Managerial Economics

Unit 1
Introduction to Managerial Economics

Economic principles assist in

rational reasoning and
defined thinking. They develop logical ability and
strength of a manager.
According to Spencer: “Managerial
economics is the integration of economic
theory with business practice for purpose
of facilitating decision making and
forward planning by management”.
Scope of Managerial Economics

1.Demand Analysis & Forecasting: A major part of

managerial decision making depends on accurate
estimates of demand. By forecasting future sales manager
prepares production schedules and employ resources
which helps mgt. to strengthen its market position & profit.

2.Cost & production Analysis: Amanager prepare cost

estimates of a range of output, and choose the optimum
level of output at which cost is minimized. Manager is
supposed to carry out the production function analysis to
avoid wastage of materials & time
3.Pricing Decisions: Success of a business firm depends upon
correct pricing policy decisions taken by it. Different pricing
method is used for various market structure, Cz price to a
great extent determines the revenue of the firm.

4.Profit Management: Aim of business firms is to earn profits

in long run. Profits are reward for uncertainty &risk bearing.
A manager should be able to take calculated risk & try to
avoid uncertainty for higher profits.

5.Capital Management: M.eco helps in planning & controlling of

capital expenditure since it involves huge amount of money &
time
 Relationship with other Disciplines.

1. Statistics & Economics: Statistical

techniques are very useful for collecting,
processing & analyzing business data,
testing & validity of economic laws before
they can be applied to business. Statistical
techniques like regression analysis,
forecasting is used in economics
2.Operation Research & Economics: OR is an
activity carried out by specialist within the firm
to help the manager to do his job of solving
decision problems.OR is also concerned with
model building but economic models are more
general &confined to broad decision making. OR
models like linear programming, queuing are
widely used in managerial economics.

3.Accounting & Economics: Accounting data &

statements reflect financial position, net loss or
net profit earned by a company. For decision-
making a manager should be familiar with
generation, interpretation & use of A/c data.
Mathematics & Economics: Managers have to
deal with quantitative concepts like demand, cost,
prices &wages. So knowledge of mathematical
concepts is imp to take decisions
5. Computers & Economics: Today each person is
dependent on computers. Managers depends on
comp for decision making. Through comp data is
presented in organized manner which facilitates
decision making.
The Important principles of managerial
economics are:

 Incremental Principle
 Equi-marginal Principle
 Opportunity Cost Principle

 Time Perspective
Principle
 Discounting Principle
 Incremental Principle

This principle states that a decision is said to be

rational and sound if given the firm’s objective of
profit maximization, it leads to increase in profit,
which is in either of two scenarios-
 If total revenue increases more than total cost
 If total revenue declines less than total cost
 Equi-marginal Principle

The laws of equi-marginal utility states that

a consumer will reach the stage of
equilibrium when the marginal utilities of
various commodities he consumes are equal.
The law of Equi-marginal utility

According to the modern economists,

this law has been formulated in form of
law of proportional marginal utility. It
states that the consumer will spend his
money- income on different goods in
such a way that the marginal utility of
each good is proportional to its price,
i.e.,
 Opportunity Cost Principle

Opportunity cost is one of the most

important and fundamental concepts in the
whole of economics. Given that we have
said that economics could be described as a
science of choice, we have to look at what
sacrifices we make when we have to make
a choice. That is what opportunity cost is
all about.
 Sacrifice of Alternatives
 Opportunity cost is the minimum price
that would be necessary to retain a
factor-service in it’s given use. It is also
defined as the cost of sacrificed
alternatives
 By opportunity cost of a decision is meant
the sacrifice of alternatives required by that
decision
 Time Perspective Principle

According to this principle, a manger should

give due emphasis, both to short- term and
long-term impact of his decisions, giving apt
significance to the different time periods
before reaching any decision
 Time periods
 Short-run refers to a time period in which some
 
factors are fixed while others are variable. The
production can be increased by increasing the quantity
of variable factors

long-run is a time period in which all

factors of production can become variable.
Entry and exit of seller firms can take place
easily
 Discounting Principle
According to this principle, if a decision
affects costs and revenues in long-run, all
those costs and revenues must be discounted
to present values before valid comparison
of alternatives is possible
 Discounting
 Discounting can be defined as a process
used to transform future rupees into an
equivalent number of present rupees.
 This is essential because a rupee worth of
money at a future date is not worth a rupee
today. Money actually has time value. For
instance, Rs.100 invested today at 10%
interest is equivalent to Rs.110 next year.
 Changes in DEMAND

1 Introduction

2. Meaning of Demand

3. Demand function

4. Types of Changes in Demand

5. Due to changes in Price

a) Extension of demand
b) Contraction of the demand

6.Due to changes in other factor

a) Increase in demand

b) Decrease in demand

7. Conclusions
 Changes in DEMAND

1. Introduction to demand
1. Introduction to demand
2. Meaning and definition of Demand
 2. Meaning and definition of Demand

The amount of a particular economic good or service that a

consumer or group of consumers will want to purchase at a
given price within a period of time.

In economics, demand is the desire to own , the ability to pay

for it, and the willingness to pay to buy a particular
commodity at Price within a given point of time.
3. Demand function
 3. Demand function

The demand function is the mathematical expression of the functional

relationship between the quantity of a good and those factors that affect
the willingness and ability of a consumer to buy the good.

Demand function > Qd = f(Px, Y , Pr, t, p, w, g, Ad, wealth, etc)

When these factor change the demand is also change.

4. Types of Changes in Demand
 4. Types of Changes in Demand

1. Due to changes in Price of the commodity

( Other factors remaining the same)

a) Extension of demand
b) Contraction of demand

2. Due to changes in other than Price – Shift in demand

( Price of the commodity remaining the same )

a) Increasing demand – Upward shift in demand

b) Decreasing in demand – Downward shift in demand
a) Extension of demand
 5. Due to changes in Price

1. Due to changes in Price of the commodity -

( Other factors remaining the same)

a) Extension of demand

Price Quantity

An extension of demand is an rise in the quantity 12,000 15 unit

demanded because the price has changed , other
factor reaming the same. 8,000 20 unit
 5. Due to changes in Price a) Extension of demand

Price Quantity

12,000 15 unit
Price of
good E1
P-12,000
8,000 20 unit

P-8,000
E2

Q -15 Q -20 E1 to E2
Quantity demanded

An extension of demand denote E1 to E2

is an rise in the quantity demanded because the price has changed
, other factor reaming the same.
a) Contraction of demand
 5. Due to changes in Price b) Contraction of demand

1. Due to changes in Price of the commodity ( Other factors remaining the same)
a) Extension of demand and

b) Contraction of demand

An CONTRACTION of demand is an fall in the quantity demanded because the

price has changed , other factor reaming the same.

Price Quantity

12,000 15 unit

15,000 10 unit
 Contraction of demand

E2 Price Quantity
P-15,000
E1
P-12,000 12,000 15 unit

Price of 15,000 10 unit

good

Q -10 Q -15

Quantity demanded

An CONTRACTION of demand is an fall in the quantity demanded

because the price has changed , other factor reaming the same.
 Extension of demand Contraction of demand

1. Are due to changes in Price of the commodity

2. The change taken place on the same demand curve – Movement along the
demand curve.
3. Leads to changes on quantity demanded
6.Due to changes in factors other than price
 6.Due to changes in factors other than price

2. Due to changes in other than Price – Shift in demand

( Price of the commodity remaining the same )

a) Increasing demand – Upward shift in demand

b) Decreasing in demand – Downward shift in demand

 2. Due to changes in other than Price – Shift in demand
( Price of the commodity remaining the same )

A shift in demand curve refers to the effect of in demand due to changes in

a factor other than price.

