MANAGERIAL

ECONOMICS

IBS-GURGAON
2018
 Learning Objectives

At the end of this lecture you will be able to-

 Appreciate the importance of studying Economics

 Understand the concept of Scarcity and Efficiency

 Differentiate between different branches of Economics

 Describe the three important problems of Economy

 Explain different types of Economies.

 WHY TO STUDY
ECONOMICS
 To get a good Job.

 To understand more deeply the reports on Inflation and
Unemployment.

 To understand what kind of policies might slow global

warming or

 What it means to say an IPOd is “made in China”

 DEFINITION OF ECONOMICS-


 Economics is the study of how societies use scarce resources
to produce valuable goods and services and distribute them
among different individuals.
 SCARCITY AND
EFFICIENCY

 Two Key Ideas in all the definition of economics-

 A. Goods are scarce

 B. Society must use its resources efficiently.

 SCARCITY

 Ours is a world of scarcity

 No society has reached a utopia of limitless

possibilities.

 A situation of scarcity is one in which goods are

limited relative to desires.
 EFFICIENCY

 Given unlimited wants, It is important that an
economy make THE BEST USE OF ITS LIMITED
RESOURCES.

 Efficiency denotes the most effective use of a

society’s resources in satisfying people’s wants and
needs.
 Efficiency

 Economic efficiency requires that an economy
produce the highest combination of quantity and
quality of goods and services given its technology
and scarce resources.

 An economy is producing efficiently when No

individual’s economic welfare can be improved
unless someone else is made Worse off.
 Essence of Economics

 To acknowledge the reality of scarcity.

 To figure out how to organize society in a way

which produces the most efficient use of resources.
 Branches of Economics

 Micro economics :

 Adam Smith – Founder of Microeconomics. Book

written by him- “The Wealth of Nations” (1776)

 Branch of economics concerned with the behavior of

individual entities such as markets, firms, and
households.
 Macro Economics

 Concerned with overall performance of the economy.

 John Maynard Keynes - “General Theory of

Employment, Interest and Money” -1936

 Macroeconomics deals with areas such as How total

investment and consumption are determined, how
central banks manage money and interest rates, What
causes international financial crises, why some
nations grow rapidly while others stagnate.
 Positive Economics Vs.
Normative Economics

 Positive Economics: Issues and questions of Facts

 Deals with questions such as-

 Why do managers earn more than supervisors?

 Do high interest rates slow the economy and lower inflation?

 These type of issues can be resolved by reference to analysis

and empirical evidence.
 Normative Economics

 Issues involves ethical and norms of fairness.

 Should unemployment be raised to ensure that price

inflation does not become too rapid.

 Should India negotiate further agreements with ASEAN

countries to lower tariffs on imports?

 Has the distribution of income in India become too unequal.

 The answers can be resolved only by discussions and

debates over society’s fundamental values.
 The Three Problems of
Economic Organization

 Three fundamental economic problems-

 1. What commodities should be produced

 2. How to produce such commodities

 3. For Whom they are produced.

 WHAT?

 What commodities are produced and In what
quantities?

 Will we produce pizzas or shirts today?

 Few high quality shirts or many cheap shirts?

 Fewer Consumption goods ( like Pizzas) and more

Investment goods (like Pizza-Making machines, which
will boost production and consumption tomorrow?
 HOW?

 How are goods produce?

 Who will do the production, with what resources

and what production techniques they will use?

 Will electricity be generated from Oil, from Coal, or

from the sun?

 Will factories be run by people or robots?

 FOR WHOM?

 For whom goods are produced?

 Who gets to eat the fruit of economic activity?

 Is the distribution of Income and Wealth fair and equitable?

 How is the National product divided among different house

holds?

 Will society provide minimal consumption to the poor, or must

people work if they are to eat.
Market ,Command, and
Mixed Economies

 Society can answer theses crucial question of What,
How and for Whom through the way society is
organized through Alternative economic system

 Two fundamentally different ways of Organizing an

economy.

Government makes Decisions are

most economic decisions made in Markets
 Market Economy

 Most economic questions and decisions are settled by the Market
Mechanism. Example- USA

 A market economy is the economy in which individuals and private

firms make the major decisions about production and consumption.

 A system of Prices, of Markets, of Profits and Losses, of incentives

and rewards determines What, How and for Whom.

 The Extreme cases of Market economy is called Laissez-Faire

Economy. Here Government do not interfere in economic
decisions.
 COMMAND
ECONOMY

 Government makes all important decisions about production and
distribution. (Example-Erstwhile Soviet Union during most of the
20th century)
 Government owns most of the means of production (land and
capital)
 Also, owns and directs the operations of enterprises in most of
the industries
 It is the employer of most workers and tells them how to do their
jobs;
 It decides how the output of the society is to be divided among
different goods and services.
 In short, government answers the major economic questions
through its ownership of resources and its power to enforce
decisions
 MIXED ECONOMY

 No contemporary society falls completely into either of these
extreme categories.

 All societies are Mixed Economies, with elements of market and

command.

 Government plays an important role in overseeing the

functioning of the market

 Government pass laws that regulates economic life produce

educational and police services and control pollution.
Every Gun that is made, every warship
launched, every rocket fired signifies, in
the final sense, a theft from those who
hunger and are not fed.

- President Dwight D Eisenhower

 
 Goods are scarce and wants are Many

 An economy must decide the most efficient allocation

of its limited resources like land, technical knowledge,
factories, etc.

 Economy must choose among different bundles of

goods (the What), select from different techniques of
production ( the How), and decide who will consume
the goods (the for Whom).
 INPUTS & OUTPUTS

 INPUTS: Commodities or services that are used to
produce goods and services.

 Another term for Inputs –Factors of Production

 Three broad categories- Land , Labor , Capital

 OUTPUT: Various useful goods or services that result

from the production process for consumption or
employed in further production.
 THE PRODUCTION
POSSIBILITY FRONTIER

 The production possibility frontier ( or PPF) shows the
maximum quantity of goods that can be efficiently
produced by an economy, given its technical knowledge
and the quantity of available inputs.
POSSIBILITIES BUTTER GUNS
(millions of (thousands)
Pounds)
A 0 15
B 1 14
C 2 12
D 3 9
E 4 5
F 5 0
Guns-Butter Tradeoff

 
 Scarce Inputs and technology imply that the
production of guns and butter is limited.

 As we go from B to D …. To C an economy is
transferring resources labor, machines and land from
the gun industry to butter industry and can thereby
increase butter production.
Future Consumption Vs.
Current Consumption

Today’s Choices Future Consequences
Capital Invst. Capital Invst.

Country 3

Country 2
B3

A3 Country 1 B2
A2
A1 B1
Current Consumption
Current Consumption
 
 Three countries start out even. They have the same PPF
but different investment rates.
 Country 1 does not invest for the future and remains at
A1 merely replacing machines.
 Country 2 abstains modestly from consumption and
invest at A2.
 Country 3 sacrifices a great deal of current consumption
and invest heavily.
 In the following years, countries that invest more
heavily forge ahead.
 Countries that invest heavily can have both higher
investment and consumption in future.
Two roads diverged in a wood, and I,
I took the one less traveled by,
And that has made all the difference. -

Robert Frost
 OPPORTUNITY COST

 Related to one of the deepest concepts of economics –
OPPORTUNITY COST.

 When you decide whether to study economics, buy a car,

or go to some university you will give something up.

 There will be a forgone opportunity.

