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Marginal utility (MU) = 𝐶𝑎𝑛𝑔𝑒
𝑖𝑛 𝑡𝑜𝑡𝑎𝑙 𝑢𝑡𝑖𝑙𝑖𝑡𝑦 𝐶𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑐𝑜𝑛𝑠𝑢𝑚𝑒𝑑
Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University.
Department Of Finance
Md. Mazharul Islam (Jony)
Economics is a social science that studies individuals' economic behavior, economic phenomena, as well as how individual agents, such as consumers, firms, and government agencies, make tradeoff choices that allocate limited resources among competing uses. People's desires are unlimited, but resources are limited, therefore individuals must make trade-offs. We need economics to study this fundamental conflict and how these trade-offs are best made.
Modern economics mainly developed in last sixty years, systematically studies individuals' economic behavior and economic phenomena by a scientific studying method - observation→ theory →observation- and through the use of various analytical approaches.
An economic theory, which can be considered an axiomatic approach, consists of a set of assumptions and conditions, an analytical framework, and conclusions (explanations and/or predications) that are derived from the assumptions and the analytical framework. Like any science, economics is concerned with the explanation of observed phenomena and also makes economic predictions and assessments based on economic theories. Economic theories are developed to explain the observed phenomena in terms of a set of basic assumptions and rules.
Microeconomic theory aims to model economic activities as the interaction of individual economic agents pursuing their private interests.
Micro Economics Vs Macroeconomics
Microeconomics is generally the study of individuals and business decisions, macroeconomics looks at higher up country and government decisions. Macroeconomics and microeconomics, and their wide array of underlying concepts, have been the subject of a great deal of writings. The field of study is vast; here is a brief summary of what each covers: Microeconomics is the study of decisions that people and businesses make regarding the allocation of resources and prices of goods and services. This means also taking into account taxes and regulations created by governments. Microeconomics focuses on supply and demand and other forces that determine the price levels seen in the economy. For example, microeconomics would look at how a specific company could maximize it's production and capacity so it could lower prices and better compete in its industry. (Find out more about microeconomics in Understanding Microeconomics.) Macroeconomics, on the other hand, is the field of economics that studies the behavior of the economy as a whole and not just on specific companies, but entire industries and economies. This looks at economy-wide phenomena, such as Gross National Product (GDP) and how it is affected by changes in unemployment, national income, rate of growth, and price levels. For example, macroeconomics would look at how an increase/decrease in net exports would affect a nation's capital account or how GDP would be affected by unemployment rate. (To keep reading on this subject, see Macroeconomic Analysis.)
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While these two studies of economics appear to be different, they are actually interdependent and complement one another since there are many overlapping issues between the two fields. For example, increased inflation (macro effect) would cause the price of raw materials to increase for companies and in turn affect the end product's price charged to the public. The bottom line is that microeconomics takes a bottoms-up approach to analyzing the economy while macroeconomics takes a top-down approach. Regardless, both micro- and macroeconomics provide fundamental tools for any finance professional and should be studied together in order to fully understand how companies operate and earn revenues and thus, how an entire economy is managed and sustained. 1.Microeconomics focuses on the markets supply and demand factors, and determines the economic price levels. 2.Macroeconomics is a vast field, which concentrates on two major areas, increasing economic growth and changes in the national income. 3.Microeconomics facilitates decision making for smaller business sectors. 4.Macroeconomics focuses on unemployment rates, GDP and price indices, of larger industries and entire economies.
Positive economics is the branch of economics that concerns the description and explanation of economic phenomena. It focuses on facts and cause-and-effect behavioral relationships and includes the development and testing of economics theories. Earlier terms were value-free economics and its German counterpart wertfrei economics. Positive economics as science, concerns analysis of economic behavior. A standard theoretical statement of positive economics as operationally meaningful theorems is in Paul Samuelson's Foundations of Economic Analysis (1947). Positive economics as such avoids economic value judgments. For example, a positive economic theory might describe how money supply growth affects inflation, but it does not provide any instruction on what policy ought to be followed. Still, positive economics is commonly deemed necessary for the ranking of economic policies or outcomes as to acceptability, which is normative economics. Positive economics is sometimes defined as the economics of "what is", whereas normative economics discusses "what ought to be". Positive economics usually answers the question "why". To illustrate, an example of a positive economic statement is as follows: The price of milk has risen from $3 a gallon to $5 a gallon in the past five years. This is a positive statement because it can be proven true or false by comparison against real-world data. In this case, the statement focuses on facts.
Normative economics is that part of economics that expresses value judgments (normative judgments) about economic fairness or what the economy ought to be like or what goals of public policy ought to be.
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but rejected the idea that only agriculture was productive. and capital as the three factors of production and the major contributors to a nation's wealth. which do not depend on such knowledge. including laissez-faire." The book identified land. because it reflects value judgments and cannot be proven true or false by comparison against real world data. land. The general Department Of Finance Jagannath University Md. and capital) will use them most profitably. which do. under competition. Smith argued for the seemingly paradoxical notion that competitive markets tended to advance broader social interests. in pursuit of their own self-interests. Smith incorporated some of the Physiocrats' ideas. In his famous invisible-hand analogy. into his own economic theories. from nonbasic judgments. labor. although driven by narrower self-interest. This leaves open the possibility of fruitful scientific discussion of value judgments. This specific statement makes the judgment that farmers need a higher living standard and that family farms need to be saved. Adam Smith Smith discusses the benefits of the specialization by division of labour. His "theorem" that "the division of labor is limited by the extent of the market" has been described as the "core of a theory of the functions of firm and industry" and a "fundamental principle of economic organization. He finds it interesting to note that "no judgments are demonstrably basic" while some value judgments may be shown to be nonbasic. This undermines the common distinction. Nature of Economic Theories Classical political economy Publication of Adam Smith's The Wealth of Nations in 1776. owners of resources (labor. so that a change of values may be purely scientific. the ideal economy is a self-regulating market system that automatically satisfies the economic needs of the populace." To Smith has also been ascribed "the most important substantive proposition in all of economics" and foundation of resourceallocation theory – that. But welfare economist Amartya Sen distinguishes basic (normative) judgments. to produce the greatest benefit for society as a whole. has been described as "the effective birth of economics as a separate discipline. But many normative (value) judgments are held conditionally. resulting in an equal rate of return in equilibrium for all uses (adjusted for apparent differences arising from such factors as training and unemployment).It is common to distinguish normative economics ("what ought to be" in economic matters) from positive economics ("what is"). to be given up if facts or knowledge of facts changes. Mazharul Islam (Jony) 4|Page . In Smith's view. This is a normative statement. He described the market mechanism as an "invisible hand" that leads all individuals. An example of a normative economic statement is as follows: The price of milk should be $6 a gallon to give dairy farmers a higher living standard and to save the family farm.
Coming at the end of the Classical tradition. with rent and profit. The force of a rapidly growing population against a limited amount of land meant diminishing returns to labor. While Adam Smith emphasized the production of income. Malthus cautioned law makers on the effects of poverty reduction policies Thomas Robert Malthus used the idea of diminishing returns to explain low living standards. Smith maintained that. pressing against a fixed supply of land. making it necessary for society to intervene. and capitalists. David Ricardo focused on the distribution of income among landowners. Malthus also questioned the automatic tendency of a market economy to produce full employment. Ricardo saw an inherent conflict between landowners on the one hand and labor and capital on the other. and John Stuart Mill writing from about 1770 to 1870. termed the 'labour theory of value'. Mazharul Islam (Jony) 5|Page . he wrote. The result. Value theory was important in classical theory. tended to increase geometrically. Classical economics focused on the tendency of markets to move to long-run equilibrium. Mill pointed to a distinct difference between the market's two roles: allocation of resources and distribution of income. which prevented the standard of living for most of the population from rising above the subsistence level. It included such notables as Thomas Malthus. was chronically low wages. John Stuart Mill parted company with the earlier classical economists on the inevitability of the distribution of income produced by the market system. workers. The market might be efficient in allocating resources but not in distributing income. He posited that the growth of population and capital. which increased arithmetically. a theme that lay forgotten until John Maynard Keynes revived it in the 1930s.. he claimed. pushes up rents and holds down wages and profits. other costs besides wages also enter the price of a commodity.. Human population. Marxism The Marxist school of economic thought comes from the work of German economist Karl Marx. Smith wrote that the "real price of every thing . He blamed unemployment upon the economy's tendency to limit its spending by saving too much. he argued. outstripping the production of food. David Ricardo. The period from 1815 to 1845 was one of the richest in the history of economic thought. Other classical economists presented variations on Smith. Department Of Finance Jagannath University Md. is the toil and trouble of acquiring it" as influenced by its scarcity.approach that Smith helped initiate was called political economy and later classical economics.
affecting both the allocation of output and the distribution of income. Keynes attempted to explain in broad theoretical detail why high labour-market unemployment might not be self-correcting due to low "effective demand" and why even price flexibility and monetary policy might be unavailing.Marxist (later. analysis of market failure and imperfect competition. Marxian) economics descends from classical economics. and the neoclassical model of economic growth for analyzing long-run variables affecting national income. such as econometrics. Neoclassical economics A body of theory later termed 'neoclassical economics' or 'marginalism' formed from about 1870 to 1910. Keynesian economics derives from John Maynard Keynes. Marx focused on the labour theory of value and what he considered to be the exploitation of labour by capital. It dispensed with the labour theory of value inherited from classical economics in favor of a marginal utility theory of value on the demand side and a more general theory of costs on the supply side. in particular his book The General Theory of Employment. was published in German in 1867. Mazharul Islam (Jony) 6|Page . In microeconomics. Such terms as "revolutionary" have been applied to the book in its impact on economic analysis. which ushered in contemporary macroeconomics as a distinct field. neoclassical theorists moved away from an earlier notion suggesting that total utility for a society could be measured in favor of ordinal utility. The term 'economics' was popularized by such neoclassical economists as Alfred Marshall as a concise synonym for 'economic science' and a substitute for the earlier. Keynesian economics John Maynard Keynes (right). which isolates how prices (as costs) and income affect quantity demanded. neoclassical economics represents incentives and costs as playing a pervasive role in shaping decision making. Interest and Money (1936). Keynesian economics has two successors. game theory. Modern mainstream economics builds on neoclassical economics but with many refinements that either supplement or generalize earlier analysis. The first volume of Marx's major work. In it. In macroeconomics it is reflected in an early and lasting neoclassical synthesis with Keynesian macroeconomics. An immediate example of this is the consumer theory of individual demand. Neoclassical economics is occasionally referred as orthodox economics whether by its critics or sympathizers. which hypothesizes merely behavior-based relations across persons. This corresponded to the influence on the subject of mathematical methods used in the natural sciences. It derives from the work of Karl Marx. Neoclassical economics systematized supply and demand as joint determinants of price and quantity in market equilibrium. Das Kapital. Post-Keynesian economics also concentrates on macroeconomic rigidities and adjustment processes. The labour theory of value held that the value of an exchanged commodity was determined by the labor that went into its production. broader term 'political economy'. In the 20th century. Research on micro foundations for their models is represented as based Department Of Finance Jagannath University Md. The book focused on determinants of national income in the short run when prices are relatively inflexible. was a key theorist in economics.
Within this group researchers tend to share with other economists the emphasis on models employing micro foundations and optimizing behavior but with a narrower focus on standard Keynesian themes such as price and wage rigidity. Mazharul Islam (Jony) 7|Page . Jagannath University. 3rd Batch. New-Keynesian economics is also associated with developments in the Keynesian fashion. It is generally associated with the University of Cambridge and the work of Joan Robinson. Md. Mazharul Islam (Jony) ID no:091541. Department Of Finance Jagannath University Md. These are usually made to be endogenous features of the models. rather than simply assumed as in older Keynesian-style ones. Department of Finance.on real-life practices rather than simple optimizing models.
b) Income demand: The income demand refers to the various quantities of goods and services which would be purchased by the consumers at various levels of incomes. Thus demand price is identical with average revenue (AR). It is assumed that other things. For example. Mazharul Islam (Jony) 8|Page . or at various incomes. The total demand for the product of an individual firm at various prices is known as firm’s demand or Individual seller’s Demand. inferior goods command large sales when incomes are at a lower level. Here we assume that the prices of the commodity or service as well as the prices of inter related goods and the tastes and desires of consumers do not change. remain unchanged. For instance. On the other hand. The demand for anything at a given price is the amount of it which will be bought per unit of time at that price. his tastes and prices of inter-related goods. Types of Demand: There are three kinds of demands are discussed. A change in the price of tea will affect the demand for coffee. The demand of the individual consumer is called Individual Demand and the total demand of all the consumers combined for the commodity or service is called Industry Demand. the demand curve is also drawn as AR curve. In other words. Department Of Finance Jagannath University Md. such as consumer’s income. The income demand shows the relationship between income and quantities demand. Price demand expresses relationship between prices and quantities. That is why. c) Cross demand: The cross demand means the quantities of goods or services which will be purchased with reference to change in price not of this good but of other inter-related goods.Bober From the point of view of the seller. ―By demand we mean the various quantities of a given commodity or service which consumers would buy in one market in a given period of time at various prices. These goods are either substitutes or complementary goods. the demand price is the average revenue (revenue per unit) or income he expects to earn from the sale of a unit of commodity. Superior goods or high priced articles command brisk sales when income increases.‖ . a) Price Demand: Price demand refers to the various quantities of a commodity or service that a consumer would purchase at a given time in a market at various hypothetical prices. or at various prices of related goods.Theory of Demand and Supply Demand: The term demand refers to the quantity of a given product that consumers will be willing and able to buy at a given price.
but we cannot say how much. Special influences: It will affect the demand for particular goods. Mazharul Islam (Jony) 9|Page . Of these types of demand. Here 𝑄𝑑 is the quantity demand and P is price. Preferences (tastes): Tastes represent a variety of cultural and historical influences. We can only say that the demand will extend when the price falls. Expectations of future prices: Expectation also brings a change in demand. it does not follow that the demand will increase exactly by 10 percent. If the price falls by 10 percent. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up. The demand for umbrellas is high in rainy season but low in sunny phoenix. the lower the quantity demanded (𝑄𝑑 ). The given conditions include: Income and wealth: As people’s incomes rise. Prices of substitutes and complements: Substitute and complement good’s price will highly affect the demand of particular goods. As a result. Population: Population clearly affects the market demand curve. The chart below shows that the demand curve is a downward slope. even if prices don’t change.In short. If prices are expected to rise in future. It may also be added that no proportionality in the change is implied. the demand for goods will increase now in the present. and everything else remains the same. P 𝑑 𝑄 Obviously. This will depend on the elasticity of demand. Department Of Finance Jagannath University Md. It varies with price and can be expressed as. the law of demand is based on the law of diminishing marginal utility. individuals tend to buy more of almost everything. Demand Curve or Demand Schedule: A Demand Curve or demand schedule is a graphical representation of the relationship between price and quantity demanded (ceteris paribus). the quantity of the good demanded will fall. It is a curve or line. Determinants of Demand: Quantity demanded (𝑄𝑑 ) is the total amount of a good that buyers would choose to purchase under given conditions. In other words. We refer to all of these things as determinants of demand. so does the opportunity cost of buying that good. the higher the price. Demand Function: Demand function is a function of Price. The Law of Demand: The Law of Demand states that when the price of a good rises. each point of which is a price𝑄𝑑 pair. That point shows the amount of the good buyers would choose to buy at that price. 𝑄𝑑 = 𝐹 𝑃 . it is the law of diminishing marginal utility which explains the law of demand. In other words. people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more.In economics the above types of demand are mostly discussed. Price demand is the most commonly spoken one.
and vice versa. Each point on the curve reflects a direct correlation between quantities demanded (Q) and price (P). for instance. if the price for a bottle of beer was $2 and the quantity of beer demanded increased from Q1 to Q2. Therefore. Movements: A movement refers to a change along a curve. and so on. a movement denotes a change in both price and quantity demanded from one point to another on the curve. at point A. the more the good will be in demand (C). the movements and shifts in relation to the demand curve represent very different market phenomena: 1. The demand relationship curve illustrates the negative relationship between price and quantity demanded. B and C are points on the demand curve. Shifts in the demand curve imply that the original demand relationship has changed. Mazharul Islam (Jony) ID no:091541. a movement occurs when a change in the quantity demanded is caused only by a change in price. Jagannath University. 3rd Batch. Shifts: A shift in a demand curve occurs when a good's quantity demanded changes even though price remains the same. Movement in the demand curve: Changes in demand or shifts in demand occur when one of the determinants of demand other than price changes. beer suddenly became the only type of alcohol available for consumption. a movement along the demand curve will occur when the price of the good changes and the quantity demanded changes in accordance to the original demand relationship. The higher the price of a good the lower the quantity demanded (A). the quantity demanded will be Q1 and the price will be P1. and the lower the price. For economics. In other words. Md. For instance. 2. then there would be a shift in the demand for beer. Department Of Finance Jagannath University Md. A shift in the demand relationship would occur if. meaning that quantity demand is affected by a factor other than price. Shifts vs.A. Mazharul Islam (Jony) 10 | P a g e . The movement implies that the demand relationship remains consistent. So. On the demand curve. Department of Finance.
