ECONOMICS OF SUPPLY & PRODUCTION Chapter 3

SUPPLY SIDE OF MARKET

Factors Determining Supply: Product Price Factor Productivities or Technology Factor Prices Prices of other products related in production Weather, Strikes and other short-run forces Firms expectations about future prospects for prices, costs, sales and the sale of economy in general Number

Elasticity of Supply
Degree of responsiveness of suply to a given

change in price
Measured by dividing the percentage change

in quantity supplied of a good by the percentage change in its price

When Elasticity of Supply is Equal to Zero Equal to Infinity Equal to One More than one but not infinity Less than one but not zero

Types of Elasticity of Supply

It is known as Perfectly Inelastic Perfectly elastic supply Unitary elastic supply Relatively Elastic Supply Relatively inelastic supply

Types of Supply Elasticity

Perfectly Inelastic: As a result of change in price, the quantity

supplied of a good remains unchanged. Elasticity of supply is zero or the good has perfectly inelastic supply. The vertical supply curve shows that irrespective of price change, the quantity supplied remains unchanged.

Types of Supply Elasticity

Relatively Less Elastic Supply As a result of change in the price of a good its

supply changes less than proportionately Relative change in quantity supplied is less than the relative change in the price.

Types of Supply Elasticity

Relative Greater Elastic Supply: Elasticity of supply is greater than 1 Quantity supplied changes substantially in

response to a small change in price Relative change in quantity supplied is greater than the relative change in price

Types of Supply Elasticity

Unit Elastic Relative change in quantity supplied is

exactly equal to the reltive change in the price. Coefficient of elasticity of supply is equal to one. Relative change in the quantity supplied is equal to the relative change in the price

Types of Supply Elasticity

Perfectly Elastic Supply Supply elasticity is infinite when nothing is

supplied at a lower price but a small increase in price causes supply to rise from zero to an indefinitely large amount Indicates that producers will supply any quantity demanded at that price

Supply Elasticities-Lessons Changes in Marginal Cost of Production: to Manager Elasticity of supply depends on increasing output
without any raise in input costs With increase in production, if marginal cost goes up, elasticity of supply would be less to that extent With increase in output, marginal cost of production rises. This results in less elastic supply in short run. Long-run supply curve is more elastic, than the short-run supply curve Industry with decreasing returns will be more elastic in long run than in short run Industry with increasing returns will be less elastic in the long run

Supply Elasticities-Lessons Response of the Producers to Manager

Supply elasticity depends on the responsiveness of

producers to change its price If supplier is reluctant to increase prices, the quantity supplied will not result in increase in prices Profit maximizing producer would increase quantity following a rise in price. Producers not keen on profit-maximizing may not raise supply in response to rise in price Farmers in developing countries respond negatively to rise in price of commodities. They deliberately produce lesser quantities to keep the prices high. High prices compensate in meeting their fixed costs of production.

Supply Elasticities-Lessons Availability of infrastructure facilities to Manager

and other inputs for expanding output:
The extent of increase in supply depends on the availability

of infrastructure facilities and availability of inputs required. Ban on import of critical raw-material cannot support increase in supply Non-availability or short-supply of skilled manpower In case of perishable goods, sound infrastructure to move goods faster across the markets Shortage of power supply, unfriendly government policy etc.

Supply Elasticities-Lessons to Manager Possibilities of substitution of

one product for others:
Change in quantity supplied of a product due to

change in its price, depends on substitution of one product for others If price of wheat rises, the farmers will try to shift all resources such as land, ferilizers away from other products such as pulses towards production of wheat Greater the possibility of shifting the resources, greater would be the elasticity of supply (of wheat)

Supply Elasticities-Lessons to Manager The Length of Time

Length of time required by the supplier to respond to a given change in price also impacts supply elasticity Longer the time required to respond, greater would be the elasticity of supply Market Period: Very short period is available and more production is not possible. This is a case of perfectly inelastic supply Short Run: It can supply smaller additional quantities by varying only few of the variables. Here it is relatively less elastic. Long Run: Firms can adjust all factors of production and even new firms will enter or leave industry, resulting long-term supply curve more elastic