 In a world of scarcity, choosing one things means giving

up something else. The opportunity cost of a decision is
the value of the good or service forgone.
 EFFICIENCY

 Efficiency means that the economy’s resources are being
used as effectively as possible to satisfy people’s desires.

 Efficiency means that the economy is on the PP frontier

rather than inside the PPF.

 Productive efficiency occurs when an economy cannot

produce more of one good without producing less of
another good; this implies that the economy is on its
PPF.
 MARKET

 A market is a mechanism through which buyers and
sellers interact to determine prices and exchange
goods, services, and assets.

 The central role of markets is to determine the price

of goods

 Prices are the balance wheel of the market

mechanism.
 THE MARKET
MECHANISM

 No single individual or organization or government is
responsible for solving the economic problems in a
market economy.

 Instead, millions of businesses and consumers engage

in voluntary trade, intending to improve their own
economic situations, and their actions are invisibly
coordinated by a system of prices and markets.
 Market Equlibrium

 Markets are constantly solving the What, How and
for whom.

 A market equilibrium represents a balance among

all the different buyers and sellers

 The market finds the equilibrium price that

simultaneously meets the desires of buyers and
sellers
 Market and Three
Economic Problems

 What goods and services will be produced is
determined by the dollar votes of consumers in their
daily purchase decisions.

 How things are produced is determined by the

competition among different producers. To
maximize profits they keep costs at a minimum by
adopting the most efficient methods of production.
 
 For Whom things are produced- Who is consuming
and how much depends on the supply and demand
in the markets for factors of production.

 Factor markets , i.e., markets for factor of production

determine wage rates, land rents, interest rates and
profits. Such prices are called factor prices.
THE INVISIBLE HANDS

 Adam Smith- “The Wealth of Nations”-1776 –saw the
harmony between private profit and public interest.

 Doctrine of Invisible Hand - private interest can lead to

public gain when it takes place in a well-functioning
market mechanism.

 According to economic theorists, under limited

conditions a perfectly competitive economy is efficient.
 Failures of Invisible
Hand

 Markets do not always lead to the most efficient outcome.

 Spillovers or External forces outside the market place- e.g.

Scientific Discoveries and Spillovers such as Pollution.

 When the income distribution is politically or ethically

unacceptable.

 Due to any of the above factors, Adam Smith’s Invisible-

hand doctrine breaks down. In such cases Government
may want to step in to correct the Flawed Invisible Hand.
 The Visible Hand-
Government

 Governments have three main economic functions in a
market economy-

 Increases efficiency by promoting competition, curbing

externalities like pollution, and providing public goods.

 Promotes equity by using tax and expenditure programs to

redistribute income toward particular groups.

 Macroeconomic stability and Growth- reducing

unemployment and Inflation while encouraging economic
growth – through fiscal and monetary policy
 Partial Vs. General
Equilibrium

 Partial Equilibrium:-
 Analysis of an equilibrium position for a particular sector of
an economy.
Example- The equilibrium of a single consumer, a single
producer, a single firm and a single Industry .

 Alfred Marshall major proponent of Partial Equilibrium

theory.

 Markets are considered to be small enough so that its

inter- dependence with the rest of the economy could be
neglected.
 General Equlibrium

 Leon Walras - Book “ Elements of Pure Economy”
 Created theoretical and Mathematical model of general
equilibrium to integrate both the effects of demand and
supply side forces in the WHOLE ECONOMY.

 General equilibrium gives an understanding of the

whole economy using a bottom –top approach,
starting with individual market and agents.

 It is different from macro economic equilibrium,

which uses top-bottom approach ( which starts with
larger aggregates)
 CASE- AUTOMOBILE EMISSION STANDARD (10 Marks)
 Most of the states in India have imposed strict tailpipe emission
standards on New automobiles. These standards have become
increasingly stringent in metros like Delhi. Currently Bharat-II is in
force. Now, as the number of cars on the roads keeps increasing, the
government must consider how stringent these standards should be
in the coming years.
The design of a program relating to control of pollution involves
a careful analysis of the ecological and health effects of auto emissions.
But it also involves a good deal of economics.

1. Evaluate the impact of the program on consumers. (4 Marks)

2. Why market oriented economy is not able to solve the problems

related to air pollution? (3 Marks)

3. Do Auto emission control program makes sense on a cost-benefit

basis? (3 Marks)
Supply & Demand
Analysis

IBS GURGAON, 2018
 Learning Objectives

 At the end of this lecture you will be able to –

 Understand the demand schedule

 Plot the Demand curve

 Define Elasticity of demand

 Calculate different type of elasticities.

 DEMAND SCHEDULE

 Amount of a commodity people buy depends on its
price.

 The higher the price of an article, other things held

constant, the fewer units consumers are willing to
buy.

 The lower its market price, the more units of it are

bought.
 DEMAND SCHEDULE
 between the market
 There exists a definite relationship
price of a good and the quantity demanded of that good,
other things held constant.
 This relationship between price and quantity bought is
called the demand schedule or the demand curve.
 Demand schedule- Price ( $ per box) Q (mn. Of
boxes per year)
A Demanded 5 10
B 4 18
C 3 26
D 2 38
E 1 54
THE DEMAND CURVE

 The Graphical representation of the demand
schedule is the demand curve.
 For the given example-
 FEATURES OF
DEMAND CURVE

 The demand curve shows the quantity of the good that
the consumers are willing to buy as the price per unit
changes. Mathematically , Q d = Qd (P)

 The demand curve slopes downward from left to right.

 Law of downward sloping demand –

When the price of a commodity is raised, other things held
constant, Consumers tends to buy less of the commodity
and vice-a-versa.
 The income effect

 Quantity demanded tends to fall as price rises for
two reasons-
 The Income Effect and Substitution Effect

 If we assume that money income is fixed, the income

effect suggests that, as the price of a good falls, real
income - that is, what consumers can buy with
their money income - rises and consumers increase
their demand.
Income Effect

 The Substitution effect

 In addition, as the price of one good falls, it
becomes relatively less expensive. Therefore, assuming
other alternative products stay at the same price, at
lower prices the good appears cheaper, and
consumers will switch from the expensive alternative
to the relatively cheaper one.

 SHIFTING OF
DEMAND CURVE

 What will happen if Income levels increases or there is
changes in preferences or tastes of consumers.

 Changes in factors like average income and preferences

can cause an entire demand curve to shift right or left.

 This causes a higher or lower quantity to be demanded

at a given price, ceteris paribus assumption.
 SHIFTING TOWARDS
RIGHT

PRICE ORIGINAL
NEW Qd
(£) Qd
1.10 0 100
1.00 100 200
90 200 300
80 300 400
70 400 500
60 500 600
50 600 700
40 700 800
30 800 900
 
PRICE ORIGINAL
NEW Qd
(£) Qd
1.10 0  
1.00 100  
90 200 100
80 300 200
70 400 300
60 500 400
50 600 500
40 700 600
30 800 700
 ELASTICITY OF
DEMAND

 Elasticity measures the sensitivity of one variable to
another.

 The percentage change in one variable due to a 1 %

increase in another variable.

 For ex. The price elasticity of demand measures the

sensitivity of quantity demanded to changes in price
 Price elasticity of
Demand

  Let quantity demanded be Q and Price be P,
 Price elasticity of demand

Ep= / = -------- = (P/Q).

 The price elasticity of demand is usually a negative

number. We consider the Absolute level.

