CH.

MICRO ECONOMICS

PRODUCER’S BEHAVIOUR AND SUPPLY.

1. PRODUCTION

 RELATED CONCEPTS OF PRODUCTION

 THEORY OF PRODUCTION- LAW OF VARIABLE PROPORTION / LAW OF RETURNS TO A

FACTOR

2. COST CONCEPTS

3. REVENUE CONCEPTS

** PRODUCER’S EQUILIBRIUM

5. SUPPLY
 LAW OF SUPPLY
 FACTORS AFFECTING SUPPLY
 CHANGE IN SUPPLY & CHANGE IN QUANTITY SUPPLIED
 PRICE ELASTICITY OF SUPPLY
PRODUCTION

IT IS THE PROCESS OF CONVERTING INPUTS INTO OUTPUT

OR

IT IS THE PROCESS OF CONVERTING FACTORS OF PRODUCTION ( LIKE , LAND – LABOUR-

CAPITAL – ENTREPRENEURSHIP etc.) INTO THE FINAL OUTPUT OF GOODS & SERVICES.

PRODUCTION FUNCTION

THE FUNCTIONAL RELATIONSHIP BETWEEN THE PHYSICAL INPUTS & THE PHYSICAL
OUTPUT IS CALLED PRODUCTION FUNCTION.

PRODUCTION FUNCTION IS GENERALLY DENOTED IN THE FORM OF ;

Q = F(X1, X2)

WHERE Q REPRESENTS THE FINAL OUTPUT - X1 & X2 ARE INPUTS OR FACTORS OF

PRODUCTION.
TOTAL PRODUCT/ TOTAL PHYSICAL PRODUCT (TP/TPP)

TOTAL PRODUCT CAN DEFINED AS THE TOTAL VOLUME OF FINAL OUTPUT PRODUCED BY A
FIRM - USING GIVEN QUANTITY OF INPUTS- DURING A GIVEN A GIVEN PERIOD OF TIME.

FOR EXAMPLE; IF 10 WORKERS IN A FACTORY PRODUCE 200 UNITS OF OUTPUT OF A GOOD IN

A MONTH, THEN THE

TP = 200 UNITS
AVERAGE PRODUCT/AVERAGE PHYSICAL PRODUCT(AP/APP)

IT IS DEFINED AS THE OUTPUT PER UNIT OF INPUT USED IN PRODUCTION . IT CAN BE

CALCULATED BY DIVIDING THE TOTAL PRODUCT BY THE NUMBER OF INPUTS USED

AP =
ACCORDING TO THE ABOVE EXAMPLE

AP = = 20 UNITS
MARGINAL PRODUCT/ MARGINAL PHYSICAL PRODUCT(MP/MPP)
THE ADDITIONAL OUTPUT PRODUCED BY EMPLOYING AN ADDITIONAL UNIT OF A
FACTOR INPUT IS CALLED THE MARGINAL PRODUCT.

THAT MEANS MARGINAL PRODUCT IS THE ADDITION MADE TO THE TOTAL

PRODUCT WHEN AN ADDITIONAL FACTOR INPUT IS USED.

MP=

FOR EXAMPLE SUPPOSE; 10 WORKERS IN A FACTORY PRODUCE 200 UNITS OF

OUTPUT(TP).

WHEN ONE MORE WORKER IS APPOINTED IF THE TP INCREASES TO 230 UNITS

THEN, THE CONTRIBUTION OF THE ADDITIONAL WORKER IS 30 UNITS WHICH IS
THE MP.
MARGINAL PRODUCT/ MARGINAL PHYSICAL PRODUCT(MP/MPP)
MARGINAL PRODUCT IS THE ADDITION MADE TO THE TOTAL PRODUCT
WHEN AN ADDITIONAL FACTOR INPUT IS USED.
M P=
FIND MARGINAL PRODUCT FROM THE FOLLOWING DATA
MP=

UNITS OF INPUT TP ( IN UNITS) MP ( IN UNITS)

(LABOUR)

0 0 0
1 100 -----
2 120 -----
3 160 -----
4 250 -----
5 250 -----
6 200 -----
UNITS OF INPUT TP ( IN UNITS) MP ( IN UNITS)
(LABOUR)
0 0 0
1 100 100
2 120 20
3 160 40
4 250 90
5 250 0
6 200 (-) 50
FIND TOTAL PRODUCT FROM THE FOLLOWING DATA
if MP= then TP = ∑ MP

