106 –

Managerial
Economics
3. Supply & Market Equilibrium

Introduction
Meaning of Supply
Law of Supply
Exceptions to the Law of Supply
Changes or Shifts in Supply
Elasticity of supply
Factors determining Elasticity of Supply
Market Equilibrium and Changes in Market Equilibrium
Production Analysis: in brief
 Supply is the specific quantity of
output that the producers are willing
and able to make available to
consumers at a particular price over a
Meaning of given period.
Supply Supply is a relative term; it is always
referred to in relation to price and
time.
 Price of the Product X

Cost of Production

The state of technology

Determinants Number of firms

of Supply The factors outside the economic sphere i.e. Natural

Calamities
Expectations of Future Prices

Govt. Regulations, Tax and Subsidy

Law of Supply

• According to the law of supply, if all

the other factors remain constant,
then a rise in the price of a particular
product in a market will increase the
supply of the product.
Assumptions of the law of supply
• The price of factors of production remain constant.
• Prices of related goods remain unchanged.
• No expectation of change in price in near future
• The technology remains unchanged.
• The no. of producers remain same.
• No change in Govt. policy in relation to payment of taxes and
subsidies.
Changes or Shifts in Supply
 Unpredictable Natural Events

Supply Constraints

Exceptions Supplier's Expectations

to the Law Monopoly and Oligopoly Market

of Supply High Competition

Perishable/ Agri Products

Rare/ Precious Products

 Elasticity of Supply measures how
responsive the quantity supplied of a
good or service is to a change in its price.

Elasticity of It reflects the extent to which producers

can adjust their production and supply
Supply in response to price changes.

helps to understand how flexible

producers are in meeting changes in
demand and pricing conditions.
 Nature of the Nature of
Industry Inputs

Factors Ability to
Time Period
Store Stocks
determining
Elasticity of Capacity
Mobility of
Factors of
Supply Utilization
Production

Production
Lag
Elasticity of supply
Use of Elasticity of Supply in
Managerial Decision making

• Determining prices of
product
• Factor pricing
• Taxation
Market Equilibrium and Changes in Market
Equilibrium
• If the buyer wanted to buy for $1 and the seller wanted to sell the
candy bar for $5, nothing would happen.
• But, if they could come to an agreement, a sale would be made.
• In economics, we call this the equilibrium.
Caselet
• TATA Motors an influential force in the Indian automotive sector, launched the
Tata Nano, branding it as the world’s cheapest car to make car ownership
feasible for every Indian family. This initiative was viewed as a groundbreaking
step in automotive marketing, aiming to transform the industry landscape.

Challenges

• The Tata Nano encountered several obstacles, notably issues with public
perception concerning its safety and quality due to the low cost and logistical
challenges in its distribution and manufacturing processes.
Solutions Implemented: Tata Motors deployed several innovative solutions to
address these issues:

• Innovative manufacturing solutions: They refined production processes to

minimize costs while maintaining quality standards.

• Strategic pricing: The low pricing was central to attracting families who
previously could only afford two-wheelers.

• Robust safety campaigns: In response to concerns about quality, Tata

Motors initiated campaigns highlighting the Nano’s safety and reliability
features.
Business Outcome

• Though Tata Nano initially captured global attention and sparked interest, its
long-term success was mixed. It became a seminal case study on the
complexities of consumer perception and the market’s readiness for radically
priced products.

• This experience gave Tata Motors important insights into market research and
consumer expectations, shaping their future strategies.
Q.1 with reference to above case discuss various determinants of demand.

Q.2 Is Law of Demand applicable in this case

Q.3 what went wrong with TATA NANO with demand analysis.

Q.4 suggest demand analysis strategy for launch of a luxury car in the price
range of 35-30 lakh.

Q.5 Discuss the role of market research in the Tata Nano’s product lifecycle.
How could better understanding of consumer expectations and market
readiness have altered the outcome?
Production
Analysis: in brief
Production

• Production means a process by

which the resources (Land, Labor,
Capital etc.) are transferred into a
better commodity or services.
• Ex. Steel from iron ore
• Production is processes that
create/add value or utility.
Production function – Relation between inputs and outputs.
How much the output will be increased when we are
increasing the inputs.