It is usually the case that demand decreases and supply increases as the unit price increases. Department Of Finance Jagannath University Md. ―We may define supply as a schedule of the amount of a good that would be offered for sale at all possible prices at any one instant of time. taxes. capital): If the price of factor increases the supply curve will shift in as sellers are less willing or able to sell goods at existing prices. Mathematically. Prices of alternative products the firm could produce: For purposes of supply analysis related goods refer to goods from which inputs are derived to be used in the production of the primary good. Supply will increase 10% . a day. Determinants of Supply: Innumerable factors and circumstances could affect a seller’s willingness or ability to produce and sell a good. Supply Function: A supply equation or supply function expresses supply 𝑄𝑠 (the number of items a supplier is willing to bring to the market) as a function of the unit price P (the price per item). Technology: A technological advance would cause the average cost of production to fall which would be reflected in an outward shift of the supply curve.Supply: Supply represents how much the market can offer at a given price. The term supply refers to the quantity of a particular product that suppliers (producers and/or sellers) will make available to the market at a particular price. hour and wage laws. For example. Special influences: Special influences affect the supply curve. a week. Cost of production: When production cost for a goods are low relative to the market price. in which the conditions of supply remain the same‖ . 𝑄𝑠 = 𝑓(𝑃). electrical and natural gas rates and zoning and land use regulations. but the willingness and ability of potential sellers to produce and sell it. the weather exerts an important influence on farming and on the ski industry. For example. it is profitable for producers to supply a great deal. Expectations of future prices: Sellers expectations concerning future market condition can directly affect supply. or during any one period of time. The supply equation is the explicit mathematical expression of the functional relationship. for example. and so on. Supply is not just the amount of something there. Mazharul Islam (Jony) 11 | P a g e . Some of the more common factors are: Prices of factors of production (labor. Government policy: Government intervention can take many forms including environmental and health regulations.Meyer At last we can say that.
Mazharul Islam (Jony) 12 | P a g e . and vice versa. Therefore. A. a movement along the supply curve will occur when the price of the good changes and the quantity supplied changes in accordance to the original supply relationship. It is a curve or line. a movement occurs when a change in quantity supplied is caused only by a change in price. The chart below shows that the supply curve is a upward slope. It should be emphasized that this list is not exhaustive. the higher the quantity supplied. B and C are points on the supply curve. the quantity supplied will be Q2 and the price will be P2. Shifts vs. each point of which is a price-𝑄𝑠 pair.We refer to all of these as determinants of supply. Movement in the Supply curve: Changes in supply or shifts in supply occur when one of the determinants of supply other than price changes. the quantity of the good supplied will also rise. At point B. All facts and circumstances that are relevant to a seller's willingness or ability to produce and sell goods can affect supply. Movements: A movement refers to a change along a curve. when the price of a good rises. A movement along the supply curve means that the supply relationship remains consistent. ↑P → ↑𝑄𝑠 . For economics. That point shows the amount of the good sellers would choose to sell at that price. This means that the higher the price. The Law of Supply: The Law of Supply states that. But unlike the law of demand. Each point on the curve reflects a direct correlation between quantities supplied (Q) and price (P). the movements and shifts in relation to the supply curve represent very different market phenomena: 1. Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue. In other words. In short. Department Of Finance Jagannath University Md. and so on. and everything else remains the same. the supply relationship shows an upward slope. Supply Curve or Supply Schedule: A Supply Curve is a graphical representation of the relationship between price and quantity supplied (ceteris paribus).
Effect of Shift in Supply and Demand: Some events cause both the supply curve and the demand curve to shift.e. Market price is determined by the interaction of the forces of demand and supply. For instance.2.e. equilibrium occurs at the intersection of the demand and supply curve. the allocation of goods is at its most efficient because the amount of goods being supplied is exactly the same as the amount of goods being demanded. If both shift. Department Of Finance Jagannath University Md. when the supply function and demand function intersect) the economy is said to be at equilibrium. a shift in the supply curve implies that the original supply curve has changed. These figures are referred to as equilibrium price and quantity. the price of the goods will be P* and the quantity will be Q*. and customers who demand the product. where there is no surplus or shortage. Equilibrium position: When supply and demand are equal (i. Market and Customer: Markets consist of individual or groups of businesses that are prepared to supply a product. Like a shift in the demand curve. which indicates no allocative inefficiency. if the price for a bottle of beer was $2 and the quantity supplied decreased from Q1 to Q2. meaning that the quantity supplied is effected by a factor other than price. Shifts: A shift in a supply curve occurs when a good's quantity supplied changes even though price remains the same. then there would be a shift in the supply of beer. a natural disaster caused a mass shortage of hops. At this point.000 papers are demanded and supplied. even if we know the direction in which each curve shifts. beer manufacturers would be forced to supply less beer for the same price. At 50 pence where 500. The equilibrium position arises where the wishes of buyers and sellers match i. In the chart. For example. A shift in the supply curve would occur if. At this point. Mazharul Islam (Jony) 13 | P a g e . for instance. then the qualitative effect on the equilibrium price and quantity may be difficult to predict. Changes in the equilibrium price and quantity depend on exactly how the curves shift.
and raising equilibrium quantity. Now if both demand and supply both shift at once. lower price of complements. ↑Q*] A leftward shift of demand would reverse the effects: a fall in both price and quantity. Such a shift will tend to have two effects: raising equilibrium price.Effect of shift in Demand: Consider first a rightward shift in Demand. the two changes have reinforcing effects on either price or quantity.] A left shift of supply would reverse the effects. so the general result is that supply shifts tend to cause price and quantity to move in opposite directions. and lowering equilibrium price. and offsetting effects on the other. Effect of shift in Supply: Consider a rightward shift of supply (caused by lower factor price. etc. or whatever). better technology. the effect on price and quantity of different demand and supply shifts: Cause If demand rises If demand falls If supply rises If supply falls Demand and Supply Shifts The demand curve shifts to the right The demand curve shifts to the left The supply curve shifts to the right The supply curve shifts to the left Effect on price and quantity Price Quantity Price Quantity Price Quantity Price Quantity At the end we can say that. This could be caused by many things: an increase in income. [↑P*. Department Of Finance Jagannath University Md. Mazharul Islam (Jony) 14 | P a g e . [↓P*. ↑Q*. higher price of substitute. This will tend to have two effects: raising equilibrium quantity. The general result is that Demand shifts cause price and quantity to move in the same direction.
elasticity refers to how strongly the quantities supplied and demanded respond to various factors. At price P1 the quantity of goods that the producers wish to supply is indicated by Q2. the quantity that the consumers want to consume is at Q1. Excess Supply: If the price is set too high. Because Q2 is greater than Q1. there are too few goods being produced to satisfy the wants (demand) of the consumers. Because the price is so low. Mazharul Islam (Jony) 15 | P a g e . which they hope to sell to increase profits. too much is being produced and too little is being consumed. too many consumers want the good while producers are not making enough of it. The quantity demanded of a good is affected by changes in the price of a good. At P1. However. The suppliers are trying to produce more goods. however. making suppliers want to supply more and bringing the price closer to its equilibrium. the quantity of goods that producers are willing to produce at this price is Q1. the quantity of goods demanded by consumers at this price is Q2. including price and other determinants. Thus. Excess Demand: Excess demand is created when price is set below the equilibrium price. Elasticity: Elasticity is a central concept in the theory of supply and demand. 1. 2. Department Of Finance Jagannath University Md. as consumers have to compete with one other to buy the good at this price. the demand will push the price up. but those consuming the goods will find the product less attractive and purchase less because the price is too high.Disequilibrium: Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*. In this context. a quantity much less than Q2. In this situation. changes in income and changes in other relevant factors. change in price of other goods. Conversely. It may carefully noted that elasticity depends primarily on proportional or percentage changes not on absolute changes in price and quantity demanded. excess supply will be created within the economy and there will be allocative inefficiency. at price P1.
They are. 𝐸𝑝 = 1 Perfectly elastic demand: When the quantity demanded changes by a very large percentage in response to an almost zero percentage change in price is known as perfectly elastic demand. The formula for the coefficient of price elasticity of demand for a good is: Price Elasticity.Types of Elasticity: Different elasticities of demand measures the responsiveness of quantity demanded to changes in variables which affect demand. 1. Mazharul Islam (Jony) 16 | P a g e . The formula is equivalent to: Department Of Finance Jagannath University Md. Symbolically. 𝐸𝑝 = ∞ Perfectly inelastic demand: When the quantity demanded remains constant as the price changes is known as perfectly inelastic demand. Symbolically. Income elasticity of demand: Income elasticity of demand measures the responsiveness of quantity demanded by changes in consumer incomes. Symbolically. We may distinguish between the three types of elasticities. Price elasticity of demand (PED): Price elasticity of demand measures the responsiveness of quantity demanded by changes in the price of the good. 𝐸𝑝 = 0 2. Positive Price Elasticity can be divided into 3 categories: Unit elastic demand: If the percentage change in the quantity demanded equals the percentage change in price is known as unit elastic demand. 𝐸𝑝 = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒 = ∆𝑄 ×100 𝑄 ∆𝑃 ×100 𝑃 = ∆𝑄 𝑄 × 𝑃 ∆𝑃 = 𝑃 𝑄 × ∆𝑄 ∆𝑃 .
Symbolically. 𝐸𝑦 = 1. the quantity of new cars demanded decreased by 20%. 𝐸𝑦 = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑝𝑢𝑟𝑐 𝑎𝑠𝑒𝑑 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐𝑎𝑛𝑔𝑒 𝑖𝑛 𝐼𝑛𝑐𝑜𝑚𝑒 = ∆𝑄 ×100 𝑄 ∆𝑌 ×100 𝑌 = ∆𝑄 𝑄 × 𝑌 ∆𝑌 = 𝑌 𝑄 × ∆𝑄 ∆𝑌 . X = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑢𝑟𝑐 𝑎𝑠𝑒 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑦 = ∆𝑄 𝑥 ×100 𝑄 𝑥 ∆𝑃 𝑦 ×100 𝑃 𝑦 = ∆𝑄𝑥 𝑄𝑥 × 𝑃𝑦 ∆𝑃𝑦 = 𝑃𝑦 𝑄𝑥 × ∆𝑄𝑥 ∆𝑃𝑦 . Income elastic: When the proportion of income spent on a good increases as income increases. Positive Income Elasticity can be divided into 3 categories: Income inelastic: When the proportion of income spent on a good decreases a income increases. P is the commodity of y and ∆𝑃 is some proportional increase in personal disposable income. [Here ∆𝑄 stands for some increase in Q.] For an example with a complement good. Inferior goods: any good in which consumers have negative income elasticity of demand. if. Department Of Finance Jagannath University Md. the cross elasticity of demand would be -2.Income Elasticity. Normal goods: Any goods whose income elasticity of demand is greater than zero. in response to a 10% increase in the price of fuel. 𝐸𝑦 < 1. 𝐸𝑦 > 1. which are substitutes. which are complements. Unit income elasticity: When the proportion of income spent on a good remains the same even though income increases. These are: Cross elasticity. Symbolically. 3. 𝐸𝑦 = 0. As with price and income elasticity. Cross elasticity of demand: Cross elasticity of demand measures the responsiveness of quantity demanded by changes in price of another good. it is sometimes more convenient to use alternative formulae for cross elasticity of demand. Symbolically. Symbolically.0. Mazharul Islam (Jony) 17 | P a g e . will have a negative cross elasticity. Two goods. Q is the quantity of commodity x. will have a positive cross elasticity while two goods.
The demand curve has a ''steep'' appearance. 𝑤) be the demand of goods 𝑥1 . using sophisticated mathematical techniques (better known as calculus) can calculate point elasticity by taking derivatives of equations. This method for computing the price elasticity is also known as the "midpoints formula". In terms of partial-differential calculus. The notion of point elasticity typically comes into play when discussing the elasticity at a specific point on a curve.𝑝 𝑘 = ∙ = 𝜕𝑝𝑘 𝑥𝑙 (𝑝. 𝑤) 𝜕𝑙𝑜𝑔𝑝𝑘 However. the point-price elasticity can be computed only if the formula for the demand function. is known so its derivative with respect to price. Arc elasticity of demand measures elasticity between two points on a curve. Point Elasticity of Demand: Point elasticity demand means the relatively responsiveness of a change in one variable to an infinitesimally small change in another variable. 𝑤) 𝑝𝑘 𝜕𝑙𝑜𝑔𝑥𝑙 (𝑝. cross elasticity will indicate complementarily or rivalry only if the commodities in question figure in the family budget in small proportions. 𝑥2 . dQd / dP. The elasticity of demand for good 𝑥𝑙 𝑝. 𝑤 with respect to price pk is 𝜕𝑥𝑙 (𝑝. demand is said to be elastic. … … 𝑥𝐿 as a function of parameters price and wealth. 𝑃 𝑑𝑄𝑑 𝐸𝑑 = × 𝑄𝑑 𝑑𝑃 In other words. If the arc or price elasticity of demand is less than 1. 𝑤 be the demand for good 𝑙. demand is said to be inelastic. If the arc or price elasticity of demand is greater than 1. Sophisticated economists. Derivatives are fancy calculus talk for infinitesimally small changes. The formula is. it is equal to the absolute value of the first derivative of quantity with respect to price (dQd/dP) multiplied by the point's price (P) divided by its quantity (Qd). The demand curve has a ''flat'' appearance. Department Of Finance Jagannath University Md. Mazharul Islam (Jony) 18 | P a g e . point-price elasticity of demand can be defined as follows: let 𝑥(𝑝. because the average price and average quantity are the coordinates of the midpoint of the straight line between the two given points. The arc elasticity is defined mathematically as: 𝐸𝑑 = 𝑃 1 +𝑃 2 2 𝑄 𝑑 +𝑄 𝑑 1 2 2 × ∆𝑄𝑑 ∆𝑃 = 𝑄 𝑃1 +𝑃2 𝑑 1 +𝑄𝑑 2 × ∆𝑄𝑑 ∆𝑃 [ where means "VERY SMALL CHANGES IN"] The arc elasticity formula is used if the change in price is relatively large. Point elasticity can be calculated in a number of different ways. It is more accurate a measure of elasticity than simple ''price elasticity''. Qd = f(P). Arc Elasticity of Demand: The arc elasticity of demand refers to the relationship between changes in price and the subsequent change in quantity demanded. and let 𝑥𝑙 𝑝.Note: It should remembered that. can be determined. 𝑤) 𝐸𝑥 𝑙 .
Find the arc elasticity of demand.∞ A decrease in the price of a good normally results in an increase in the quantity demanded by consumers because of the law of demand. or unitarily elastic demand Ed = . Using this midpoint formula (with price designated as P and quantity designated as Q) average price elasticity of demand is: Solution: midpoint = elasticity midpoint = elasticity 𝑄𝑧 −𝑄𝑥 𝑄 𝑧 +𝑄 𝑥 2 ÷ 𝑃𝑧 −𝑃𝑥 𝑃 𝑧 +𝑃 𝑥 2 6−4 6+4 2 ÷ 8−12 8+12 2 = ÷ 5 2 −4 10 midpoint = 0. For an example with a complement good. 20 The % change in quantity is = .667 The % change in price is Therefore PED = −0.7 Example: If the price declines from $12 to $8. and conversely.18 Ans.0. Solution: Arc elasticity of demand assumes that we should calculate using the midpoint between 40 and 20 which equals 30 and the midpoint between 10 and 12 which 11. Department Of Finance Jagannath University Md. in response to a 10% increase in the price of fuel.1 Elastic or relatively elastic demand . unit elasticity.1 < Ed < 0 Unit elastic. Now. Cross elasticity of demand is measured as the percentage change in demand for the first good divided by the causative percentage change in the price of the other good.667 0. the PED for a good or service is referred to by different descriptive terms depending on whether the elasticity coefficient is greater than. As summarized in the table above. equal to.0 elasticity Elasticities of demand are interpreted as follows: Value Descriptive Terms Perfectly inelastic demand Ed = 0 Inelastic or relatively inelastic demand .1 Perfectly elastic demand Ed = . from point X to point Z.0. unitary elasticity. the cross elasticity of demand would be -2.18 2𝑝 11 30 = 0. quantity demanded decreases when price rises.4 ÷ -0. the quantity demanded increases from 4 to 6. Mazharul Islam (Jony) 19 | P a g e . Examples: 1. the quantity of new cars demanded decreased by 20%.∞ < Ed < . or less than −1.Formula for Average of 'midpoint' elasticity of demand (change in Q / average Q ) (change in P / average P) Example: If the Price increases from 10p to 12p and Quantity falls from 40 to 20. if.4 = -1. = -3.
