. Now, we will discuss the laws in detail. There are two kinds of laws of returns:
Laws of returns
Law of variable proportions

Law of returns to scale

Increasing returns Increasing returns to scale

Constant returns Constant returns to scale

Diminishing returns Decreasing returns to scale

Let's discuss the laws of variable proportions first.

Law of Variable Proportions: Production With One Variable Factor

The laws of returns associated with 'one variable input' are called the Laws of Variable Proportions. It is a
short-run phenomenon.

In Lesson-1 of this unit, you learnt that Production is a function of both capital and labour. It is, however,
possible for a firm to increase production by holding capital constant and employing more and more of
labour. This is actually true in the short run, because the supply of capital is inelastic in the short-run.

When production is carried out with capital as a fixed factor and labour as a variable factor, or when more
and more of labour is used with a fixed amount of capital, capital-labour proportions change. The change
in factor proportions causes a change in output at a certain rate. The relationship between the changing
factor proportions and the output is generalised in the forms of certain laws of production which are called
the laws of variable proportions.
Main theme of the law
The law of variable proportions can be stated as follows:
If more and more of a variable input is applied to a fixed input, the total output initially increases at an
increasing rate, but beyond a certain level of output, it increases at a diminishing rate. More precisely, if
some factors are held constant and more and more units of a variable factor are employed, the marginal
product of the variable factor initially increases, then decreases and eventually turns negative.

Therefore, the law of variable proportions refers to three regions of production: increasing returns,
diminishing returns and negative returns. These are discussed below with a table and also with figure.

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Three regions of production
Table 5.1 presents the three regions of production. The regions of production are also shown by three
regions indicated in Figure 5.12. In Region-1, marginal productivity of labour (MPL) continues to increase
making total product (TPL) increase at an increasing rate. In region-2, MPL starts falling so that TP
increases at a decreasing rate. In Region-3, MPL becomes negative and TPL starts falling. The reasons for
increasing, diminishing and negative returns are given below.

Table 5.1: Increasing, diminishing and negative returns

No. of Total product Marginal product Average product

worker (TP) (MPL) (APL)
s (N) (tonnes) (tonnes) (tonnes) Region
TPn-TPn-1 TP/N
1 25 25 25
2 68 43 34 1
3 117 49 39
4 172 55 43
5 220 48 44
6 258 38 43
7 287 29 41 2
8 288 1 36
9 252 (-) 36 28
10 190 (-) 62 19 3

Region-1: Increasing returns

The increasing returns to one variable factor is depicted by the Region-1 of Figure 5.12. We see that the
portion of the TP curve in region-1 is growing at an increasing rate, i.e., the slope of the TP curve,
marginal product, in Region-1 is increasing. The reason is as follows:
Given the production technology, the size of the capital, the fixed factor, is given.

Region-1 Region-2 Region-3

Total, marginal and average product

300-
250-
TP
200-
150-
100-
50-
0
50-
100- APL
Labor
1 2 3 4 5 6 7 8 9 10 11 12
MPL

Figure 5.12: Total, marginal and average product curve

It is indivisible. Therefore, a certain minimum labour is required to make the optimum use of the capital.
If a smaller number of workers are used, capital remains underutilised. This under-utilisation of the fixed
factor, capital, causes the firm come out with returns at an increasing rate as it increases the employment

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of the variable factor, labour. Let us suppose that optimum capital-labour combination is 1:5. That is, one
unit of capital is optimally used with 5 workers. Under this condition, if less than 5 workers are employed,
the plant or machine would remain under-utilised. When more and more workers are added, utilisation of
machine increases and also the productivity of additional workers. Another reason for increase in labour
productivity is that, employment of additional workers leads to advantages of division of labour, until
optimum capital-labour combination is reached.

Region -2: Diminishing Returns

Once the optimum capital-labour ratio is reached employment of additional workers will amount to
substitution of capital with labour. But technically, one factor can substitute another only to a limited
extent. In other words, there is a limit to which one input can be substituted for another. That is, the
elasticity of substitution between inputs is not infinite. Hence, to replace the same amount of capital and
to achieve the labour productivity at the optimum level of capital-labour combination, more and more
workers will have to be employed. As a result, capital/labour ratio decreases. It means worker gets less
and less capital to work with. As a result, marginal productivity of labour decreases.

