BUSINESS ECONOMICS - Iycmou.digitaluniversity.ac/WebFiles/MCom_M17... · Business Economics 8 Business Economics - I ... He defines managerial economics as “the study ... “managerial

COM 231

BUSINESS ECONOMICS - I

M. Com (M 17) – Part ISemester - II

(Compulsory)

YASHWANTRAO CHAVAN MAHARASHTRA OPEN UNIVERSITYDnyangangotri, Near Gangapur Dam, Nashik 422 222, Maharashtra

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YASHWANTRAO CHAVAN MAHARASHTRA OPEN UNIVERSITY

Vice-Chancellor : Dr. M. M. SalunkheDirector (I/C), School of Commerce & Management : Dr. Prakash DeshmukhState Level Advisory CommitteeDr. Pandit Palande Dr. Suhas Mahajan Dr. V. V. MorajkarHon. Vice Chancellor Ex-Professor Ex-ProfessorDr. B. R. Ambedkar University Ness Wadia College of Commerce B.Y.K. College, NashikMuaaffarpur, Bihar Pune

Dr. Mahesh Kulkarni Dr. J. F. Patil Dr. Ashutosh RaravikarEx-Professor Economist Kolhapur Director, EDMU,B.Y.K. College, Nashik Ministry of Finance, New Delhi

Dr. A. G. Gosavi Dr. Madhuri Sunil Deshpande Dr. Prakash DeshmukhProfessor Professor Director (I/C)Modern College, Shivaji Nagar, Pune Swami Ramanand Teerth Marathwada School of Commerce & Management

University, Nanded Y.C.M.O.U., Nashik

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N I B M , Pune Y.C.M.O.U., Nashik

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School of Commerce & Management, Y.C.M.O.U., Nashik

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M. Com. ( M 17) Part – I (Business Economics - I)

(Compulsory)

Semester - II

Contents Pages

Unit 1. Nature, Scope and Definition of Managerial (Business) Economics 7 to 12

Unit 2. Importance, Contribution and Basic Concepts 13 to 16

Unit 3. Concept of Elasticity 17 to 28

Unit 4. Cardinal and Ordinal Utility 29 to 41

Unit 5. Revealed Preference Theory 42 to 50

Unit 6. Demand Forecasting Techniques 51 to 61

Unit 7. Theory of Production – I 62 to 71

Unit 8. Theory of Production – II 72 to 80

Unit 9. Economics and Diseconomies of Scale 81 to 80

Unit 10. Cost Concept 89 to 95

Unit 11. Theories of Costs 96 to 102

Unit 12. Optimum Production in The Short Run 103 to 105


INTRODUCTION

This book of self-instructional material is based on the syllabus for the subject“Business Economics” - I (Com. 231). In practice sometimes some peoplecall this paper is Managerial Economics because most of the topics coveredby business economics and concepts, theories and tools developed thereindeal with decision making and practical management in the working of abusiness unit, a firm or enterprise.

This book deals with basic concepts in business economics - i.e. - demand,supply, elasticity, revenue and cost concepts and curves, market structure,production function, demand projection.

The authors have kept in mind the fact that students here an distantstudents, sprend over a large territory, different environment and do nothave regular interaction with feachers. Therefore, if has been our ulmosteffort to simplify, without affecting scientific quality and precision, inthe organization of SIM. Necessary numerical examples and diagrams areused in explaination.

Comment, and modification and addition if any and welcome.

The editor and authors are grateful to the authorities of the YCMOU forguidance and co-operation.

Nashik - January, 2016.

J. F. PatilEditor


Business Economics

6 Business Economics - I

NOTES


Business Economics - I 7

NOTES

Nature, Scope and Definitionof Managerial (Business)

EconomicsUNIT 1 : NATURE, SCOPE AND

DEFINITION OF MANAGERIAL(BUSINESS) ECONOMICS

Structure

1.0 Introduction

1.1 Objectives

1.2 Subject Description

1.2.1 Nature and Scope of Business Economics

1.2.2 Scope of Managerial (Business Economics)

1.3 Summary

1.4 Some Important Words and their meaning

1.5 Questions for Self-Study

1.6 Answers to question for self study

1.7 Exercises

1.8 Field Work

1.9 Books for further reading

1.0 INTRODUCTION

The term managerial economics or business economics is of recent origin ineconomics literature. We will use the managerial economics as synonymous withbusiness economics. Managerial Economics became a separate branch ofeconomics, more particularly after 2nd world was and growth of global businessthrough corporate organization, larger scale of operations and rapid improvementsand progress in technology vis-à-vis production and distribution. Modern business– industry and trade, involves large man-power, intensive and extensive divisionof labour, large amounts of financial capital and huge infrastructure. Most efficientuse of such large complexes of productive systems requires highly competentand constantly dynamic management with full and precise understanding of basicconcepts of economics.

1.1 OBJECTIVES OF THE UNIT

The reader, after careful reading the contents of this unit, will be in a position tounderstand in an elaborate way –

I. Definition of managerial economics.

II. Meaning of managerial economics.

III. Scope of managerial economics.

It is always essential to understand the basic meaning of study area along with aproper grasp of scope of the topic and know the exact definition of what we arestudying. In this sub-unit we focus only on meaning, scope and definition ofmanagerial economics.


Business Economics


NOTES

1.2 SUBJECT DESCRIPTION

We discuss below some introductory aspects of the subject under study. It is asimple, as far as possible, non-technical explanation of the content and scope ofthe subject, here managerial economics.

1.2.1 DEFINITION OF MANAGERIAL ECONOMICS

The phrases Managerial Economics and Business Economics are broadly used tomean the same thing. However, business economics is a term used to meaneconomics which a business man should understand. Managerial Economics,however, emphasises managerial functions, attributes and attitudes and abilitiesrequired for carrying out managerial functions in any business manufacturing,trade, financial services, agriculture and other services. In simple, managerialeconomics enables a businessman to make proper economic decisions andundertake proper timely, precise and effective forward planning.

Managerial economics evolved with the growth of industry and trade – hunting,pastoral activities, agriculture, primary craft based industry, organised trade andfinance (commerce) and modern manufacturing and services industry. It is theresult of some organisers, businessmen and consultants in the field writing downtheir experiences, difficulties and solutions.

We will examine some definitions of managerial economics in order to pinpointthe exact meaning of managerial economics.

(i) Joel Dean : He defines managerial economics as –

“It is a departure from the main stream of economic writings on thetheory of firm; much of which is too simple in its assumptions and toocomplicated in its logical development to be managerially useful”. Inclearer-words, simplification of rigorous economic theory is managerialeconomics. Therefore, many experts in the field, believe that managerialeconomics is the methodology of economics useful for the analysis ofbusiness situations.

Many believe that managerial economics is the logic of economics asapplied to practical situations.

(ii) Prof. Watson : Let us examine Prof. Watson’s definition of managerialeconomics. According Prof. Watson managerial economics is definedas – “Price theory in the service of business executives.” In other words,various aspects of price-theory, when made amenable to applicationand solution of business problems, constitute managerial economics.

(iii) Prof. W. W. Haynes : He defines managerial economics as “the studyof the allocation of resources available to a firm or other units ofmanagement among activities of that unit.” Each unit of businessorganization undertakes activities like collection of raw material,processing the same; packaging, distributing and advertising and finallyselling the product, storage and inventory, human resource managementetc. where at every step a decision regarding allocation of limitedresources in a productive, efficient manner requires understanding ofbasic economics principles.

(iv) Prof. Gillis : Prof. Gillis maintains that ‘managerial economics dealsalmost exclusively with those business situations which can be quantifiedand dealt within a model or at least, approximately quantitatively.” In



NOTES


Economics

other words, application of various principles, theories, laws and rulesof economics to business related decision making, is managerialeconomics.

(v) Spencer and Siegelman : According to Spencer and Siegelman,“managerial economics is the integration of economic theory withbusiness practice to facilitate decision making and forward planning.”In other words, managerial economics needs proper understanding ofeconomic theory as also an understanding of planning for future.

(vi) Eugene and James Papas : For Eugene and James Papas, managerialeconomics requires “the application of economic theory andmethodology to business administration practices.”

(vii) McNair and Miriam define managerial economics as the use ofeconomic modes of thought to analyse business situations.

(viii) McGurial and Moyre make a more direct statement. According to them“managerial economics is the application of economic theory andmethodology to decision making problems faced by both public andprivate institutions.

(ix) Finally, we must note that for Prof. Mansfield managerial economicsis concerned with application of economic concepts and economicanalysis to the problem of formulating rational managerial decisions.

It is thus clear that – managerial economics

l Uses economics principles.

l Uses economic theory.

l Uses economic logic.

l Uses economic methodology.

to examine –

l Business situations.

l Business problems.

l Allocation of resources.

to arrive at –

l Rational managerial decisions.

l Scientific economic decisions.

And –

l Uses economics knowledge for forward planning.

For –

l Efficient allocation of resources to maximise economic gain for thebusiness unit.

1.2.2 MEANING OF MANAGERIAL ECONOMICS

Economics, according to Lord Lionel Robbins is a study of human behaviour as arelationship between unlimited ends and scarce means which have alternativeuses ‘Economic man aims at, in consumption, maximum utility and in production,maximization of profits. Management is a way, scientific way of striking a balancebetween multiplicity of requirements and scarcity of means with alternative uses.Managerial economics is therefore a science which deals, more with behaviour


Business Economics


NOTES

of an entity (individual, partnership, corporate, non-govt. govt. and public,charitable etc.) in the attempt to allocate and use scarce resources most efficientlyto maximise profits, sales, minimise costs and reach positions of optimizationand equilibrium in its material, economic functioning.

1.2.3 SCOPE OF MANAGERIAL ECONOMICS

The scope of managerial economics is vast and complex. We have already notedtwo main functions of managerial economics.

l Decision making.

l Forward Planning.

The scope of managerial economics is decided by these two functions. Naturally,various economic decisions comprise first part of scope of managerial economics.If we carefully think over, it is realised that there are many major areas in whichbusinessmen are required to take decisions. These areas are –

(i) Decisions regarding demand condition.

(ii) Decisions regarding supply conditions.

(iii) Decisions regarding cost-conditions.

(iv) Decisions regarding pricing of products in different kinds of marked.

(v) Decisions regarding manpower, recruitment, training, placement,promotion, termination and other working conditions.

(vi) Decisions regarding profit management.

(vii) Decisions regarding macro-economic conditions.

(viii) Decisions regarding financing and capital.

(ix) Decisions regarding choice of technology.

(x) Decisions about planning and policy.

No business unit wills be successful without a proper assessment of demand forits product. He, the business owner, has to estimate potential demand, actualdemand, change in demand, tastes and habits behind demand, and factors affectingdemand. He must realise that quantity of his product also determines demand. Hehas to understand elasticity of demand w.r.t. charges in income, prices and otherfactors. He must also know about cross and substitution classification of demandfor this product.

After ascertaining and estimating demand, the businessman will have totake decisions regarding production and costs. These decisions include, what toproduce, how much to produce, how to produce (technology); how to procureraw material, at what prices, in what quantities and level of inventories. Thebusinessman requires to know about production function, returns to scale, divisionof labour, factor substitution, industrial location etc. He must also take decisionsregarding recruitment of man power, distribution channels competing goods andsales promotion.

The manager of business firm is continuously faced with various pricingdecisions, under different market conditions. This requires proper market analysis.The price of the product, prices to be paid for raw materials, labour, capital andoverheads and many other things. The businessman must know various pricingpolicies like – average cost pricing, cost plus pricing, discriminatory pricing,going rate pricing etc.



NOTES


Economics

The scope of managerial economics can be shown with following chart.

Managerial Decision Problem

l Product price

l Volume of output

l Make or Buy

l Technology

l Inventory

l Advertising, media and intensity

l Labour-hiring, training, placement, pay-benefits (HRM)

l Investment and financing

Economic Concepts

l Framework for division

l Theory of consumer behaviour

l Theory of the firm

l Theory of market structure and pricing

Decision Sciences

l Tools and Techniques of Analysis

l Numerical analysis

l Statistical Estimation

l Forecasting

l Game Theory

l Optimization

Managerial Economics

l Use of economic concepts and decision sciences

l Methodology to solve managerial decision problems

l Optimal solutions to managerial decision problem.

1.3 SUMMARY

l Managerial Economics is application of economic logic to solve businessproblems and business planning and take business decision.

1.4 SOME IMPORTANT WORDS AND THEIRMEANING

l Management – Taking decisions and planning.

l Economics – Science of Choice.

l Managerial Economics – taking economic decisions and organisingfuture economic behaviour.

l Forward planning – planning for future short, medium and long-term.


Business Economics


NOTES

1.5 QUESTIONS FOR SELF STUDY

i) What is managerial Economics?

ii) What are different areas of business decision making?

1.6 ANSWERS TO QUESTION FOR SELF

STUDY

(i) According to Prof. Watson – “Managerial Economics is price theory inthe service of business executives.

(ii) Following are different avers of business decision making.

l Demand conditions

l Supply conditions

l Production system

l Pricing of product and factors of production

l Profit maximization

l Macro economic conditions.

1.7 EXERCISES

(i) Explain in detail the scope of managerial economics.

(ii) Discuss various decisions making situations in business.

1.8 FIELD WORK

l Meet a businessman and discuss with him his business problems. Writedown the gist of your discussion.

1.9 BOOKS FOR FURTHER READING

l ‘Managerial Economics – Analysis for Business Decisions’, by HagueD.C.

r r r



NOTES

Importance, contributionand basic conceptsUNIT 2 : IMPORTANCE, CONTRIBUTION

AND BASIC CONCEPTS

Structure

2.0 Introduction

2.1 Objectives of the Unit


2.3 Summary

2.4 Some Important Words and their meaning


2.6 Answers to question for self study

2.7 Exercises

2.8 Field Work


2.0 INTRODUCTION

This unit briefs about importance of managerial economics, its contribution andexplains some of the basic concepts.

2.1 OBJECTIVES OF THE UNIT

This unit will enable the reader to understand –

I. Importance of the subject business / managerial economics.

II. Contribution of business economics.

III. Important basic concepts in managerial economics.


2.2.1 BASIC APPROACH

We all know that every firm ultimately aims at profit maximization-profits basicallydepend on the difference between price-received and cost incurred in theproduction of the good. In other words, the profits will be decided by the decisionof the businessman, regarding prices of inputs, quantity produced and sold, pricesof output etc. In all these respects, the business man will have to take decisionswith a view to maximising profit.

There are certain factors like changes in govt. policy, change in GDP, change inbank-rates, CRR, exchange rate, planning which we call as macro-economicfactors. Changes in such macro-economic factors do affect the working andsuccess of business firms. A businessman, who is not alert to change in macro-economic factors, may come into trouble any time. Whenever, there are changes


Business Economics


NOTES

in macro-factors, the businessman with have to revise his decision regarding whatto produce, how to produce, how much to produce and the price at which it is tobe sold.

Regarding the second major function-forward planning, the businessman must bein a position to take decisions regarding – estimates of future demand, possibilitiesof change in tastes and habits, emergence of competing goods, changes in govt.policy and other macro factors. He has to have access to reliable data in thisrespect.

Finally, we can conclude that reliable information and knowledge regardingdemand and supply, cost and revenue, production conditions, pricing, marketconditions macro-factors and various aspects of business environment constitutethe scope of the business economics.

2.2.2 CONTRIBUTION OF MANAGERIALECONOMICS TO BUSINESS DECISION MAKING

Managerial economics uses basic economic analysis to take business decisions.

Theory of consumer behaviour, that is demand analysis helps business decisionmaking regarding size of demand, elasticity of demand, demand forecasting anddecision about changes in product price.

Theory of production (Firm) enables businessmen to decide upon productiontechnology, scale of production, factor-combination, location of unit and buyingof raw material and other inputs.

Theory of market equips the businessmen with alternative decision pattern inresponse to type of market competition he faces, e.g. monopoly, duopoly oligopoly,monopolistic completion and perfectly competitive market. It is a well-knowneconomic fact, that with increasing market competition the businessmen loses,more and more his price making power and has to take prices given by the market.Economics has developed (in its developed quantitative firm) various techniquesof measurement and fore-cast of demand, supply, elasticity and other economicvariables which make business decision making more and more precise and reliablewith advances in econometrics, the capacity to predict well as to more meaningfullyexplore economic causation, has improved, which strengthens capacity ofbusinessmen to take decisions.

2.3 SUMMARY

Managerial economics helps businessmen in making choices and taking economicdecisions regarding resource allocation, factor & product pricing, technology,location and profit maximization. It also helps in scientific forward planning inrespect of all the business aspects mentioned above.

2.4 SOME IMPORTANT WORDS AND THEIRMEANING

There are a set of basic concepts or postulates in economics which very effectivelycan guide a businessmen in taking business decision. These basic concepts orpostulates are briefly explained below –



NOTES

Importance, contributionand basic concepts

(i) Choice - a basic economic problem : According to Lord Robbinseconomics is fundamentally a science of choice between alternativeswith limited resources. Resources are always limited. They havealternative uses. Therefore, economics is making a profitable choice.Businessmen are always confronted with such choices.

(ii) The Principle of tradeoff : When our resources are limited and wehave to buy or obtain say both X and Y, then with limited resources, Ican have more of X only when Ireduce use of Y by some units. Withlimited resources, I cannot increase consumption of both X and Y at thesame time. This is known as principle of trade of.

(iii) The opportunity cost : The real cost of some thing is something thatwe give up to get that thing. Suppose I have only Rs. 100/-. I can usethat amount to buy a ticket to a multiplex and enjoy a cinema. But if buya book on economics for Rs. 100/- then I have to forget about cinema.Therefore, opportunity cost of having a book is giving up enjoying acinema.

(iv) Incentives are causes for change in human behaviour : When pricesor attributes of goods change, human demand for those goods alsochanges. Law of demand is a very simple but clear example of howincentives change human behaviour. If you reduce the price of particulartype of Banarash silk sari, many more buyers will buy more units ofthat sari. Similarly if you improve quality (in terms of colour, durability,design) of your product, people will buy more units of your product,even at the same price.

(v) Margin : It is generally believed that human behaviour is rational. Ifyou are rational, you consider the effects of your change in behaviouri.e. marginal benefits and marginal costs – A rational decision is onewhere marginal benefits are greater than marginal costs. In case, as theresult of our decision, marginal benefits are exactly equal to marginalcosts, you will not change your earlier economic behaviour.

There are many other basic concepts in economics which need to be grasped –

These are –

(vi) Trade benefits all parties involved (buyer as well seller)

(vii) Free markets organise economic activity efficiently.

(viii) When market is not perfectly competitive, government action mayimprove market outcome.

(ix) National income (GDP) which depends on capacity of the economy toproduce goods and services determines a country’s standard of living ina direct way.

(x) Larger money supply, at least in short period, causes inflation.

(xi) At higher levels of inflation, unemployment is lower, and vice-a-versa.

(xii) Price-mechanism that operates in market, ensures distribution of goodsand services (products and factors) efficiently.

(xiii) Forces of demand and supply give us the basic framework for economicanalysis and decision making.


Business Economics


NOTES

2.5 QUESTIONS FOR SELF-STUDY

1. Explain the importance of managerial economics

2. List the contribution of managerial economics.

3. List the basic concepts of managerial economics.

2.6 ANSWERS TO QUESTION FOR SELF

STUDY

1. Managerial economics assists business executives to take importantbusiness decisions like, what to produce, how to produce, how much toproduce, pricing the product, factors utilization, sales promotion, andmaximisation profits. It also helps businessmen in forward planningregarding the aspects mentioned above.

2. Managerial Economics contributes to business management in followingways –

(a) Allocation of resources.

(b) Factor utilization.

(c) Choice of production techniques

(d) Sourcing raw materials.

(e) Sales promotion.

(f) Price setting.

(g) Identifying markets.

3. Basic concepts in managerial economics are - choice, trade off,opportunity cost, incentives, margin, market.

2.7 EXERCISES

1. Discuss various economic decisions a businessmen has to take?

2. Explain basic elementary concepts in managerial economics.

2.8 FIELD WORK

l Discuss with a small group of shop-keepers their initial and regularproblems while decision making is involved.


l ‘Managerial Economics – Analysis for Business Decision’, HagueD. C.

r r r



NOTES

Concept of Elasticity

UNIT 3 : CONCEPT OF ELASTICITY

Structure

3.0 Introduction

3.1 Objectives


3.3 Summary

3.4 Important Words and their meaning


3.6 Answers to question for Self-Study

3.7 Exercises

3.8 Field Work


3.0 INTRODUCTION

Concept of elasticity, regarding demand and supply, more so in regard to demandis a vital tool of economic analysis and decision making. This unit explain elasticityconcept in all its important aspects.