 If, Ep
Ep
Ep= 1 : - Demand is Unitary Elastic
 
 In general, Price Elasticity of demand for a good
depends on the availability of substitute goods.

 If there are more close substitute for a commodity,

the demand will be highly Price elastic.

 When there are no close substitutes, demand will

tend to be Price Inelastic.
 Income Elasticity of
Demand

  Usually, Demand for most goods usually rises when
aggregate income rises.

 The income elasticity of demand is the percentage

change in the quantity demanded, Q, due to a 1
percent increase in income, I, I
Ei =--------= ---------
Q
CROSS PRICE ELASTICITY OF
DEMAND

  Cross Price elasticity of Demand refers to the
percentage change in the quantity demanded for a good
that result from a 1 percent increase in the price of
another. For Ex. Tea and Coffee
Pc
 EQt,Pc= _________ = _________ ; Qt – quantity of tea
Qt Pc- Price of Coffee

 Here, Cross elasticity will be positive as Goods are

Substitutes.
 Complimentary Goods

 Some goods are compliments because they tend to be
used together.

 An increase in the price of one tends to push down the

consumption of the other. For ex. Petrol and Motor
Oil.
 If the price of petrol goes up, the demand for petrol
goes down- Motorist will drive less. Thus, demand for
motor oil falls. In this case Cross price elasticity of
motor oil with respect to price is negative.
Linear Demand Curve

  Ep at point e = 0

 Ep at point c = -1

 Ep at point a= -
 Price elasticity of demand
depends not only on the
slope of the demand curve
but also on the price and
quantity.
 
Infinitely Elastic Demand Completely Inelastic Demand

Price Price

D
P
D

Quantity
Q Quantity
 
 Que1: If a 3 % increase in the price of corn flakes
causes a 6 percent decline in the quantity demanded,
what is elasticity of Demand?

 Que-2: A consumer spends all his income on two

goods X and Y. If a 50 % increase in the price of good
X does not change the amount consumed of good Y,
what is the price elasticity of demand for good X?
 The Supply Curve

 The quantity of a good that producers are willing to
sell at a given price, Ceteris Paribus (holding
constant any other factors that might affect the
quantity supplied)

 The supply curve is the relationship between the

quantity supplied and the price.

 QS = QS (P)
 
 Supply curve is upward sloping Curve.

 Higher the price , the more firms are able and willing to
produce and sell.

 If the production costs fall, firms can produce the same

quantity at a lower price OR a larger quantity at the
same price.

 The Supply curve shifts to the right. From S1 to S2.

 Other Variables

 Quantity producers are willing to produce or sell
depends on other variables besides price.

 Production costs such as WAGES, Interest Cost, Raw

Material Cost etc.

 Any increase or Decrease in such cost , Given the Price

remains at the same level, will make the quantity
supplied to decrease or Increase accordingly..

 EQUILIBRIUM

 The two curve Demand Curve and Supply Curves
intersect at the Equilibrium.

 Equilibrium is also known as Market Clearing Price and

Quantity.

 At this price (P0),

Quantity Supplied = Quantity Demanded.
 The Market Mechanism

 The Market Mechanism is the tendency in a free market for the price to
change until the Market Clears- i.e.

QUANTITY SUPPLIED = QUANTITY DEMANDED

 If the price were initially above the market clearing prices P0 ,

Producers will try to produce and sell more than consumers are
willing to buy. A situation of SURPLUS will result

 SURPLUS Situation –
Quantity supplied > Quantity demanded.

To clear this surplus sellers will start lowering their prices.
Eventually Equilibrium will reach.
MARKET EQUILIBRIUM
 
 If Prices were initially below P0- A Shortage situation
will arise.

 Here, Quantity demanded > Quantity Supplied

 Producers will react by increasing prices and expand Output.

 Again, the price would eventually reach P0.

Changes in Market
Equlibrium

 
 When the Supply curve shifts to the right, the market
clears at a lower price P2 and larger quantity Q3.

 When the demand curve shifts to the right, the

market clears at a higher price P and larger quantity
demanded.
Effects of Govt. Intervention
–Price control

 PRICE CONTROL
C

  P  is below the equilibrium price of P .
E

 At PC, sellers are willing to offer A1 apartments.

 Consumers would like to rent A2 apartments at the price
ceiling of PC.
 Because PC is below the equilibrium price, there is a
shortage of apartments equal to (A2 – A1).
 (Notice that if the price ceiling were set above the
equilibrium price it would have no effect on the market
since the law would not prohibit the price from settling at
an equilibrium price that is lower than the price ceiling.)
 
 This excess demand sometimes take the form of
QUEUES.

 These queues are the result of Price controls.

 Sometimes, it SPILLS OVER into other markets where

it artificially increases demand.
For Ex.:- Natural gas price controls caused potential
buyers of gas to use Oil instead

 Some people gain and Some loose from price control.


 

Consumer behaviour
 Learning Objectives
will be able to –
At the end of this lecture you

 Understand the Choice & Utility Theory

 Define Marginal Utility & Law of Diminishing

Marginal Utility

 Derive Market Demand and Consumer Surplus and Its

Application.

 Analyze Indifference Curve and Forecasting Demand.

 
 https://
www.youtube.com/watch?v=wFrGhooQheU

 https://
www.youtube.com/watch?v=DD128Y0P9YU
 https://www.youtube.com/watch?v=huI0k5mFVto

 https://www.youtube.com/watch?v=LOjyVoGTGj8
 Choice and Utility
Theory

 Fundamental issue in microeconomics

 How consumer with a limited income decides which

goods and services to buy?

 How Consumers allocate their incomes across goods

and how this allocation decision determines the
demands for various goods and services.
 Three Basic steps

 Consumer Preferences – to find the reasons people
might prefer one good to another.

 Budget Constraints- Consumers have limited incomes

restricting the quantities of goods they can buy.

 Consumer Choices- Given their preferences and limited

incomes, consumers choose to buy combination of goods
that maximizes their satisfaction
 Market Basket
 of one or more goods.
 A list with specific quantities
For Ex. - Various food items in a grocery cart,
quantities of food, clothing and housing that a
consumer buys each month etc.
MARKET UNITS OF UNITS OF
BASKET FOOD CLOTHING
A 20 30
B 10 50
C 40 20
D 30 40
E 10 20
F 10 40
 
 Theory of Consumer behavior asks whether
consumers prefer one market basket to another.

 Consumer usually select market basket that make

them as well off as possible.
 Basic Assumptions

 Three Basic Assumptions about consumer ‘s preferences-
1. COMPLETENESS: -
 Preferences are assumed to be complete. In other words,
consumers can compare and rank all possible baskets.
 Thus for any two market baskets A and B, a consumer
will prefer either A to B or will prefer B to A or will be
indifferent between the two.

 By indifferent means that person will be equally satisfied

with either basket.
 
2. Transitivity- Preferences are Transitive.
If A>B and B>C then A>C

Transitivity is regarded as necessary for consumer

consistency.

3. More is Better than Less:- Goods are assumed to be

desirable. Consequently , consumers always prefer more
of any good to less. Consumers are never satisfied or
Satiated (assumption of Non Satiation)
 CARDINAL & ORDINAL
MEASUREMENT

 Exact amount of measurement in absolute numbers
For Ex.- Bill gates - $ 56 Billion
Warren Buffet- $ 45 Billion
Steve Jobs - $ 14.5 billion
Oprah Winfrey- $ 2.7 billion

ORDINAL MEASUREMENT –
 Here number denotes ranking
For Ex. Bill Gates – 1, Warren Buffet -2, Steve Jobs-3
and so on.
 UTILITY

 UTILITY denotes satisfaction.

