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MICROECONOMICS

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DIRECTORATE OF DISTANCE EDUCATION


Gomal University Dera Ismail Khan
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Microeconomics
DEFINITION of 'Microeconomics'
The branch of economics that analyzes the market behavior of individual consumers and
firms in an attempt to understand the decision-making process of firms and households. It
is concerned with the interaction between individual buyers and sellers and the factors
that influence the choices made by buyers and sellers. In particular, microeconomics
focuses on patterns of supply and demand and the determination of price and output in
individual markets (e.g. coffee industry).

Definition
Study of the economic behavior of individual units of aneconomy (such as
a person, household, firm, or industry) and not of the aggregate economy (which is
the domain ofmacroeconomics). Microeconomics is primarily concerned with
the factors that affect individual economic choices, the effect of changes in these factors
on the individual decisionmakers, how their choices are coordinated by markets, and
how prices and demand are determined in individual markets. The main subjects covered
under microeconomics include theory of demand, theory of the firm, and demand for
labor and other factors of production

I. INTRODUCTION

Microeconomics (from Greek prefix mikro- meaning "small") is a branch


of economics that studies the behavior of individuals and firms in making decisions
regarding the allocation of limited resources. Typically, it applies
to marketswhere goods or services are bought and sold. Microeconomics examines how
these decisions and behaviors affect thesupply and demand for goods and services, which
determines prices, and how prices, in turn, determine the quantity supplied and quantity
demanded of goods and services.
One goal of microeconomics is to analyze the market mechanisms that establish relative
prices among goods and services and allocate limited resources among alternative uses.
Microeconomics also analyzes market failure, where markets fail to
produce efficient results, and describes the theoretical conditions needed for perfect
competition. Significant fields of study in microeconomics include general equilibrium,
markets under asymmetric information, choice under uncertainty and economic
applications of game theory. Also considered is the elasticity of products within the
market system.

Assumptions and definitions


Microeconomic theory typically begins with the study of a single rational and utility
maximizing individual. To economists, rationality means an individual possesses
stable preferences that are both complete and transitive. The technical assumption that
preference relations are continuous is needed to ensure the existence of autility function.
Although microeconomic theory can continue without this assumption, it would
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make comparative statics impossible since there is no guarantee that the resulting utility
function would be differentiable.
Microeconomic theory progresses by defining a competitive budget set which is a subset
of the consumption set. It is at this point that economists make the technical assumption
that preferences are locally non-satiated. Without the assumption of LNS (local non-
satiation) there is no guarantee that a rational individual would maximize utility. With the
necessary tools and assumptions in place the utility maximization problem (UMP) is
developed.
The utility maximization problem is the heart of consumer theory. The utility
maximization problem attempts to explain the action axiom by imposing rationality
axioms on consumer preferences and then mathematically modeling and analyzing the
consequences. The utility maximization problem serves not only as the mathematical
foundation of consumer theory but as a metaphysical explanation of it as well. That is, the
utility maximization problem is used by economists to not only
explain what or how individuals make choices by why individuals make choices as well.
The utility maximization problem is a constrained optimization problem in which an
individual seeks to maximize utility subject to a budget constraint. Economists use
the extreme value theorem to guarantee that a solution to the utility maximization
problem exists. That is, since the budget constraint is both bounded and closed, a solution
to the utility maximization problem exists. Economists call the solution to the utility
maximization problem a Walrasian demand function or correspondence.
The theory of supply and demand usually assumes that markets are perfectly competitive.
This implies that there are many buyers and sellers in the market and none of them have
the capacity to significantly influence prices of goods and services.
This is studied in the field of collective action and public choice theory. "Optimal
welfare" usually takes on a Paretian norm, which is a mathematical application of
the Kaldor–Hicks method. This can diverge from the Utilitarian goal of
maximizingutility because it does not consider the distribution of goods between people.
Market failure in positive economics (microeconomics) is limited in implications without
mixing the belief of the economist and their theory.

Importance and Significance of Microeconomics

The study of Microeconomic theory helps in following:

 Understanding operation of economy at a micro level - The study of


Microeconomics helps us in understanding various market situations which are
possible in any economy. It helps in understanding the economic reasons behind the
decisions like – What to Produce? For whom to produce? How much to Produce? etc.

 Optimization of resource allocation - The study of Microeconomics helps in


understanding that how a firm or an industry etc can maximize its production
efficiency and the profit by appropriate allocation and utilization of resources at its
disposal.
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 Minimization of Cost - The study of Microeconomics helps in the determination


of optimum production point for a firm/industry.The theory also helps in determining
the point of cost minimization for a firm

 Understanding Consumer Behaviour - The study of Marginal Utility theory,


Revealed Preference Hypothesis, Consumer Indifferance curves etc give useful
insight into consumer behaviour and thus help in understanding and predicting the
consumer behaviour in varied market situations.

 Demand Forecasting - The theory of Demand and Demand analysis, elasticity of


demand etc help in understanding and predicting demand of a product.

 Impact of change in Price/Income/Prices of related goods etc on the demand


of a Product - The study of Microeconomic theory can help an individual firm to
understand the impact of change in price, income, prices of related goods etc on the
demand the good or service which the firm is offering to the market.

 Government Policy Making - The study of demand theory, supply theory,


market theory etc can help the government in policy making at macro level. For
example the study of microeconomic theory can help in deciding appropriate tax
policy, pricing policy of the public goods and services, impact of tax policy in
reducing inequality of income and wealth etc

 Foreign trade and exchange rate determination - Microeconomic theory of


demand, supply, elasticity of demand etc help in understanding the impact of change
in tariff on the terms of trade. Similarly, microeconomic theory of demand,supply etc
helps in understanding the exchange rate determination process in the foreign
exchange market.

 Maximisation of Social Welfare - The study of Microeconomic theory can help


in deciding the appropriate allocation of resources, commodities and output mix for
the maximization of the social welfare.

Applied microeconomics

Applied microeconomics includes a range of specialized areas of study, many of which


draw on methods from other fields.Industrial organization examines topics such as the
entry and exit of firms, innovation, and the role of trademarks. Labor
economics examines wages, employment, and labor market dynamics. Financial
economics examines topics such as the structure of optimal portfolios, the rate of return
to capital, econometric analysis of security returns, and corporate financial
behavior. Public economics examines the design of government tax and expenditure
policies and economic effects of these policies (e.g., social insurance programs). Political
economy examines the role of political institutions in determining policy
outcomes. Health economics examines the organization of health care systems, including
the role of the health care workforce and health insurance programs. Urban economics,
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which examines the challenges faced by cities, such as sprawl, air and water pollution,
traffic congestion, and poverty, draws on the fields of urban geography and sociology.

i) Wants and Scarcity

A basic condition of human existence which means that people are never
totally satisfied with the quantity and variety of goods and services the
consume. It means that people never get enough, that there's always
something else that they would want or need. Unlimited wants and needs
are one half of the fundamental problem of scarcity that has plagued
humanity since the beginning of time. The other half of the scarcity
problem is limited resources.
Unlimited wants and needs essentially means that people never get enough, that there is
always something else that they would like to have.

For example, once Duncan Thurly eats a hearty breakfast of pancakes and sausage, is he
satisfied? Perhaps. But then in a couple of hours he wants a tuna salad sandwich for
lunch. Then he wants linguini with alfredo sauce and bottle of Chianti for dinner. And
then wants a bedtime snack of chocolate chip cookies and milk.

Before long, the morning sun pops up and Duncan is hungry. It is breakfast time all over
again. Quite obviously, no one EVER permanently satisfies that old hunger need.

What about other needs, like clothing, cars, or kitchen appliances. Once Duncan has a
car, then he HAS a car and his car need is satisfied, right? The same can be said for
other goods, right? Once Duncan has a can opener, then his can-opener need is satisfied,
right?

This seems to imply that, in principle, Duncan could obtain every good that satisfies his
assorted wants and needs. Perhaps. But once he has a car, then he needs gasoline, and
motor oil, and insurance, and fuzzy dice to hang from the rear view mirror, and more
gasoline, and new tires, and an oil change, and more gasoline, and... the list of needs goes
on.

Wants or Needs

To understand why wants and needs are unlimited, consider the phrase "wants and
needs." Wants and needs is the term for... well... wanting and needing things. Human
people want some things like hot fudge sundaes and red sports cars. Human people need
other things like food, water, and oxygen.
 Needs: Needs are best thought of as physiological or biological requirements for
maintaining life, such as the need for air, water, food, shelter, and sleep.
 Wants: Wants are then the psychological desires that are not essential for life but
that make life just a little more enjoyable.

Satisfaction
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Now, consider the process of fulfilling wants and needs. Satisfaction is the process of
successfully fulfilling wants and needs. Whether a good is wanted or needed, it provides
satisfaction.

Consider the simple process of consuming a hot fudge sundae:

 Duncan Thurly has a craving for a hot fudge sundae.


 Duncan eats a hot fudge sundae.
 Duncan no longer craves a hot fudge sundae.
 Duncan has been satisfied, at least as far as his hot fudge sundae desire is
concerned.

Motivation

The vast number of unsatisfied wants and needs is important because it provides people
with the motivation to take action. Being hungry in the morning motivates Duncan to
whip up some pancakes and sausage. Being hungry before bedtime motivates Duncan to
seek out chocolate chip cookies. Similar motivations exist for lunch and dinner. Duncan
buys a car because he needs to travel, Duncan buys a can-opener because he needs to
open cans, Duncan buys clothing because he needs protection from the weather and does
not want to hear people snicker when he passes by wearing nothing but sandals and a
baseball cap.

For economics, the pursuit of satisfaction, the act of satisfying wants and needs, is
extremely important. It motivates people to take action, to buy goods, to work, to
produce, to consume. Duncan is motivated to buy a hot fudge sundae because he wants a
hot fudge sundae. However, because wants and needs are unlimited, so too is his
motivation to take action.

Alternatives

One of the most important aspects of unlimited wants and needs is not so much the
philosophical question whether or not wants and needs are ultimately limited or
unlimited, but the pragmatic observation that the number of unsatisfied wants and needs
is so vast that alternatives run rampant. Using resources to satisfy Duncan's car need, for
example, means that his can-opener need, his cousin's clothing need, and a vast number
of alternative needs remain unsatisfied.

DEFINITION of 'Scarcity'
Scarcity refers to the basic economic problem, the gap between limited – that is, scarce
– resources and theoretically limitless wants. This situation requires people to make
decisions about how to allocate resources efficiently, in order to satisfy basic needs and as
many additional wants at possible. Any resource that has a non-zero cost to consume is
scarce to some degree, but what matters in practice is relative scarcity.

ii) Functions of Economic System


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There are four primary types of economic systems in the world: traditional, command,
market and mixed. Each economy has its strengths and weaknesses, its sub-economies
and tendencies, and, of course, a troubled history.

Below we examine each system in turn and give ample attention to the attributes listed
above. It’s important to understand how different parts of the world function
economically, as the economy is one of the strongest forces when it comes to balancing
political power, instigating war and delivering a high (or low) quality of life to the
people it serves. Anyone interested in economics on a global level should check out this
fantastic course on the crisis of capitalism and why the global economy is teetering
on the verge of collapse.

1. Traditional Economic System

A traditional economic system is the best place to start because it is, quite literally, the
most traditional and ancient type of economy in the world. There are certain elements
of a traditional economy that those in more advanced economies, such as Mixed, would
like to see return to prominence.

Where Tradition Is Cherished: Traditional economies still produce products and


services that are a direct result of their beliefs, customs, traditions, religions, etc. Vast
portions of the world still function under a traditional economic system. These areas
tend to be rural, second- or third-world, and closely tied to the land, usually through
farming. However, there is an increasingly small population of nomadic peoples, and
while their economies are certainly traditional, they often interact with other economies
in order to sell, trade, barter, etc. Learn about the complexities of globalization and how
it shapes economic relationships and affects cultures with this great class on the
geography of globalization.

Minimal Waste: Traditional economies would never, ever, in a million years see the
type of profit or surplus that results from a market or mixed economy. In general,
surplus is a rare thing. A third-world and/or indigenous country does not have the
resources necessary (or if they do, they are controlled by wealthier economies, often by
force), and in many cases any surplus is either distributed, wasted, or paid to some
authority that has been given power.

Advantages And Disadvantages: Certainly one of the most obvious advantages is that
tradition and custom is preserved while it is virtually non-existant in market/mixed
economies. There is also the fact that each member of a traditional economy has a more
specific and pronounced role, and these societies are often very close-knit and socially
satisfied. The main disadvantage is that traditional economies do not enjoy the things
other economies take for granted: Western medicine, centralized utilities, technology,
etc. But as anyone in America can attest, these things do not guarantee happiness,
peace, social or, most ironically of all, economic stability.

2. Command Economic System


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In terms of economic advancement, the command economic system is the next step up
from a traditional economy. This by no means indicates that it is fairer or an exact
improvement; there are many things fundamentally wrong with a command economy.

Centralized Control: The most notable feature of a command economy is that a large
part of the economic system is controlled by a centralized power; often, a federal
government. This kind of economy tends to develop when a country finds itself in
possession of a very large amount of valuable resource(s). The government then steps in
and regulates the resource(s). Often the government will own everything involved in the
industrial process, from the equipment to the facilities.

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Level 1 Economics curriculum.

Supposed Advantages: You can see how this kind of economy would, over time, create
unrest among the general population. But there are actually several potential
advantages, as long as the government uses intelligent regulations. First of all, a
command economy is capable of creating a healthy supply of its own resources and it
generally rewards its own people with affordable prices (but because it is ultimately
regulated by the government, it is ultimately priced by the government). Still, there is
often no shortage of jobs as the government functions similarly to a market economy in
that it wants to grow and grow upon its populace.

Hand In The Cookie Jar: Interestingly – or maybe, predictably – the government in a


command economy only desires to control its most valuable resources. Other things,
like agriculture, are left to be regulated and run by the people. This is the nature of a
command economy and many communist governments fall into this category.

You should also consider this micro and macro economics program. It’s been
approved by the CFA institute and focuses on the impact of economic variables on the
financial market and industry.

3. Market Economic System

A market economy is very similar to a free market. The government does not control
vital resources, valuable goods or any other major segment of the economy. In this way,
organizations run by the people determine how the economy runs, how supply is
generated, what demands are necessary, etc.

Capitalism And Socialism: No truly free market economy exists in the world. For
example, while America is a capitalist nation, our government still regulates (or
attempts to regulate) fair trade, government programs, moral business, monopolies, etc.
etc. The advantage to capitalism is you can have an explosive economy that is very well
controlled and relatively safe. This would be contrasted to socialism, in which the
government (like a command economy) controls and owns the most profitable and vital
industries but allows the rest of the market to operate freely; that is, price is allowed to
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fluctuate freely based on supply and demand. If you want to know how the global
economy works and the role you play in it, check out this sweet class on Economics
Without Boundaries.

Market Economy And Politics: Arguably the biggest advantage to a market economy
(at least, outside of economic benefits) is the separation of the market and the
government. This prevents the government from becoming too powerful, too
controlling and too similar to the governments of the world that oppress their people
while living lavishly on controlled resources. In the same way that separation of church
and state has been to vital to America’s social success, so has a separation of market
and state been vital to our economic success. Yes, there is something wary about a
system which to be successful must foster constant growth, but as a result progress and
innovation have occurred at such incredible rates as to affect the way the world
economy functions.

4. Mixed Economic System

A mixed economic system (also known as a Dual Economy) is just like it sounds (a
combination of economic systems), but it primarily refers to a mixture of a market and
command economy (for obvious reasons, a traditional economy does not typically mix
well). As you can imagine, many variations exist, with some mixed economies being
primarily free markets and others being strongly controlled by the government. Learn
more about an essential part of our economy with this free post on understanding the
stock market.

Benefits Of A Mixed Economy: In the most common types of mixed economies, the
market is more or less free of government ownership except for a few key areas. These
areas are usually not the resources that a command economy controls. Instead, as in
America, they are the government programs such as education, transportation, USPS,
etc. While all of these industries also exist in the private sector in America, this is not
always the case for a mixed economy.

Disadvantages Of A Mixed Economy: While a mixed economy can lead to incredible


results (America being the obvious example), it can also suffer from similar downfalls
found in other economies. For example, the last hundred years in America has seen a
rise in government power. Not just in imposing laws and regulations, but in actually
gaining control, becoming more difficult to access while simultaneously becoming less
flexible. This is a common tendency of mixed economies.

Please Respect The Thin Line: A current, pivotal debate between Democrats and
Republicans is the amount of governmental control. Can a true balance exist? Where
should there be more government regulation? Where should there be less? These
questions have no real answer; it is subjective, and therefore only a relatively small
portion of the population will, at any given time, agree with the state of a mixed
economy. It must be a strong form of government indeed to avoid collapsing under this
constant pressure.
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iii) Micro economic Theory and the Price System

The theory that we study in this book makes up the core of economic theory, but by no
means exhausts it. We investigate here the structure and operation of a market economy
in its broadest theoretical outline; and it is within this general body of theory that most
other branches of economic theory find their place. We are provisionally able to refrain
from paying attention to these other branches of theory only by drastically simplifying the
hypothetical market economy we deal with. Once the theory of the simplified market
process has been mastered, then more complex and particular market situations can be
dealt with by logical extensions of the theory.

In our study, for example, we ignore the possibility of trade between two separate market
economies; we therefore do not study the theory of international trade with its impact on
the market process within each country. Again, in our study, we almost completely ignore
the special role played by the government as an economic agent; we therefore do not
study the theory of public finance and the modifications brought about in the market
process by governmental taxation, expenditures, or debt. We do not consider, in our study,
the numerous complexities that are introduced into the market process by the various
possible institutions connected with money; we therefore do not study monetary theory.In
the same way [12] (and partly as a result of these simplifications) we do not consider the
possibility that market forces might arise that can disrupt periodically the smooth
operation of the market process; in other words we ignore the necessity to construct
a theory of the trade cycle; and so on.

In our study, therefore, we construct the theoretical framework within which all aspects of
the economic theory of a market economy must be set. We follow through the
fundamental market forces upon which and through which the impact of any special,
additional economic forces will be felt. The theoretical attack upon any particular
economic problem in the market must then be carried out against the background of this
general and widely accepted theory of the market.

Price system,

Price system, a means of organizing economic activity. It does this primarily by


coordinating the decisions of consumers, producers, and owners of productive resources.
Millions of economic agents who have no direct communication with each other are led
by the price system to supply each other’s wants. In a modern economy the price system
enables a consumer to buy a product he has never previously purchased, produced by a
firm of whose existence he is unaware, which is operating with funds partially obtained
from his own savings.

Prices are an expression of the consensus on the values of different things, and every
society that permits exchanges between people has prices. Because prices are expressed
in terms of a widely acceptable commodity, they permit a ready comparison of the
comparative values of various commodities—if shoes are $15 per pair and bread 30 cents
per loaf, a pair of shoes is worth 50 loaves of bread. The price of anything is its value in
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exchange for a commodity of wide acceptability: the price of an automobile may be some
50 ounces of gold or 25 pieces of paper currency. (See also money.)

A system of prices exists because individual prices are related to each other. If, for
example, copper rods cost 40 cents a pound and the process of drawing a rod into wire
costs 25 cents a pound, then it will be profitable to produce wire from a copper rod if its
price exceeds 65 cents. Conversely, it will be unprofitable to produce wire if its price falls
below 65 cents. Competition will hold the price of wire about 25 cents per pound above
that of rods. A variety of such economic forces tie the entire structure of prices together.

The basic functions of economic systems


Every economic system provides solutions to four questions: what goods and services
will be produced; how they will be produced; for whom they will be produced; and how
they will be allocated between consumption (for present use) and investment (for future
use). In a decentralized (usually private enterprise) economic system, these questions are
resolved, and economic coordination is achieved, through the price mechanism.

Product and quantity


Even the simpler economy of a traditional society must choose between food and shelter,
weapons and tools, or priests and hunters. In a modern economy the potential variety of
goods and services that may be produced is immense. Consider, for example, the
thousands of new book titles that are published each year—or the hundreds of colours of
paint or the thousands of styles of clothing that are brought to the market annually. Each
of these actual collections is much smaller than the amount that could be produced.

A price system weighs the desires of consumers in terms of the prices they are willing to
pay for various quantities of each commodity or service. The payment for the services of
a skilled surgeon (a price much influenced by the number of surgeons) reflects the unique
nature of those skills for the buyer-patient, whereas the price of an electric popcorn
popper reflects the minor convenience it provides. Of course, the amount consumers
agree to pay will be influenced by their wealth as well as their desires, but for any single
consumer, relative desire is proportional to the price offered.

Production
The second question an economy must answer involves deciding how the desired goods
are to be produced. There is more than one way to grow wheat, train lawyers, refine
petroleum, and transport baggage. The efficient production of goods and services requires
that certain fundamental rules be followed: no resource should be used in producing one
thing when it could be producing something more valuable elsewhere, and each product
should be made with the smallest-possible amount of resources.

A functioning price system induces all participants in the economy to steer their resources
toward activities that yield a reward. Jobs that pay a high price for labour will attract
workers seeking the reward of a high salary. Crops that yield a greater profit will attract
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more farmers to cultivate them. Similarly, capital will be drawn from a faltering trade and
redirected to an industry where it can earn higher returns.