3.1 OBJECTIVES

The study of this unit will acquaint the reader with –

I. Definition of concept of elasticity.

II. Various types of elasticity of demand.

III. Elasticity of Supply.

and IV. Applications of the concept of elasticity.


3.2.1 ELASTICITY CONCEPT

In this part we examine- the concepts of elasticity of demand, its different typesand also the concept of elasticity of supply.

The objectives of this sub unit are – to

(i) understand the concept of elasticity with regard to demand and supply.

(ii) evolve and use precise formulae for measuring different types ofelasticity of demand and supply.

and (iii) Solve practical examples of elasticity of demand and supply.


Business Economics


NOTES

3.2.2 INTRODUCTION

In economics, the concept of elasticity in regard to demand and supply, constitutesa basic element of foundation of economic principles and decision making.

According to law of demand given other things, a change in price of a commoditycauses opposite changes in demand for that commodity at a given time. To bemore elaborate, given other things.

l A decrease in price of X will increase quantity demanded of X or;

l A increase in price of X will decrease quantity demanded of X. In brief,changes in price of X and quantity demand of X are inversely related.

l However, in regard to supply, changes in price of X and quantity suppliedof X, are directly related. i.e. if price of X increase, supply of X willincrease and vice-r-versa.

l The concept elasticity is a measure of intensity or degree of response ofdemand or supply of a commodity, to a change in the price of acommodity.

3.2.3 THE CONCEPT OF ELASTICITY

Broadly elasticity is a measure of change in effect due to a change income.

In economic theory, there are certain fundamental laws e.g.

Law of Demand and Law of Supply

These are causal relations between price of commodity X and changes in demandfor and supply of such commodity X due to changes in the price.

It is normally accepted that –

P of X and D of X are inversed related.

P of X and S of X are directly related – of course where other things remainconstant.

3.2.4 PRICE ELASTICITY OF DEMAND

The law of demand in economics tells us that other things being constant- a changein price induces an opposite change in the quantity demanded of the commodity.But this relationship indicates only the direction of change. If we want to measurethe quantity of change in demand due to a certain quantity of change in price, wemust use the concept of elasticity of demand. In this case, other things which aresupposed to be constant are income, habits and tastes of the consumer and pricesof other close substitutes in the market.

Price Elasticity of Demand is, according to Marshall, the responsiveness of demandfor a commodity X to change in price of that commodity, Price elasticity or asBoulding calls it relative elasticity, measures the proportionate change in quantitydemanded due to proportionate change in price of the commodity. Let us considerthe following formula.

Relative change in quantity demanded of commodity XEpx = _____________________________________________

Relative change in price of commodity X



NOTES

Concepts of Elasticityqx px Epx = ____ ) ____

qx px

qx Px= ____

V___

px qx

Where Px = Original price of X

Qx = Original quantity of X demanded

Qx = change in quantity demanded

Px = change in price of X.

Let us explain this formula by a numerical example. Suppose price of sugar is Rs.30 per kilogram. At this price, demand for sugar of a family, at a given time is 10Kgs. Suppose price of sugar increases to Rs. 32 per Kg. The demand goes downby 2 Kg. What is the price elasticity of demand for sugar? Let us calculate.

Px = Rs. 30/- Kg.

Qx = 10 Kgs.

Qx = 10 – 8 Kg. = 2 Kgs. ............. (Demand falls – ve)

Px = 32 – 30 = Rs. 2 ............. (Price increases + ve)

Edp = ___V

___

= __V

__

= __V

__

= 3

Elasticity of demand for sugar wrt price is 3, highly elastic. Normallynegative sign is disregarded. Negative sign indicates inverse relationbetween price and demand changes.

3.2.5 TYPES OF PRICE ELASTICITY OF DEMAND :-

Price Elasticity of demand for different goods differs – following are differenttypes of price elasticity of demand.

(a) Perfectly Elastic Demand :-

In Fig. 1 PD is a demand curve.

OP is price and demand is infinite.

If there is slight change (rise) inprice demand disappears – A slightfall in price increases demandinfinitely in a fully competitivemarket-demand tends to perfectlyelastic demand curve is parallel toOX axis.

(b) Normal Elastic Demand :-

This is shown in Fig. 1.2 when price is OP, demand is OD. When price is OP1

demand in OD1. When % change in demand is greater then % change in price,

210

+230

22

3010

11

31


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NOTES

price-elasticity is greater than 1. The demand curve stopes downward to the leftand is fatter. In fig. 1.2-A we show is a steeper demand curve. Here % change inprice is greater than % change in demand, therefore demand is less elastic.Therefore price-elasticity is less than one.

In fig. 1.2 & 1.2-B, we show a demand curve with a unitary elastic demand. Inthis CRX % change in demand and % change in price are equal. Therefore, priceelasticity of demand is equal to one. It is unitary.

In fig. 1.2-C, we show a demand curve, which is parallel to OY axis (vertical toOX axis). Such a demand is perfectly inelastic. Any change in price does notchange the quantity demanded.

Normal goods have more or less elastic demand. Goods which are basic necessitiesor essential have inelastic demand. Luxury goods have elastic demand.

3.2.6 INCOME ELASTICITY OF DEMAND

Price is not the only factor which influences demand. There are other factorslike changes in income, which affect demand even when price remainsconstant.

Respensiveness of demand to change in income measures income elasticityof demand. The formula for measuring income-elasticity of demand is asunder.

% change in demandIncome Elasticity of Demand = ___________________

% change in income



NOTES

Concepts of ElasticitySymbolically,

Q Y Eyd = ___

V__

Y Q

Where,

Eyd = Income elasticity of demand

Q = Change in quantity demanded

Y = Change in income.

When value of income elasticity is greater than one, proportionate change inquantity demanded is greater than proportionate change in income. When valueof income elasticity in less than one, proportionate change in demand is less thatproportionate change in income, zeroincome elasticity of demandindicates that change income (+ or! ) does not affect quantitydemanded. If increased incomereduces quantity demanded or vice-versa; income elasticity becomesnegative.

Figure 1.3-A, B, C show differenttypes of income elasticity in respectof different kinds of goods.

In Fig. 1.3-A, DD1 is a demand curvewrt income. It is flatter and rises toleft. With a fall in income from I toI1 demand falls from Q to Q. (vice-versa). It is evident that a smallchange in income causes a bigchange in demand. Thus here incomeelasticity is greater than one,indicating superior good.

In this figure, we depict the exampleof normal goods, where % change indemand will be less than % changein income. With a fall in income fromI to I1, demand falls from OQ to OQ1.% change in demand is less than %change in income. This is the case ofnormal goods.

Fig. 1.3-C shows the example ofinferior goods. In case of such goods,with a rise in income-demand fallsand vice-versa. In fig. 1.3-C incomefalls from I to I1 and demand risesfrom Q to Q1.

Curves of the nature of 1.3-A, B & Care sometimes called as EngelCurves.


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NOTES

3.2.7 CROSS ELASTICITY OF DEMAND

Just as price of a good affects demand, factors like income and prices of othercommodities also affect demand. In the previous paragraph we examined variouspossibilities of income elasticity of demand.

Now we examine the concept of cross-elasticity of demand. Now suppose thereare two goods X and Y. When we examine the responsiveness of demand for X,(without change in its price) to a change in the price of Y, we measure CrossElasticity.

The formula for measuring cross elasticity of demand for X wrt (with respect to)a change in the price of Y is given under.

X Py Exy = ____

V___

PY X

Where,

Exy = Cross Elasticity of demand for X wrt. To change in price of Y.

X = Change in demand for X good.

Y = Change in price of Y.

Py = Original price of Y.

X = Original demand for X.

When we measure cross elasticity of demand for X wrt Y, we keep price of Xconstant and consumer’s income constant.

3.2.8 COMPETITIVE GOODS AND COMPLEMENTARYGOODS AND CROSS ELASTICITY

It is evident that nature of goods X andY will influence value of crosselasticity.

If X and Y are competitive goods, i.e.they are substitutes for each other, thecross elasticity of X wrt Y is positive.

If price of Basamati rise increases, thedemand for Ajara Ghansal alsoincreases. Similarly when price ofBasamati decreases, the demand forAjara Ghansal also decreases. This isbecause consumer always tries tosubstitute cheaper good for dearergood. This is shown in figures 1.4-Aand 1.4-B.

Substitute Goods :-

In this case, demand curve D D1, ispositively sloped, which means if priceof Y increases, demand for X will alsoincrease. This is the case of substitutegoods like tea and coffee.



NOTES

Concepts of ElasticityComplementary Goods :-

In this case, if price of Y falls, demand for X increases and if price of Y increases,demand for X also decreases. Such relationship is observed for complementarygoods like tea powder and sugar.

3.2.9 FACTORS INFLUENCING PRICE - ELASTICITYOF DEMAND

There are a number of non-price factors which influence price-elasticity of demand.These include necessities for which Ep is inelastic e.g. foodgrains, salt, milkedible oil etc. Demand Ep for luxuries like paintings and historical things is elastic.Ep for durable goods like footwear, clothes etc is elastic. Goods like electricitywhich has multiple uses, have elastic demand. Demand for substitute goods ishowever elastic but for joint goods inelastic. It is also seen that price electricityof demand is influenced by share of spending on a commodity in total consumerspending. Price elasticity or various directly with share of spending on thatcommodity in total spending. Finally, very low levels of price initially, do notcreate significant changes in demand due to small changes in price. Rising incomelevel and more equal distribution of incomes increase price elasticity of demand.In the long run, price elasticity of demand tends to increase. Greater and moreinclusive infrastructure tends to increase price elasticity of demand.

3.2.10 ELASTICITY OF SUPPLY

The responsiveness of supply to changes in price (other things remaining constant)is elasticity of supply. The formula for measuring price-elasticity of supply isgiven below.

S P Es = ___

V__

P S

As relationship between price andsupply is basically positive, other thingsremaining constant, when pricedecreases, supply decreases and whenprice increases, supply also increases.Price elasticity of supply is, howeverdetermined in the long run by supply ofraw materials, technology, industrialpeace and govt. policy.

Normally, the supply curve is upwardsloping to the right as given in Fig. 1.5.

SS is a supply curve sloping upwards to the right. When price increases from P toP1 supply increases from Q to Q1. Threfore, Es is equal to –

% change in supplyEs = ________________

% change in price

QQ1 PP1Es = ____ ) ___

OR OP

QQ1 OQEs = ____

V___

PP1 OP


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NOTES

It is elastic, in this case greaterthan one.

Fig. 1.5-A is a case of infinitelyelastic supply which is very rare.

Fig. 1.5-B is a case of perfectlyinelastic supply. This may happens invery short period. But, supply isnormally more or less elastic.

3.2.11 MEASUREMENTOF ELASTICITY

There are three methods of measuringprice-elasticity of demand; namely

(i) Total outlay Method orTotal Expenditure Method.

(ii) Point Method.

(iii) Arc Method.

We explain these methods in the following paragraphs.

Total Outlay Method :-

This is also known as Total Expenditure or Total Revenue method. Total revenueof a firm is price (= AR) of the commodity and quantity of goods sold. Normally,firms aim at maximising total revenue.

TR = Price X Quantity sold Where TR = Total revenueTR = ARX Quantity sold AR = Average Revenue. In a competitive

market AR = Price.

Total outlay (= expenditure = Revenue) method of measuring price – elacticitywas developed by Dr. Marshall. A seller will always look to changes in totalrevenue as a responce to change in price. Let us take one example.

Table1.1 Demand Schedule(for Wheat, Salt and Butter)

(Rs.)

Price Quantity P x Q = TR Quantity P x X = TR Quantity P x Q = TRP. demanded Total Revenue demanded Total revenue demanded Total revenue

Rs. / Wheat For Wheat of Salt for Salt of butter for butterKg. Kg. Rs. Kg. Rs. Kg. Rs.

Rs.10 200 2000 10 100 20 200

Rs. 8 220 1760 12.5 100 30 240

Rs. 5 300 1500 20 100 50 250

Source : Business Economics – By Dr. J. F. Patil & others,Phadke Prakashan, Kolhapur-2003, P.64.

In the case of wheat, we find that, with falling price, total revenue is also falling.It is clear that price elasticity of demand for wheat is less than one (less elastic).In the case of salt, although there is fall in price, and quantity demanded increases,the total revenue is constant. In such a case, price – elasticity of demand is unitary.In the case of butter however, with fall in price, quantity demand increases

A



NOTES

Concepts of Elasticitysignificantly and TR increases. This is an example of more than one elasticity ofdemand. We can conclude –

l When fall in price leads to decreasing TR, demand is less than unitelastic.

l When fall in price leads to constancy in TR, demand is Unitary elastic.

l When fall in price leads to increasing total revenue TR demand is morethan one elastic.

3.2.12 THE POINT METHOD OF MEASURING PRICEELASTICITY OF DEMAND

This method is also known asgeometric method of measuring priceelasticity of demand. This method isbased on demand curve. When weconsider a demand curve (normally acurve sloping downwards to right), wetake a point on the curve and thenconsider a small change in it andmeasure elasticity value in a geometricway, therefore, it is also called asgeometric method of measuring price– elasticity of demand – Let us nowexamine a diagram in this regard andmeasure price-elasticity of demand.

According to established analysis –

Lower segment of demand curvePoint Easticity of Demand = ____________________________

Upper segment of demand curve

In this figure, AF is the usual demand curve. OY measure price and DX measuresquantity demanded. A, B, C, D, E are points on the AF demand curve. Now as perour formula,

AF Ep at point A = ____ = = infinite

Zero

DFEp at point D = ___ = < 1.

AA

ZeroEp at point F = ____ = zero.

A

BFEp at point C =

____ = 1 because CF = AC.

AC

BFEp at point B = ____ = > 1

AB

The numerical values of Ep can be found if we practically measure thedistances.


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3.2.13 ARC METHOD OF MEASURING ELASTICITY

Point method of measuring elasticity is useful only when demand curve is linearstraight line. However,demand curves are rarelystraight-line – they areusually curvilinear.Moreover, point methodmeasures elasticity forslight changes in price. Inpractice, businessmen areinterested to find outdemand response over arange. In such cases ARCmethod is used.

In this diagram, AB is ademand curve. P and R aretwo points on the curve (PRconstitutes the ARC)

According to ARC method, price elasticity of demand is measured by the followingformula.

OQ1 – OQ OP + OP1Ep = _________ H _________ OQ1 + OQ OP – OP1

Where,

OQ = quantity demanded at price OP

OQ1 = quantity demanded at price OP1

OP = original price

OP1 = changed price

We can take a numerical example,

Price of Dawat Rise/Kg. Quantity Demanded

Rs. 50/- 100 Kg.

Rs. 40/- 150 Kg.

Let us put these values in the above quotation.

Ep = _________ H ______

= ____ H __

= ___ H __

= – __

= – 1.8

demand is significantly elastic.

100 – 150100 + 150

5 + 45 – 4

– 50250

91

– 15

91

95



NOTES

Concepts of Elasticity3.2.14 APPLICATION OF THE CONCEPT OF PRICEELASTICITY OF DEMAND

The concept of price – elasticity of demand is useful in taking decisions regarding.

l Product pricing.

l Pricing of factors of production.

l Deciding upon export and imports.

l Deciding which goods to tax. Normally goods with less elastic demandare taxed indirectly (Sales tax, excise duties, customs)

l Government spending on subsidies.

3.3 SUMMARY

Concepts of elasticity wrt demand and supply, with changing prices and incomes,constitute a basic part of decision making tools to be used by businessmen. Moreimportantly, elasticity can be measured numerically. It is also a tool of policymaking for consumers, producers and govt.

3.4 IMPORTANT WORDS AND THEIRMEANING

(i) Elasticity : It means responce of a variable to a change in causedvariable.

(ii) Price Elasticity of demand : It is elasticity of demand due to smallchanges in the price of the commodity.

(iii) Income Elasticity of Demand : It is elasticity of demand due to changesin income of the consumer.

(iv) Cross Elasticity of Demand : It is elasticity of demand due to a changein the price of a substitute good.

3.5 QUESTIONS FOR SELF-STUDY

1. What is price elasticity of demand?

2. What is income elasticity of demand?

3.6 ANSWERS TO QUESTION FOR SELF-STUDY

1. Price elasticity of demand means degree of responsiveness of demandto small changes in price of the product, other things remaining constant.

2. Income Elasticity of demand means degree of responsivers of demandto changes in income of the buyers, other things remaining constant.


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3.7 EXERCISES

l Explain methods of measuring elasticity of demand wrt pricechanges.

3.8 FIELD WORK

l Collect price and demand data for onions in a market for two days afort-night apart and calculate elasticity values.


l ‘Managerial Economics – Analysis for Business Decisions’, Hogue D.C.

r r r



NOTES

Cardinal and Ordinal Utility

UNIT 4 : CARDINALAND ORDINALUTILITY

Structure

4.0 Introduction

4.1 Unit Objectives

4.2 Subject description

4.2.1 Cardinal and ordinal utility

4.2.2 Cardinal utility approach

4.2.3 Ordinal utility approach

4.3 Summary

4.4 Key terms

4.5 Questions and Exercises

4.6 Further reading and exercises

4.0 INTRODUCTION

Consumption is the beginning of all the productive and economic activities.Households make demand for goods and services to satisfy their various needs.Businessess produce or buy and sell various goods and services that are indemanded. So, demand is the basis of all productive activities. In other words,demand is the mother of production. The demand theory or the theory of consumerbehaviour seeks to explain the decision making behaviour of the consumer indemanding a particular commodity. Therefore, it is necessary for businessmanagers to have a clear understanding of the source of demand, the factorsinfluencing buyers, decision regarding the quantity of products and the techniquesof market demand forecasting. Knowledge about market demand is vital for thebusiness managers in creating price, sales and output strategies. In this unit youwill read about neo-classical utility analysis i.e. the theory of consumer demandas built by Marshall, Pigou and others. The neo-classical utility analysis is basedon the cardinal measurement of utility which assumes that utility is measurableand additive. This unit will also describe the ordinal utility analysis i.e. the theoryof consumer behaviour as built by Prof. Hicks, a popular alternative theory ofconsumer’s demand is the indifference curve analysis.

4.1 UNIT OBJECTIVES

After studying this unit, you should be able to –

l Understand the cardinal utility approach of consumer behaviour.

l Understand the ordinal utility approach of consumer behaviour.

l Show consumer’s equilibrium according to cardinal utility approach.

l Present and analysis consumer’s equilibrium by ordinal utility approach.


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4.2.1 CARDINAL AND ORDINAL UTILITY

Economists have offered consumer behaviour theories on the basis of themeasurement of utility. There are three approaches to the analysis of consumerbehaviour.

(i) Cardinal Utility Approach : It was developed by the classicaleconomists, viz. Gossen, William Stanley Jcvons, Leon Walras, KarlMenger. Neo-classical economist, Alfred Marshall (1890) madesignificant improvements in the cardinal utility approach. So, it is called‘Marshallian Utility Theory’ or Neo-Classical Utility Theory’ of demand.

(ii) Ordinal Utility Approach : It is also known as indifference curveanalysis. The indifference technique was invented and used by FrancisEdge worth (1881), Irving Fisher (1892), Vilfred Pareto (1906), E.ESlutsky, W.E Johnson and A.L Bowley. However, J.R Hicks and R.G.DAllen (1934) developed systematically the ordinal utility theory as apowerful analytical tool of consumer analysis.

(iii) Revealed Preference Approach : Samuelson formulated (1947)‘revealed preference theory of consumer behaviour. It is a behaviouristordinal utility analysis as distinct from the introspective ordinal utilitytheory of Hicks and Allen.

The Marshallian cardinal utility approach is based on cardinal measurement ofutility. Neo-classical economists believe that utility is measurable and cardinallyquantifiable. It can be measured like height, weight, length and temperature. Theyused a term ‘utile’ as the measure of utility under the assumption that one unit ofmoney equals one ‘utile’ and they also assumed that marginal utility of moneyremains constant.

This method of measuring utility has been rejected by the modern economist. Inpractice it is impossible to measure the utility of any commodity in a cardinalway. Numerous factors affect the consumer’s mood, which are impossible todetermine and quantify. Thus, cardinal utility analysis is defective in severalrespects. Indifference curve analysis adopted the more rational assumption ofordinal measurement of utility. The ordinality implies that the consumer is able tocompare the level of satisfaction from the two goods. It may not be possible forconsumer to tell how much utility a particular combination gives, but it is alwayspossible to tell which one between any two combinations is preferable to him. Anindifference curve as a locus of points which show equal satisfaction to theconsumer.