(15 − 10) ÷ 15. because an increase in price is likely to increase the quantity supplied to the market and vice versa. It is calculated as per the following formula: 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑 ∆𝑄 𝑃 Supply Elasticity 𝐸𝑠 = = × 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑄 ∆𝑃 At last we can say that. Supply elasticity is defined as the percentage change in quantity supplied divided by the percentage change in price. the percentage change is 50%.00 to $1. If the price moves from $1. Note: 1.e.e. Effective demand: Effective demand refers to a desire for a product that is backed up by a purchasing decision. Price. the percentage change is −33. High elasticity indicates the supply is sensitive to changes in prices. If quantity demanded increases from 10 units to 15 units. The relationship between demand and supply underlie the forces behind the allocation of resources.4. so the price elasticity of supply is 2%/5% or 0. Percentage change in quantity supplied divided by the percentage change in price: Value 𝑬𝒔 > 1 𝑬𝒔 < 1 𝑬𝒔 = 𝟏 𝑬𝒔 = 𝟎 𝑬𝒔 = ∞ Department Of Finance Descriptive Terms supply is price elastic supply is price inelastic Supply is price unitary elastic supply is perfectly inelastic supply is perfectly elastic following a change in demand Jagannath University Md. (15 − 10) ÷ 10 (converted to a percentage). therefore. 3. Elasticity of supply is measured as the ratio of proportionate change in the quantity supplied to the proportionate change in price. Responsiveness of producers to changes in the price of their goods or services. 2.05. is a reflection of supply and demand. it is not the same thing as demand.. i. Price elasticity of supply (PES): Price elasticity of supply measures the responsiveness of quantity supplied to changes in price. Mazharul Islam (Jony) 20 | P a g e . low elasticity indicates little sensitivity to price changes. But if quantity demanded decreases from 15 units to 10 units. the quantity of pens increased by 2%. For demand to be effective the consumer needs to have the money required to make the purchase. and as a result the quantity supplied goes from 100 pens to 102 pens.3%. As a general rule. The value of elasticity of supply is positive. Wants: A want is simply a desire for a product. Also called price elasticity of supply. and no elasticity means no relationship with price. and the price increased by 5%. 3.2.. demand and supply theory will allocate resources in the most efficient way possible. i. if prices rise so does the supply. In market economy theories.
but when prices remain high over several years. Duration: for most goods. eventually. as more and more consumers find they have the time and inclination to search for substitutes. as people can easily switch from one good to another if an even minor price change is made. it may become necessary for consumers to replace their present cars. whereas food in general would have an extremely low elasticity of demand because no substitutes exist. This does not hold for consumer durables such as the cars themselves. When fuel prices increase suddenly. more consumers will reduce their demand for fuel by switching to carpooling or public transportation. Complexity of Production: Much depends on the complexity of the production process. That is 1. such as with corporate expense accounts.Examples: 1. the longer a price change holds. the higher the elasticity is likely to be. The labor is largely unskilled and production facilities are little more than buildings . the higher the elasticity tends to be. consumers may still fill up their empty tanks in the short run. For example.125 = 9. such as the case of insulin for those that need it. the PES for specific types of motor vehicles is Department Of Finance Jagannath University Md. so one would expect demand to be less elastic. as people will pay more attention when purchasing the good because of its cost. for instance. demand is likely to be more inelastic. the lower the elasticity. Breadth of definition of a good: the broader the definition of a good (or service). Thus the PES for textiles is elastic. resulting in more inelastic demand. as people will attempt to buy it no matter the price. Percentage of income: the higher the percentage of the consumer's income that the product's price represents. the higher the elasticity is likely to be. the lower the elasticity. Company X's fish and chips would tend to have a relatively high elasticity of demand if a significant number of substitutes are available. On the other hand. Who pays: where the purchaser does not directly pay for the good they consume. Brand loyalty: an attachment to a certain brand—either out of tradition or because of proprietary barriers—can override sensitivity to price changes. Textile production is relatively simple. A number of factors can thus affect the elasticity of demand for a good: Availability of substitute goods: the more and closer the substitutes available.76 Determinants: Price elasticity of demand The overriding factor in determining PED is the willingness and ability of consumers after a price change to postpone immediate consumption decisions concerning the good and to search for substitutes ("wait and look"). Mazharul Islam (Jony) 21 | P a g e . Necessity: the more necessary a good is. however. Price elasticity of Supply Significant determinants include: Reaction time: The PES coefficient will largely be determined by how quickly producers react to price changes by increasing (decreasing) production and delivering (cutting deliveries of) goods to the market. Then the elasticity of supply is (2894-1304)/1304 divided (90-80)/80.22/0. investing in vehicles with greater fuel economy or taking other measures. Suppose the price of beer increases from 80c per gallon to 90c and the quantity supplied increases from 1304 to 2894.no special structures are needed.
An example would be the change in the supply for cookies caused by a one percent increase in the price of sugar. total revenue = price × quantity. and P(Q) is the inverse demand function (the demand function solved out for price in terms of quantity demanded). the percentage change the amount of the good supplied caused by a one percent increase in the price of a related good is an input elasticity of supply if the related good is an input in the production process. Time to respond: The more time a producer has to respond to price changes the more elastic the supply. i. Total revenue: Total revenue is the total money received from the sale of any given quantity of output.e. the effectiveness of the congestion charge in reducing road congestion. Some relevant issues that directly use elasticity of demand and supply include: Taxation: The effects of indirect taxes and subsidies on the level of demand and output in a market e. or letting TR be the total revenue function. For example. The elasticity will affect the ways in which price and output will change in a market.g. TR(Q) = P(Q) × Q Where Q is the quantity of output sold. a cotton farmer cannot immediately respond to an increase in the price of soybeans. The total revenue is calculated as the selling price of the firm's product times the quantity sold. For example. Inventories: A producer who has a supply of goods or available storage capacity can quickly respond to price changes. Excess capacity: A producer who has unused capacity can quickly respond to price changes in his market assuming that variable factors are readily available. Useful applications of price elasticity of demand and supply The key is to understand the various factors that determine the responsiveness of consumers and producers to changes in price. skilled labor. Mazharul Islam (Jony) 22 | P a g e . a large suppliers network and large R&D costs. Other elasticities can be calculated for non-price determinants of supply. or the impact of higher duties on cigarettes on the demand for tobacco and associated externality effects Changes in the exchange rate: The impact of changes in the exchange rate on the demand for exports and imports Exploiting monopoly power in a market: The extent to which a firm or firms with monopoly power can raise prices in markets to extract consumer surplus and turn it into extra profit (producer surplus) Government intervention in the market: The effects of the government introducing a minimum price (price floor) or maximum price (price ceiling) into a market Elasticity of demand and supply also affects the operation of the price mechanism as a means of rationing scarce goods and services among competing uses and in determining how producers respond to the incentive of a higher market price. Department Of Finance Jagannath University Md. Auto manufacture is a multi-stage process that requires specialized equipment. And elasticity is also significant in determining some of the effects of changes in government policy when the state chooses to intervene in the price mechanism. relatively inelastic.
Example: A promoter has properly estimated the demand curve for seats at an event to be Q = 40,000 − 2000P where P is the price of a seat. The inverse demand curve, which determines price as a function of quantity, is therefore represented by P(Q) = 20 − Q / 2000. We therefore have TR(Q) = 20Q − Q2 / 2000
Effect on total revenue
A set of graphs shows the relationship between demand and total revenue (TR). As price decreases in the elastic range, TR increases, but in the inelastic range, TR decreases. TR is maximized at the quantity where PED = 1.
Generally any change in price will have two effects in total revenue: The price effect: an increase in unit price will tend to increase revenue, while a decrease in price will tend to decrease revenue. The quantity effect: an increase in unit price will tend to lead to fewer units sold, while a decrease in unit price will tend to lead to more units sold. Because of the inverse nature of the relationship between price and quantity demanded (i.e., the law of demand), the two effects affect total revenue in opposite directions. But in determining whether to increase or decrease prices, a firm needs to know what the net effect will be. Elasticity provides the answer: The percentage change in total revenue is equal to the percentage change in quantity demanded plus the percentage change in price. (One change will be positive, the other negative.)
The relationship between the price elasticity of demand and total revenues:
Price elasticity of demand and total revenue: 1. Elasticity of demand is important because it predicts what may happen to total revenue received when a company changes the price of a product. 2. When the price elasticity of demand for a good is inelastic (𝐸𝑑 < 1), the percentage change in quantity is smaller than that in price. Hence, when the price is raised, the total revenue of producers rises, and vice versa. 3. When the price elasticity of demand for a good is elastic (𝐸𝑑 > 1), the percentage change in quantity is greater than that in price. Hence, when the price is raised, the total revenue of producers falls, and vice versa.
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4. When the price elasticity of demand for a good is unit elastic (or unitary elastic) (𝐸𝑑 = 1), the percentage change in quantity is equal to that in price. Hence, when the price is raised, the total revenue remains unchanged. The demand curve is a rectangular hyperbola. 5. When the price elasticity of demand for a good is perfectly elastic (𝐸𝑑 = ∞), any increase in the price, no matter how small, will cause demand for the good to drop to zero. Hence, when the price is raised, the total revenue of producers falls to zero. The demand curve is a horizontal straight line. A ten-dollar banknote is an example of a perfectly elastic good; nobody would pay $10.01, yet everyone will pay $9.99 for it. 6. When the price elasticity of demand for a good is perfectly inelastic (Ed = 0), changes in the price do not affect the quantity demanded for the good. The demand curve is a vertical straight line; this violates the law of demand. An example of a perfectly inelastic good is a human heart for someone who needs a transplant; neither increases nor decreases in price effect the quantity demanded (no matter what the price, a person will pay for one heart but only one; nobody would buy more than the exact amount of hearts demanded, no matter how low the price is).
In microeconomics, marginal revenue (MR) is the extra revenue that an additional unit of product will bring. It is the additional income from selling one more unit of a good; sometimes equal to price. It can also be described as the change in total revenue divide the change in the number of units sold. More formally, marginal revenue is equal to the change in total revenue over the change in quantity when the change in quantity is equal to one unit. Change in total revenue Marginal Revenue =
Change in sales
This can also be represented as a derivative when the units of output are arbitrarily small. (Total revenue) = (Price that can be charged consistent with selling a given quantity) times (Quantity) or 𝑇𝑅 = 𝑃 𝑄 . 𝑄 . Thus, by the product rule: 𝑑𝑇𝑅 𝑑𝑃 𝑑𝑄 𝑑𝑃 𝑀𝑅 = = ∙ 𝑄 + ∙ 𝑃 = 𝑄. + 𝑃. 𝑑𝑄 𝑑𝑄 𝑑𝑄 𝑑𝑄 For a firm facing perfectly competitive markets, price does not change with quantity sold (
so marginal revenue is equal to price. For a monopoly, the price received will decline with quantity 𝑑𝑃 sold ( < 0), so marginal revenue is less than price. This means that the profit-maximizing 𝑑𝑄
quantity, for which marginal revenue is equal to marginal cost (MC) will be lower for a monopoly than for a competitive firm, while the profit-maximizing price will be higher. When demand is elastic, marginal revenue is positive, and when demand is inelastic, marginal revenue is negative. When the price elasticity of demand is equal to 1, marginal revenue is equal to zero. Example: A promoter has properly estimated the demand curve for seats at an event to be Q = 40,000 − 2000P
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where P is the price of a seat. The inverse demand curve, which determines price as a function of quantity, is therefore represented by P(Q) = 20 − Q / 2000. We therefore have TR(Q) = 20Q − Q2 / 2000. Marginal revenue is the slope of total revenue: MR (Q) = 20 − Q / 1000.
Marginal revenue is commonly represented by a marginal revenue curve, such as the one labeled MR and displayed in the exhibit to the right. This particular marginal revenue curve is that for peer sales by Phil the peer grower, a presumed perfectly competitive firm. The vertical axis measures marginal revenue and the horizontal axis measures the quantity of output (pounds of peer). Although quantity on this particular graph stops at 10 pounds of peer, the nature of perfect competition indicates it could easily go higher.
Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University.
Relationship between marginal revenue with price elasticity of demand:
Price elasticity of demand is defined as the measure of responsivenesses in the quantity demanded for a commodity as a result of change in price of the same commodity. In other words, it is percentage change in quantity demanded as per the percentage change in price of the same commodity. In economics and business studies, the price elasticity of demand (PED) is a measure of the sensitivity of quantity demanded to changes in price. It is measured as elasticity that is it measures the relationship as the ratio of percentage changes between quantity demanded of a good and changes in its price. Drinking water is a good example of a good that has inelastic characteristics in that people will pay anything for it (high or low prices with relatively equivalent quantity demanded), so it is not elastic. On the other hand, demand for sugar is very elastic because as the price of sugar increases, there are many substitutions which consumers may switch to. In microeconomics, Marginal Revenue (MR) is the extra revenue that an additional unit of product will bring. It can also be described as the change in total revenue/change in number of units sold. More formally, marginal revenue is equal to the change in total revenue over the change in quantity when the change in quantity is equal to one unit (or the change in output in the bracket where the change in revenue has occurred). This can also be represented as a derivative. (Total revenue) = (Price demanded) times (Quantity)
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Md. Mazharul Islam (Jony)
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if we know only the order of finish in a horse race. Marginal utility can be defined as the change in the total utility resulting from a one-unit change in the consumption of a commodity per unit of time.. In other words. Utility measured by rank alone is known as ordinal utility. Cardinal measures are possible when incremental units are constant and reasonably objective.Theory of Consumer Behavior Utility analysis: Utility analysis is a quantitative method that estimates the dollar value of benefits generated by an intervention based on the improvement it produces in worker productivity. Ordinal analysis assumes that between any two bundles of goods. Instead. C. Department Of Finance Jagannath University Md. For example. As long as people can consistently rank different bundles of goods by the satisfaction generated.e.. B. is assumed measurable in meaningful. Marginal utility: The last unit of commodity consumed at any particular time is known as final or marginal utility.g. Ordinal measurement of utility Satisfaction is not cardinally measurable. derive 100 utils from eating a slice of pizza (units utils) Ordinal utility approach: ordinal utility approach does not assign values. Thus. ordinal utility is sufficient to model consumer behavior. but utility is roughly measurable at best. . including computing a return on their investment in implementing it. etc. inferring that the winner beat the second place finisher by precisely as much time as the second horse beat the third would be an unjustified stretch. DX2.. Mazharul Islam (Jony) 26 | P a g e . a person either prefers one to the other or is indifferent between the bundles—i. If we know rank. relative numbers provide rankings like first.. tied. E. A generic utility function is described mathematically as follows. that one fried chicken yields 147 utils more satisfaction for the president than a few pieces of dry white toast—all that really matters is that he prefers the chicken to the toast.. At last we can say that. ordinal utility analysis cannot tell us. second. Utility analysis provides managers information they can use to evaluate the financial impact of an intervention. for example. but the reverse is not true. absolute numbers. For example.. Xn) Utility concepts Cardinal utility approach: cardinal utility approach assumes that we can assign values for utility. individuals can provide an ordering of bundles. like temperature or distance. the utils generated by each brownie you eat or book you read would be recorded as if you have utilometer imbedded in your frontal lobe. Cardinal versus Ordinal utility Early economists assumed that people are able (perhaps only subliminally) to assign meaningful utility numbers (utils) to their satisfaction in one situation vis-à-vis their satisfaction in an alternative situation. any cardinal measurement is also ordinal (fixed increments establish rank). it does not follow that we know cardinal intervals between bundles A. U = f(X1. As far as we know no one is born equipped with a utilometer to precisely measure satisfaction. Cardinal measurement of utility Satisfaction. instead works with a ranking of preferences. etc.
The utility in question should be the utility of the marginal or final unit that is consumed. 2. Suppose a big family consumes several kg of wheat at a time. yield less satisfaction. Conditions of Marginal Utility: Marginal utility is based upon two essential conditions: 1. the edge of his appetite has been blunted. If the customer is forced to take more the satisfaction may become negative or the utility may change in disutility. For example. and the second toast. By the time he start taking second. Department Of Finance Jagannath University Md. If it purchases only one kg of wheat. For example. meeting with a less urgent want. yielding 10 and 9 units of utility respectively. and its utility becomes the marginal utility. and its utility. Mazharul Islam (Jony) 27 | P a g e . Law Of Diminishing Marginal Utility This law can be stated as the fall in marginal utility of any good due to successive consumption of that good. Satisfactions of human wants follow some very important laws and one of them in the law of diminishing marginal utility. The additional satisfaction goes on decreasing with every successive toast till it drops down to zero. the satisfaction of third less than of the second. Suppose it is 100.Marginal utility (MU) = 𝐶𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡𝑜𝑡𝑎𝑙 𝑢𝑡𝑖𝑙𝑖𝑡𝑦 𝐶𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑐𝑜𝑛𝑠𝑢𝑚𝑒𝑑 = ∆𝑇𝑈 ∆𝑄 ∙ Example: If a man takes two oranges at the time. Suppose a person start-eating piece of bread one after another. For example. Consumption should take place at any particular time or the act o consumption should be regular and unbroken. The law refers to the common experience of every consumer. then it would be the marginal unit. the second unit is marginal unit and its utility namely 9. could be the marginal utility. If this family purchases 5 kg of wheat the marginal utility declines. and soon. is the marginal utility of oranges. The first toast gives him great pleasure. If it is purchase another kg of wheat then second kg becomes the marginal unit.