Shift in demand taken place due to the changes in

1. Income of the consumer

2. Price of related goods
3. Advertisement
4. Government policy
5. Taste and preference
6. etc
2. Due to changes in other than Price – Shift in demand
( Price of the commodity remaining the same )

a) Increasing demand – Upward shift in demand

b) Decreasing in demand – Downward shift in demand

a) Increase in demand
 a) Increase in demand

2. Due to changes in other than Price – Shift in demand

( Price of the commodity remaining the same )

a) Increasing demand – Upward shift in demand

•An increase in income of

the consumer E1
P-12,000
• High level of advertisement

Price of
good
Q -15

Quantity demanded
 a) Increase in demand

2. Due to changes in other than Price – Shift in demand

( Price of the commodity remaining the same )

a) Increasing demand – Upward shift in demand

Price of
good E1
E2
P-12,000

Q -15 Q -20

Quantity demanded
b) Decrease in demand
2. Due to changes in other than Price – Shift in demand
( Price of the commodity remaining the same )

a) Increasing demand – Upward shift in demand

b) Decreasing in demand – Downward shift in demand

 a) Increase in demand

2. Due to changes in other than Price – Shift in demand

( Price of the commodity remaining the same )

b) Decreasing demand – downward shift in demand

•A fall in in income of the

consumer E1
P-12,000
• Low level of advertisement

Price of
good
Q -15

Quantity demanded
 a) Increase in demand

2. Due to changes in other than Price – Shift in demand

( Price of the commodity remaining the same )

b) decreasing demand – downward shift in demand

Price of
good E2 E1
P-12,000

Q -10 Q -15

Quantity demanded
7. Conclusions
DEMAND FORECASTING
 Meaning & Definition of
Demand
Forecasting
Demand forecasting is a systematic process
that involves anticipating the demand for
the product and services of an
organization in future under a set of
uncontrollable and competitive forces.

Accurate demand forecasting is essential

for a firm to enable it to produce the
required quantities at the right time and
arrange well in advance for various inputs.
 Meaning & Definition of
Demand
Forecasting
In the words of Cundiff and Still, “Demand
forecasting is an estimate of sales during a
specified future period based on proposed
marketing plan and a set of particular
uncontrollable and competitive forces.”

Demand forecasting enables an organization to

take various business decisions, such as planning
the production process, purchasing raw materials,
managing
METHODS OF DEMAND
FORECASTING
A) Qualitative Techniques/ Opinion
Polling Method
-In this method, the opinion of the buyers, sales
force and expert could be gathered to determine
the emerging trend in the market.
- Suited for short term demand forecasting.
-Demand forecasting for new product can b made
by qualitative techniques.

The opinion polling methods of demand

forecasting are of following kinds:

1) Consumer Survey Method

2) Sales Force Opinion Method
3) Delphi Method
 1) Consumer Survey
Method
Survey method is one of the most common and direct
methods of forecasting demand in the short term. This
method encompasses the future purchase plans of
consumers and their intentions. In this method, an to
organization conducts surveys with consumers
determine the demand for their existing products and
services and anticipate the future demand accordingly.

Survey method include:

a) Complete Enumeration Survey
b) Sample Survey and Test Marketing
c) End Use
 1) Consumer Survey
Method
a) Complete Enumeration Survey:
In this method records the data & aggregates of
consumers
If the data is wrongly recorded than Demand Forecasting going
wrong, than this method will be totally useless.

b) Sample Survey & Test Marketing:

Only few customers selected and their views collected.
Based on the assumption that the sample truly
represents the population.
This method is simple and does not cost much
The main disadvantage is that the sample may not be a true
representation of the entire population.
 1) Consumer Survey
Method

c) End Use Method:

This method Focuses on Forecasting the demand
for
intermediary Goods.
Under this method, the sales of a Product are
projected through a survey of its end users.

Example:
Milk is a commodity which can be used as an
intermediary good for the production of ice cream,
and other dairy products.
 2) Sales Force Opinion
Method
-In this method , instead of consumers, the opinion of the
opinion of salesman is sought.
-It is also referred as the “grass root approach” as it is a
bottom- up method that requires each sales person in the
company to make an individual forecast for his or her
particular sales territory.
- The composite of all forecasts then constitutes the sales
forecast for the organisation.

-The main advantage is that the collecting data from its own
employees is easier for a firm than to do it from external
parties.
-The main disadvantage is that the sales force may give
biased views as the projected demand affects their future job
prospects.
 3) Delphi
Technique
This method is also known as expert opinion method.
In this method seeks the opinion of groups of Expert through
mail about the expected level of Demand.
The identity of expert is kept secret.
These opinion exchanged among the various experts and
their reactions are sought and analyzed.
The process goes on until some sort of unanimity is arrived at
among all the experts.

The advantage is that the forecast is reliable as it is based

on the
opinion of people who know the product very well.
The disadvantage is that the method is subjective and not
based on scientific analysis.
 B) Quantitative Techniques/
Statistical or Analytical
Methods
These are forecasting techniques that make use of historical
quantitative data.

A statistical concept is applied to the existing data in order to generate

the predicted demand in the forecast period.

The statistical methods, which are frequently used, for making

demand projection are:
1) Trend Projection Method
2) Barometric Method
3) Regression Method
4) Econometric Method
 1) Trend Projection
Method
-An old firm can use its own data of past years regarding sales in past years.
-These data are known as time series of sales.
-Assumes that past trend will continue in future.
-Past trend is extrapolated (generalised).

The trend can be estimated by using any one of the following methods:
a) Graphical Method
b) Least Square Method
c) Time Series Data
d) Moving Average Method
e) Exponential Smoothing
 1) Trend Projection
Method
a) Graphical Method:
A trend line can be fitted through a series graphically. The
direction of curve shows the trend.
The main drawback of this method is that it may show the trend but not
measure it.

b) Least Square Method:

 1) Trend Projection
Method
c) Time Series Data: a period of time recording historical
changes in price, income, and other relevant variables
Data collected over

 influencing demand for a commodity.

 Time series analysis relates to the determination of
changes in a variable in relation to time.

 d) Moving Average Method:

 The moving average of the sales of the past years is
computed. The computed moving average is taken as
forecast for the next year or period.
 This is based on the assumption that future sales are
the average of the past sales.
 1) Trend Projection
Method

e) Exponential Smoothing:
It uses a weighted average of past data as the basis for a
forecast.
The procedure gives heaviest weight to more recent
information and smaller weights to observations in the more
distant past.
The reason for this is that the future is more dependent on
the
recent past than on the distant past.
 2) Barometric
Method
In barometric method, demand is predicted on the basis of past
events or key variables occurring in the present.
This method is also used to predict various economic indicators,
such as saving, investment, and income.
This method was introduced by Harvard Economic Service in 1920
and further revised by National Bureau of Economic Research
(NBER) in 1930s.
This technique helps in determining the general trend of business
activities.
For example, suppose government allots land to the XYZ society
for constructing buildings. This indicates that there would be high
demand for cement, bricks, and steel.
The main advantage of this method is that it is applicable even in
the absence of past data.
 3) Regression
Method

This method is undertake to measure the relationship

between two variables where correlation appears to exist.

E.g. The age of the air condition machine and the annual repair
expenses.

This method is purely based on the statistical data.

 4) Econometric
Method

It is assumed that demand is determined by one or more

variables. E.g. income, population, etc.

Demand is forecast on the basis of systematic analysis of

economic relations by combining economic theory with
mathematical and statistical tools.
 Importance of Demand
Forecasting

1) Production Planning:
Expansion of output of the firm should be abased on the
estimates of likely demand, otherwise there may be
overproduction and consequent losses may have to be
faced.