4.2.2 CARDINAL UTILITY APPROACH

The Marshallian cardinal approach is based on the following postulates :-

• Concept of utility and its cardinal,

• The law of diminishing marginal utility, and

• The law of equi-maiginal utility.

Cardinal approach helps to explain consumer’s equilibrium i.e., how a consuniercan derive maximum utility out of his given limited resources. The capacity of a



NOTES

Cardinal and Ordinal Utilitycommodity to satisfy the human wants is called as its utility. In other words,utility is the level of satisfaction derived by the consumer from the purchase of acommodity. Consumers demand goods because of goods utility. The Marshallianutility analysis try to explain the inverse relationship between the price and quantitydemanded. According to Marshalian analysis, utility is cardinally measurable orquantitative. It can be measured like height, weight, length. In simple words, theutility means want satisfying power of a commodity. It is also defined as propertyof the commodity which satisfies the wants of the consumers.

Total Utility and Marginal Utility :-

It is important to distinguish between total utility and marginal utility. When theconsumer buys apples he receives them in units, 1, 2, 3, 4, 5 etc. The total utilityof a commodity to a consumer is the sum of utilities which he obtains fromconsuming a certain number of units of the commodity, as shown in table 4.1.

Table 4.1 : Total utility and marginal utility

Units of Apple Total Utility in Units Marginal utility in Units

0 0 0

1 20 20

2 34 14

3 46 12

4 56 10

5 61 05

6 59 !2

7 54 !5

In the above table, the first apple has 20 utility and it is the best out of the lotavailable to him and thus gives consumer the highest satisfaction. When an appleis taken by the consumer, total utility derived by the person is 20 utils and becausethis is the first apple its marginal utility is also 20. The second apple will naturallybe the second best with lesser amount of satisfaction or utility than the first andhas 14 utils. The total utility rises to 34 (20 + 14) but marginal utility falls to 14.Total utility is the sum total of utilities obtained by the consumer from differentunits of a commodity. It will be seen from the above table that as the consumptionof apple increases to 5, marginal utility from the additional apple goes ondiminishing. When the consumer takes 5 apples, his total utility of all the 5 unitsgoes up to 61 utils. It means that total utility is the function of the quantity of thecommodity consumed.

Marginal utility is the addition made to total utility by having an additional unitof the commodity. It means that, it is the extra utility which consumer gets whenhe consumes more unit of the commodity. It is clear from the above table. Whenthe consumer takes two apples instead of one apple, his total utility increasesfrom 20 to 34 utils. It means that the consumption of the second unit of thecommodity has made addition to the total utility by 14 utils. Here, marginal utilityis equal to 14 utils. Beyond consumption of 5 apples, total utility declines andtherefore, marginal utility becomes negative.

Algebracally, the marginal utility (mu) of N units of a commodity is the totalutility (TU) of N units minus the total utility N – 1, marginal utility can be expressedas under :-


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NOTES

TU

Q

MUN = TUN – TU N – 1

In other words,

MUN = _____, where DQ = 1.

The Law of Diminishing Marginal Utility :-

The law states that with successive increase in the consumption commodity, themarginal utility of a commodity will fall. Marginal utility is the utility derivedfrom the marginal or the last unit consumed. Total utility may be defined as thesum of the utility derived from all the units consumed of the commodity. In orderto maximise total utility, a household will not spend all its money income on aparticular commodity but on different commodities. This law applies to householdconsumption.

The Law of Equi-marginal Utility :-

The law states that a household will attain equilibrium when the marginal utilitiesof various commodities that it consumes are equal. This law explains consumer’sequilibrium. Consumer allocates his income in such a way that he could getmaximum satisfaction. This law is also known as law of substitution. It explainshow a consumer allocates his limited income between various goods in order toget maximise utility.

According to this law, a consumer will be at equilibrium

when,

MUx MUy MUz_____ = _____ = _____ = MU per unit of money income Px Py Pz

i.e. the ratio of marginal utilities and price are equalised in purchasing the variouscommodities. In other words, in order to be in equilibrium, the ratio of marginalutility of good X to its price should be equal to the ratio of marginal utility ofgood Y to its price, and so on. In simple words, the consumer gets maximumsatisfaction when the marginal utility of the commodity is equal among varioususes.

Diagrammatic Illustration

The law of equi-marginal utility can be explained with the help of a utility scheduleas follows :-

Table 4.2 : Marginal Utility Schedule

Quantity Goodx Good* Px = Rs. 6 Py = Rs. 5

TU MU TU MU

1 60 60 41 41

2 148 48 76 35

3 189 41 106 30

4 224 35 133 27

5 254 30 159 26

6 274 20 184 25



NOTES

Cardinal and Ordinal UtilityAssume, the consumer has income of Rs. 60. The consumer will allocate hisincome between two commodities in such a way that the ratios of marginal utilitiesto the respective prices of the two commodities are equal. In order to be inequilibrium the consumer will buy 5 units of X and 6 units of Y,

where, 30 25___ = ___ = 5 6 5

Subject to the budget constraint, where

(6 H 5) + (5 H 6) = Rs.60

The consumer gets total utility equal to (254 + 184) = 438 utils. Any othercombination of X and Y would yield only lesser total utility.

Assumptions of Cardinal utility analysis :-

Marshallian utility analysis of demand is based upon certain importantassumptions. The basic assumptions of cardinal utility approach are as follows :-

1. Utility of any commodity can be measured quantitatively or numerically.The consumer can express how much utility he gets from any commodity.Thus, a person can say that he derives utility equal to 15 utils fromthe consumption of a unit of a commodity and 20 utils from theconsumption of a unit of another commodity. (Here utils is used tomeasure the utility.)

2. Utilities are independent. It means that utility of each commodity isexperienced independently in a given bundle of various commodities.On this hypothesis, the utility which a consumer derived from A good isthe function of the quantity of that good only and not of B and C. Itmeans that, the utility which a consumer obtains from a good does notdepend upon the quantity consumed of other goods.

3. Utilities are additive. It means the consumer can make the total of theutilities derived from different units of the commodity.

4. The utility derived from each additional unit in succession tends to belesser and lesser in the axiom of the cardinal approach.

5. The marginal utility of any commodity is measured in terms of moneyand marginal utility of money to be constant at all levels of income ofthe consumer.

6. Marshall adopted the introspective method of analysis to observe theconsumer’s experience about marginal utility. This method uses self-observation method.

Limitations of the Marshallian Approach

Marshallian cardinal utility approach is criticised on the following grounds :

1. Marshall assumes that utility is measurable cardinally i.e. quantitatively.However, in practice it is impossible to measure the utility of anycommodity in a cardinal way.

2. Since utility cannot be measured quantitatively, it is wrong to assumethat the utility is additive.

3. Another limitation of Marshallian cardinal utility analysis is that itassumed utilities are independent. But in actual life, utilities are


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NOTES

interdependent. The utility of a commodity depends upon the change inthe consumption of its related goods i.e. competitive or complementarygoods.

4. The assumption of the constant marginal utility of money is also wrong.Marginal utility of money is not constant. Hicks argues that money isalso commodity and its marginal utility also diminishes slowly.

5. The utility analysis does not analyse the price effect completely. It failsto distinguish between the substitution effect and the income effect.

The cardinal utility approach is illogical, illusory and unrealistic. However, itleads to more scientific, systematic and comprehensive analysis of demand whichis known as indifference curve analysis.

4.2.3 ORDINAL UTILITY APPROACH

Various limitations or defects of cardinal utility analysis resulted in an ordinalutility approach to demand theory. It is known as indifference curve analysis.This technique was invented and used by Francis Y. Edgevvorth (1881) to showthe possibility of exchange of commodities between two individuals. This wasalso used by Irving Fisher, EdgeWorth, Vilfred Pareto, Eugen E. Slutsky, W.EJohnson and A.LBowley to explain consumer’s equilibrium. In 1934, J. R Hicksand R. G. D. Allen developed systematically the ordinal utility theory as a powerfulanalytical tool of consumer analysis.

There is fundamental difference between cardinal utility analysis and ordinalutility analysis. Ordinal utility approach discards the concept of cardinalmeasurement of utility. It adopted the more rational assumption of ordinalmeasurement of utility. According to ordinalists, all that is required to analyseconsumer’s behaviour is that the consumer should be able to order his preferences.He is able to differentiate the level of satisfaction qualitatively, but notquantitatively.

Indifference Curve

Professor Hicks popularised the innovation of the indifference curve approach tothe theory of demand in his ‘Value and Capital’ published in 1939. An indifferencecurve is defined as the locus of points, each representing a different combinationof two goods but yielding the same level of satisfaction or utility. Since eachcombination of two goods yields the same level of satisfaction, the consumer isindifferent between any two combinations of goods when it comes to making achoice between them. At that time, the consumer can rank various combinationsof goods according to their level of satisfaction. After ranking variouscombinations, the consumer is able to tell which combination he prefers more oris indifferent between some combinations. When such combinations are plottedgraphically the resulting curve is known as indifference curve. Indifference curveis also called equal utility curve.

A rational consumer seeks to maximise his level of satisfaction from the goodsthe buys. He gives preference to goods with consideration of their prices. Suchpreferring of different goods and their combinations in a set order of preferencesis termed as the scale of preferences.

An indifference curve is based on an indifference schedule. An indifferenceschedule is a list of alternative combinations in the stocks of two goods which



NOTES

Cardinal and Ordinal Utilityyield equal satisfaction to the consumer. Indifference schedule showing differentcombinations of two goods is presented below.

Table 4.3 : Indifference Schedule

Combination Apple Bananas

A 1 + 25

B 2 + 20

C 3 + 16

D 4 + 13

E 5 + 11

Above indifference schedule indicates various combinations of two goods whichgive equal satisfaction to the consumer. The consumer is indifferent to any ofthese combinations whether he gets A, B, C, D, or E. He will neither be better offnor worse off whichever combination he has. The consumer may pick up any oneof the five combinations of apple and bananas. The total satisfaction derived bythe consumer will remain the same irrespective of the combination chosen byhim. He is, therefore, indifferent towards different combinations. The satisfactionof 1 apple and 25 bananas is equal to 5 apples and 11 bananas.

An indifference curve can be drawn with the help of the indifference schedule. Itis shown in the following figure.

Fig. 4.1 : Indiference Curve

Figure 4.1 shows an indifference curve, drawn by joining combinations A, B, Cand D of apples and bananas. The combinations of the two commodities i.e appleand banana, given in the indifference schedule or those indicated by theindifference curve are by no means the only combinations of the two commodities.Each combination yield the same level of satisfaction. Although, the variouscombinations contain different quantities of the apples and bananas, consumerscale of preference for the different combinations, however, is the same. Anotherindifference curves can be drawn above or below the indifference curve given inFigure 4.1. A set of indifference curves or a family of indifference curvesrepresenting different levels of satisfaction is called an indifference map.


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Assumptions of Ordinal Utility Theory

The indifference curve analysis of consumer’s behaviour is based on the followingassumptions :-

1. The consumer is a rational being. He aims at maximising his totalsatisfaction, given his income and prices of goods and services heconsumes.

2. Consumer can rank different combinations of two goods in order ofpreference.

3. Consumer’s behaviour is consistent. Consistent means that, if consumerprefers A to B in one period, he will not prefer B to A in another periodor treat them as equal.

4. Non-satiation, i.e. the consumer always prefers more quantities of goodsto lesser quantities.

5. Consumer’s choices arc transitive. It means, when he prefers combinationA in the indifference map to combination B, and B to C, then A must bepreferred to B.

6. The ordinal utility approach assumes diminishing marginal rate ofsubstitution. The marginal rate of substitution means the rate at which aconsumer is willing to substitute one commodity for another.

Properties of Indifference Curves

The important properties or characteristics of indifference curves are asfollows :-

1. Indifference curves have a negative slope :-

It is one of the important features of indifference curves. In the words of Hicks,“so long as each commodity has a positive marginal utility, the indifference curvemust slope downward to the right”. When the consumer makes sacrifice of somegood, it must be compensated by the gain of the other good. In other words,consumer will have to curtail the consumption of one commodity if he wants toconsume larger quantity of another commodity to maintain the same level ofsatisfaction. It makes the indifference curve slope downwards from left to right.In figure 4.1 IC is the indifference curve which slopes downward from left toright.

2. Indifference curves are convex to the origin :-

Not only is an indifference curve downward sloping, it is also convex to theorigin. It implies that indifference curve is relatively steeper at left hand portionand flatter to the right hand. Convexity means that the curve is so bent that isrelatively steep towards the Y-axis and relatively flat towards the X-axis. Theindifference curve becomes convex to the origin because the marginal rate ofsubstitution decreases. As can be seen in figure 4.1, as the consumer moves downfrom point A towards point D, the MRS= y/x goes on diminishing. This can beverified from table 4.2.

3. Indifference curve can neither intersect nor he tangent :-

This means that there cannot be a common point between the two indifferencecurves. This is because each indifference curve represents a specific level of



NOTES

Cardinal and Ordinal Utilitysatisfaction and each point on an indifference curve gives a level of equalsatisfaction.

4. Upper indifference curves represent a higher level of satisfaction :-

Every indifference curve to the right or at a higher level indicates higher level ofsatisfaction.The indifference map represents an ordinal measurement of utility.Thus, a higher indifference curve represents a higher level of satisfaction ofcomparison with a lower indifference curves. It can be explained with the help ofFig. 4.2.

Fig. 4.2 : Upper Indiference Curve

In figure 4.2 IC1, and IC2 and IC3, are three indifference curves. The consumergets more units of both goods on IC2 at point B than at point A on the lowerindifference curve. Here, an upper indifference curve contains all along its lengtha larger quantity of both the goods than the lower indifference curve. Thus, theconsumer gets more satisfaction when he moves on to a higher level of indifferencecurve.

Consumer’s Equilibrium

A rational consumer attains an equilibrium position when his motive of maximizingsatisfaction is realised. So, he always tries to reach the highest possible indifferencecurve. But there is a limitation to consumer of money income to spend. When theconsumer gets maximum satisfaction from his limited income he is in equilibrium.Indifference curve technique helps a consumer to reach equilibrium position.

Consumer’s equilibrium is based upon a number of assumptions which are asfollows :-

(i) The consumer is rational and wants to maximise his satisfaction.

(ii) The consumer has a fixed amount of money income to spend.

(iii) The consumer has an indifference map which indicates scale ofpreferences.

(iv) Prices of two goods do not change.

(v) Goods are homogeneous and divisible.

(vi) Consumer has full knowledge of market conditions.


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NOTES

Consumer’s Equilibrium is illustrated in Fig 4.3.

Figure 4.3 : Consumer’s equilibrium

In Figure 4.3, indifference map along with price line AB is shown. Good X ismeasured on OX axis and good Y is measured on OY axis. AB is the price-linewhich shows budget constraint of the consumer. IC1, IC2, and IC3 are theindifference curves which indicate consumer’s scale of preferences. These threeindifference curves represent different level of satisfaction. Consumer can derivemore satisfaction on IC2 than on IC1

.

The consumer can purchase any combination lying on the price line or budgetline AB. In case, he spends all his money income on good Y he can buy OAquantity, and similarly, if he spends all his money income on commodity X, hecan buy OB quantity. The consumer will try to choose that combinationwhich lies on the highest indifference curve. But, consumer cannot attainequilibrium at point K, because it is beyond his budget line. Similarly, the consumerwill reject combination they, E and T, as D yield lesser satisfaction. P point is thepoint which lies on the highest possible indifference curve. Consumer attainsequilibrium at this point. At this point, both the conditions of equilibrium arcsatisfied, viz.

(i) The budget line is tangent to the indifference curve.

(ii) The indifference curve must be convex to the origin.

These conditions are fulfilled at point P. So the consumer is in equilibrium atpoint P.

Superiority of indifference curve technique :-

The indifference curve analysis is an improvement over the Marshallian utilityanalysis because it is based on fewer and more realistic assumptions.

1. The Marshalian utility analysis assumes that utility to be cardinallymeasurable. In other words, it believes that utility is quantifiable. It isunrealistic. The indifference curve analysis assumes that utility is merelyorderable and not quantitative. The ordinal method and the assumptionof transitivity make indifference curve technique more realistic.



NOTES

Cardinal and Ordinal Utility2. Indifference curve analysis studies combinations of two goods insteadof one good.

3. It provides a better classification of goods into substitutes andcomplements. However, Marshallian utility analysis is based upon thehypothesis of independent utilities.

4. Indifference curve analysis of demand is free from the assumption ofconstant marginal utility of money. In other words, in indifference curveanalysis, it is not necessary to assume constant marginal utility of money.

5. The superiority of indifference curve analysis lies in the fact that itdiscusses the income effect when the consumer’s income changes; theprice effect when the price of a particular good changes. It also explainsthe dual effect in the form of the income and substitution effects.

Critique of indifference curve analysis :-

Indifference curve analysis has come in for criticism on several grounds. Themain points of criticism are as follows :-

1. Professor D. H. Robertson does not find anything new in the indifferencecurve analysis and regards it simply the old wine in a new bottle.

2. For avoiding the difficulty of measuring utility quantitatively, theindifference curve analysis is toned to make unrealistic assumption thatthe consumer possesses complete knowledge if his whole scale ofpreference or indifference map.

3. This analysis can demonstrate and analyse consumer’s behavioureffectively only in simple cases. In other words, the observed marketbehaviour of the consumer cannot be explained objectively. Prof. Hicksalso admits this shortcoming of indifference curve analysis.

4. Indifference curve analysis cannot formalise consumer’s behaviour whenuncertainty or risk is present.

5. The indifference curve assumes that the consumer acts rationally. Infact, consumer is not rational.

Despite these criticisms, the indifference curve analysis is still regarded superiorto the Marshallian utility analysis.

4.3 SUMMARY

In this unit you have learned about neo-classical utility analysis i.e. the theory ofconsumer demand as built by neo-classical economist. This analysis is based oncardinal measurement of utility. There are three approaches to the analysis ofconsumer behaviour i.e. cardinal utility approach, ordinal utility approach andrevealed preference approach. Cardinal utility approach has been rejected bymodern economists. Ordinal utility approach adopted the more rational assumptionof ordinal measurement of utility. An indifference curve is a locus of points whichshow equal satisfaction to the consumer.

4.4 KEY TERMS

l Utility : The total satisfaction derived from the consumption of goodsand services.


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NOTES

l Total utility : The total utility of a co mmodity to a consumer is the sumof utilities which he obtains from consuming a certain number of unitsof the commodity.

l Marginal utility : Marginal utility is the addition made to total utilityby having an additional unit of the commodity.

l Indifference Curve : It is defined as the locus of points, eachrepresenting a different combination of two goods but yielding the samelevel of satisfaction or utility.

4.5 QUESTIONS AND EXERCISES

1. Distinguish between cardinal and ordinal utility.

2. Explain the law of diminishing marginal utility.

3. State and explain the law of diminishing marginal utility.

4. What is meant by consumer equilibrium? How does a consumermaximise his satisfaction in cardinal utility analysis?

5. Explain the law of equi-marginal utility. How does it explain consumerequilibrium?

6. Discuss the main assumptions and defects of utility analysis?

7. On what grounds Marshall’s cardinal utility analysis has been criticised?

8. Distinguish between cardinal utility and ordinal utility which is morerealistic?

9. Explain in detail the properties of indifference curves.

10. What are indifference curves? What are the assumptions on whichindifference curve analysis of demand is based?

11. Explain the concept of ordinal utility. How is the ordinal utility conceptdifferent from cardinal utility concept?

12. What is meant by consumer’s equilibrium? Explain it with indifferencecurve approach.

13. Explain consumer’s equilibrium condition with the help of indifferencecurve approach.

14. Discuss superiority of indifference curve technique over utility analysis.

15. Explain criticisms of indifference curve analysis.

16. Write short notes :-

(i) Cardinal utility approach.

(ii) Ordinal utility approach.

(iii) Total utility and marginal utility.

(iv) The law of diminishing marginal utility.

(v) The law of equi-marginal utility.

(vi) Assumptions of cardinal utility analysis.

(vii)Limitations of the cardinal utility analysis.

(viii) Indifference schedule.

(ix) Indifference curve.