The law of equi-marginal utility can be explained with the help the diagrams. the consumer has no preference for one bundle over another. an indifference curve represents the possible combinations of (usually two) goods that. 4. Limited money income. an indifference curve is a graph showing different bundles of goods. We now assume that the consumer spends Rs. The consumer is not deriving maximum satisfaction except the combination of expenditure of Rs. Indifference curve: In microeconomic theory. There is a toss of utility equal to the area C’PEE’. 1. between which a consumer is indifferent. the added utility is equal to the area CQ’ N’N. result in a given constant level of happiness or utility. The loss in utility (tea) is greater than that of its gain in cigarettes. at each point on the curve. The Marshallian approach to consumer’s equilibrium is based on the following assumptions. 1. Utility is cardinally measurable. less utility to the consumer than the foregoing unit.2) on tea and OC (Rs. 3. 2. Mazharul Islam (Jony) 28 | P a g e .00 on tea and Rs. 3. the expenditure on tea falls from OP amount (Rs.00 on tea and Rs. a consumer is in equilibrium when he distributes his given money income among various goods in such a way that marginal utility derived from the last rupee spent on each good is the same. Department Of Finance Jagannath University Md. 5. other things remaining the same. A consumer has limited amount of money income to spend. That is. MU is the marginal utility curve for tea and KL of cigarette.” Equi-marginal Utility: The principle of equal marginal utility occupies an important place in the cardinal utility analysis.00 (OQ’) on cigarettes. When a consumer spends OP amount (Rs. On the other hand. when consumed. In other words. In the diagram. The marginal utility of money remains constant to the consumer as he spends more and more of it on the purchases of goods. Every consumer is rational in the purchase of goods. the marginal utility derived from the consumption of both the items (Tea and Cigarettes) is equal to 8 units (EP=NC). 2. If CQ’ more amount is spent on cigarettes.00 on cigarettes. The marginal utilities of different commodities are independent of each other and diminish with more and more purchases. Assumptions: The main assumptions of the law of equi-marginal utility are as under: 1.2) to OC’ amount (Rs. Independent utilities.00 on cigarettes and by no other alteration in the expenditure.3) on cigarettes. 3.00 on tea (OC’ amount) and Rs. 4. According to this. The consumer gets the maximum utility when he spends Rs. Law of diminishing utility may be stated as follow“Each unit of commodity gives. each measured as to quantity. Constant marginal utility of money. 2.00).Therefore.
Mazharul Islam (Jony) 29 | P a g e . with (2). y). Indifference Map: A graph of indifference curves for an individual consumer associated with different utility levels is called an indifference map. in the third dimension. Negatively (Downward) sloped: That is. Points yielding different utility levels are each associated with distinct indifference curves. Higher IC: Transitive with respect to points on distinct indifference curves. +) quadrant of commodity-bundle quantities. successively larger doses of the other good are required to keep satisfaction unchanged. is excluded. Properties of Indifference curves: Indifference curves are typically represented to be: Positive quadrant: Defined only in the positive (+. does not have a local maximum for any x and y values. An indifference curve describes a set of personal preferences and so can vary from person to person. The main use of indifference curves is in the representation of potentially observable demand patterns for individual consumers over commodity bundles. As a consumer decreases consumption of one good in successive units. if each point on I2 is (strictly) preferred to each point on I1.additions to utility per unit consumption are successively smaller. each point on I3 is preferred to each point on I1. such that more of either good (or both) is equally preferred to no increase. A negative slope and transitivity exclude indifference curves crossing. That is. One can equivalently refer to each point on the indifference curve as rendering the same level of utility (satisfaction) for the consumer. U. convex preferences imply a bulge toward the origin of the indifference curve. since straight lines from the origin on both sides of where they crossed would give opposite and intransitive preference rankings. as quantity consumed of one good (X) increases. Utility is then a device to represent preferences rather than something from which preferences come. (If utility U = f(x.) The negative slope of the indifference curve reflects the law of diminishing marginal utility. satiation. Convex (sagging from below): With (2). Non-intersecting: Complete. Each point on the map represents the same elevation.They are all equally preferred. Department Of Finance Jagannath University Md. total satisfaction would increase if not offset by a decrease in the quantity consumed of the other good (Y). no two curves can intersect (otherwise non-satiation would be violated). That is as more of a good is consumed total utility increases at a decreasing rate . and each point on I3 is preferred to each point on I2. An indifference curve is like a contour line on a topographical map. So. such that all points on an indifference curve are ranked equally preferred and ranked either more or less preferred than every other point not on the curve. Equivalently.
the budget constraint states that. So. 𝑃2 ) and the amount of money a consumer has to spend. Suppose we observe prices of two goods. and without reference to any actual graph. Budget set: Budget set is a set of affordable consumption bundles at prices (𝑃1 . Example: Let good 2 be money that the consumer can use to spend on other goods. the budget line expresses the maximum amount of a good that an individual can consume. given the prices of goods. Calculate how much of good 2 the consumer could buy by spending all income on good 2: Department Of Finance Jagannath University Md. Mazharul Islam (Jony) 30 | P a g e . the line traced would be the budget line of the individual. M = 𝑃1 𝑄1 + 𝑃2 𝑄2 If we were to plot this line on a graph that has 𝑄1 as the vertical axis and 𝑄2 as the horizontal axis. m. 𝑄2 ) that solve the equation above just exhaust the consumer's income. The budget constraint tells us that total spending cannot exceed m. Alternative representation of the budget line 𝑚 𝑃1 𝑄2 = − 𝑄1 𝑃2 𝑃2 Which tells us how many units of good 2 the consumer needs to consume in order to just satisfy the budget constraint given consumption of x1 units of good 1. Easy way to draw a budget line for given prices (𝑃1 . We can say that. given his budget or income. we can think of quantities of good X on the horizontal axis and quantities of good Y on the vertical axis. Often we define good 2 as a "composite good" that stands for everything else that the consumer might want to consume other than good 1. 𝑄2 ) that tell us how much the consumer is choosing to consume of good 1 and how much the consumer is choosing to consume of good 2. Consumption bundle: Two numbers(𝑄1 . More generally. The term is often used when there are many goods. 𝑃2 ) and income m: 1. Note that then p2 = 1. Properties of the budget set (opportunity set): Budget line is the set of bundles that cost exactly m 𝑃1 𝑄 1 + 𝑃2 𝑄2 = m All bundles (𝑄1 .Budget Line: If there are only two goods. Affordable consumption bundles are those that don't cost any more than m. In a two good case. 𝑃2 ) and income m. an individual consumer can consume only such amounts of the goods that his income allows. we can write 𝑃1 𝑄 1 + 𝑄2 ≤ 𝑚 which we read as "the amount of money spent on good 1 plus the amount of money spent on all other goods must be no more than the total amount of money the consumer has to spend". and a certain amount of the other good available that the consumer has decided to consume. Budget constraint: 𝑃1 𝑄 1 + 𝑃2 𝑄2 ≤ 𝑚 Where 𝑃1 𝑄1 is spending on good 1 and 𝑃2 𝑄2 is spending on good 2. (𝑃1 .
Department Of Finance Jagannath University Md. the set of goods that a consumer can afford changes as well. Note: Negative sign tells that ∆𝑄2 and ∆𝑄1 must always have opposite signs . Calculate how much of good 1 the consumer could buy by spending all income on good 1: 𝑚 𝑄1 𝑚𝑎𝑥 = 𝑃1 𝑄2 𝑚𝑎𝑥 = 3. Change in income affects only the intercept and not the slope of the line.𝑚 𝑃2 2. An increase in income from m to m’ results in a parallel shift outward of the budget line. Changes in the budget line: Clearly. Plot these two points on the appropriate axes of the graph and connect them with a straight line Slope of the budget line ( 𝟏 ): 𝑷𝟐 𝑷 Slope of the budget line measures the rate at which the market is willing to substitute good 1 for good 2. as prices and income change. Mazharul Islam (Jony) 31 | P a g e . 1. 𝑃1 𝑄1 + 𝑃2 𝑄2 = m 𝑃1 (𝑄1 + ∆𝑄1 ) + 𝑃2 (𝑄2 + ∆𝑄2 ) = m by subtracting the _rst equation from the second we can get 𝑃1 ∆𝑄1 ) + 𝑃2 ∆𝑄2 ) = 0 and rearranging ∆𝑄2 𝑃1 = ∆𝑄1 𝑃2 ∆𝑄 Where 2 is the rate at which good 2 can be substituted for good 1. But this is just the slope of the ∆𝑄1 budget line.to satisfy the budget constraint by consuming more of good 2 the consumer must sacrifice some of good 1. Changes in income Recall alternative representation of the budget line 𝑄2 = 𝑚 𝑃2 𝑃1 𝑃2 − 𝑄1 .
An easier way to see 𝑃2 how the budget line changes is to use the same approach as we used before to draw the budget line Intuitively: vertical intercept does not change because it does not depend on 𝑃1 (if all income is spent on good 2. then the budget 𝑃2 line will be flatter If price 2 increases less than price 1. when all income is spent on good 1 then the horizontal intercept must shift inward. 𝑃1 𝑚 𝑄1 + 𝑄2 = 𝑃2 𝑃2 𝑃2 𝑚 𝑄1 + 𝑄2 = 𝑃1 𝑃1 𝑃1 𝑃2 𝑄 + 𝑄 = 1 𝑃2 1 𝑃1 2 When we set one of the prices to 1. the budget line will be steeper The numeraire: The budget line. Mazharul Islam (Jony) 32 | P a g e . but the budget line becomes steeper since 1 will become larger. 𝑃1 𝑄1 + 𝑃2 𝑄2 = 𝑚 can be also written as. What happens to the budget line when we change the prices of good 1 and good 2 at the same time? If we increase both prices by t the budget line becomes 𝑚 𝑡𝑃1 𝑄1 + 𝑡𝑃2 𝑄2 = 𝑚 ⇔ 𝑃1 𝑄 1 + 𝑃2 𝑄2 = 𝑡 so multiplying both prices by t is the same as dividing income by t. Vertical intercept is 𝑃 unchanged. Department Of Finance Jagannath University Md.2. However. The numeraire price is the price relative to which we are measuring the other price and income. Changes in prices Consider increasing price 1 while holding price 2 and income fixed. Increase in both prices by the same amount shifts budget line inward Decrease in both prices by the same amount shifts budget line outward 𝑃 If price 2 increases more than price 1 the absolute value of − 1 goes down. we often refer to that price as the numeraire price. price of good 1 is irrelevant).
This measure is used as a tool in policy analysis. In other words. it is presumed that their objective is to maximize total utility. Department Of Finance Jagannath University Md. subject to these constraints. but it is assumed that there is no increase/decrease in his/her real income. is referred to as the consumer's problem. which entails decisions about how much the consumer will consume of a number of goods and services. The consumer's effort to maximize total utility. Effect of price. The solution to the consumer's problem. the consumer faces a number of constraints. The producer surplus is the amount that producers benefit by selling at a market price mechanism that is higher than the least that they would be willing to sell for. In maximizing total utility. The consumer surplus (sometimes named consumer's surplus or consumers' surplus) is the amount that consumers benefit by being able to purchase a product for a price that is less than the most that they would be willing to pay. income and substitution effect: Price Effect (PE): The effect on consumer equilibrium when price of one commodity changes while price (s) of other commodity and income of the consumer remain the same. Substitution Effect (SE): The effect on consumer's equilibrium when price of a commodity falls/rises the consumer increases/decreases the purchase of the commodity.Consumer Equilibrium When consumers make choices about the quantity of goods and services to consume. Consumer surplus is the difference between the maximum price a consumer is willing to pay and the actual price they do pay. is referred to as consumer equilibrium. Mazharul Islam (Jony) 33 | P a g e . the most important of which are the consumer's income and the prices of the goods and services that the consumer wishes to consume. Consumer and producer Surplus The term surplus is used in economics for several related quantities. so he/she remain on the same indifference curve. Income Effect (IC): The effect on consumer equilibrium when income of the consumer changes while prices remain the same.
an Engel curve shows how the quantity demanded of a good or service changes as the consumer's income level changes. Engel curves are used for equivalence scale calculations and related welfare comparisons. Real-world businesses generally own or control some of their inputs. as income increases. and determine properties of demand systems such as agreeability and rank. it bends toward the y-axis for necessities and towards the x-axis. 2. no producer surplus accrues to the individual firm. the Engel curve has a negative gradient. 1. the Engel curve remains upward sloping in both cases. Empirical Engel curves are close to linear for some goods. normal. and hence whether the good is an inferior. Engel curve An Engel curve describes how a consumer’s purchases of a good like food varies as the consumer’s total resources such as income or total expenditures vary. and highly nonlinear for others. If the markets for factors are perfectly competitive as well. 3.Note that producer surplus generally flows through to the owners of the factors of production: in perfect competition. holding other prices and income constant. they will buy less of the inferior good because they are able to purchase better goods. Income is shown on the Y-axis and the quantity demanded for the selected good or service is shown on the X-axis. meaning that they receive the producer's surplus due to them: this is known as normal profit. A good’s Engel curve determines its income elasticity. This is the same as saying that economic profit is driven to zero. 4. Engel curves may also depend on demographic variables and other consumer characteristics. That is. For normal goods. Money Income Engel Curve Quantity consumed of good X Graphically Presentation: The Engel curve is represented in the first-quadrant of the Cartesian coordinate system. It is named after the 19th century German statistician Ernst Engel. and is a component of the firm's opportunity costs. Derivation of Demand and Engel Curve: The demand function is a relationship between the quantity of a good/service that an individual will consume at different prices. In economics. producer surplus ultimately ends up as economic rent to the owners of scarce inputs such as land. Every point on the demand function is a utility maximizing point. the quantity demanded increases. Mazharul Islam (Jony) 34 | P a g e . the demand curve is a translation from Department Of Finance Jagannath University Md. In effect. or luxury good. the Engel curve has a constant slope. For luxury goods. That means that as the consumer has more income. the Engel curve has a positive gradient. For goods with Marshallian demand function generated by a utility in Gorman polar form. For inferior goods.
utility metric space into dollar metric space. When the price consumption is horizontal. An Engel curve is the locus of combinations of goods that an individual would consume if they were faced with changes in income holding all prices constant. The income effect defines whether the good is an inferior good or a normal good. the total outlay on X remains the same even though price of X rises. In graphical terms this is represented as in the diagrams below. the elasticity of demand for good X unitary. If the Engel curve is upward sloping. Income and Substitution Effects The total effect of a price change is the summation of the substitution and income effect.e. Elasticity measurement along with Engel curve : The shape of Engel curve shows the degree of elasticity of demand. Pictorially this would mean a parallel shift in the budget constraint either up or down if income rises or falls. i. To construct the demand curve simply vary the price of one good holding the price of other goods and income constant. Thus. Department Of Finance Jagannath University Md. In other words.e. respectively. has zero slope). the demand for good X is inelastic and if it is downloads sloping.. parallel to X axis (i. Mazharul Islam (Jony) 35 | P a g e . Therefore. point 'e' in the diagram below is a point on the demand curve.. this shows that prices or expenditure information provides a measure of people's preferences and can be used in making assessments with respect to valuation. i. This Engel curve is also known as an income-consumption curve..e. Income Effect is the change in the quantity consumed due to a relative increase in a change of income while holding prices constant.e. Note that the equilibrium points in the upper diagram have their counterparts in 'quantity space' in the lower diagram. the elasticity is unitary.. i. the demand will be elastic. An Engel curve is also associated with the development of the demand curve from the utility maximizing framework. The substitution and income effect can work in opposite direction of each other. greater than one or less than one. Substitution Effect is the change in the quantity consumed due to a change in the price of the good. while holding other prices for goods constant and utility constant.
the total effect is usually positive. One example: Potatoes in Ireland during the potato famine of the 1840s. Inferior Goods: An inferior good can be defined as a good whose consumption has a negative correlation with the income effect. it is possible for the total effect to be negative. Department Of Finance Jagannath University Md. Therefore. Money price is the price of a good expressed in monetary units. Giffen goods are extremely rare. the total effect is certainly positive. For an inferior good. as we saw from the diagram above. This means that most inferior goods are also normal (they have downward-sloping demand). But the substitution effect is almost always bigger than the income effect. It is the ratio between the money prices of the two goods. The substitution effect is positive as always. And the income effect is positive for a superior good. The income effect is large enough to swamp the substitution effect. that made the effective incomes of the Irish much smaller because potatoes were a staple of their diets. Mazharul Islam (Jony) 36 | P a g e .Relative price: Relative price has meaning only when applied to two goods. Intersecting Substitution effect and Income Effect: We know. Therefore. This means that all superior goods are normal (they have downward-sloping demand). But for some inferior goods. which means the effects work in opposite directions. CLASSIFICATIONS OF CONSUMER GOODS: Normal Goods: A normal good can be defined as a good whose consumption has a positive correlation with the income effect. the Irish cut back on their consumption of ―luxury‖ foods like meat and bought more potatoes (or so said Samuel Giffen). the total effect is usually positive. Total Effect = Substitution Effect + Income Effect The substitution effect is always positive. When the price of potatoes rose. These goods are called Giffen goods (which have upward-sloping demand). and there is some debate as to whether they even exist. With their smaller incomes. The income effect is negative for an inferior good.