This same price system seeks to achieve production efficiency through competition. If
one firm, for instance, can design, produce, and distribute shoes while using fewer
resources than its rivals, it will make larger profits; it is therefore motivated to discover
more efficient combinations of inputs and plant locations, to devise wage systems to
stimulate its workers, to use computers to manage inventories and streamline shipping,
and so forth.

Distribution
The third question an economy answers involves determining who gets the product. For
example, if family A acquires $5,000 worth of goods this year and family B receives five
times as much, how is this division to be decided? The incomes of individuals are
determined by the quantities of resources (labour skills, capital in all its forms) they own
and the prices they receive for the use of these resources. Workers are encouraged by the
price system to acquire new skills and to exercise them diligently, and families are
encouraged to save (capital accumulation) because of the rewards paid as interest or
dividends. Inherited ability and wealth also contribute to the distribution of income.

If the price system is working reasonably well (some of the common failures will be
noted later), it performs all of these economic functions with remarkable subtlety and
precision. Society desires not only the correct amount of wheat but also that it be
consumed more or less evenly over the crop year, with a surplus to carry over in case of a
partial failure of the next year’s crop. The price system provides a seasonal price pattern
that encourages the holding of inventories rather than early splurging and richly
rewards speculators who correctly anticipate a crop failure and hold grain that will
alleviate it. In the same way, the desires of every sizable group of consumers (or resource
owners) are registered through the price system; entrepreneurs are incited by price offers
to provide opera and musical comedy, kosher food, and Persian delicacies.

The workings of the price system


The complexity and variety of tasks performed by the price system will be illuminated by
an examination of three specific economic problems.

The choice of occupation


Individuals must be distributed among occupations in such a way as to serve two basic
purposes. First, the labourer must be placed where he is most productive—making certain
that Enrico Fermi becomes a physicist rather than a chef and that there are not too many
plumbers and too few electricians. Second, the individual worker should be given an
occupation that is congenial to him; since he will spend a large part of his life at work, it
will be a better life if he can choose the type he prefers.

The price of labour is the instrument by which workers are distributed among
occupations: wages in rapidly growing occupations and rapidly growing parts of the
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nation are higher than in corresponding employment in declining occupations and areas.
The choice of occupation involves, however, much more than simply a comparison of
wage rates. The following are a few of the complications: (1) The wages of an occupation
must as a rule be sufficient to compensate the costs of training. (2) The wages of an
occupation must be sufficient to compensate special disadvantages (such as a large
chance of unemployment). (3) Wages must be higher in large cities than in small because
living costs are higher in large cities. (4) Wages must compensate workers for their
additional skill as they acquire experience (they usually reach a peak of earnings between
ages 40 and 55) and thereafter decline as the worker’s efficiency declines. (5) Wages will
reflect differences in taxation, fringe benefits (pensions, vacations), etc. Accordingly, the
wage structure even for a single occupation in a single city is elaborate. When a single
wage (price) is imposed upon an occupation, labourers are no longer properly distributed
by wages; for example, a city school system that pays all teachers of given experience the
same wage finds it difficult to staff its less-attractive schools.

The preferences of the individual worker cannot be given full play, or each person would
become president of the corporation at a sumptuous salary. Yet the labourer may choose
to live in California rather than Maine; then the price system will incite employers to
move their operations to California, where they can hire this labourer more cheaply. The
labourer may prefer to work long hours or short hours, and employers are induced by
wage offers to cater to the labourer’s diverse preferences. In fact, it is equally appropriate
to speak of the worker’s buying conditions of work and of the employer’s buying the
services of the worker.

The conservation of resources


A society has some resources that can be replaced by investment; timber, for example, is
now largely grown as a commercial crop. Farmland is a more ancient example: the
fertility of soil can be increased by prudent cultivation. Other resources are not
replaceable, such as coal and petroleum. How does the price system conserve these
exhaustible resources?

The method of using a resource is independent of the pattern over time of income and
expenditures that the owner of the resource desires. Suppose that a farm will have a value
of $100,000 if it is maintained at a constant level of fertility and yields a yearly income of
$10,000 forever but that it can be cultivated (“mined”) intensively to yield $12,000 a year
for five years at the cost of a much reduced yield thereafter, with a value of $90,000.
Even if the farmer is in urgent need of immediate funds and does not expect to live more
than five years, he will still cultivate the farm at the uniform rate. Only then is it worth its
maximum value to him, and only then (by sale or mortgage) can he obtain the largest-
possible funds even in the near future. In short, one need not adapt his expenditure pattern
to his income pattern so long as he can borrow or lend.

If the growth of consumption or the decline of reserves threatens the exhaustion of


supplies of a resource, then the price of that resource will rise and promise to rise more in
the future, and this rise will serve to reduce current consumption and to reward the owner
of the resource for holding back much of the supply for the future. This rise in price will
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therefore also stimulate buyers to find more economical ways of using the commodity
(for example, burning the fuel more efficiently) and stimulate producers to find new
supplies or substitute products. The price system will therefore ensure that the supply of
the resource will be stretched out so that the resource will be available in both the present
and the future.

Limitations and failures of the price system


The price system is an extraordinarily powerful instrument in organizing an economic
system, but it is subject to three broad classes of limitations.

Private and public price control


Sometimes prices are not permitted to do their work. Monopolies are able to exert control
over prices, and they use it, sensibly enough, to raise their profits above the level allowed
by competition. The monopolist (or group of colluding enterprises) sets prices at a level
such that prices are above costs or, to use words of identical significance, such that
resources earn more in the monopolized industry than they can earn elsewhere. The basis
of the monopoly is its ability to prevent outsiders from entering the industry to share in
the unusual profits and, by the act of producing, actually serve to eliminate them.

The fixing of prices by monopolists reduces the income of society. This is, in fact, the
only well-established criticism (on grounds of efficiency) to be levied against
monopolies; there is no reason to assume that they will make products less-suited to
consumer tastes or innovate more slowly or pay lower wages or otherwise misallocate
resources. But the basic inefficiency led, first in the United States in 1890 and then
increasingly in European nations, to governmental policies to maintain or restore
competition.

Public price control has two aspects. A large part of public regulation is intended to
correct monopolistic pricing (or other failures of the price system); this includes most
public-utility regulation in the United States (transportation, electricity, gas, etc.).
Whatever the success of these endeavours—and on the whole there has been a substantial
decline in confidence in the regulatory bodies—they are usually instructed to achieve the
goals of an efficient price system.

Other public price controls are designed to serve ends outside the reach of the price
system. Prices of farm products are regulated (raised) in most nations with the intention
of improving farmers’ incomes, and the fixing of interest rates paid by banks is
undertaken to improve bank earnings. Such policies are invariably defended on various
economic and ethical grounds but reflect primarily the political strength of large and
well-organized producer groups.

Imperfect knowledge and tastes


Another limitation to which the price system is subject has to do with the control of
knowledge and tastes. To the extent that an economic actor, whether a consumer, a
labourer, or an investor, is poorly informed, he is likely to make decisions whose
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consequences are much different from those he desired and expected. What follows
relates only to consumer decisions, but parallel issues arise in labour markets, securities
markets, etc.

A consumer can satisfy his desires only if he makes intelligent purchases—that is, only if
the goods he buys are what he believes them to be. How can the consumer know whether
the meat is free of disease or whether the washing machine will function well and long or
whether the fabric of the garment is one synthetic fibre or another? To ascertain these
facts personally, the consumer would have to be a versatile scientist equipped with a
superb laboratory, and then he would need to spend so much time testing goods that he
would have little time to enjoy them.

iv) Positive and Normative Economics

Positive and normative economic thought are two specific branches of economic
reasoning. Although they are associated with one another, positive and normative
economic thought have different focuses when analyzing economic scenarios.

Positive Economics

Positive economics is a branch of economics that focuses on the description and


explanation of phenomena, as well as their casual relationships. It focuses primarily on
facts and cause-and-effect behavioral relationships, including developing and testing
economic theories. As a science, positive economics focuses on analyzing economic
behavior. It avoids economic value judgments. For example, positive economic theory
would describe how money supply growth impacts inflation, but it does not provide any
guidance on what policy should be followed. "The unemployment rate in France is higher
than that in the United States" is a positive economic statement. It gives an overview of
an economic situation without providing any guidance for necessary actions to address
the issue.

Normative Economics

Normative economics is a branch of economics that expresses value or normative


judgments about economic fairness. It focuses on what the outcome of the economy or
goals of public policy should be. Many normative judgments are conditional. They are
given up if facts or knowledge of facts change. In this instance, a change in values is seen
as being purely scientific. Welfare economist Amartya Sen explained that basic
(normative) judgments rely on knowledge of facts.

An example of a normative economic statement is "The price of milk should be $6 a


gallon to give dairy farmers a higher living standard and to save the family farm. " It is a
normative statement because it reflects value judgments. It states facts, but also explains
what should be done. Normative economics has subfields that provide further scientific
study including social choice theory, cooperative game theory, and mechanism design.

Relationship Between Positive and Normative Economics


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Positive economics does impact normative economics because it ranks economic policies
or outcomes based on acceptability (normative economics). Positive economics is defined
as the "what is" of economics, while normative economics focuses on the "what ought to
be. " Positive economics is utilized as a practical tool for achieving normative objectives.
In other words, positive economics clearly states an economic issue and normative
economics provides the value-based solution for the issue .
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II. DEMAND, SUPPLY AND MARKET

i) Demand Curve, Individual and Market Demand Curve

At higher prices, the quantity demanded is less than at lower prices. A


demand schedule indicates that, typically, there is an inverse relationship between the
price of a product and the quantity demanded. This relationship is easiest to see when a
graph is plotted, as shown.

Demand curves generally have a negative gradient


indicating the inverse relationship between quantity
demanded and price.

There are at least three accepted explanations of why


demand curves slope downwards:

The law of diminishing marginal utility

The income effect

The substitution effect

Diminishing marginal utility

One of the earliest explanations of the inverse relationship between price and quantity
demanded is the law of diminishing marginal utility. This law suggests that as more of
a product is consumed the marginal (additional) benefit to the consumer falls, hence
consumers are prepared to pay less. This can be explained as follows:

Most benefit is generated by the first unit of a good consumed because it satisfies all or a
large part of the immediate need or desire.

A second unit consumed would generate less utility - perhaps even zero, given that the
consumer now has less need or less desire.

Utility

While total utility continues to rise from extra consumption, the additional (marginal)
utility from each bar falls. If marginal utility is expressed in a monetary form, the greater
the quantity consumed the lower the marginal utility and the less the rational consumer
would be prepared to pay.

BARS TOTAL UTILITY MARGINAL


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UTILITY
1 100
2 190 90
3 270 80
4 340 70
5 400 60
6 450 50
7 490 40
8 520 30
8 540 20
The income effect

The income and substitution effect can also be used to explain why the demand curve
slopes downwards. If we assume that money income is fixed, the income effect suggests
that, as the price of a good falls, real income - that is, what consumers can buy with
their money income - rises and consumers increase their demand.

Therefore, at a lower price, consumers can buy more from the same money income,
and, ceteris paribus, demand will rise. Conversely, a rise in price will reduce real income
and force consumers to cut back on their demand.

The substitution effect

In addition, as the price of one good falls, it becomes relatively less expensive. Therefore,
assuming other alternative products stay at the same price, at lower prices the good
appears cheaper, and consumers will switch from the expensive alternative to the
relatively cheaper one.

It is important to remember that whenever the price of any resource changes it will trigger
both an income and a substitution effect.

Exceptions

It is possible to identify some exceptions to the normal rules regarding the relationship
between price and current demand.

Giffen Goods

Giffen goods are those which are consumed in greater quantities when their price rises.
These goods are named after the Scottish economist Sir Robert Giffen, who is credited
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with identifying them by Alfred Marshall in his highly influentialPrinciples of


Economics (1895).

In essence, a Giffen good is a staple food, such as bread or rice, which forms are large
percentage of the diet of the poorest sections of a society, and for which there are no close
substitutes. From time to time the poor may supplement their diet with higher quality
foods, and they may even consume the odd luxury, although their income will be such
that they will not be able to save. A rise in the price of such a staple food will not result in
a typical substitution effect, given there are no close substitutes. If the real incomes of the
poor increase they would tend to reallocate some of this income to luxuries, and if real
incomes decrease they would buy more of the staple good, meaning it is an inferior
good. Assuming that the money incomes of the poor are constant in the short run, a rise in
price of the staple food will reduce real income and lead to an inverse income effect.
However, most inferior goods will have substitutes, hence despite the inverse income
effect, a rise in price will trigger a substitution effect, and demand will fall. In the case of
a Giffen good, this typical response does not happen as there are no substitutes, and the
price rise causes demand to increase.

Example

For example, a family living on the equivalent of just $150 a month, may purchase some
bread (say 50 loaves at $2 each, which is the minimum they need to survive), and a
luxury item at $50. If the price of bread rises by 25% to $2.50 per loaf, continuing to
purchase 50 loaves would cost the individual $125, making the luxury unaffordable. They
cannot reduce their consumption of bread, given that their current consumption is the
minimum they require, and they cannot find a suitable substitute for their stable food. Not
being able to afford the luxury would leave the family with an extra $25 to spend, and,
given no alternatives to bread, they would purchase 10 more loaves each month. Hence
the 25% price increase has resulted in a 20% increase in the demand for bread - from 50
to 60 loaves.

Individual Demand
The individual demand curve for a good, service, or commodity, is defined with the
following in the background:

 The specific good, service, or commodity.


 A unit for measuring the quantity of that commodity.
 A unit for measuring price.
 A convention on whether sales taxes are included in the stated price.
 A certain economic actor (individual, household, or firm -- profit-making,
nonprofit, or governmental)
 A time frame within which the demand is measured.
 An economic backdrop that includes all the determinants of demand other
than the unit price of that commodity.

The demand curve is a curve drawn with:


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 The vertical axis is the price axis, measuring the price per unit of the commodity.
 The horizontal axis is the quantity axis, measuring the quantity of the commodity
demanded by the specific economic actor.

Here quantity demanded is understood to be the maximum quantity that the economic
actor would be ready, willing, and able to purchase at the given price.
Note that the individual demand curve makes sense only ceteris paribus -- all other
determinants of demand being kept constant.
The term individual demand is used for the entire price-quantity relationship depicted
pictorially by the demand curve. Explicitly, the individual demand fuctionrefers to the
function that outputs, at any given price, the quantity demanded at that price. A demand
schedule is a discrete version of the demand curve, specifying demand values for a
number of different prices.

Relation with market demand curve


The market demand curve for a good within a given market is obtained by adding up the
individual demand curves of all economic actors in that market.
A lot of interesting and quirky phenomena may be obtained at the level of individual
demand curves but may become less visible (due to smoothing and averaging out) at the
aggregate level because of the canceling out or smoothing out effects. Some examples are
discussed below:

 For items where purchase quantities are discrete, individual demand curves are by
nature discontinuous, while aggregate demand curves are likely to be continuous
given sufficient heterogeneity among individuals. Note that individual demand
quantities could be fractional even with discrete purchase quantities -- for instance,
my weekly number of loaves of bread purchased could be if I purchase a loaf of
bread every second day.
 Individual demand curves are more likely to exhibit sharp discontinuities for other
reasons: Individuals may use threshold prices and reference prices to determine which
item to purchase and how much. For instance, if, for me, and are equivalent
goods (i.e., they are perfect substitute goods for each other, then I buy none of
when its price exceeds that of , but I shift my entire consumption to when its
price drops below that of . The price of is thus a point of discontinuity in the
demand curve. In the aggregate, the heterogeneity of individuals ensures that they do
not all perceive the same pairs of goods as perfect substitutes, and hence these jumps
are less likely to occur.
 Various violations of the law of demand, both rational and irrational, are more
likely to be seen at the individual level than at the aggregate level: For instance,
the Giffen good phenomenon and the Veblen good phenomenon may play an
important role in the consumption behavior of one individual or household, but
because of differing incomes and differing tastes and preferences that lead individuals
to value substitutes differently, the phenomena would not apply to all economic
actors. Since an aggregate Giffen good phenomenon depends on the phenomenon
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affecting a large number of individuals, aggregate Giffen good phenomena may be


much rarer than individual Giffen good phenomena. The same holds for various forms
of mild irrationality and idiosyncratic behavior.

Market Demand
Market demand provides the total quantity demanded by all consumers. In other words, it
represents the aggregate of all individual demands. There are two basic types of market
demand: primary and selective. Primary demand is the total demand for all of the brands
that represent a given product or service, such as all phones or all high-end watches.
Selective demand is the demand for one particular brand of product or service, such as
the iPhone or a Michele watch. Market demand is an important economic marker because
it reflects the competitiveness of a marketplace, a consumer’s willingness to buy certain
products and the ability of a company to leverage itself in a competitive landscape. If
market demand is low, it signals to a company that they should terminate a product or
service, or restructure it so that it is more appealing to consumers.

Market Demand Curve Definition


The market demand curve is the summation of all the individual demand curves in a
given market. It shows the quantity demanded of the good by all individuals at varying
price points. For example, at $10/latte, the quantity demanded by everyone in the market
is 150 lattes per day. At $4/latte, the quantity demanded by everyone in the market is
1,000 lattes per day. The market demand curve gives the quantity demanded by everyone
in the market for every price point. The market demand curve is typically graphed and
downward sloping because as price increases, the quantity demanded decreases. It can
also be provided as a schedule, which is in table format.

Equation
To determine the market demand curve of a given good, you have to sum all the
individual demand curves for the good in the market. Here is the algebraic equation for
market demand. The quantity demanded (Q) is a function of price (P) and it is summing
all the individual demand curves (q), which are also a function of price. The subscripts
one through n represent all the individuals in the market.

Examples of Market Demand Curves


To make things easy, let's assume we have two people in the market for lattes (we all
know this is extremely simplified!), Jack and Jill. This table shows the individual demand
schedules for lattes. The column on the far right is the summation of the individual
demand curves, which becomes the market demand curve.
At $3 per latte, Jill would buy 24 lattes a month and Jack would buy 15. Therefore, the
market demand at $3 per latte is 39 per month. You can also graph the market demand
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curve, which is the most common method of presenting a demand curve. This graph
shows the same market demand curve as the table.
ii) Movement versus Shift in Demand Curve

The position of the demand curve will shift to the left or rightfollowing a change
in an underlying determinant of demand.

Increases in demand are shown by a shift to the right in the demand curve. This could be
caused by a number of factors, including a rise in income, a rise in the price of a
substitute or a fall in the price of a complement.

Demand schedule

A shift in demand to the right means an increase in the quantity demanded at every price.
For example, if drinking cola becomes more fashionable demand will increase at every
price.

PRICE (£) ORIGINAL Qd NEW Qd


1.10 0 100
1.00 100 200
90 200 300
80 300 400
70 400 500
60 500 600
50 600 700
40 700 800
30 800 900
Increases in demand

An increase in demand can be illustrated by a shift in the demand curve to the right.

Decreases in demand

Conversely, demand can decrease and cause a shift to the left of the demand curve for a
number of reasons, including a fall in income, assuming a good is a normal good, a fall in
the price of a substitute and a rise in the price of a complement.

Demand schedule
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For example, if the price of a substitute, such as fizzy orange,falls, then less cola is
demanded at each price, as consumers switch to the substitute.

PRICE (£) ORIGINAL Qd NEW Qd


1.10 0
1.00 100
90 200 100
80 300 200
70 400 300
60 500 400
50 600 500
40 700 600
30 800 700

Decreases in demand are shown by a shift of the demand curve to the left.

The basic difference between a move along a demand curve and a change in the curve is
that the former is caused by a change in price while the latter is not. A move along the
curve results in a different quantity demanded at a different price. A change in demand
means that a different quantity will be demanded at a given price than was demanded
before the change in demand occurred.

Let us look at this with regard to the DVD of a particular movie. Let us say the price is
now $15. But then the price drops to $10. All other things being equal, more people will
buy the DVD at the lower price. This is a movement along a given demand curve. There
has been no change in how many people would buy the DVD at $15. Instead, the price
has changed, causing a change in how many people will buy.

Now let us look at how the curve could move. Let us say the DVD is selling for $15 but
then the star of the movie commits a ghastly crime in real life. His popularity plummets
and many fewer people want to buy the movie. In this case the price can remain at $15
MUHAMMAD ISMAIL 03147963120 24

but many fewer people will buy the DVD. This is an instance in which the demand has
actually changed.

iii) Individual and Market Supply Curve and Market Equilibrium

The table in Figure 5 shows the quantity supplied by Ben, an ice-cream seller, at
various prices of ice cream. At a price below $1.00, Ben does not supply any ice
cream at all. As the price rises, he supplies a greater and greater quantity. This is
the supply schedule, a table that shows the relationship between the price of a
good and the quantity supplied, holding constant everything else that influences
how much producers of the good want to sell.
The graph in Figure 5 uses the numbers from the table to illustrate the law of
supply. The curve relating price and quantity supplied is called the supply curve.
The supply curve slopes upward because, other things equal, a higher price means
a greater quantity supplied.

Market equilibrium is one of the most important concepts in the study of economics. In
this lesson, you'll learn what market equilibrium is and how it is established, and you'll
also be provided some examples. A short quiz follows the lesson.