NOTES

Cardinal and Ordinal Utility(x) Assumptions of ordinal utility theory.

(xi) Properties of indifference curves.

(xii)Consumers equilibrium.

(xiii) Superiority of indifference curve technique.

(xiv) Critique of indifference curve analysis.

4.6 FURTHER READINGS AND REFERENCES

1. Mithani D,M. (2008) : ‘Managerial Economies’, Himalaya publishingHouse, Mumbai.

2. Dingra I.C. and V.K. Garg (2005) : ‘Micro Economics and IndianEconomic Environment’, Sultan Chand & Sons, New Delhi.

3. Patil J.F. and others (2004) : ‘Managerial Economies’, PhadkePrakashan, Kolhapur.

4. Banerjee,AandS,Mukherji(1985): ‘Topics in Managerial Economies’,New Central Book Agency, Kolkata.

5. Gupta G.S. (1990) : ‘Managerial Economies’ Tata McGraw Hill, NewDelhi.

6. Mehla P.L. (1997) : ‘Managerial Economics Analysis, Problems andCases’, Sultan Chand & Sons, New Delhi.

7. Koutsoyiannis A. (1971) : ‘Modern Micro Economies’, Macmillan,London.

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UNIT 5 : EVEALED PREFERENCETHEORY

Structure

5.0 Introduction

5.1 Unit Objectives


5.2.1 Choice reveals preference

5.2.2 Assumptions of revealed preference theory

5.2.3 Explanation of revealed preference theory

5.2.4 Critical evaluation of the revealed preference theory

5.2.5 Consumer choice under risk

5.3 Summary

5.4 Key terms


5.6 Further reading and references

5.0 INTRODUCTION

In the previous unit, you have learned Marshallian cardinal utility analysis, whichassumes that utility is measurable and additive. You have also learned Hicks andAllen’s ordinal utility approach. In this unit you will read about behaviouristordinal utility theory as formulated by Prof. Samuelson in his book “Foundationsof Economic Analysis.”

5.1 UNIT OBJECTIVES


l Understand behaviourist ordinal utility theory i.e. revealed preferencetheory.

l Evaluate cardinal utility approach and ordinal utility approach.

l Analysis superiority of revealed preference theory.

l Understand different approaches of consumer choice under risk.


In succession to Hicks-Allen ordinal utility approach, Samuelson (1947)formulated his own ‘Revealed Preference Theory’ of consumer behaviour. Thistheory is based on observed consumer behaviour in the market. On the basis ofactual observations, Professor P.A Samuelson realistically examines how aconsumer reacts to changes in price and income. Samuelson adopted a new



NOTES

Revealed Preference Theory

approach known as behaviourist approach to explain the consumer choice. Sothis theory is called as behaviourist ordinal utility theory.

Samuelson’s approach is objectively based on actual observations. The mainadvantage of this theory is that the ‘law of demand’ can be directly derived fromthe revealed preference axioms without using indifference curve and most of itsrestrictive assumptions.

5.2.1 CHOICE REVEALS PREFERENCE

Prof. P. A. Samuelson’s theory of demand is based on the revealed preferenceaxiom which states that choice reveals preference. According to this axiom orhypothesis, when a consumer buys a combination of two goods out of variousalternative combinations either because he likes this combination in relation toothers or this is cheaper than others. It means that he reveals his preference.Suppose the consumer buys A combination out of various alternatives i.e. B, Cand lying below the line PL such as D, E and G. It means he considers all otheralternative combinations which he could have purchased to be inferior to A. Itmeans that he reveals his preference for A combination. In other words, he rejectsall other alternative combinations open to him. Thus, according to Prof. Samuelson,choice reveals preference. This is explained in figure 5.1.

Figure 5.1 : Choice reveals preference

In the above figure, good X is shown on OX axis and good Y is shown on Y axis.PL is the income of consumer or budget line. The budget line PL represents agiven price-income situation. The triangle OPL is the area of choice for theconsumer which shows the various combinations of X and Y on the given price-income-situation PL. It means that the consumer can buy or choose anycombination lying within the triangle OPL. A, B, C, D, E, F and G arethe combinations open to him. But combinations H and I are beyond the reachof the consumer being dearer for him because they lies above his price-incomeline PL. The consumer can buy or choose any combination out of A, B and Con the line PL or D, E, F, G below this line. If he chooses A combination, it isrevealed as preferred to B and C. Combinations below price-income line will berejected because they are inferior to A. Therefore, A is revealed as preferred toother combinations. Consumer can do this for two reasons. First, A combinationmay be cheaper than the other combinations on the line and below the line. Second,A combination may be dearer than others, but he likes this combination in relationto others.

P

Y

O XL

B

E

GD

F

H

IA

C

Goo

dY

Good X


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5.2.2 ASSUMPTIONS OF REVEALED PREFERENCETHEORY

This theory is based on the following straightforward assumptions.

1. The consumer is assumed to be a rational being. Rationality impliesthat he prefers a combination of larger stock of the two goods to a smallerone.

2. It is assumed that the choice of the consumer is always consistent andnot contradictory to earlier choice. It means if he chooses combinationA to B, he will not choose B to A under the same conditions.

3. An important feature of Samuelson’s theory is that it is based on strongordering. It means consumer reveals his positive and definite preferencefor a particular combination of the two goods against all otherpossibilities rejected by him under the given price-income situation.

4. The revealed preference approach is based on positive income elasticityassumption. It means when his income increases, the consumer alwaystends to buy more of the given commodity.

5. This theory is fundamentally based on ‘axioms of preference’, wherethe axioms are expressed not in terms of what a consumer prefers butwhat he chooses. It means consumer’s choice for a particular combinationof the two goods within his budget reveals his definite preference.

5.2.3 EXPLANATION OF REVEALED PREFERENCETHEORY

The revealed preference theory can be explained by using following Figure no.5.2. There are two commodities X and Y Prices of X and Y are given and consumerhas a given money income. According to this theory, “Given the budgetaryconstraint and alternative combinations of goods having the same price, if aconsumer chooses a particular combination, he reveals his preference for thecombination.

Fig. 5.2 : Revealed Preference Theory



NOTES

Revealed Preference TheoryIn the above figure, the initial price line is AC. It means consumer’s budgetaryconstraint has been shown by his budget line AC. If consumer chooses a particularcombination of X and Y (OL of X good and OK of Y good) represented bypoint T on the budget line, it implies that he prefers point T to any other point onthe budget line. Any point below the budget line and above the budget line willnot be prefered by the consumer because it will be smaller and cheapercombination of two goods and larger and more expensive combination of twogoods respectively.

Let us now suppose that the price of X increases, price of Y remaining the same.So that budget line AC shifts to AB. It means due to increase in price of Xthe consumer has to buy smaller quantities of X. This shift in budget lineresulted in two effects viz. income and substitution effect. The increase in priceof x good has reduced the real income of the consumer and it has changedthe relative prices of X and Y good also. Let us now decompose the incomeand substitution effects of the price effect by using the Slutskian method.We increase the income of the consumer to such an extent that he can buy theearlier combination of goods. This has been done by drawing a budget line DEthrough point T. Since the budget line passes through point T, it implies that thecombination of X and Ygoods indicated by T are still available to the consumer.Therefore, the consumer will not choose any other combination of X and Ygood.Thus, demand forX decreases as a result of increase in the price of X. Thisestablishes the law of demand.

Superiority of revealed preference theory :-

Samuelson’s revealed preference theory is superior to the Marshallian cardinalutility theory and Hicks Allen’s ordinal utility theory of demand.

1. Samuelson’s revealed preference theory is the first theory to applybehaviourist method to derive demand theorem from observedconsumer behaviour.

2. Utility and indifference curve approach focuses on continuityassumption. However, revealed preference theory believes that there isdiscontinuity because the consumer can have only one combination.

3. Revealed preference theory provides the basic for welfare economicsin terms of observable behaviour based on consistent choice.

5.2.4 CRITICAL EVALUATION OF THE REVEALEDPREFERENCE THEORY

The revealed preference approach is superior in many respects compared to earlierapproaches. The theory is a major advancement to the theory of demand. It can beexplained as under.

1. Marshallian and Hicksian approaches are introspective and providepsychological explanations of consumer behaviour. On the other hand,revealed preference theory is based on observed behaviour of theconsumer. The behaviouristic approach is more scientific and practicalone..

2. Prof. Samuelson has used the principle of consistency insteal ofmaximization. This is less restrictive assumption.


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3. The indifference curve approach required continuity assumption. Therevealed preference hypothesis does not assume continuity. It assumesconsistency.

4. The revealed preference theory provides a basis for constructing theindex number of Cost of living.

5. The revealed preference theory does not require the use of the conceptof utility to derive the demand curve.

Prof. Samuelson’s revealed preference theory suffers from certain drawbacks. Itis not a general theory of demand. It has bias towards strong ordering. It has alimited scope of applicability and it over-stresses the consistency condition ofrationality. However, its superiority over earlier approach cannot be denied. Thisapproach has laid a foundation of pragmatic approach to demand.

5.2.5 CONSUMER CHOICE UNDER RISK

Cardinal utility approach and ordinal utility approach ignore the possibility ofuncertainty and risk involved in consumer’s alternative choices. The recentdevelopments in demand theory analyses the consumer’s behaviour where he hasto choose between risky and uncertain alternatives. Famous mathematician Johnvon Neumann and a well known economist Oskar Morgenstern in their famousbook ‘Theory of Games and Economic Behaviour’ have gone, without disputingthe ordinal utility approach, one step forward to suggest a measure of utility whererisk is involved in choice-making. Friedman, Savage and Markowitz have alsotried to explain the consumer’s choice under risk.

The consumer may face different types of uncertainties or risks while making hisdecision. The consumer may face following different types of uncertainties.

(i) Uncertainty regarding prices of the goods.

(ii) Uncertainty regarding income of the consumer.

(iii) Uncertainty regarding availability of goods.

Out of three uncertainties, the uncertainty regarding income of the consumer isthe major one. In practical life some food items like and fruits, cloths may createrisk to life and health. When someone takes insurance, then he is also makingchoice when uncertainty is involved. It means that a consumer has to make achoice of the goods and services under the condition of risk.

Daniel Bernoulli explanation :-

The Swiss mathematician Daniel Bernoulli made his first attempt to formulatethe consumer’s behaviour under uncertainty in 18th century. He tried to resolveSt. Petersburg Paradox.

St. Petersburg Paradox states that a rational consumer will not accept the riskychoice even though there is a possibility of winning the option. In other words,people are not willing to bet at better than 50 percent of winning money inparticular kind of gamble are greater that the money they bet. This paradox wasresolved by Daniel Bernoulli. He adopted utility analysis to explain it. He focuseson marginal utility of money. According to him, in that case, consumer can measurethe marginal utility of money and the marginal utility of money diminishes asincome increases. Daniel Bernoulli’s explanation can be explained by usingfollowing diagram.



NOTES

Revealed Preference Theory

Figure 5.3 : Daniel Bernoulli’s explanation

In the above figure, income is shown on the OX axis and expected utility is shownon the OY axis. MU curve shows the expected marginal utility of income.Consumer compares the possibility of losing the bet and consequent loss inexpected income and marginal utility and similarly, he considers the marginalutility of the expected income which he can get if he wins the bet. From the abovediagram, it is clear that he gets marginal utility of ABCD (shaded area) fromadditional income, when he has a chance of winning the bet. But, if he loses thebet he finds that the reduction in marginal utility is to the tune of CDEF. Here,expected loss of income by losing the bet is larger than the expected addition inmarginal utility from additional income by winning the bet. So, he will not bet ashe is rational.

Neumann – Morgenstern explanation :-

When the consumer faces situation of making choice under uncertainty, he hasto consider the expected utility. In this regard Neumann and Morgenstemprovide a measure (or an index) of utility in terms of N-M index. The primeobjective of N-M index is to show that marginal utility of money decreases. N-Mindex helps to make a choice for uncertain or risk alternatives. The N-M hypothesissuggests that if an individual behaves consistently, it is possible to construct his‘utility index’ and express his preferences numerically. It does not measure theintensity of introspective satisfaction or pleasure nor is it the N-M purpose ofmeasuring ‘cardinal’ utility. This index serves a useful purpose by providing abasis for rational thinking and prediction, particularly where uncertainty and riskare involved.

Friedman – Savage approach

Nobel prize winner Milton Freidman and L.J Savage extended the Neumann-Morgenstern approach and addressed a question, ‘does marginal utility of moneyalways diminish?’ This approach tried to explain why the same group of peoplebuy insurance and also engage in gambling. In this respect, Friedman-Savage putforward an important hypothess that as income of the consumers increases, itsmarginal utility first decreases over certain level of income, and then increasesover certain level of income, and ultimately it decreases as income of the consumerstendes to increase, In this range they are not willing to take risk.

D A

C

B

Y

O XE

F

MU

Gain

Loss


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5.3 SUMMARY

In this unit you have learned about behaviourist ordinal utility approach. In thesuccession of Hicks-Allen ordinal utility approach. Prof. Samuelson formulatedhis own Revealed Preference Theory of consumer behaviour. The main advantageof this theory is that the law of demand can be directly derived from the revealedpreference axioms without using indifference curve and most of its restrictiveassumptions. This theory is the first theory to apply behaviourist method to desireor demand thereon from observed consumers behaviour. Prof. Samuelson’s theoryis superior to the Marshallian cardinal utility theory and Hicks Allen’s ordinalutility theory of demand.

5.4 KEY TERMS

l Rationality : The consumer prefers more units of goods within the givenlevel of income is the meaning of rationality.

l Strong ordering : When consumer selects any combination of goods,he selects that by rejecting the other alternative combinations. It meanshe has certain strong preferences.

l Risk : In financial economics, refers to the variability of the returns onan inverstment.

l Budget Line : A line indicating the combination of commodities that aconsumer can buy with a given income at a given set of prices.


1. Choice revels preference elucidate.

2. Crtically examine the revealed preference theory of demand.

3. What is meant by revealed preference hypothesis’ ? Explain Samuelson’srevealed preference theory of demand based on it.

4. ‘Choice reveals preference.’ Explain this statement critically.

5. State the assumptions of the revealed preference theory of demand.

6. Discuss the distinguishing features of the Revealed PreferenceHypothesis in the theory of consumer’s behaviour.

7. Revealed preference theory makes a major advancement in the theoryof demand. Discuss.

8. What are the limitations of the indifference curve analysis as an analyticalinstrument? How far is the theory of revealed preference an improvementin this respect?

9. Critically examine revealed preference theory of consumer’s behaviour.Is it superior to indifference curve theory of consumer’s behaviour?

10. How does consumer make his choice under uncertainty?

11. How is consumer choice finalised under conditions of risk? Explaindifferent approaches.



NOTES

Revealed Preference Theory12. Write Short notes –

(i) Choice reveals preference.

(ii) Assumptions of revealed preference theory.

(iii) Superiority of revealed preference theory.

(iv) Criticism of the revealed preference theory.

(v) Consumer choice under risk.

(vi) Daniel Bernoulli’s explanation of utility.

(vii)Different approaches of consumer choice under risk.

5.6 FURTHER READING AND REFERENCES

1. Koutsoyiannis A. (1971) : ‘Modern Micro Economics’, MacMillan,London.

2. Samuelson Paul A and William D. Nordhaus (2010) : ‘Economics’, TataMcGraw Hill Education Private Ltd., New Delhi.

3. Kreps Daud M. (1990) : ‘A Cource in Microeconomic Theory’, PrincetonUniversity Press, Princeton.

4. Layard P. R. G. and A. W. Alters (1978) : ‘Microeconomic Theory’,McGraw Hill, New Delhi.

5. Sen A. (1999) : ‘Microeconomics : Theory and Applications’, OxfordUniversity Press, New Delhi.

6. Stigler G. (1996) : ‘Theory of Price’, 4th edition, Princeton Hall of India,New Delhi.

7. Varian H. (2000) : ‘Microeconomic Analysis’, W. W. Norton, New York.

8. Hirshleifer J. and A. Glazer (1997) : ‘Price Theory and Applications’,Prentice Hall of India, New Delhi.

9. Green H. A. G. (1971) : ‘Consumer Theory’, Penguin Harmondsworth.

10. Mithani D. M. (2008) : ‘Managerial Economics’, Himalaya PublishingHouse, Mumbai.

11. Dingra I. C. And V. K. Garg (2005) : ‘Microeconomics and IndianEconomic Environment’, Sultan Chand & Sons, New Delhi.

12. Henderson J. M. And R. E. Quant (1980) : ‘Microeconomic Theory : AMathematical Approach’, McGraw Hill, New Delhi.

13. Green H. And V. Walch (1975) : ‘Classical and Neo-Classical Theoriesof General Equilibrium’, Oxford University Press, London.

14. Borch K. H. (1968) : ‘The Economics of Uncertainty’, PrincetonUniversity Press, Princeton.

15. Diamond and Rothschild (Eds.) (1978) : ‘Uncertainty in Economics’,Academic Press, New Delhi.

16. Samuelson P. A. (1947) : ‘Foundations of Economic Analysis’.


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17. Patil J. F. and Others (2014) : ‘Managerial Economics’, PhadkePrakashan, Kolhapur.

18. Banerjee A. And S. Mukherjee (1985) : ‘Topics in ManagerialEconomics’, New Central Book Agency, Kolkatta.

19. Gupta G. S. (1990) : ‘Managerial Economics’, Tata McGraw Hill, NewDelhi.

20. Mehta P. L. (1997) : ‘Managerial Economics Analysis, Problems andCases’, Sultan Chand, New Delhi.

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Demand ForecastingTechniquesUNIT 6 : DEMAND FORECASTING

TECHNIQUES

Structure

6.0 Introduction

6.1 Unit Objectives


6.2.1 Estimation of demand for consumer durables and non-durables

6.2.2 Need for demand forecasting

6.2.3 Methods of demand forecasting

6.3 Summary

6.4 Key terms


6.6 Further reading and References

6.0 INTRODUCTION

The demand theory seeks to explain the decision making behaviour of the consumerin demanding a particular commodity. In the previous unit, you have learnedabout the demand theory or the theory of consumer behaviour. After studying thetheory of consumer behaviour, it is necessary for business managers to have aclear understanding of the estimation of demand for consumer durables and non-durables or methods of demand forecasting. Knowledge about market demand isvital for the business manager in creating price, sales and output strategies againstdynamic changes in the economy or particularly in the determinants of demand.In this situation, forecasting of demand becomes an important function of themanagerial economist under the conditions of uncertainty. In this unit you willread about estimation of demand for consumer durables and non-durables. Thisunit will also describe the need of demand forecasting and methods of demandforecasting.

6.1 UNIT OBJECTIVES


l Explain estimation of demand for consumer durables.

l Explain estimation of demand for consumer non-durables.

l Understand need for demand forecasting.

l Understand various methods of demand forecasting.


In modern business, production is often made in anticipation of demand, andanticipation of demand implies forecasting of demand.


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6.2.1 ESTIMATION OF DEMAND FOR CONSUMERDURABLES AND NON-DURABLES

For all practical purpose, a business firm may seek to estimate the demand functionfor its product. Forecasting of demand is an estimate of future demand for a givencommodity or sale of a firm. The demand estimation is a first step to a demandforecasting. Demand estimation can be useful in certain business decision making.For examples; A wine manufacturer may be interested in knowing the impact ofincrease in excise duties on wine on its sales. A firm would like to know howmuch is the demand for its products. An automobile manufacturer wants to knowhow much increase in his sales of cars is possible by advertising more or to spendmore on advertising.

There are some important steps in estimating demand for a product. Initial step isto identify the demand determinants and to specify the demand function for theproduct. Other steps are choice of statistical technique, data collection, empiricalprocess, result reporting, interpretation and evaluation. Here, we shall discussdurable and non-durable consumer goods and specify the demand functions forthe two categories of consumer goods.

Estimating Demand for Consumer Durables

These goods can be consumed a number of times or repeatedly used withoutmuch toss to their utilily. These goods include residential buildings, cloths,households gadgets (TV microwave ovens, refrigerators, air conditioners),computers, laptops etc. In estimating demand for consumer durables, the firststep is to identify and specify the determinants of demand. The demand forconsumer durables is also known as long-term demand. The major determinantsof demand for consumer durables are as follows.:-

(i) Price of the commodity (PN)

(ii) Income of the consumer (Y)

(iii) Prices of related commodities (PR)

(iv) Taste of the household (T)

(v) Availability of credit facilities to buy commodities (c)

(vi) Other factors (U) like distribution of income, size of population,composition of population, sociological factors etc.