Region - 3: Negative Returns

The negative marginal return is only a theoretical possibility. As shown in Figure 5.12, Region-3 in
production begins when marginal productivity of labour turns negative. At this region, total production
begins to fall. The reasons for MPL becoming negative are both technical and managerial.
• Technical reasons: As mentioned earlier, employing more labour beyond the optimum capital-labour
combination means substituting another. In our case here, this limit is given by MPL = 0. Any addition
of labour beyond this limit leads to overcrowding, lower availability of tools and equipments which
causes fall in total production. Besides, use of more and more labour results in excessive exploitation
of capital. This reduces its contribution to production. For example, use of excessive labour on a piece
of land reduces its fertility. That is why, the law of diminishing returns is more applicable to
agriculture.
• Managerial reasons: Overcrowding gives labour an opportunity to shift work responsibility to others.
Instead of cooperating with each other, they come in each other' way. With excess labour, it becomes
increasingly difficult to fix accountability. Labour can therefore avoid the work.

The Laws of Returns to Scale

In the previous paragraphs, we discussed production with one variable input (labour), holding the other
input (capital) constant. Here we will discuss input-output relationships under the condition that all the
inputs (labour and capital) are proportionately and simultaneously changed. When all the inputs are
proportionately increased, the scale of production, the size of the firm increases. The laws that pertain to
the input-output relationships under the condtion of changing scale of prodution are called the Laws of
Returns of Scale. The laws of returns to scale are a long-term phenomenon.

In the long run, supplies of both labour and capital are elastic. Therefore, the firms can employ more of
both labour and capital to increase their production. In this section, the question that we will answer is:
how does total output behave when all the inputs are proportionately changed?

When all the inputs are proportionately increased, there are technically three possible ways in which total
output may increase. For example, if all the inputs are doubled, the resulting output may more than
double, double and grow less than double. This kind of output behaviour gives three kinds of returns to
scale as given below:

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 Initial input Initial Changed Changed Returns to scale
combination output input output
level combination
K+L 20 2K + 2L 50 Increasing returns to scale
K+L 20 2K + 2L 40 Constant returns to scale
K+L 20 2K + 2L 30 Decreasing returns to scale

• If increase in output is more than proportional to the increase in inputs, it means increasing return to
scale.
• If increase in output is proportional to increase in inputs, it gives constant returns to scale.
• If increase in output is less than proportional to the increase in inputs, it gives decreassing returns to
scale.

Increasing Returns to Scale

As stated above, the law of increasing returns to scale implies that output increases more than
proportionately to the increase in inputs. For example, when inputs increase by 50% output increases by
more than 50%; when inputs are increased by 100%; output increases by more than 100% and so on. This
kind of returns to change in scale is illustrated in Figure 5.13. Isoquants EQ1 and EQ2 represent two
different levels of production, 20 units, 50 units respectively. Product line OA show the relationship
between inputs and output. For instance, movement from point a to b denotes doubling the inputs, labour
and capital. As Figure 5.13 shows, input combination increases form K + L to 2K + 2L. The movement
from a to b also indicates increase in output from 20 units to 50 units. This means that when inputs are
doubled output has more than doubled. This reveals increasing returns to scale.

The Causes of Increasing Returns to Scale

The returns to scale increase because of Economics of Scale. There are at least three kinds of economies

A
Capital

→ Product line
b
2K

EQ2=50
a
K

EQ1=20
0 L
L 2L
Labour
Figure 5.13: Increasing returns to scale

of scale that make plausible reasons for increasing returns to scale.