PROCUTION & COST CONCEPTS-REVIEW

ISOQUANT
The term isoquant means same or equal

quantity An isoquant schedule consists of alternative combinations of the inputs (say capital K, and labour L) which yield a given quantity of output of a good (say X) An isoquant curve (usually called only an isoquant) is a graphic counterpart of an isoquant schedule It is a locus of all the combinations of the inputs which produce a given output

Isoquant Schedule
Combination Units of Capital Units of Labour Output of good X Marginal Rate of Technical Substitution (DL/DK) 1 2 3 4 5 6 7 8 9 2 3 5 8 12 17 23 30 38 50 45 40 35 30 25 20 15 10 400 400 400 400 400 400 400 400 400 5.0 2.5 1.7 1.25 1.0 0.8 0.7 0.6

Hypothetical Isoquants
We have a set of three

hypothetical isoquant curves numbered 1, 2 and 3 Input labour (L) is measured along X-axis and input capital (K) is measured along Y-axis Each isoquant is a locus of the alternative combinations of two inputs capital (K) and labour (L) which yield a given quantity of output of good X each of the three isoquants contains three parts,
the part in which it is concave to X-

axis and is moving away from Y-axis, the part in which it is downward sloping and is convex to the origin, and the part in which it is convex to X-axis and is upward sloping

Both output and inputs are measured in physical quantities. The isoquant represents their physical relationship. The prices of inputs and output are not brought into picture. Good X is produced with the help of only two inputs, say capital (K) and labour (L). Both inputs are subject to diminishing marginal physical productivity. With an increase in the quantity of an input, its marginal productivity can not only fall to zero, it can even become negative. This assumption is dropped only for illustrating special cases. Both inputs are perfectly divisible. This implies that the quantities of the inputs can be varied in extremely small amounts. Technologically, inputs can be combined only within a certain range. Accordingly, a proportionate increase in inputs may or may not result in a proportionate increase in output.

ISOQUANTS ASSUMPTIONS

Marginal Rate of Technical Substitution of L for K (MRTSL,K)

This concept is a measure of the rate at which one input can

be substituted by another without changing the total output. If the firm adds DL to input L and discards a corresponding quantity DK of K, such that there is no change in output, then marginal rate of technical substitution of L for K (MRTSL,K) is defined as DK/DL. In addition, MRTSL,K is also equal to MPL/MPK, that is, the ratio of the marginal productivity of the two inputs Addition in output on account of increasing L is given by DL.MPL while the corresponding reduction in output equals DK.MPk, that is, DK.MPk = DL.MPL , so that DK/DL = MPL/MPK MRTSL,K is also equal to the slope of the tangent drawn to the isoquant at the relevant point

MRTSL,K
Take a point P on the

isoquant, then MRTSL,K is the slope of the tangent AB to it

Similarly, if we move from

point P to point P, that is, if we consider an increase in input L by an amount DL with a corresponding reduction in K by an amount DK, then MRTSL,K is given by DK/DL

P P

Properties of Isoquants

A typical isoquant has three regions, on account of diminishing marginal productivity of both inputs. When marginal productivity of both inputs is positive but diminishing, the isoquant has a negative slope and is also convex to the origin as in the case of indifference curves). In this region MRTSL , K falls as we move from left to right, and its sign is negative. At the left-most end of this region, (point R), MPK touches zero, and MRTSL,K approaches infinity. The tangent to isoquant at this point becomes parallel to Y-axis. Similarly, at the right-most end of this region (point S), MPL touches zero, and MRTSL,K declines to zero. The slope of the tangent to isoquant at this point is zero and it is parallel to X-axis. Having reached the left-most end of the central region of the isoquant, if input K is increased still further, MPk becomes negative. As a result, to keep output unchanged, an addition to K has to be accompanied by an increase in L also. Accordingly, the isoquant slopes upwards with concavity towards Xaxis (the labour-axis). In this region, MRTSL,K has a positive sign and its numerical value falls as we increase both inputs. Having reached the right-most end of the central region of the isoquant, if input L is increased still further, MPL becomes negative. As a result, to keep output unchanged, an addition to L has to be accompanied by an increase in K. Accordingly, the isoquant slopes upwards with a convexity towards labouraxis (X-axis). In this region, MRTSL,K has a positive slope and its numerical value increases as we increase both inputs.