The general form of the demand function can be expressed as follows.

D = F(PN,Y, PR,T, C, U)

Once the nature of demand function is specified, the second step is the choice ofstatistical technique and then follow other steps for estimating demand forconsumer durables. Demand estimation of these goods is not an easy task.

Estimating Demand for Consumer Non-Durables

These goods include all those goods and services which can be used only once.These goods are also known as ‘single - use consumer goods’ or ‘perishableconsumer goods.’ ‘Single goods are those goods which get destroyed as soon asthey are consumed e.g. food, coal, cold and hot drinks, etc. Demand for thesegoods depends upon household’s disposal income, price of the commodity and itsrelated goods and population and its characteristics. The demand function forconsumer non-durables is expressed as –



NOTES

Demand ForecastingTechniques

DN = F (Y, S, P)

where, DN = Demand for commodity N,

Y = Household’s disposable income

S = Population

P = Price of the commodity N and its related goods.

There rest of the process of estimating demand for consumer non-durables is thesame as the one used for estimating the demand for consumer durables.

6.2.2 NEED FOR DEMAND FORECASTING

In modern business, production is often made in anticipation of demand.Anticipation of demand implies demand forecasting. Demand forecasting meanspredicting the future demand for a product. It also means expectations about thefuture course of development. We know the future is not certain. But not entirelyso. Hence, one can hopefully predict the future and reasonable gain. Demandforecasting is very necessary or essential in the course of business decision making.Its need may be traced as under :-

1. Demand forecasting is very important in preparing production plans bythe firm. It means expansion or reduction of output should be based onthe estimates of likely demand. In order to avoid over stock or understock of finished goods or raw material, a reliable estimate of the futuredemand would be a must.

2. Sales forecasting is based on the demand forecasting. If short termdemand forecast is available, suitable sales policy can be formulated bythe firm. Short term demand forecasting is also useful for setting salestargets and giving incentives to the distributors and buyers.

3. Business decisions related with forward planning (future planning)become important in the long period. Long term demand forecastingwould help to plan, expand and diversify the firm. It is also importantfor developing and introducing new products in the market.

4. Demand forecasting is necessary for determining the growth rate of thefirm and its lont-term investment programmes, It is useful in investmentdecisions.

5. With the help of demand forecasting, the firm may ascertain the financialrequirements and long term funds may be arranged.

6. Demand forecasting is essential for planning and scheduling production,purchase of raw materials, spare parts, acquistion of finance andadvertising.

7. Demand forecasting is also important in identifying and entering thenew market.

6.2.3 METHODS OF DEMAND FORECASTING

There are various methods of demand forecasting. But there is no unique methodof demand forecasting which always guarantees the best result. The choice of themethod depends upon objective of demand forecasting, availability of requireddata, cost of forecasting etc. In demand forecasting a judicious mixture of statisticalskill and rational judgement is needed. With the help of statistical techniques,data can be collected, classified, tabulated, analysed and interpreted. On the other


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hand, sound judgement is a prime requisite for good demand forecasting. Anefficient demand forecasting should strike a balance between statistical techniquesand sound judgement.

Following is the chart of forecasting of demand techniques.

Chart 6.1 : Demand forecasting techniques

for Established Products for New Products

Opinion poll method Statistical methods

Consumer’s Collective Expert’s Survey Opinion Opinion Method Method Method

Trend Barometric Regression Projection technique method

Method

Evolutionary Substitute Growth Opinion Sales Method Method Curve Poll Experience

Method Method Method

Following are the important methods of demand forecasting.

I. Opinion poll methods

1. Consumer’s survey method.

2. Collective opinion method.

3. Expert’s opinion method.

II. Statistical methods

1. Trend projection method

2. Barometric technique

3. Regression method

I. Opinion Poll Method :-

These methods are generally used where the purpose is to make short-run forecastof demand. In this method, the survey of opinions of the people is undertaken.The consumer survey method of demand forecasting involves direct interview ofthe potential consumers. The success of this method depends on there liablity ofthe sample and skill of the interviewer in getting current information. In thismethod, the firm may go in for complete enumeration or sample surveys. In thecase of complete enumeration, the firm has to go for a door-to-door surveycontacting all the customers in the region. Under the sample survey method, somerepresentative customers are selected on a random basis as samples.



NOTES


Opinion poll method is also known as ‘sales force opinion method.’ This methodaims at collecting the opinions of those who are supposed to possess knowledgeof the market, e.g. sales representatives, and consultants. The firm collectsinformation from these representatives and on the basis of their response it forecastsdemand. Instead of depending upon the opinion poll of customers, firm can obtainviews of the experts.

This method is used to consolidate the divergent experts opinions and to arrive ata compromise estimate of future demand. This is also known as ‘Delphi Technique’of investigation. This technique is simple. This method is best suited in situationswhere intractable changes are occuring.

II. Statistical Method

Statistical techniques have proved to be very useful in demand forecasting.They are to be used in combination for accuracy and cross-checkingpurposes. The important statistical methods used in the demand forecasting areas follows :-

Long run tendency of a time-series to increase or decrease over a period of time isknown as trend. Time scries analysis relates to the determination of a change in avariable in relation to time. As earlier said, a trend is a long-term increase ordecrease in the variable. For example, the time series of population in India exhibitson upward trend while the trend for tiger is downward. Graphic method and leastsquare method are most important methods of measuring trend. In a graphicmethod, all values for different years are plotted on a graph and a smooth freehandcurve is drawn passing through as many points a possible. In this graph, thedirection of freehand curve-upward or downward - shows the trend.

It can be explained with the help of following data.

Table 6.1 : Sales of Company

Year Sales (Rs. Crore)

2007 05

2008 10

2009 15

2010 05

2011 15

2012 30

2013 30

2014 35

With the help of above data, the direction of the free-hand curve can be drawn. Itshows the trend.

Under the least squares method, a trend line is fitted to the time series sales datawith the aid of statistical techniques. This technique is used to find a trend linewhich ‘best fits’ the available data. Fitting trend equation is a formal technique ofprojecting the trend in demand. It is a mathematical procedure. When a timeseries data reveals a rising trend in sales, then a straight-line trend equation of thefollowing form is fitted;


Business Economics


NOTES

Y = a + bx

where Y represents sales, a and b are the values that are to be estimated from thepast data of sales. Here, a and b are constant. X is the year number for which theforecast is to be made.

Figure 6.1 : Trend of Sales of Company

Illustration : Calculate trend values from the following data using the least squaresmethod and estimate sales for the year 2014, 2015 and 2016.

Year : 2008 2009 2010 2011 2012 2013

Sales(Rs.Lakh) : 83 92 71 90 169 200

Solution :

In order to estimate the linear trend of sales the following general equation isused :-

y = a + bx

In order to solve the above equation we have to make use of the following normalequations :

y = na + bx

xy = ax + bx2

These values can be calculated as shown in the following table.

Year Year No Sales(Y) x2 xy(x) (Rs. Lakh)

2008 1 83 1 83

2009 2 92 4 184

2010 3 71 9 213

2011 4 90 16 360

2012 5 169 25 845

2013 6 200 36 1200

n=6 x=21 y=705 x2=91 xy=2885

Y

O

35

30

25

20

15

10

5

2007 2008 2009 2010 2011 2012 2013 2014X

Sales(Rs. Crores)

Actual Values

Trend line

Years



NOTES

83535


Substituting the above values in the two normal equations :-

705 = 6a + 21b ....................... (1)

2885 = 21a + 91b ....................... (2)

Multiplying equation (l) by 7 and equation (2) by 2

4935 = 42a + 147b ....................... (3)

5770 = 42a + 182b ....................... (4)

Subtracting equation (4) from equation (3)

! 835 = !35b

or 35b = 835

b = ____ = 23.85

Substituting the value of b in equation (1)

705 = 6a + 500.99

6a = 204.01

a = 34

Thus, a = 34 and b = 23.85

Trend values of sales for different years can be calculated as follows :-

Year number of 2008 or x = I, y = 34 + 23.85 H (1) = 57.85 lakh

Year number of 2009 or x = 2, y = 34 + 23.85 H (2) = 8 ] .7 lakh

Year number of 2010 or x = 3, y = 34 + 23.85 H (3)= J05.55 lakh

Year number of 2011 or x = 4, y = 34 + 23.85 H (4) = 129.4 lakh



For 2014, 2015 and 2016, the trend value of sale will be as follows :-

When x = 7, y = 34 + 23.85 H (7) = 200.95 lakh

When x = 8, y = 34 + 23.85 H (8) = 224.8 lakh

When x = 9, y = 34 + 23.85 H (9) = 248.65 lakh

Alternative Method

Problem given above could be solved by an alternative method as follows :-

Year x = 2 years Sales (Y) x2 xy Trend(1982.5) Rs. Lakh values

2008 !5 85 25 !415

2009 !3 92 9 !276

2010 !1 71 1 !71

2011 1 90 1 90

2012 3 169 9 507

2013 5 200 25 1000

n = 6 y = 705 x2 = 70 xy = 835


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NOTES

Since the number of years is even (n = 6), origin is taken as 1982.5

a = ___ = ___ = 11.92

b = _______ = 835 = 11.92

Trend values of sales for different years can be calculated as follows : Using thegeneral equation y = a + bx

When x = !5, y = 117.5 + 11.92 (!5) = 57.4 lakh.

Whenx = !3, y = 117.5 + 11.92 (!3) = 81.24 lakh.

When x = !I, y = 117.5 + 11.92 (!1) = 105.08 lakh.

When x = 1, y = 11.75 + 11.92 (1) = 128.92 lakh.

When x = 3, y = 11.7.5 + 11.92 (3) = 152.76 lakh.

When x = 5, y = 11.7.5 + 11.92 (5) = 176.6 lakh.

For 2014, 2015 and 2016 the trend value of sales will be as follow;

When x = 7, y = 117.5 + 11.92(7) = 200.94 lakh.

When x = 9, y = 117.5 + 11.92(9) = 224.78 lakh.

When x = 11, y = 117.5 + 11.92(11) = 248.62 lakh.

Another important statistical technique of demand forecasting is barometrictechnique. It is based on the assumption that the future can be predicted fromcertain events occuring in the present. Different economic indicators i.e. income,saving, expenditure, investment, etc. can be used to predict the market trend. Inthis method, it is not needed to depend upon the past data for demand forecasting.

Most commonly for demand forecasting purposes, the parameters of the demandfunction are estimated with regression analysis. In regression, a quantitativerelationship is established between demand which is a dependent variable andthe independent variables, i.e., determinants of demand such as income of theconsumer, prices of related goods, price of the commodity, advertisement cost,etc.

Criteria of a good demand forecasting :-

Various methods of demand forecasting differ in terms of scope, cost, flexibilityand the necessary skill and sophistication. It is becoming increasingly difficultfor the firms to keep pace with frequent changes in demand. Following are thecriteria of a good demand forecasting, which can be used for choosing the suitablemethod of forecasting.

(i) Accuracy : Forecast should be accurate as for as possible. The degreeof accuracy may differ according to the objectives of the forecast.Accuracy must be judged by examining the past forecasts in the light ofthe present situation.

(ii) Durability : Durability implies for what period the forecasting powerremains useful. It has an important bearing on the allowable cost of theforecast.

(iii) Simplicity : There are various methods of demand forecasting. Somemathematical techniques can also be used for demand forecasting.

y

N705

6

xy

H2.70



NOTES


However, it is not possible to all producers to make use of intricatetechniques. Therefore, a simple method is always more comprehensivethan a complicated one.

(iv) Economy : The firm is surely interested in getting accurate forecasts,but forecasting should have lesser costs as for as possible. It should becomposed of the costs of forecasting and benefits from increasedaccuracy.

(v) Timelines : There is always a time gap between the occurrence of anevent or change in the determinants of demand and its forecasts.Therefore, the job of the demand forecasting should be done in time oras early as possible. Because, a time consuming method may delay thedecision making process.

(vi) Flexibility : The demand forecasting should be amenable to adjustmentwith the changing conditions. The forecast should be maintained up todate and changes should be incorporated in forecast procedure, time totime.

.

6.3 SUMMARY

In this unit you have learned about estimation of demand and demand forecasting.To reduce uncertainty in planning for future production levels demand forecastingis essential. Good forecasting of future demand is important for calculating rateof return on capital investment. Demand forecasting is essential for planning andscheduling production, purchase of raw materials, spare parts, acquition of financeand advertising. It is clear that it is necessary for business managers to have aclear understanding of the estimation of demand for consumer durables and non-durables and also demand forecasting.

6.4 KEY TERMS

l Forecasting of demand : It is an estimate of future demand for a givencommodity or sale of a firm.

l Short term forecasting : It relates to a period not exceeding a year.

l Long term forecasting : It refers to the forecasts prepared for longperiod during which the firm’s scale of operations or the productioncapacity may be expanded or reduced.

l Trend : Long term tendency of a time-series to increase or decreaseover a period of time is known as trend.


1. What is demand forecasting?

2. Give demand function for non-durable goods.

3. Give demand function for durable goods.

4. Explain estimation of demand for consumer durables and non-durables.

5. What is the significance of demand forecasting in business decisions?


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NOTES

6. Explain the significance of statistical methods of demand forecasting?

7. What is meant by trend?

8. Distinguish between consumer’s survey method and sales force opinionmethod.

9. State four criteria of good demand forecasting?

10. What is demand forecasting? What are the methods of demandforecasting?

11. What is demand forecasting? What is its utility?

12. Explain various methods of demand forecasting.

13. What is meant by demand forecasting? Why is it so important for themanagement of business firms?

14. Write short notes –

(i) Estimating demand for consumer durables.

(ii) Estimating demand for consumer non-durables.

(iii) Demand forecasting.

(iv) Need for demand forecasting.

(v) Methods of demand forecasting.

(vi) Opinion poll method of demand forecasting.

(vii)Statistical methods of demand forecasting.

(viii) Least squares method.

(ix) Criteria of a good demand forecasting.

15. The annual sales of a company are given as follows :-

Year : 2009 2010 2011 2012 2013

Sales (Rs. In thousands) : 45 56 58 46 75

Using the method of least squares, estimate the sales for 2014.

(Answer : Rs. 80,000)






5. Diamond and Rothschild (Eds.) (1978) : ‘Uncertainty in Economics’,Academic Press, New Delhi.




NOTES




9. Green H. and V. Walch (1975) : ‘Classical and Neo-Classical Theoriesof General Equilibrium’, Oxford University Press, London.




13. Henderson J. M. and R. E. Quant (1980) : ‘Microeconomic Theory : AMathematical Approach’, McGraw Hill, New Delhi.



16. Dingra I. C. and V. K. Garg (2005) : ‘Microeconomics and IndianEconomic Environment’, Sultan Chand & Sons, New Delhi.


18. Banerjee A. and S. Mukherjee (1985) : ‘Topics in ManagerialEconomics’, New Central Book Agency, Kolkatta.



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UNIT 7 : THEORY OF PRODUCTION – I

Structure

7.0 Introduction

7.1 Unit Objectives


7.2.1 Production function

7.2.2 Production with one variable input-Law of diminishing returns

7.2.3 Assumptions of the Law

7.2.4 Diagrammatic presentation

7.2.5 Significance of the Law

7.3 Summary

7.4 Key Terms


7.6 Further Reading and References

7.0 INTRODUCTION

Production is a continuous process. This process involves the transformation ofinputs into output. The inputs could be land, labour, capital, entrepreneurship etc.and output could be goods and services. Goods and services are produced by afirm. The production process involves various costs and they vary differently atdifferent levels of output. Achieving optimum efficiency in production orminimizing cost for a given production is the important objective of the businessmanagers. In a competitive market, survival of a firm depends on their ability toproduce more goods and services at a competitive cost. Therefore, businessmanagers endeavour to maximize output from a given quantity of inputs orminimize the production cost. In this case, business managers have to face somefundamental questions.

(i) Whether to produce or not?

(ii) What input combination to use for optimum production?

(iii) How does output change when quantity of inputs is increased?

(iv) What type of technology to use in reducing the cost of production.

This unit ‘Theory of Production’ provides a theoretical answer to these questionsthrough economic models. Theory of production provides tools and techniques toanalyse the input output relationships. In this unit you will learn the productiontheory and different concepts of production.



NOTES

Theory of Production – I7.1 UNIT OBJECTIVES

After studying this unit, you should be able –

l To introduce and illustrate production function.

l To explain the laws of production with one variable input.

l To understand significance of Law of variable proportions.


7.2.1 PRODUCTION FUNCTION

The production function expresses a functional relationship between quantitiesof inputs and outputs. In other words, a production function refers to a functionalrelationship, under the given technology, between physical rates of input andoutput of a firm, per unit of time. It shows the maximum output which can beobtained for a given combination of inputs. Basically, production function is anengineering concept, but it is widely used in business economics for studyingproduction behaviour. In the words of Stigler, “The production function is thename given to the relationship between rates of input of productive services andthe rate of output of product. It is the economist’s summary of technologicalknowledge.” In a general mathematical form the production function is –

Q = f (L, M, N, K, T)

Where,

Q = Maximum quantity of output

f = Functional relationship

L = Labour input

M = Management (efficiency parameters)

N = Land (natural resources)

K = Capital

T = Technology

This production function is called as general production function because itexplains the functional relationship between input and output. But it cannotexplain exact quantities of inputs and outputs. All above variables enter theactual production function of a firm However, for the sake of convenience andsimplicity in the analysis of input-output relations, economists use a two- inputproduction function, viz., capital (K) and labour (L). We write the productionfunction as :-

Q = f (L, K)

Where, Q = Quantity of output produced per time unit

f = Functional relationship’

L = Labour

K = Capital

This function defines the maximum rate of output obtainable for a given rateof capital and labour input. The production function can be expressed in termsof geometric curves specifying the maximum output that can be obtained for


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NOTES

the given combination of factor inputs. Such a production function is shown infigure 7.1.

Fig. 7.1 : Production with one variable input-Law of diminishing returns

This production function implies the maximum quantity of product that can beproduced (Q) given the total volume of capital (K) and the total number of labours(L). Increasing production will require increase in labour and capital. Whetherthe firm can increase both labour and capital depends on the time period. Thefunctional relationship between changes in inputs and consequent changes in outputdepends on the time element i.e. short run and long run time periods.

Short run refers to a period during which supply of certain factors of production(viz. land and capital) is supposed to be inelastic. In this case, the inputs of somefactors of production cannot be varied. However, in the short run, in order to havemore output it is possible to increase the quantities of one input while keeping thequantities of other inputs constant. It means that, in the short period, some factorsare fixed and some are variable. A fixed factor is one whose quantity cannot bevaried during the time under consideration. On the other hand, variable factor isone whose amount can be changed during the relevant period. Short run productionfunction implies a restricted set of choices open to the firm on account ofinelasticity of fixed factors. This aspect of the production function is known asthe law of variable proportions.

However, in the long run, the firm can employ more of both labour and capital.There is no constraint on production. The production can be adjusted by changingboth the inputs i.e. fixed and variable. In other words, the longer the length of thetime period under consideration, the more likely it is that the input will be variableand not fixed. Thus, in the long run, there is a full scope for adjustment betweenfactors in the production process. This is known as returns to scale.

It means that the firm would have two types of production functions. These are

(i) Short run production function; and

(ii) Long run production function.

In the short run, the firm can adjust the variable input like labour. So, this functionis called as single variable production function, which can be expressed as

Q = f (L)

On the other hand, in the long run, the firm can adjust all the inputs like labourand capital. So this function is called as two variable production function, whichcan be expressed as

Q = f (L, K)



NOTES

Theory of Production – I7.2.2 PRODUCTION WITH ONE VARIABLE INPUTLAW OF DIMINISHING RETURNS

The production function has been explained by different economists in differentways to formulate laws relating to the relationship between inputs and outputs.Output can be produced by keeping one factor or some factors fixed while otherfactors are varied. The law of diminishing marginal returns is based upon thistype of production function. First, it was explained by Thomas Malthus, DavidRicardo and J. S. Mill. It was elaborated and refined by the Prof. Alfred Marshall.His approach considers three different stages of the operation of the laws ofreturns. If the number of units of a variable factor is increased, keeping otherfactors constant, how output changes is the concern of this law. While keepingone factor (capital) constant as the quantities of other input (labour) are changedthe output will change. In this case, in the beginning total product increases at anincreasing rate, then at a constant rate and finally at a diminishing rate. The lawof variable proportions depicts this type of relationship between input and outputin the short run.