) Thus. the demand curve will be upward instead of downward sloping. Superior goods: Superior goods make up a larger proportion of consumption as income rises. that is. In the first panel. Inferior and Giffin Goods: When the price of X rises. and. so the move from A to B is leftward. it must have a high price. so that X is Giffen. B is to the left of A. In the second panel. X is an inferior good. If X is inferior. that is. as the price increases. therefore. B is to the right of C. that is.In both panels. and therefore are a type of normal goods in consumer theory. This move from A to C is always leftward. Mazharul Islam (Jony) 37 | P a g e . or B is to the right of A ( this happens when the income effect is large). the move from C to B is rightward. (For a normal good. the move from C to B is also leftward. along with that. the consumer moves from A to B. A superior good also may be a luxury good that is not purchased at all below a certain level of income. X is Giffen. This allows two possibilities. consumption decreases. Either B is to the left of A ( this happens when the income effect is small). Such a good must possess two economic characteristics: it must be scarce. this move can be broken down into a substitution effect (from A t C) followed by an income effect (from C to B). If X is normal. Income and Substitution effect of Normal. Department Of Finance Jagannath University Md. X is not Giffen. X is not giffen. B is to the right of A Giffen goods: A Giffen good is a good whose consumption increases as its price increases. so that X is not Giffen.
a chocolate bar. the total utility is the maximum. Your marginal utility (and total utility) after eating one chocolate bar will be quite high.probably because you are starting to feel full or you have had too many sweets for one day. But if you eat more chocolate bars.Distinguish between total utility and marginal utility: Total utility (TU): Total utility is the total satisfaction which a consumer derives from the consumption of a particular good over a period of time. Notice how the first chocolate bar gives a total utility of 70 but the next three chocolate bars together increase total utility by only 18 additional units. 𝑈4 . When the marginal utility comes to zero or we say the point of satiety is reached. 𝑈3 . his total utility will be. More precisely. 𝑇𝑢 = 𝑈1 + 𝑈2 + 𝑈3 + 𝑈4 + 𝑈5 Marginal Utility (MU): It can also be described as the extra satisfaction which a consumer gets from consuming additional unit of a good. Department Of Finance Jagannath University Md. Mazharul Islam (Jony) 38 | P a g e . For example. it is defined as the. This table shows that total utility will increase at a much slower rate as marginal utility diminishes with each additional bar. 𝑇𝑢 𝑛 here means total utility derived from the consumption of n units of a good and 𝑇𝑢 𝑛 −1 is the total utility derived from the consumption of 𝑛 − 1units. If consumption is increased further from this point of satiety. 𝑈2 . It may here be noted that as a person consumes more and more units of a commodity. For example. 𝑈5 utility from the successive units of a good. the pleasure of each additional chocolate bar will be less than the pleasure you received from eating the one before . ∆𝑇 Thus. Let's say that after eating one chocolate bar your sweet tooth has been satisfied. 𝑀𝑢 = 𝑢 ∆𝑄 Here∆𝑇𝑢 = Change in total utility and ∆𝑄 = change in consuming an additional unit of a good. a person consumes five units of a commodity and derives 𝑈1 . addition to the total utility obtained from the consumption of one more unit. the marginal utility becomes negative and the total utility begins to diminish. the marginal utility of the additional units begins to diminish but the total utility goes on increasing at a diminishing rate. It can also be expressed as 𝑀𝑢 = 𝑇𝑢 𝑛 − 𝑇𝑢 𝑥 −1 . For example. the marginal utility of second glass of water is the change in total utility resulting from consuming the second glass of water.
then they are willing to pay a lower price. he can buy same quantity of commodity with less money or he can purchase greater quantities of same commodity with same money. when prices are low they might still have some disposable income for purchases of other items. If buyers receive less satisfaction. it slopes downwards from left to right depicting that with increase in price. i. Diminishing Marginal Utility states that the extra satisfaction obtained from a good decline as larger amounts are consumed. It should not be confused with products bought as status symbols or for CONSPICUOUS CONSUMPTION. Mazharul Islam (Jony) 39 | P a g e .Giffen Paradox Proposed by Scottish economist Sir Robert Giffen (1837-1910) from his observations of the purchasing habits of the Victorian poor.e. When combined with the law of supply (or other relevant supply principles) the result is the market model. The market provides a powerful tool for analyzing exchanges. The reasons for a downward sloping demand curve can be explained as follows1. it is equivalent to decrease in income of the consumer as now he has to spend more for buying the same quantity as before. Giffen paradox is explained by the fact that if the poor rely heavily on basic commodities like bread or potatoes. Thus. these other purchases are no longer possible. Income effect. The reasons for a downward sloping demand curve Demand curve has a negative slope.e. the purchasing power of consumer increases. the consumer tend to consume more of the commodity whose price has fallen . they tend to substitute that commodity for other commodities which have not become relatively dear. which generates the law of demand. Relation between Diminishing Marginal Utility and Law of Demand: The law of demand is the scientific relation between demand price and quantity demanded that captures the demand side of the market. Giffen paradox states that demand for a commodity increases as its price rises. it becomes relatively cheaper compared to other commodities whose price have not changed. Thus. The downside of this explanation is the inability to measure the actual utility derived from consuming a good. quantity demanded falls and vice versa. Department Of Finance Jagannath University Md.With the fall in price of a commodity. resource allocation. This change in purchasing power due to price change is known as income effect.When price of a commodity falls.i. thereby forcing the poor to concentrate all their purchasing power on the bread or corn. if the price of a commodity rises. As bread or corn prices rise. Substitution effect. and efficiency. 2. Similarly.
if a consumer wants to purchase larger quantities. This is what the law of demand also states. an individual purchases in such a manner that the marginal utility of the commodity is equal to the price of the commodity. So as to get maximum satisfaction. 3rd Batch. Department Of Finance Jagannath University Md. Law of diminishing marginal utility– It is the basic cause of the law of demand. then the price must be lowered.3. Mazharul Islam (Jony) 40 | P a g e . The law of diminishing marginal utility states that as an individual consumes more and more units of a commodity. Thus. Md. When the price of commodity falls. a rational consumer purchases more so as to equate the marginal utility and the price level. Mazharul Islam (Jony) ID no:091541. Department of Finance. the utility derived from it goes on decreasing.
a production function can be expressed as: 𝑄 = 𝑓(𝑥1 . Production function as a graph Any of these equations can be plotted on a graph. With too much variable input use relative to the available fixed inputs. and all points on the function show the maximum quantity of output obtainable at the specified level of usage of the input. the variable input is being used too intensively. Almost all economic theories presuppose a production function. Production at times is also defined as all economic activities minus consumption. and the declining production function beyond point C. and C. The Production Function: The production function refers to the physical relationship between the inputs or resources of a firm and their output of goods and services at a given period of time. This function is an assumed technological relationship. . B. either on the firm level or the aggregate level. the employment of additional units of inputs produces no additional outputs (in fact. all points below are technically feasible. that is a production process that has multiple co-products or outputs. Mazharul Islam (Jony) 41 | P a g e . labor. This general form does not encompass joint production. land or raw materials). … . based on the current state of engineering knowledge. There are several ways of specifying the production function. In microeconomics and macroeconomics. a production function is a function that specifies the output of a firm. From the origin. the quantity of outputs also increases. the company is experiencing negative returns to variable inputs. In a general mathematical form. 𝑥𝑛 ) Where: Q = quantity of output 𝑥1 . 𝑥3 . but rather is an externally given entity that influences economic decision-making. the production function is one of the key concepts of mainstream neoclassical theories. total output starts to decline). 𝑥𝑛 = quantities of factor inputs (such as capital.Theory of Production Production Production is an economic activity that makes goods available for consumption. Beyond point C. A typical (quadratic) production function is shown in the following diagram under the assumption of a single variable input (or fixed ratios of inputs so they can be treated as a single variable). or an entire economy for all combinations of inputs. It is the process of creating goods or services using various available resources. In this sense. All points above the production function are unobtainable with current technology. indicating that as additional units of inputs are used. an industry. and diminishing total returns. ceteris paribus. In the diagram this is illustrated by the negative marginal physical product curve (MPP) beyond point Z. the production function is rising. … . 𝑥2 . 𝑥2 . 𝑥3 . . through points A. it does not represent the result of economic choices. Department Of Finance Jagannath University Md.
Quadratic Production Function From the origin to point A. In Stage 3. as can be seen from the declining MPP curve beyond point X. From point A to point C. too much variable input is being used relative to the available fixed inputs: variable inputs are over-utilized in the sense that their presence on the margin obstructs the production process rather than enhancing it. the firm is experiencing positive but decreasing marginal returns to the variable input. output increases but at a decreasing rate. Both marginal physical product (MPP. it is common to divide its range into 3 stages. Mazharul Islam (Jony) 42 | P a g e . output increases at an increasing rate. mathematical necessity requires that the marginal curve must be below the average curve Stages of production To simplify the interpretation of a production function. output increases at a decreasing rate. Point B is the point beyond which there are diminishing average returns. Beyond point B. the ratio of output to the variable input) are rising. although a firm facing a downward-sloped demand curve might find it most profitable to operate in Stage 1. the derivative of the production function) and average physical product (APP. as shown by the declining slope of the average physical product curve (APP) beyond point Y. As additional inputs are employed. a price-taking firm will always operate beyond this stage. In Stage 2. The output per unit of both the fixed and the variable input Department Of Finance Jagannath University Md. the firm is experiencing increasing returns to variable inputs. The optimum input/output combination for the price-taking firm will be in stage 2. because output is rising while fixed input usage is constant. However the average product of fixed inputs (not shown) is still rising. and the average and marginal physical product are declining. In Stage 1 (from the origin to point B) the variable input is being used with increasing output per unit. Point B is just tangent to the steepest ray from the origin hence the average physical product is at a maximum. As additional units of the input are employed. Because the output per unit of the variable input is improving throughout stage 1. In this stage. The inflection point A defines the point beyond which there is diminishing marginal returns. the employment of additional variable inputs increases the output per unit of fixed input but decreases the output per unit of the variable input. the latter reaching a maximum at point B (since the average physical product is at its maximum at that point).
Leontief Production Function (Short-run Production Function): A production function that assumes that inputs are used in fixed proportions. This means that total output will still be rising – but increasing at a decreasing rate as more workers are employed. The Short Run Production Function The short run is defined in economics as a period of time where at least one factor of production is assumed to be in fixed supply i. Diminishing returns to labor occurs when marginal product of labor starts to fall. the change in total output will at first rise and then fall. In the short run. Factors of production Production function shows the relationship between the quantity of a good/service produced (output) and the factors or resources (inputs) used. Raw material inputs are a variable factor and unskilled labor is usually thought of as a variable factor. plant and machinery) is fixed and that production can be altered by suppliers through changing the demand for variable inputs such as labor.declines throughout this stage. 3. Often the amount of land available for production is also fixed.e. 2. components. Types of Production Functions 1. the highest possible output is being obtained from the fixed input. The inputs used for producing these goods and services are called factors of production.e. A graphically presentation is given below- Department Of Finance Jagannath University Md. Mazharul Islam (Jony) 43 | P a g e . it cannot be changed. Fixed factor of production: A fixed factor of production is one whose input level cannot be varied in the short run. the law of diminishing returns states that as we add more units of a variable input (i. As we shall see in the following numerical example. eventually a decline in marginal product leads to a fall in average product. Linear Production Function (Long-run Production Function): A production function that assumes a perfect linear relationship between inputs & total output. Variable factor of Production: A variable factor of production is one whose input level can be varied in the short run. We normally assume that the quantity of capital inputs (e.g. Capital refers to resources such as buildings and machinery etc. Capital is usually a fixed factor. At the boundary between stage 2 and stage 3. labor or raw materials) to fixed amounts of land and capital. Cobb-Douglas Production Function: A production function that assumes some degree of substitutability between inputs. raw materials and energy inputs.
fixed. Mazharul Islam (Jony) 44 | P a g e . Average and Marginal Physical Product Curves The average product typically varies as more of the input is employed. then the average product of variable labour input is 5 units per day. The continuous marginal product of a variable input can be calculated as the derivative of quantity produced with respect to variable input employed. A more general mathematical concept capturing the relation between total product and it's assorted inputs. In short run the output of goods and services is increased by introducing additional variable factor to the production process to a said quantity of fixed factors. can be found in production function. like capital. The discrete marginal product of capital is the additional output resulting from the use of an additional unit of capital (assuming all other factors are fixed). so this relationship can also be expressed as a chart or as a graph. It is the output of each unit of input. it is assumed that total product changes from changes in the quantity of a variable input like labor. both variable and fixed. When constructing this curve. If there are 10 employees working on a production process that manufactures 50 units per day. Department Of Finance Jagannath University Md. Marginal Physical Product The marginal physical product of a variable input is the change in total output due to a one unit change in the variable input (called the discrete marginal product) or alternatively the rate of change in total output due to an infinitesimally small change in the variable input (called the continuous marginal product). while we hold one or more other inputs. It can be obtained by drawing a vector from the origin to various points on the total product curve and plotting the slopes of these vectors. Law of variable proportions This law is called law of variable proportions because output of firm changes with the variation in factor-proportions. It can be obtained from the slope of the total product curve. The marginal physical product curve is shown (MPP). Average Physical Product The average physical product is the total production divided by the number of units of variable input employed. A typical average physical product curve is shown (APP).Total product curve A curve that graphically represents the relation between total production by a firm in the short run and the quantity of a variable input added to a fixed input.
This tells us how productive workers are on an average. Refer to the table below: Labour (workers/day) 1 2 3 4 5 6 7 8 Total Product (shirts per day) 2 5 9 12 14 15 15 14 Marginal product (shirts per additional worker) 3 4 3 2 1 0 -1 Average Product (shirts per worker) 2. and then the proportion between the fixed and variable factors is changed. Thus after a point every additional unit of factor added will result in a smaller increase in output.Law of variable proportions outlines the various possible output scenarios due to the change in the proportions of fixed and variable factors used for production. The law of variable proportion is also known as law of diminishing marginal returns or law of diminishing returns. If we increase the number of a factor (labor) keeping all other factors fixed (capital). Mazharul Islam (Jony) 45 | P a g e .80 2.00 2.50 2. The law has several assumptions as below: one input is variable while others are fixed in the short run all units of the variable input are same and have equal efficiency no change in production technology factors of production like land and labor can be used in different proportions For instance. Total product is the maximum output that a given quantity of input can produce.00 3. The law of variable proportions implies that as we keep on adding the variable factor of production the marginal product of that factor keeps on decreasing progressively.75 The numbers in the above table shows that as additional number of workers are put on work the total production of shirts increases. ∆TP MP = ∆L Average product is the average quantity of shirts produced by each worker. To further understand this let us consider an example of production of shirts in a factory.14 1. hiring additional employees (a variable resource) to work at a factory will initially increase output but eventually it will become more and more difficult to generate additional output from the fixed resources (due to plant size and equipment limitations) and thus the total output will increase at a decreasing rate and ultimately will start decreasing. TP AP = L Department Of Finance Jagannath University Md.50 3. Marginal product is the increase in total output due to an increase in a unit of input (labor) with all other inputs remaining constant.00 2.