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• Technical and Managerial Indivisibilities: Certain inputs, particularly mechanical equipments and
managerial skills, used in the process of production are available in a given size. Such inputs cannot
be divided into small sizes to suit the small scale of production. For example, half a tractor cannot be
used; one third of a water pump cannot be used. Similarly, half of a manager cannot be employed, if
part-time employment is not acceptable. Because of their indivisibility, such factors have to be
employed in a minimum quantity even if scale of production is much less than their capacity output.
Therefore, when scale of production is increased by increasing all inputs, the productivity of
indivisible factors increases exponentially. This results in increasing returns to scale.
• Higher Degree of Specialisation: Another factor causing increasing returns to scale is higher degree
of specialisation of both labour and machinery, which becomes possible with increase in scale of
production. The use of specialised labour and machinery increases productivity per unit of inputs.
Their cumulative effects contribute to the increasing returns to scale. Besides, managerial
specialisation contributes a great deal in increasing production.
• Dimensional Relations: Increasing returns to scale is also a matter of dimensional relations. For
example, when the size of a room (12' × 10' = 120 sq. ft.) is doubled to 24' × 20', the area of the room
is more than doubled, i.e., 24' × 20' = 480 sq. ft. When diameter of a pipe is doubled, the flow of water
is more than doubled. Following this dimensional relationship, when the labour and capital are
doubled, the output is more than doubled over some level of output.

Constant Returns to Scale

When change in output is proportional to the change in inputs, it shows constant returns to scale. Constant
returns to scale has been illustrated in Figure 5.14. The lines OA is product line indicating three
hypothetical techniques of production. The isoquants, EQ1= 20 and EQ2=40 indicate the two different
levels of output. In the figure, the movement from point a to b indicates doubling both the inputs. That is,
K increases to 2K and L increases to 2L. When inputs are doubled, output is also doubled, i.e., output
increases from 20 to 40.
This kind of relationship between inputs and output exhibits the constant returns to scale.

A
Capital

→ Product line
b
2K

EQ2=40
a
K

EQ1=20
0 L
L 2L
Labour
Figure 5.14: Constant returns to scale

The constant returns to scale are also attributable to the limits of the economies of scale. With the
expansion in the scale of production, economies arise from such factors as indivisibility of certain factors,
greater possibility of specialisation of capital and labour, use of labour-saving techniques of production,

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etc. But there is a limit to the economies of scale. When economies of scale disappear and diseconomies
are yet to begin, the returns to scale becomes constant. The diseconomies arise mainly because of
decreasing efficiency of management and scarcity of certain inputs.
The constant returns to scale are said to occur also in productive activities in which factors of production
are perfectly divisible.

Decreasing Returns of Scale

The firms are faced with decreasing returns to scale when a proportionate increase in inputs, K and L,
leads to a less than the proportional rise in the output. That is, when inputs are doubled, output is less than
doubled and so on. The decreasing returns to scale have been illustrated in Figure 5.15. As the Figure
shows, when inputs, K and L, are doubled, i.e., increased from K+L to 2K+2L, the output increases from
20 to 30 units, which is less than the proportionate increase. The movement from point a to b indicates
doubling both the inputs. But output is less than doubled.

A
Capital

→ Product line
b
2K

EQ2=30
a
K

EQ1=20
0 L
L 2L
Labour
Figure 5.15: Decreasing returns to scale

Causes of Decreasing Returns to Scale

The decreasing returns to scale are attributed to the following two things:
• Managerial diseconomies: The most important factor causing diminishing returns to scale is 'the
diminishing return to management', i.e., managerial diseconomies. As the size of the firm expands,
managerial efficiency decreases.
• Limitedness of the natural resources: Another factor responsible for decreasing returns to scale is the
limitedness or exhaustibility of the natural resources. For example, doubling of coal-mining plants
may not double the coal output because of limitedness of coal deposits or difficult accessibility to coal
deposits. Similarly, doubling the fishing fleet may not double the fish output because the availability
of fish may decrease when fishing is carried out on an increasing scale.

Comparison between the Law of Variable Proportions and Returns to Scale

The basic difference between the law of returns to a variable factor and the law of returns to scale lies in
the assumptions and conditions on which these laws are based.
• The law of returns to a variable factor allows only one input to vary, holding all other inputs constant,
whereas in the case of the law of returns to scale all the inputs are variable.

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 • The law of returns to a variable factor is a short run phenomenon, because, supply of capital in the
short run is inelastic. On the contrary, the law of returns to scale is a long run phenomenon,
because, supply of all the inputs in the long run is elastic and more and more of their quantities
can be employed.