2) Sales Forecasting:
Sales forecasting is based on the demand forecasting.
Promotional efforts of the firm should be based on the
sales forcasting
 Importance of Demand
Forecasting
3) Control of Business:
For controlling the business, it is essential to have a well
conceived budgeting of costs and profits that is based on
the forecast of annual demand.

4) Inventory Control:
A satisfactory control of business inventories, raw
materials, intermediate goods, finished product, etc.
requires satisfactory estimates of the future
requirements which can be traced through demand
forecasting.
 Importance of Demand
Forecasting

5) Economic Planning and Policy Making:

The government can determine its import and export
policies in view of the long-term demand forecasting for
various goods in the country.

6) Growth and Long- term Investment Programs:

Demand forecasting is necessary for determining the
growth rate of the firm and its long-term investment
programs and planning.
Law of Demand
 Concept of
Demand

Demand for a commodity refers to the desire to buy a commodity

backed with sufficient purchasing power and the willingness to spend.

For Example: You desire to have a Car, but you do not have enough
money to buy it. Then, this desire will remain just a wishful thinking, it will
not be called demand.

If inspite of having enough money, you do not want to spend it on Car,

demand does not emerge.

The desire become demand only when you are ready to spend money to
buy Car.
 Concept of
Demand

In Economics, demand refers to effective demand, which implies

three things:

a) Desire,
b) Means to purchase, and
c) On willingness to use those means for that purchase
 Demand & Quantity
Demanded

The term Demand refers to various quantities of commodity that the

consumer is ready to buy at different possible prices of a
commodity.

The term Quantity Demanded refers to a specific quantity to be

purchased against a specific price of a commodity.

Example: A Consumers’ Demand is 2 ice creams if the price per ice

cream is Rs.15, and 4 ice cream if the price per ice cream is Rs.10.

Quantity Demanded is 4 ice creams if price happens to be Rs. 10 per

ice cream.
 Demand Schedule & Demand
Curve

Demand Schedule is that schedule which expresses the relation

between different quantities of the commodity demanded at different
price.

According to Samuelson, “The table relating to price and quantity

demanded is called the demand schedule.

Demand Curve is simply a graphic representation of demand schedule.

According to Leftwitch, “The Demand Curve represents the maximum

quantities per unit of time that consumer will take at various prices.

Demand Schedule and Demand Curve are of two types

1) Individual Demand Schedule & Individual Demand Curve
2) Market Demand Schedule & Market Demand Curve
Individual Demand Schedule &
Individual Demand Curve
Refers to a tabular representation of quantity of products
demanded by an individual at different prices and time.
 Individual Demand Schedule &
Individual Demand Curve

It is seen that as the price of the commodity increases, quantity

demanded tends to decrease.

And when price falls, the quantity demanded increases.

In Figure points a, b, c, d, and e demonstrates the relationship

between price and quantity demanded at different price levels. By
joining these points, we have obtained a curve, DD, which is termed
as the individual demand curve.

The slope of an individual demand curve is downward from left

to right that indicates the inverse relationship of demand with
price.
 Market Demand Schedule & Market
Demand Curve
In every market, there are several consumers of a commodity. Market demand
schedule shows total demand of all the consumers in the market at different prices
of the commodity.
 Demand Function or
Determinants of
Demand

Demand Function shows the relationship between demand for a commodity

and its various determinants.
It shows how demand for a commodity is related to, say price of the commodity or
income of the consumer or other determinants.

There are two types of Demand Function:

a) Individual Demand Function

b) Market Demand Function

 Demand
Function
Individual Demand Function Market Demand Function

Individual Demand function shows Market Demand Function shows

how demand for a commodity, by how market demand for a
an individual consumer in the commodity (or aggregate demand
market, is related to its various for a commodity in the market) is
determinants. It is Expressed as: related to its various determinants.
Dx = f (Px, Pr, Y, T, E) Mkt. Dx = f (Px, Pr, Y, T, E, N, Yd)
Here, Dx: Quantity Demanded of commodity X
Px : Price of the Commodity X
Y : Consumer’s Income
T : Consumer’s Taste & Preferences
E: Consumer’s Expectations
N : Population Size
 Determinants of Demand / Factors
Affecting Demand

1) Price of the Commodity: The law of demand states that other things
being constant the demand of the commodity is inversly related to its
price. It implies that rise in price of commodity brings about a fall in its
purchase and vice versa.
 Determinants of
Demand /
2) Price of Related Goods:Factors
Demand for a commodity is also influenced by
change in price of related goods. These are of two types:
Affecting
a)Substitute Goods:Demand
These are he goods which can be substituted for
each other, such as tea and coffee, or ball pen and ink pen.

In case of such goods, increase in the price of one causes increase in the
demand for the other and decrease in the price of one causes decrease
in the demand for the other.
b) Complementary Goods: Complementary goods are those which
complete the demand for each other, and therefore, demanded together.

For Example Pen and ink, Car and Petrol.

In case of complementary goods, a fall in the price of one causes

increases in the demand for the other and rise in the price of one causes
decrease in the demand for others.
3) Income of the Consumer: The ability to buy a commodity depends upon
the income of the consumer. When the income of the consumer
increases, they buy more and when the income falls they buy less.

4) Expectations: If the consumer expects that price in future will rise, he

will buy more quantity in present, at the existing price.
likewise, if he hopes that price in future will fall, he will buy less quantity in
present, or may even postpone his demand.
5) Taste and Preferences: Taste and preferences include fashion, custom
etc. Taste and preferences can be influenced by advertisement, change
in fashion, climate, new inventions, etc.
Other thing being equal, demand for those goods increases for which
consumer develop tastes and preferences.
Contrary to it, if a consumer has no taste or preference for a product, its
demand will decrease.

Bell bottom
To Pencil
cut
6) Population Size: Demand increases with the increase in population and
decreases with decrease in population.
Composition of population (male, female ratio) also affects the demand.
E.g. Female population increases, demand for goods meant for women
will go up.

7) Distribution of Income: if income is equally distributed, there will be

more demand. If income is not equally distributed, there will be less
demand.
In case of unequal distribution, most will not have enough money to buy
things.
 Law of
Demand

The Law of Demand States that, other things being constant (Ceteris
Peribus), the demand for a good extends with a decrease in price and
contracts with an increase in price.

In other words, there is an inverse relationship between quantity

demanded of a commodity and its price.

The term other thing being constant implies that income of the consumer,
his taste and preferences and price of other related goods remains
constant.
 Assumptions Law of
Demand

1) Tastes and Preferences of the consumers remain constant.

2) There is no change in the income of the consumer.

3) Prices of the related goods do not change.

4) Consumers do not expect any change in the price of the commodity

in near future.
 Explanation
•
The table shows that when the price of say, orange,
is Rs. 5 per unit, 100 units are demanded. If the
price falls to Rs.4, the demand increases to 200
units.
 demand increases to
•
 In the figure, point.

This is clear from points Q, R, S, and T. Thus, the

demand curve DD1 shows increase in demand of
orange when its price falls. This indicates the inverse
relation between price and demand.

•
1) Law of Diminishing Marginal Utility:

According to this law, as consumption of a commodity increases, the

utility from each successive unit goes on diminishing to a consumer.

Accordingly, for every additional unit to be purchased, the consumer

is willing to pay less and less price.

Thus, more is purchased only when price of the commodity falls.

2) Income Effect:

Income effect refers to change in quantity demanded when real income of

the buyer changes as a result of change in price of the commodity.

Change in the price of a commodity causes change in real income of the

consumer.

