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Pooja Dutt
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1 What are production function and its uses? Explain the two types of production
functions.
Production function and its uses
Two types of production functions
Answer: Production function
The entire theory of production centers revolves around the concept of production function. A
production function expresses the technological or engineering relationship between physical
quantity of inputs employed and physical quantity of outputs obtained by a firm. It specifies a
flow of output resulting from a flow of inputs during a specified period of time. It may be in the
form of a table, a graph or an equation specifying maximum output rate from a given amount of
inputs used. As it relates inputs to outputs, it is also called input-output relation. The
production is purely physical in nature and is determined by the quantum of technology,
availability of equipments, labor, raw materials, etc. employed by a firm.
A production function can be represented in the form of a mathematical model or equation as Q
= f (L, N, K.etc) where Q stands for quantity of output per unit of time and L, N, K etc are the
various factor inputs like land, capital, labour, etc which are used in the production of output.
The rate of output Q is thus, a function of the factor inputs L, N, K etc, employed by the firm per
unit of time.
Generally speaking, there are two types of production functions. They are as follows:
1. Short run production function In this case, the producer will keep all fixed factors as
constant and change only a few variable factor inputs. In the short run, we come across two kinds
of production functions:
Quantities of all inputs both fixed and variable will be kept constant and only one
variable input will be varied, for example, law of variable proportions.
Quantities of all factor inputs are kept constant and only two variable factor inputs are
varied, for example, iso-quants and iso-cost curves.
2. Long run production function In this case, the producer will vary the quantities of all
factor inputs, both fixed as well as variable in the same proportion, for example, the laws of
returns to scale. Each firm has its own production function which is determined by the state of
technology, managerial ability, organizational skills, etc of a firm.
It may be in the following manner:
1. The quantity of inputs may be reduced while the quantity of output may remain same.
2. The quantity of inputs may be reduced while the quantity of output may increase.
3. The quantity of inputs may be kept constant while the quantity of output may increase.
If there are any improvements in the firm, the old production function is disturbed and a new one
takes its place.

2 Monopoly is the situation there exists a single control over the market producing a
commodity having no substitutes with no possibilities for anyone to enter the industry to
compete. In that situation, they will not charge a uniform price for all the customers in the
market and also the pricing policy followed in that situation.
Define Monopoly
Features of Monopoly
Kinds of Price Discrimination
Answer: Monopoly means existence of a single seller in the market. Monopoly is that market
form in which a single producer controls the whole supply of a single commodity which has no
close substitutes. Monopoly may be defined, as a condition of production in which a single firm
has the power to fix the price of the commodity or the output of the commodity. It is a situation
there exists a single control over the market producing a commodity having no substitutes with
no possibilities for anyone to enter the industry to compete.
Features of monopoly
Anti-thesis of competition Absence of competition in the market creates a situation of
monopoly and hence, the seller faces no threat of competition.
Existence of a single seller There will be only one seller in the market who exercises
single control over the market.
Absence of substitutes There are no close substitutes for the sellers product with a
strong cross elasticity of demand. Hence, buyers have no alternatives.
Control over supply Seller will have complete control over output and supply of the
commodity.
Price maker The monopolist is the price maker and in taking decisions on price
fixation, he or she is independent. He or she can set the price to the best of his or her
advantage. Hence, the monopolist can either charge a high price for all customers or
adopt price discrimination policy if there are different types of buyers.
Entry barriers Entry of new firms is difficult. Hence, monopolist will not have direct
competitors in the market.
Firm and industry is same There will be no difference between the firm and an
industry.
Nature of firm The monopoly firm may be a proprietary concern, partnership concern,
Joint Stock Company or a public utility which pursues an independent price-output
policy.
Existence of super normal profits There will be opportunities for supernormal profits
under monopoly, because market price is greater than the cost of production.
Kinds of price discrimination:
Discrimination of the first degree Under price discrimination of the first degree, the
producer exploits the consumers to the maximum possible extent, by asking to pay the
maximum he/she is prepared to pay rather than go without the commodity. In this case,
the monopolist will not allow any consumers surplus to the consumer. This type of price
discrimination is called perfect discrimination.