 A subjective pleasure that a person derives from consuming a

good or service.

 It is want satisfying power of a commodity.

For example- Chocolates have want satisfying power for
having something sweet.

 More precisely, it refers to how consumers rank different goods

and services.

 If basket A has higher Utility than basket B for Mr. X, then Mr. X
will prefer A over B.
 UTILITY

 Utility is a scientific construct that economists use to
understand how rational consumers make decision.

 In the theory of demand, we assume that people

maximizes their utility.

 It means that they choose the bundle of consumption

goods that they prefer most.
 MARGINAL UTILITY

 The expression ‘Marginal’ is a key term in economics
and always means ‘Additional’ or ‘Extra’.

 When you consume an additional unit of a

commodity you will get some additional satisfaction
or Utility. The increment to your utility is called
Marginal Utility.

 “Marginal utility denotes the additional utility you

get from the consumption of an additional unit of a
commodity.”
 Law of Diminishing
Marginal Utility

 One of the fundamental idea behind demand theory is
‘Law of diminishing Marginal utility.’

 This law states that the amount of extra or marginal

utility declines as a person consumes more and more
of a good.

 The Law of diminishing Marginal utility states that,

as the amount of a good consumed increases, the
marginal utility of that good tends to decline.
 Marginal Utility
Quantity of

Total Utility Marginal
a good (U) Utility (MU)
consumed
(Q)
0 0
1 4 4
2 7 3
3 9 2
4 10 1
5 10 0

 
 From graph we see that-
 1. Total utility rises with consumption, but it rises at
a decreasing rate, showing diminishing marginal
utility.

 The Law of Diminishing Marginal utility implies that

the Marginal Utility curve must slope downwards.
 The EQUI MARGINAL
Principle

 The fundamental condition of maximum satisfaction or
utility is the equimarginal principle.

 A consumer will achieve maximum satisfaction or utility

when the marginal utility of the last dollar spent on a
good is exactly the same as the marginal utility of the
last dollar spent on any other good.

 The common marginal utility per dollar of all

commodities in consumer equilibrium is called the
marginal utility of income.
 Equimarginal Principle

 It measures the additional utility that would be
gained if the consumer could enjoy an extra dollar’s
worth of consumption.

 If Marginal utilities are MUs and Prices Ps of the

different goods then fundamental condition of
consumer equilibrium is
 MU Good 1/P1=MU Good 2/P2=MU Good 3/P3=….= MU per $
of Income
Consumer’s Equilibrium

 If Consumer distributes his expenditure rationally
among commodities, X, Y, Z, etc., the following
relationship will hold good in equilibrium.

 MU of X/ Price of X = MU of Y/Price of Y = MU of
Z/Price of Z = MUM

 where MUM is the common marginal utility of

money (i.e., marginal utility of a rupee).
 Consumer’s Surplus

 Consumer’s surplus = What a consumer is willing to pay minus what he
actually pays.

 CS = ∑ Marginal utility – (Price x Number of units of a commodity

purchased)

Marshall’s Measure of Consumer Surplus:

 measures extra utility or satisfaction which a consumer obtains from the

consumption of a certain amount of a commodity over and above the
utility of its market value.

 Thus the total utility obtained from consuming water is immense while
its market value is negligible.

 Marginal Utility
and Consumer Surplus
 Total utility derived by the consumer

from OM units of the commodity will be
equal to the area under the demand or
marginal utility curve up to point M. That
is, the total utility of OM units in Fig. 14.2
is equal to ODSM.

 In other words, for OM units of the good

the consumer will be prepared to pay the
sum equal to Rs. ODSM. But given the
price equal to OP, the consumer will
actually pay the sum equal to Rs. OPSM
for OM units of the good.

 It is thus clear that the consumer derives

extra utility equal to ODSM minus OPSM
= DPS, the shaded area.
 Indifference Curve

 Consumer preferences can be graphically expressed
by Indifference Curve.

 An Indifference Curve represents all combinations of

Market Basket that provide a consumer with the same
level of satisfaction.

 This consumer is Indifferent among the Market basket

represented by the points graphed on the curve.
Indifference Curve

Indifference Map- Set of
Indifference curves

 The shape of
Indifference Curves

 Indifference curves are Downward Sloping curves

 This is due to our assumption that more of a good is better

than less.

 If an IC sloped upward, this means a consumer would be

indifferent between two market baskets even though one of
them had more of both food and clothing.

 Downward shape describes how a consumer is willing to

substitute one good for another.
Marginal Rate of
Substitution

 Marginal Rate of
substitution

 The amount of one good that a consumer will give up
to obtain more of another.

 The MRS of food F for clothing C is the maximum

amount of clothing that a person is willing to give up
to obtain one additional unit of food.

 For Ex.:- MRS 3, means that the consumer will give up

3 units of clothing to obtain 1 additional unit of food.
 The shape of
Indifference Curves

 Indifference curves are Downward Sloping curves

 This is due to our assumption that more of a good is

better than less.

 If an IC sloped upward, this means a consumer would

be indifferent between two market baskets even though
one of them had more of both food and clothing.

 Downward shape describes how a consumer is willing

to substitute one good for another.
 Convexity of
Indifference curve
inward) due to the
 IC are convex ( or bowed
Diminishing Marginal Rate of substitution.

 Convex means that the slope of the indifference

curve increases (i.e., becomes less negative) as we
move down along the curve.

 That is, Indifference curves is convex if the MRS

diminishes along the curve

 BUDGET
CONSTRAINTS

 Budget constraints means Limited Income.
 
 Budget constraints restricts consumer behavior by forcing the consumer to select a
bundle of goods that is affordable.

 Mathematically, Px.X+ Py.YM

Where Px and Py – prices of good x and y and X and Y are quantities of goods x and
y purchased. M represents total income of consumer.

The Budget sets defines the combinations of goods X and Y that are
affordable for the consumer
 BUDGET LINE

 If the consumer spends all his income on the two goods, this
equation becomes equality. This relation is called Budget line.
Px.X + Py.Y= M

 In other words, the budget line defines all the combinations of

goods X and Y that exactly exhaust the consumer’s income.

 Dividing both sides of above equation by Y and solving for Y

we get - Y= M/Py –Px/PyX
 That is , Y is a linear function of X with vertical intercept of M/Py and a slope of –Px/Py.
Budget Line

 Consumer’s Equilibrium:
Interplay of budget line and
indifference curves

 In the given diagram, IC1,
IC2 and IC3 are three
different indifference curves
and AB is a budget line.
 A consumer can only
consume such combinations
of goods which lie upon the
budget line at a given
income level and constant
price of goods X and Y.
 Conditions of
Consumer’s Equilibrium

 The following are the conditions of consumer’s
equilibrium-

 Budget line should be tangent to the indifference curve

 At the point of equilibrium, slope of the budget line =

slope of the indifference curve

 Indifference curve should be convex to the point of

origin.
Changes in Income and
Price

 Substitution Effect and
Income Effect

  If good 1 becomes cheaper, it means that you have to give up less of good 2
to purchase good 1. The change in the price of good 1 has changed the rate at
which the market allows you to "substitute" good 2 for good 1. The trade-off
between the two goods that the market presents the consumer has changed.