SAMPLE QUESTIONS FOR REVIEW!!1!! !

1. What are the factors of production? Define wage, rent, interest and profit. Define input
and output.
2. Define Total product (TP), Marginal Product (MP) and Average product (AP).
3. Distinguish between short-run. Long-run and momentary run.
4. What the firm’s decision rules: Shutdown or produce? When profitable to produce?
5. What is production function? Define short-run and long-run production functions. Cobb-
Douglas production function.
6. Graphical form of short-run and long-run production functions. When does production
function shift?
7. Identify which of the following are the short-run and which ones are long-run production
functions: (i) Q=AK2L, (ii) Q=AK0.6L0.4 (iii) Q=AK0L0.8 (iv) Q=100L2
8. Describe the law of decreasing returns to variable proportions? How this law is different
from the law of decreasing returns to scale? Identify which of the following are
increasing, decreasing or constant returns to scale production functions: (i) Q=AKL2, (ii)
Q=AK0.5L0.4, (iii) Q=AK0.4L0.6, (iv) Q=50KL0.5.
9. Distinguish between economies of scale and diseconomies of scale.
10. Suppose, NM Ltd. is a chocolate producing firm. Its present level of output is 20 ton per
week. The total input cost for 20 ton chocolate is Tk. 200000.00. To meet high market
demand for its product, the firm planned to triple its level of production. If the firm’s
production function is Q=AK0.6L0.4, how much the inputs should be increased by the firm
to get the desired level of output and what additional input cost the firm will incur?

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11.

CHAPTER- 06(B):
COSTS
WHAT IS COST?
In economics, business, retail, and accounting, a cost is the value of money that has been used up to
produce something, and hence is not available for use anymore.

DIFFERENT CONCEPTS RELATED TO COST

IMPLICIT COST vs. EXPLICIT COST
An implicit cost occurs when one foregoes an alternative action but does not make an actual
payment. Implicit costs are related to forgone benefits of any single transaction. On the other
hand, an explicit cost is an easy accounted cost, such as wage, rent and materials. It can be
transacted in the form of money payment and is lost directly. For instance, the explicit cost of
going to a concert includes the concertgoer's ticket and cold drinks, but the implicit cost includes
the pay he would have earned if he had chosen to work instead.

IMPLICIT COSTS, EXPLICIT COSTS, AND TOTAL (ECONOMIC) COSTS

Impicit Cost + Explicit Cost = Total Cost. Implicit cost is NOT equal to total cost, but a
component of it. A simple example: Paul builds a cabinet. He spends 2 hours building the
cabinet. He could have been working instead and normally makes $25/hour at his job. Since he
was building a cabinet he wasn't paid for this time. The materials to make the cabinet cost him
$20.
• His Explicit Costs are: $20 in materials
• His Implicit Costs are: $25/hr x 2 hrs= $50 of foregone pay
• His Total Costs are: $20 in materials + $50 of foregone pay = $70 Total Costs

ACCOUNTING vs. ECONOMIC COSTS

Accounting costs are the monetary value of expenditures for supplies, services, labor, products,
equipment and other items purchased for use by a business or other accounting entity. It is the amount
denoted on invoices as the price and recorded in bookkeeping records as an expense or asset cost basis.
These type of costs are same as the explicit costs.

Economic cost, also referred to as opportunity cost is the value of the best alternative that was not chosen
in order to pursue the current endeavour—i.e., what could have been accomplished with the resources
expended in the undertaking. It represents opportunities forgone. This type of cost includes the
opportunity costs of all resources that are being used currently.

SUNK COSTS
In economics and business decision-making, sunk costs are costs that cannot be recovered once they have
been incurred. For example, when one pre-orders a non-refundable and non-transferable movie ticket, the
price of the ticket becomes a sunk cost. Even if the ticket-buyer decides that he would rather not go to the
movie, there is no way to get back the money he originally paid. Therefore, the sunk cost of the ticket
should have no bearing on the decision of whether or not to actually go to the movie.