Discrimination of the second degree In case of discrimination of the second degree,

the monopolist charges different prices for markets of the same commodity, but not at a
maximum possible rate but at a lower rate. The monopolist will leave a certain amount of
consumers surplus with the consumers. This is done to keep the consumers satisfied and
prevent the entry of potential rivals. This method is adopted by railway companies.
Discrimination of the third degree In case of discrimination of the third degree, the
markets are divided into many sub-markets or subgroups. The price charged in each case
roughly depends on the ability to pay of different subgroups in the market. This is the
most common type of discrimination followed by a monopolist.

3 A cost-schedule is a statement of variations in costs resulting from variations in the levels

of output and it shows the response of costs to changes in output. If we represent the
relationship between changes in the level of output and costs of production, we get different
types of cost curves in the short run. Define the kinds of cost concepts like TFC, TVC, TC,
AFC, AVC, AC and MC and its corresponding curves with suitable diagrams for each.
Kinds of cost concepts like TFC, TVC, TC, AFC, AVC, AC and MC and its corresponding
curves suitable diagrams.
Answer: Total fixed cost (TFC)
TFC refers to total money expenses incurred on fixed inputs like plant, machinery, tools and
equipments in the short run. Total fixed cost corresponds to the fixed inputs in the short run
production function. TFC remains the same at all levels of output in the short run. It is the same
even when output is nil. It indicates that whatever may be the quantity of output, whether 1 to 6
units, TFC remains constant.

Total Variable Cost (TVC)

TVC refers to total money expenses incurred on the variable factor inputs like raw materials,
power, fuel, water, transport and communication, etc, in the short run. Total variable cost
corresponds to variable inputs in the short run production function. It is obtained by summing up
the quantities of variable inputs multiplied by their prices. The formula to calculate TVC is as
follows. TVC = TC - TFC. TVC = f (Q), i.e., TVC is an increasing function of output. In other
words TVC varies with output. It is nil, if there is no production. Thus, it is a direct cost of
output.

Total cost (TC)

Total cost refers to the aggregate money expenditure incurred by a firm to produce a given
quantity of output. The total cost is measured in relation to the production function by
multiplying the factor quantities with their prices. TC = f (Q) which means that TC varies with
output. TC includes all kinds of money costs, both explicit and implicit cost. Normal profit is
included in the total cost as it is an implicit cost. It includes fixed as well as variable costs.
Hence, TC = TFC +TVC.

Average fixed cost (AFC)

Average fixed cost is the fixed cost per unit of output. When TFC is divided by total units of
output, AFC is obtained, Thus, AFC = TFC/Q.

Average variable cost (AVC)

The average variable cost is variable cost per unit of output. AVC can be computed by dividing
the TVC by total units of output. Thus, AVC = TVC/Q. The AVC will come down in the
beginning and then rise as more units of output are produced with a given plant. This is because,
as we add more units of variable factors in a fixed plant, the efficiency of the inputs first
increases and then decreases.

Average total cost (ATC) or average cost (AC)

AC refers to cost per unit of output. AC is also known as the unit cost since it is the cost per unit
of output produced. AC is the sum of AFC and AVC. Average total cost or average cost is

obtained by dividing the total cost by total output produced. AC = TC/Q. Also, AC is the sum of
AFC and AVC. In the short run, AC curve also tends to be U-shaped. The combined influence of
AFC and AVC curves will shape the nature of AC curve.

Marginal cost (MC)

Marginal Cost may be defined as the net addition to the total cost as one more unit of output is
produced. In other words, it implies additional cost incurred to produce an additional unit. It is
necessary to note that MC is independent of TFC and it is directly related to TVC as we calculate
the cost of producing only one unit. In the short run, the MC curve also tends to be U-shaped.

4 Inflation is a global Phenomenon which is associated with high price causes decline in the
value for money. It exists when the amount of money in the country is in excess of the
physical volume of goods and services. Explain the reasons for this monetary phenomenon.
Define Inflation
Causes for Inflation
Answer: Inflation is commonly understood as a situation of substantial and rapid increase in the
level of prices and consequent deterioration in the value of money over a period of time. It refers
to the average rise in the general level of prices and fall in the value of money. Inflation is an
upward movement in the average level of prices. The opposite of inflation is deflation, a
downward movement in the average level of prices. The common feature of inflation is rise in
prices and the degree of inflation may be measured by price indices.