 At the same time, if good 1 becomes cheaper it means that your money
income will buy more of good 1. The purchasing power of your money has
gone up; although the number of dollars you have is the same, the amount
that they will buy has increased.

 The first part—the change in demand due to the change in the rate of
exchange between the two goods—is called the substitution effect. The
second effect—the change in demand due to having more purchasing power
—is called the income effect.
Substitution & Income
effect.

 Substitution effect and
income effect

 The pivot gives the

substitution effect, and
the shift gives the
income effect.
Deriving The Demand
curve

 The price of pizza is $4, the
quantity demanded of pizza is two.
 If the price of pizza decreases, the
budget constraint becomes flatter
and the consumer can purchase
more pizza, say the price of pizza
drops to $2 and consumer
purchases 4 units.

 If the price drops to $1.33, the

quantity demanded increases to 5.
Plotting each of the price and
quantity demanded points creates
the demand curve for p

 QUIZ

 http://global.oup.com/us/companion.websites/978
0199397129/student/chapt1/multiplechoice/
The Production
Function

 The Production
Function

 Production process utilizes two inputs Capital (K) and Labor
(L).

 Production function summarizes the technology available for

converting capital and labor into output.

 The production function is an engineering relationship that

defines the maximum amount of output that can be produced
with a given set of inputs.

 Mathematically, the production function Q=F(K,L)

Short Term versus Long
Term

 Managers job is to use the available production
function efficiently

 i.e., to determine how much of each input to use to

produce output

 In the short term, some factors of production are

fixed and this limits the choices of managerial
decision
 
 The short term is defined as the time frame in which there are fixed
factors of production.

 Suppose Capital and Labor are the only two inputs in production
and Capital is fixed in the short term.

 Therefore, In short run Production function is function of Labor

only, as Capital is fixed.

 Q=f(L)= F(K*,L)

 The Long Run is defined as the horizon over which the manager
can adjust all factors of production. (usually >3 years)
 
 Three most important measures of productivity are-
Total Product, Average Product, Marginal Product.

1. Total Product:- Maximum level of output that can be

produced with a given amount of Inputs.
This is the amount that would be produced if the
optimum units of Labor put forth maximum effort.

2. Average Product- Total product divided by the quantity

used of the input.
 

 In
  particular, the average product of Labor (AP L)
APL=Q/L
 And the average product of Capital (AP K)
APK = Q/K

Marginal Product – MP of an input is the change in total output

due to last unit of an input.
Therefore, The marginal product of capital MPk=

AND, Marginal product of Labor MP L=

The Law of diminishing
marginal returns
 amounts of the variable
 Law states that - as successive
input, i.e., labor, are added to a fixed amount of other
resources, i.e., capital, in the production process the
marginal contribution of the additional variable resource
will eventually decline.
 As the marginal product begins to fall but remains positive,
total product continues to increase but at a decreasing rate.

 As long as the marginal product of a worker is greater than

the average product the average product will rise.

 Thus the marginal product will always intersect the average

product at the maximum average product.
 THREE STAGES OF
PRODUCTION

 STAGE-I:- Marginal product rises, reaches maximum
and then falls due to law of diminishing returns while
average product rises and reaches maximum.

 STAGE-II:- Marginal product falls till it becomes Zero

while average product keeps on falling but is positive

 Stage III:- Marginal Product is Negative, i.e.,

Contribution of the additional labor to the total output
is Negaitve.
3 stages of Production

 
 A Rational producer
should not produce in
Stage I and Stage II.
 It should produce in
Stage-II. Why?
 Technological Changes

 As knowledge of new and more efficient methods of
production become available, technology changes.

 Furthermore new inventions may result in the

increase of the efficiency of all methods of production.
At the same time some techniques may become
inefficient and drop out from the production function.

 These changes in technology constitute technological

progress.
Technological Progress

 
 Graphically the effect of innovation in processes is
shown with an upward shift of the production
function , or a downward movement of the
production isoquant.

 This shift shows that the same output may be

produced by less factor inputs, or more output may
be obtained with the same inputs.
 Economies of Scale

As plant capacity increases, firms are able to specialize their labor and
capital to a greater degree.

Workers can specialize on doing a limited number of tasks extremely well.

Another factor contributing to economies of scale is the spreading out of
the design and start up costs over a greater output amount. 

For many products, significant costs are in  design and development. For
example in the movie industry, the marginal cost of making a second copy
of a movie is nearly zero and as copies of the movie are produced, the
average cost declines significantly.  Some film makers will film the movie
and its sequel at the same time to lower the per unit costs.
 RETURNS TO SCALE

 In the long run all factors of production are variable.
No factor is fixed.

 Accordingly, the scale of production can be changed

by changing the quantity of all factors of production.

 “The term returns to scale refers to the changes in

output as all factors change by the same
proportion.”- Koutsoyiannis
 
 Returns to scale are of the following three types:
1. Increasing Returns to scale.
2. Constant Returns to Scale
3. Diminishing Returns to Scale

 Suppose, initially production function is as follows:

P = f (L, K)
 Now, if both the factors of production i.e., labour and
capital are increased in same proportion i.e., x, product
function will be rewritten as.
 Increasing Return to
Scale

 Increasing returns to scale or diminishing cost refers
to a situation when all factors of production are
increased, output increases at a higher rate.

 It means if all inputs are doubled, output will also

increase at the faster rate than double. Hence, it is
said to be increasing returns to scale.

 This increase is due to many reasons like division

external economies of scale. Increasing returns to
scale can be illustrated with the help of a diagram 
IRS

 Diminishing returns

 Diminishing returns or increasing costs refer to that production
situation, where if all the factors of production are increased in a
given proportion, output increases in a smaller proportion.

 It means, if inputs are doubled, output will be less than doubled.

If 20 percent increase in labour and capital is followed by 10
percent increase in output, then it is an instance of diminishing
returns to scale.

 The main cause of the operation of diminishing returns to scale is

that internal and external economies are less than internal and
external diseconomies. 
DRS

Constant Return to Scale

 Constant returns to scale or constant cost refers to the production
situation in which output increases exactly in the same proportion
in which factors of production are increased.

 In simple terms, if factors of production are doubled output will

also be doubled.

 In this case internal and external economies are exactly equal to

internal and external diseconomies. This situation arises when after
reaching a certain level of production, economies of scale are
balanced by diseconomies of scale. This is known as homogeneous
production function. Cobb-Douglas linear homogenous production
function is a good example of this kind.
CRS

 Expansion Path

 The point where the iso-cost line is tangent to an isoquant represents the
least cost combination of the two factors for producing a given output.

 If all points of tangency like LMN are joined by a line, it is known as an

output- factor curve or least-outlay curve or the expansion path of a
firm.

 Salvatore defines expansion path as “the locus of points of producer’s

equilibrium resulting from changes in total outlays while keeping
factor prices constant.”

 It shows how the proportions of the two factors used might be changed
as the firm expands.

 Economies of Scope

While economies of scale lowers the per unit cost as more of the
same output is produced, economies of scope lowers the per unit
cost as the range of products produced increases. For example, if
a restaurant that provides lunch and dinner began to offer
breakfast, the fixed costs of the kitchen equipment and the seating
area could be spread out over a larger number of meals served
decreasing the overall cost per meal. Likewise a gas station that
already must have a service attendant and building can lower the
per unit cost by providing convenience store items such as drinks
and snacks. Since the cost of producing or providing these
products are interdependent, providing both lowers the cost per
unit.
 