The Law of Diminishing Returns

It was originally explained by the classical economists with reference to agricultureIn agriculture, it was observed that as the units of one input (labour) are increasedby keeping other input (land) fixed, the total production does not increase in thesame proportion. The classical economist stated this law as the law of diminishingreturns. Marshall stated this law as under:

“An increase in capital and labour applied in the cultivation of land causes ingeneral a less than proportionate increase in amount of produce raised, unless ithappens to coincide with an improvement in the arts of agriculture.”

This law was originally explained in connection with land and agriculture.However, it is applicable in all fields of production like industry, mining, fishing,house construction along with agriculture.

The Law of Variable Proportions

This is the modem version of the law of diminishing marginal returns. Moderneconomists explained the law of variable proportions. This law illustrates threestages of production that show the relationship between average product andmarginal product. Under this law it is assumed that only one factor of productionis variable while other factors are fixed. Various economists stated this law in thefollowing manner,

(i) Prof. Leftwitch : “The law of variable proportions states that if a variablequantity of one resource is applied to a fixed amount of other input,output per unit of variable input will increase but beyond some pointthe resulting increases will be less and less, with total output reaching amaximum before it finally begins to decline.”

(ii) George Stigler : “As equal increments of one input are added, the inputsof other productive services being held constant, beyond a certain pointthe resulting increments of product will decrease i.e. the marginalproducts will diminish.”

(iii) Prof. F. Benham : “As the proportion of one factor in a combination offactors is increased, after a point first the marginal and then the averageproduct of the factor will diminish.”


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NOTES

It is evident from the above definitions that as we increase units of one factor bykeeping other factor constant, initially the total output increases but finally aftera point, it tends to decline.

7.2.3 ASSUMPTIONS OF THE LAW

The law of variable proportions is based on following assumptions.

(i) Only one factor is variable while others are held constant.

(ii) All units of the variable factor are homogeneous.

(iii) The technique of production does not change.

(iv) It is possible to change the proportions in which the various factors(inputs) are combined.

(v) It is applicable in the short run.

Under such circumstances, the physical relationship between input (variable factorproportions) and output is described by the law of variable factor proportion. It isalso known as the ‘Law of non-proportional returns.’

To clarify the relationship further, we may adopt the following concepts of productviz., total product, average product and marginal product.

(i) Total Product (TP) : It refers to the total volume of goods producedduring a specified period of time. In the short run, the total productincreases with an increase in the variable factor input.

(ii) Marginal Product (MP) : The rate at which total product increases isknown as marginal product, In other words, marginal product meansthe addition to the total product resulting from a unit increase in thequantity of the variable factor.

(iii) Average Product (AP) : It refers to the total product per unit of a givenvariable factor. It can be known by dividing total product by the totalnumber of units of the variable factor.

To illustrate the working of this law, let us take a hypothetical production scheduleof a firm as given in table 7.1.

Table 7.l : Production Schedule

Fixed Variable Total Average MarginalFactor Factor Product Product Product Stage

(Labour) (TP) (AP) (MP)

10 1 10 10 10 Stage I

10 2 24 12 14 (Increasing Returns)

10 3 42 14 18

10 4 56 14 14

10 5 60 12 04 Stage II

10 6 60 10 0 (Diminishing Returns)

10 7 56 8 ! 4 Stage HI

10 8 40 5 !16 (Negative Returns)



NOTES

Theory of Production – IWe can make following conclusion on the basis of the production schedulegiven above.

(i) The law of diminishing marginal returns becomes evident in the marginalproduct column. In the first stage, the total output increases at anincreasing rate till third unit of variable factor. Then it increases at adecreasing rate. Average product also rises. This is analytically describedas the stage of increasing returns. In this stage, marginal product is greaterthan zero, average product rising and marginal product is greater thanaverage product.

(ii) The second stage starts with decline in average product. Reaching thecertain point the marginal product begins to diminish. In this stage bothaverage and marginal product decline but the fall in marginal product ishigher. The rate of increase in total product slows down. Total productreaches its maximum as the marginal product reaches to zero. This isthe stage of diminishing returns.

(iii) The third stage starts as the marginal product turns to be negative. Whenthe marginal product becomes zero, the total product is maximum. Theaverage product declines. Further, when the marginal product becomesnegative, the total product begins to decline in the same proportion.This is the stage of negative returns.

7.2.4 DIAGRAMMATIC PRESENTATION

The law of variable proportions can be explained by using following diagram :-

Fig. 7.2 : Three Stages of Production

In the above diagram, the X-axis measures the units of a variable factor employedi.e. labour, the Y-axis measures the total product, average product and marginal

Tota

l, A

vera

ge a

nd M

argi

nal P

rodu

ct


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NOTES

product. The TP curve shows the total product, AP curve shows average productand MP curve represents marginal product.

The first stage goes from the origin to the point where the average product is themaximum. The total product curve has an upward slope up to point W, and then itmoves downward. In the first stage, the marginal product increases, i.e. the totalproduct increases at an increasing rate. Thus, this stage relates to increasing averagereturns. In this situation, the law of increasing returns is said to operate. The mainreason for increasing returns in this stage is that in the beginning the fixed factoris large in quantity than the variable factor.

The second stage goes from the point where the average product is maximum tothe point where the marginal product is zero. In this stage both average and marginalproduct decline but the fall in marginal product is higher. In this stage, total productincreases at a diminishing rate. This is the crucial stage for the firm, because it iswithin this stage that the firm determines its level of the actual operation. Themarginal product decreases because a given quantity of fixed factors, is combinedwith larger and larger amounts of variable factors.

In the third stage, total product starts declining and the marginal product becomesnegative. This stage is the stage of negative returns, when the input of a variablefactor is much excessive in relation to the fixed components in the productionfunction. Excess quantity of variable factors causes, negative returns. Productionwill not take place in this stage.

7.2.5 SIGNIFICANCE OF THE LAW

The law of variable proportions has a great significance both from theoreticaland practical points of view. Marshall applied the operation of this law toagriculture, fisheries, mining, forests and the building industries. This law is usefulto businessmen in their short run production planning at the micro level. The lawshows the appropriate stage of production. The output will not be taken in the laststage when the returns are negative. In the words of Wicksteed, the law ofdiminishing returns, “is as universal as the law of life itself.” Ricardo also basedhis theory of rent on this principle. The Malthusian theory of population is alsobased on this principle. According to this theory, food supply does not increasefaster than the growth in population because of the operation of the law ofdiminishing returns in agriculture.

7.3 SUMMARY

In this unit you have learned about production function and production with onevariable input i.e. law of variable proportions. The production function expressesa functional relationship between quantities of inputs and outputs. In other words,the technological – physical relationship between inputs and outputs is referredto as the production function. Production function can be classified into two typesi.e. short-run production function and long run production function. In the shortrun, the firm cannot change all the inputs to adjust the output. However, the firmcan adjust the variable input like labour. When the quantity of one factor is varied(labour) keeping the quantities of other factors constant (land, capital etc.) theoutput will change. The law of variable proportions depicts this relationshipbetween input and output in the short run. It occupies an important place ineconomic theory.



NOTES

Theory of Production – I7.4 KEY TERMS

l Production Function : It refers to the functional relationship, underthe given technology, between physical rates of input and output of afirm, per unit of time.

l The Short Run : It is defined as a period of time over which the inputsof some factors of production cannnot be varied.

l The Long Run : It is defined as a period of time long enough to permitvariations in the inputs of all factors of production employed by a firm.

l Total Product : Total product of a factor is the amount of total outputproduced by a given amount of the factor, other factors held constant.

l Average Product : Average product of a factor is the total outputproduced per unit of a factor employed. Symbolically,

Total ProductAverage Product = _______________________________

Number of units of a factor employed

l Marginal Product : Marginal product of a factor is the addition to thetotal production by the employment of an extra unit of a factormathematically,

QMPL = ____

L

Or

Change in total productMarginal product of Labour = _______________________

Change in units of Labour

l The Law of variable proportions : As the proportion of one factor ina combination of factors is increased after a point, the average andmarginal production of the factor will diminish.


1. What is a production function?

2. State and explain the law of variable proportions. Which is the beststage in this law and why?

3. Explain the law of diminishing returns. Does it equally apply to industryand agriculture?

4. What is production function? Explain its main features.

5. Discuss the short-run production function.

6. Explain the law of variable proportions.

7. “As the proportion of one factor in a combination of factors is incresed,after a point, the marginal and average product of that factor willdiminish.” Discuss the statement.


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NOTES

8. Explain the Law of variable proportions. Why does this law operate?

9. Is it true to say that the law of diminishing returns is universal?

10. What are the three stages of short run production function? Why does itnot make any economic sense to produce in stage 1 or 3 ?

11. State and illustrate with the help of a schedule and diagram the law ofincreasing returns.

12. State and illustrate with the help of a schedule the law of diminishingreturns.

13. Fill in the blanks in the following table :-

Number of variable total Average MarginalInput (Labour) Product Product Product

1 2 — —

2 — 25 —

3 — — 40

4 — — 30

5 — — 20

6 150 — —

7 153 — —

8 — — 0

9 — — !4

10 — — !5

14. Write Short Notes :-

(i) Production function.

(ii) Types of production function.

(iii) Production with one variable input.

(iv) Law of variable proportions

(v) The Law of diminishing returns.

(vi) Concepts of product.

(vii)Significance of the Law of variable propertions.






5. Diamond and RothSchild (Eds.) (1978) : ‘Uncertainty in Economics’,Academic Press, New Delhi.



NOTES

Theory of Production – I6. Layard P. R. G. and A. W. Alters (1978) : ‘Microeconomic Theory’,McGraw Hill, New Delhi.


8. Green H. And V. Walch (1975) : ‘Classical and Neo-Classical Theoriesof General Equilibrium’, Oxford University Press, London.






14. Varian H. (2000) : ‘Microeconomic Analysis’, W.W. Norton, New York.



17. Dingra I. C. And V. K. Garg (2005) : ‘Microeconomics and IndianEconomic Environment’, Sultan Chand & Sons, New Delhi.


19. Green H. A. G. (1971) : ‘Consumer Theory’, Penguin Harmonds worth.


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UNIT 8 : THEORY OF PRODUCTION – II

Structure

8.0 Introduction

8.1 Unit Objectives


8.2.1 Production with two variable inputs : Law of Returns to Scale

8.2.2 Assumptions of the Law

8.2.3 Diagrammatic Presentation

8.2.4 Estimation of production function

8.3 Summary

8.4 Key Terms


8.6 Further Reading and References

8.0 INTRODUCTION

In the previous unit, you have learned about meaning of production function,production function with one variable input i.e. law of variable proportions orlaw of diminishing returns. In it we have discussed that a firm can change its levelof production by changing the quantity of the variable factors i.e. labour in theshort run. In the long run, all factors become variable. When a firm changes thequantity of both the factors i.e. fixed factors and variable factors (plant, equipment,building, labour) in the long run, it changes its scale of production. In this unityou will learn the production function with two variable inputs i.e. law of returnsto scale you will also learn the estimation of production function.

8.1 UNIT OBJECTIVES


l To understnad the production function with two variable inputs i.e. lawof returns to scale.

l To understand estimation of production function.


8.2.1 PRODUCTION WITH TWO VARIABLE INPUTS :LAW OF RETURNS TO SCALE

In the long run there is no constraint on production. The production can be adjustedby changing both the inputs i.e. fixed and variable. In fact, all factors becomevariable in the long run. That means, in the long run, the size of a firm can be



NOTES

Theory of Production – IIexpanded as the scale of production is enhanced. Firm can change production bychanging all the factors of production. If we increase all the factors of productionin the same proportion, how the production will change will be explained by thelong-run production function. Long run production function is also known as lawof returns to scale.

The law of returns to scale describes the relationship between outputs and scaleof inputs in the long run. It assumes that there is possibility of changing all theinputs simultaneously and in the same, proportion. According to Roger Mikee,the law of returns to scale refers, “to the relationship between changes in outputand proportionate changes in all factors of production.” It explains how asimultaneous and proportionate increase in both labour (L) and capital (K) affectsthe total output at various levels of input combination.

8.2.2 ASSUMPTIONS OF THE LAW

The law of returns to scale is based on following assumptions :-

(i) All factors are variable but enterprise is fixed.

(ii) All units of factors are homogeneous.

(iii) Technique of production is unchanged.

(iv) There is perfect competition.

(v) Returns are measured in physical terms.

Explanation

What happens when a producer changes his scale of production? This is explainedby the law of returns to scale, There are three phases of returns in the long run,viz. (i) increasing returns to scale, (ii) constant returns to scale; and (iii) decreasingreturns to scale. If increase in output is greater than proportional increase in theinputs, it means increasing returns to scale. Returns to scale become constant asthe increase in total product is in exact proportion to the increase in inputs, itmeans constant returns to scale. If increase in output is less than proportional tothe increase in inputs, it means decreasing returns to scale. This principle of returnsto scale is explained with the help of following table.

Table No. 8.1 : Returns to scale in physical units

Labour Capital Total Marginal ProductionProduct Product Function

1 2 10 10 Increasing

2 4 23 13 returns

3 6 39 16

4 8 58 19 Constant

5 10 77 19 returns

6 12 94 17 Decreasing

7 14 109 15 returns

8 16 120 11

This table reveals that in the beginning with the scale of production of (1 labour+ 2 capital), total output is 10. To increase output when the scale of production is


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doubled, total returns are more than doubled. The total output is increasing at anincreasing rate. It shows increasing returns to scale. In the second stage, if thescale of production is increased, total output will increase in such a way that themarginal returns become constant. The marginal product remains constant. Thisis the stage of constant returns. Finally, the same addition in the scale of productionhas resulted in output to increase at a decreasing rate. This is the stage of decreasingreturns.

8.2.3 DIAGRAMATIC PRESENTATION

The law of returns to scale can be shown diagram at ically in the followingway.

Fig. 8.1 : Scale of Production

In figure 8.1, AD is the returns to scale curve where from A to B returns areincreasing, from B to C, they are constant and from C onwards they are decreasing.

Economists make use of isoquants to explain the operation of the returns to scale.The term ‘isoquant’ has been derived from iso meaning ‘equal’ and quant meaningquantity. Therefore, isoquant is also known as equal-product curve or productionindifference curve. An isoquant joins all those combinations of factor inputs whichyield the same level of output. In other words, an isoquant curve is a locus ofpoints representing the various combinations of two inputs-labour and capital-yielding the same output. Returns to scale could be explained using isoquantsrepresenting different levels of output.

(i) Increasing returns to scale

If a proportionate change in both the inputs, labour and capital, leads to morethan proportionate change in output, it exhibits increasing returns to scale,digramatically, increasing returns to scale may be represented as in Fig. 8.2.

Fig. 8.2 : Increasing returns to Scale



NOTES

Theory of Production – IIIn figure 8.2, IQ1, IQ2 and IQ3 are isoquants which represent output of 50, 100and 150 units respectively. The increasing returns to scale is illustrated in thisfigure. In this figure, the distance between two isoquants becomes less and lessi.e. in order to double output from 50 to 100, input increase is less than double. Inother words, the cost on labour and capital increases, but it is less than theproportionate increase in output. Here, OA > AB > BC.

Returns to scale increase because of the invisibility of the factors of production.Indivisibility means that certain inputs like capital equipments and managerialskills cannot be divided into a smaller size to suit a smaller scale of production.When a business expands, the returns to scale increase because the productivityof indivisible factors increases exponentially. Another factor causing increasingreturns to scale is higher degree of specialization of both machinery and labour.With specialization, efficiency of inputs increases and increasing returns to scalefollow. Another factor causing increasing returns to scale is internal economiesof production.

(ii) Constant returns to scale

When a proportionate change in output equals the proportional change in inputs,it exhibits constant returns to scale. Diagrammatically, constant returns to scalemay be represented as in figure 8.3.

Fig. 8.3 : Constant returns to scale

In figure 8.3, IQ1, IQ2 and IQ3 are isoquants which represent output of 50, 100and 150 units respectively. The constant return to scale is illustrated in this figure.In the figure, successive isoquants are equidistant from one another along the rayOP. In order to get an equal increase in output, the factor proportion required toraise the output rises in an equal proportion. Constant returns to scale operatewhen he total output increases exactly in the same proportion as an increase inthe quantity of factor inputs. Here, OA = AB = BC.

Increasing returns to scale do not continue indefinitely. When economies of scaledisappear and diseconomies are yet to begin, the returns to scale become constant.Further, when factors of production are perfectly divisible and homogeneousreturns to scale are constant.

(iii) Decreasing returns to scale

If a proportionate change in both the inputs, labour and capital, leads to less than


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proportionate change in output, it exhibits decreasing returns to scale. Whenpowerful diseconomies are met by feeble economies of certain factors, decreasingreturns to scale set in. When inputs arc doubled, output is less than doubled andso on. Diagrammatically, decreasing returns to scale may be represented as infigure 8.4.

Fig. 8.4 : Decreasing returns to Scale

In figure 8.4, IQ1, IQ2 and IQ3 are isoquants which represent output of 50, 100and 150 units respectively. The decreasing returns to scale is illustrated in thisfigure. It implies that for a given increase in output, a more than proportionateincrease in the quantities of factor inputs are required. Here, OA < AB < BC. Ifthere are decreasing returns to scale, the distance between a pair of isoquantswould become longer on the expansion path.

Indivisible factors may become inefficient and less productive as the industry-continues to expand after a certain limit. Large management creates difficultiesof control. The problem of supervision and coordination becomes complex andintractable in a large scale of production. To these internal diseconomies are addedexternal diseconomies of scale. These arise from diminishing productivities ofthe factors. All these factors tend to raise costs and the expansion of the firmsleads to diminishing returns to scale.

8.2.4 ESTIMATION OF PRODUCTION FUNCTION

In the process of decision making, a manager should understand clearly therelationship between the inputs and outputs. A production function refers to thefunctional relationship, under the given technology, between physical rates ofinput and output of a firm, per unit of time. It is the mathematical form. There aremany inputs used in the production function. However, economists present a simpleproduction function, assuming a two factor model viz, labour and capital.

On operational basis, there are two types of production functions :

(i) Short run production function, and

(ii) Long run production function.



NOTES

Theory of Production – IIIn the short run, the firm cannot change all the inputs to adjust output. The firmcannot change fixed input like capital, i.e. supply of capital (K) is taken to beconstant. However, the firm can adjust the variable input like labour (L). It meansproduction can be increased only by increasing the units of labour. So short runproduction function will be -

Q = f (L)

Where,

Q = Total production

f = function of

L = Labour quantity

However, in the long run, the production can be adjusted by changing both theinputs i.e. fixed and variable. In fact, all the inputs become variable inputs in thelong run. It means production can be increased by increasing the units of labourand capital. So, long run production function will be

Q = f (L, K)

Therefore, the first step in estimating the production is to decide whether thepurpose is to estimate short run production function or long run productionfunction. Second step in the estimation of production function is to collect thedata on inputs used and production. After deciding nature of production function,the estimator is required to find the empirical form of production function to beestimated. For empirical measurement various mathematical relationshipssuch as linear, quadratic, cubic and power are used. Following are the fivetypes of linear and non-linear models of production functions applied in empiricalstudies :-

(i) Linear production function.

(ii) Quadratic production function.

(iii) Cubic production function.

(iv) Power production function.

(v) Cobb-Douglas production function.

The linear production function represents straight line for the production curve,when the production function is plotted on a graph. The quadratic productionfunction is useful to know the quantum of diminishing returns. The cubicproduction function highlights the operation of the law of non-proportional returnsto the variable factors. When estimated value is presented graphically, initiallymarginal product curve is rising and then falling. The power function is expressedin logarithmic terms. All these production functions consider single variable factorat a time. However, Cobb-Douglas production function considers two variablefactor inputs. The logarithmic form of Cobb-Douglas production functions canbe estimated by using least-square regression technique.

Time series analysis, cross section analysis and engineering analysis are the threetypes of statistical analyses used for estimation of a production function. Timeseries analysis is appropriate for a single firm that has not undergone significantchanges in technology during the time span analysed. In the cross-section analysis,we may use regression techniques to estimate the relationship between the amountsof the inputs and the resulting output. In engineering analysis we use technicalinformation supplied by the engineer. The data in this analysis is collected fromexperience with day-to-day working of the technical process.


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8.3 SUMMARY

In this unit you have learned about production function in the long run or productionwith two variable factors i.e. law of returns to scale. For the analysis of productionfunction with two variable factors we made use of the concept called isoquants.These iso-quants are also called the iso-product or equal product curves whichare similar to indifference curves of the theory of consumption. The nature ofreturns to scale is very important for a firm. Because its effect on cost of productioninfluences the firm’s ability to compete with other firms of various sizes in thesame industry. It occupies an important place in economic theory.