With a fall in price, real income increases. Accordingly, demand for the
commodity expands.
3) Substitution Effect:

Substitution effect refers to substitution of one commodity for the other

when it becomes relatively cheaper.

Thus, when price of commodity X falls, it becomes cheaper in relation to

commodity Y. Accordingly, X is substituted for Y.
4) Size of Consumer Group:

When price of a commodity falls, it attracts new buyers who now can
afford to buy it.

5) Different Uses:

Many goods have alternative uses. Milk, for example, is used for making
curd, cheese and butter. If price of milk reduces its uses will expand.
Accordingly, demand for milk expands.
 Exception to the Law of
Demand

In certain cases, the demand curve slopes up from left to right, i.e., it has
a positive slope.

Under certain circumstances, consumers buy more when the price of a

commodity rises, and less when price falls. Many causes are attributed to
an upward sloping demand curve.
Exception to the Law of
Demand

1) Articles of Distinction: This exception was first of

all discussed by Veblen.

According to him, articles of distinction have more

demand only if their prices are sufficiently high.

Diamond, jewellery, etc; have more demand

because their prices are abnormally high. It is so
because distinction is bestowed in diamond,
jewellery etc., by the society because of their being
costly.

If their prices fall, they will no longer be considered

as articles of distinction and so their demand will
decrease.
 Exception to the Law of
Demand
2) The Giffen Goods:
A study of poor farmers of Ireland by Sir Giffen in the 19th century
revealed that the major portion of their income was spent on potatoes
and only a small amount was spent on meat.
Potatoes were cheap but meat was costly. When the price of potatoes tend to
increase consumption of meat was curtailed to economies their expenditure and
as a result of this they saved money and spent more on potato to meet their food
deficiency.
In this way quantity purchase rises even when prices of potatoes rises.

For Example, Suppose the minimum monthly consumption of food grains by a poor
household is 20 Kg Bajra (Inferior good) and 10 Kg Rice (superior good). The
selling price of Bajra is Rs 5 per kg, and the rice is Rs 10 per kg, and the
household spends its total income of Rs 200 on the purchase of these items.
Suppose, the price of Bajra rose to Rs 6 per kg then the household will be forced
to reduce the consumption of rice by 5 Kg and increase the quantity of Bajra to 25
Kg in order to meet the minimum monthly requirement of food grains of 30 kg.
 Exception to the Law of
Demand

3) Highly Essential Good:

In case of certain highly essential items
such as life- saving drugs, people buy a
fixed quantity at all possible price. Heart
patients will buy the same quantity of
‘medicine’ whether price is high or low. Their
response to price change is almost nil.

In cases of such commodities, the demand

curve is likely to be a vertical straight line .
At a price OP1, the heart patient consumer
demands OD amount of ‘medicine’. In spite
of its price rise to OP2, the consumer buys
the same quantity of it.
 Exception to the Law of
Demand

4) Emergencies: During emergencies such as war, natural calamity- flood,

drought, earthquake, etc., the law of demand becomes ineffective. In
such situations, people often fear the shortage of the essentials and
hence demand more goods and services even at higher prices.

5) Bandwagon Effect: This is the most common type of exception to the

law of demand wherein the consumer tries to purchase those
commodities which are bought by his friends, relatives or neighbors.
Here, the person tries to emulate the buying behavior and patterns of the
group to which he belongs irrespective of the price of the commodity
.For example, if the majority of group members have smart phones then
the consumer will also demand for the smartphone even if the prices are
high.
 Change in Quantity
Demanded &
Change in Demand
• In economics the terms change in quantity demanded and change in
demand are two different concepts.

• Change in quantity demanded refers to change in the quantity purchased

due to increase or decrease in the price of a product.

• In such a case, it is incorrect to say increase or decrease in demand rather

it is increase or decrease in the quantity demanded.

• On the other hand, change in demand refers to increase or decrease in

demand of a product due to various determinants of demand, while keeping
price at constant.
 Extension and Contraction of
Demand (Change In Quantity
Demanded)
• The variations in the quantities demanded of a product
with change in its price, while other factors are at
constant, are termed as expansion or contraction of
demand. Expansion of demand refers to the period
when quantity demanded is more because of the fall in
prices of a product. However, contraction of demand
takes place when the quantity demanded is less due to
rise in the price o a product.

• For example, consumers would reduce the

consumption of milk in case the prices of milk increases
and vice versa. Expansion and contraction are
represented by the movement along the same demand
curve. Movement from one point to another in a
downward direction shows the expansion of demand,
while an upward movement demonstrates the
contraction of demand.
Increase and Decrease in Demand
(Change in Demand)
• Increase and decrease in demand are referred to
change in demand due to changes in various other
factors such as change in income, distribution of
income, change in consumer’s tastes and preferences,
change in the price of related goods, while Price factor is
kept constant Increase in demand refers to the rise in
demand of a product at a given price.

• On the other hand, decrease in demand refers to the fall

in demand of a product at a given price.

• Increase and decrease in demand is represented as the

shift in demand curve. In the graphical representation of
demand curve, the shifting of demand is demonstrated
as the movement from one demand curve to another
demand curve. In case of increase in demand, the
demand curve shifts to right, while in case of decrease
in demand, it shifts to left of the original demand curve.
Change in Quantity Demanded &
Change in Demand
Law of Supply
 What is supply?
‘Supply refers to the quantity of a commodity
which producers or sellers are willing to
produce and offer for sale at a particular
price’, in a given market, at a particular period
of time
 The three important aspects of
supply are….

• Supply is a desired quantity

• Supply is always explained with reference to
price
• Time during which it is offered for sale
 Supply Schedule and Supply
Curve
Supply schedule shows a tabular representation of law of
supply. It presents the different quantities of a product that a
seller is willing to sell at different price levels of that product.

The graphical representation of supply schedule is called

supply curve.

Supply Schedule and Supply Curve are of two types

1) Individual Supply Schedule & Individual Supply Curve
2) Market Supply Schedule & Market Supply Curve
 Individual supply schedule &
Individual
Refers to a supply schedule that represents the different quantities of a product
Supply
supplied by an individual seller Curve
at different prices.

Price of Milk (Per Quantity

liter in Rs) Supplied (1000
per day in
liters)
10 10
12 15
14 20
16 25

The supply curve is showing a straight line and an upward slope. This implies that
the supply of a product increases with increase in the price of a product.
 Market Supply schedule &
Market
Refers to a supply schedule that represents the different quantities of a product
Supply
that all the suppliers in the market are Curve
willing to supply at different prices.

Price of Individual Supply Market

Product Supply
X
A B C
100 750 500 450 1700
200 800 650 500 1950
300 900 750 650 2300
400 1000 900 700 2600

Market supply curve also represents the direct relationship between the quantity
supplied and price of a product.
 Supply Function or Determinants
of Supply
Supply function studies the functional relationship between supply of a
commodity and its various determinants.

Sx = f ( PX, PR, NF, G, PF, T, EX, GP)

Where,
Sx = Supply of a Commodity
PX = Price of the Commodity
PR = Price of the Related Goods
NF = Number of Firms
G = Goal of the Firm
PF = Price of factors of Production
T = Technology
EX = Expected Future Price
GP = Government Policy
 Price of the
Commodity
There is a direct relationship between price of a
commodity and its quantity supplied. When price
increases, supply also increases because it motivate
the firm to supply more in order to get more profit.
When price decreases, smaller quantity will be
supplied as profit decreases.
 Price of Related
Goods
Producers always have the tendency of shifting from the
production of one commodity to another commodity. If the
prices of another commodity increases, especially substitute
goods, producers will find it more profitable to produce that
commodity by reducing the production of the existing
commodity.