Definition of Market Equilibrium

Market equilibrium is a market state where the supply in the market is equal to the
demand in the market. The equilibrium price is the price of a good or service when the
supply of it is equal to the demand for it in the market. If a market is at equilibrium, the
price will not change unless an external factor changes the supply or demand, which
results in a disruption of the equilibrium.

Supply, Demand & Equilibrium


If a market is not at equilibrium, market forces tend to move it to equilibrium. Let's break
this concept down.
If the market price is above the equilibrium value, there is an excess supply in the market
(a surplus), which means there is more supply than demand. In this situation, sellers will
tend to reduce the price of their good or service to clear their inventories. They probably
will also slow down their production or stop ordering new inventory. The lower price
entices more people to buy, which will reduce the supply further. This process will result
in demand increasing and supply decreasing until the market price equals the equilibrium
price.
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If the market price is below the equilibrium value, then there is excess in demand (supply
shortage). In this case, buyers will bid up the price of the good or service in order to
obtain the good or service in short supply. As the price goes up, some buyers will quit
trying because they don't want to, or can't, pay the higher price. Additionally, sellers,
more than happy to see the demand, will start to supply more of it. Eventually, the
upward pressure on price and supply will stabilize at market equilibrium.

Examples of Market Equilibrium


Flat Screen TVs
Imagine that you make flat screen televisions. Your flagship model is a 72-inch plasma
that currently wholesales to your retailers at $2,500. Unfortunately, your warehouse has
recently been filling a bit too quickly with 72-inch plasmas. This is probably because
each of your three largest competitors has finally gotten around to introducing their own
72-inch televisions, which means that there are a bunch more 72-inch televisions on the
market.
Market Supply versus Individual Supply
Just as market demand is the sum of the demands of all buyers, market supply is
the sum of the supplies of all sellers. The table in Figure 6 shows the supply
schedules for two ice-cream producers—Ben and Jerry. At any price, Ben’s supply
schedule tells us the quantity of ice cream Ben supplies, and Jerry’s supply
schedule tells us the quantity of ice cream Jerry supplies. The market supply is the
sum of the two individual supplies.

iv) Price, Income and Cross Elasticities of Demand

Price elasticity of demand (PED) shows the relationship between price and quantity
demanded and provides a precise calculation of the effect of a change in price on quantity
demanded.

The following equation enables PED to be calculated.

We can use this equation to calculate the effect of price changes on quantity demanded,
and on the revenue received by firms before and after any price change.

For example, if the price of a daily newspaper increases from £1.00 to £1.20p, and the
daily sales falls from 500,000 to 250,000, the PED will be:

- 50% / + 20%
= (-) 2.5
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The negative sign indicates that P and Q are inversely related, which we would expect
for most price/demand relationships. This is significant because the newspaper supplier
can calculate or estimate how revenue will be affected by the change in price. In this case,
revenue at £1.00 is £500,000 (£1 x 500,000) but falls to £300,000 after the price rise
(£1.20 x 250,000).

The range of responses

The degree of response of quantity demanded to a change in price can vary considerably.
The key benchmark for measuring elasticity is whether the co-efficient is greater or less
than proportionate. If quantity demanded changes proportionately, then the value of PED
is 1, which is called ‘unit elasticity’.

PED can also be

Less than one, which means PED is inelastic.

Greater than one, which is elastic.

Zero (0), which is perfectly inelastic.

Infinite (∞), which is perfectly elastic

PED along a linear demand curve

PED on a linear demand curve will fall continuously as the curve slopes downwards,
moving from left to right. PED = 1 at the midpoint of a linear demand curve.

PED and revenue

There is a precise mathematical connection between PED and a firm’s revenue.

There are three ‘types’ of revenue:

Total revenue (TR), which is found by multiplying price by quantity sold (P x Q)


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Average revenue (AR), which is found by dividing total revenue by quantity sold
(TR/Q). Consider these figures and calculate Total, Marginal and Average
Revenue.

Marginal revenue (MR), which is defined as the revenue from selling one extra
unit. This is calculated by finding the change in TR from selling one more unit.

PRICE
Qd TR MR AR
(£)
10 1
9 2
8 3
7 4
6 5
5 6
4 7
3 8
2 9
1 10

Answer

Study the patterns of numbers and see if you can analyse the relationships between the
three measures of revenue – then answer the following:

How are price and average revenue connected?

What happens to total revenue as output increases?

What is the connection between total revenue and marginal revenue?

How are marginal revenue and average revenue connected?

Observations

When TR is at a maximum, MR = zero, and PED = 1.


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1. Price and AR are identical, because AR = TR/Q, which is P x Q/Q, and


cancel out the Qs to get P.

1. A curve plotting AR (=P) against Q is also a firm’s demand curve.

2. TR increases, reaches a peak and decreases.

· Why does a firm want to know PED?

There are several reasons why firms gather information about the PED of its products. A
firm will know much more about its internal operations and product costs than it will
about its external environment. Therefore, gathering data on how consumers respond to
changes in price can help reduce risk and uncertainly. More specifically, knowledge of
PED can help the firm forecast its sales and set its price.

Sales forecasting

The firm can forecast the impact of a change in price on its sales volume, and sales
revenue (total revenue, TR). For example, if PED for a product is (-) 2, a 10% reduction
in price (say, from £10 to £9) will lead to a 20% increase in sales (say from 1000 to
1200). In this case, revenue will rise from £10,000 to £10,800.

Pricing policy

Knowing PED helps the firm decide whether to raise or lower price, or whether to price
discriminate. Price discrimination is a policy of charging consumers different prices for
the same product. If demand is elastic, revenue is gained by reducing price, but if demand
is inelastic, revenue is gained by raising price.

Income elasticity of demand (YED) shows the effect of a change in income on quantity
demanded. Income is an important determinant of consumer demand, and YED shows
precisely the extent to which changes in income lead to changes in demand. YED can be
calculated using the following equation:
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Normal goods

When the equation gives a positive result, the good is a normal good. A normal good is
one where demand is directly proportional to income. For example, if, following an
increase in income from £40,000 to £50,000, an individual consumer buys 40 DVD films
per year, instead of 20, then the coefficient is:

+100/+25

= (+) 4.0

The positive sign means that the good is a normal good, and because the coefficient is
greater than one, demand for the good responds more than proportionately to a change in
income. This indicates the good is not a necessity like food, and would be considered a
relative luxury for this individual.

Inferior goods

When YED is negative, the good is classified as inferior. For example, if, following an
increase in income from £40,000 to £50,000, a consumer buys 180 loaves of bread per
year instead of 200, then the YED is:

-10/+25

= (-) 0.4

The negative sign means that the good is inferior, and, because the coefficient is less than
one, demand for the good does not respond significantly to a change in income. This
indicates that the good is not particularly inferior compared with a good which has a YED
of > (-)1.

The sign and the number provide different information about the relationship between
income and demand. Income elasticity of demand can also be illustrated by Engel
curves.

Why does a firm want to know YED?

There several reasons why a firm would want to know YED, including the following:

Sales forecasting
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A firm can forecast the impact of a change in income on sales volume (Q), and sales
revenue (P x Q).

For example, a hypothetical car manufacturer has calculated that YED with respect to its
luxury car is (+) 3.8, and it has also undertaken research to discover that consumer
incomes will rise by 2% next year. It can now predict the impact of this change.

Exercise

Using the YED equation, calculate the effect on sales.

The same producer sells a small car with a YED of (-) 5. Using the YED equation, and
assuming income also increases by 2%, calculate the effect on sales.

Answers 

Pricing policy

Knowing YED helps the firm decide whether to raise or lower price following a change
in consumer incomes. If incomes are falling and YED is positive, a reduction in price
might help compensate for the reduction in demand.

Diversification

Firms can diversify and offer a range of goods with different YEDs to spread the risks
associated with changes in the level of national income. For example, a car manufacturer
may produce cars with a range of YED values, so that sales are stabilised as the economy
grows and declines.

YED and the business cycle

Changes in real national income tend to be cyclical. The demand for normal goods
increases when the economy is expanding, but decreases when the economy is
contracting. Conversely, the demand for inferior goods is counter-cyclical.
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The higher the positive value for YED, the greater the effect of a change in national
income on consumer demand.

Cross Elasticity of Demand:


This measures how sensitive consumer purchases of one product (X) are to a change in
the price of some other product (Y)

Substitute Goods
 Cross elasticity of demand is positive if the sales of product X moves in the same
direction as a change in the price of product Y
 larger positive cross-elasticity coefficient = greater substitutability between the
two products
Complementary Goods
 Cross elasticity is negative: increase in price of product X decreases the demand
for product Y
 Larger negative cross-elasticity coefficient = greater complementarity between the
two goods
Independent Goods
 Zero/near-zero cross elasticity = two products are unrelated
 A change in one product's price has no effect on the other product's demand
Application
 A product's substitutability, measured by the cross-elasticity coefficient, is
important in businesses and government because the demand for their products is directly
affected by the price of other products.
v) Demand, Total Revenue and Marginal Revenue (MR)

Revenue is the income a firm retains from selling its products once it has paid indirect
tax, such as VAT. Revenue provides the income which a firm needs to enable it to cover
its costs of production, and from which it can derive a profit. Profit can be distributed to
the owners, or shareholders, or retained in the business to purchase new capital assets or
upgrade the firm’s technology.

Revenue is measured in three ways:

Total revenue

Total revenue (TR), is the total flow of income to a firm from selling a given quantity of
output at a given price, less tax going to the government. The value of TR is found by
multiplying price of the product by the quantity sold.

Average revenue
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Average revenue (AR), is revenue per unit, and is found by dividing TR by the quantity
sold, Q. AR is equivalent to the price of the product, where P x Q/Q = P, hence AR is
also price.

Marginal revenue

Marginal revenue (MR) is the revenue generated from selling one extra unit of a good or
service. It can be found by finding the change in TR following an increase in output of
one unit. MR can be both positive and negative.

Revenue schedule

A revenue schedule shows the amount of revenue generated by a firm at different prices.

TOTAL MARGINAL
PRICE (£) QUANTITY
REVENUE REVENUE
(000) DEMANDED
(000) (000)
10 1 10
9 2 18 8
8 3 24 6
7 4 28 4
6 5 30 2
5 6 30 0
4 7 28 -2
3 8 24 -4
2 9 18 -6
1 10 10 -8
Revenue curves
Total revenue

Initially, as output increases total revenue (TR) also increases, but at a decreasing rate. It
eventually reaches a maximum and then decreases with further output.

Less competition in a given market is likely to lead to higher prices and the possibility of
higher super-normal profits.
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Average revenue

However, as output increases the average revenue (AR) curve slopes downwards. The AR
curve is also the firm’s demand curve.

Marginal revenue

The marginal revenue (MR) curve also slopes downwards, but at twice the rate of AR.
This means that when MR is 0, TR will be at its maximum. Increases in output beyond
the point where MR = 0 will lead to a negative MR.

Total revenue is the amount of total sales of goods and services. It is calculated by
multiplying the amount of goods and services sold by the price of the goods and services.
Marginal revenue is directly related to total revenue because it measures the change in the
total revenue with respect to the change in another variable.

Marginal revenue measures the change in revenue that results from a change in the
amount of goods or services sold. It indicates how much revenue increases for selling an
additional unit of a good or service. To calculate marginal revenue, divide the change in
total revenue by the change in the quantity sold. Therefore, the marginal revenue is the
slope of the total revenue curve. Use the total revenue to calculate marginal revenue.

For example, suppose a company that produces toys sells one unit for $10 for each of its
first 100 units. If it sells 100 toys, its total revenue would be $1,000 (100 * 10). The
company sells the next 100 toys for $8 a unit. Its total revenue would be $1,800 (1,000 +
100*8).

Suppose the company wanted to find its marginal revenue gained from selling its 101st
unit. The total revenue is directly related to this calculation. First, the company must find
the change in total revenue. The change in total revenue is $8 ($1,008 - $1,000). Next, it
must find the change in the toys sold, which is 1 (101-100). Thus, the marginal revenue
gained by producing the 101st toy is $8.
vi) Geometry of MR Determination: MR, Price and Elasticity of Demand
Price Elasticity Explained
Price elasticity describes what happens to the demand for a product as its price changes.
The relationship is "inverse," with demand rising as the price falls and falling as the price
MUHAMMAD ISMAIL 03147963120 34

rises. For highly elastic goods and services, demand changes dramatically as the price
changes. Luxury items such as big-screen TVs usually have a high elasticity. In contrast,
inelastic goods and services tend to have a fairly consistent level of demand even if the
price changes. Gasoline provides a good example. Most people who buy it have no
choice but to buy it and cannot significantly cut back on their consumption without
purchasing a new vehicle or changing their habits.

Marginal Revenue Explained


Marginal revenue is the additional revenue a company generates by selling more units of
a product or service. For example, at a price of $200, a company might sell 10 homemade
wooden tables, for revenue of $2,000. But if it sells the tables at a lower price of $190 --
thereby making the product more affordable and increasing demand -- it will typically
sell more tables. If it sells 11 tables at $190 apiece, that comes out to $2,090 in revenue --
$90 extra than at the $200 price point. So in this case, the marginal revenue that comes
from increasing sales from 10 to 11 tables by decreasing the price from $200 to $190
equals $90. In practice, companies often maximize marginal revenue by starting out at a
higher price, waiting for sales to drop off and only then lowering the price.

The ultimate source of power in a market, even a monopolistic market, is the consumer,
who still responds to price by changing his demand level. As a consumer, you get to
decide whether you’re willing and able to purchase a good at a given price.
In theory, the monopolist can charge any price it wants, but practically, the monopolist
can’t charge too high of a price or you won’t buy the good. The monopolist is constrained
by your willingness to pay the price it charges.
For example, economists consider De Beers a resource monopoly because it effectively
controls the world’s supply of diamonds. And although diamonds are very popular, if De
Beers keeps raising its price, consumers will start substituting other precious gems, such
as rubies and emeralds, for diamonds. Thus, as diamond prices increase, the quantity of
diamonds consumers purchase will decrease.
The monopolist’s pricing decision is subject to the constraint imposed by consumer
demand. If the monopolist charges too high of a price, nobody wants to buy its product.
So, if the monopolist wants to sell more product, it must lower price as indicated by the
market demand curve.
The inverse relationship between price and quantity demanded is the critical element in
monopoly price setting. Because a single firm provides the entire quantity of the
commodity in the market, the demand for the monopolist’s product, represented by a
lower-case d, is the same as the market demand, represented by a capital D.
The market demand possesses the usual characteristics; an inverse relationship between
price and quantity demanded and changing price elasticity of demand along the demand
curve. In order to sell more of its product, the monopolist must lower its price, not only
for the additional unit but for every other unit as well.
MUHAMMAD ISMAIL 03147963120 35

The illustration also shows the relationship between a monopolist’s demand and marginal
revenue. Remember that marginal revenue is the change in total revenue that occurs when
one additional unit of a good is produced and sold. Because the monopolist’s demand
curve is identical to the market demand curve, the monopolist can sell an additional unit
of output only by lowering the product’s price.
Assuming no price discrimination (charging different customers different prices for the
same good), this lower price is charged for all units of the commodity sold. As a
consequence, the firm’s marginal revenue curve lies below its demand curve. Marginal
revenue is less than price.
Marginal revenue — the change in total revenue — is below the demand curve.
Marginal revenue is related to the price elasticity of demand — the responsiveness of
quantity demanded to a change in price. When marginal revenue is positive, demand is
elastic; and when marginal revenue is negative, demand is inelastic. The output level at
which marginal revenue equals zero corresponds to unitary elasticity. This occurs at the
quantity qu in the illustration.
A linear demand curve has the form

where P is the good’s price in dollars and q is the quantity demanded. Constants in the
equation are represented by a and b — a is the intercept of the demand curve (where the
demand curve intersects the vertical axis) and bis the demand curve’s slope.
Total revenue, TR, equals price times quantity or

Marginal revenue, MR, equals the derivative of total revenue taken with respect to
quantity

If you compare the marginal revenue equation with the demand equation, you see that
both equations have an intercept represented by a. The slope of the demand equation is
represented by –b, while the slope of the marginal revenue equation is –2b. Thus, for a
MUHAMMAD ISMAIL 03147963120 36

linear demand curve, the marginal revenue curve starts at the same intercept as the
demand curve, but its slope is twice as steep.
Elasticity of Demand
This is a value that is calculated by the percentage change of demand for a product
divided by the percentage change in the price of a product. Elasticity of demand is a
valuable calculation to predict how suppliers or consumer will respond to a change is
price of a demanded product. If we use the chewing gum example and say that this
suppliers choses to lower it's cost by $.25 for a new price of $.75 and the demand is now
12 units. With these values we can calculate this consumer own price elasticity of demand
by dividing the percentage change in quantity (12-10)/10=.2 by the percentage change in
price (1-.75)/1=.25. For this example the own price elasticity of demand is .8 which
shows that the demand for chewing gum, in this example, is rather inelastic to price
changes.

Formula for Own Price Elasticity of Demand

Ex = Own Price Elasticity of Demand of Good x 聽 at Qx and Px below


%<| Qx = the Percentage Change in Quantity Demanded of Good x
%<| Px = the Percentage Change in Price of Good x

E = ( %<| Qx) / ( %<| Px )

More about Elacticity of Demand is located 聽 in this MBAecon site as well.

Relationship Between Marginal Revenue and Elasticity of Demand


The relationship between MR and ED is that each measurement is important in
managerial decisions on price and quantity. For example if a managers understands the
elasticity of demand for its product, he or she will be able to make in informed decision
on how consumers will react to a price increase or decrease. If the manager decides to
raise the price of the product and demand for the product is elastic, consumers will likely
purchase less of the product.

Formula

MR = Marginal Revenue
P = Price of the Good
E = Own Price Elasticity of Demand

MR = P * [ ( 1 + E ) / ( E ) ]

Formula Consequences

 When E is between negative infinity (exclusive) and -1 (exclusive), then demand


is elastic, and the formula implies that MR is positive.
 When E = -1, demand is unitary elastic, and the formula imlies that MR is
positive.
MUHAMMAD ISMAIL 03147963120 37

 When E is between -1 (exclusive) and 0 (exclusive), demand is inelastic, and


marginal revenue is negative.

Additional Principles

A.) Total Revenue Test - if the demand is elastic, then an increase in price will lead to a
decrease in total revenue. This is true because, according to the formula, the decrease in
quantity sold, as a percentage, will more than counteract the increase in revenue from
charging larger pirces. So on the contrary, if demand is elastic, then a decrease in prices
will lead to a increase in total revenue.

On the other hand, if the demand is inelastic, then an increase in price will lead to an
increase in total reveune. This is true because, according to the formula, the increase in
revenue, as a percentage, is larger than the decrease in demand that will result from the
pirce increase. So on the contrary, if demand is inelastic, then a decrease in price will lead
to an decrease in total revenue.

B.) Total revneue is maximized at the point where demand is unitary elastic (where the
own price elasticity of demand is equal to 聽 negative one

Real World Examples


Example 1: Jesse works at the Superplex 8, which is a major movie theatre in his town.
His manager, Sharon, has recently hired economic consultants that have told her that at
the current of popcorn, the elasticity of demand is -0.75. Sharon tells Jesse to raise the
price of an order of popcorn from $5 to $6. Jesse, a mathematics student, says, "That is a
20% rise in the price of popcorn!" Customers will revolt and buy many fewer orders of
popcorn, or none at all."

Answer 1: 聽 While Jesse is mathematically correct, he could use a little help in


economics. Since the elasticity of demand for popcorn is -0.75, that means that the
demand is inelastic at that point. Taking it further, this means that the total revnue will
rise with an increase in the price.
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III. THEORY OF CONSUMER BEHAVIOUR

i) Cardinal and Ordinal Approaches.

Cardinal approach is the one, which rests on the assumption that utility can be
measured. Here it implies that utility can be quantified. In cardinal approach, utility is
stated or measured in what is known as ‘utils’. What are these utils? These are the
measurements of utility, although in real terms they are not like the standard units of
measurements like miles, kilometres, metres and so on. So if the utils are not like the
standard measurement units, then what do they explain? How do we then comprehend the
concept of utils? For instance, a sandwich may provide a utility of 30 utils and a burger
may provide a utility of 40 utils to a consumer. It shows that burger has more utility to the
consumer than the sandwich has and by how many utils the burger provides more utility,
is also inferred. Consider another example, wherein one glass of lime water provides a
utility of 10 utils, one glass of apple juice provides a utility of 20 utils and a single glass
of mango milkshake provides a utility of 35 utils to a consumer. In this case also, the
utility provided to the consumer is brought out through the utils and one can understand
how a consumer prefers mango milk shake over apple juice and apple juice over lime
water through the number of utils. But here care needs to be taken that this does not
imply any conclusion or relation between the three choices but just the preferences of the
consumer. The example indicates the difference of utils between the lime water and apple
juice and between apple juice and mango milkshake.
So, the above examples indicate that cardinal utility makes use of utils to arrive at the
utility. The underlying satisfaction that a consumer derives from a product is put into
utils and hence unlike other measurement unit utils rest upon the intangible satisfaction or
contentment, which in itself is not physical in nature.
Does cardinal utility facilitate utility comparisons across individuals? We need to realize
that the above examples, which were cited by us, indicate the preferences of the
consumer. These preferences may vary across the consumers and therefore it would not
be appropriate to generalize or make interpersonal comparisons. Another important aspect
in this case, is the proportion of amount spent on the products. Do more amounts paid,
indicate more utils? Consider a consumer who shells out 100 Rupees on a chocolate cake
and 150 Rupees on a cheese cake. The utility he/she derives from one chocolate cake is
50 utils, whereas that from one cheese cake is 45 utils. So here the settling factor is the
preference, likes and dislikes of the consumer. Even though the consumer has paid more
for the cheese cake, the utility for him is more through the chocolate cake simply because
his preference is skewed towards chocolate cake rather than cheese cake.