8.4 KEY TERMS

l Isoquant : An isoquant joins all those combinations of factor inputswhich yield the same level of output.

l Constant returns to Scale : If we increase all factors (i.e. scale) in agiven proportion and the output increases in the same proportion, returnsto scale are said to be constant.

l Increasing returns to Scale : It occurs when the total output increasesin a larger proportion than the proportionate increase in the factor inputalong a given scale.

l Diminishing returns to Scale : It implies that for a given increase inoutput, a more than proportionate increase in the quantities of factorinputs is required.

l Laws of returns to Scale : An increase in all the factor inputs in thesame proportion by the firm results in increase in total output in a largerproportion than the proportionate increase in the factor inputs initially.Then total output increases at the same rate as the factor inputs areincreased, but finally, the increase in total output is less than the increasein the rate of factor inputs.


1. Explain the laws of returns to scale.

2. Explain the laws of retruns to scale using the isoquants.

3. What is a production function? How does a long run production functiondiffer from a short run production function?

4. What is meant by linear homogeneous production function?

5. What is meant by constant returns to scale? Represent it by an isoquantmap.

6. What is meant by increasing returns to scale? Explain the factors thatcause increasing returns to scale.

7. Discuss the long run production function.

8. What do you understand by the law of constant returns? Explain withthe help of a diagram.



NOTES

Theory of Production – II9. What do you understand by returns to scale?

10. Explain the difference between short run and long run productionfunction. Cite one example of this difference in a business situation.

11. State and explain the law of returns to scale.

12. Write Short Notes :-

(i) Production function.

(ii) Assumptions of the returns to scale.

(iii) Increasing returns to scale.

(iv) Constant returns to scale.

(v) Diminishing returns to scale.

(vi) Isoquants.

(vii)Estimation of production function.








7. Diamond and Roth Schild (Eds.) (1978) : ‘Uncertainty in Economics’,Academic Press, New Delhi.








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14. Varian H. (2000) : ‘Microeconomic Analysis’, W.W. Norton, New York.







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Economies & Diseconomiesof ScaleUNIT 9 : ECONOMIES & DISECONOMIES

OF SCALE

Structure

9.0 Introduction

9.1 Unit Objectives


9.2.1 Economies and Diseconomies of Scale

9.2.2 Forms of Internal Economies

9.2.3 Forms of External Economies

9.2.4 Diseconomies of Scale

9.3 Summary

9.4 Key terms


9.6 Further Reading and Exercises

9.0 INTRODUCTION

In the previous unit, you have learned about production function with two variableinputs; law of returns to scale. In it you have learned about increasing returns toscale, constant returns to scale and diminishing returns to scale, three differentlevels of output. The growing large scale production in the modern business isdue to the expansion of large firms producing commodities. Large scale productionis economical in the sense that the cost of production is low, which implies thebenefits derived by a producer by expanding its scale of production. The low costis a result of what is called ‘economies of scale’. In this unit you will learn themeaning of economies of scale, forms of internal and external economies, anddiseconomies of scale.

9.1 UNIT OBJECTIVES


l To understand internal economies of scale.

l To understand external economies of scale.

l To understand diseconomies of scale.


9.2.1 ECONOMIES AND DISECONOMIES OF SCALE

The scale of production means the size of the production unit of a firm. Asproduction increases with the increase in quantities of labour, land and capital,the scale of production expands. The scale of production varies with the size of


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the firm. The large scale production has a definite advantage over small scaleproduction. These advantages, in technical language are referred to as economiesof scale.

Economies of Scale

Economies of scale imply the benefits derived by a producer by expanding itsscale of production. In other words, economies of scale means anything whichserves to minimize average cost of production in the long run as the scale ofoutput increases. Marshall classified economies of large scale production intointernal economies and external economies. (Diagram 9.1)

Diagram 9.1 : Economies of Scale

Internal economies External economies

Technical Managerial Marketing Financial Risk minimizingEconomies Economies Economies Economies Economies

(1) Economies (1) Delegation (1) Economies inof superior of detail cost of obtainingTechniques credit

(2) Economies (2) Functionalof increased specialisation (1) DiversificationDimensions of output

(3) Economies of (1) Economies (2) Diversificationlinked process in the purchase of market

of raw materials(4) Economies

of use of (2) Economies in (3) Diversificationby-products the sales of of sources

produced goods of supply(5) Economies of increased

specialisation

Economies Economies Economies of concentration of Information of Specialisation

Internal Economies

Internal economies are internal to a firm when its costs of production are reducedand output increases. These economies are not enjoyed by other firms operatingin the industry. In other words, internal economies accrue to a firm largely becauseof its own efforts. It means that internal economies are exclusively available tothe expanding firm. These economies are the function of the size of the firm.

External Economies

External economies are those economies which arc shared by all the firms in anindustry when its size expands. They are available to all the firms of an industry- they are not specific to any one particular firm. Thus they are the function of thesize of the industry.



NOTES

In short, internal economies are specific to only one expanding firm, while theexternal economies are common to all firms in an industry. In other words,economies of size of a firm are ‘internal economies’ and those of the size of industryare ‘external economies’.

9.2.2 FORMS OF INTERNAL ECONOMIES

The internal economies of scale can be broadly classified under five heads asfollows:

1. Technical economies.

2. Managerial economies.

3. Marketing economies.

4. Financial economies.

5. Risk-minimising economies.

1. Technical Economies

Technical economies are those which arise to a firm from the use of better machinesand techniques of production. Use of better machines and techniques of productionleads to arise in the level of output and reduction in the average cost of productionand there by create technical economies. Technical economies can be classifiedinto five kinds:

(i) Economies of superior techniques : As a firm expands, it can usesuperior techniques and high-qualiy machines. It raises the operationalefficiency of the firm and enables it to produce more at a lower cost.

(ii) Economies of increased dimensions : Certain technical economies maybecome available just on account of increased dimensions. For example,the cost of manufacturing a double-decker bus is lower as compared tothe cost of two ordinary buses.

(iii) Economies of linked process : A large firm is able to reduce its per unitcost of production by linking the various processes of production. Forexample, large sugar manufacturing firm or composite dairy unit.

(iv) Economies of use of by-products : A large firm is able to utilise itswaste material as a by-product. Cane pulp and molasses of big sugarfactories can be effectively used by the paper industry and liquordistilleries.

(v) Economies of increased specialisation : A large firm is able to reapeconomies by dividing its production process into sub-processes. It leadsto increased specialization, enhanced productivity and reduced cost ofproduction.

2. Managerial Economies

With the increasing scale of output, greater managerial economies are reaped byan expanding firm. Managerial economies arise from specialization in managementand mechanization of managerial functions. For example, a large firm can hiregood manager by paying a handsome salary, so its overall administration will bemore efficient as well as economical. Functional specialization can be introducedby setting up specialized departments under specialized personnel, There may bea separate head for manufacturing, assembling, packing, marketing, generaladministration, etc. Besides, large firms can afford to adopt the advanced techniques

Economies & Diseconomiesof Scale


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of communications. This leads to functional specialization which increases theproductive efficiency of the firm.

3. Marketing Economies

Marketing economies are referred as economies of buying (of raw materials,inputs) and selling (goods produced). Large establishments have a strongbargaining power and get a preferential treatment from the firms they deal with.They buy their requirements of various inputs in bulk and more cheaply than asmall one. They can afford to advertise on television screens, in magazines andnewspapers. Thus a large firm is able to reap the economies of marketing.

4. Financial Economies

Large establishments can procure cheap and timely finance from the banks andfinancial institutions and market also because it possesses large assets and goodreputation. The large firms can also easily raise fresh capital by issue of sharesand debentures because big firms are usually regarded less risky by investors.Investors may be willing to lend capital to such firms even at a lower rate ofinterest than to small firms.

5. Risk-Minimising Economies

Business enterprises have to face several risks. However, a large firm by producinga wide range of products is in a position to minimise or eliminate business risksby spreading them over. The spreading of risk can be done by a large firm in thefollowing ways.

(i) Diversification of output : The large firm is able to reduce risks bycounter-balancing the loss of one product by the gain from other products.

(ii) Diversification of market : The large firm is able to reduce risks bycounter-balancing the fall in demand in one market by the increaseddemand in other markets. Diversification of market takes care of therisks which arise on account of fluctuations in demand.

(iii) Diversification of sources of supply : In large establishments, thereare less chances of disruption of output as a result of scarcity of rawmaterials.

9.2.3 FORMS OF EXTERNAL ECONOMIES

External economies are those economies which are shared by all firms in anindustry. These economies (advantages) benefit all firms within the industry asthe size of the industry expands. The external economies can be classified asunder:

1. Economies of concentration.

2. Economies of information.

3. Economies of specialization.

1. Economies of concentration

When an industry is concentrated in a particular area, all the member firms derivemutual advantages through the training of skilled labour, provision of bettertransport facilities, stimulation of improvements, etc. In other words, availability



NOTES

of skilled labour, improved means of transport and communication, offices ofbanks, insurance companies and other financial institutions, cheap and better powerresources, all these facilities tend to lower the unit cost of production of all thefirms in the industry.

2. Economies of information

When a number of firms are located in one place, many associations and foramsare formed as trade associations, chambers of commerce etc. These institutionsenable the firms to interact on a common platform, tackle common problems andvoice their grievances. Besides, an industry is in a better position to set up researchlaboratories than a large firm because it is able to pool larger resources. Statistical,technical and other market information becomes more rapidly available to allfirms in a growing industry.

3. Economies of specialization

When an industry expands in size, firms start specializing in different processesand the industry benefits on the whole. New subsidiary industries may grow up toserve the needs of the main industry. For example, in the cotton textile industrysome firms may specialize in ginning, spinning, weaving, dyeing and bleaching.This type of specialization benefits the entire industry by way of a rise in efficiencyand a fall in the unit cost of production.

9.2.4 DISECONOMIES OF SCALE

Beyond a particular limit, certain disadvantages of large scale production emerge.Internal and external diseconomies are the limits to large scale production. Inother words, diseconomies of scale are disadvantages that arise due to theexpansion of the production scale and lead to a rise in the cost of production.Generally, the following factors of diseconomies of scale limit the size of thefirm.

1. Financial diseconomies : A big firm needs huge capital. However,capital or finance may not be easily available in the required amount atthe appropriate time and at reasonable cost.

2. Managerial diseconomies : Diseconomies begin to appear first at themanagement level. There is a limit beyond which a firm becomesunwieldy and hence unmanageable. Because as firm expands,complexities and problems of management increase.

3. Diseconomies of risk-taking : As the scale of production increasesrisks also increase with it. The larger the output, obviously the greaterwill be the loss. An error of judgment may adversely affect sales orproduction which may lead to great loss.

4. Marketing diseconomies : The expansion of a firm beyond a certainlimit may also involve marketing problems. Firms under monopolisticcompetition will have to undertake extensive advertising and salespromotion efforts and expenditure which ultimately lead to higher costs.

5. Labour diseconomies : Overcrowding of labour leads to a loss of controlover labour productivity and there are more chances of occurrence ofgrievances and industrial disputes which prove to be costly to the largefirm.



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9.3 SUMMARY

In this unit you have learned about economies and diseconomies of scale. Theeconomies of scale may be classified as (i) internal economies, and (ii) externaleconomies. Internal economies are those economies which are open to anindividual firm, when its size expands. External economies implies gains accruingto all the firms in an industry from the growth of that industry. Indivisibilities andthe specialisation are the two main factors that give rise to internal economies.Increase in the scale, beyond the optimum level, results in diseconomies of scale.Beyond a particular limit, certain disadvantages of large scale production emerge.

9.4 KEY TERMS

l Economies of Scale : Imply the benefits derived by a producer byexpanding its scale of production.

l Large scale production : It refers to the production of a commodity ona large scale, with a large plant size firm.

l Internal economies : The economic advantages which accrue to thefirms and industry with the expansion of the scale of production arereferred to as the economies of scale.

l External economies : These are those economies or advantages whichare shared by all the firms in an industry or in a group of industrieswhen their size expands.


1. Distinguish between internal and external economies. Give an accountof internal economies.

2. What are the types of internal economies?

3. What are the major types of external economies?

4. Discuss the various economies of large scale production.

5. What are the major types of diseconomies?

6. Discuss the economies of scale of an expanding software firm inBangalore.

7. What is meant by ‘economies of scale?’ Explain the important internaland external economies of scale.

8. What are the internal economies of scale? Explain the main internaleconomies.

9. What are external economies of scale? Explain the main externaleconomies.

10. Write short notes –

(i) Economies of scale.

(ii) Internal economies.



NOTES

(iii) External economies.

(iv) Technical economies.

(v) Managerial economies.

(vi) Marketing economies.

(vii)Financial economies.

(viii) Risk-minimising economies.

(ix) Economies of concentration.

(x) Economies of information.

(xi) Economies of specialization.

(xii)Diseconomies of scale.

9.6 FURTHER READINGAND EXERCISES



3. Samuelson Paul A. and William D. Nordhaus (2010) : ‘Economics’,Tata McGraw Hill Education Private Ltd., New Delhi.









12. Diamond and Roth Schild (Eds.) (1978) : ‘Uncertainty in Economics’,Academic Press, New Delhi.





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Cost Concept

UNIT 10 : COST CONCEPT

Structure

10.0 Introduction

10.1 Unit Objectives

10.2 Cost Concepts

10.2.1 Accounting Cost Concepts

10.2.2 Analytical Cost Concepts

10.3 Summary

10.4 Key terms


10.6 Books for Further Reading

10.0 INTRODUCTION

The production cost is an important aspect of all business analysis and decisions.In other words we can say that the cost of production is the soul of any industry orbusiness. The knowledge of cost concepts is very much useful for taking businessdecisions like minimizing the cost, search the weak points in productionmanagement, determining of price and dealers margin, finding the optimum levelof output and estimating the cost of business operations etc. This unit providesinformation related to different cost concepts.

10.1 UNIT OBJECTIVES

After studying this unit, you should be able —

l To understand accounting cost concepts.

l To understand analytical cost concepts.

10.2 COST CONCEPTS

According to Hanson, the cost of production of a commodity is “the sum of allthe payments to the factors of production engaged in the production of thatcommodity.” Cost of production includes different cost concepts like money cost,real cost, opportunity cost, actual cost etc. These concepts can be devided intotwo groups on the basis of their nature and purpose.

10.2.1 ACCOUNTING COST CONCEPTS

A. Money Cost

For producing any commodity a firm requires various inputs like labour, rawmaterial, power etc. Firms monetary expenditure of all these inputs is called as


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money cost. In short, the monetary expenditure of a firm on all the required inputsto produce a given volume of output is called money cost.

Accountant and economists use the term money cost in different ways. From theaccountant’s point of view, money costs include only those costs, for which areaccounted for by the firm or for which cash is paid by the firm. It includes wagesand salaries, rent of land and building, cost of raw material, power charges, interestpayments, direct - indirect taxes and other expenses like selling cost, transportcost etc. If, we take all these items together it is called as Explicit Cost ofproduction. In other words, explicit cost means all those payments made in termsof money by a firm to others for the involvement of services of factors required inthe process of production. It is also called Expenditure costs.

Economist use the term money cost in wider sense. It includes all above items ofexplicit costs plus values of those inputs which are owned by the enterpreneurhimself called as implicit cost.

E.g. In the process of production the enterpreneure may have supplied his owncapital in production, for which no interest amount is paid. But, if the enterpreneurinvests his capital elsewhere than his business, he will earn some interest.Therefore, such interest is to be inputed and taken as implicit cost. It includes,rent of enterpreneur’s own factory premises, wages for the enterpreneur’s ownlabour return on enterpreneur’s own capital and normal profits to the enterpreneurfor his managerial functions. There are also called Non-expenditure costs becausethese items do not involve actual payments.

B. Real Cost

It is purely a subjective concept. Real cost refers to all types of exertions andsacrifices of the factors of production in the process of, a commodity production.e.g. To produce any commodity, the capitalist has to sacrifice and wait, in thesense that, he has to abstain from current consumption so as to save, invest andwait for the returns as well as the workers have to exert, toil and put in efforts.According to Marshall, “Real cost means the exertions of all different kinds oflabour that are directly or indirectly involved in making it; together with theabstinence or rather the waitings required for saving the capital used in making it.In short, real cost is a purely subjective concept and it is highly relevant to ourwhole society.

C. Opportunity Cost or Alternative Cost

In modern economic analysis the concept of opportunity cost occupies an importantplace. We know that the productive resources are scarce and have alternativeuses. Because of scarce resources the production of one commodity can only bedone at the cost of some other commodity. According to Benham ‘’the opportunitycost of anything is the next best alternative that could be produced instead by thesame factors or by an equivalent group of factors costing the same amount ofmoney.”

This concept can be made more clear with the help of an example. There aresome factors which are used for the manufacture of a railway engine which mayalso be used for the production of an equipment for the farm. Therefore, thealternative cost of the production of a railway engine is the output of the farmequipment sacrificed, which could have been produced with the same amount offactors that have gone into the making of a railway engine. It should be notedthat, the resources available to the producer are limited, obviously, he can not use



NOTES

them for producing railway engine and farm equipments simultaneously. Hisdecision to build railway engine implies the loss of opportunity to make farmequipments. Shortly, it means the sacrifice of the alternative use of the resourcesi.e. for making farm equipments.

D. Business Costs and Full Cost

There are some expenses which are incurred in carrying out a business. Such typeof all expenses are included in business cost. This concept is similar to real oractual cost. Business cost includes all the payments as well as firm’s contractualobligations together with the book cost of depreciation on plant and equipment. Itis used for accounting business profits and losses, filling income-tax returns andfor other legal purposes.

Business costs, normal profit and the opportunity cost together constitutethe concept of full cost. We have already discussed about business cost andopportunity cost. Normal profit is the essential minimum earning in addition tothe alternative or opportunity cost, which a firm must receive to remain in itspresent occupation.

10.2.2 ANALYTICAL COST CONCEPTS

A. Fixed Costs And Variable Cost

Fixed costs are those costs which do not change with changes in the volume ofoutput in the short run. Shortly, costs that do not vary for a certain level of outputare known as fixed costs. It is also called overhead costs because there costs arecommon to all the units of the commodity produced by a firm. Fixed costs arealso called supplementary or indirect costs as well as unavoidable contractualcosts. The fixed costs include interest on capital, insurance premium, propertyand business taxes, annual license fees, rent of the factory premises, salarypayments of permanent staff, depreciation and maintenance costs etc.

Variable costs are those costs which vary with changes in the level of output inthe short run. Shortly, when output increase these costs increse and when outputfalls variable costs decrease. Therefore, when output is nill, no variable cost hasto be incurred. Variable costs are also known as direct costs, prime costs as wellas avoidable costs.

The variable cost includes wages of labour, transport costs, sales tax and exciseduty, cost of raw material, cost of fuel and power, advertisement expenses etc.

One thing should be noted here that, in the long run, nothing remains fixed and allfactors become variable. Therefore, the distinction between fixed and variablecosts is valid only in a short-run period. In the short run some factors remainconstant and others change with the level of output.

B. Total Costs (TC)

Total costs is the total of all types of expenditures incurred by a firm for producinga given output. Briefly, it is the aggregate of the costs of all the inputs used by afirm to produce a given output. In the short run period a firm has to incur fixedand variable costs to produce a given output. Thus, the total costs of production isthe sum of total fixed costs and total variable costs.

TC = TFC + TVC

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(i) Total Fixed Cost (TFC)

The aggregate cost of all the fixed inputs used by a firm in the short run denotesthe term total fixed costs. It is also known as overhead costs/supplementary costs/indirect costs. TFC remains constant at all levels of output in the short run.

(ii) Total Variable Cost (TVC)

The aggregate cost of all the variable inputs used by the firm at each level ofproduction denotes the total variable cost (TVC). It is also known as prime costsor direct cost.TVC vary with change in the level of output.

C. Average Fixed Cost (AFC)

If we divide the total fixed cost (TFC) by the total number of units produced (Q),we obtain average fixed cost (AFC).