For Example: Suppose the seller of tea notice that the price of
coffee increases . They may reduce the amount of resources
devoted to the selling of tea in favour of coffee.
 Number of
Firms
Market supply of a commodity depends upon
number of firms in the market.

Increase in the number of firms implies increase in

the market supply, and decrease in the number of
firms implies decrease in the market supply of a
commodity.
 Goal of the
Firm
If goal of the firm is to maximise profits, more
quantity of the commodity will be offered at a higher
price.

On the other hand, if goal of the firm is to maximise

sale more will be supplied even at the same price.
 Price of the Factor of
Production
Supply of a commodity is also affected by the price of factors
used for the production of the commodity.

If the factor price decreases, cost of production also reduces.

Accordingly, more of the commodity is supplied at its existing
price.

Conversely, if the factor price increases cost of production

also increases. In such a situation less of the commodity is
supplied at its existing price.
 Change in
Technology
Change in technology also affects supply of the commodity.

Improvement in the technique of production reduce cost of

production. Consequently, more of the commodity is supplied
at its existing price.
 Expected Future
Price
If the producer expects price of the commodity to rise in the
near future, current supply of the commodity will reduce.

If, on the other hand, fall in the price is expected, current

supply will increase.
 Government
Policy
‘Taxation and Subsidy’ policy of the government affects
market supply of the commodity.

Increase in taxation tends to reduce supply. On the other

hand, subsidies tend to increase supply of the commodity.
Law of
Supply
 THE LAW OF
SUPPLY
‘Law of supply states that other things remaining the same,
the quantity of any commodity that firms will produce and
offer for sale rises with rise in price and falls with fall in price.’

i.e. Higher the price, higher will be quantity supplied and

lower the price smaller will be quantity supplied.

‘Other things remaining the same’ means determinants other

than own price such as technology, goals of the firm,
government policy, price of related goods etc. should not
change.
 THE LAW OF
SUPPLY
Price of Rice Quantity
(Rs) Supplied (kg)
10 5
11 6
12 7
13 8
14 9
15 10
16 11
SS Slopes upward from left to right.
It shows positive relationship between price of the commodity
and its quantity supplied.
As price rises quantity supplied also rises.
 Assumptions of the Law of
Supply
• There is no change in the prices of the factors of production.

• There is no change in the technique of production.

• There is no change in the goal of firm.

• There is no change in the prices of related goods.

• Producers do not expect change in the price of the

commodity in the near future.
Elasticity of
Supply
 Elasticity of
Supply
The law of supply indicates the direction of change—if price
goes up, supply will increase. But how much supply will rise in
response to an increase in price cannot be known from the
law of supply.

To quantify such change we require the concept of elasticity

of supply that measures the extent of quantities supplied in
response to a change in price.
 Elasticity of
Supply
Elasticity of supply measures the degree of responsiveness of
quantity supplied to a change in own price of the
commodity. It is also defined as the percentage change in
quantity supplied divided by percentage change in price.

It can be calculated by using the following formula:

ES = % change in quantity supplied/% change in price
Symbolically,
ES = ∆Q/Q ÷ ∆P/P = ∆Q/∆P × P/Q
 Types of Elasticity of
Supply
Like elasticity of demand, there are five cases of E :
S

(a) Elastic Supply (ES>1):

(b) Inelastic Supply (ES< 1):

(c) Unit Elasticity of Supply (ES = 1):

(d) Perfectly Elastic Supply (ES = ∞):

(e) Perfectly Inelastic Supply (ES = 0):

 Perfectly Elastic Supply (ES =
∞)
The economic interpretation of this supply curve is that an
unlimited quantity will be offered for sale at the price OP. If
price slightly drops down below OP, nothing will be supplied.

 The supply curve PS1 drawn in

Figure has an elasticity of supply

equal to infinity. Here the supply
curve has been drawn parallel to the
horizontal axis.
 Perfectly Inelastic Supply (ES
= 0)
This curve describes that whatever
the price of the commodity, it may
even be zero, quantity supplied
remains unchanged at OQ. This sort
of supply curve is conceived when we
consider the supply curve of land
from the viewpoint of a country, or
the world as a whole.
 Unitary Elasticity of Supply (ES
= 1)
If price and quantity supplied change
by the same magnitude, then we
have unit elasticity of supply.

Any straight line supply Curve passing

through the origin, such as the one
shown in Figure, has an elasticity of
supply equal to 1. This can be verified
in this way.
 Relatively Elastic Supply
(E S >1)
Supply is said to be elastic when a
given percentage change in price
leads to a larger change in quantity
supplied. Under this situation, the
numerical value of Es will be greater
than one but less than infinity.

Here quantity supplied changes by a

larger magnitude than does price.
 Relatively Inelastic Supply (ES<
1)
Supply is said to be inelastic when a
given percentage change in price
causes a smaller change in quantity
supplied.

Figure depicts inelastic supply curve

where quantity supplied changes by
a smaller percentage than does price.
Measurement of Price
Elasticity of
Supply
Measurement of Price Elasticity of
Supply
This concept is parallel to the concept of price elasticity of
demand.

It points out the reaction of the sellers to a particular change in

the price of the commodity. It explains the quantitative changes
in supply of a commodity, due to a given change in the price of
the commodity.

Methods for Measuring Price Elasticity of Supply:

Price elasticity of supply can be measured by the following
methods:
1. Percentage Method
2. Geometric method
 1. Percentage
Method
Like elasticity of demand, the most
common method for measuring
price elasticity of supply (Es) is
percentage method. This method is
also known as ‘Proportionate
Method’.

According to this method, elasticity

is measured as the ratio of
percentage change in the quantity
supplied to percentage change in the
price.
 1. Percentage
For
Method
Example: A producer offers to sell 400 units of a
commodity when its price is Rs. 10 per unit, while only 200
units are offered if the price reduces to Rs. 5 per unit. Find
elasticity of supply.

Solution:
ES = Percentage Change in quantity supplied
Percentage change in Price

= 200 x 10
5 400
ES = 1
 2. Geometric
Method
This method studies five different situations of
`elasticity of supply as under:
(i) Es = 1, unitary elasticity: when a straight line upward
sloping supply curve starts from the point of origin. in this case
percentage change in quantity supplied is equal to the percentage
change in price
 (ii) Es >1 , or Greater unitary
Elasticity:
When a straight line upward sloping supply curve starts
from the percentage change in price . than Y-axis. In this
case , percentage change in quantity supplied is greater than
percentage change in price.
 (iii)Es<1, or Less that Unitary Elasticity:

When a straight line upward sloping curve starts form the X-axis. In
this case , percentage change in quantity supplied is less than
percentage change in price.
 (iv) Es = 0 , or Perfectly Inelastic
Supply:
It refers to a situation in which there is no change in supply
remains unchanged it is a situation in which price has no
influence on supply. In this case, supply curve is a vertical
straight line as given fig.
 (V) Es = or perfectly elastic
supply :
It refers to a situation in which supply is infinite corresponding to
a particular price of the commodity . Accordingly, a slightest fall
in price causes an infinite change in supply , reducing it to zero .
In this case , supply curve is a horizontal straight line .
 Factors Affecting Elasticity of
Supply
1) Nature of the Inputs Used: If factors of production are
those which are commonly used (and therefore easily
available), supply of the commodity will be elastic. On the
other hand, if specialised factors are used (which are not
easily available), supply will be less elastic.