Causes of inflation
I. Demand side
Increase in money supply Supply of money in circulation increases on account of the
following reasons: deficit financing by the government, expansion in public expenditure,
expansion in bank credit and repayment of past debt by the government to the people,
increase in legal tender money and public borrowing.
Increase in disposable income Aggregate effective demand rises when disposable
income of the people increases. Disposable income rises on account of the following
reasons: reduction in the rates of taxes, increase in national income while tax level
remains constant, and decline in the level of savings.
Increase in private consumption expenditure and investment expenditure An
increase in private expenditure both on consumption and on investment leads to
emergence of excess demand in an economy. When business is prosperous, business
expectations are optimistic and prices are rising. More investments are made by private
entrepreneurs causing an increase in factor prices. When the income of the factors rise,
there is more expenditure on consumer goods.
Increase in exports An increase in the foreign demand for a countrys exports reduces
the stock of goods available for home consumption. This creates shortages in the country
leading to a rise in price level.
Existence of black money The existence of black money in a country due to
corruption, tax evasion, black-marketing, etc. increases the aggregate demand. People
spend such unaccounted money extravagantly and create unnecessary demand for goods
and services thus causing inflation.
II. Supply side
Shortage in the supply of factors of production When there is shortage in the supply
of factors of production like raw materials, labour, capital equipments, etc. there will be a
rise in their prices. Thus, when supply falls short of demand, a situation of excess demand
emerges creating inflationary pressures in an economy.
Operation of law of diminishing returns When the law of diminishing returns
operates, increase in production is possible only at a higher cost which de-motivates the
producers to invest in large amounts. Thus, production will not increase proportionately
to meet the increase in demand. Hence, supply falls short of demand.
Hoardings by traders and speculators During the period of shortage and rise in
prices, hoardings of essential commodities by traders and speculators with the objective
of earning extra profits in the future creates an artificial scarcity of commodities. This
creates a situation of excess demand paving the way for further inflation.
Hoardings by consumers Consumers may also hoard essential goods to avoid payment
of higher prices in the future. This leads to an increase in the current demand, which in
turn stimulates prices.
Role of trade unions Trade union activities leading to industrial unrest in the form of
strikes and lockouts also reduce production. This will lead to creation of excess demand
that eventually brings a rise in the price level.

Role of natural calamities Natural calamities such as earthquake, floods, and drought
conditions also affect the supplies of agricultural products adversely. They also create
shortage of food grains and raw materials, which in turn creates inflationary conditions.

5 Discuss the practical application of Price elasticity and Income elasticity of demand.
Practical application of price elasticity
Practical application of Income elasticity
Answer: Practical application of price elasticity
1. Production planning It helps a producer to decide about the volume of production. If
the demand for his products is inelastic, specific quantities can be produced while he has
to produce different quantities, if the demand is elastic.
2. Helps in fixing the prices of different goods It helps a producer to fix the price of his
product. If the demand for his product is inelastic, he can fix a higher price and if the
demand is elastic, he has to charge a lower price. Thus, price-increase policy is to be
followed if the demand is inelastic in the market and price-decrease policy is to be
followed if the demand is elastic. Similarly, it helps a monopolist to practise price
discrimination on the basis of elasticity of demand.
3. Helps in fixing the rewards for factor inputs Factor rewards refer to the price paid for
their services in the production process. It helps the producer to determine the rewards for
factors of production. If the demand for any factor unit is inelastic, the producer has to
pay higher reward for it and vice-versa.
4. Helps in determining the foreign exchange rates Exchange rate refers to the rate at
which currency of one country is converted in to the currency of another country. It helps
in the determination of the rate of exchange between the currencies of two different
nations. For e.g. if the demand for US dollar to an Indian rupee is inelastic, in that case,
an Indian has to pay more Indian currency to get one unit of US dollar and vice-versa.
5. Helps in determining the terms of trade t is the basis for deciding the terms of trade
between two nations. The terms of trade implies the rate at which the domestic goods are
exchanged for foreign goods. For e.g. if the demand for Japans products in India is
inelastic, we have to pay more in terms of our commodities to get one unit of a
commodity from Japan and vice-versa.
6. Helps in fixing the rate of taxes Taxes refer to the compulsory payment made by a
citizen to the government periodically without expecting any direct return benefit from it.
It helps the Finance Minister to formulate sound taxation policy of the country. He can
impose more taxes on those goods for which the demand is inelastic and lower taxes if
the demand is elastic in the market.
7. Helps in declaration of public utilities Public utilities are those institutions which
provide certain essential goods to the general public at economical prices. The
government may declare a particular industry as public utility or nationalise it, if the
demand for its products is inelastic.
Practical application of income elasticity of demand
1. Helps in determining the rate of growth of the firm If the growth rate of the
economy and income growth of the people is reasonably forecasted, in that case, it is
possible to predict expected increase in the sales of a firm and vice-versa.