Remains above the MP curve Continues to decrease but always remains above zero Stages Stage 1 Stage 2 Stage 3 Relationship between Marginal Product (MP) and Average Product (AP) We can observe the relationship between MP and AP as below. As we can see from the figure up to three input units the production increases at increasing rate and thus marginal product (MP) is highest.As we can see from the above table. At 7 input units the total product is maximum and MP is zero. the average increases. At this point AP is highest and after this AP also starts to decline. After this MP curve starts declining and intersects average product (AP) curve. At this stage AP=MP Starts to diminish. Thereafter TP starts decreasing leading to negative marginal product The three stages of production as shown above in the figure above can be summarized as follows: Total Product(TP) Increase at increasing rate and then at diminishing rate Continues to increase and reaches its maximum Starts decreasing Marginal Product (MP) Initially increases and reaches the maximum point. MP>AP. marginal product at first increases and then starts decreasing. Department Of Finance Jagannath University Md. The relationship between these 3 product concepts and input can be further explained using the three product curves below In the figure above the input (labor) is shown on x axis while the output (shirts) are shown on the y axis. When the marginal is greater than the average. Mazharul Islam (Jony) 46 | P a g e . Average product also similarly first increases and then starts decreasing. thereafter starts decreasing Continues to decrease and reaches to zero Moves to negative territory Average product (AP) Increases and reaches its maximum.
but AP continues to be positive always. Department Of Finance Jagannath University Md. So in the long run there is enough time to effect changes in the scale operations or to introduce other adjustment in the organization set. there are number of decisions that a firm will have to make about the scale of its operations. the average decreases. Each point on an isoquant is technically efficient. Same number of outputs can be produced using different input combinations. then. Isoquant is the combination of all such combination of inputs which produces same output. The position chosen will have implications for the amount of labor demanded. Firms can enter or leave the marketplace. the average does not change (it is either at maximum or minimum). the location of its operations and the techniques of production it will use. Curves farther out in the northeast direction have more output.up of the firm. labor. and the cost (and availability) of land. Since the quantity produced will remain unchanged on an isoquant. Q is fixed level of production. Isoquant curves are also called Equal product or isoproduct curve. In economic models. On a curve we have different combinations of L and K that give the same amount of output. In other words. Thus we have an isoquant curve for every level of output. the firm can increase its output by enlarging the size of its plant or increasing the scale of its operations.K). Properties of isoquants We now set forth the typically assumed characteristics of isoquants when labor. L = labor and K = Capital are variable Different resources/ inputs are required for production of goods. When the marginal is less than the average. the producer is indifferent for different input combinations. Isoquants Isoquants are those combination of inputs or factors of production which provides an equal or same quantity of output. Later we will say more about what the firm uses as a guide to choice of position in the graph. can build any desired scale of plant. AP=MP. All factors are variable none is fixed. the long-run time frame assumes no fixed factors of production. capital. In the long run. In fact the firm in the long period. Long run production Function Long run refers to that period of time in which all inputs are variable. If the demand for the firm's product increases. When the marginal is equal to the average. Where. MP<AP. and capital goods can be assumed to vary. Mazharul Islam (Jony) 47 | P a g e . MP can be zero or negative. and output are continuously divisible. raw materials. For a production function which denotes isoquant: Q=F(L. In this concept it explains the laws of return to scale. an isoquant is a curve (or locus of points) showing all possible combinations of the input physically capable of producing a given (fixed) level of output.
c) The same shirt can be made with less laborers but with a larger increase in machinery. a) A shirt can be made with large amount of labor and small amount machinery. This is also known as Leontief isoquant or input-output isoquant. Because. the resulting isoquant map generated is represented in fig. Isoquants are convex to the origin due to diminishing marginal rate of technical substitution. Each isoquant has a negative slope and is convex to the origin. b) The same shirt can be made with less laborers. in a power plant equipped to burn oil or gas. the quantity of capital must be reduced so as to keep output constant. with a given level of production Q3. Higher isoquant represents higher level of output. If two isoquants intersect each other it would mean that with the same unit of labor and capital. which is absurd.e. Department Of Finance Jagannath University Md. oil and gas are perfect substitutes. Isoquants for perfect substitutes and perfect compliments If the two inputs are perfect substitutes. Isoquant slopes downwards from left to right. two wheels and frame are required to produce a bicycle. Isoquant Q1 shows all technologically efficient combinations of labor and capital that can be used to produce 290 units of output. input X can be replaced by input Y at an unchanging rate. Various amounts of electricity could be produced by burning gas. Types of Isoquants There are three types of Isoquants. these cannot be interchanged. The perfect substitute inputs do not experience decreasing marginal rates of return when they are substituted for each other in the production function. 2. when quantity of input labor is increased. Hence the isoquant would be a straight line. Linear isoquants: In linear isoquants there is perfect substitutability of inputs. No two isoquants intersect each other. A. Isoquant Q2 is drawn for 415 units and Q3 for 475 units. they are. oil or combination i. For example. 3. two different levels of output can be produced. 1. by increasing machinery. For example. Convex isoquants: In convex isoquants there is substitutability between inputs but it is not perfect. higher isoquant consists of more of both labor and capital. Right-Angle isoquants: In right-angle isoquants there is complete non-substitutability between inputs. For example. Mazharul Islam (Jony) 48 | P a g e . Because.
the use of the isocost line pertains to cost-minimization in production. For the two production inputs labor and capital. 𝑄 = 𝑟𝐾 + 𝑤𝐿 Where. with fixed unit costs of the inputs. K is the amount of capital used. and Q is the total cost of acquiring those quantities of the two inputs. In diagram AB line is the isocost line. with capital plotted vertically and labor plotted 𝑤 horizontally. the isoquant map takes the form of fig. the point of tangency between any isoquant and an isocost Department Of Finance Jagannath University Md.g. input X and input Y can only be combined efficiently in the certain ratio occurring at the kink in the isoquant. Although similar to the budget constraint in consumer theory.If the two inputs are perfect complements. equals the ratio of unit costs of labor and capital. r represents the rental rate of capital. Specifically. Isocost: Isocost is ratio of change of capital to labor. The slope is: − . B. it shows all the pairs of K and L for which the cost of the firm remains same. The absolute value of the slope of the isocost line. The firm will combine the two inputs in the required ratio to maximize profit. In economics an isocost line shows all combinations of inputs which cost the same total amount. Mazharul Islam (Jony) 49 | P a g e . 𝑟 The isocost line is combined with the isoquant map to determine the optimal production point at any given level of output. Line close to origin indicates lower cost outlay. A pair of capital and Labour on the right side of Isocost line e. with a level of production Q3. Any pair below the isocost line is purchasable but with smaller cost. as opposed to utility-maximization. L is the amount of labor used. the equation of the isocost line is. A producer can purchase any of these pairs for given budget. Combination L is not Purchasable. w represents the wage rate of labor.
𝑤 The slope of the isocost curve is equal to the negative of the relative input price ratio. It shows the behavior of output when all factor are altered in the same proportion. Economies of scale: Economies of scale. Mazharul Islam (Jony) 50 | P a g e . Department Of Finance Jagannath University Md. in microeconomics. Doubling all inputs leads to less than double the output. 2. Doubling all inputs results in more than double the output. A decrease in cost. − . An increase in cost. Shifts in isocost curves If the constant level of total cost associated with a particular isocost curve changes. the average cost of each unit decreases from C to C1.line gives the lowest-cost combination of inputs that can produce the level of output associated with that isoquant. holding input price constant. the isocost curve shifts parallel. refers to the cost advantages that a business obtains due to expansion. leads to a parallel upward shift in the isocost curve. Law of Returns to Scale The law of return to scale is long run concept. Returns to scale are of three types. Diseconomies of scale (also called decreasing returns to scale) occur when long run average Cost rises as output rises. 𝑟 This ratio is important because it tells the manager how much capital must be given up if 1 more unit of labor is purchased. Equivalently. There are factors that cause a producer’s average cost per unit to fall as the scale of output is increased. 1. Diseconomies of scale: Diseconomies of scale are the forces that cause larger firms to produce goods and services at increased per-unit costs. it gives the maximum level of output that can be produced for a given total cost of inputs. In the long run volume if production can be changed by changing all factor of production. leads to a parallel downward shift in the isocost curve. As quantity of production increases from Q to Q2. Isocost curves Isocost curves are lines that show the various combinations of inputs that may be purchased for a given level of expenditure at given input price. holding input price constant. One for each level of total cost. This is a property of the production function. Properties of isocost curves: An infinite number of isocost curves exist. Economies of scale (also called increasing returns to scale) occur when long run average total cost declines as output rises.
thus it exhibits increasing returns to scale (doubling inputs more than doubles output). the production function y = f(x) is convex. output (y) increases. the production function y = f(x) is concave. if a doubling or trebling of all factors causes a doubling or trebling of output. additional production will increase per-unit costs 3. who can specialize in tasks they excel at. Thus. Constant returns to scale: Constant returns to scale are an attribute of a production function. x) increase. Some inputs only need to be used once. no matter how much output is produced. At low levels of output (around y1). Reasons for economies of scale: Higher production allows for the employment of more workers.The rising part of the long-run average cost curve illustrates the effect of diseconomies of scale. As all our inputs (in this case. like programmers of computer software. Beyond Q1 (efficient output). Department Of Finance Jagannath University Md. Constant returns to scale occur when long run average total cost does not vary with output. Note: the relationship between convexity and concave production functions and returns to scale can be violated unless the f (0) = 0 assumption is imposed. Mazharul Islam (Jony) 51 | P a g e . thus it exhibits decreasing returns to scale (doubling inputs less than doubles output). (Assembly line) Larger batches allow for lower setup costs. the only input. If we increase all factors in a given proportion and the output increase in the same proportion. At high levels of output (around y3). We can conceive of different returns to scale diagrammatically in the simplest case of a oneinput/one-output production function y = f (x) as in graph (note: this is not a total product curve!). returns to scale are said to be constant. but at different rates. returns to scale are constant.
In fixed functions.Reasons for diseconomies of scale: Coordination costs rise exponentially as the organization gets bigger. There are three basic types of linear cost functions: fixed. Cost function is formed as. Mazharul Islam (Jony) 52 | P a g e . For intermediate levels of output. then can change based on related activity. Returns to Scale in isoquants: Cost Function The cost function is a function of input prices and output quantity. Just build another factory. the cost is the same regardless of activity. there are often constant returns to scale: duplicate what you are doing. then total costs and output should double. variable functions change the cost depending on activity. and total functions combine the two — a cost will be fixed to a certain point. the term cost function is a financial term used by economists and mangers within businesses to understand how costs behave. 𝑄 = 𝑥0 + 𝑥1 𝑦 + 𝑥2 𝑦 2 + 𝑥3 𝑦 3 Total fixed cost Total variable cost where: Q – total production cost. The cost function shows how a cost changes as the levels of an activity relating to that cost change. y – production quantity Department Of Finance Jagannath University Md. hire more workers and managers. In other words. variable. and total. Its value is the cost of making that output given those input prices. If it is not a big deal to coordinate the two factories.
In this case equilibrium is at a point where given is isocost is tangent to the highest IQ. When cost is given: A producer is in equilibrium when maximum output is produced with given cost. it will only get output level of IQ1 which is not best level of output. but it shows higher cost for same output level. A combination of factors which makes a producer to be in equilibrium is called optimum combination. Jagannath University. Department Of Finance Jagannath University Md. Given this budget. On the other hand if firm produces at point K. Mazharul Islam (Jony) ID no:091541. In this diagram cost or budget of the producer is given and shown by AB isocost line. The output level shown by IQ can be produced at point L. Therefore equilibrium of producer is at point E. it is called producers equilibrium or optimal combination of two factors of production. a firm cannot produce IQ3 level of output as it is beyond the reach of the producer. On the other hand this output level cannot be produced at CD isocost line. Equilibrium of producer can be defined in following situations. Department of Finance. 1. When output is given: A producer will be in equilibrium when given output is produced with minimum cost. 2. 3rd Batch. Therefore equilibrium of producer is at point E. The equilibrium of producer is determined at a point where Isoquant is tangent to Isocost curve.Equilibrium of Producer When a producer combines such a combination of two factors which yield maximum output for given cost or produces given output for minimum cost. Md. Mazharul Islam (Jony) 53 | P a g e . In this situation equilibrium is at a point where IQ becomes tangent to lowest Isocost. The equilibrium of the producer is at E where isocost line AB is tangent to given IQ.
That is. in order to keep up the same production levels is called MRTS . is negative. Therefore. Because capital has been reduced. The MRTS at point b on the q2 isoquant in the figure equals the absolute value of the slope of the straight line that is tangent to the isoquant at that point. more units of labor will be required to replace each unit of capital. The more of one input you use. ∆𝐿 ∆𝐾 ∆𝐿 We can interpret the marginal rate of technical substitution (MRTS) graphically. each unit of capital remaining is likely to be more productive. the productivity of capital falls. Department Of Finance Jagannath University Md. The MRTS falls as we move down along an isoquant. increasing amounts of another input must be used to produce the same level of output. the absolute value of decreases. ∆𝐾 . the extra amount of one input which has to be added to compensate for an amount of another input which decreases. we have to give up less capital for each unit of labor added to keep output constant. the productivity of labor falls. this approximation becomes exact. The MRTS is approximately equal to the absolute value of the ∆𝐾 slope of the line from point b to point c. Alternatively. The minus sign is added in order to make MRTS a positive MRTS is defined as: 𝑀𝑅𝑇𝑆 = − number. When more capital is added to the production process in place of labor. Mazharul Islam (Jony) 54 | P a g e . When more labor is added to the production process in place of capital. the less productive it is relative to the other input. as more and more labor is substituted for ∆𝐾 capital while holding output constant. Over the relevant range of production the ∆𝐿 marginal rate of technical substitution diminishes.Marginal rate of technical substitution Since the two inputs can be substituted for one another to maintain a constant level of output. the rate at which one input is substituted for another along an isoquant is called the marginal rate of technical substitution MRTS . In other words. as we move down and to the right along an isoquant along which the MRTS is diminishing. As ∆𝐿 and ∆𝐿 ∆𝐾 become small. Yields typical ―bowed-in‖ isoquants. which equals (the rise divided by the run). the marginal product of labor is likely to diminish. Law of Diminishing Marginal Rate of Technical Substitution As less of one input is used. As more and more labor is added. since . the slope of the isoquant.
Output maximization is a good thing for a company. being able to make products efficiently allows for higher levels of production. Cost minimization is the behavioral assumption that an individual or firm will seek to purchase a given amount of goods or inputs at the least cost. Theoretically. total economic welfare is maximized. production efficiency will include all of the points along the production possibility frontier. Cost minimization is comparable to other objectives. Production Efficiency Production efficiency measures whether the economy is producing as much as possible without wasting precious resources. but can be a bad thing for consumers if the company starts to use cheaper products or decides to raise prices. however. This goal. Economic Efficiency Economic or Allocative efficiency is achieved when the value consumers place on a good or service (reflected in the price they are willing to pay) equals the cost of the resources used up in production. sale prices.Output Maximization A process that companies undergo to determine the best output and price levels in order to maximize its return. The company will usually adjust influential factors such as production costs. In other words. including utility maximization and profit maximization. Department Of Finance Jagannath University Md. but this is difficult to measure in practice. It must now do so at the lowest cost possible. is generally used when circumstances constrain a decision. For example. There are two main profit maximization methods used. Cost Minimization In case of cost minimization the process or goal of incurring the least possible opportunity cost in the pursuit of a given activity. then a maximum level of production has been reached. and they are Marginal Cost-Marginal Revenue Method and Total Cost-Total Revenue Method. and output levels as a way of reaching its profit goal. Condition required is that price equal to marginal cost. If the economy can't make more of a good without sacrificing the production of another. there will exist a single cost-minimizing combination of inputs for any level of output. Because resources are limited. other things being equal. Mazharul Islam (Jony) 55 | P a g e . By making certain assumptions. a government agency has been assigned the task of building a bridge. When this condition is satisfied.
The production efficiency locus can be translated to a diagram for goods X and Y. As production of one good (say X) increases at the expense of good Y. Without the tax. however. yet with the policy the government has to import this amount of rice at the world price at a total cost equal to Q1Q2BC. Production-Possibility Frontier (PPF) In economics. In Point C. obviously. From the economy's point of view. This triangle is commonly labeled the "production efficiency loss" of the rice subsidy. sometimes called a production-possibility curve or product transformation curve. producers would be earning total rents (profits) equal to the area ACJ. The difference . the triangular area BCG. is the additional cost to the economy of importing rice at a higher opportunity cost than domestic production. In Point A. given the society's technology and the amount of factors of production available. producer surplus has been reduced. is a graph that shows the different rates of production of two goods and/or services that an economy can produce efficiently during a specified period of time with a limited quantity of productive resources. In Point B. At the lower domestic price. producers could produce the (Q1-Q2) amount of rice at a cost equal to the area Q1Q2GC. The difference. the amount of extra good X that can be produced with each additional unit of inputs (factors) is less than the previous extra good X. more X and less Y. a small amount of X is produced. In the absence of the tax. the reduction in production from Q1 to Q2 is inefficient. If opportunity cost of producing more and more of a particular good increases. a lot of Y. or factors of production. Mazharul Islam (Jony) 56 | P a g e .In the producers' point of view. The PPF shows the maximum amount of one commodity that can be obtained for any specified production level of the other commodity (or composite of all other commodities).the shaded area ACGF . producers only earn rents equal to the area FGJ. due to the lower price received by producers. even more X and Less Y. then the highest combination of output occurs near the middle of the ppf. Department Of Finance Jagannath University Md. a production-possibility frontier (PPF). Points along the locus represent different combinations of X and Y produced.represents the loss in producer surplus due to the tax.