2) Natural Constraints: The elasticity of supply is also

influenced by the natural constraints in the production of a
commodity. If we wish to produce more teak wood, it will
take years of plantation before it becomes usable. Supply
of teak wood will therefore be less elastic.
 Factors Affecting Elasticity of
Supply
3) Risk Taking: The elasticity of supply depends on the
willingness of entrepreneurs to take risk. If entrepreneurs
are willing to take risk, the supply will be more elastic. On
the other hand, if entrepreneurs hesitate to take risk, the
supply will be inelastic.

4) Nature of the commodity: Perishable goods are relatively

less elastic in supply than durable goods, because it is
difficult to store the perishables.
 Factors Affecting Elasticity of
Supply
5) Time Factor: Longer the time period, greater will be the
elasticity of supply. Because, over a longer period of time,
more and more factors are easily available and their input
can be changed to increase ( or decrease) output of the
commodity.
THEORYOF COST

PROF. SHAMPA NANDI

 CONCEPTOF COST

Cost is defined as those expenses faced

by a business in the process of supplying
goods and services to consumers.
 TYPESOF COST

1) Opportunity Cost And Actual Cost:

Opportunity Cost is the loss of earnings due to lost opportunities.
The opportunity cost may be defined as the loss of expected
returns from the second use of the resources foregone for availing
the gains from their best possible use.

Actual cost are those, which are actually incurred by the payment
of labour, material, plant building, machinery, etc. The total money
expenses, recorded in the books of accounts are, the actual cost.
 TYPESOF COST

2) Direct Cost and Indirect Cost:

Direct Costs are the costs that have direct relationship with a unit
of operation, i.e. , they can be easily and directly identified or
attributed to a particular product, operation or plant. For Example:
the salary for a branch manager is a direct cost when the branch is
a costing unit.
Indirect cost are those cost whose source cannot be easily and
definitely traced to a plant, a product, a process or a department.
For example: Stationery, depreciation on building, decoration
expenses etc.
 TYPESOF COST
3) Incremental Cost And Sunk Cost:
Incremental cost denote the total additional cost associated with
the marginal batch of output. These costs are addition to the costs
resulting from a change in the nature and level of business activity.

A sunk cost is a cost that an entity has incurred, and which it can no
longer recover by any means. Sunk costs should not be considered
when making the decision to continue investing in an ongoing
project, since these costs cannot be recovered.
For Example : A company spends $20,000 to train its sales staff in
the use of new tablet computers, which they will use to take
customer orders. The computers prove to be unreliable, and the
sales manager wants to discontinue their use. The training is a sunk
cost, and so should not be considered in any decision regarding the
computers.
 TYPESOF COST
4) Explicit Cost And Implicit Cost:
Explicit costs are those payments that must be made to the factors
hired from outside the control of the firm. They are mandatory
payments made by the entrepreneur for purchasing or hiring the
services of various productive factors which do not belongs to him.
Such payment as rent, wages, interest, etc.
Implicit costs refers to the payment made to the self owned
resources used in production. They are the earnings of owner’s
resources employed in their best alternatives.
 TYPESOF COST

5) Historical Cost And Replacement Cost:

The historical cost is the actual cost of an asset incurred at the time
the asset was acquired. It means the cost of plant at a price
originally paid for it.
In contrast, replacement cost means the price that would have be
paid currently for acquiring paid for it.
So historical costs are the past costs and replacement costs are
present costs.
For Example, suppose that the price of a machine in 2003 was Rs.
200000 and its present price is Rs. 500000, the actual cost of Rs.
200000 is the historical cost while Rs. 500000 is the replacement
cost.
 TYPESOF COST

6) Urgent Cost and Postponable Cost:

Urgent costs are those costs that are necessary for the
continuation of the firm’s activities. The cost of raw materials,
labour, fuel, etc., may be its examples which have to be incurred if
production is to take place.
The cost which can be postponed for some time, i.e., whose
postponement does not effect the operational efficiency of the firm
are called postponable costs.
For example: Maintenance costs can be postponed for the time
being.
 TYPESOF COST

7) Shut Down Costs and Abandonment Costs:

Shut down costs may be those which would be incurred in the
event of a temporary cessation of business activities and which
could be saved if operations are continued. Shut down cost, in
addition to fixed cost, covers the additional expenses in looking
after the property till not disposed off.
Abandonment costs on the other hand, are the cost of retiring a
fixed asset from its use. If, for example, the costs related to
discontinuance of a plant. Therefore, abandonment, thus involves
permanent cessation of activity.
 TYPESOF COST
8) Fixed Costs and Variable Costs:
Fixed costs are those, which are fixed in volume for a certain given
output. Fixed cost does not vary with the variation in the output
between zero and a certain level of output. The costs that do not
vary for a certain level of output are known as fixed cost. The fixed
costs include:
i)Cost of managerial and administrative staff,
ii) Depreciation of machinery
iii) Maintenance of land etc.
Variable costs are those, which vary with the variation in the total
output. Variable costs include cost of raw materials, direct labour
charges, etc.
 TYPESOF COST

9) Total Cost, Average Cost, and Marginal Cost:

Total Cost (TC) represents the value of the total resources
requirements for the production of goods and services.
Average Costs (AC) It is obtained by dividing the total costs (TC) by
the total output (Q), i.e. AC= TC/Q
Marginal Costs (MC) is the addition to the total cost on account of
producing and additional unit of the product or, marginal cost is
the cost of marginal unit produced. It may be defined as:
MC= TC/ Q
 TYPESOF COST

10) Short Run Costs and Long Run Costs:

Short run cost are the cost, which vary with the variations in
output, the size of the firm remains the same.
Long run cost, in the other hand, are the cost, which are incurred
on the fixed asset, like plant, building, etc. such costs have long run
implications, the long run simply refers to a period of time during
which all inputs can be varied.
COSTFUNCTION
 COSTFUNCTION
The concept of cost function refers to mathematical relation
between cost of a product and the various determinants of cost.
In cost function the dependent variable is unit cost or total cost and
the independent variable are the price of factor, the size of the
output or nay other relevant phenomenon.
C = f (O, S, T, P,…)

C = Cost
O = Level of Output
S = Size of Plant
T = Time under Consideration
P = Price of the factor of production
DETERMINANTS OFCOSTFUNCTION
 DETERMINANTS OFCOSTFUNCTION

1. Level of Output:
There is positive relationship between total output and total cost. As the
output increases the total cost also increases. The cost may rise or fall
by different rates in different periods of time.

2. Size of Plant:
Size of plant or scale of operation is inversely related to cost. As the
scale of operation increases the cost declines but only up to a certain
point.
 DETERMINANTS OFCOSTFUNCTION

3. Price of Inputs:
The cost also depends on the price of factors of production. Any
increase in prices of input will also increase the cost.

4. Managerial Efficiency:
Managerial efficiency has direct bearing on cost function. With the
increase inefficiency the cost declines and productivity increases,
and economies the cost.
 DETERMINANTS OFCOSTFUNCTION

5. State of Technology:
State of technology also influences the cost. Better the technology
better is the technological efficiency. How best we can produce
with the available technology determines the level of costs.

6. Time under Consideration:

COST– OUTPUT RELATIONSHIP
 COSTOUTPUT RELATIONSHIP

The theory of cost deals with the behaviour of cost in relation to

change in output. In other words, the cost theory deals with the
cost output relationship.
The basic principle of the cost behaviour is that the total cost
increases with the increase in output.
But the specific form of cost function depends on whether the time
framework chosen for cost analysis is short – run or long – run.
It is important to know that some costs remains constant in the
short run while all costs are variable in the long run.
COST– OUTPUT RELATIONSHIP IN THE
SHORT- RUN
 COSTOUTPUT RELATIONSHIPIN THESHORT- RUN

Short run is the period wherein only some of the factors are held
constant and some are variable. Therefore, the costs associated with
both fixed and variable inputs form part of the short period costs.
Short – Run Total Cost:
TC = TFC + TVC
The costs which are found in the short period:
1) Total Fixed Cost
2) Total Variable Cost
3) Total Cost
4) Average Cost :
a) Average Variable Cost b) Average Fixed Cost c) Average Total Cost
5) Marginal Cost
 TOTALFIXEDCOST(TFC)

Total fixed cost is the sum of fixed cost which remains same
irrespective of the level of output.
This is the expenditure incurred by the firm on the fixed
factors of production.
For example, the money incurred on land, building,
machinery, etc. remains the same whatever is the amount
of output.