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DIFFERENT MEASURES OF COST
There are various measures of cost. For example, Total cost (TC), Average Cost (AC), Total Fixed Cost
(TFC), Totl Variable Cost (TVC), Marginal Cost (MC).
Total fixed cost (TFC) is the sum of the spending on the fixed inputs. TFC is the sum of the fixed costs
(both explicit and implicit) incurred by an entrepreneur. Total variable cost (TVC) is the sum of the
amounts spent for each of the variable inputs used. Variable inputs give rise to variable cost. The
entrepreneur has to increase the usage of the variable inputs if she/he wants to increase her/his output
level. As a result, TVC increases when output level increases. If there is zero output, no units of the
variable input need to be employed. If we add up the TFC with TVC, we get total cost (TC). It is shown
by the following equation: TC = TFC + TVC
Average cost(AC) is the cost for per unit of the output produced or to be produced. We can get AC by
dividing TC by quantity produced (Q), i.e., AC=TC/Q. As TC=TFC + TVC, we can write AC as the sum
of AFC and AVC too.
PROOF
AC= TC/Q = (TFC + TVC)/Q
= TFC/Q + TVC/Q
= AFC + AVC
Marginal Cost(MC) is the cost incurred for producing an additional unit of a product. That means, the
change in the total cost due the increase in the total output by one unit is marginal cost. We can get MC by
the following formulae: MC=∆TC/∆Q. MC can also be defined as the change in total variable cost due top
an increase in the total output by one unit. That means, MC=∆TVC/∆Q
PROOF
MC= ∆TC/∆Q = ∆ (TFC + TVC)/ ∆Q
= ∆TFC + ∆TVC)/ ∆Q
= ∆TFC/∆Q + ∆TVC/∆Q
= 0/∆Q + ∆TVC/∆Q = ∆TVC/∆Q

PROBLEM
From the data given below, calculate total variable cost (TVC), marginal cost (MC), average
cost (AC), average fixed cost (AFC) and average variable cost (AVC):

Quantity Total Total Total Marginal Average Average Average

(Units) cost Fixed cost Variable cost cost Fixed cost Variable Cost
Q (TC) (TFC) cost (TVC) (MC) (AC) (AFC) (AVC)
1 1000 500
2 1400 500
3 1575 500
4 1600 500
5 2200 500

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NATURE OF THE COST: SHORT-RUN COST vs. LONG-RUN COST
A firm owner has to incur costs when she/he undertakes production activities. She/he has to pay rent to
the landowner, wages to the labour, and interest to the owner of capital. In other words, she/he has to buy
her/his raw materials to be used in the production process. The nature of cost of production depends on
two things, viz., (a) the physical conditions of production and the input prices and (b) the period of time.

WHAT IS SHORT-RUN COST?

In the production analysis, we defined short run as a period of time in which certain types of inputs cannot
be changed regardless of the level of output. At least one input must be fixed in the short run. The usage
of the variable inputs, however, can be changed in the short run. The amount of money spent for fixed
inputs are short-run fixed cost. The various fixed inputs have unit prices. The fixed explicit cost is simply
the sum of unit prices multiplied by the fixed number of units used. In the short run, implicit costs are also
fixed. Thus, it is an element of fixed cost. Total fixed cost (TFC) is the sum of the short-run explicit fixed
cost and the implicit cost incurred by an entrepreneur. Variable inputs in the short run give rise to variable
cost. The entrepreneur has to increase the usage of the variable inputs if she/he wants to increase her/his
output level in the short run. As a result, total variable cost (TVC) increases when output level increases.
If there is zero output, no units of the variable input need to be employed. Variable cost is zero and total
cost is equal to fixed cost at the zero level of output. Total variable cost (TVC) is the sum of the amounts
spent for each of the variable inputs used. The short-run total cost (STC) is the sum of total variable cost
and total fixed cost. It is shown by the following equation:
STC = TFC + TVC

SHORT-RUN COST CURVES

In Figure 5.1, we measure output level along the horizontal axis and different types of cost along the
vertical axis. The horizontal line marked TFC shows that total fixed cost does not depend on the level of
output; it is fixed at all levels of output. The curve STC shows how short-run total cost increases with the
level of output. The gap between short-run total cost (STC) and total fixed cost (TFC) measures the total
variable cost (TVC) of production. It can easily be seen from the figure that both STC and TVC increase
STC
STC, TFC,TVC