UNITS OF INPUT TP ( IN UNITS) MP ( IN UNITS)

(LABOUR)
0 0 0
1 ----- 50
2 ----- 80
3 ----- 120
4 ----- 200
5 ----- 0
6 ----- (-) 150
if M P= then TP = ∑ MP

UNITS OF INPUT TP ( IN UNITS) MP ( IN UNITS)

(LABOUR)

0 0 0
1 50 50
2 130 80
3 250 120
4 450 200
5 450 0
6 300 150
THE FIXED FACTORS & VARIABLE FACTORS OF PRODUCTION

PRODUCTION IS THE RESULT OF COMBINED EFFORTS OF THE FACTORS OF

PRODUCTION & THESE FACTORS MAY BE FIXED OR VARIABLE.

FIXED FACTORS ARE THOSE FACTORS OF PRODUCTION WHICH DO NOT

CHANGE WITH THE CHANGE IN THE TOTAL OUTPUT OF A FIRM

FIXED FACTORS REMAIN THE SAME, DURING A GIVEN PERIOD OF TIME,

EVEN WHEN THE TOTAL OUTPUT IS INCREASED OR DECREASED.

BUILDINGS, LAND, MACHINERY, PLANTS & TOP MANAGEMENT ARE SOME

COMMON EXAMPLES OF FIXED FACTORS.

A VARIABLE FACTORS, ON THE OTHER HAND, ARE THOSE FACTORS OF PRODUCTION

WHOSE QUANTITY CHANGES IN RESPONSE TO A CHANGE IN THE TOTAL OUTPUT OF A

FIRM.

SUCH FACTORS ARE REQUIRED MORE, WHEN OUTPUT IS MORE & ARE REQUIRED LESS,

WHEN OUTPUT IS LESS

WHEN THE OUTPUT IS ZERO, THERE IS NO REQUIREMENT OF VARIABLE FACTORS -

RAW MATERIALS, ORDINARY LABOR, POWER, FUEL etc. ARE EXAMPLES OF VARIABLE

FACTORS.
EXAMPLE OF FIXED FACTORS & VARIABLE FACTORS

CONSIDER THE EXAMPLE OF A HOCKEY STICK MANUFACTURER WHO WILL NEED THE
FOLLOWING TO MANUFACTURE HOCKEY STICKS:

RAW MATERIALS SUCH AS TIMBER – LABOR- MACHINERY & FACTORY BUILDING

SUPPOSE THE DEMAND FOR HOCKEY STICKS HAS GREATLY INCREASED, PROMPTING
THE COMPANY TO PRODUCE MORE STICKS. IT SHOULD BE ABLE TO ORDER MORE RAW
MATERIALS WITH LITTLE DELAY, SO THE RAW MATERIALS ARE VARIABLE INPUT.

ADDITIONAL LABOR WILL BE NEEDED, BUT THAT COULD COME FROM AN EXTRA SHIFT
AND OVERTIME, SO THIS IS ALSO A VARIABLE INPUT ( VARIABLE FACTORS)

ADDING AN EXTRA FACTORY BUILDING, MACHINERY & EQUIPMENTS, ON THE OTHER HAND,
MIGHT NOT BE A VARIABLE INPUT. IT MIGHT BE TIME-CONSUMING TO ADD THEM & CERTAINLY
NOT SOMETHING THAT COULD BE DONE IN A SHORT PERIOD OF TIME, SO THEY ARE THE FIXED
INPUT ( FIXED FACTORS)
SHORT RUN & LONG RUN
IN THE STUDY OF ECONOMICS, THE SHORT RUN & THE LONG RUN DON'T REFER TO A
SPECIFIC PERIOD OF TIME, SUCH AS FIVE YEARS OR THREE MONTHS OR TWO WEEKS OR A
COUPLE OF DAYS - RATHER, THEY ARE CONCEPTUAL TIME PERIODS.

THE PRIMARY DIFFERENCE BETWWEN SHORT RUN & THE LONG RUN IS RELATED TO THE
FLEXIBILITY & OPTIONS WITH REFERENCE TO PRODUCTION OF A GOOD – THE DECISION -
MAKERS/ BUSINESS MEN HAVE IN A GIVEN SCENARIO.