They are also called Overhead Costs.

 TOTALFIXEDCOST(TFC)
Output Level Fixed Cost

costs
(Q) (Rs.)

100 2000

200 2000

2000
TFC

300 2000

400 2000

500 2000 O Q
100 200 300 400 500
TFC Curve is a horizontal curve parallel to the X-axis which tells us
that total fixed cost remains the same at all levels of output.
 TOTALVARIABLECOST(TVC)

Total variable costs are those costs of production that

change directly with output.
They rises when output increases, and falls when output
declines.
If there is no output the total variable cost will be zero.
They include expenses on raw materials, power, taxes,
advertising, etc.
Marshall has called variable cost as ‘Prime Cost’ or
‘Avoidable Cost’.
 TOTALVARIABLECOST(TVC)
Output Level Variable Cost
(Q) (Rs.)

0 0

1 50

2 90

3 120
4 150

5 190

6 270
 TOTALVARIABLECOST(TVC)

In the short run cost diagram shows that total variable cost
varies directly with the volume of output.
TVC curve starts from the origin, upto a certain range it
remains concave from below and then it becomes convex.
If taken from a different angle we can say that initially the
variable cost rises but with diminished rate and later the
variable cost rises with increased rate.
This makes the TVS curve inversely S-shaped.
 TOTAL COST(TC)

Total costs are the total expenses incurred by a firm in

producing a given quantity of a commodity.
When we add TFC and TVC it becomes total cost (TC).
They include payment for rent, interest, wages, and
expenses on raw materials, electricity, water, etc.
 RELATIONBETWEENTFC,TVCAND TC

• In order to determine the total costs of a firm, we aggregate

fixed as well as variable costs at different levels of output
i.e.
• TC = TFC + TVC
• TFC = TC – TVC
• TVC = TC – TFC
RELATIONBETWEENTFC,TVCAND TC
 RELATIONBETWEENTFC,TVCAND TC

• In the figure TFC is parallel to X-axis. This curve starts from

the point on the Y-axis meaning thereby that fixed cost will
be incurred even if the output is zero.
• On the other hand, total variable cost curve rises upward
showing thereby that as output increases, total variable
cost also increases. This curve starts from the origin which
shows that when the output is zero, variable costs are also
nil.
• The total cost curve has been obtained by adding vertically
total fixed cost curve and total variable cost.
 SHORT– RUNAVERAGE COST

The concept of average cost is more relevant from the point

of view of a firm because per unit cost helps in explaining
the pricing of a product in a better way rather than the total
cost.
The concept of average cost is divided in to two”
(a) Average Fixed Cost
(b) Average Variable Cost
 AVERAGEFIXEDCOST
Average fixed cost is the total fixed cost divided by the
number of units of output produced.
Thus:
 AVERAGEFIXEDCOST
Since, total fixed cost is a constant
quantity, average fixed cost will steadily
fall as output increases, thus, the average
fixed cost curve slopes downward
throughout the length.

In Figure the average fixed cost curve

slopes downward with a view to touch the
horizontal axis. But it will not be so
because AFC can never be zero. Thus, it is
clear that as output increases, average
fixed costs go on diminishing.
 AVERAGEVARIABLECOST

Average variable cost is the total variable cost divided by

the number of units of output produced.
AVC = TVC / Q
AVC = Average variable costs.
TVC = Total variable costs
Q = Output
 AVERAGEVARIABLECOST
• Generally, the AVC falls as output
increases from zero to the normal
capacity output due to the law of
increasing returns. But beyond the
normal capacity output, the AVC
will rise steeply because of the
operation of the law of diminishing
returns.

• In Figure the average variable cost

curve assumes the U- shape.
Initially, the AVC curve falls, after
having the minimum point the
curve starts rising.
 AVERAGETOTALCOST/AVERAGECOST
“The average cost of production is the total cost per unit of
output.” In other words average cost of production is the
total cost of production divided by the total number of units
produced.
Suppose, the total cost of producing 500 units is Rs. 1000,
the average cost will be:
AVERAGETOTALCOST/AVERAGECOST
 MARGINAL COST

• Marginal cost is an addition to the total cost caused by

producing one more unit of output. For instance, the total
cost for the production of 100 units is Rs. 5000. Suppose
the production of one more unit costs Rs. 5000. It will be
called the marginal cost.
FEWPROBLEMSTO PRACTICE
 EXAMPLE1

The output and total cost data for a firm is given below.
Work out the following costs: TFC,TVC,AFC,AVC,ATC & MC at
various level of output.

Units of 0 1 2 3 4 5 6
Output
Total 120 180 200 210 225 260 330
Cost
 SOLUTION
Remember:
(i) At zero output, TC=TFC. Therefore, TFC = Rs. 120
(ii) MC is the additional cost of producing an additional unit of output. So, MC of 1
unit of output equals 60 (180-120).

Units of TC TFC TVC AFC AVC ATC MC

Output (TC-TFC) TFC/Q TVC/Q TC/Q TCn - TCn-1
0 120 120 0 - - - -

1 180 120 60 120 60 180 60

2 200 120 80 60 40 100 20

3 210 120 90 40 30 70 10

4 225 120 105 30 26.25 56.25 15

5 260 120 140 24 28 52 35

6 330 120 210 20 35 55 70

 EXAMPLE2
Complete the following table:

Units of TC TVC TFC AFC AVC ATC MC

Output TFC/Q TVC/Q TC/Q TCn - TCn-1
1 60 30

2 40

3 45

4 55

5 75

6 120

7 210
 SOLUTION

Units of TFC TVC TC AFC AVC ATC MC

Output (TFC+TVC) TFC/Q TVC/Q TC/Q TCn - TCn-1

1 60 30 90 60 30 90 90

2 60 40 100 30 20 50 10

3 60 45 105 20 15 35 5

4 60 55 115 15 13.75 28.75 10

5 60 75 135 12 15 27 20

6 60 120 180 10 20 30 45

7 60 210 270 8.6 30 30.6 90

 EXAMPLE3
Complete the following table:

Units of TFC TVC TC AVC ATC MC

Output
0 60 - - - - -

1 - 30 - - - -

2 - - 100 - - -

3 - - - - - 5

4 - - - - 28.75 -

5 - - - 15 - -

6 - - - - - 45
 SOLUTION
i) Zero output row: At zero output TFC =TC= 30
ii) One unit output row: TFC + TVC = 60 +m 30 = 90m = TC
iii) Two units output row: TC – TFC = 100 – 60 = 40 = TVC
iv) Three units output row: TC of 2 Units=100.MC of 3rd unit = 5. so,TC of 3units = 110+5 =105
v) Four units output row: ATC X Q = 28.75 X 4 = 115 = TC
vi) Five units output row: AVC X Q = 15 X 5 = 75 = TVC
vii) Six units of output row: TCof 5units= 135, MC of 6th unit= 45, So, TC of 6units =135+45 =180
Units of TFC TVC TC AVC ATC MC
Output TFC + AVC
0 60 0 60 - - -
1 60 30 90 30 90 30
2 60 40 100 20 50 10
3 60 45 105 15 35 5
4 60 55 115 13.75 28.75 10
5 60 75 135 15 27 20
6 60 120 180 20 30 45
COSTOUTPUT RELATIONSHIP IN LONG-
RUN
 LONGRUN COST

Long run means time period long enough to make the

entire productive factors variable
In the long run all factors of production become variable.
The entrepreneur has number of choices to change the
plant size and level of output.
The long run cost curve is also known as planning curve.
The long run average cost curves is derived from short run
average cost curves.
 LONGRUNAVERAGECOST
Long run average cost is also known as :
1) Envelope Cost:
It is also known as “envelope cost” because it encloses all
short run average cost curves.
The curve is created as an envelope of an infinite number
of short-run average total cost curves.