2. Helps in the demand forecasting of a firm It can be used in estimating future demand
provided that the rate of increase in income and the Eyis for the products are known.
Thus, it helps in demand forecasting activities of a firm.
3. Helps in production planning and marketing The knowledge of Eyis essential for
production planning, formulating marketing strategy, deciding advertising expenditure
and nature of distribution channel, etc. in the long run.
4. Helps in ensuring stability in production Proper estimation of different degrees of
income elasticity of demand for different types of products helps in avoiding overproduction or under production of a firm. One should also know whether rise or fall in
income is permanent or temporary.
5. Helps in estimating construction of houses The rate of growth in incomes of the
people also helps in housing programmes in a country. Thus, it helps a lot in managerial
decisions of a firm.
6 Discuss the scope of managerial economics.
Definition of Managerial Economics
Scope of Managerial Economics
Answer: Managerial economics is a science that deals with the application of various economic
theories, principles, concepts and techniques to business management in order to solve business
and management problems. It deals with the practical application of economic theory and
methodology in decision-making problems faced by private, public and non-profit making
organizations.
Scope of Managerial Economics
Objectives of a firm
Historically, profit maximization has been considered as the main objective of a business unit.
All business organizations have multiple objectives which are multidimensional out of which
some are supplementary and some are competitive. Few others are inter-connected and few
others are opposing. There are various goals like social, economic, organizational, human, and
national.
Demand analysis and forecasting
Mostly, a firm is a producing unit. It produces different kinds of goods and services. It has to
meet the requirements of consumers in the market. The basic problems like: what to produce;
where to produce; for whom to produce; how to produce; how much to produce and how to
distribute them in the market, are to be answered by a firm. Hence, the firm has to study in detail
about the various determinants of demand, nature, composition and characteristics of demand,
elasticity of demand, demand distinctions, demand forecasting, etc.
Production and cost analysis
Production means conversion of inputs into the final output. It may be either in physical or in
monetary terms. Physical production deals with the production of outputs by a firm, by
employing different factor inputs in proper proportions. Always, the most basic goal of any firm
is to increase the output. Production analysis deals with production function, laws of returns,
returns to scale, economies of scale, etc.
Pricing decisions, policies and practices

Pricing decisions means to fix the prices for all the goods and services of any firm. This is based
on the pricing policy and practices of that particular firm. Amongst all the policies the most
important policy of any firm would be the price setting policy. The pricing decision depends on
the revenue (amount), income (level) and profits (volume) earned by a firm. Hence, we have to
study price-output determination under different market conditions, objectives and
considerations of pricing policies, pricing methods, practices, policies, etc. We also study price
forecasting, marketing channel, distribution channel, sales promotion policies, etc.
Profit management
Basically, a firm can be a commercial or a business unit. Consequently, its success or failure is
measured in terms of the amount of profit it is able to earn in a competitive market. The
management gives top most priority to this aspect. There are many theories in profit
management, like emergence of profit, functions of profit and its measurement, profit policies,
techniques, profit planning, profit forecasting and breakeven point.
Capital management
This is one of the essential areas of business unit. The success of any business is based on proper
management and adequate capital investment. Business managers, as part of cost-benefit
analysis, have to study the cost of employing capital and the rate of return expected from each
and every project. Under capital management, managers should assess capital requirement,
methods of capital mobilization, capital budgeting, optimal allocation of capital, selection of
highly profitable projects, cost of capital, return on capital, planning and control of capital
expenditure, etc.
Linear programming and theory of games
The term linear means that the relationships handled can be represented by straight lines and the
term programming implies systematic planning or decision-making. It implies maximization or
minimization of a linear function of variables subject to a constraint of linear inequalities.