 
 Production with two
variable
 Inputs
 In Long run, both the Inputs Labor and Capital is
variable.
 Firm can produce its outputs by combining different
amounts of Labor and Capital
 ISOQUANTS

 The word 'iso' is of Greek origin and means equal or same
and 'quant' means quantity. An isoquant may be defined as:

 "A curve showing all the various combinations of two factors

that can produce a given level of output. The isoquant shows
the whole range of alternative ways of producing the same
level of output".

 The modern economists are using isoquant, or "ISO" product

curves for determining the optimum factor combination to
produce certain units of a commodity at the least cost.
Combinations Factor X
 Factor Y Total Output

A 1 14 100 METERS

B 2 10 100 METERS

C 3 7 100 METERS

D 4 5 100 METERS
100 METERS
E 5 4

 
 The five factor combinations of X and Y are plotted and are
shown by points a, b, c, d and e. if we join these points, it forms
an 'isoquant'.

 An isoquant therefore, is the graphic representation of an iso-

product schedule.

 It may here be noted that all the factor combinations of X and Y

on an iso-product curve are technically efficient combinations.

 The producer is indifferent as to which combination he uses for

producing the same level of output. It is in this way that an iso
product curve is also called 'production indifference curve'.
Isoquant Map

 An isoquant map shows
a set of iso-product
curves.
 Each isoquant represents
a different level of
output.
 A higher isoquant shows
a higher level of output
and a lower isoquant
represents a lower level
of output.
Marginal Rate of Technical
Substitution (MRTS)
we use concept of marginal
 In producers equilibrium
rate of technical substitution (MRTS) which is similar
to Marginal rate of substitution of theory of demand. 

 Marginal rate of technical substitution (MRTS) is: "The

rate at which one factor can be substituted for another
while holding the level of output constant".

  The slope of an isoquant shows the ability of a firm to

replace one factor with another while holding the
output constant.
 
  MRTS= -Change in capital input/change in Labor input

 For example, if 2 units of factor capital (K) can be

replaced by 1 unit of labor (L), marginal rate of technical
substitution will be : MRS = 2/1= 2:1

Also,along an Isoquant

 
 The decline in MRTS along an Isoquant for
producing the same level of output is named as
diminishing marginal rates of technical education.

 The decline in MRTS along an isoquant as the firm

increases labor for capital is called Diminishing
Marginal Rate of Technical Substitution.
 Iso Cost Line

 A firm can produce a given level of output using
efficiently different combinations of two inputs.

 For choosing efficient combination of the inputs, the

producer selects that combination of factors which
has the lower cost of production.

 The information about the cost can be obtained from

the isocost lines
 
 An isocost line is also called outlay line or price line or factor
cost line. 

 An isocost line shows all the combinations of labor and capital

that are available for a given total cost to-the producer.

 Just as there are infinite number of isoquants, there are infinite

number of isocost lines, one for every possible level of a given
total cost.

 The greater the total cost, the further from origin is the
isocost line.
Isocost Line

 
 The isocost line plays a similar role in the firm's decision
making as the budget line does in consumer's decision
making.

 The only difference between the two is that the consumer has
a single budget line which is determined by the income of the
consumer. Whereas the firm faces many isocost lines
depending upon the different level of expenditure the firm
might make.

 A firm may incur low cost by producing relatively lesser

output or it may incur relatively high cost by producing a
relatively large quantity.
 Law of Variable
Proportions

 Keeping other factors fixed, the law explains the
production function with one factor as variable.

 In the short run when output of a commodity is to be

increased, the law of variable proportions comes into
operation.
 Definitions

 “As the proportion of the factor in a combination of
factors is increased after a point, first the marginal
and then the average product of that factor will
diminish.” Benham
 “An increase in some inputs relative to other fixed
inputs will in a given state of technology cause
output to increase, but after a point the extra output
resulting from the same additions of extra inputs will
become less and less.” Samuelson
 Assumptions

Law of variable proportions is based on following
assumptions-
i) Constant Technology:
The state of technology is assumed to be given and
constant. If there is an improvement in technology the
production function will move upward.
ii) Factor Proportions are Variable:
The law assumes that factor proportions are variable. If
factors of production are to be combined in a fixed
proportion, the law has no validity.
 
iii) Homogeneous Factor Units:
The units of variable factor are homogeneous. Each unit
is identical in quality and amount with every other unit.
iv) Short-Run:
The law operates in the short-run when it is not
possible to vary all factor inputs.
 Explanation of the Law

 In order to understand the law of variable
proportions we take the example of agriculture.
Suppose land and labour are the only two factors of
production.

 By keeping land as a fixed factor, the production of

variable factor i.e., labour can be shown with the
help of the following table:



 Postponement of the
Law

 The postponement of the law of variable proportions
is possible under following conditions:

(i) Improvement in Technique of Production:

 The operation of the law can be postponed in case
variable factors techniques of production are improved.
(ii) Perfect Substitute:
 The law of variable proportion can also be postponed in
case factors of production are made perfect substitutes
i.e., when one factor can be substituted for the other.
ANALYSIS OF COST
 Accounting Cost

 An accountant is concerned with the financial
statements.

 Accountants tend to take a retrospective look at a

firm’s finances as they have to keep track of assets and
liabilities and evaluate past performance.

 Accounting costs include actual expenses and

depreciation expenses for capital equipment, which
are determine for tax purposes.
 ECONOMIC COST

 Economist thinks of cost differently from an accountant.

 Economists take a forward-looking view of the firm.

 They are concerned with what costs are expected to be in the

future, and

 How the firm would be able to rearrange its resources to

lower its costs and improve its profitability.

 They are concerned with opportunity costs.

 EXAMPLE
a building, and, therefore,
 Consider a firm that owns
pays no rent for office space. Does this mean that the
cost of office space is zero for the firm? Though an
accountant might treat this cost as zero, an economist
would consider the rent that the firm could have
earned by leasing the office space to another company.

 This foregone rent is an opportunity cost of utilizing

the office space and should be included as part of the
economic cost of doing business.
 SUNK COST

 A sunk cost is a Cost that an entity has incurred, and which it can no longer
recover by any means.

 Sunk costs should not be considered when making the decision to continue
investing in an ongoing project, since these costs cannot be recovered.

 Instead, only relevant costs should be considered. However, many

managers continue investing in projects because of the sheer size of the
amounts already invested in the past. They do not want to "lose the
investment" by curtailing a project that is proving to not be profitable, so
they continue pouring more cash into it.

 Rationally, they should consider earlier investments to be sunk costs, and

therefore exclude them from consideration when deciding whether to
continue with further investments.
 Examples

 Marketing study. A company spends $50,000 on a marketing
study to see if its new product will succeed in the
marketplace. The study concludes that the it will not be
profitable. At this point, the $50,000 is a sunk cost. The
company should not continue with further investments in
this project, despite the size of the earlier investment.

 Research and development. A company invests $ 200,000 over

several years to develop a new mobile phone model. Once
developed the market is indifferent, and buys no units. The
$200,000 development cost is a sunk cost, and so should not
be considered in any decision to continue or terminate the
product.
 
 Training. A company spends $20,000 to train its sales
staff in the use of new tablet computers, which they
will use to take customer orders. The computers
prove to be unreliable, and the sales manager wants
to discontinue their use. The training is a sunk cost,
and so should not be considered in any decision
regarding the computers.