Cardinal Approach to Utility :

The Cardinalist school asserts that utility can be measured and quantified. It means, it is
possible to express utility that an individual derives from consuming a commodity in
quantitative terms. Thus, a person may express the utility he derives from consuming an
apple as 10 utils or 20 utils.Moreover, it allows consumers to compare and define the
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difference in utilities perceived in two commodites. Thus, it allows an individual to state


that commodity A (accruing an utility of 20 utils) gives double the utility of commodity B
( which accrues an utility of 10 utils).

Ordinal Approach to Utility :

The ordinalist school asserts that utility cannot be measured in quantitative terms. Rather,
the consumer can compare the utility accruing from different commodities (as a
combination of them) and rank them in accordance with the satisfaction each commodity
(or combination of commodities) gives him.

Thus, the cardinal approach to the measurement of utility believes that utility derived
from the consumption of a commodity can be expressed in quantitative terms. The
ordinalist approach rejects this and states that the consumer at best can rank the various
commodities (or combination of them) in accordance with the satisfaction that he expects
from their consumption.

Total Utility and Marginal Utility :

Total utility (TU) is the aggregate utility derived by a consumer after consuming all the
available units of a commodity. Thus, it is the sum of all the utilities accruing from each
individual units of the commodity.

Marginal utility (MU), on the other hand, is the utility flowing from an additional unit of
a commodity, over and above what had been consumed.

ii) Consumer Equilibrium and Income Consumption Curve

All consumers strive to maximize their utility. We try to get as much satisfaction as we
can. The consumer’s scale of preference is derived by means of indifference mapping that
is a set of indifference curves which ranks the preferences of the consumer. Getting to the
indifference curve which is farthest from the origin gives the highest total utility.
Although the goal of the consumer is maximization of satisfaction, the means of
achieving the goal is not clear. Higher indifference curve not only gives higher
satisfaction but also are more expensive. Here we are confronted with the basic conflict
between preferences and the prices of the commodities consumer wants to consume. With
a given amount of money income to spent, we cannot attain the highest satisfaction but
have to settle for less.

Assumptions

Conditions for consumer's equilibrium

 1.A given budget line must be tangent to an indifference curve , or the marginal
rate of substitution between commodity X and commodity Y (MRS x,y) must be equal
to the price ratio between the two goods .
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 2.At the point of equilibrium, indifference curve must be convex to the origin.

The limitation on utility maximization is evident. We want to reach the highest


indifference curve with our limited income. You can go only as far as your budget
constraint allows. Suppose you have only 50 rupees to spend on good X and good Y. The
price of a unit of X is 10 rupees where as the price of good Y is 5 rupees. You can have as
many as 5 units of good X if you want to forsake good Y. Similarly you can have 10 units
of good Y with the same 50 rupees.The budget constraints illustrates all combination of
goods you can buy with a limited income. In this case the budget line illustrates the
combination of X and Y , that can be purchased with 50 rupees.

Above diagram explain the process of consumer’s equilibrium . The consumer’s


preference scale is described by means of indifference mapping .Then we impose a
budget line that reflects our income. In this case we have r 50 and the price of good X and
good Y is r 10 and r 5 respectively. Therefore, we can afford only those combinations that
are on or inside the price line GH.

In this diagram every combination on the price line GH cost you the same amount of
money. In order to maximize the utility , we will try to reach the highest indifference
curve which you could get with a given expenditure of money and given prices of two
goods.The budget line touches IC2 at point E represents the most utility. This is the
highest attainable indifference curve with which you can get OQ1 units of good X and
OQ2 units of good Y for r 50. Any other affordable combinations on the price line GH
gives you less satisfaction, because that will be on a lower indifference curve IC1. With
this we conclude that the point of tangency between the budget line and an indifference
curve represents optimal consumption. It is the affordable combination that maximize our
utility.

At the tangency point E the slope of the price line GH and indifference curve are equal.
Slope of the indifference curve shows the marginal rate of substitution of X for Y. The
price line indicates the ratio between the prices of two goods (PX/PY). Thus at the
equilibrium point E,MRSXY=Price of good x/Price of good y= PX/PY

The tangency between the given price line and an indifference curve is a necessary but
MUHAMMAD ISMAIL 03147963120 41

not a sufficient condition consumer’s equilibrium .The second condition for consumer’s
equilibrium is convexity of indifference curve to the origin .Which means MRSxy is
falling at the point of equilibrium.

In fig no -1 indifference curve IC2 is convex to the origin at point E, is the optimum or
best choice for the consumer .The consumer attains a stable equilibrium position where
he is able to consume the most preferred combination which gives him highest utility. In
figure no -2 ,IC1 is concave to the origin at point E. Price line AB is tangent to the
indifference curve IC1 at point E and the marginal rate of substitution of X for Y is equal
to the price ratio of two goods (PX/PY). But E cannot be the position of stable
equilibrium because satisfaction would not be maximum .There are other combinations
like G and H in the given price line will be on higher indifference curve .The congumer
by moving along the given price line AB can go to other tangency pointsuch as G and H
and obtain greater satisfaction than at point E.

Marginal Utility and Price

The slope of the indifference curve shows the marginal rate of substitution of good X for
good Y, while the slope of price line indicates the ratio between prices of two goods i.e.
( PX /PY). Consaumer equilibrium was represented as the combination of good X and
good Y can be written as
=
Alternatively,
=
This equation explains that at the point of equilibrium the relative marginal utilities of
good X and good Y should equal to their relative prices. In other words , if good X cost
twice as much as good Y , then marginal utility of good X must yield double , then the
consumer is in an optimal state.
The slope of the budget constraint equal the relative prices of the two goods. In Fig-1, the
slope of the price line equal to the price of goods X and good Y. It means the rate of
substitution between the good X and good Y is 1:2. The relative marginal utilities of the
two goods are reflected in the slope of the indifference curve. It is the marginal r ate of
substitution which is equal to the relative marginal utilities of the two goods.
MUHAMMAD ISMAIL 03147963120 42

At the point of optimal consumption E in fig-1 the budget constraint is tangent to the
indifference curve IC2. Which means,
Or Marginal rate of substitution of X for Y =

Consumer's Equilibrium and Non-normal cases

As we discussed earlier , indifference curves are usually convex to the origin .Convexity
of indifference curve implies the marginal rate of substitution of X for Y decreases .The
possibility of concavity cannot be ruled out in some exceptional cases. But at the same
time concavity implies increasing marginal rate of substitution of X for Y .The
consumer will choose or buy only one good.

Fig No-3
The price line AB is tangent to the indifference curve IC2 . But the consumer cannot be in
equilibrium at point E because it can obtain grater satisfaction by moving along the given
price line .Consumers satisfaction increases by either moving upward or downward till he
reaches the extremity points A on the y-axis or B on the x –axis.
In these cases consumer will choose only one of two goods, depending on his scale of
preference and level of satisfaction between good x and good y. In the above diagram A
lies on a higher indifference curve than Therefore the consumer will choose only Y and
buy OA of commodity Y. It is also noted that consumer is not tangent to the indifference
curve at point A .Therefore consumer’s equilibrium cannot be establish at point A .
In case of perfect complementary goods ,the shape of the indifference curve have a right
–angled .The equilibrium of the consumer cannot be established because only one point
of the indifference curve is tangent to the price line AB.
The Income Consumption Curve is the set of optimal bundles when income changes,
while preferences and prices of goods are kept constant. Pictured below is the curve for a
normal good. The ICC for an inferior good bends backwards.

iii) Engel’s Curve and Demand Curve

Consumer income (Y) is a key determinant of consumer demand (Qd). The relationship
between income and demand can be both direct and inverse.

Normal goods
MUHAMMAD ISMAIL 03147963120 43

In the case of normal goods, income and demand are directly related, meaning that an
increase in income will cause demand to rise and a decrease in income causes demand to
fall. For example, luxuries like cars and computers are normal goods for most people.

Inferior goods

In the case of inferior goods income and demand are inversely related, which means that
an increase in income leads to a decrease in demand and a decrease in income leads to an
increase in demand. For example, necessities like bread are often inferior goods.

It should be noted that ‘normal’ and ‘inferior’ are purely relative concepts. Any good or
service could be an inferior one under certain circumstances. Even luxury goods can
become inferior over time. Video players were once luxuries, but as incomes have risen
consumers have switched to DVDs.

Engel curves

Engel Curves, named after 19th Century German statistician Ernst Engel, illustrate the
relationship between consumer demand and household income.

Engel curves for normal goods slope upwards – the flatter the slope the more luxurious
the good, and the greater the income elasticity. In contrast, Engel curves for inferior
goods have a negative slope.

Demand for the three goods, shown here, all respond very differently to the same change
in income, Y to Y1. Demand for the normal good increases from Q to Q1, demand for the
luxury good rises much more, to Q2, and demand for the inferior good falls from Q to
Q3.

iv) Engel’s Curve and Income Elasticity of Demand

Income Elasticity (of Demand)


 Definition: A measure of the responsiveness of the demand curve to changes in
the income of the people demanding the good
 Equation: (∆X/X) × (∆I/I); often simplified to (∆X/∆I) × (I/X)
 The equation in plain English: the ratio of the percentage change in demand for a
good (X) to the percentage change in income of consumers
MUHAMMAD ISMAIL 03147963120 44

Income elasticity is a tool used to figure out


consumer purchasing behavior regarding a
certain product when incomes are raised or
lowered. This is typically done by
drawing a graph with consumer
indifference curves at different levels of
utility and budget constraint lines. When
we do this and connect all the different
points of tangency between indifference
curves and budget constraint lines, we get
an Income Expansion Path (I.E.P.) that
represents all the utility-maximizing combinations of the good we are interested in (good
X) and money spent on all other goods (good Y). See the graph below for an example.

It is important to note that this is a normal good. Most goods behave normally, which
means that as a consumer's income rises, they purchase more of a given good. This graph
gives us enough information to create an Engel Curve for good X.

The Engel Curve


 Definition: Curve plotting Expenditure on Good X (which is the same as the
Quantity of X times a constant price) versus Income

Below we have the Engel Curve for the good X shown in the graph above. Note the
points here correspond to the points on the I.E.P. from the previous graph and the curve
has a positive slope, indicative of a normal good. The price of good X has been set as $1.
(Be careful. Textbooks usually put income I on the horizontal axis and consumption of X
on the vertical axis. The diagram below has them in the reverse of the usual positions.)

A luxury good is a specific type of normal good and is sometimes classified differently.
It is a good that behaves like a normal good, but as income rises, a higher percentage of
total income is spent on the good (it has a high income elasticity). Examples include
jewelry, fashionable clothing, and fine alcohols.
MUHAMMAD ISMAIL 03147963120 45

Inferior Goods
 Definition: As income rises,
consumers purchase less of an inferior
good

Below we have the I.E.P. for an inferior


good, along with the standard indifference
curves and budget lines.

Engel Curve for an Inferior Good:

Assume a price of $1 for good X. Note the negative slope of


the curve, a characteristic of an inferior good. Examples
include used cars, Ramen noodles, and bus fare.
v) Price Consumption Curve and Demand Curve
We have already seen how the price consumption curve traces the
effect of a change in price of a good on its quantity demanded.
However, it does not directly show the relationship between
the price of a good and its corresponding quantity demanded.
It is the demand curve that shows relationship between price
of a good and its quantity demanded. In this section we are
going to derive the consumer's demand curve from the price
consumption curve . Figure.1 shows derivation of the
consumer's demand curve from the price consumption curve
where good X is a normal good.
FIGURE.1 Derivation of the Demand Curve: Normal Goods
The upper panel of Figure.1 shows price effect where good X is a normal good. AB is the
initial price line. Suppose the initial price of good X (P x) is OP. e is the initial optimal
consumption combination on indifference curve U. The consumer buys OX units of good
X. When price of X (Px)falls, to say OP1, the budget constraint shift to AB1. The optimal
consumption combination is e1 on indifference curve U1. The consumer now increases
consumption of good X from OX to OX 1 units. The Price Consumption Curve (PCC) is
rising upwards.

Chart.1 shows the demand relationship derived form the price consumption curve.

Chart.1
MUHAMMAD ISMAIL 03147963120 46

The lower panel of Figure.1 shows this price and corresponding quantity demanded of
good X as shown in Chart.1. At initial price OP, quantity demanded of good X is OX.
This is shown by point a. At a lower price OP 1, quantity demanded increases to OX1. This
is shown by point b. DD 1 is the demand curve obtained by joining points a and b. The
demand curve is downward sloping showing inverse relationship between price and
quantity demanded as good X is a normal good.
In this section we are going to derive the consumer's demand curve from the price
consumption curve in the case of inferior goods. Figure.2 shows derivation of the
consumer's demand curve from the price consumption curve where good X is an inferior
good.

Derivation of the Demand Curve: Inferior Goods


The upper panel of Figure.2 shows price effect where good X is an inferior good. AB is
the initial price line. Suppose the initial price of good X (P x)is OP. e is the initial optimal
consumption combination on indifference curve U. The consumer buys OX units of good
X. When price of X Px) falls, to say OP1, the budget constraint shift to AB1. The optimal
consumption combination is e1 on indifference curve U1. The consumer now reduces
consumption of good X from OX to OX1 units as good x is inferior. The Price
Consumption Curve (PCC) is rising upwards and bending backwards towards the Y-axis.

Chart.1 shows the demand relationship derived form the price consumption curve.
Chart.2

The lower panel of Figure.2 shows this price and corresponding quantity demanded of
good X as shown in Chart.2. At initial price OP, quantity demanded of good X is OX.
This is shown by point a. At a lower price OP1, quantity demanded decreases to OX1.
This is shown by point b. DD1 is the demand curve obtained by joining points a and b.
The demand curve is upward sloping showing direct relationship between price and
quantity demanded as good X is an inferior good.
In this section we are going to derive the consumer's demand curve from the price
consumption curve in the case of neutral goods. Figure.3 shows derivation of the
consumer's demand curve from the price consumption curve where good X is a neutral
good.

FIGURE.3 Derivation of the Demand Curve: Neutral Goods


MUHAMMAD ISMAIL 03147963120 47

The upper panel of Figure.3 shows price effect where good X is


a neutral good. AB is the initial price line. Suppose the initial
price of good X (Px) is OP. e is the initial optimal consumption
combination on indifference curve U. The consumer buys OX
units of good X. When price of X (Px)falls, to say OP1, the
budget constraint shift to AB1. The optimal consumption
combination is e1 on indifference curve U1 at which the
consumer buys same OX units of good X as it is a neutral good. The Price Consumption
Curve (PCC) is a vertical straight line.

Chart.3 shows the demand relationship derived form the price consumption curve.

Chart.3

The lower panel of Figure.3 shows this price and corresponding quantity demanded of
good X as shown in Chart.3. At initial price OP, quantity demanded of good X is OX.
This is shown by point a. At a lower price OP 1, quantity demanded remains fixed at OX.
This is shown by point b. DD1 is the demand curve obtained by joining points a and b.
The demand curve is a vertical straight line showing that the consumption of good X is
fixed as good X is a neutral good.
Demand Curve
You should use the demand curve when considering how to price a single product.
Generally, the lower the price, the higher the demand will be. The demand curve can have
a steep slope or a gentle slope, depending on the product. This means that for some items,
a slight change in price can greatly affect the demand for it, while other products
experience a much steadier demand despite price changes. You have to experiment with
the pricing on individual products to determine how price will affect demand.

Price Consumption Curve


The Price Consumption Curve deals with two equally attractive products a consumer may
be considering. The curve also takes into account the customer’s budget. The two
products can be entirely different from each other, such as gas and food, and you assume
the consumer wants or needs both of them. At the point where the price for the two
products together is in the customer’s budget and she can have both of them, you find
equilibrium. If you raise your price, the consumer may cut back on purchases of the other
product for awhile, but a sustained price increase on your part can cause the buyer to
forgo your product because of the perceived need for the other one over yours.

Price Consumption Curve and Price Elasticity of Demand


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It is also possible to know with indifference curve analysis whether price elasticity is
more than one, equal to one or less than one. It is from the slope of price consumption
curve that we are able to judge the price elasticity of demand.

Let us take Fig. 13.19 where on the Y-axis money income is measured and on X-axis the
quantity of a commodity X. It is assumed that the consumer has OA amount of money to
spend. Each of the indifference curves drawn between the two axes will show the various
combinations of money and good X among which consumer is indifferent. To begin with,
AB is the price line.

The slope of the price line AB, i.e., OA/OB will give the price of good X. At this price
(i.e., with price line AB) the consumer is in equilibrium at point Q1 on indifference curve
IC1and is buying OX1 of good X. Thus, in this equilibrium position, he is having
combination of OX1 of good X and OY1 of money. It means that he has spent AY1 of
money on the good X and has obtained OX1 of its quantity. Let price of good X falls,
money income of the consumer remaining the same, so that we get a new price line AC.
The new price of good X will be given by the slope of the new price line AC, i.e.,
OA/OC.

With this lower price or with price line AC, the consumer is in equilibrium at Q2 on
indifference curve IC2. At this new equilibrium position Q2 the consumer is getting
OX2of good X and amount OY2 of money is let with him. It means that at the lower
price of good X he has spent AY2 amount of money on it which is greater than the
amount AY1of money which he spent at the original price.

Thus, with the fall in price, his expenditure on the good X has increased. Similarly, when
the price of good X falls further so that AD is now the relevant price line, consumer is in
equilibrium at Q3 where he is spending AY3 amount of money and is having
OX3 quantity of the good X. Money expenditure AY3 is
greater than AY2.

It is thus clear that in the present case when the price


consumption curve is sloping downward (i.e., PCC has a
negative slope), with the reduction in price of the good X the
consumer’s money outlay on the good X increases. In Fig.
13.19 indifference map depicting preferences of the consumer
is such that we get a downward sloping consumption curve
which means, as explained above, that with the fall in the price of good X, consumer’s
expenditure on it rises.

In Fig. 13.21, indifference or preference map of the consumer is such that it yields an
upward- sloping price consumption curve PCC (that is, the slope of the price
consumption curve is positive). It will be seen that in this case consumer’s outlay on the
good decreases with the fall in the price of the good. When the price falls and the price
line shifts from AB to AC, the quantity demanded of the good rises from OX1 to OX2 but
consumer’s expenditure on the good X falls from AY1 to AY3.
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Likewise, when price falls further and as a result price line shifts from AC to AD, though
quantity demanded of the good X rises from OX2, to OX3, consumer’s expenditure on
the good X fall s from AY2 to AY3. Thus upward sloping price consumption curve means
a decline in consumer’s expenditure as the price of the good X falls.

Since a fall in consumer’s expenditure as a result of the fall in price means that demand
for the good is inelastic, upward-sloping price consumption curve will therefore show
inelastic demand, i.e., elasticity will be less than one.

To sum up, downward-sloping price consumption curve for a good means that demand
for the good is elastic, upward-sloping price consumption curve means that demand for
the good is inelastic and horizontal straight-line price consumption curve means that
demand for the good is unit elastic.

In our above analysis, we have drawn such indifference-preference maps which yield
such a price consumption curve that shows either only price consumption curve that
shows either only elastic demand, or only inelastic demand, or only unitary elastic
demand over its entire range.

Since elasticity of demand varies at different prices, we can also draw such an indifferent
map that yields price consumption curve which shows different elasticities at different
price levels. This we have depicted in fig. 13.22 where it will be seen that from Q1 to
Q2 price consumption curve is sloping downward, therefore over this range demand for
the good is elastic (i.e., ep> 1).

From Q2to Q3 price consumption curve is horizontal, therefore, the elasticity is here
equal to unit (i.e. ep = 1). From Q3 to Q4 and onward price consumption curve slopes
upward, so over this range demand for the good is inelastic (i.e. ep<1).
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IV. TOPICS IN CONSUMER DEMAND


The branch of economics devoted to the study of consumer behavior,
especially as it applies to decisions related to purchasing goods and
services through markets. Consumer demand theory is largely centered on
the study and analysis of the utility generated from the satisfaction of
wants and needs. The key principle of consumer demand theory is the law
of diminishing marginal utility, which offers an explanation for the law of
demand and the negative slope of the demand curve.
Consumer demand theory provides insight into an understanding market demand and
forms a cornerstone of modern microeconomics. In particular, this theory analyzes
consumer behavior, especially market purchases, based on the satisfaction of wants and
needs (that is, utility) generated from the consumption of a good.