TFC Therefore, AFC = _____

Q

e. g. During a particular period of time the total fixed cost (TFC) of a firmis Rs. 10,000. When the number of units produced Q is 100 units the AFC willbe _

When Q is 100 units, the AFC will be

10000 Rs. = ______ = Rs. = 100

100

When Q is 200 units, the AFC will be _

10000 Rs. = ______ = Rs. = 50

200

Since the total fixed cost (TFC) remains constant at all levels of output, theAFC falls as output (Q) increases. Thus, per unit of output AFC is variable.

D. Average Variable Cost (AVC)

If the total variable cost (TVC) is divided by the number of units produced(Q), we obtain average variable cost (AVC). Therefore,

TVCAVC = _____

Q

E.g. The total variable cost (TVC) of a firm is Rs. 500 and output Q is 50units, the AVC will be Rs 500/50 = Rs. 10. Since the TVC of a firm vary withlevel of output, the AVC also varies with output.

E. Average Total Cost (ATC)

If the total cost is divided by the number of units produced, we obtainaverage total cost (ATC). Therefore,

TCAVC = ____

.Q

In the short run, since the total cost (TC) is the sum of total variable cost(TVC) and total fixed cost (TFC) similarly the average cost (AC) is also sum ofaverage variable cost (AVC) and average Fixed cost (AFC).



NOTES

.TCThus, AVC = ____

.Q

Since, TC = TVC + TFC

TVC + TFCTherefore, AC = ___________

Q

TVC TFCSince, ____ = AVC and ____ = AFC

Q Q

Therefore, AC = AVC + AFC

e.g. If, the total cost (TC) of a firm producing 200 units of output (Q) is

10000Rs. 10,000 the average cost (AC) will be Rs. _____ = Rs.50

200

Since the AC can also be obtained by adding AVC and AFC at each level ofoutput, let us further suppose the firm producing 200 units of output (Q) incursTVC of Rs. 2000 and TFC of Rs. 8000. In such a case the AVC will be

2000 8000_____ = Rs. 10 and AFC of the firm will be _____ = Rs. 40. 100 200

Therefore, the AC = Rs. 10 (AVC) + Rs.40 (AFC) = Rs. 50.

Average cost is cost per unit of output produced. Therefore, it is also referredto as unit cost.

F. Marginal Cost (MC)

Marginal cost is defined as the addition made to the total cost when one more unitis produced. Briefly marginal cost is the extra cost of producing one extra unit ofoutput. Marginal cost is calculated as TCn _ TCn_1 where n is the number ofunits produced. E.g. The TC of producing 200 units is Rs. 10000 and that forproducing 201 units is Rs. 10080, the MC will be Rs. 80 (Rs. 10080_10000).

Marginal cost is also denoted as.

TCMC = _____

Q

or

change in total costMC = _________________

change in output

Where, denotes change in total cost and change in output.

10.3 SUMMARY

The cost of production of a commodity is “the sum of all the payments to thefactors of production engaged in the production of that commodity”. Cost ofproduction includes different cost concepts like money cost, real cost, opportunitycost, actual cost etc. These concepts can be devided in two groups on the basis oftheir nature and purpose i.e. (a) Accounting Cost Concepts and (b) AnalyticalCost Concepts.

CHECK YOURPROGRESS

1. Explain theanalytical costconcepts.

Cost Concept


Business Economics


NOTES

Accounting cost concepts include, money cost, real cost, opportunity or alternativecost as well as business and full cost.

For producing any commodity a firm requires various inputs like labour, rawmaterial, power etc. firms monetary expenditure of all these inputs is called asmoney cost. Implicit cost includes, rent of entrepreneur’s own factory premises,wages for the entrepreneur’s own labour return on entrepreneur’s own capitaland normal profits to the entrepreneur for his managerial functions. Real costrefers to all types of exertions and sacrifices of the factors of production in theprocess of a commodity production. According to Benham, “the opportunity costof anything is the next best alternative that could be produced instead by the samefactors or by an equivalent group of factors costing the same amount of money”.Business costs, normal profit and the opportunity cost together constitute theconcept of full cost. There are some expenses which are incurred in carrying outa business such type of all expenses are included in business cost.

Analytical cost concepts includes, fixed cost and variable cost, total cost, averagevariable cost, average total cost and marginal cost etc.

Fixed costs are those costs which do not change with changes in the volume ofoutput in the short run, variable costs are those costs which vary with changesin the level of output in the short run. Total costs is the total of all type ofexpenditures incurred by a firm for producing a given output. TFC remains constantat all levels of output in the short run. TVC vary with change in the level ofoutput. If we divide the TFC by the total number of units produced, we obtainAFC. If the TVC is divided by the number of units produced, we obtain AVC. Ifthe total cost is divided by the number of units produced, we obtain ATC. Marginalcost is defined as the addition made to the total cost when one more unit isproduced.

10.4 KEY TERMS

l Fixed Costs : Costs, which do not vary with output change in short-run.

l Variable Costs : Costs, which changes in the same direction as theoutput changes.

l Opportunity Cost : Is output of Y good lost by producing a certaingood X.

l Total Costs : Sum of all fixed and variable costs.


1. Explain the following cost concepts in brief.

(a) Money Cost.

(b) Real Cost.

(c) Opportunity Cost.

(d) Business and full cost.



NOTES

2. Explain with illustration the distinction between the following.

(a) Fixed cost (F. C.) and variable cost (V. C.)

(b) Average variable cost (AVC) and Average total cost (A.T.C.)

(c) Fixed cost (F.C.) and Marginal Cost (M.C.).


1. Ahuja H. L. : ‘Advanced Economic Theory’, S. Chand and Co., NewDelhi.

2. Appannaiah H. R., Reddy D. N. and Shanthi S. : ‘Economics forBusiness’, Himalaya Publishin House, Mumbai, 2005.

3. Chaturvedi D. D., Gupta S. L. and Pal Sumitra : ‘Business EconomicsText and Cases’, Galgotia Publishing Company, New Delhi, 2006.

4. Dwivedi D. M. : ‘Managerial Economics-Theory and Application’,Himalaya Publishing House, Mumbai, 2006.

5. Hizshleifer J. and A. Glazer (1997) : ‘Price Theory and Applications’,Prentice Hall of India, New Delhi.

6. Jeffrey M. Perlof : ‘Micro Economics’ (IInd Ed.), Tata Pearson EducationAsia, 2001.

7. Lipsey R. G. : ‘Introduction to Positive Economics’, Oxford UniversityPress, New Delhi.

8. Misra S. K. and Puri V. K.: ‘Economics for Managerial Text and Cases’,Himalaya Publishing House, Mumbai, 2006.


10. N. Gregozy Mankiw : ‘Principles of Economics’, (IInd Ed.), Thomson-South-Western, 2001.

11. Patil J. F. and Others (2014) : ‘Managerial Economics’, (IIIrd Edition),Phadke Prakashan, Kolhapur.

12. Samuelson Paul A. and William D. Nordhaus (2010) : ‘Economics’,(16th Edition), Tata McGrow Hill Education Private Ltd., New Delhi,1998.

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UNIT 11 : THEORIES OF COSTS

Structure

11.0 Introduction


11.2 Theories of Costs

11.2.1 Short Run Cost Curves

11.2.2 Long Run Cost Curves

11.3 Summary

11.4 Key terms



11.0 INTRODUCTION

The cost of production is the soul of any industry or business. Shortly, the cost ofproduction is an important aspect of all business analysis and decisions. In theprevious unit (No. 10) we have discussed the cost concepts in detail. As alreadymentioned the knowledge of cost concepts and its theories are very much usefulfor taking business decisions like minimizing the cost, search the weak points inproduction management, determining of price and dealers margin, finding theoptimum level of output and estimating the cost of business operations etc. Thisunit provides information related to theories of costs.


After studying the unit, you should be able –

l To analyse the short run costs curves.

l To analyse the long run costs curves.

11.2 THEORIES OF COSTS

The cost curves of a firm can be divided in to two heads i.e. short run cost curvesand long run cost curves.

11.2.1 SHORT RUN COST CURVES

Short run means a period-of time in which a firm can decrease or increase itslevel of output by changing only its variable factors and not the fixedfactors.Therefore, in short run period some factors are fixed and some are variable.The costs related to fixed and variable factors are called fixed and variable costsrespectively. We have already seen that, TC = TFC + TVC.

It can be made more explicit with the help of the following cost schedule. Thisschedule also provides the per unit or average cost of a firm in the short run.



NOTES

Theories of CostsTable No. 1: Short term cost schedule

Units Total Total Total Average Average Average Marginaloutput Fixed Variable Cost Fixed variable Total Cost

(Q) Cost Cost (TC) Cost Cost Cost (MC)(TFC) (TVC) (AFC) (AVC) (ATC/AC)

0 50 0 50 0 0 0 -

1 50 20 70 50 20 70 20

2 50 35 85 25 17.5 42.5 15

3 50 60 110 16.66 20 36.66 25

4 50 100 150 12.5 25 37.5 40

5 50 145 195 10 29 39 45

6 50 190 240 8.33 31.66 40 45

7 50 237 287 7.11 33.85 40.96 47

8 50 284 334 6.25 35.5 41.75 47

The following major observations can be made from the cost schedule inthe above table.

(1) AFC is continuously falling because TFC is constant for all units ofoutput and this fixed amount is distributed among more and more unitsas output rises.

(2) AVC declines in primary stage but later starts increasing with a rise inoutput.

(3) The summation of AFC and AVC is the AC.

(4) The addition made to total cost (TC) when one more unit is produced asstated earlier is MC.It also shows a similar trend as the AC.

(A) (B)

Fig. 11.1 : Short-run total cost curves

In Fig. l1.1 (A) OX axis shows output and OY axis shows cost.Total fixed cost(TFC) is parallel to the ox axis, because it is constant for all units of output. OP isthe fixed cost of a firm , even when output is zero. Therefore TFC curve startsfrom point P on OY axis. The total variable cost curve (TVC) starts from theorigin which means that variable costs are zero when output is zero.Total variablecost (TVC) curve rises in upward direction indicating that it increases along withan increase in output. Total cost (TC) is the sum of TFC and TVC.

In Fig. 11.1 (B), The continuously falling curve from left to right towards the oxaxis is AFC curve.The AFC can never touch or cross the ox axis.


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The slightly U shaped curve is average variable cost (AVC) At first AVC fallswith a rise in output because of the increasing returns experienced by a firm, butafter a certain point, AVC will rise steeply left to right due to diminishing returnsto scale.

The sum of AFC and AVC is the average cost (AC) curve, As shown in the figureAC is U shaped curve. In primary stage with the rise in output the average costdeclines and after a certain point it starts rising.

Marginal cost curve is the MC. At first, it falls, when it reaches a minimum pointthereafter rises steeply with rise in output. At the minimum point of AC and AVC,curves the MC curve intersects them, from below as shown in the fig.

Relationship Between MC and AC

A. In primary stage, AC is greater than MC (AC > MC).

B. AC becomes constant at the 6th unit of output (Schedule no. 1) and MCand AC both are rising but MC starts rising earlier than AC.

C. When MC decreases it pulls AC down and when MC increases , it pushesAC up. Therefore ,MC intersects AC at its minimum.

Fig. 11.2 : Relationship between MC and AC

In Fig 11.2, OX axis shows, output and OY axis sbows cost. MC and AC are shortrun marginal and average cost curves. Up to OQ units of output the average cost(AC) is greater than the marginal cost (MC) At point A (OQ output), the averagecost (AC) curve is at its minimum level and at this point the marginal cost (MC)curve intersects the average cost (AC) curve from below. Beyond OQ outputboth AC and MC curves are moving left to right upwards, but MC curves is aboveAC curve because now the marginal cost (MC) is greater than the average cost(MC > AC).

11.2.2 LONG RUN COST ANALYSIS

As we know, a long run is period of time in which all factors become variable anda firm can increase its level of output through enlarging its scale of operations. lnthe long run, not a single factor is fixed and all can be varied to expand output.Therefore, no fixed factors and the firm has no fixed costs in the long run. Thereforein the long run there will be only two cost curves i.e. a long run, average cost(LAC) curve and long run marginal cost (LMC) curve.

(A) Long Run Average Cost Curve (LAC)

Some economists called the LAC as the planning curve Because a firm plans to

CHECK YOURPROGRESS

1. Explain the shortrun cost curves withthe help of costschedule.

2. Diagramaticallyexplain the relation-ship between MCand AC.



NOTES

produce output in the long run only by choosing a plant on the long run averagecost curve (LAC) corresponding to the given output. The LAC is also called‘envelope curve’, since it envelopes a family of short run average cost curvesfrom below, Another important thing is that there are infinite number of short runaverage cost curves included in LAC.

Fig. 11.3 : Long-run Average Cost Curve

In Fig. 11.3, OX axis shows output and OY axis shows average cost. LAC is thelong run average cost curve and SAC1, SAC2 and SAC3 are the short run averagecost curves, the firm has a series of SAC each having a minimum point showingthe minimum average cost, when the firm has only one plant, BQ is the minimumSAC. The SAC decreases to B1 Q1 because of economies of scale when the secondplant is added, but after the inclusion of the third plant the SAC rises to B2 Q2. ASshown in the fig. we can draw the long run average cost curve LAC by joining thebottom of SAC1, SAC2 and SAC3 to LAC.

(B) Long Run Marginal Cost Curve (LMC)

It is usefull to know how the long run marginal cost curve LMC is derived. TheLMC curve can be derived from the LAC curve, because LMC is related to LACin the same way as the short run marginal cost curve (SMC) is related to short runaverage cost curve (SAC) In Fig 11.4. We see how the LMC is derived.

Fig. 11.4 : Derivation of LMC

In Fig 11.4, OX axis shows output and OY axis shows cost of the firm. SAC1,SAC2, SAC3 are the short run average cost curves and LAC is the long run averagecost curve. For deriving the LMC, the tangency points between SAC1, SAC2,

Theories of Costs


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NOTES

SAC3 and the LAC (i.e. J, K, L) should be considered. These points determine theoutput levels in the long run production planning e.g. If we draw perpendicularsfrom point J, K, L and to OX axis ,the corresponding output levels will be OQ,OQ1, and OQ2, At point T,the perpendiculars JQ intersects the SMC1. It meansthat at output OQ, LMC is TQ If output increases from OQ to OQ1, marginal cost(MC) will be KQ1 likewise, if perpendicular LQ2 is extended upward at point V,it intersects SMC3 and VQ2 measures the LMC at output OQ2. If we join thepoints T, K and V through a line, we get long run marginal cost curve LMC.which will represent the behavior of marginal cost in the long run.

Long run average cost curve LAC like the short run AC curve is U shaped. But itis less pronounced and flatter than the short run average cost curve SAC. Thiswill happen because, there is sufficient time for a firm to make all adjustmentsand operate efficiently thereby reducing the AC, besides ,in short run the variablecosts do not rise as sharply Thus, the long run average cost curve LAC is flatterthan the short run average cost curve SAC. Like short run, the long run marginalcost curve LMC intersects the long run average cost curve LAC at its minimumpoint.

It is shown in the Fig. 11.5.

Fig. 11.5 : Long-run Cost Curves

11.3 SUMMARY

The cost curves of a firm can be divided into two heads i.e. short run cost curvesand long run cost curves.

Short run means a period of time in which a firm can decrease or increase its levelof output by changing only its variable factors and not the fixed factors. Therefore,in short run period some factors are fixed and some are variable. The costs relatedto fixed and variable factors are called fixed and variable costs respectively.

TC = TFC + TVC

AFC is continuously falling because TFC is constant for all units of output andthis fixed amount is distributed among more and more units as output rises. AVCdeclines in primary stage but later starts increasing with rise in output. Thesummation of AFC and AVC is the AC. The addition made to total cost (TC)when one more unit is produced as stated earlier is MC. It also shows a similartrend as the AC.

Long run is period of time in which all factors become variable and a firm canincrease its level of output through enlarging its scale of operations. In the longrun, not a single factor is fixed and all can be varied to expand output. Therefore,no fixed factors and the firm has no fixed costs in the long run. Therefore, in the

CHECK YOURPROGRESS

1. Diagramaticallyexplain the LAC.

2. Diagramaticallyexplain the LMC.



NOTES

long run there will be only two cost curves i.e. a long run average cost (LAC)curves and long run marginal cost (LMC) curve.

The LAC is also called ‘envelope curve : Another important thing is that there areinfinite number of short run average cost curves included LAC. The LMC curvecan be derived from the LAC curve, because LMC is related to LAC in the sameway as the short run marginal cost curve (SMC) is related to short run averagecost curve (SAC).

11.4 KEY TERMS

l Fixed Costs : Costs, which do not vary with output change in short-run.

l Variable Costs : Costs, which changes in the same direction as theoutput changes.

l Total Costs : Sum of all fixed and variable costs.


1. Explain the relationship between short run average cost (SAC) curvesand short run marginal cost (SMC) curves.

2. Discuss the short run cost curves with cost schedule.

3. Explain the relationship between marginal cost (MC) and average cost(AC).

4. Diagrammatically analyse the long run cost curve LAC and LMC.










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UNIT 12 : OPTIMUM PRODUCTION IN THESHORT RUN

Structure

12.0 Introduction


12.2 Optimum Production in the Short Run

12.3 Summary

12.4 Key terms



12.0 INTRODUCTION

We have already studied the cost concepts and theories of costs in previous twounits. In this unit we will study the optimum production in the short run as well asthe behaviour of the short run average total cost (SATC) curve.


After studying the unit, you should be able –

l To explain the optimum production in the short run.

l To understand the behaviour of the short run average total cost curve(SATC).

12.2 OPTIMUM PRODUCTION IN THE SHORTRUN

Short run refers to a period of time in which adjustments are not possible in thecontext of production function, it implies a period of time in which some factorsof production are fixed while others are variable. Increasing production in theshort run is therefore possible only with the help of variable factors like labour.The law of variable proportions is the law which explains behavior of productionwhen variable factors are changed alongwith a given quantity of fix factor. Thelaw exhibits three stages of production inwhich production first increases atincreasing rate then at decreasing rate andfinally at negative rate.

The law of variable proportions, whichreflects the behavior of production in shortrun, gives rise to a short run average totalcost curve of U shape as shown in theabove Fig. 12.1.

Fig. 12.1 : Optimum productionin the short run

Theories of Costs


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NOTES

As can be seen from the above Fig. 12.1, the average total cost in the short runand the output will shape the relationship as represented by the SATC (short runaverage total cost) curve. With the increase in output average cost will first fall,then reach the minimum level and finally start going up. This shape of the shortrun average total cost curve is the result of input output relationship in the shortrun. As stated above, in the short runincreasing quantities of variable factorsare applied to the given quantity offixed factors. In order to increase theoutput initially the fixed factor arerelatively more and therefore whenincreasing quantities of a variablefactors are applied, fixed factors startgetting fully utilized, this results intoincrease in output and decrease in cost.This happens because of the benefitsassociated with division of work whichbecome available as more and morevariable factors are applied to a givenquantity of fixed factors.

SATC can take a flatter shape (as shownin Fig. no. 12.2) or it can becomesteeper as indicated below in Fig. no.12.3. This depends mainly on thetechnology being used.

With the increase in the quantities ofvariable factors the given quantity offixed factors starts getting overexploited, resulting into decrease inproduction and increase in cost. Thishappens because the scope for divisionof work and specialization becomesalmost zero.

So, in the short run, the average total cost curve first falls up to a point due to thebenefits resulting from division of work and specialization and then goes up asthe scope for division of work ceases to exist. Therefore, in the short run it makesperfect sense to increase the production until the benefits associated with divisionof work and specialization are fully reaped. After this, increasing productionbecomes uneconomical. The bottom point of SATC curve (P) is the point wherethe average cost is minimum on account of the full utilization of the fixed factorsthrough division of work and therefore, the output corresponding to this minimumpoint is the optimum output in the short run.

12.3 SUMMARY

l Short run refers to a period of time in which adjustments are notpossible in the context of production function, it implies a period oftime in which some factors of production are fixed while others arevariable.

l The law of variable proportions, which reflects the behaviour ofproduction in short run, gives rise to a short run average total cost curveof U shape.

Fig. 12.2 : Flatter shape of SATC

Fig. 12.3 : Steeper shape of SATC

Y

O X

Ave

rage

Tota

lCos

t

Output

SATC

Y

O X

Ave

rage

Tota

lCos

t

Output

SATC



NOTES

l SATC can take a flatter shape or it can become steeper. This dependsmainly on the technology being used.

l The optimum output in the short run is given by the minimum point ofthe SATC curve.

12.4 KEY TERMS

l SATC


1. Explain the optimum production in the short run.

2. Diagrammatically explain the different shapes of short-run average totalcost (SATC) curve.














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