 A sunk cost is also known as a stranded cost.

 Fixed Cost and Variable
Cost

 Fixed cost – A cost that does not vary with the level of
output.
 This cost can be eliminated only by going out of business.
 Example- Expenditures on Factory/office Building, Plant &
Machineries, Maintenance, Insurance, Electricity, Salaries
of few Key executives etc.

 Variable Cost- A cost that varies as output varies

 Example- Expenditure on Wages and Salaries, raw

materials used increases as output increases.
 
 Variable costs refer to those costs which change with
the change in the volume of output. These costs are
unavoidable or contractual costs. Marshall called
these costs as “Prime Costs”, “Direct Costs” or
“Special Costs”.

 Variable costs include expenditure on transport,

wages of labour, price of raw material etc. Thus,
according to Dooley, “Variable costs are one which
varies as the level of output varies.”
Total Cost &Variable
Cost

 Theory of cost

 Generally theories of costs can be divided into two
parts:

 Traditional Theory of Costs/Short Run

Cost Curves:
 In traditional theory, costs are generalized in two
parts on the basis of time period i.e. costs in short
run and costs in long run period.
 
 Costs are mainly of the following types:
1. Total cost
2. Average cost
3. Marginal Cost
 Total Cost
 According to Dooley-

 “Total cost of production is the sum of all
expenditure incurred in producing a given volume
of output.”

 In other words, the amount of money spent on the

production of different levels of a good is called total
cost. 
 Marginal and Average
Cost

 Marginal Cost (MC):- Also called as Incremental
cost.
 The increase in cost that results from producing one
extra unit of output.
 Fixed cost does not change as the firm’s level of
output changes, therefore , Marginal cost is equal to
increase in Variable cost or the increase in Total cost
that results from an extra unit of output.
Total/Average/Marginal
Cost Cost

 
 Total Fixed Cost (TFC) – costs independent of output, e.g.
paying for factory
 Marginal cost (MC) – the cost of producing an extra unit of
output.
 Total variable cost (TVC) = cost involved in producing more
units, which in this case is the cost of employing workers.
 Average Variable Cost AVC = Total variable cost / quantity
produced
 Total cost TC = Total variable cost (VC) + total fixed cost
(FC)
 Average Total Cost ATC = Total cost / quantity


 Costs in the short run

 Short run cost curves tend to be U shaped because
of Diminishing returns.

 In the short run, capital is fixed.

 After a certain point, increasing extra workers leads

to declining productivity. Therefore, as you employ
more workers the marginal cost increases.

 
 Because the short run marginal cost curve is sloped
like this, mathematically the average cost curve will
be U shaped.

 Initially, average costs fall. But, when marginal cost

is above the average cost, then average cost starts to
rise.

 Marginal cost always passes through the lowest

point of the average cost curve.
Average Cost Curves

 ATC (Average Total
Cost) = Total Cost /
quantity

 AVC (Average Variable

Cost) = Variable cost /
Quantity

 AFC (Average Fixed

Cost) = Fixed cost /
Quantity
 
 The low­est point of the AVC curve is called the shut
(close)- down point and that of the ATC curve the
break-even point.

 Finally, we see that MC lies below both AVC and

ATC over the range in which these curves decline

 MC lies above them when they are rising.

 Long Run Total Cost

 Definition:
The time period during which all the factors (except
factor prices and the state of technology or art of
production) is variable is called the long run and the
associated curve that shows the minimum cost of
producing each level of output is called the long- run
total cost curve.
 Long Run Cost Curves

 The long-run cost curves are ‘U’ shaped for different
reasons.

 It is due to Economies of Scale and Diseconomies of Scale.

 If a firm has high fixed costs, increasing output will lead

to lower average costs.

 However, after a certain output, a firm may experience

diseconomies of scale. This occurs where increased output
leads to higher average costs. For example, in a big firm, it
is more difficult to communicate and coordinate workers.


 The Shape of the LAC

 Shape of LAC is due to Economies and Diseconomies of Scale.

 The shape of the long-run average cost depends on certain

advantages and disadvantages associated with large scale
production. These are known as economies and diseconomies
of scale.

 Economies of Scale:

 Various factors may give rise to economies of scale, that is, to

decreasing long-run average costs of production.
 Factors for Economies
of Scale

 Greater Specialization of Resources

 More Efficient Utilization of Equipment

 Reduced Unit Costs of Inputs

 Utilization of by-products

 Growth of Auxiliary Facilities

 Diseconomies of Scale

 This is attributable to the following two main rea­
sons:

 Decision-Making Role of Management

 Competition for Resources


 
  Where economies of scale are negligible, diseconomies
may soon assume paramount signifi­cance causing LAC to
turn up at a relatively small volume of output. (Panel A)

 In other cases, economies of scale assume strate­gic

significance.

 Even after the efficiency of man­agement starts declining,

technological economies of scale may offset the
diseconomies over a wide range of output. Thus, the LAC
curve may not slope up­ward until a very large volume of
output is pro­duced (Panel B)
 
 In many actual situations, however, neither of these
extremes describes the behaviour of LAC.

 A very modest scale of operation may not set in until

a very large volume of output is produced.

 In such a situation, LAC would have a long

horizontal sec­tion as shown in Panel C 
 
 However, not all firms will experience diseconomies
of scale.

 It is possible the LRAC could just be downward

sloping.
 PLANT SIZE and Cost

 In the long run, the firm can change the size of the
plant.

 Starting from zero output level, succes­sively larger

plants typically have lower and lower ATC up to some
output level and then successively higher ATC curves
beyond.

 The three representative ATC curves associated with

the three successively larger plants are shown in Fig.

 
 Plant I is the best plant for output levels less than 900 units
because its AC curve is the lowest to the left of point a.

 Plant II is the best plant size for output levels between 900
to 2,000 units, because its AC curve is the lowest between
point a and b.

 Plant III is the best plant size for output levels greater than
2,000 units, since its AC curve is the lowest beyond point
b.
 
 If these are only three possible plant sizes, the long run
ATC curve will consist of -
 the segments of Plant I’s AC curve up to point a,
 the segment of plant II’s AC curve between points a and b,
and
 the segment of Plant Ill’s AC curve from point of b and so
on.

 The thick LAC is composed of the three lowest branches of

SACs. This is why the LAC is called the envelope curve.
 
 We get the smooth envelope Long run cost curbe.

 Samuelson: “In the long run, a firm can choose its

best plant sizes and its lower envelope curve.”

 Since there is an infinite number of choices, we get

LAC as a smooth envelope. And, as in the short-run,
we can derive LMC from LAC, and LMC emerges
from the minimum point of LAC with a smoother
slope than the SMC curve.

Cost Elasticity

 On the basis of the
relation between MC and
AC we can develop a
new concept, viz., the
concept of cost elasticity.

 It measures the
responsiveness of total
cost to a small change in
the level of output.
 Economies of scope

 Economies of scope occur when a firm can gain
efficiencies from producing a wider variety of products.
 These efficiencies can involve lower average costs. It
can also involve increased revenue from being able to
increase sales in new, related markets.
 It is similar to concept of Economies of scale – where
higher output leads to lower average costs. But, there is
a difference. Economies of scope is not about producing
the same good at lower average cost, but using its size
and resources to produce similar or related goods.
Starbucks instant coffee

 Starbucks has a strong brand name for coffee retail
on the high street. It took the decision to produce an
instant coffee – making use of its own financial
resources and brand name.