IN THE SECOND EDITION OF "ESSENTIAL FOUNDATIONS OF ECONOMICS," AMERICAN

ECONOMISTS MICHAEL PARKIN & ROBIN BADE GIVE AN EXCELLENT EXPLANATION OF THE
DISTINCTION BETWEEN THE TWO WITHIN THE BRANCH OF MICROECONOMICS:

"THE SHORT RUN IS A PERIOD OF TIME IN WHICH THE QUANTITY OF AT LEAST ONE INPUT IS
FIXED AND THE QUANTITIES OF THE OTHER INPUTS CAN BE VARIED.

THE LONG RUN IS A PERIOD OF TIME IN WHICH THE QUANTITIES OF ALL INPUTS CAN BE
VARIED.
"THERE IS NO FIXED TIME THAT CAN BE MARKED ON THE CALENDAR TO SEPARATE THE

SHORT RUN FROM THE LONG RUN.

THE SHORT RUN AND LONG RUN DISTINCTION VARIES FROM ONE INDUSTRY TO ANOTHER.

THE SHORT RUN IS THE PERIOD IN WHICH A COMPANY CAN INCREASE PRODUCTION BY

ADDING MORE OF RAW MATERIALS , MORE LABOR etc. BUT NOT BY ANOTHER FACTORY

BUILDING, MACHINARY etc.

CONVERSELY, THE LONG RUN IS THE PERIOD IN WHICH ALL INPUTS ARE VARIABLE,

INCLUDING EVEN THE FACTORY BUILDING, MACHINARY, LAND etc. IT MEANS THAT THERE

ARE NO FIXED FACTORS OR CONSTRAINTS PREVENTING AN INCREASE IN THE PRODUCTION

OF OUTPUT FOR A FIRM IN THE LONG RUN.

THE LAW OF VARIABLE PROPORTION / THE LAW OF RETURNS TO A FACTOR

IT IS A SHORT- RUN THEORY OF PRODUCTION- IN SHORT RUN SOME FACTORS ARE

FIXED FACTORS & SOME ARE VARIABLE FACTORS.

THERFORE, A FIRM CAN’T CHANGE THE QUANTITY OF THE FIXED FACTORS TO

INCREASE THE PRODUCTION - HOWEVER THE FIRM CAN MAKE USE OF MORE OF THE
VARIABLE FATORS TO INCREASE THE PRODUCTION.

SUPPOSE- A FIRM USES MORE OF A VARIABLE FACTOR (LIKE; LABOUR) KEEPING ALL
OTHER FACTORS CONSTANT, THEN ACCORDING TO THE LAW OF VARIABLE PROPORTION-
THE TP / TOTAL OUTPUT - WILL PASS THROUGH THREE STAGES SUCH AS;
 THE STAGE OF INCREASING RETURNS TO A FACTOR
 THE STAGE OF DIMINISHING RETURNS TO A FACTOR & FINALLY
 THE STAGE OF NEGATIVE RETURNS TO A FACTOR
1. THE STAGE OF INCREASING RETURNS TO A FACTOR
THIS IS THE INITIAL STAGE OF PRODUCTION & IN THIS STAGE THE TP
INCREASES AT AN INCREASING RATE (HIGH RATE) DUE TO INCREASE IN THE
MARGINAL PRODUCT OF THE VARIABLE FACTOR( LABOUR)
2. THE STAGE OF DIMINISHING RETURNS TO A FACTOR
THIS IS THE SECOND STAGE OF PRODUCTION & IN THIS STAGE THE TP WILL
INCREASE AT A DIMINISHING RATE ( LOW RATE) DUE TO THE FALL IN THE
MARGINAL PRODUCT OF THE VARIABLE FACTOR ( LABOUR)
3. THE STAGE OF NEGATIVE RETURNS TO A FACTOR
THIS IS THE FINAL STAGE OF PRODUCTION & IN THIS STAGE THE TP STRATS
FALLING AS THE MARGINAL PRODUCT OF THE VARIABLE FACTOR
BECOMES NEGATIVE

THE THEORY CAN BE EXPLAINED WITH THE HELP OF A NUMERICAL EXAMPLE

AS GIVEN BELOW;
THE TABLE SHOWS THE CHANGES IN THE TP & MP
WHEN A FIRM USES MORE OF A VARIABLE FACTOR
( LABOUR) AGAINST SPECIFIC QUANTITY OF FIXED
FACTORS

1. THE STAGE OF INCREASING RETURNS TO A FACTOR

THIS IS THE INITIAL STAGE & IN THIS STAGE THE TP

INCREASES AT AN INCREASING RATE (HIGH RATE)
DUE TO INCREASE IN THE MARGINAL PRODUCT OF
THE VARIABLE FACTOR.