D
A
B C TVC

E
TFC

Q
O Q1
Output
Figure 5.1. Different types of short-run cost curves

at a decreasing rate initially when output level increases, and then both increase at an increasing rate. It
should be noted here that the shape of STC derives from the shape of the short-run total product curve; the

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shape of STC is just the opposite of the shape of the short-run total product curve. We know that the
short-run total product curve increases at an increasing rate and then it increases at a decreasing rate.
If we divide short-run total cost (STC), total variable cost (TVC), and total fixed cost (TFC) by the level
of output, we obtain short-run average total cost SATC, short-run average variable cost (SAVC) and short
run average fixed cost (SAFC) respectively. The relations are shown below:

SATC = STC/Q
SAVC = TVC/Q
SAFC = TFC/Q
SATC = STC/Q = (TVC+TFC)/Q = TVC/Q + TFC/Q = SAVC + SAFC

Short-run marginal cost is defined as the change in short-run total cost due to one unit change in output.
SMC = ∆STC/∆ Q = ∆TVC/∆Q

Alternatively, the average cost curves can be derived geometrically from the STC and TFC curves. First,
we find the values of SAC, SAVC, SAFC, and SMC at a particular level of output like Q1 along the
horizontal axis. Then we find these values at all levels of output. Finally, by plotting these values, we get
the different types of average cost curves. For example, we are interested in finding the values of SAC,
SAVC, SAFC, and SMC at output level Q1 in Figure 5.6. SATC at Q1 is found by dividing total cost,
Q1A, by the level of output, Q1. SAFC is equal to total fixed cost, Q1 E, divided by the level of output, Q1.
Finally, SMC is calculated as the value of the slope of the tangent at point A, which is equal to DC
divided by BC.

Nature of Short-run Average Cost Curves

Short-run average total cost SATC is the sum of short-run average fixed cost (SAFC) and short-run
average variable cost (SAVC).
SATC = SAFC + SAVC
SAFC declines continuously when the level of output increases, because the quotient TFC/Q falls
continuously with increasing units of output. SAFC is a rectangular hyperbola approaching both axes
asymptotically. SAVC is normally U-shaped, falling initially as output level increases. It reaches a
minimum value at a certain level of output and starts rising after that.

Why is Short-run Average Variable Cost Curve (SAVC) U-shaped?

There are two explanations for the U-shape of SAVC:
First, SAVC is related to average productivity of the variable input in the short run. We know that SAVC
is equal to TVC divided by Q:
SAVC = TVC/Q
But TVC is nothing but the of product price of the variable input and quantity of the variable input.
Assuming labour to be our variable input, we can write SAVC as follows:
SAVC = TVC/Q = PLL/Q = PL/(Q/L) = PL/APL
Where,
PL = Price of labour
L = Quantity of labour
Q = Output level
APL = Q/L = Average productivity of labour

SAVC is found to be the reciprocal of average productivity of labour if we assume that price of labour
does not depend on the level of employment. We know that the average productivity curve is inverted U-
shaped in the short run. Hence the SAVC curve is U-shaped in the short run.

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Second, in the short run certain inputs are fixed. Each fixed input needs a certain number of labour force
for its optimum utilization. We assume that the number of labour force applied to each fixed input in the
short run increases gradually starting from zero. Initially, a small number of labour input is applied to the
fixed input. Average productivity is, therefore, low and short run average variable cost is high at the initial
stage. Average productivity of labour starts rising as the number of labour input increases. As a result,
SAVC starts falling. As the number of variable input, labour, keeps increasing, average productivity of
labour becomes maximum when the fixed inputs are put to optimum their utilization. Corresponding to
this point of labour employment, SAVC becomes the minimum. If we increase the number of labour force
beyond the optimum utilization point, average and marginal productivity of labour start falling due to
mismanagement and chaotic conditions prevailing in the firm. Consequently, SAVC starts rising after the
optimum utilization points of the fixed inputs. This ends the explanation of the U-shape of SAVC.