This relationship can be shown in functional form as

Q = f (L,M,N,K,T)
Where,
Q = Quantity of Output
L = Labour
M = Management
K = Capital
N = Natural Resources (Land)
T = Technology
Q is a dependent variable
Other factors are Independent Factors
• The short-run refers to a period of time in which the supply of
certain inputs (e.g., plant, building, machinery, etc.) is fixed or is
inelastic and are used in a fixed quantity.
• Long-run refers to a period of time in which the supply of all the
inputs is elastic.
Types of production function:
• These two types of relationships have been explained in the form
of laws.
i) Law of variable proportions ( short run production function)
ii) Law of returns to scale ( long run production function)
Law of Variable Proportions –
• Law of variable propositions explains the pattern of output in the short-run as
the units of variable inputs are increased to increase the output.
• The law states that if we increase the quantity of only one input keeping other
inputs fixed, TP initially increases at increasing rate then at decreasing rate
and finally at a negative rate.
• It can be summed up in 3 phases:
1. When TP rises at increasing rate, MP increases
2. When TP rises at decreasing rate, MP starts falling
3. When TP falls, MP becomes Negative
Assumptions of the Law:
• The state of technology remains constant. If there is any
improvement in technology, the average and marginal output will
not decrease but increase.
• Only one factor of input is made variable and other factors are
kept constant. This law does not apply to those cases where the
factors must be used in rigidly fixed proportions.
• All units of the variable factors are homogenous.
Phases Machine Labor Total Marginal
Product Product TP = Total Product
1 1 10 10 Increasing Total amount of output
1 2 30 20 Returns to produced by all variable
Phase I Factor inputs in combination with
(Spread of fixed inputs
Fixed Costs)
1 3 45 15 Diminishing Marginal Product =
Returns to Additional Product
Phase II 1 4 52 7
Factor
1 5 52 0 Assumption = There are
1 6 48 -4 Negative only 2 factors. I.e. Machine
Phase III Returns to (Fixed) and Labor (Variable)
Factor

Law of Variable Proportions – Short

Run Production Function
Law of
Variable
Proportions –
Graph
Law of Returns to Scale -
Long Run Production
Function

• Law of returns to scale explains the

pattern of output in the long run as
all the units of inputs are increased
• Changes in output when all factors
change in the same proportion are
referred to as the law of return to
scale.
• This law applies only in the long run
when no factor is fixed, and all
factors are increased in the same
proportion to boost production.
Law of Returns to Scale

• the Law of returns to scale explains how a simultaneous and proportionate

increase in all the inputs affects the total output at its various levels.
• When a firm expands, its scale increases all its inputs proportionally, then
technically there are three possibilities.
(i) The total output may increase proportionately
(ii) The total output may increase more than proportionately
(iii) The total output may increase less than proportionately.
Phases of Law of Returns to Scale

Stage Name Behaviour Reasons

I Increasing RTS % Change in O/P is greater than % Specialisation
change in I/P Division of Labor
1L+1K = 100Q Cost Benefits
2L+2K = 300Q Expansion in firm
(Economies of Scale)
II Constant RTS % Change in O/P is equal Economies of Scale + Diseconomies
to % change in I/P of Scale
1L+1K = 100Q
2L+2K = 200Q
III Decreasing RTS % Change in O/P is less than Diseconomies of Scale > Economies
% change in I/P of Scale
1L+1K = 100Q
2L+2K = 120Q
Law of Returns to Scale - Graph
Isoquant

• The term Isoquants is derived from the words ‘iso’ and ‘quant’ – ‘Iso’
means equal and ‘quant’ implies quantity. Isoquant therefore, means
equal quantity.
• isoquants or iso- product curves are similar to indifference curves of the
theory of demand.
• Isoquants curves represent the different combinations of inputs
producing a particular quantity of output. Any combination on the
Isoquant represents the some level of output.
Isoquant
Q= f (L, K)
Where ‘Q’, is the units of output is a function of the quantity of two
inputs ‘L’ and ‘K’.

Thus an Isoquant shows all possible combinations of two inputs,

which are capable of producing equal or a given level of output.
Since each combination yields same output, the producer
becomes indifferent towards these combinations.
 • Production function of the linear
Cobb-Douglas homogenous type is invented by Junt wicksell
and first tested by C. W. Cobb and P. H.
production Dougles in 1928. This famous statistical
production function is known as
function: CobbDouglas production function.
The production function shows that one percent change in labour input, capital
remaining the same, is associated with a 0.75 percent change in output.
Similarly, one percent change in capital, labour remaining the same, is
associated with a 0.25 percent change in output.