HENCE THIS STAGE OPERATES UNTILL THE

EMPLOYMENT OF THE 3rd UNIT OF LABOUR WHERE
THE TP INCREASES AT AN INCREASING RATE FROM
0 – 18 UNITS DUE TO INCREASE IN THE MP OF
2. THE STAGE OF DIMINISHING RETURNS TO A FACTOR

THIS IS THE SECOND STAGE & IN THIS STAGE THE TP

INCREASES AT A DIMINISHING RATE ( LOW RATE) DUE TO

THE FALL IN THE MARGINAL PRODUCT OF THE VARIABLE

FACTOR.

HENCE THIS STAGE STARTS FROM THE EMPLOYMENT OF

THE 4th UNIT OF LABOUR AND OPERATES UNTILL THE

EMPLOYMENT OF THE 7th UNIT OF LABOUR WHERE THE TP

INCREASES AT A DECREASING RATE FROM 24 – 30 UNITS

AND REMAINS CONSTANT AT 30 UNITS DUE TO DECREASE

IN THE MP OF LABOUR FROM 6 – 0 UNITS.

3. THE STAGE OF NEGATIVE RETURNS TO A FACTOR

THIS IS THE FINAL STAGE & IN THIS STAGE THE

TP STRATS FALLING & THE MARGINAL PRODUCT
OF THE VARIABLE FACTOR BECOMES NEGATIVE.

THIS STAGE STARTS FROM THE EMPLOYMENT

OF THE 8th UNIT OF THE VARIABLE FACTOR
(LABOUR )

IN THIS STAGE THE TP FALLS FROM 30 UNITS TO

28 UNITS & THE MP OF THE VARIABLE FACTOR
(LABOUR) BECOMES NEGATIVE (-) 2
THE STAGES OF THE LAW OF VARIABLE
PROPORTION CAN BE EXPLAINED WITH THE
HELP OF A DIAGRAM AS GIVEN BELOW
 TP IS MAX.
TP / MP

STAGE I STAGE II STAGE III

TP CURVE

MP IS 0

MP IS NEGATIVE
UNITS OF VARIABLE FACTOR

MP CURVE
ACCORDING TO THE DIAGRAM TP &MP ARE REPRESENTED ON THE y -AXIS AND THE
UNITS OF THE VARIABLE FACTOR ARE REPRESENTED ON THE x- AXIS. TP & MP CURVES
ARE INVERSE - U SHAPED CURVES.

IN THE FIRST STAGE TP & MP CURVES ARE RISING REFLECTING THE PHASE OF
INCREASING RETURNS TO A FACTOR .

IN THE SECOND STAGE TP CURVE IS INCREASING AT A LOW RATE AND MP CURVE SLOPES
DOWNWARD REFLECTING THE PHASE OF DIMINISHING RETURNS TO A FACTOR .

THE SECOND STAGE ENDS WHERE THE TP CURVE IS AT ITS MAXIMUM AND THE MP CURVE
INTERSECTS THE x- AXIS REFLECTING THAT ANY FURTHER ADDITION OF THE VARIABLE
FACTOR CAN’T CONTRIBUTE MORE TO THE TP.

IN THE THIRD STAGE TP CURVE SLOPES DOWNWARD AND MP CURVE IS FALLING BELOW
THE x -AXIS REFLECTING THE PHASE OF NEGATIVE RETURNS TO A FACTOR .
REASONS FOR THE LAW OF INCREASING RETURNS TO A FACTOR

BETTER UTILIZATION OF THE FIXED FACTOR:

 IN THE FIRST PHASE, THE SUPPLY OF THE FIXED FACTORS IS TOO LARGE, WHERE AS THE
VARIABLE FACTOR IS TOO FEW. SO THE FIXED FACTORS ARE NOT FULLY UTILIZED.