 This is an economy of scope, as it is greater variety of

coffee. Interestingly some asked whether it was a
good idea because instant coffee is an anathema for
serious coffee connoisseurs, and it could harm its
brand image for high quality coffee.
 
 Using brand name to enter different markets

 tesco-finance

 A large supermarket like Tesco or Sainsbury’s can use its

powerful brand name to enter a completely different market
to groceries – selling financial services, credit cards,
insurance and banking. The firm makes use of its brand
name, customer data and regular contact with potential
customers to diversify into becoming a much more
encompassing firm.
 Break Even Analysis

 Break Even Analysis in economics, business, and cost
accounting refers to the point at which total cost and
total revenue are equal.

 A break even point analysis is used to determine the

number of units or revenue needed to cover total
costs (fixed and variable costs).


 Break Even Analysis

 Break even quantity = Fixed costs / (Sales price per unit –
Variable cost per unit)

 Fixed costs are costs that do not change with varying output (i.e.
salary, rent, building machinery).
 Sales price per unit is the selling price (unit selling price) per unit.
 Variable cost per unit is the variable costs incurred to create a unit.

  Sales price per unit minus variable cost per unit is the contribution
margin per unit. For example, if a book’s selling price is $100 and its
variable costs are $5 to make the book, $95 is the contribution
margin per unit and contributes to offsetting the fixed costs.
Break Even Point-Graph

 
 The Break Even Analysis is important to business owners
and managers in determining how many units (or
revenues) are needed to cover fixed and variable expenses
of the business.
 Therefore, the concept of break even point is as follows:
 Profit when Revenue > Total Variable cost + Total Fixed
cost
 Break-even point when Revenue = Total Variable cost +
Total Fixed cost
 Loss when Revenue < Total Variable cost + Total Fixed
cost
 Example

 Mr. Raghav is the managerial accountant in charge of
Company A, which sells water bottles. He previously
determined that the fixed costs of Company A consist
of property Tax, a lease, and executive salaries, which add up
to $100,000. The variable costs associated with producing one
water bottle is $2 per unit. The water bottle is sold at a
premium price of $12. To determine the break even point of
Company A’s premium water bottle:

   Break even quantity = $100,000 / ($12 – $2) = 10,000

 Therefore, given the fixed costs, variable costs, and selling

price of the water bottles, Company A would need to sell
10,000 units of water bottles to break even.

MARKET STRUCTURE
ANALYSIS AND
ESTIMATION
 PERFECT
COMPETITION
 CHARACTERISTICS

 Perfect Competition or Competitive markets -also
referred to as pure, or free competition

 Combination of a wide range of firms,

 Free entry or Exit, i.e., No entry or exit barriers.

 Characteristics

 Considers prices as information, since each bidder
only provides a relative small share of the Good to
the market and thus do not exert a noticeable
influence on it.

 Therefore, perfect competitors cannot influence the

levels of market clearing prices.

 Also, buyers are numerous and disperse, which also

means that they cannot influence pric
 Assumptions

 This market model is based on a set of assumptions, each
of them representing a necessary but insufficient
condition to ensure Perfect Competition. These
assumptions are:

1-Homogeneous product: all firms offer the same goods,

with the same characteristics and quality as the others.

2 -Large number of agents: there should be a sufficient

quantity of buyers and sellers, so that no action from a
single agent will affect the market structure or its prices.
 
3-No entry or exit barriers: there has to be free entry and
exit of agents in the market. This assumption is of special
interest for firms, which must be able to enter or leave the
market freely.

4-Price flexibility: price adjustments to changes happen as

fast as possible. Usually, price changes are assumed
instantaneous.

5 -Free and perfect information: all agents have perfect

knowledge of products and their prices, and everything else
related to them, as well as free access to this information.
 
6 -Perfect factor mobility: all factors should be able to change so
adjustments processes can be carried out with the greatest efficiency.

7 -No government intervention: markets should be left alone as

government intervention would only lead to imbalances in
perfectly competitive markets

8. Perfect Competition among Buyers and Sellers:

In this purchasers and sellers have got complete freedom for
bargaining, no restrictions in charging more or demanding less,
competition feeling must be present there
 
9. Absence of Transport Cost:
There must be absence of transport cost. In having less or
negligible transport cost will help complete market in
maintaining uniformity in price.

10.  One Price of the Commodity:

There is always one price of the commodity available in the
market.

11. Independent Relationship between Buyers and Sellers

 
 There are assumed to be no externalities, that is no
external costs or benefits to third parties not involved
in the transaction.

 Firms can only make normal profits in the long run,

although they can make abnormal (super-normal)
profits in the short run.
 
 There should not be any attachment between sellers and purchasers in
the market.

 Here, the seller should not show pick and choose method in accepting
the price of the commodity.

 “Perfect Competition is a pure myth.” - Perfect competition markets are

almost impossible to find in the real word as all markets have some type
of imperfection.

 This is the reason they are mostly considered only theoretically.

However, its study helps understand real world markets and their
phenomena.
 Firms are price taker

 The single firm takes its price from the industry, and
is, consequently, referred to as a price taker.

 The industry is composed of all firms in the industry

and the market price is where market demand is
equal to market supply.

 Each single firm must charge this price and cannot

diverge from it.
Supply and Demand in
Perfect Competition

 Let’s say there is a single individual, Joan.

 Joan’s demand for, let’s say, books, is

such as shown in the adjacent graph.

 If the price of a book is $35 or more, Joan

won’t demand any (point a), given her
preferences (basically, she would rather
spend her money on something else).

 However, if the price of books goes down

to $30, she will want to buy one (point b).
If it decreases to $20, Joan will buy two
books (point c), and so on.

 By joining all the points (a-h), we’ll get

Joan’s demand curve.
 
 From a macroeconomic point of view, the demand
curve is just the aggregation of all demand curves
from all buyers in a particular market.

 Let’s say the market for books has only two buyers:
Joan and her classmate Edward.

 The horizontal sum of Joan and Edward’s demand

curves will give us the market demand.

 SUPPLY

 starting with an individual’s offer, let’s say his name is Robert.

 Robert is willing to supply books for $10 or more, i.e, Robert won’t
supply any books for $5 (point a).

 However, if the price of books goes up to $10, he will be willing to sell

one book (point b).

 If it increases to $15, Robert will sell two books (point c), and so on.

 By joining all the points (a-g), we’ll get Robert’s supply curve. Notice
that the supply curve goes up and seems not to have limits, an
assumption made for simplicity’s sake.

 Market Supply Curve

 The market’s supply
curve is just the
aggregation of all supply
curves from all sellers in
a particular market.

 Let’s say the market for

books has only two
sellers: Robert and the
librarian next door,
Gregory.
 Equilibrium and
market clearing

 The demand and supply curves define the market clearing, that is,
where the demand of the products meets its supply.

 An equilibrium point, with its corresponding price and quantity of

equilibrium.

 Disequilibrium occur when the amount demanded does not equal the
amount supplied. In situations in which the quantity demanded is
higher than the quantity supplied, the market is suffering from an
excess demand. When the opposite occurs results in an excess supply.

 Prices will have to gradually adjust through different market

mechanisms until the equilibrium

Movements vs. shifts:

 Movement Vs. Shifts

 When analysing demand and supply and their
respective curves, it is important to distinguish
between two aspects:

 movements along curves and

 shifts in curves.