A basic version of this theory, primarily taught in introductory courses, involves the
analysis of total and marginal utility, especially the role played by the law of diminishing
marginal returns. A more sophisticated version of the theory, more commonly found at
the intermediate course level and above, relies on the analysis of indifference curves and
relative utility, with a key role play by decreasing marginal rate of substitution. Both
versions provide insight into the law of demand and the negative slope of the demand
curve.

A Little History

The notion that market demand depends on the satisfaction of wants and needs has been
an essential part of the economic analysis of markets since at least the time of Adam
Smith. However, three scholars working in progression from the late 1700s to the late
1800s gave the development of consumer demand theory a large, formal boost.
 Jeremy Bentham: The first major advance in the development of consumer
demand theory was provided by Jeremy Bentham in the late 1700s. Bentham
coined the term "utility" in reference to the satisfaction of wants and needs. He
also developed the notion that people are motivated by the desire to maximize
utility. Bentham firmly believed that utility was a measurable, quantifiable
characteristic of a person, much like height or weight.
 John Stuart Mill: The theoretical work developed by Bentham was extended and
popularized by John Stuart Mill, whose father James Mill was a contemporary and
close friend of Bentham. The elder Mill introduced the younger Mill to the
thoughts and teachings of Bentham at an early age. John Stuart Mill expanded and
promoted these consumer demand principles in a number of publications,
including his book, Principles of Political Economic, which was the dominate
economics textbook for several decades.
 William Stanley Jevons: A major improvement in consumer demand theory was
provided by William Stanley Jevons with the notion of marginal utility. Jevons
also developed the rule of consumer equilibrium, stating that consumers purchase
goods such that the ratio of marginal utilities is equal to the ratio of prices. Along
MUHAMMAD ISMAIL 03147963120 51

the way, Jevons helped to transform consumer demand theory (as well as
microeconomics in general) into a rigorous mathematical science.

Utility

A basic formulation of consumer demand theory involves an Utility Analysis


analysis of the total utility and marginal utility derived from the
consumption of a good. The focal point of utility analysis is
usually a table of the total and marginal utility generated by
consuming different quantities of a good, such as the one
displayed in the exhibit to the right.

This analysis is based on the presumption that the amount of


utility generated from the consumption of a good can be explicitly
measured. The standard measurement unit is "utils."

This particular set of numbers illustrates the total and marginal utility generated by riding
a roller coaster at the local amusement park. The key bits of information presented in this
table are:

 First, the far left column presents the number of rides on the roller coaster, which
is the quantity of the good consumed. It increases from 0 hours to 8 rides.

 Second, the middle column indicates the total utility, or the cumulatively amount
of utility, obtained from the rides. For example, taking 3 roller coaster rides
generates 27 utils of total utility. Most notably, total utility generally increases
with the number of rides. However, it does reach a maximum for the 6 rides, then
declines.
 Third, the far right column shows marginal utility, or the amount of additional
utility derived from each extra ride. For example, because 2 rides generates a total
utility of 20 utils and 3 rides generates a total utility of 27 utils, the amount of
extra utility generated by taking the third ride on the roller coaster is 7 utils.
 Fourth, marginal utility in the far right column declines with additional rides on
the roller coaster. This reflects the law of diminishing marginal utility, the key
economic principle underlying utility analysis.

The Law of Diminishing Marginal Utility

The law of diminishing marginal utility states that marginal utility, or the extra utility
obtained from consuming a good, decreases as the quantity consumed increases. In
essence, each additional good consumed is less satisfying than the previous one. This law
is particularly important for insight into market demand and the law of demand.

If each additional unit of a good is less satisfying, then a buyer is willing to pay less. As
such, the demand price declines. This inverse law of demand relation between demand
MUHAMMAD ISMAIL 03147963120 52

price and quantity demanded is a direct implication of the law of diminishing marginal
utility.

Indifference Curves

A more advanced form of consumer demand Indifference Curve Analysis


theory involves the analysis of indifference
curves. An indifference curve, such as the
one labeled U in the exhibit to the right,
presents all combinations of two goods that
provide the same amount of utility. Hence a
consumer is "indifferent" between
consuming any combination of the two
goods anywhere on the curve.

Indifference curve analysis relies on a relative ranking of preferences between two goods
rather than the absolute measurement of utility (utils) derived from the consumption of a
particular good.

Key bits of insight obtained from this diagram are:

 First, the indifferent curve representing equal utility obtained from any
consumption combination of the two goods (time at the beach and time at an
amusement park) is represented by U.
 Second, the consumer is faced with an income or budget constraint,I, which
shows the alternative combinations of the two goods that the buyer can purchase
given a specific amount of income and existing prices.
 Third, the negative slope of the budget constraint reflects the tradeoff between the
consumers ability to purchase the two goods. Purchasing more of one good
necessarily means the consumer must purchase less of the other.
 Fourth, the negative slope and convex shape of the indifference curve reflects the
tradeoff between the consumers willingness to purchase the two goods. In
particular, the convex shape reflects the decreasing marginal rate of substitution
between the two goods.

Decreasing Marginal Rate of Substitution

The decreasing marginal rate of substitution means that a consumer is willing to give up
increasingly smaller quantities of one good in order to obtain more of another good. The
reason is that as more of a good is consumed it becomes relatively less satisfying.

A decreasing marginal rate of substitution generalizes the law of diminishing marginal


utility. However, rather than stating that the incremental satisfaction declines absolutely,
it states that incremental satisfaction declines relative to that obtained from other goods.
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Moreover, like the law of diminishing marginal utility, the decreasing marginal rate of
substitution used in indifference curve analysis provides insight into market demand and
the law of demand. If a good generates less relative satisfaction, then a buyer is wiling to
pay a relatively lower price, which also explains the inverse law of demand relation
between demand price and quantity demanded.

Applying the Theory

Consumer demand theory is primarily directed toward an understanding of market


demand and the law of demand. However, it provides a great deal of insight into all sorts
of human behavior and activities. A short list includes:
 Labor Supply: Insight into the quantity of labor that workers are willing to supply
at different wages can be obtained with consumer demand theory by analyzing the
tradeoff between labor and leisure activities.
 Household Production: In a similar manner, insight into the amount of work
performed around the house, without explicit compensation, be analyzed using
consumer demand theory.
 Crime: The choice between committing a crime and not committing a crime can
also be investigated using consumer demand theory, with the "price" paid for
criminal activities based on the probability of being caught and punished.
 Voting: The amount of time and effort devoted to voting in elections has also been
subjected to analysis using consumer demand theory.

A complete list of areas that have been or can be analyzed and better understood using
consumer demand theory is limited only by the choices people make and the types of
activities they pursue. In essence, consumer demand theory can be applied to virtually
any form of human behavior that involves a tradeoff and a choice.

i) Substitution and Income Effects

Changes in price can affect buyers' purchasing decisions; this effect is called the income
effect. Increases in price, while they don't affect the amount of your paycheck, make you
feel poorer than you were before, and so you buy less. Decreases in price make you feel
richer, and so you may feel like buying more.

What if we're looking at two goods at once? For instance, a fast food chain sells
hamburgers and hot dogs. If the price of hamburgers goes up, but the price of hot dogs
stays the same, you might be more inclined to buy a hot dog. This tendency to change
your purchase based on changes in relative price is called the substitution effect. When
the price of hamburgers goes up, it makes hamburgers relatively expensive and hot dogs
relatively cheap, which influences you to buy fewer hamburgers and more hot dogs than
you usually would. Likewise, a decrease in hamburger price would cause you to eat more
hamburgers and fewer hot dogs, according to the substitution effect.
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The income effect also affects buying decisions when there are two (or more) goods.
When the price of hamburgers goes up, it makes you feel relatively poorer, so your
tendency might be to buy fewer of both hamburgers and hot dogs.

If you look at the combined results of the income effect and the substitution effect, the
total effect is a little unclear. According to the income effect, an increase in the price of
hamburgers decreases consumption of both hamburgers and hot dogs. According to the
substitution effect, however, hamburger consumption drops, but hot dog
consumption rises. Thus, while it is clear what happens to hamburger consumption, since
both effects tend to cause a decrease, we cannot be sure what happens to hot dog
consumption, since there is both an increase (substitution effect) and a decrease (income
effect).

Table of Income and Substitution Effects


While we cannot be absolutely certain about the net result, in general, the substitution
effect is stronger than the income effect. That is, when the price of hamburgers goes up,
you will most likely eat fewer hamburgers and more hot dogs, since the change in relative
prices (substitution effect) affects you more than the perceived change in your income
(income effect).

Another factor influencing demand is one which marketers and advertisers are always
trying to understand and target: buyers' preferences. What do people like? When and how
do they like it? Still looking at soda, it makes sense that people drink more soda when it's
hot, or when they're eating a meal, or when they've been exercising. In these cases,
buyers' preferences have changed: they want the soda more, and are therefore willing to
pay more for the same good. Likewise, if it's snowing, fewer people will crave a cold
soda, and the price they are willing to pay for a cold soda is lower, although they may be
willing to pay a little extra money for a hot coffee.

ii) Substitution and Income Effects in Normal and Superior goods.

Are all goods the same? Is more always better? Up to this point, we have been assuming
that when we have more money, or feel like we have more money, we will tend to buy
more goods. It makes sense: the more money we have, the more we buy. If we have less
money, or if the price goes up, however, we tend to buy less. Because this is usually the
case, we call such goods normal goods. If you buy more of a good when you have more
money, that good is a normal good. If the price of a normal good increases, you buy less.
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There are some exceptions, however: not all goods are normal goods. For instance, if an
increase in your income causes you to buy less of a good, that good is called an inferior
good. For instance, "poor college students" often satisfy themselves with generic soda
and cheap ramen. When they get jobs and a steady income, however, they might forego
the cheap soda and ramen in favor of Coke and pasta. In this example, the generic soda
and cheap ramen are inferior goods.

Why is this true? Consider the case where the price of good A goes up.

Income and Substitution Effects with Normal and Inferior Goods


The substitution effect makes B relatively cheaper, so consumption of B will increase,
and consumption of A will decrease. The income effect makes the buyer feel poorer, and
so consumption of A will decrease, but consumption of B will increase. Remember that
consumption of an inferior good varies inversely with income: when you are rich, you
buy less, when you are poor, you buy more.
If the A is still normal and B is still inferior, and the price of A falls, then the substitution
effect will cause higher consumption of A and lower consumption of B, and the income
effect will cause higher consumption of A and lower consumption of B. Because the
buyer now feels richer, they are less inclined to buy the inferior good.

Income and Substitution Effects with Normal and Inferior Goods


Another exception is the case where an increase in price causes an increase in demand.
This results in an upward-sloping demand curve, and the good is called a Giffen good.
Giffen goods are theoretically possible, but very improbable, since it is unlikely that an
increase in price causes increase in demand. One possible justification for a Giffen good
is that people associate higher prices with status, luxury, and quality, so that a higher price
might increase the perceived value of a good. In reality, however, this effect is
outweighed by the overwhelming tendency to prefer lower prices: even if a few people
prefer the added cachet of a high-priced luxury good, the general public will prefer lower
prices. Another possible case that could cause a Giffen good is the case in which a good is
inferior and the income effect outweighs the substitution effect. To illustrate, assume that
ACME Cola is an inferior good.
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v) Substitution and Complementary by Cross Elasticity of Demand.

The measure of responsiveness of the demand for a good towards the change in the price
of a related good is called cross price elasticity of demand.

Definition: The measure of responsiveness of the demand for a good towards the change
in the price of a related good is called cross price elasticity of demand. It is always
measured in percentage terms.

Description: With the consumption behavior being related, the change in the price of a
related good leads to a change in the demand of another good. Related goods are of two
kinds, i.e. substitutes and complementary goods. In case the two goods are not related, the
Coefficient of Cross Elasticity is zero.
Cross elasticity of demand (XED) is the responsiveness of demand for one product to a
change in the price of another product. Many products are related, and XED indicates just
how they are related.

The following equation enables XED to be calculated.

% change in (∆) quantity demanded of good A % change in (∆) price of good B

Substitutes

When XED is positive, the related goods are substitutes. For example, if the price of
Coca Cola increases from 50p to 60p per can, and the demand for Pepsi Cola increases
from 1m to 2m per year, the XED between the two products is:

+100/+20 = (+) 5

The positive sign means that the two goods are substitutes, and because the coefficient is
greater than one, they are regarded as close substitutes.

Complements

When XED is negative, the goods are complementary products. The equation is the same
as for substitutes.

For example, if the price of Cinema Tickets increases from £5.00 to £7.50, and the
demand for Popcorn decreases from 1000 tubs to 700, the XED between the two products
will be:

-30/+50 = (-) 0.6


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The negative sign means that the two goods are complements, and the coefficient is less
than one, indicating that they are not particularly complementary.

Why does a firm want to know XED?

Knowing the XED of its own and other related products enables the firm to map
out its market. Mapping allows a firm to calculate how many rivals it has, and
how close they are. It also allows the firm to measure how important its
complementary products are to its own products.

This knowledge allows the firm to develop strategies to reduce its exposure to the
risks associated with price changes by other firms, such as a rise in the price of a
complement or a fall in the price of a substitute.

Risks can be reduced in a number of ways, including adopting the following


strategies:

Horizontal integration

Horizontal integration usually means merging with a rival, such as the merger of
pharmaceutical giants Glaxo Wellcome and SmithKline Beecham to
createGlaxoSmithKline (GSK) in 2000. Horizontal integration occurs when two
or more firms producing similar products merge with each other, or where one
takes over the other.

Vertical integration

Vertical integration means merging with a complement producer, such as a


record producer merging with or taking over a record store, or radio station

Alliances and collusion

Joint alliances with competitors can also take place, such as Sony-
Ericsson combining resources to create mobile phones.

Collusion is also a possibility. For example, firms may enter into price fixing
agreements so that they avoid having to fight a price war. This is more likely to
occur inoligopolostic markets, where there are only a few competitors.
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V. THEORY OF PRODUCTION

In economics, production theory explains the principles in which the business has to take
decisions on how much of each commodity it sells and how much it produces and also
how much of raw material ie., fixed capital and labor it employs and how much it will
use. It defines the relationships between the prices of the commodities and productive
factors on one hand and the quantities of these commodities and productive factors that
are produced on the other hand.

Concept
Production is a process of combining various inputs to produce an output for
consumption. It is the act of creating output in the form of a commodity or a service
which contributes to the utility of individuals.

In other words, it is a process in which the inputs are converted into outputs.

Function
The Production function signifies a technical relationship between the physical inputs
and physical outputs of the firm, for a given state of the technology.

Q = f (a, b, c, . . . . . . z)

Where a,b,c ....z are various inputs such as land, labor ,capital etc. Q is the level of the
output for a firm.

If labor (L) and capital (K) are only the input factors, the production function reduces to

Q = f(L, K)

Production Function describes the technological relationship between inputs and outputs.
It is a tool that analysis the qualitative input – output relationship and also represents the
technology of a firm or the economy as a whole.

Production Analysis
Production analysis basically is concerned with the analysis in which the resources such
as land, labor, and capital are employed to produce a firm’s final product. To produce
these goods the basic inputs are classified into two divisions −

Variable Inputs
Inputs those change or are variable in the short run or long run are variable inputs.

Fixed Inputs
Inputs that remain constant in the short term are fixed inputs.

Cost Function
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Cost function is defined as the relationship between the cost of the product and the
output. Following is the formula for the same −

C = F [Q]

Cost function is divided into namely two types −

Short Run Cost


Short run cost is an analysis in which few factors are constant which won’t change
during the period of analysis. The output can be changed ie., increased or decreased in
the short run by changing the variable factors.

Following are the basic three types of short run cost −

Long Run Cost


Long-run cost is variable and a firm adjusts all its inputs to make sure that its cost of
production is as low as possible.

Long run cost = Long run variable cost

In the long run, firms don’t have the liberty to reach equilibrium between supply and
demand by altering the levels of production. They can only expand or reduce the
production capacity as per the profits. In the long run, a firm can choose any amount of
fixed costs it wants to make short run decisions.

Law of Variable Proportions


The law of variable proportions has following three different phases −

 Returns to a Factor
 Returns to a Scale
 Isoquants

In this section, we will learn more on each of them.

Returns to a Factor
Increasing Returns to a Factor

Increasing returns to a factor refers to the situation in which total output tends to
increase at an increasing rate when more of variable factor is mixed with the fixed factor
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of production. In such a case, marginal product of the variable factor must be increasing.
Inversely, marginal price of production must be diminishing.

Constant Returns to a Factor

Constant returns to a factor refers to the stage when increasing the application of the
variable factor does not result in increasing the marginal product of the factor – rather,
marginal product of the factor tends to stabilize. Accordingly, total output increases only
at a constant rate.

Diminishing Returns to a Factor

Diminishing returns to a factor refers to a situation in which the total output tends to
increase at a diminishing rate when more of the variable factor is combined with the
fixed factor of production. In such a situation, marginal product of the variable must be
diminishing. Inversely the marginal cost of production must be increasing.

Returns to a Scale
If all inputs are changed simultaneously or proportionately, then the concept of returns to
scale has to be used to understand the behavior of output. The behavior of output is
studied when all the factors of production are changed in the same direction and
proportion. Returns to scale are classified as follows −

Increasing returns to scale − If output increases more than proportionate to the


increase in all inputs.

Constant returns to scale − If all inputs are increased by some proportion,


output will also increase by the same proportion.

Decreasing returns to scale − If increase in output is less than proportionate to


the increase in all inputs.

For example − If all factors of production are doubled and output increases by more
than two times, then the situation is of increasing returns to scale. On the other hand, if
output does not double even after a 100 per cent increase in input factors, we have
diminishing returns to scale.

The general production function is Q = F (L, K)

Isoquants
Isoquants are a geometric representation of the production function. The same level of
output can be produced by various combinations of factor inputs. The locus of all
possible combinations is called the ‘Isoquant’.

Characteristics of Isoquant

 An isoquant slopes downward to the right.


 An isoquant is convex to origin.
 An isoquant is smooth and continuous.
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 Two isoquants do not intersect.

Types of Isoquants

The production isoquant may assume various shapes depending on the degree of
substitutability of factors.

Linear Isoquant

This type assumes perfect substitutability of factors of production. A given commodity


may be produced by using only capital or only labor or by an infinite combination of K
and L.

Input-Output Isoquant

This assumes strict complementarily, that is zero substitutability of the factors of


production. There is only one method of production for any one commodity. The
isoquant takes the shape of a right angle. This type of isoquant is called “Leontief
Isoquant”.

Kinked Isoquant

This assumes limited substitutability of K and L. Generally, there are few processes for
producing any one commodity. Substitutability of factors is possible only at the kinks. It
is also called “activity analysis-isoquant” or “linear-programming isoquant” because it is
basically used in linear programming.

Least Cost Combination of Inputs

A given level of output can be produced using many different combinations of two
variable inputs. In choosing between the two resources, the saving in the resource
replaced must be greater than the cost of resource added. The principle of least cost
combination states that if two input factors are considered for a given output then the
least cost combination will have inverse price ratio which is equal to their marginal rate
of substitution.

Marginal Rate of Substitution

MRS is defined as the units of one input factor that can be substituted for a single unit of
the other input factor. So MRS of x2 for one unit of x1 is −

=
Number of unit of replaced resource (x2)Number of unit of added resource (x1)

Price Ratio (PR) =


Cost per unit of added resourceCost per unit of replaced resource

=
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Price of x1Price of x2

Therefore the least cost combination of two inputs can be obtained by equating MRS
with inverse price ratio.

x2 * P2 = x1 * P1

i) Production Function

However much of a commodity a business firm produces, it endeavours to produce it as


cheaply as possible. Taking the quality of the product and the prices of the productive
factors as given, which is the usual situation, the firm’s task is to determine the cheapest
combination of factors of production that can produce the desired output. This task is best
understood in terms of what is called the production function, i.e., an equation that
expresses the relationship between the quantities of factors employed and the amount of
product obtained. It states the amount of product that can be obtained from each and
every combination of factors. This relationship can be written mathematically
as y = f (x1, x2, . . . , xn; k1, k2, . . . , km). Here, y denotes the quantity of output. The
firm is presumed to use n variable factors of production; that is, factors like hourly paid
production workers and raw materials, the quantities of which can be increased or
decreased. In the formula the quantity of the first variable factor is denoted by x1 and so
on. The firm is also presumed to use m fixed factors, or factors like fixed machinery,
salaried staff, etc., the quantities of which cannot be varied readily or habitually. The
available quantity of the first fixed factor is indicated in the formal by k1 and so on. The
entire formula expresses the amount of output that results when specified quantities of
factors are employed. It must be noted that though the quantities of the factors determine
the quantity of output, the reverse is not true, and as a general rule there will be many
combinations of productive factors that could be used to produce the same output.
Finding the cheapest of these is the problem of cost minimization.