 THEREFORE, WHEN THE VARIABLE FACTOR IS INCREASED AND COMBINED WITH FIXED FACTORS,
THEN THE FIXED FACTORS ARE BETTER UTILIZED AND THE TP INCREASES AT AN INCREASING
RATE.

INCREASED EFFICIENCY OF VARIABLE FACTOR:

 WHEN THE VARIABLE FACTOR IS INCREASED AND COMBINED WITH THE FIXED FACTORS, THEN
THE VARIABLE FACTOR CAN BE UTILIZED IN A MORE EFFICIENT MANNER.

 FOR EXAMPLE WITH THE INCREASE IN THE QUANTITY OF THE VARIABLE FACTOR DIVISION OF
LABOR IS POSSIBLE. THIS LEADS TO GREATER CO-ORDINATION- HIGH DEGREE OF
SPECIALIZATION AND THE TP INCREASES AT AN INCREASING RATE.
REASONS FOR THE LAW OF DIMINISHING RETURNS TO A FACTOR
OPTIMUM COMBINATION OF FACTORS:

 AMONG THE DIFFERENT COMBINATIONS BETWEEN VARIABLE AND FIXED FACTOR, THERE IS ONE
OPTIMUM COMBINATION, AT WHICH TOTAL PRODUCT (TP) IS MAXIMUM. AFTER REACHING THE
OPTIMAL COMBINATION , THE MARGINAL RETURN OF VARIABLE FACTOR BEGINS TO DIMINISH.

 FOR EXAMPLE, IF A MACHINERY (FIXED FACTOR) IS AT ITS OPTIMUM USE, WHEN 4 LABORS ARE
EMPLOYED, THEN ADDITION OF ONE MORE LABOR WILL INCREASE TP BY VERY LESS AMOUNT AND MP
WILL START DIMINISHING.

IMPERFECT SUBSTITUTES:

 DIMINISHING RETURNS TO A FACTOR OCCURS BECAUSE FIXED AND VARIABLE FACTORS ARE
IMPERFECT SUBSTITUTES OF ONE ANOTHER. THERE IS A LIMIT TO THE EXTENT TO WHICH ONE FACTOR
OF PRODUCTION CAN BE SUBSTITUTED FOR ANOTHER.

 FOR EXAMPLE, LABOR CAN BE SUBSTITUTED IN PLACE OF CAPITAL OR CAPITAL CAN BE SUBSTITUTED
IN PLACE OF LABOR TILL A PARTICULAR LIMIT. BUT, BEYOND THE OPTIMUM LIMIT, THEY BECOME
IMPERFECT SUBSTITUTES OF ONE ANOTHER, WHICH LEADS TO DIMINISHING RETURNS.
REASONS FOR THE LAW OF NEGATIVE RETURNS TO A FACTOR

INSUFFICIENCY OF FIXED FACTORS:

 THE NEGATIVE RETURNS TO A FACTOR APPLY BECAUSE SOME FACTORS OF PRODUCTION ARE OF
FIXED NATURE, WHICH CAN NOT BE INCREASED WITH INCREASE IN VARIABLE FACTOR IN THE
SHORT RUN.

POOR COORDINATION BETWEEN VARIABLE AND FIXED FACTOR:

 WHEN VARIABLE FACTOR BECOMES TOO EXCESSIVE IN RELATION TO FIXED FACTORS, THEN THEY
OBSTRUCT EACH OTHER. IT LEADS TO POOR CO-ORDINATION BETWEEN VARIABLE AND FIXED
FACTOR. AS A RESULT, TOTAL OUTPUT FALLS INSTEAD OF RISING AND MARGINAL PRODUCT
BECOMES NEGATIVE.

DECREASE IN EFFICIENCY OF VARIABLE FACTOR:

 WITH CONTINUOUS INCREASE IN VARIABLE FACTOR, THE ADVANTAGES OF SPECIALIZATION AND

DIVISION OF LABOR START DIMINISHING. IT RESULTS IN INEFFICIENCIES OF VARIABLE FACTOR,
WHICH IS ANOTHER REASON FOR THE NEGATIVE RETURNS TO EVENTUALLY SET IN.