Properties of Isoquants
An isoquant is a continuous curve. This property follows

from the assumption that both inputs are perfectly divisible. An isoquant which is farther away from the origin represents greater output because, in its convex section, marginal productivity of both inputs is positive. However, the absolute difference in their output in not indicated by their physical distance. As in the case of indifference curves, no two isoquants intersect each other. They also need not be parallel to each other, either horizontally or vertically. Similarly, no two isoquants can touch each other - that is, they cannot have any common point. This result follows because a given combination of inputs is assumed to result only in one given output.

Equilibrium of the Firm Iso-cost Line

A firm is assumed to pursue the objective of maximising profit. It aims at minimising per unit cost of output which is the same thing as

maximising output per unit of cost The use of isoquants in the determination of a firms equilibrium necessitates the use of firms isocost line as well We measure units of input capital (K) along Y-axis and units of labour (L) along X-axis An isocost line represents a set of combinations of inputs L and K which the firm can acquire for a given total cost or budget. if PK and PL are respective prices of the two inputs, K and L and the firm is to incur a total cost TC, then the equation of the isocost line is given by, TC = K.PK + L.PL where K stands for the quantity of capital employed by the firm and L denotes the quantity of labour input used by it.

Equilibrium of the Firm

Since the firm can buy, at the most TC/ PK,

amount of K, therefore, the starting point of the isocost line on Y axis is given by the distance (TC / PK) from origin O. Similarly, it touches X-axis at a distance of (TC/ PL) from the origin. It is a straight line with a negative slope (PL / PK). For example, if TC = 300, PK = 10, and PL = 15, the firm can buy at the most 30 units of capital or 20 units of labour The isocost line is, therefore, a straight line (such as RS), which is the locus of input combinations like (0K +20L), (1k + 19.3L), (2K + 18.7L), (3K + 18L), ..(30K + 0L) It has a constant negative slope with a numerical value of (30/20 = 1.5) The market allows the firm to choose any combination of inputs K and L along the isocost line. It does not permit the firm to move to the right side of this line. And the firm, on grounds of its economic rationality, does not move to the left of it. The equilibrium position of the firm lies somewhere on the isocost line only.

Equilibrium at Tangency
The fact that the isocost line of the

firm is a straight line with a negative slope and the middle region of each isoquant is convex to the origin, ensures that the isocost line is tangent to one and only one isoquant Further, it is this point of tangency which determines the equilibrium position of the firm. RS is the isocost line of the firm. As the firm moves from point R towards point S, it successively shifts from a lower isoquant to a higher one At point E, it is tangent to isoquant 3 which is the highest which the market allows the firm In case, the firm moves further towards S, it slides to a lower isoquant. Thus, at E firm reaches a situation of maximum output with a given cost-the position of maximum profits

COST CONCEPTS
OUTLAY COSTS AND OPPORTUNITY

COSTS
Outlay costs involve financial expenditure at

some time and hence are recorded in the books of account Opportunity costs relate sacrificed alternatives; they are not recorded in the books of account in general

COST CONCEPTS
Direct costs and Indirect Costs Direct costs are costs that are readily identified and are traceable to a particular product, operation or plant Indirect costs are not readily identifiable with any specific goods, services, operations etc., but are charged on jobs or products in standard accounting practice. (Eg. Expenditure on electricity)

FIXED AND VARIABLE COSTS

Fixed costs are not a function of output, they do

not vary with output up to a certain level of activity Fixed costs cannot be avoided. These costs are fixed as long as operations are going on. They can be avoided only when the operations are closed. Variable costs are a function of output in the production period. Wages and cost of raw material are variable costs. Variable costs vary directly and sometimes proportionately with output.

SHORT RUN COSTS

The term short run does not represent a fixed time period.