The cost of production is simply the sum of the costs of all of the various factors. It can
be written:

in which p1 denotes the price of a unit of the first variable factor, r1 denotes the annual
cost of owning and maintaining the first fixed factor, and so on. Here again one group of
terms, the first, coversvariable cost (roughly“direct costs” in accounting terminology),
which can be changed readily; another group, the second, covers fixed cost (accountants’
“overhead costs”), which includes items not easily varied. The discussion will deal first
with variable cost.

ii) Fixed and Variable Inputs

FIXED INPUT:
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An input whose quantity cannot be changed in the time period under


consideration. The relevant time period is usually termed the short run.
The most common example of a fixed input is capital. The alternative to
fixed input is variable input. A fixed input, such as capital, provides the
"capacity" constraint for the short-run production of a firm. A variable
input, such as labor, provides the means of changing short-run production.
As larger quantities of a variable input are added to a fixed input, the
variable input becomes less productive, which is the law of diminishing
marginal returns.
A fixed input is a resource or factor of production which cannot be changed in the short
run by a firm as it seeks to change the quantity of output produced. Most firms have
several fixed inputs in short-run production, especially buildings, equipment, and land.
However, in the analysis of short-run production, a great deal of insight is achieved by
focusing on the fixed role of capital.

Short-Run Taco Production

As an illustration of fixed inputs, consider the short-run production of Shady Valley's


favorite lunch time meal, Super Deluxe TexMex Gargantuan Tacos (with sour cream and
jalapeno peppers). The key fixed input for Waldo Millbottom, the owner and proprietor of
Waldo's TexMex Taco World, is the restaurant and accompanying capital equipment.

In the day-to-day production of TexMex Gargantuan Tacos, Waldo does not concern
himself with the size of the restaurant, number of tables and chairs, amount of kitchen
equipment, and available parking spaces. The quantities of these items are fixed in the
short run.

In the short-run, Waldo is primarily interested in having a sufficient quantity of labor--


waitpersons, kitchen help, etc. Waldo alters the quantity of labor to change the quantity of
production.

Usually Capital, But Not Always

The designation of capital as a fixed input is not just an arbitrary choice made to ease the
economic exposition of short-run production. Capital is usually an input that cannot be
changed quickly. If a firm wants to add a half dozen additional machinists to its
workforce, it can probably do so in a few weeks. However, if a firm wants to add 50,000
square feet of factory space, then the construction company probably needs a year or two
to complete this job. In terms of short-run production, labor is typically variable and
capital is typically fixed.

However, not all firms are typical. In some examples of short-run production, capital is
the variable input and labor is the fixed input. One illustration is offered by the academic
world of higher education. The labor of tenured faculty (with emphasis on "tenured")
tends to be a fixed input in the production of education. By contrast, some forms of
MUHAMMAD ISMAIL 03147963120 64

capital, especially computer equipment, are more easily changed and can be thought of as
variable inputs in the production of education.

VARIABLE INPUT:

An input whose quantity can be changed in the time period under


consideration. The most common example of a variable input is labor.
Variable inputs provide the means used by a firm to control short-run
production. The alternative to variable input is fixed input. A fixed input,
like capital, provides the capacity constraint in production. As larger
quantities of a variable input, like labor, are added to a fixed input like
capital, the variable input becomes less productive, which is the law of
diminishing marginal returns.
A variable input is a resource or factor of production which can be changed in the short
run by a firm as it seeks to change the quantity of output produced. Most firms use
several variable inputs in short-run production, especially labor, material inputs, and
energy. However, in the analysis of short-run production, a great deal of insight is
achieved by focusing on the variable use of labor.
iii) Concept of Short Run and Long Run

DEFINITION of 'Long Run'


A period of time in which all factors of production and costs are variable. In the long
run,firms are able to adjust all costs, whereas in the short run firms are only able to
influence prices through adjustments made to production levels. Additionally, whereas
firms may be a monopoly in the short-term they may expect competition in the long-
term.
In economics, long-run models may shift away from short-turn equilibriums, in which
supply and demand react to price levels with more flexibility.

DEFINITION of 'Short Run'


In economics, it is the concept that within a certain period of time, in the future, at least
one input is fixed while others are variable. The short run is not a definite period of time,
but rather varies based on the length of the firm's contracts. For example, a firm may have
entered into lease contracts which fix the amount of rent over the next month, year or
several years. Or the firm may have wage contracts with certain workers which cannot be
changed until the contract renewal.

iv) Total, Average and Marginal Products

TOTAL PRODUCT:

The total quantity of output produced by a firm for a given quantity of


inputs. Total product is the foundation upon which the analysis of short-
run production for a firm is based. The usual framework is to analyze total
product when a variable input (labor) changes, while a fixed input (capital)
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does not change. Two related concepts derived from total product are
average product and marginal product.
Total product is the overall quantity of output that a firm produces, usually specified in
relation to a variable input. Total product is the starting point for the analysis of short-run
production. It indicates how much output a firm can produce according to the law of
diminishing marginal returns.

The Law of Diminishing Marginal Returns

Total product does not increase in a linear fashion due to the law of diminishing marginal
returns. This law states that as more of a variable input is added to a fixed input in short-
run production, then the marginal product (that is, the marginal returns) of the variable
input eventually declines.

For example, the second employee of Waldo's TexMex Taco World might increase taco
production from 20 to 50 (a change of 30 tacos), the sixth worker increases production
only from 110 to 120 (a change of 10 tacos).

The Total Product Curve

The total product curve is a graphical Total Product Curve


representation of the relation between the total
product and the variable input. The total product
curve for Gargantuan Taco production is
displayed to the right.

The "overall" slope of this curve is positive,


with extra workers "generally" leading to
greater production. However, the curve has a
distinctive shape, emerging steeply from the
origin, then flattening, and eventually declining.
The shape of this curve is attributable to the law of diminishing marginal returns.

Consistent with the numbers in the table, the curve reaches a peak of 125 Gargantuan
Tacos at both 7 and 8 workers. To the left of this peak of 125 Gargantuan Tacos, extra
workers increase the production and to the right of the peak extra workers actually reduce
total taco production.

Average and Marginal

Two related product measures are derived directly from total product--average
product and marginal product.
 Average Product: This is the amount of output produced per worker, found by
dividing the total product by the number of workers. If, for example, Waldo's
TexMex Taco World has a staff of 5 that generates a total product of 110 tacos,
then average product is 22 tacos.
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 Marginal Product: This is the change in total product resulting from a change in
the number of workers. Marginal product indicates how the total production of
TexMex Gargantuan Tacos changes when an extra worker is hired or fired. For
example, hiring a 5th worker means that Waldo's TexMex Taco World total
product increases from 95 to 110 tacos. The addition of 5th worker results in the
production of an additional 15 TexMex Gargantuan Tacos.

MARGINAL PRODUCT:

The change in the quantity of total product resulting from a unit change in
a variable input, keeping all other inputs unchanged. Marginal product,
usually abbreviated MP, is found by dividing the change in total product
by the change in the variable input. Marginal product, which occasionally
goes by the alias marginal physical product (MPP), is one of two measures
derived from total product. The other is average product.
Marginal product is the extra output generated by an extra input. Marginal product lies at
the very foundation of the analysis of short-run production, playing THE critical role in
the explanation of the law of supply and the upward-sloping supply curve using the law
of diminishing marginal returns. Of the myriad of short-run production-related terms
(includingtotal product, average product, fixed input, variable input, short run, long run)
marginal product is by far the most important.

The formula for specifying and calculating marginal product from total product is given
as:

change in total product


marginal product =
change in variable input

The proper economic interpretation of marginal product is as the contribution of the last
unit of variable input to total production. That is, how much does total product change by
adding the last unit? If, for example, the marginal product of labor is 25 tacos, then this
means that employing the last worker causes total product to increase by 25 tacos. Does
this mean the last worker personally produces 25 tacos? No, not at all. Or at least, not
necessarily. It means that having this person employed by the firm causes total product to
increase by 25 tacos. More often that not, this added worker makes existing workers more
productive.

Marginal Taco Production

The table at the right summarizes the hourly production by Waldo's TexMex Taco World
of Super Deluxe TexMex Gargantuan Tacos (with sour cream and jalapeno peppers). The
total product numbers presented can be used to derive the marginal product.
MUHAMMAD ISMAIL 03147963120 67

The column on the left is the variable input, specifically the Marginal Taco Product
number of workers employed by Waldo's TexMex Taco World,
which ranges from 0 to 10. The center column is the total
product, the total number of TexMex Gargantuan Tacos
produced each hour, which ranges from a low of 0 to a high of
125 before declining to 110. Keep in mind that the taco
production from these workers depends on a given amount of
fixed inputs, Waldo's TexMex Taco World restaurant and all of
the capital that goes with it.

Missing from this table is any mention of marginal product.


This apparent oversight can be rectified with a few button
clicks.

First, consider this question: What is the contribution of the first worker to total
Gargantuan Taco production? Or put another way: What is the change in total product
resulting from a change in the variable input?

To answer these questions, note that total hourly Gargantuan Taco production with zero
workers is also zero. No input, no output. But with one worker busily making Gargantuan
Tacos, the hourly taco production increases to 20. The change in total product resulting
from the employment of the first worker is 20. Click the [First] button to verify that the
marginal product of the first worker is 20 tacos.

How about the marginal product of the second worker? A click of the [Second] button
reveals that employing the second worker adds 30 Gargantuan Tacos to the hourly taco
production of Waldo's TexMex Taco World. This number is found by taking the
difference between total hourly taco production with one worker (20 Gargantuan Tacos)
and the total hourly taco production with two workers (50 Gargantuan Tacos).

Now consider the marginal product of the third worker. Adding a third worker boosts
total hourly taco production from the 50 Gargantuan Tacos produced by two workers to
75 Gargantuan Tacos produced by three workers. This means that the marginal product of
the third worker is 25 Gargantuan Tacos.

To display marginal products associated with the addition of the remaining workers, click
the [Others] button.

What interesting and useful information can be derived from this expanded table?

First, the marginal product of workers increases for the first two workers, reaching a
peak of 30 Gargantuan Tacos, then declines thereafter. The increasing marginal
product observed for the first few workers illustrates increasing marginal returns and
the decreasing marginal product observed for all subsequent workers
illustrates decreasing marginal returns. Moreover, the decreasing marginal products is
MUHAMMAD ISMAIL 03147963120 68

attributable to the law of diminishing marginal returns, THE key principle underlying
the study of short-run production.

Second, notice that marginal product decreases so much that it becomes zero for the
eighth worker and even becomes negative for the ninth and tenth workers. The zero
value of marginal product for the eighth worker also occurs where the total product
has reached its maximum value. Coincidence? Not at all. The peak of the total
product curve has a zero slope. Marginal product is another term for the slope of the
total product curve.

The Marginal Product Curve

The marginal product curve is a graphical representation of Marginal Product Curve


the relation between marginal product and the variable input.
The marginal product curve for Gargantuan Taco production
is displayed to the right.

The "general" slope of this curve is negative, with incremental output declining for larger
workforces. However, the marginal product curve is actually "hump" shaped, with a
positive slope giving way to a negative slope. Consistent with the numbers in the table,
the curve reaches a peak of 30 Gargantuan Tacos for the second worker.

Total and Average

Two related product measures are total product and average product.
 Total Product: This is the total quantity of output produced by a firm for a given
quantity of inputs. Total product is the foundation upon which the analysis of
short-run production for a firm is based. It also provides the basis for calculating
marginal product.
 Average Product: This is the amount of output produced per worker, found by
dividing the total product by the number of workers. If, for example, Waldo's
TexMex Taco World has a staff of 5 that generates a total product of 110 tacos,
then average product is 22 tacos.

AVERAGE PRODUCT CURVE:

A curve that graphically illustrates the relation between average product


and the quantity of the variable input, holding all other inputs fixed. This
curve indicates the per unit output at each level of the variable input. The
average product curve is one of three related curves used in the analysis of
the short-run production of a firm. The other two are total product curve
and marginal product curve.
The average product curve illustrates how average product is related to avariable input.
While the standard analysis of short-run production relates average product to labor, an
average product curve can be constructed for any variable input.
MUHAMMAD ISMAIL 03147963120 69

The diagram to the right graphically represents Average Product Curve


the relation between average product and the
variable input. This particular curve is derived
from the hourly production of Super Deluxe
TexMex Gargantuan Tacos (with sour cream
and jalapeno peppers) as Waldo's TexMex Taco
World restaurant employs additional workers.
The number of workers, measured on
the horizontal axis, ranges from 0 to 10 and the
average Gargantuan Taco production per
worker, measured on thevertical axis, ranges
from 0 to 25.

The shape of this average product curve is worth noting. For the first two workers of
variable input, average product increases. This is reflected in a positive slope of the
average product curve. After the third worker, the average product declines. This is seen
as a negative slope. While average product continues to decline, it never reaches zero nor
becomes negative. To do so would require total product to become zero and negative,
which just does not happen.

The hump-shape of the average product curve indirectly results from increasing and
decreasing marginal returns. The upward-sloping portion of the average product curve, up
to the second worker, is indirectly due to increasing marginal returns. The downward-
sloping portion of the average product curve, after the third worker, is indirectly due to
decreasing marginal returns. and the law of diminishing marginal returns.

vi) Stages of Production

The three stages of production are characterized by the slopes, shapes, and
interrelationships of the total, marginal, and average product curves. The
first stage is characterized by a positive slope of the average product
curve, ending at the intersection between the average product and marginal
product curves; the second stage by continues up to the point in which the
marginal product becomes negative, at the peak of the total product curve;
and the third stage exists over the range of in which the total product curve
is negatively sloped. In Stage I, average product is positive and increasing.
In Stage II, marginal product is positive, but decreasing. And in Stage III,
total product is decreasing.
Short-run production by a firm typically encounters three distinct stages as a larger
amounts of a variable input (especially labor) are added to afixed input (such as capital).
The first stage results from increasingaverage product. The second stage sets it at the
peak of average product, experiencing a wide range of decreasing marginal returns, and
the law of diminishing marginal returns. The third stage is then characterized by negative
marginal returns and.

Three Product Curves


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The three stages of short-run production are Three Stages


readily seen with the three product curves--total
product, average product, andmarginal product.
A set of product curves is presented in the
exhibit to the right. The variable input in this
example is labor.

The top panel contains the total product


curve (TP). It generally rises, reaches a peak,
then falls. The bottom panel contains
themarginal product curve (MP) and
the average product curve (AP). Both curves
rise a bit for small quantities of the variable
input labor, then decline. Marginal product
eventually turns negative, but average product
remains positive.

The three short-run production stages are


conveniently labeled I, II, and III, and are
separated by vertical lines extending through
both panels.

Stage I

Short-run production Stage I arises due to increasing average product. As more of the
variable input is added to the fixed input, the marginal product of the variable input
increases. Most importantly, marginal product is greater than average product, which
causes average product to increase. This is directly illustrated by the slope of the average
product curve.

Consider these observations about the shapes and slopes of the three product curves in
Stage I.

 The total product curve has a positive slope.


 Marginal product is greater than average product. Marginal product initially
increases, the decreases until it is equal to average product at the end of Stage I.
 Average product is positive and the average product curve has a positive slope.

Stage II

In Stage II, short-run production is characterized by decreasing, but positive marginal


returns. As more of the variable input is added to the fixed input, the marginal product of
the variable input decreases. Most important of all, Stage II is driven by the law of
diminishing marginal returns.

The three product curves reveal the following patterns in Stage II.
MUHAMMAD ISMAIL 03147963120 71

 The total product curve has a decreasing positive slope. In other words, the slope
becomes flatter with each additional unit of variable input.
 Marginal product is positive and the marginal product curve has a negative slope.
The marginal product curve intersects the horizontal quantity axis at the end of
Stage II.
 Average product is positive and the average product curve has a negative slope.
The average product curve is at its a peak at the onset of Stage II. At this peak,
average product is equal to marginal product.

Average product remains positive but the average product curve has a negative slope.

Economic Production

These three distinct stages of short-run production are not equally important. Stage I, and
with largely increasing marginal returns, is a great place to visit, but most firms move
through it quickly. Because each variable input is increasingly more productive, firms
employ as many as they can, as quickly as they can. Stage III, with negative marginal
returns, is not particularly attractive to firms. Production is less than it would be in Stage
II, but the cost of production is greater due to the employment of the variable input. Not a
lot of benefits are to be had with Stage III.

Stage II, with decreasing but positive marginal returns, provides a range of production
that is suitable to most every firm. Although marginal product declines, additional
employment of the variable input does add to total production. Even though production
cost rises with additional employment, there are benefits to be gained from extra
production. The trick is to balance the extra cost with the extra production.

As a matter of fact, because Stage II tends to be the choice of firms for short-run
production, it is often referred to as the "economic region." Firms quickly move from
Stage I to Stage II, and do all they can to avoid moving into Stage III. Firms can
comfortably, and profitably, produce forever and ever in Stage II.

vii) Linearly Homogeneous Production Function; and Cobb-Douglas Production


Function.

Many studies have been undertaken to empirically study and statistically calculate the
relationship between physical inputs and physical output. One of such empirical
production functions is 聽 Cobb Douglas Production Function. It is intermediate
between a linear and a fixed proportion production function. It is given by a formula ------
Q = AL 伪 K 尾
Where Q is total output,
L stands for quantity of labour,
K is quantity of capital,聽
A, 伪 and 尾 are positive constants.
MUHAMMAD ISMAIL 03147963120 72

Empirically it was found that, 75% increase in output can be attributed to increase in
labour input and the remaining 25% was due to capital input. It was also found that the
sum of exponents of Cobb-Douglas production function is equal to one. That is 伪 + 尾 is
equal to one. This implies that it is a linearly homogenous production function.
Following are important features of Cobb-Douglas Production Function
1. Average Product of factors of production used up in this function depends upon the
ratio in which the factors are combined for the production of commodity under
consideration
2. Marginal Product of factors of production used up in this function also depends upon
the ratio in which the factors are combined for the production of commodity under
consideration
3. Cobb-Douglas production function is used in obtaining marginal rate of technical
substitution ( the rate at which one input can be substituted for the other to produce same
level of output) between two inputs.
Linear Homogeneous Production Function
The Linear Homogeneous Production Function implies that fall the factors of’production
are increased in slime proportion. the output also increases in the same proportion. That
is. the doubling of all inputs will double the output and trebling them will result in the
trebling of the output, aim so on. This represents a case of constant returns to scale. This
type of production function is called by the economists as a well behaved production
function because it can be easily handled and used in empirical studies. It can he used by
computers in calculations. That is why it is widely used in linear programming and input-
output analysis . It is extensively used in model analysis of production. distribution and
economic growth. This is a production function which is homogeneous of the first degree.
That is, it shows that the increase in output in the same proportion follows a given change
in the factors of production. This has been put mathematically as.
This fun is homogeneous of Kth degree. If K is equal to one then this homogeneous fun
is homogeneous the first degree and if l( is equal to two it is homogeneous of the second
degree, and so on. If (( is greater than one the production function gives increasing
returns to scale and if it is less than one it gives decreasing returns to scale. In the case of
homo- -igneous production function, the expansion path is always a straight line through
the means that in the case of homogeneous production function of the first degree. given
constant relative factor prices. the proportions between the factors used will always be the
Whatever the level of output. This makes the task of the entrepreneur easy . Having hit on
an optimum factor proportions, he need not change the decision so long as the relative
prices the factors remain unchanged.
ix) Isoquants and Isocost lines

L) and Capital (K) that will produce a certain output Q. Mathematically, the data that an
isoquant projects is expressed by the equation

f (K,L) = Q
K

MUHAMMAD ISMAIL 03147963120 KA =10 A 73

Q=25

B Q=15
KB = 2
Q=5

2 = LA 8 = LB L

Figure 9.1- An Isoquant Map


Each curve shows the rate at which L can be substituted
for K, or vice versa, while keeping output constant.

This equation basically says that the output that this firm produces is a function of Labor
and Capital, where each isoquant represents a fixed output produced with different
combinations of inputs. A new isoquant emerges for every level of output (See Figure
9.1). Isoquants have certain properties that resemble that of indifference curves – convex
to the origin, downward sloping, and nonintersecting curves.
The Marginal Rate of Technical Substitution (MRTS) equals the absolute value of the
slope. The MRTS tells us how much of one input a firm can sacrifice while still
maintaining a certain output level. The MRTS is also equal to the ratio of Marginal
Productivity of Labor (MPL): Marginal Productivity of Capital (MPK). The mathematical
form of how Labor (L) can be substituted for Capital (K) in production is given by:

MRTS (L for K)= -dK/dL = MPL/MPK

For Example: When going from point B to A in Figure 9.1, the Slope = (8 units of
Capital)/(-6 units of Labor). The MRTS (L for K) = -(8/-6) = 4/3 between points B and A,
which means that 4 units of Capital can substitute for 3 units of labor.

Isocosts:
An isocost line (equal-cost line) is a Total Cost of production line that recognizes all
combinations of two resources that a firm can use, given the Total Cost (TC). Moving up
or down the line shows the rate at which one input could be substituted for another in the
input market. For the case of Labor and Capital, the total cost of production would take
on the form:

TC = (WL) + (RK)

TC= Total Cost, W= Wage, L= Labor, R= Cost of Capital, K= Capital

Example: A company producing widgets encounters the following costs- cost of capital is
$25000, labor cost is $15000, and the total cost the firm is willing to pay is $150,000.
K

150,000 = 15,000L + 25,000K

10 L

Figure 9.2 : Isocost Line


The slope of this line is Wage (W)/ Cost of Capital (R)
W/R= (-15,000)/(25,000)= -0.6
For every one unit of L the firm wants to hire, they
must give up 0.6 units of K

Show the isocost line graphically.