The CES production function is a type of production function that displays constant elasticity of substitution. Constant Elasticity of Substitution In economics. 𝑄′ = 𝐴𝐾′𝛼 𝐿′𝛽 By substitution. Mazharul Islam (Jony) 57 | P a g e . Alternatively. It is measured as the ratio of proportionate change in the relative demand for two goods to the proportionate change in their relative prices. Then. See also elasticity of technical substitution. given by: 𝑠𝑙𝑜𝑝𝑒 = − 𝜕𝑓 (𝐾 .𝐿) 𝜕𝐾 𝜕𝑓 (𝐾 . 𝛼 + 𝛽 >1 indicates increasing returns to scale. say. respectively. Cobb-Douglas production function which has the form 𝑄 = 𝐴𝐾 𝛼 𝐿𝛽 where: Q = total production (the monetary value of all goods produced in a year) L = labor input K = capital input A = total factor productivity α and β are the output elasticities of labor and capital. then 𝑐 𝛼+𝛽 < c. Elasticity of Substitution Elasticity of substitution is the elasticity of the ratio of two inputs to a production (or utility) function with respect to the ratio of their marginal products (or utilities). Constant elasticity of substitution (CES) is a property of some production functions and utility functions.𝐿) 𝜕𝐿 . With two factors of production. so this is a case of decreasing returns to scale. In other words. K and L. The mathematical definition is: 𝐿 −1 𝜕 𝑠𝑙𝑜𝑝𝑒 𝐾 𝐸 = 𝐿 𝜕 𝑠𝑙𝑜𝑝𝑒 𝐾 where "slope" denotes the slope of the isoquant. These values are constants determined by available technology. or two or more types of productive inputs into an aggregate quantity. It measures the curvature of an isoquant. it refers to a particular type of aggregator function which combines two or more types of consumption. the Cobb–Douglas functional form of production functions is widely used to represent the relationship of an output to inputs. The elasticity of substitution between factors of production is a measure of how easily one factor can be substituted for another. Let 𝐾′ = 𝑐𝐾 and 𝐿′ = 𝑐𝐿. it is a measure of the curvature of a production isoquant. and 𝛼 + 𝛽 =1 indicates constant returns to scale. Elasticity of substitution shows to what degree two goods or services can be substitutes for one another. This aggregator function exhibits constant elasticity of substitution. the production technology has a constant percentage change in factor Department Of Finance Jagannath University Md.Cobb–Douglas production function and Its Properties In economics. Responsiveness of the buyers of a good or service to the price changes in its substitutes. If 𝛼 + 𝛽 <1. More precisely. 𝑄′ = 𝐴 𝑐𝐾 𝛼 (𝑐𝐿)𝛽 Which reduces to 𝑐 𝛼+𝛽 𝐴𝐾 𝛼 𝐿𝛽 or 𝑄′ = 𝑐 𝛼 +𝛽 𝑄 .
The general form of the CES production function is: 𝑛 𝑄 = 𝑓 𝑖=0 1 (𝑠−1) 𝑎𝑖 𝑠 𝑥𝑖 𝑠 𝑠 (𝑠−1) Where Q = Output. 𝑠 (1−𝑟) The CES production function exhibits constant elasticity of substitution between capital and labor. we get the Cobb-Douglas function.s= = Elasticity of substitution. in the limit as s approaches 1.(e.2. a = Share parameter.. Leontief. s = Elasticity of substitution. Labor) CES production function is: 𝑄 = 𝑓(𝑎𝐾 𝑟 + 1 − 𝑎 𝐿𝑟 )𝑟 1 Where Q = Output. x = Production factors (i = 1. labour and capital) proportions due to a percentage change in marginal rate of technical substitution. 3rd Batch. Department of Finance. a = Share parameter. Mazharul Islam (Jony) 58 | P a g e . f = Factor productivity. Mazharul Islam (Jony) ID no:091541. as s approaches 0 we get the linear (perfect substitutes) function. L = Primary production factors (𝑠−1) 1 (Capital and Labor). and for s approaching infinity.n). Md. K.g. Department Of Finance Jagannath University Md. we get the Leontief (perfect complements) function.. f = Factor productivity. The two factor (Capital. Jagannath University. r = . linear and Cobb-Douglas production functions are special cases of the CES production function. That is.
its marginal product is 10 but when 2nd unit of the variable factor is applied then this produces additional 20 units thus marginal product of every next unit of variable factor goes on increasing under the law of increasing return." This is due to the fact that the combination does not represent a correct proportion of the factors. Fixed productive capacity: The fertility of land and the productive capacity of machinery have fixed maxima. it can be stated that if a variable factor is combined with some fixed factors. after a point the average and marginal product of that factor will diminish. This law can be stated in the following words: ―If Successive units of variable factors are applied to a fixed factor then up to a point the marginal product of the factor will increase. Benham states the law thus: "As the proportion of one factor in a combination of factors is increased. Mazharul Islam (Jony) 59 | P a g e . This results in diminishing returns. Employment beyond a point overstrains the fixed factor (land or machinery). In the words of Chapman. There is too much of one factor in relation to others. provided that additional Department Of Finance Jagannath University Md. its marginal product is 50 but when 2nd unit of the variable factor is applied then this produces additional 40 units thus marginal product of every next unit of variable factor goes on decreasing under the law of decreasing returns CAUSES OF DIMINISHING RETURNS There are many causes which are responsible for the law of diminishing returns. In a general way. According to this table when first unit of variable factor is applied to the 10 units of fixed factor. According to this table when first unit of variable factor is applied to the 10 units of fixed factor. "The expansion of an industry. this is called law of increasing return. In this table we assume that law of diminishing returns starts from the very first unit of variable factor although in practice its application starts beyond the optimal combination of fixed and variable factors. the average and the marginal return for that variable factor will diminish. When proper balance is restored the law of diminishing returns will no longer operate. FF 10 10 10 10 10 VF 1 2 3 4 5 MP 50 40 30 20 10 This table explains the law of diminishing returns.‖ FF 10 10 10 VF 1 2 3 MP 10 20 30 10 10 4 5 40 50 This table explains the law of increasing return. Scarcity of the factors: The supply of the various factors of production beyond a point becomes relatively inelastic and if demand continues to increase the prices of these factors will rise. Law of Diminishing Returns The law of diminishing returns simply refers to a principle of combination of the factors.LAWS OF RETURNS Law of Increasing Returns Law of increasing return discusses initial changes in production when units of variable factors are applied to a fixed factor.
after a point. This is so. Jagannath University. is invariably accompanied at once or eventually by decreasing returns. Mazharul Islam (Jony) 60 | P a g e . The additional supply of factors cannot be arranged. Mazharul Islam (Jony) ID no:091541. Defective combination of factor: Beyond a point of optimum combination. Department of Finance. "What the law of diminishing returns really states is that there is a limit to the extent to which one factor of production can be substituted for another.supplies of some agent in production which is essential cannot be obtained. other things being equal. As Mrs. 3rd Batch. because the work of supervision and organization. Md." Limited capacity for organization and supervision: Even if it were possible to increase productive capacity indefinitely and to substitute one factor for another. That is why beyond a point law of diminishing returns sets in. diminishing returns set in. Imperfect substitutes: Factors of production cannot be substituted for one another. Robinson says. would become so heavy and cumbersome that it becomes difficult for a single farmer or entrepreneur to manage. Department Of Finance Jagannath University Md. the diminishing returns would still ultimately set in.
etc. Salary to Gatekeeper. E. Direct Costs & Indirect Costs Direct Costs are Costs that are readily identified and are Traceable to a particular Product. Outlay Costs:Involves Actual Expenditure of Funds. Points along the curve describe the trade-off between the goods.e. Manufacturing Costs to a Product Line.g.Outlay Co sts are recorded in the Books of Accounts as it involves Financial Expenditure at some Time. Interest. Explicit cost refers to the out of pocket or cash expenditures a firm makes to outsiders to supply resources. Opportunity cost is measured in the number of units of the second good forgone for one or more units of the first good. Implicit Costs: Implicit cost imputed cost of self-owned or self employed resources based on their opportunity costs .In other words. is that.g. E. Rent. Wages. Electric Power. Indirect Costs are Costs that are not readily identified and are not Traceable to a particular Product. Prices of Factors of Production.g. T = Technology. Scale of Operations. The sacrifice in the production of the second good is called the opportunity cost (because increasing production of the first good entails losing the opportunity to produce some amount of the second). 𝑇. implicit cost refers to the money payments the self-employed resources could have earned in their best alternative employment. Department Of Finance Jagannath University Md. P = Factor Price. and fees paid to bankers and lawyers are all included among the firm's explicit costs. Operation or Plant.COSTS OF PRODUCTION Cost Analysis: Cost Analysis refers to the Study of Behavior of Cost in relation to one or more Production Criteria like size of Output. In other words. Opportunity Cost Principle The economic cost of an input used in a production process is the value of output sacrificed elsewhere. costs paid in cash. payments to suppliers of raw materials. 𝐶 = 𝑓(𝑄. If there is no increase in productive resources. a firm that uses its own building for production purposes forgoes the income that it might receive from renting the building out. The opportunity cost of an input is the value of foregone income in best alternative employment. K = Capital. Cost Function: The cost function refers to the mathematical relation between cost of a product and the various Determinants of costs. Wages paid to workers. increasing production of a first good entails decreasing production of a second. etc.. Although not traceable but bears Functional Relationship to Production. 𝑃. 𝐾) Here. For example. In other words. Operation or Plant. Explicit Costs: Explicit costs. because resources must be transferred to the first and away from the second. Mazharul Islam (Jony) 61 | P a g e . Cost Analysis related to the Financial Aspects of Production Relations against Physical Aspects. Q = Quantity produced or output..
Economic efficiency means the economy is doing the best job possible of satisfying unlimited wants and needs with limited resources. In other words. There is no waste of material inputs. that producers are doing the best job possible of combining resources to make goods and services. The fact that economic profits are zero implies that the firm's reserves are enough to cover the firm's explicit costs and all of its implicit costs. Economic profits: Economic profits are total revenues minus explicit and implicit costs. Mazharul Islam (Jony) 62 | P a g e . There are no workers standing idly around waiting for spare parts. of addressing the problem of Department Of Finance Jagannath University Md. Normal profits: A firm is said to make normal profits when its economic profits are zero. The maximum amount of physical production is obtained from the given resource inputs. Accounting profits: Accounting profits are the firm's total revenues from sales of its output. Thus. Technical efficiency is a prerequisite for allocative or economic efficiency. technical efficiency. Rent. In a broad sense. This is also termed either efficiency or allocative efficiency. etc. Normal profit is an implicit cost TECHNICAL EFFICIENCY: Generally Technical efficiency refers to obtaining the greatest possible production of goods and services from available resources and should be contrasted with economic or allocative efficiency. minus the firm's explicit costs. such as the rent that could be earned on the firm's building or the salary the owner of the firm could earn elsewhere. economic profits are accounting profits minus implicit costs. Fixed Cost may disappear on the Complete Shut Down of Business. Variable Costs vary Directly or sometimes Proportionately with Output. Wages & Cost of Raw Materials.g. Variable Costs are costs that are a Function of Output in the Production Period e. normal profits. production is achieved at the lowest possible opportunity cost. that is. that is. ECONOMIC EFFICIENCY: Generally Economic efficiency refers to obtaining the most consumer satisfaction from available resources.Fixed Cost does not vary with the Volume of Output within a Capacity Level. Interest on Loans. resources are allocated in such a way that consumer satisfaction is at its highest possible level. In essence.g. Because satisfaction is derived from consuming goods and services. In a broad sense. Alternatively stated. the difference between economic profits and accounting profits is that economic profits include the firm's implicit costs and accounting profits do not. These implicit costs add up to the profits the firm would normally receive if it were properly compensated for the use of its own resources— hence the name. Depreciation. Types of Profit The difference between explicit and implicit costs is crucial to understanding the difference between accounting profits and economic profits. economic efficiency requires the greatest possible level of production.Fixed Costs & Variable Costs Fixed Costs require a Fixed Expenditure of Funds irrespective of the Level of Output e. Technical efficiency means that natural resources are transformed into goods and services without waste. Economic efficiency is achieved if the highest possible level of satisfaction is obtained from given resources.
the firm's variable costs must also increase. the economy must first achieve technical efficiency. Fixed costs cannot be changed in the short run. some of the input factors the firm uses in production are fixed. etc. Total Cost (TC): The sum of fixed cost and variable cost at each level of output. while technical efficiency is necessary for economic efficiency. Variable costs first increase by a decreasing amount. While technical efficiency might be achieved in the production of purple spotted stuffed animals. Salaries to top management Variable Cost: The firm also employs a number of variable factors of production. which are independent of the quantity of a good produced and include inputs (capital) that cannot be varied in the short term. In order to increase output. labor. total cost (TC) describes the total economic cost of production and is made up of variable costs. Even if production is zero. the cost of these fixed factors is the firm's fixed costs. Fixed Cost: In the short-run. such as buildings and machinery. Therefore. but later it increase by increasing amounts (due to MP curve) Examples: payments for materials. Mazharul Islam (Jony) 63 | P a g e . insurance premiums. and costs that change with level of output. depicted as a horizontal line. Total fixed cost(TFC) are the sum of all of the fixed cost. the greater the total variable cost. and a portion of deprecation on equipment and buildings. This means that we can change the intensity at which the fixed plant is used. allocative or economic efficiency is not achieved if no one actually wants purple spotted stuffed animals and they remain stored in a big purple warehouse.scarcity." Graphically. Average Cost. plus fixed costs. In economics. and Marginal Cost can be divided into 2 components --fixed costs and variable costs. as firm output increases. Variable costs can be changed in the short run. Short run cost The Short Run is a period of time too brief for an enterprise to alter its plant capacity. Total cost in Department Of Finance Jagannath University Md. Total Variable Costs (TVC) is the sum of all of the variable costs. However. Short run cost function: 𝐶 = 𝑓(𝑄) Total Cost. The cost of these variable factors of production is the firm's variable costs. it does not guarantee economic efficiency. power. If no output is produced. Can be controlled in the short run by changing production levels Total variable cost increases as the amount of output increases. Beyond current control Examples: Rental payments. cost of ingredients. the firm must increase the number of variable factors of production that it employs. The larger the output. which vary according to the quantity of a good produced and include inputs such as labor and raw materials. however. interest on a firm's debts. Total fixed cost is more commonly referred to as "sunk cost" or "overhead cost. then total variable cost is zero. insurance premiums. To achieve economic efficiency. transportation services. fuel.