Why is Short-run Average Total Cost Curve (SATC) U-shaped?

The shape of short run average total cost SATC curve depends on the shapes of SAFC and SAVC.
Initially SATC falls because both SAFC and SAVC fall initially. SATC continues to fall even when
SAVC starts rising after its minimum point. This happens, because the rate of fall of SAFC is greater than
the rate of rise of SAVC. After some units of output, the rate of rise of SAVC becomes greater than the
rate of fall of SAFC. From that point, rise in SAVC offsets the fall in SAFC. As a result, SATC starts
rising with the increase in the level of output.
The preceding discussion explains why SATC is also U-shaped. Like SATC, short-run marginal cost
(SMC) curve is also U-shaped. SMC derives its shape from the shape of short-run marginal productivity
curve. The following equation shows how SMC and marginal productivity (MPL) are related to each
other.
SMC = ∆STC/∆ Q = ∆(L.PL)/∆Q = PL/(∆Q/∆L) = PL/MPL
If we assume PL to be fixed regardless of the level of employment, we find SMC to be the reciprocal of
MPL. Since MPL curve is inverted U-shaped, SMC curve will be U-shaped.

Now let's explain how short-run marginal cost (SMC) curve is related to SAFC, SAVC and SATC curves.

RELATIONSHIP BETWEEV SHORT-RUN AVERAGE COST AND MARGINAL COST

CURVES
It should be noted that SMC has no relationship with TFC and hence with SAFC. SMC is less than SAVC
as long as SAVC continues to fall in the initial stage. SMC equals SAVC at the minimum point of SAVC.
SMC is greater than SAVC as long as SAVC continues to rise. Similar relationship holds between SMC
and SATC. SMC is less than SATC as long as SATC decreases, the two become equal at the minimum
point of SATC and SMC remains greater than SATC as long as SATC increases. Figure 5.2 shows the
different types of short-run average cost curves.
SMC SMC
SATC SATC
SAVC
SAFC SAVC

SAFC
Q
O Q1 Q2 Q3
Figure 5.2: Short-run average cost curves Page-82
In the Figure 5.2, we measure different types of costs along the vertical axis and the level of output along
the horizontal axis. It is evident from the Figure 5.2 that SAFC declines continuously and becomes
asymptotic to the horizontal axis as the level of output increases. SAFC is also measured by the gap
between SATC and SAVC. The gap is very large initially and narrows down as SAVC becomes
asymptotic to SATC as Q increases. SAVC declines initially and becomes minimum at Q2 level of output.
It begins to rise after Q2. The SATC curve falls initially to its minimum at output level Q3, and it starts
rising after that. Both the SATC and SAVC curves are U-shaped for reasons discussed earlier, The SMC
curve is also U-shaped, falling initially to Q1 level of output and then starts rising. The SMC curve cuts
the SAVC and SAC curves at their minimum points corresponding to Q2 and Q3 levels of output,
respectively.

WHAT IS LONG-RUN COST?

In the long run, all inputs can be varied to obtain the minimum cost of production. The firm can increase
its output level by changing production plants in the long run. There is no fixed input and hence no fixed
cost in the long run. Hence the long-run total cost curve starts from the origin indicating that total cost is
zero when output is zero.

Derivation of Long-run Cost Curves

Moreover, it can be shown that the long-run total cost curve is an envelope of the short-run total cost
curves, the firm owner faces a new short run total cost (STC) curve when she/he changes production
plant, she/he can reduce total cost of production by changing production plants and STCs.
STC LTC LTC
STC3 STC2 STC1
U
T2
S

T1
Q Q
O Q1 Q2 O
Figure 5.3 Figure 5.4

In Figure 5.3, we showed three STC curves for three plants. If the entrepreneur wants to produce Q1 level
of output, she/he can use one of the three production plants. Her/his total cost of production is Q1U with
plant-1, Q1 S with plant-2 and Q1 T with plant-3 her/his minimum total cost is Q1T1 with plant-3. By
joining minimum cost points like T1 and T2, we obtain the long-run total cost curve (LTC) which starts
from the origin as shown in Figure 5.4. Like STC, LTC also increases at a decreasing rate initially and
then it increases at an increasing rate.