2) Planning Curve:
With the help of this curve a firm can plan as to which plant
it should use to produce different quantities, so that
production is obtained at the minimum cost.
 LONGRUNAVERAGECOST

The LRAC curve is U-shaped, reflecting economies of scale

when it is negatively- sloped and diseconomies of scale
when it is positively sloped.

In some industries, the LRAC is L-shaped, and economies of

scale increase indefinitely. Initially the long-run average cost
rapidly falls but after a point it remains flat throughout or at
its right-hand end it may even slope gently downward.
LONGRUNAVERAGECOSTCURVE
 LONGRUNAVERAGECOSTCURVE

if the anticipated rate of output is 200

units per unit of time, the firm will
choose the smallest plant It will build
the scale of plant given by SAC1 and
operate it at point A. This is because of
the fact that at the output of 200 units,
the cost per unit is lowest with the
plant size 1 which is the smallest of all
the four plants.
In case, the volume of sales expands to
400, units, the size of the plant will be
increased and the desired output will
be attained by the scale of plant
represented by SAC2 at point B.
 LONGRUNAVERAGECOSTCURVE
If the anticipated output rate is 600
units, the firm will build the size of
plant given by SAC3 and operate it
at point C where the average cost is
$26 and also the lowest The
optimum output of the firm is
obtained at point C on the medium
size plant SAC3.

If the anticipated output rate is

1000 per unit of time the firm
would build the scale of plant given
by SAC5and operate it at point E.
 LONGRUNAVERAGECOSTCURVE
If we draw a tangent to each of the
short run cost curves, we get the
long average cost (LAC) curve. The
LAC is U-shaped but is flatter than
tile short run cost curves.
Mathematically expressed, the
long-run average cost curve is the
envelope of the SAC curves.

In this figure , the long-run average

cost curve of the firm is lowest at
point C. CM is the minimum cost at
which optimum output OM can be,
obtained.
 What is Free Trade?
Occurs when there are no artificial
barriers put in place by governments to
restrict the flow of goods and services
between trading nations.
Advantages and Disadvantages of
Free Trade.

 Advantages of free trade.

• Increased production
• Production efficiencies
• Benefits to consumers
• Foreign exchange gains
• Employment
• Economic growth
 Disadvantages of free trade.
• With the removal of trade barriers, structural
unemployment may occur in the short term.

• Increased domestic economic instability from

international trade cycles, as economies become
dependent on global markets.

• International markets are not a level playing

field .

• Developing or new industries may find it difficult

to become established in a competitive
environment .

• Free trade can lead to pollution and other

environmental problems.

• Pressure to increase protection during the GFC.

Why shouldn’t countries protect their own producers
from Free Trade?

You could say that it's OK for countries to protect

their own producers. However, in that case, all
countries should be allowed to do this. At the
moment, the trade rules are unfair. Some countries
are forced to accept goods from abroad, while others
protect their markets with
Import tariffs: also known as custom duties, which
are taxes imposed on goods when they enter a
country or one of a group countries such as EU.
Quotas: which are quantitative restrictions on the
import of goods.
and subsidies: are sums of money given by the
government to producers.
Advantage and Disadvantage of Free Trade with
regarding to developed and developing
countries.

Advantages
Higher Employment Rates
Less Child Labor
Access to New Markets
Higher Levels of Investment Capital
Increased Life Expectancy
 Disadvantages
Unrealistic Policy
Non-Cooperation of Countries
Economic Dependence
Political Slavery
Unbalanced Development
Dumping
Harmful Products
International Monopolies
Reduction in Welfare of Certain Groups
 Harmful to Less Developed Countries:
Free trade is harmful for the less developed countries for the following
reasons:
i. Competition under free trade is unfair and unhealthy. The less
developed countries find it difficult to compete with the economically
advanced countries.

ii. Under free trade, gains of trade are unequally distributed depending
upon the level of development of different countries. The terms of
trade are favourable for the developed countries, and unfavourable for
the poor countries.

iii. Less developed countries generally experience unfavourable balance of

payments. The problem of un-favourable balance of payments cannot
be solved under free trade policy.

iv. Free trade policy adopted by the British government in India led to the
destruction of Indian cottage and small scale industries.

v. The less developed countries cannot protect their infant industries

under the policy of free trade.

vi. Free trade may endanger economic and political independence of the
backward nations.
Oligopoly market
Definition of oligopoly
An oligopoly is an industry dominated by a few large firms. For example, an
industry with a five-firm concentration ratio of greater than 50% is considered
a monopoly.
he main features of oligopoly
•An industry which is dominated by a few firms.

Interdependence of firms – companies will be affected by how other firms set

price and output.

Barriers to entry. In an oligopoly, there must be some barriers to entry to enable

firms to gain a significant market share. These barriers to entry may include brand
loyalty or economies of scale. However, barriers to entry are less than monopoly.

Differentiated products. In an oligopoly, firms often compete on non-price

competition. This makes advertising and the quality of the product are often
important.

•Oligopoly is the most common market structure

Kinked demand curve
A kinked demand curve occurs when the demand curve is not a straight line but
has a different elasticity for higher and lower prices.

The logic of the kinked

demand curve is based on
•A few firms dominate the
industry
•Firms wish to maximise
profits
Impact of price rise
•If a firm increases the price, then it becomes more expensive than rivals and therefore, consumers
will switch to its rivals.
•Therefore for a price rise, there is likely to be a significant fall in demand. Demand is, therefore, price
elastic.
•In this case, of increasing price firms will lose revenue because the percentage fall in demand is
greater than the percentage rise in price.

Impact of price cut

•If a firm cut its price, it is likely to lead to a different effect. In the short term, if a firm cuts price it would
cause a big increase in demand and therefore would lead to a rise in revenue. The firm would gain
market share.
•However, other firms will not want to see this fall in market share and so they will respond by also
cutting price to follow the first firm. The net effect is that if all firms cut price – the individual firm will
only see a small increase in demand.
•Because there is a ‘price war’ demand for a firm is price inelastic – there is a smaller percentage rise
in demand.
•If demand is inelastic and price falls, then revenue will fall.
xample of a kinked demand curve in practice

•One possibility is the market for petrol. It is homogenous and consumers are price sensitive.

•If one petrol station increased the price there would be a shift to other petrol stations.

•However, if one petrol station cuts price, other firms may feel obliged to follow suit and also cut price –
therefore a price cut would be self-defeating for the first firm.

How realistic is the kinked demand curve in practice?

•In many oligopolies, firms may have a degree of brand differentiation. Mobile phone companies can
increase the price but consumers are willing to pay because the price is not the dominant factor. Some
petrol stations may increase price and not see elastic demand because they have the best location.

•Firms may not want to defend market share. Rather than getting pulled into a price war, some firms
may not respond to price cut but concentrate on non-price competition to retain an advantage.