Characteristics. and then increases again as the Law of Diminishing Returns sets in at the low levels of output production is relatively inefficient and costly. Mazharul Islam (Jony) 64 | P a g e . reaches a minimum. it is a graphically simple curve to outline. average cost or unit cost is equal to total cost divided by the number of goods produced (the output quantity. Average cost In economics.. Note: Area between TC (total cost) and TVC (total variable cost) equals the TFC (total fixed costs). TC = TFC + TVC The rate at which total cost changes as the amount produced changes is called marginal cost. This is also known as the marginal unit variable cost. as the AFC continues to decrease. ATC: Average Total Cost ATC = TC/Q = TFC/Q + TVC/Q = AFC + AVC Can be found graphically by adding vertically the AFC and AVC curves Vertical distance between ATC and AVC curves measures AFC at any level of output The vertical distance between ATC and AVC curves will continue to decrease. increases by the same amount as variable cost Because the total cost is simply the variable cost + fixed cost. for example).economics includes the total opportunity cost of each factor of production as part of its fixed or variable costs. Department Of Finance Jagannath University Md. Average costs affect the supply curve and are a fundamental component of supply and demand. since TC-TVC=TFC. 𝑇𝐶 𝐴𝐶 = 𝑄 Per Unit Cost or Average Costs AFC: average fixed costs which is the total fixed cost divided by the quantity AFC = TFC/Q declines as output increases (spreading the overhead) AVC: average variable costs which is the total variable cost divided by the quantity AVC = TVC/Q declines as variable resources (labor) increase output. Q). It is also equal to the sum of average variable costs (total variable costs divided by Q) plus average fixed costs (total fixed costs divided by Q). Average costs may be dependent on the time period considered (increasing production may be expensive or impossible in the short term.
for example. jump fix cost increase or decrease dependent to steps of volume increase. At each level of production and time period being considered. Mathematically. building a new factory. Eventually. constant terms independent to volume and occurring with the respective lot size. Consequently. however. the firm's total product will increase at a rate less than the rate at which new workers are hired. it is the cost of producing one more unit of a good. 𝑑𝑇𝐶 𝑀𝐶 = 𝑑𝑄 In general terms.Marginal cost In economics and finance. If one calculates the change in total cost for each different level of total product reported and divides by the corresponding marginal product of labor reported. Note that the marginal cost will change with volume. the marginal cost of those extra vehicles includes the cost of the new factory. the marginal product of the variable factor will begin to decline. Relationship between Marginal cost and Marginal product The firm's marginal cost is related to its marginal product. In practice. Mazharul Islam (Jony) 65 | P a g e . and other costs are considered fixed costs. That is. as a non-linear and non-proportional cost function includes variable terms dependent to volume. This behavior is a consequence of the relationship between marginal cost and marginal product and the law of diminishing returns. marginal cost is the change in total cost that arises when the quantity produced changes by one unit. all costs are marginal. marginal costs include all costs which vary with the level of production. Department Of Finance Jagannath University Md. If producing additional vehicles requires. the marginal cost (MC) function is expressed as the first (order) derivative of the total cost (TC) function with respect to quantity (Q). then starts to rise. and over the longest run. the firm's total product increases at a rate that is greater than the rate of new workers hired. the firm's marginal costs will be decreasing. labor rises. As the marginal product of the variable input. The result is that the firm's marginal costs will begin rising. one arrives at the marginal cost figure. the analysis is segregated into short and long-run cases. The marginal cost falls at first. the marginal cost is the cost of the next unit produced referring to the basic volume. So at each level of production. by the law of diminishing returns. marginal cost at each level of production includes any additional costs required to produce the next unit.
a nuclear plant would be extremely inefficient (very high average cost) for production in small quantities. Q = Quantity produced or output. 𝑃. Department Of Finance Jagannath University Md. marginal cost is greater than average cost. The high fixed capital costs are a barrier to entry. The long run elasticity of supply will be higher. Long run production function: 𝐶 = 𝑓(𝑄. The means that we can change capacity and intensity. Long Run The Long Run is extensive enough for firms to change quantities of all resources employed. When average cost is neither rising nor falling (at a minimum or maximum). its maximum output for any given time period may essentially be fixed. Industries where fixed marginal costs obtain. or have discontinuities. marginal cost equals average cost. similarly. K = Capital. 𝑇. Long-run cost curves Cost curves appropriate for long-run analysis are more varied in shape than short-run cost curves and fall into three broad classes. which has no fuel expense. P = Factor Price. Zero fixed costs (long-run analysis) / constant marginal cost: since there are no economies of scale. limited maintenance expenses and a high up-front fixed cost (ignoring irregular maintenance costs or useful lifespan). T = Technology. For example. dangerous or extremely costly. 𝐾) Here. Mazharul Islam (Jony) 66 | P a g e . An example may be hydroelectric generation. Minimum efficient scale / maximum efficient scale: marginal or average costs may be non-linear. such as electrical transmission networks. marginal cost is less than average cost. may meet the conditions for a natural monopoly. Average cost curves may therefore only be shown over a limited scale of production for a given technology.Relationship between Average Cost and Marginal Cost When average cost is declining as output increases. The average cost curve slopes down continuously. Other special cases for average cost and marginal cost appear frequently: Constant marginal cost/high fixed costs: each additional unit of production is produced at constant additional expense per unit. the marginal cost to the incumbent of serving an additional customer is always lower than the average cost for a potential competitor. because once capacity is built. approaching marginal cost. as new plants could be built and brought on-line. When average cost is rising. average cost will be equal to the constant marginal cost. and production above that level may be technically impossible.
a cost curve is a graph of the costs of production as a function of total quantity produced. since they permit a few large firms to drive all smaller competitors out of business. average cost is about the same at all levels of output except the very lowest. AVC. Automobile and steel manufacturing are leading examples. as a cotton mill expands by increasing the number of spindles. There are various types of cost curves. Decreasing costs are characteristic of manufacturing in which heavy.In constant-cost industries. and vice versa. When MP rises. Cost curve In economics. productively efficient firms use these curves to find the optimal point of production. automated machinery is economical for large volumes of output. The two basic categories of cost curves are total and per unit or average cost curves. Decreasing costs are inconsistent with competitive conditions. Mazharul Islam (Jony) 67 | P a g e . all related to each other. Finally. Constant costs prevail in manufacturing industries in which capacity is expanded by replicating facilities without changing the technique of production. in increasing-cost industries average costs rise with the volume of output generally because the firm cannot obtain additional fixed capacity that is as efficient as the plant it already has. at least until the plant is large enough to supply an appreciable fraction of its market. The most important examples are agriculture and extractive industries. MC falls. Department Of Finance Jagannath University Md. average cost declines as the rate of output grows. where they make the most profits. AVC falls. In a free market economy. and vice versa. When AP rises. ATC. In decreasing-cost industries. and MC would rise and those cost curves would all shift upward. Reasons for Shifts of the Cost Curves: Change in resource cost Change in technology When the price of labor or some other variable input rise. The MC curve and the AVC curve are mirror images of the MP and AP curves.
Department Of Finance Jagannath University Md. 2. Jagannath University. 6. 5. Total Fixed Cost Total Variable Cost Total Cost Average Fixed Cost Average Variable Cost Average Total Cost Marginal Cost (TFC) (TVC) (TC=TVC+TFC) (AFC=TFC/Q) (AVC=TVC/Q) (AC=AFC+AVC) (MC= ∆AVC/∆Q Md. 3rd Batch. Mazharul Islam (Jony) ID no:091541. 4. 3. Department of Finance. 7. Mazharul Islam (Jony) 68 | P a g e .7 Cost Concepts (Short-run): 1.
Perfect information: Prices and quality of products are assumed to be known to all consumers and producers. how much and for whom to produce different commodities. Still. where they generate the most profit. Perfect competition serves as a benchmark against which to measure real-life and imperfectly competitive markets. Market is actually a very logical mechanism that helps answer the basic economic questions of what. Perfect factor mobility: In the long run factors of production are perfectly mobile allowing free long term adjustments to changing market conditions. Basic assumptions required for conditions of Perfect competition to exist Generally. Zero entry and exit barriers: It is relatively easy for a business to enter or exit in a perfectly competitive market. there are few if any perfectly competitive markets. perfect competition describes markets such that no participants are large enough to have the market power to set the price of a homogeneous product. And also because of the popularity of auctions as a rationing device for allocating scarce resources among competing ends. System continually allocates goods and services to various units with the help of a pricing mechanism. and no participant influences the price of the product it buys or sells. Perfect competition In economic theory. say for commodities or some financial assets. Profit maximization: Firms aim to sell where marginal costs meet marginal revenue. may approximate the concept. Homogeneous products: The characteristics of any given market good or service do not vary across suppliers. Zero transaction costs: Buyers and sellers incur no costs in making an exchange (perfect mobility). Department Of Finance Jagannath University Md. Because the conditions for perfect competition are strict. Following are some of the features of a perfect market. Economists have become more interested in pure competition partly because of the rapid growth of e-commerce in domestic and international markets as a means of buying and selling goods and services. buyers and sellers in some auction-type markets. a perfectly competitive market exists when every participant is a "price taker". Infinite buyers and sellers: Infinite consumers with the willingness and ability to buy the product at a certain price.Market Market Economy The market is a system where buyers and sellers exchange goods or services. Mazharul Islam (Jony) 69 | P a g e . and infinite producers with the willingness and ability to supply the product at a certain price. Constant returns to scale: Constant returns to scale ensure that there are sufficient firms in the industry.
Some firms may be experiencing sub-normal profits because their average total costs exceed the current market price. the firm is making an economic loss (or subnormal profits) Department Of Finance Jagannath University Md. At the profit maximising level of output. the firm shown has high short run costs such that the ruling market price is below the average total cost curve. Mazharul Islam (Jony) 70 | P a g e . the profit-maximising output is Q1. The firm sells Q1 at price P1. In the diagram above. In the diagram below. In the diagram shown above. A firm maximises profits when marginal revenue = marginal cost. the AR curve also becomes the Marginal Revenue curve (MR). price P1 is the market-clearing price and this price is then taken by each of the firms. Other firms may be making normal profits where total revenue equals total cost (i.Determining Price of Commodity for the Perfectly Competitive Industry and Firm In the short run the equilibrium market price is determined by the interaction between market demand and market supply. Their profits depend on the position of their short run cost curves.e. they are at the break-even output). Because the market price is constant for each unit sold. The area shaded is the economic (supernormal profit) made in the short run because the ruling market price P1 is greater than average total cost. Not all firms make supernormal profits in the short run.
It takes decision regarding reduction and sales of goods. As such. Determination of Firm’s Equilibrium: There are two methods for the determination of firm’s equilibrium: 1. Profit is maximized. and with a horizontal demand curve ep equals infinity. If marginal revenue is the additional revenue from 1 additional unit. the profit maximizing firm in perfect competition produces where P=MC. 2. A firm would not like to change its level of output only when it is earning maximum profit. By the relationship between marginal revenue and price. and the firm should decrease production. Mazharul Islam (Jony) 71 | P a g e . partnership or Joint Stock Company. we need to know the revenue and costs of the business. 4. Profit Maximization under Perfect Competition To maximize profit. and marginal cost is rising. Equilibrium: It indicates a situation or a point of rest . Marginal cost is the additional cost from 1 additional unit. we can see that the perfectly competitive firm achieves this condition by setting output where marginal cost equals price. Equilibrium of the Firm: Whenever a firm attains the stage from where it does not want to move forward or backward it is said to be in equilibrium. 3. A firm may be in the form of sole proprietorships. Marginal revenue and marginal cost approach. When marginal revenue = marginal cost (MR=MC). 1. When MR < MC.It refers to a stage of no change from where a firm does not want to move into any of the directions.There are some features of a firm which are as follows: Firm is a single unit engaged in production and sale of goods It is a decision making entity. It always attempt to maximize profit and minimize costs A firm will be in equilibrium when it maximizes its profits. Since MR=P(1-1/ep). Department Of Finance Jagannath University Md. revenue is increasing faster than costs and the firm should increase production. A firm maximizes profits when MR = MC. Total revenue and total cost approach 2. however. When MR > MC. revenue from the additional unit is less than additional cost.Firm Firm refers to a production unit which employs factors of production to produce goods and services for the market .
because losses are then less than TFC. a firm operating at a loss [R < TC (revenue less than total cost) or P < ATC (price less than unit cost)] must decide whether to continue to operate or temporarily shutdown. average cost. as long as it covers its variable costs. Where ATC = AVC + AFC.2. A company is considered to have shut down. Shut Down in the Short Run under Perfect Competition Shutting down is a short-run decision. A company has exit the industry when it has made a permanent decision to leave the industry. A firm that has shut down is not producing. This way. shut down when P (AR = MR) < AVC. its total revenue becomes zero. and average variable cost curves on the firm's demand curve. The figure uses short run cost curves because production decisions occur in a short run environment. The firm still retains its capital assets. So the company should continue producing its product. Basically. The Department Of Finance Jagannath University Md.A firm's production decision can be found by superimposing marginal cost. The firm therefore produces where profit equals marginal cost. to minimize the losses and so the company's short-run supply curve = MC curve above AVC. In the short run. if it temporary ceases production but keeps fixed capital. as shown in figure 10. Now if a business shuts down. The decision to temporarily shut down a business depends on a few factors. So average fixed cost is the vertical distance between average variable cost and average total cost. Mazharul Islam (Jony) 72 | P a g e . and its total cost equals the fixed cost. total revenue is greater than total variable cost.
The firm should continue to operate if R . So the firm’s profit equals fixed costs or (. Department Of Finance Jagannath University Md. incurring variable costs and paying fixed costs. If companies are making more than zero economic profits. which is a long run condition. Restated. exit if total revenue is less than total cost (P < ATC).FC. Long run equilibrium Long run equilibrium in a competitive market means existing firms have no ability to expand or contract to increase profits. the firm can resume production. and prices increase. Thus. no reason to exit the industry. By shutting down a firm avoids all variable costs. On the other hand if VC > R then the firm is not even covering its production costs and it should immediately shut down. If the revenue the firm is receiving is greater than its total variable cost (R > VC) then the firm is covering all variable cost plus there is additional revenue (contribution). a company will make zero economic profits in the long run. enter if total revenue is greater than total cost (P > AC). which can be applied to fixed costs. At last it can be finalized here that. An operating firm is generating revenue.FC ≥ . there is no entry and no exit. the difference between revenue. it will encourage other firms to enter the industry to share in these profits. if R ≥ VC then firm should operate. In other words.FC).VC . ―In the short run a firm should continue to operate if price exceeds average variable costs‖.FC which simplified is R ≥ VC. When to Leave An Industry (permanent) A business should leave the industry when revenue is less than cost of operating in the long run. In competitive markets. If companies are making zero economic profits. A decision to shut down means that the firm is temporarily suspending production. It does not mean that the firm is going out of business (exiting the industry). R. VC. Another way to state the rule is that a firm should compare the profits from operating to those realized if it shutdown and select the option that produces the greater profit. and variable costs. Because fixed cost must be paid regardless of whether a firm operates they should not be considered in deciding whether to produce or shutdown. the rule is that for a firm to continue producing in the short run it must earn sufficient revenue to cover its variable costs. The operating firm's profit is R . If R < VC the firm should shut down. is the contribution to fixed costs and any contribution is better than none. In other words.VC . and gives new investors no incentive to enter. the firm must still pay fixed costs. The rationale for the rule is straightforward. If market conditions improve. The rule is conventionally stated in terms of price (average revenue) and average variable costs. However the firm still has to pay fixed cost. Mazharul Islam (Jony) 73 | P a g e . Thus in determining whether to shut down a firm should compare total revenue to total variable costs (VC) rather than total costs (FC + VC).shutdown rule states. A firm that is shutdown is generating zero revenue and incurring no variable costs. However.
price equals marginal cost (the profit-maximizing rule). there is no change in investment that can increase profit. new firms would enter. there is no incentive for entry or exit. Each firm in the market maximizes its profit. and market forces will push up the price until P = min(ATC). If we have P < min(ATC).Assuming the representative firm has a u-shaped long run average cost curve. because the firm is at its minimum long run average cost. there are profit opportunities. in long-run equilibrium the typical firm earns zero economic profit so there is no further incentive for firms to enter the market. The demand curve only determines the equilibrium quantity and not the price in the long run. competitive market long run equilibrium is reached when price equals minimum long run average cost. so there is no incentive for other firms to enter the market In addition to the conditions above. SMC. The quantity of the product supplied equals the quantity demanded 2. firms are making losses. but no more. Department Of Finance Jagannath University Md. Each firm in the market earns zero economic profit. If we have P > min(ATC). then whatever quantity is demanded would be willingly supplied. P = min(ATC). firms would exit. Market Equilibrium in the Long Run In the long run. Thus. Since price equals average cost. Market short run supply (SRS) and demand (D) establish a market price of Pm. and we are in equilibrium. where short run marginal cost. an output of qm in figure 10. At that price the firm maximizes profit at qm. and price equals short-run average total cost (zero economic profit). and market forces will push down the price until P = min(ATC). the market price is determined solely by cost considerations. A market reaches a long-run equilibrium when three conditions hold: 1. Firms make a normal return. profit is zero. equals Pm and both short run average cost and long run average cost are at their minimum values. Moreover.17. If we have P = min(ATC). given the market price 3. We find the interesting paradox that the drive to make above normal returns (profits) results in a zero profit equilibrium in the competitive market. In long-run equilibrium. Mazharul Islam (Jony) 74 | P a g e .
a firm may acquire control over product through a patent on a basic process of production or the product itself. etc.g. 3rd Batch. a firm may become a monopolist because government awards an exclusive market franchise. Therefore. Mazharul Islam (Jony) ID no:091541.e. IPRs like a drug patent. In theory the monopolist is considered inefficient because the quantity supplied is less and the price higher than under perfect competition. Department of Finance. Monopoly exists for one or more of four reasons. The monopolist producer tends equates marginal revenue and marginal cost rather than price equal to marginal cost. Monopolies are thus characterized by a lack of economic competition for the good or service that they provide and a lack of viable substitute goods. market power exercised by a single buyer facing many producers. Md. In a monopoly market. one firm may control the entire supply of a basic input. e. a monopoly exists when a specific individual or an enterprise has sufficient control over a particular product or service to determine significantly the terms on which other individuals shall have access to it. First. i. e. equilibrium points for the market and for the firm are the same. water supply. The inverse of a monopoly or monophony can also exist. a firm may become a monopolist because the average cost of producing the product reaches a minimum at an output sufficient to supply the entire market .a natural monopoly. the entire market supply is accounted by one firm. Department Of Finance Jagannath University Md. Fourth. Monopoly is mitigated only by competition from substitutes. electric power. Mazharul Islam (Jony) 75 | P a g e . The firm is able to choose the price-quantity combination to maximize its profits.g. Second. Jagannath University. Third.Monopoly In economics.