It is a functional concept and represents that time interval over which the firm is not able to alter every input It is stuck with some fixed inputs also. It means that irrespective of the volume of output, the firm must incur a fixed amount of expenditure on these factors. These are, therefore, termed fixed costs Correspondingly, expenditure incurred on variable factors are known as variable costs and they change with the level of output. It is obvious that total cost (TC) is the summation of total fixed costs (TFC) and total variable costs (TVC)

Average and Marginal Cost of a Firm

Average Cost of a Firm

Average Fixed Cost (AFC) Curve : Since total fixed costs do not change with

output, therefore, average fixed cost (AFC) declines with increase in the level of output and tends to infinity when output reaches zero. For a single unit of output, AFC equals TFC. At one end, this curve approaches Y-axis, without ever touching it, with a reduction in output; and at the other, it approaches X-axis, without ever touching it, with an increase in output. Average Variable Cost (AVC) Curve : As we have seen above, with a given plant, returns to variable factors pass through three phases of increasing, constant and diminishing returns. Accordingly, AVC curve is a U-shaped one. In the initial stages, it slopes downwards with an increase in output. However, the reduction in average variable cost slows down till AVC stops declining further and becomes constant. This is followed by the phase in which AVC curve slopes upwards on account of diminishing returns. Total Average Cost, or just Average Cost (ATC or AC) Curve : This curve represents the average of all costs incurred by the firm for a given output and is the summation of AFC and AVC. Graphically, it is obtained by vertical addition of the AFC and AVC curves. AC curve lies above AVC curve. At each point, its vertical distance from AVC curve is exactly equal to the distance of AFC curve from Xaxis. AC curve is U-shaped and with increasing output, its vertical distance from AVC keeps declining

MARGINAL COST OF FIRM

Marginal cost is addition to total cost on account of the production of an additional unit. Symbolically, it is TCN TCN-1. However, it should be noted that in the short run, the firm cannot vary its fixed factors. Therefore, its costs can change only on account of a change in variable costs. Therefore, in the short run, MC gets defined as VCN - VCN-1. For this reason, MC curve is related to only AVC curve. When AVC is decreasing, MC is less than it and MC curve lies below AVC curve. However, when the rate of fall of AVC slows down, MC curve reaches its lowest value and starts increasing and meets AVC curve at the lowest point of the latter. In other words, when AVC is constant, MC is equal to it. In the next phase, when AVC curve slopes upwards, MC curve rises faster than the former and lies above it. MC curve need not intersect AC curve at the lowest point of the latter. Whether it does so or not would depend upon the rate at which AVC increases compared with the rate at which AFC decreases. MC curve will intersect AC curve at its lowest point only if the rate of increase in AVC equals that of fall in AFC.

Long Run Costs

Economies of Scale
As businesses grow costs of production decrease

Output grows proportionately faster than use of inputs Prices remaining constant, leads to lower costs per unit In the long run, increasing returns to scale in the firms long run production function. Lowest point on LAC curve occurs at the output level, at which returns to scale are just balanced by the forces of decreasing scale

Bigger businesses gain some advantages over smaller

businesses through Economies of Scale There are two types of Economies of Scale:

Internal Economies External Economies

Example:
Daimler Chrysler own the following brands:

Purchasing economies of scale can be achieved by bulk buying parts that can be used across all brands such as Wiper Blades

Diseconomies of Scale
There are limits to the amount a business can

grow If businesses grow to large they start to suffer from Diseconomies of Scale These diseconomies happen because the larger the business the more difficult it becomes to manage

Some common diseconomies of scale:

1. Decision making 2. Managerial problems 3. Communication problems 4. Co-ordination/control problems 5. Staffing problems

Case Study: Deepak Nitrate Ltd &

Dharamsi Morarjee Chemical Company

Product: Resorcinal a high value additive

used in manufacture of tyres Background: High energy tariffs and steep drop in import duties necessitated the two companies to come together to process Resorcinal. Manufacture of Resorcinal involves two processes viz.,
Sulfonation (combining benzene and sulphuric

acid) Fusion (process of mixing sulfonatedproduct with caustic soda to form resarcino