MUHAMMAD ISMAIL 03147963120 74

The equation represented by the data is: 150,000= (15000)L + (25000)K


Setting L=0, we find the y-intercept to be K=6. Setting K=0, we find the x-intercept to be
10 (See Figure 9.2)
xi) Output Maximization and Cost minimization

We can conceptually divide the profit maximization problem into two sub-problems:

 What is the lowest cost combination of inputs that will produce a level of output
equal to y?
 What is the output level y that will maximize profits?

Cost minimization is a necessary (but not sufficient) condition for profit maximization.
Even when a producer is not a price taker in the output market, or when the solution to
the profit maximization problem is not well defined (say, due to increasing returns), the
producer must still minimize costs.

Assumptions:

 Production function is y = f(x1,x2). The production function is assumed to


be quasi-concave.
 The producer is a price taker in the input market.

The producer chooses x1 and x2 (the choice variables) to minimize C(x1,x2) (the objective
function)

minimize C(x1,x2) = w1 x1 + w2 x2

subject to the constraint

f(x1,x2) = y

The parameters of this problem are w1, w2, and y.

Form the Lagrangian function:

L = w1 x1 + w2 x2 + λ ( y - f(x1,x2) )

The variable λ is called the Lagrange multiplier for the constraint.

The FOC for this minimization problem is:

∂L/∂x1 = w1 - λ f1 (x1,x2) = 0
∂L/∂x2 = w2 - λ f2 (x1,x2) = 0
∂L/∂λ = y - f(x1,x2) = 0
MUHAMMAD ISMAIL 03147963120 75

Sufficient SOC for minimization is that all the border-preserving principle minor
determinants of the matrix

[ -λ f11 -λ f12 -f1 ]


H = [ -λ f21 -λ f22 -f2 ]
[ -f1 -f2 0 ]

are negative.

Interpretation: The FOC imply w1/w2 = f1/f2. That is, the ratio of factor prices is equal to
the marginal rate of technical substitution.

The assumption of quasi-concavity guarantees that the SOC is satisfied. Alternatively, if


we abandon the assumption of quasi-concavity, the SOC implies that the production
function is locally quasi-concave at the optimal input combination. Here, the quasi-
concavity condition is equivalent to the condition of diminishing MRTS.

The SOC does not say anything about returns to scale. Even if we have an increasing
returns to scale production function (e.g., y = x1 x2), the cost-minimization problem still
has a well defined solution.

The FOC can be considered as three equations in three unknowns (x1, x2, λ). Given any
parameter values for w1, w2, and y, we can solve these equations for the unknowns. Of
course, the solution values depend on the values of the parameters. If x 1~, x2~, and λ~ are
the solutions to the cost minimization problem, we emphasize the dependence of these
optimal choice functions on the parameters by writing x1~ = x1~ (w1,w2,y) and x2~ =
x2~ (w1,w2,y). These functions are different from the factor demand functions derived
from the profit maximization problem. We call them cost-minimizing factor demand
functions orconditional factor demand functions.

By definition, if you substitute the optimal choice functions into the FOC equations, the
equations are always satisfied. We therefore write

w1 - λ~ (w1,w2,y) f1( x1~ (w1,w2,y), x2~ (w1,w2,y) ) ≡ 0


w2 - λ~ (w1,w2,y) f2( x1~ (w1,w2,y), x2~ (w1,w2,y) ) ≡ 0
y - f( x1~ (w1,w2,y), x2~ (w1,w2,y) ) ≡ 0

Consider how w1 affects factor demand. Use the identities above, differentiate with
respect to w1, and employ the chain rule of differentiation, we get

1 - λ f11 (∂x1~/ ∂w1) - λ f12 (∂x2~ /∂w1) - f1 (∂λ~ /∂w1) = 0


0 - λ f21 (∂x1~/ ∂w1) - λ f22 (∂x2~ /∂w1) - f2 (∂λ~ /∂w1) = 0
0 - f1 (∂x1~ /∂w1) - f2 (∂x2~ /∂w1) - 0 (∂λ~ /∂w1) = 0

In matrix notation:
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[ -λ f11 -λ f12 -f1 ] [ ∂x1~/∂w1 ] = [ -1 ]


[ -λ f21 -λ f22 -f2 ] [ ∂x2~/∂w1 ] = [ 0 ]
[ -f1 -f2 0 ] [ ∂λ~/∂w1 ] = [ 0 ]

Use Cramer's rule to get

∂x1~/∂w1 = | -1 -λ f12 -f1 | /


| 0 -λ f22 -f2 | / | H |
| 0 -f2 0 |/

= -1 | -λ f22 -f2 | / | H |
| -f2 0 |/

The determinant in the numerator is a border-preserving principal minor determinant, so


by the SOC it is negative (verify!). Similarly, the SOC also requires the | H | < 0.
Therefore ∂x1~ /∂w1 < 0 (downward sloping conditional factor demand curve).

We can also solve for ∂x2~/ ∂w1:

∂x2~/∂w1 = | -λ f11 -1 -f1 | /


| -λ f21 0 -f2 | / | H |
| -f1 0 0 |/

= 1 | -λ f21 -f2 | / | H |
| -f1 0 |/

The determinant in the numerator is not a border-preserving principal minor determinant,


so in general its sign is undetermined. But for the two-input case, this determinant
is negative, so ∂x2~/ ∂w1 > 0. (Why? Theory implies ∂x1~ /∂w1 < 0. So when
w1 increases, we use less x1, but we still want to produce the same amount of
output y. This is achieved by increasing the use of x2.)

If you are curious, you can do a similar comparative statics analysis for w 2. You will then
verify that

∂x1~/ ∂w2 = ∂x2~/ ∂w1

Let's also try the comparative statics for y. Differentiate the FOC with respect to y and
write in matrix notation, we have

[ -λ f11 -λ f12 -f1 ] [ ∂x1~/∂y ] = [ 0 ]


[ -λ f21 -λ f22 -f2 ] [ ∂x2~/∂y ] = [ 0 ]
[ -f1 -f2 0 ] [ ∂λ~/∂y ] = [ -1 ]

Therefore,
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∂x1~/∂y = | 0 -λ f12 -f1 | /


| 0 -λ f22 -f2 | / | H |
| -1 -f2 0 |/

= -1 | -λ f12 -f1 | / | H |
| -λ f22 -f2 | /

The determinant in the numerator is not a border-preserving principal minor determinant,


so this derivative cannot be signed. If ∂x 1~/∂y > 0, then x1 is a "normal factor." If
∂x1~/∂y < 0, then we call it an "inferior factor."

We have not derived any comparative statics for the λ~ (w1,w2,y) function. But if we do it,
we will see that all the partial derivatives have ambiguous signs.

Finally, if we look at the FOC equations again, and consider the effect of changing all
input prices from (w1, w2) to (tw1, tw2) while keeping the parameter y unchanged. The
FOC become

tw1 - λ f1 (x1,x2) = 0
tw2 - λ f2 (x1,x2) = 0
y - f(x1,x2) = 0

If ( x1~, x2~, λ~ ) solve the original FOC equations, then ( x1~, x2~, tλ~ ) must solve the new
set of equations. We therefore conclude that

x1~ (tw1, tw2, y) ≡ x1~ (w1, w2, y)


x2~ (tw1, tw2, y) ≡ x2~ (w1, w2, y)

That is, the conditional input demand functions are homogeneous of degree 0 in
w1 w2 (but not in y). (Since λ~ (tw1, tw2, y) ≡ t λ~(w1, w2,y), we also see that the
λ~() function is homogeneous of degree 1.)

SUMMARY: Properties of conditional input demand functions

 xi~ (w1, ..., wn, y) is homogeneous of degree 0 in the input prices.


 ∂xi~/ ∂wi < 0 (downward sloping conditional factor demand curve)
 ∂xi~/ ∂wj = ∂xj~/ ∂wi (symmetry)

Relationship between cost minimization and profit maximization

If we compare the FOCs for the profit-maximization problem with the FOCs for the cost
minimization problem, we can see that they will give the same solution values for x 1 and
x2 if the value of the Lagrange multiplier is λ = p. From introductory microeconomics, we
know that a condition for profit maximization is Marginal Cost = p. This is a hint that the
Lagrange multiplier can be interpreted as Marginal Cost.
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The FOC implies λ = w1/f1 = w2/f2. What is the marginal cost of producing one unit of
output? Well, we can produce more outputs by using more x 1. If the marginal product of
x1 is f1, we need 1/f1 units of x1 to produce one more unit of output. Each unit of x 1 costs
w1, so the cost of 1/f1 units of x1 is w1/f1. This is another hint that λ can be interpreted as
Marginal Cost. More on this later.

If you want to produce y = y*(p,w1,w2) units of output, the cost-minimizing input bundle
must be the same as the profit-maximizing input bundle. So we must have

x1~ (w1, w2, y*(p,w1,w2) ) ≡ x1* (p,w1,w2)

Differentiate the identity with respect to, say w1, we get

∂x1~/ ∂w1 + (∂x1~ /∂y) (∂y*/∂w1) = ∂x1*/∂w1

To find out what ∂x1~/∂y is, we differentiate the identity with respect to p to get

(∂x1~ /∂y) (∂y*/∂p) = ∂x1*/∂p

So ∂x1~ /∂y = (∂x1*/∂p) / (∂y*/∂p). Substitute this expression back in:

∂x1~/ ∂w1 - ∂x1*/ ∂w1 = - (∂x1*/∂p) (∂y*/∂w1) / (∂y*/∂p)

Since the symmetry condition ensures that the ∂x 1*/∂p = - ∂y*/∂w1, the numerator is a
square must be positive. The denominator is also shown to be positive, so the
whole term is positive. I.e., ∂x1~/ ∂w1 > ∂x1*/∂w1. But because demand curves are
negatively sloped, this means that the derivative of the profit-maximizing demand
function is larger in absolute value than is the derivative of the cost-minimizing
demand function. Consider the effect of an increase in w 1 on the profit-
maximizing choice of x1:

∂x1*/∂w1 = ∂x1~/∂w1 + (∂x1~/∂y) (∂y*/∂w1)


^ ^
substitution scale
effect effect

The substitution effect is always negative. The scale effect is also always negative ( for
"normal factors," ∂x1~/∂y > 0 and ∂y*/∂w1 < 0; for "inferior factors," ∂x1~/∂y < 0
and ∂y*/∂w1 > 0). The two effects reinforce each other.

xii) Laws of Returns and Elasticity of Substitution.

Suppose that Josh wants to expand his business and mow more lawns. He could lease
another lawnmower. This might enable him to work more steadily, because if one
lawnmower runs out of gas or requires maintenance, he can use the other lawnmower.
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But leasing another lawnmower will not enable Josh to double the number of lawns that
he mows.

The fact that doubling the number of lawnmowers will not double the number of lawns
one person can mow is an illustration of the law of diminishing returns. When a
production process requires many inputs (or "factors"), adding more of one input usually
results in a less-than-proportionate increase in output.

Suppose that Josh keeps just one lawnmower, but he tries to double the number of lawns
he mows by working longer. He will get tired, and he will find that working eight more
hours does not enable him to mow eight more lawns in a day. That is another illustration
of the law of diminishing returns.

Constant Returns to Scale

In theory, if you double all inputs in a production process, you should be able to double
the output. That is called constant returns to scale.

In practice, businessmen tend to look at scale in terms of increases in some inputs but not
in others. If they can double output without having to double all inputs, they say that
there are economies of scale. For example, if Josh can double the number of lawns
mowed by adding another worker and another lawnmower--but without having to add
another pickup truck--then his business has economies of scale.

In general, suppose that you can produce x units of output with a given set of inputs.
Now, suppose we double the level of inputs, and ask whether or not we get 2x units of
output. We describe the returns to scale as follows:

Output Returns to Scale


more than 2x economies of scale, or increasing returns
exactly 2x constant returns to scale
less than 2x diseconomies of scale, or diminishing returns

There is an argument to be made that any business ought to have constant returns to scale
if you can identify all inputs and increase them proportionately. However, in practice,
there are inputs, such as managerial supervision, that are nearly impossible to increase
proportionately. For example, suppose that Josh's inputs consist of four workers
(including himself), four lawnmowers, and one pickup truck. If he doubles all of those
inputs, then the second pickup truck will have to go to work at a different neighborhood,
and it will be more difficult for Josh to supervise the workers. Thus, Josh's business is
likely to exhibit diminishing returns once he has to use more than one pickup truck.

Diminishing returns arise when an important factor or input is fixed, in that it cannot be
increased along with other factors. Economists believe that just about any business is
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subject to diminishing returns at some point. However, many businesses have increasing
returns at normal levels of output.

Substitution

Suppose that there are two types of lawnmowers--economy and deluxe. With the
economy lawnmower, Josh can mow 800 lawns in a season. With the deluxe lawnmower,
he can mow 840 lawns in a season. At $25 a lawn, the deluxe lawnmower is worth $1000
more for a season. If the economy lawnmower costs $300 to lease and the deluxe
lawnmower costs $800 to lease, he should go for the deluxe lawnmower. However, if the
deluxe lawnmower costs $1500 to lease, Josh should stick with the economy lawnmower.

The decision of which lawnmower to use is an example of substitution. If the price is


right, Josh will substitute the deluxe lawnmower for the economy lawnmower.

Another type of substitution involves capital and labor. Suppose that Josh runs his
business with four workers (including himself) and four lawnmowers. What would make
him use five workers and three lawnmowers, or vice-versa?

Suppose that a worker needs a lawnmower to be productive, and that lawnmowers


sometimes break down. It might be worthwhile for Josh to have spare lawnmowers and
fewer workers, so that workers never have to sit idle because of mechanical failure.

Alternatively, suppose that lawnmowers are very costly to lease, but that labor is
inexpensive. Josh might want to have more workers than lawnmowers, so that when one
worker is taking a break that worker's lawnmower is used by another worker. That way,
lawnmowers never sit idle.

Josh's decisions about substitution between capital and labor will depend on two general
factors.

1. Technology.

Different combinations of workers and lawnmower will produce different levels of output
in terms of lawns mowed. The results of different combinations of labor and capital
constitute the technology that is available to Josh.

2. Relative prices.

The wages of workers and the leasing cost of different lawnmowers help determine
whether Josh wants to use more or less of either input. A higher hourly wage rate would
lead Josh to use less labor and more capital. A higher leasing cost would lead him to use
less capital and more labor. The ratio of the leasing cost to the wage rate is called
a relative price.
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VI. THEORY OF COST

The burden sustained in order to perform a certain activity, to carry out a certain
production, to achieve certain goals.

In a balance sheet, costs raise commercial liabilities to be settled. They should not be
confused with money outflows.

By contrast, in economics, most formal models ignore this distinction between costs
and payments.

Cost categories

Actual costs refer to real transactions, wherease opportunity costs refer to the
alternative taken into consideration by decision makers who might want to choose the
line of activity which minimise the costs. From an external point of view, it is difficult to
ascertain which are the alternative considered.

Discretionary costs are not strictly necessary for current production but correspond to
strategic goals (e.g. improving the firm's image through an advertising institutional
campaing).

Attributed costs are computed values from accountancy that are conventionally
attributed to products as part of the process trying to establish profitable prices by
appropriate routines.

Production costs

Given a specific product version, production costs are usually classified according to their
responsiveness to different levels of production attained.

Fixed costs are simply not responsive to production levels.

If there are only fixed costs, the total costs follow this rule:

For instance, the cost of renting an office is a fixed cost, since usually the contract
fixes it for a certain period of time (say one year), without any reference to the income
produced by the operations that take place in the same office.
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The firm deciding to rent this office, however, will have usually expected to be able to
afford it as well as to be reasonably sure that it will not be too small for the kind of
operation it intends to carry out.

This brings us to an important conclusion: a very common situation is that of quasi-


fixed costs. They are flat in a certain range of (expected) production but they are forced
to jump to higher levels if certain thresholds are overcome. Near these thresholds, in fact,
quality deterioration of output and other negative phenomena take place.

Symmetrically, below other minimum thresholds in level of activities, the same costs
become unaffordable and will probably be reduced. Here you have the graph of total
costs when there are only quasi-fixed costs:

Variable costs grow with higher levels of production (proportionally or not). If there
are only variable costs, at zero production the total costs will be zero. Total costs will
follow for instance this rule:

In particular, economies of scale describe situation when the total costs rise less than
proportionally to production increases, as you see in the following diagram:

Dis-economies of scale represent the opposite situation:


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Constant return to scale are the intermediate situation in which the growth in
production is exactly matched by the same percentage increase in total costs,
i.e. elacticity of costs to production levels is 1:

In this case, productivity is constant.

To understand the sources of economies of scale is helpful to consider that total


costs for production inputs depends on two components: the quantity and the price of
the inputs.

Accordingly, it is often useful to distinguish two broad reasons for cost to rise: an
increase of the input quantity or a soaring price for input. This allow for distinguishing
different reasons for costs behaviours in reaction to changes in production levels.

In particular, economies of scale can be due:

a) to savings in average physical quantity of input when the production is higher (e.g.
electricity dispersion is lower in percentage when the electricity throughput is high);

b) to reduction in prices paid when buying larger quantities (e.g. because of stronger
power in purchase negotiation).

If sales increase, variable costs rise and fixed costs remain the same. To make
experiments with different situations, you can use the free Costs software, distributed by
the Economics Web Institute.

Total and average costs

Total costs are the sum of all costs. By dividing the total costs by the quantity produces,
one gets the average costs: how much a unit of production costs ("unit cost").

Average costs can be directly compared with price to compute profitability: if the
price is higher than average cost, the production is profitable.
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Total profits will be given by multiplying the average profit with the quantity
produced and sold.

Identically, total profits can be obtain as total revenues less total costs.

The relationship between total revenue and total costs depending on the production
level is analysed by the so-called "break-even analysis".

Let's see mathematically what component crucially influences average costs at two
widely different levels of production.

In the simplified situation of a production process characterised by a fixed cost


(F) plus a proportionally-growing variable cost (VC), total costs (TC) are described
by the easy formulas below:

TC = F + VC×q

where q is the quantity of good.

Average costs (AC) are thus the following:


AC= TC/q = F/q + VC

The first term of the right side (F/q) decreases systematically the higher the production
level (q). At low production levels, this reduction is quantitatively relevant wherease for a
high q it is not.

In fact, for high q, the average cost is practically equal to variable cost VC.

i) Concept of Costs

Opportunity Cost
The resources of any firm operating in the market are limited and investment options are
many. The firm therefore has to decide or select only those investment
opportunities/options which provide the firm with the best return or best income on
investment. This means that if a firm can invest money/ resources only in one investment
option then the firm will select that investment option which promises best return on
investment to the firm. In other words while doing so the firm gives up/rejects the next
best option for investing the funds. The opportunity cost of a company is thus this
income/ return which the firm could have earned on the next best investment alternative.
This can also be understood by a simple example - Let us assume that an individual has
two job offers in hand. One job offer is promising him a salary of Rs. 30, 000 per month
while the other job offer will ensure salary of Rs. 25, 000 per month. If the job profile and
other factors related to the job offers are more or less same then it can be easily expected
that the individual will select the job offer which will provide him with higher salary that
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is salary of Rs. 30, 000 per month. Thus, in this case, the opportunity cost is the return
involved in the next best alternative i.e; Salary of Rs. 25, 000 in the next best job offer.
Concept of opportunity cost is closely related to the concept of Economic profit or
Economic Rent. A firm earns or makes Economic profit only when besides covering
various costs of operation, a firm is also able to earn more than its opportunity cost (or its
possible earnings under the next best investment alternative). Opportunity Cost is also
termed as Implicit Cost.
Economic Profit is thus earned only when following is true for the Firm:
Income of a Firm > Various Costs of Operations + Opportunity Cost
OR Economic Profit = Earnings or Revenue of Firm - Ecomomic Costs. Here
Economic Cost is various expenses of the business plus the opportunity cost
Some simple examples of Opportunity Cost and Economic Profit are discussed in
following three brief case studies.
Understanding Opportunity Cost and Economic Profit

 CASE 1: Mr. Subodh has two job opportunities in hand. First job opportunity can
help him to earn Rs. 20, 000 per month and the second opportunity can get him Rs.
17, 000 per month. Under normal circumstances Mr. Subodh will opt for the job
opportunity which can help him to earn Rs. 20, 000 per month. In the process Subodh
rejects the other job opportunity which can help him to earn Rs. 17, 000 per month. In
this case Opportunity cost of Mr. Subodh is Rs. 17, 000 per month as this is the
income which the can be earn from the next best alternative.