Derivation of Long-Run Average and Marginal Cost Curves

It can be shown that long-run average cost (LAC) curve is also an envelope of short-run average cost
(SAC) curves. It is true, because, the producer can lower the average cost of
production by changing production plants in the long run. Figure-5 shows the derivation of LAC from a
number of SATC curves.

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 SMC3 SMC5
SAC SMC1 SATC5
E6
SMC SATC1
E11 LAC
LAC SMC2
E1 E2 SMC4
SATC2 SATC4 E7
E8 SATC3 E10
E3
E9 E4 E5

Q
0 Q1 Q2 Q3 Q4 Q5
Figure 5.5: Derivation of long-run average cost curve (LAC)
In Figure 5.5, we measure short-run costs along the vertical axis and level of output along the horizontal
axis. In this diagram, we show five short-run average total cost (SATC) curves, each representing one
production plant. The SATC curves have been numbered according to the number of production plants,
Suppose the producer produces Q1 level of output with production plant-1. The producer wants to increase
his production level to Q2, which he can produce using his old plant-1 or using the new plant-2. Her/his
average cost of production is Q2E2 in plant-1 and Q2E3 in plant-2. Her/his will use plant-2 since his
overage cost of producing Q2 level of output is lower in plant-2 (Q2E3 <Q2E2). Similarly, she/he will
produce Q3 level of output using plant-3. Her/his average cost of production of Q4 level of output will be
lower if she/he uses plant-4 instead using plant-3 (Q4E5 <Q4E6). She/he will use plant-5 for producing Q5
level of output. By joining the points of minimum average cost like E1, E3, E4, E5 and E7, we get the long-
run average cost (LAC) curve. It is easily seen that the long-run average cost of production will be
minimum if the producer produces Q3 level of output using plant-3. The plant giving rise to long-run
minimum average cost is known as the optimum plant, which is plant-3 in Figure 5.10. We also
notice that LAC is tangent to the SATC curves in their falling portions to the left of the optimum plant.
LAC is tangent to the SATC curves in their rising portions to the right of the optimum plant. At the long
run minimum cost level of output Q3, the LAC curve is tangent to the SATC curve at its minimum point.
It should be noted here that like SATC, LAC curve is also U-shaped, though it is flatter than the
SATC curve. Unlike the LAC curve, the long-run marginal cost curve is not the envelope of the short-run
marginal cost (SMC) curves. We know that there is a short-run marginal cost curve corresponding to each
short-run average cost curve. We find the short-run marginal cost of each level of output produced in the
long run. We obtain the long run marginal cost (LMC) curve by joining the points showing short-run
marginal cost of producing the different levels of output in the long run. For example, the short-run
marginal cost is Q1E8 for Q1, Q2E9 for Q2, Q3E1 for Q3, Q4E10 for Q4 and Q2E11 for Q5 level of output. We
obtain the LMC curve by joining the points like E8, E9,E4, E10 and E11. In Figure 5.6, we show both the
LAC and LMC curves derived in Figure 5.5.

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 LAC
LMC
LMC

LAC

0 Q
Q3

Figure 5.6: Long-run average and marginal cost curves

We observe that LMC is less than LAC as long as LAC continues to fall. LMC is equal to LAC at the
minimum point of LAC curve LMC is greater than LAC as long as LAC continues to rise.

SAMPLE QUESTIONS FOR REVIEW!!1!! !

1. Identify TVC, MC, AC, AFC, AVC from the following data:
Quantity (Q) → 1 2 3 4 5
Total Cost (TC) 150 190 207 210 300
Fixed Cost (FC) 50 50 50 50 50
2. Explain the relationship between Average cost and Marginal cost.
3. Define explicit costs, implicit/hidden/opportunity costs, accounting cost and economic cost.
4. Identify the above types of costs from real life examples
5. Define Total revenue (TR), Marginal revenue (MR) and Average revenue (AR).
6. Suppose the cost function is: C = 420 + 60Q + Q2.. Find MC, FC, AC, AVC, AFC, etc.

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