Deepak Nitrate had a capacity of 350 tpa Dharamsi Morarjee had a capacity of 250 tpa Total domestic capacity 600 tpa Resorcinal, which costs about Rs.300 per Kg,

Case Study: Deepak Nitrate Ltd & Dharamsi Morarjee Chemical Company

currently faces threat from cheaper imports

Case Study: Deepak Nitrate Ltd & Dharamsi Morarjee Chemical Company
Solution required: To be able to sell below

Rs.300/Kg in domestic market Strategy to economise: With Dharmas having the capacity to manufacture sulphuric acid, it will be involved in the first stage and sell the sulforated mixture to Deepak Nitrate for the manufacture of the final product

Case Study: Deepak Nitrate Ltd & Dharamsi Morarjee Chemical Company
Both companies will share the final product depending on the

current production status Dharmsi will shut down its existing fusion process unit and concentrate only on Sulfornation Deepak Nitrate will stop its Sulforanation facility R&D activities will be focussed on the respective areas. Deepak Nitrates manufacturing facility is located in Pune and Dharamsi s plant is at Roha Conclusion: Arrangement enabled both companies to sell products at cheapest prices.

Economies of scope deals with reducing per

ECONOMIES OF SCOPE

unit cost of goods produced. Per unit costs depend on

Changes in factor input or returns to scale and Number of goods produced by a firm or

economies of scope

Reduction of a firms per unit cost by producing

two or more goods jointly rather than separately is a result of economies of scope

Measurement of Economies of Scope

SC = C(Q1) + C(Q2) C(Q1,Q2) /C(Q1) +

C(Q2) Where
C(Q1, Q2) = the firms cost of jointly producing

the goods in the respective quantities C(Q1) = the cost of producing good 1 alone and C(Q2) = the cost of producing good2

Economies of Scope Examples

Broad-banding Multiple products produced by same

equipment

Measurement of Economies of ScopeExample

SC = C(Q1) + C(Q2) C(Q1,Q2) /C(Q1) +

C(Q2) SC = (12 + 8 -17) / 12 + 8) = 0.15 (or 15% cost savings in comparision to separae production)

DIFFERENCE BETWEEN SCALE AND SCOPE PARADIGM

Economies of Scale Old style technology Standardisation Cost advantage from volume Separable variable costs Task specialisation Work as a social activity Expensive flexibility Large plant

Economies of Scope

Computer Technology Diversification Cost advantage from variety Joint Costs Multi-mission companies Unmanned system Profitable flexibility Disaggregated capacity

Internal and External Economies

Internal Economies
Those Specifically related to

External Economies
Benefits the whole industry

the business itself eg:1. Production 2. Purchasing 3. Marketing 4. Financial 5. Managerial 6. Risk spreading

and not specific firms

1. Skilled labour in the area 2. Better road and rail

networks 3. Improves the reputation of the area 4. Attracts other businesses

Internalized External Economy being laid close to an Eg: A railway line

existing factory

Externalized Internal Diseconomy

Passing on private

discomforts to public Chemical Plant Pollutants

LARGE & SMALL FIRMS Economies & Diseconomies

Large Firms Small Firms

Technology: Technology used is normally based High capital intensive technique is on cost linked to capitalization used Faces risk of recession- losses due Labour intensive techniques is to huge investment used, avoids risk of diseconomies Huge capital investment required Prefers to start small

Small firms offer advantages like skill information, family jobs, flexibility, independent and prompt decision making Survival of small firms along side large firms happens in a competitive industry

RETURN (Physical) MONEY COSTS IMPLICATIONS Economies of scale (volume) INTERNAL ECONOMIES -Technical -Financial -Commercial -Managerial -Risk -Diversifying -Misc.Categories EXTERNAL DISECONOMIES -Technical -Financial -Commercial -Managerial -Risk -Diversifying -Misc.Categories Economies of scope (variety) INTERNAL ECONOMIES -Technical -Financial -Commercial -Managerial -Risk -Diversifying -Misc.Categories EXTERNAL DISECONOMIES -Technical -Financial -Commercial -Managerial -Risk -Diversifying -Misc.Categories

Internalized External economies

Externalized Internal Economies