The co efficient of determination R2 means that 94 percent of the variations on

the dependent variable (p) were accounted for by the variations in the
independent variables (L and c).
Economies of
Scale
• When a firm expands its size of production by
increasing all the factors, it secures certain
advantages known as economies of production.
• Marshall has classified these economies of
large-scale production into internal economies
and external economies.
• Internal economies are those, which are opened to a single
factory or a single firm independently of the action of other firms.
• Internal economies are generally caused by two factors
1. Indivisibilities 2. Specialization
• as output increases the indivisible factors which were being used
below capacity can be utilized to their full capacity thereby
reducing costs. Such indivisibilities arise in the case of labour,
machines, marketing, finance and research
• specialization will lead to greater productive efficiency and to
reduction in costs.
Internal Economies:

• Technical Economies
• Managerial Economies
• Marketing Economies
• Financial Economies
• Risk bearing Economies
• Economies of Research
• Economies of staff welfare
External Economies:

• External economies are those benefits, which are shared

in by a number of firms or industries when the scale of
production in an industry or groups of industries
increases.
External Economies:
• Economies of Concentration
• Economies of Information
• Economies of Welfare
• Economies of Disintegration
DISECONOMIES OF LARGE SCALE PRODUCTION

Internal Diseconomies:
• Financial Diseconomies
• Managerial diseconomies
• Marketing Diseconomies
• Technical Diseconomies
• Diseconomies of Risk-taking
External Diseconomies:
• costs of transportation increases due to congestion.
• considerable delays in getting raw materials and sending finished
products to the marketing centers.
• The localization of industries may lead to scarcity of raw material,
shortage of various factors of production like labour and capital,
shortage of power, finance and equipments.
 Case Scenario: Mother
Dairy's Supply Decision
• Mother Dairy, a prominent Indian
dairy brand, supplies fresh milk to
consumers daily. Since milk is
perishable, the company faces
unique supply decision challenges. It
needs to balance production and
supply with fluctuating demand,
keeping in mind that any surplus
could result in wastage, while a
shortage could lead to unmet
demand and loss of customer trust.
Several factors complicate this decision:

1.Demand Variability: Demand for milk can vary due to seasonal factors
(increased demand during festivals) or unexpected factors (e.g., rising
health awareness, market competition).
2.Perishability: Milk has a short shelf life, requiring rapid distribution
and consumption to avoid spoilage.
3.Supply Chain Constraints: Dairy farmers are the primary suppliers,
and factors like animal feed costs, weather, and transportation can
impact milk supply.
4.Pricing Pressure: Mother Dairy must keep prices competitive to retain
customers but also cover costs associated with perishability and
supply chain risks.
• What key factors
should Mother Dairy
consider in its
supply decision?
Case: AlphaTech Manufacturing
Background:

AlphaTech is a mid-sized electronics manufacturer specializing in high-quality smartphones

and tablets. The company has observed a steady increase in demand, but its production
processes need improvement to meet growing market expectations. The management is
evaluating ways to increase output while keeping costs under control. The company is also
considering automation to improve efficiency.

Production Details:

AlphaTech has two main production inputs: labor and machinery.

The production function follows diminishing returns, meaning each additional unit of labor or
machinery adds less output than the previous unit.

The company currently operates at 80% capacity utilization.

Cost Structure:
Fixed costs include rent, machinery maintenance, and administration costs.
Variable costs primarily consist of labor and materials.

AlphaTech’s current production capacity is 10,000 units per month.

The cost per unit reduces when production levels are higher due to economies of scale.

Challenge:
AlphaTech’s management needs to determine the optimal production level to maximize
profit. Additionally, they are evaluating the potential benefits of investing in automation,
which could reduce labor costs in the long run but requires significant upfront capital
investment.
• What production function best represents AlphaTech’s manufacturing process?
Explain your reasoning with respect to the law of diminishing returns.
• How should AlphaTech analyze its short-run and long-run production decisions,
especially regarding labor and machinery?
• If AlphaTech invests in automation, how might this impact its cost structure in both
the short run and long run?
• Describe the concept of economies of scale and how it could apply to AlphaTech’s
situation.
• What factors should AlphaTech consider when deciding whether to reach full
capacity utilization or invest in new production technology?
• What factors should AlphaTech consider when deciding whether to reach full
capacity utilization or invest in new production technology?
• If demand increases significantly, should AlphaTech consider expanding production
capacity, and why?