In above case Economic Profit or Economic Rent is Rs. 3, 000. This has been
obtained after deducting Rs. 17, 000 (opportunity cost) from Rs. 20, 000

 CASE 2: Miss. Kanta can invest her money under the following two investment
options (a) Investment in Shares. Such Investment (investment made in the shares) is
likely to provide Miss Kanta with return of 20% per annum. (b) Investment in
Government Bonds which can provide Miss. Kanta with return of 10% per annum on
the amount invested in the bonds. If it is assumed that risk involved in investing in the
stocks/shares is very moderate then Miss. Kanta will most likely invest in shares (on
account of higher return on investment in shares in comparison to the bonds. In this
case the opportunity cost is the return of 10% per annum, which can be earned by
Miss Kanta in the next best investment alternative

 CASE 3: A Company 'Venus Automobiles limited', involved in the production of


two and three wheeler automobiles, is thinking of diversifying its business operations.
There are two diversification options the company can choose between. One option is
that the company can open company owned and opearted automobile service stations
and the other option is that company can enter into the business of producing
automobile spare parts. If it is expected that option of opening the company owned
and operated service stations will generate an additional profit (post charging various
expenses) of Rs. 9 million for the company while the option of production of spare
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parts will generate profit of Rs. 10 million for the company. As expected profit after
charging various expenses is higher in the automobile spare part business, the
company will choose to diversify in the spare part business. Thus, in this case, the
opportunity cost will be the profit of Rs. 9 million, which the company is expected to
earn in the nest best alternative that is starting company owned and operated service
station business

For the above case, let us assume, that the company actually earns accounting profit
of Rs. 9.8 million on its business of producing and marketing automobile spare
parts. The Economic Profit or Economic Rent then will be the amount of Rs. 0.8
million obtained after deducting Rs. 9 million (opportunity cost) from Rs. 9.8 million
(profit earned)
Money Cost and Real Cost

Money Cost of production is the actual monetary expenditure made by company in the
production process. Money cost thus includes all the business expenses which involve
outlay of money to support business operations. For example the monetary expenditure
on purchase of raw material, payment of wages and salaries, payment of rent and other
charges of business etc can be termed as Money Cost.
Real Cost of production or business operation on the other hand includes all such
expenses/costs of business which may or may not involve actual monetary expenditure.
For example if owner of a business venture uses his personal land and building for
running the business venture and he/she does not charge any rent for the same then such
head will not be considered/included while computing the Money Cost but this head will
be part of Real Cost computation. Here the cost involved is the Opportunity Cost of the
land and building. If the promoter of the company had not used the land and building for
the business venture then the land and building could have been used elsewhere for some
other enture and could have generated some income for the promoter. This income/rent
which could have been earned under the next best investment option is the opportunity
cost which needs to be considered while calculating the Real Cost for the firm.
Private Cost and Social Cost

The actual expenses of individuals/ firms which are borne or paid out by the individual or
a firm can be termed as Private Cost. Thus for a business firm this may include expenses
like Cost of Raw Material, Salaries and Wages, Rent, Various Overhead Expenses etc.
On the other hand Private Cost for an individual will be his or her private expenses such
as expense on food, rent of house, expenses on clothing, expenses on travel, expenses on
entertainment etc.
Social Cost on the other hand includes Private Cost and also such costs which are not
borne by the firm but by the society at large. For example the cost of damage or disutility
caused by the operations of a firm in an economy may not be borne by the firm in
question but it impacts the society at large and thus such cost is added to the Private Cost
to find the Social Cost of producing the product. Such Cost (that is cost not borne or paid
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out by the firm) is also known as External Cost. Another example of external cost can be
the cost of providing the basic infrastructure facilities like good roads, sewage system or
network, street lights etc. Cost of such facilities is not borne by a business firm even
though the firm is benefits from such facilities. Such costs (External Costs) are thus
added to the Private Cost to find the Social Cost of producing a product or good.
Above can be understood by following example: If a Tannery firm (A firm processing
animal skins) releases its toxic wastes in the river flowing nearby its factory premises
then this act of the Tannery firm results in water pollution and environmental damage.
The Cost of such damage/loss (also known as External Cost) is added to the private costs
of the tannery firm to get fair idea of Social cost involved in the production of the product
in question.
Social Cost of an individual will include his private cost and the cost of damage on
account of his actions (that has resulted in doing harm/damage to the environment/society
at large).

Fixed Cost, Variable Cost, Average Cost and Marginal Cost

Fixed Cost is that cost which does not change (that is either goes up or goes down)
irrespective of whether the firm is operating or not. For example on account of Strike on
account of Lockout in Maruti-Suzuki’s Manesar plant the production process stands still.
Even when the plant is not operating the Firm still has to bear such expenses which are
indirect in nature. For Example Rent of the factory premises, Wages of administrative
employees etc. In other Fixed cost is not related direct production/manufacturing
expenses.
Variable Cost on the Other hand is directly proportional to the production operations. As
the size of production at any business grows, along with that grow the variable expenses.
As the name suggests, the variable expenses vary with the business operations. When the
firm is not operating on account of Strike/Lockout etc, then the variable cost of the firm is
Zero
Average Cost is the cost that is obtained after dividing Total Cost with the number of
units produced.

 Total Cost = Fixed Cost + Variable Cost


 Average Cost = Total Cost / Units of Good produced

Marginal Cost is the change in the Total cost when an additional unit of good is produced.
In other words Marginal Cost is difference between total Cost of producing ‘N + 1’ units
of good and ‘N’ units of good.

 Marginal Cost = TC (n+1) - TC(n)

Following table can help in understanding the cost concepts like Total Cost (TC),
Average Cost (AC), Marginal Cost (MC) etc
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Understanding Fixed, Variable, Total, Average and Marginal Cost

Number of
Fixed Variable Total Average Marginal
Units
Cost Cost Cost Cost Cost
Produced

1 10 5 15 15 15

2 10 10 20 10 5

3 10 17 27 9 7

4 10 30 40 10 13

5 10 45 55 11 15

In the above table, it is clearly visible that Fixed cost (which is 10) remains same
irrespective of the number of units of the good being produced. On the other hand the
Variable Cost is increasing as the number of units of good being produced is increasing.
Thus, Variable Cost is going up from 5 to 10 and from 10 to 17 etc as the number of units
of good being produced is increasing. Again it can be seen from the above table that Total
Cost is the sum total of Fixed Cost and Variable Cost. Thus Total Cost is 15 for the first
unit (where 10 is Fixed Cost and 5 is Variable Cost). Again for producing 2 units, the
Total Cost is 20 (where 10 is Fixed Cost and remaining 10 is the Variable Cost). Above
Table also clearly indicates that the Average Cost is being obtained by dividing Total Cost
with the number of units of good being produced. Thus for the first unit of good being
produced it is 15. This value has been obtained by dividing Total Cost (15) with the
number of units of good produced (1). Similarly, the Average Cost of producing two units
is 10, which is obtained by dividing Total Cost (20) with number of units produced (2).
On the other hand Marginal Cost is the change in the total cost when an additional unit of
good is being produced. Thus for the first unit of good being produced, it is 15. This
value is obtained by deducting from the Total Cost of producing 'One' unit of good (15)
the Total Cost of producing 'Zero' units of good. For producing the second unit, the
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marginal cost is 5. This is obtained by deducting from the Total Cost of producing 'two'
units of good (20) the Total Cost of producing 'one' unit of good (15)

Summary of Cost Concepts


Various cost concepts help in understanding the business operations and cost involved in
business operation of the firms better. For example opportunity cost is the return involved
in the next best alternative. Social cost is the cost of damage caused by a business
firm/individual to society at large. Private cost are the varied business expenses which a
firm/individual has to bear on account of its business/personal operations pertaining to
the business of the firm.
Points to Remember are as follows:

 The opportunity cost of a company is thus this income/ return which the firm can
earn on the next best investment alternative.
 Money Cost of production is the actual monetary expenditure made by company
in the production process. Money cost thus includes all the business expenses which
involve outlay of money to support business operations.
 Real Cost of production or business operation includes all such expenses/costs of
business which may or may not involve actual monetary expenditure. Economic cost
includes all the accounting expenses and the Opportunity cost or implicit cost of the
business.
 The actual expenses of individuals/ firms in the market can be termed as private
cost. Thus for a business firm this may include expenses like Cost of raw material,
salaries and Wages, Rent, Various overhead expenses etc. For an individual his/her
private expenses can be expenses on food, rent of house, expenses on clothing,
expenses on travel, expenses on entertainment etc can be considered as Private Costs.
 Social Cost on the other hand includes the private costs of individuals and firms
and also the cost of damage/disutility caused by the operations of individuals and the
business firms. For example is a Tannery releases its toxic wastes in the river flowing
nearby then such act results in water pollution and environmental damage. Such
damage/loss/cost is added to the private costs to get fair idea of Social cost.
 Fixed Cost: Fixed Cost is that cost which does not change (that is either goes up
or goes down) irrespective of whether the firm is operating or not.
 Variable Cost on the Other hand is directly proportional to the production
operations. As the size of production at any business grows, along with that grow the
variable expenses. As the name suggests, the variable expenses vary with the business
operations. When the firm is not operating on account of Strike/Lockout etc, then the
variable cost of the firm is Zero
 Average Cost on the other hand is the cost that is obtained after dividing Total
Cost with the number of units produced.
 Marginal Cost is the change in the Total cost when an additional unit of good is
produced. In other words Marginal Cost is difference between total Cost of producing
‘N + 1’ units of good and ‘N’ units of good.

ii) Short run Cost Theory


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A famous statement made by celebrated economist J.M. Keynes states that "In the Long
Run we are all dead". Thus, while undergoing any learning on microeconomic theory it
becomes important for us to know that what is meant by the terms Short Run and
the Long Run in economic theory.
'Short Run' is the time period in which if a firm wishes to increase its output it can do so
by changing only certain variable inputs or factors of production like Labour, Raw
material etc while certain other nputs or factors of production like Capital.
Short run is the time period during which if a firm wishes to increase its output then it can
do so only by changing the variable factors ( like Labor). Other factors (like capital)
remain fixed in the short run or in other words cannot be varied on account of time
limitation applicable on the company.
Types of Short Run Cost Functions

Linear Cost Function


In case, for a firm or a company, its variable cost changes in the same proportion as the
output of the firm, then a straight line or linear relationship is observed between the
output generated by the firm and the cost involved in the producing the same. It is
possible for us to express this relationship by using the mathematical equation of a
straight line. This can be as follows:
For the above equation following terms mean as follows: TC = Total
Cost, a and b are constant. Q is the Quantity Produced.
Here, the constant ‘a’ indicates the value of total cost when the output of the firm is
zero. This value of total cost will be equal to the fixed cost of the firm as at this point
the variable cost of the firm will be zero as the output of the firm is zero. On the
other hand constant ‘b’ indicates the slope of straight line curve depicting the
relationship between the cost and the output.
The linear relationship existing between Cost and Output is exprssed in the following
table:
Quantity'Q' FC VC TC=FC+VC AFC=FC/Q AVC=VC/Q ATC=TC/Q
0 10 0 0 0 0 0 0
1 10 2 12 10.0 2 12.0 2
2 10 4 14 5.0 2 7.0 2
3 10 6 16 3.33 2 5.33 2
4 10 8 18 2.5 2 4.5 2
5 10 10 20 2.0 2 4.0 2
6 10 12 22 1.67 2 3.66 2
7 10 14 24 1.43 2 3.42 2
8 10 16 26 1.25 2 3.25 2
9 10 18 28 1.11 2 3.11 2
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10 10 20 30 1 2 3.0 2

In the above table 'Q' is the quantity produced


FC is Fixed Cost
VC is Variable Cost
TC is Total Cost (Which is FC + VC)
AFC is Average Fixed Cost obtained by dividing FC with Q
AVC is Average Variable Cost obtained by dividing VC with Q
ATC is Average Total Cost obtained by dividing TC with Q and
MC is Marginal Cost obtained by subtracting the Total Cost of producing 'n' number of
goods from the Total Cost of producing 'n = 1' number of goods
The diagrammatic representation of such a straight line cost curve will be as
follows:

The diagrammatic representation of the Average Cost and the Marginal Cost for the
Linear Cost function will be as follows:

Quadratic Cost Function


A Quadratic Cost function can be mathematically depicted as follows:
In the above stated Quadratic equation ‘a' is constant indicating the value of total cost
when the output of the firm is zero. The value of total cost in such a case will be equal to
the fixed cost of the firm as at this point the variable cost of the firm will be zero. While,
the constants ‘b’ and ‘c’, indicate the slope of the quadratic cost function. A Quadratic
Cost function can be expressed as follows:

Quantity'Q' FC VC TC=FC+VC AFC=FC/Q AVC=VC/Q ATC=TC/Q


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0 10 0 0 0 0 0 0
1 10 4 14 10.0 4 14.0 4
2 10 10 20 5.0 5.0 10.0 6
3 10 17 27 3.33 5.66 9 7
4 10 26.4 36.4 2.5 6.6 9.1 9.4
5 10 37 47 2.0 7.4 9.4 10.6
6 10 50 60 1.67 8.33 10.0 13
7 10 67 77 1.43 9.57 11 17
8 10 92 102 1.25 11.5 12.75 25
9 10 132 142 1.11 14.66 15.77 40

In the above table 'Q' is the quantity produced


FC is Fixed Cost
VC is Variable Cost
TC is Total Cost (Which is FC + VC)
AFC is Average Fixed Cost obtained by dividing FC with Q
AVC is Average Variable Cost obtained by dividing VC with Q
ATC is Average Total Cost obtained by dividing TC with Q and
MC is Marginal Cost obtained by subtracting the Total Cost of producing 'n' number of
goods from the Total Cost of producing 'n = 1' number of goods
The digramtic representation of Quadratic Cost function can be as follows:

The shape of Average cost curve and the Marginal cost curve under the Quadratic Cost
function can be as follows:

Cubic Cost Function


The Cubic Cost function can be mathematically depicted
as follows:
If the cost function is Cubic then following can be the shape of the TC (Total Cost),
FC (Fixed Cost) and the TVC (Total Variable Cost) curves:

In the above diagram, the shape of the total variable cost curve is like inverse ‘S’. This
shape indicates that if more and more of the variable factor is applied to the fixed factor
then the output of the firm initially increases at an increasing rate then at a constant rate
and finally it starts to diminish. Please refer to the On account of the above the Average
Variable cost initially decreases, reaches its minimum
and finally it starts to increase again. This also results in
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the increase in the Total Variable Cost and the Total Cost at a diminishing rate initially,
then at a constant rate at finally at an increasing rate
The shape of the ATC (Average Total Cost), MC (Marginal Cost) and AVC (Average
Variable Cost) curves under the Cubic Cost function will be as follows:

The above depicted Cubic Cost Function can also be explained by using the following
Cost values as stated in the following table:
Again, in the above table 'Q' is the quantity produced
FC is Fixed Cost
VC is Variable Cost
TC is Total Cost (Which is FC + VC)
AFC is Average Fixed Cost obtained by dividing FC with Q
AVC is Average Variable Cost obtained by dividing VC with Q
ATC is Average Total Cost obtained by dividing TC with Q and
MC is Marginal Cost obtained by subtracting the Total Cost of producing 'n' number of
goods from the Total Cost of producing 'n = 1' number of goods
Shape of the Long run Average Cost.

Long Run Costs

Long run costs are accumulated when firms change production levels over time in
response to expected economic profits or losses. In the long run there are no fixedfactors
of production. The land, labor, capital goods, and entrepreneurship all vary to reach the
the long run cost of producing a good or service. The long run is a planning and
implementation stage for producers. They analyze the current and projected state of the
market in order to make production decisions. Efficient long run costs are sustained when
the combination of outputs that a firm produces results in the desired quantity of the
goods at the lowest possible cost. Examples of long run decisions that impact a firm's
costs include changing the quantity of production, decreasing or expanding a company,
and entering or leaving a market.

Short Run Costs

Short run costs are accumulated in real time throughout the production process. Fixed
costs have no impact of short run costs, only variable costs and revenues affect the short
run production. Variable costs change with the output. Examples of variable costs include
employee wages and costs of raw materials. The short run costs increase or decrease
based on variable cost as well as the rate of production. If a firm manages its short run
costs well over time, it will be more likely to succeed in reaching the desired long run
costs and goals.

Differences

The main difference between long run and short run costs is that there are no fixed factors
in the long run; there are both fixed and variable factors in the short run . In the long run
the general price level, contractual wages, and expectations adjust fully to the state of the
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economy. In the short run these variables do not always adjust due to the condensed time
period. In order to be successful a firm must set realistic long run cost expectations. How
the short run costs are handled determines whether the firm will meet its future
production and financial goals.

Economics and Diseconomics of Scale

Economies of scale – As the production increases, efficiency of production also


increases. . The advantages of large scale production that result in lower unit (average)
costs (cost per unit) is the reason for the economies of scale is that the total costs are
shared over the increased output.

There are two types of economies of scale:

1.Internal economies of scale


2.External economies of scale

Internal economies of scale refers to the advantages that arise as a result of the growth
of the firm. hen a company reduces costs and increases production, internal economies of
scale have been achieved.
Internal economies of scale relate to the lower unit costs a single firm can obtain by
growing in size itself. There are five main types of internal economies of scale.

Bulk-buying economies

As businesses grow they need to order larger quantities of production inputs. For
example, they will order more raw materials. As the order value increases, a business
obtains more bargaining power with suppliers. It may be able to obtain discounts and
lower prices for the raw materials.

Technical economies

Businesses with large-scale production can use more advanced machinery (or use existing
machinery more efficiently). This may include using mass production techniques, which
are a more efficient form of production. A larger firm can also afford to invest more in
research and development.

Financial economies

Many small businesses find it hard to obtain finance and when they do obtain it, the cost
of the finance is often quite high. This is because small businesses are perceived as being
riskier than larger businesses that have developed a good track record. Larger firms
therefore find it easier to find potential lenders and to raise money at lower interest rates.

Marketing economies

Every part of marketing has a cost – particularly promotional methods such as advertising
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and running a sales force. Many of these marketing costs are fixed costs and so as a
business gets larger, it is able to spread the cost of marketing over a wider range of
products and sales – cutting the average marketing cost per unit.

Managerial economies

As a firm grows, there is greater potential for managers to specialise in particular tasks
(e.g. marketing, human resource management, finance). Specialist managers are likely to
be more efficient as they possess a high level of expertise, experience and qualifications
compared to one person in a smaller firm trying to perform all of these roles.

External economies of scale

External economies of scale refers to the advantages firms can gain as a result
of the growth of the industry. It is normally associated with a particular area. External
economies of scale occur outside of a firm, within an industry. Thus, when an industry's
scope of operations expands due to, for example, the creation of a better transportation
network, resulting in a subsequent decrease in cost for a company working within that
industry, external economies of scale are said
to have been achieved.

External economies of scale occur when a firm


benefits from lower unit costs as a result of the
whole industry growing in size. The main
types are:

Transport and communication links improve

As an industry establishes itself and grows in a


particular region, it is likely that the
government will provide better transport and
communication links to improve accessibility to the region. This will lower transport
costs for firms in the area as journey times are reduced and also attract more potential
customers.

Training and education becomes more focused on the industry

Universities and colleges will offer more courses suitable for a career in the industry
which has become dominant in a region or nationally.

Other industries grow to support this industry

A network of suppliers or support industries may grow in size and/or locate close to the
main industry. This means a firm has a greater chance of finding a high quality yet
affordable supplier close to their site.

Diseconomies of scale
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Economic theory predicts that a firm may become less efficient if it becomes too large.
The additional costs of becoming too large are called diseconomies of scale.

Diseconomies of scale result in rising long run average costs which are experienced when
a firm expands beyond its optimum scale, at Q.

Examples of diseconomies include:

1. Larger firms often suffer poor communication because they find it difficult to
maintain an effective flow of information between departments, divisions or between
head office and subsidiaries. Time lags in the flow of information can also create
problems in terms of the speed of response to changing market conditions. For
example, a large supermarket chain may be less responsive to changing tastes and
fashions than a much smaller, ‘local’ retailer.
2. Co-ordination problems also affect large firms with many departments and divisions,
and may find it much harder to co-ordinate its operations than a smaller firm. For
example, a small manufacturer can more easily co-ordinate the activities of its small
number of staff than a large manufacturer employing tens of thousands.

3. ‘X’ inefficiency is the loss of management efficiency that occurs when firms become
large and operate in uncompetitive markets. Such loses of efficiency include over
paying for resources, such as paying managers salaries higher than needed to secure
their services, and excessive waste of resources. ‘X’ inefficiency means that average
costs are higher than would be experienced by firms in more competitive markets.

4. Low motivation of workers in large firms is a potential diseconomy of scale that


results in lower productivity, as measured by output per worker.

5. Large firms may experience inefficiencies related to theprincipal-agent problem. This


problem is caused because the size and complexity of most large firms means that
their owners often have to delegate decision making to appointed managers, which
can lead to inefficiencies. For example, the owners of a large chain of clothes
retailers will have to employ managers for each store, and delegate some of the jobs
to managers but they may not necessarily make decisions in the best interest of the
owners. For example, a store manager may employ the most attractive sales assistant
rather than the most productive one.

Economies of Scale
In their most basic form, economies of scale refer to the idea that as more products are
produced the marginal cost, or cost per unit, decreases because of increased efficiencies.
Overhead costs can be shared over more products. Often the desire for economies of scale
drives an organization to become larger or to merge with a like-minded company, which
can bring additional efficiencies or opportunities. But economies of scale have their
limits.
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Diseconomies of Scale
Diseconomies of scale come about when a business or organization becomes so big, or so
inefficient, that the cost-per-unit of its products and services starts to rise A business can
only grow so much before the benefits of growth begin to create additional costs and
resources. Additional output becomes more expensive. Complexities take over and
bureaucracies dominate. A good thing has turned sour. Thus, the goal for business and
other organizations is to find the point of equilibrium in which economies of scale thrive
and stave off the diseconomies.