Biyani Girls College, Jaipur

I Internal Examination-2018

B Com I (P+H)

Subject: Business Economics

Time: 1.5 Hrs. SET-A M.M.40

Q.1 Very short answer type questions (2*5=10 marks)

1. Define Indifference Map.

Ans. The Indifference Map is the graphical representation of two or more

indifference curves showing the several combinations of different quantities of

commodities, which consumer consumes, given his income and the market

price of goods and services.

2. Define Opportunity Cost.

Ans. The term "opportunity cost" comes up often in finance and economics when

trying to choose one investment, either financial or capital, over another. It serves

as a measure of an economic choice as compared to the next best one. For

example, there is an opportunity cost of choosing to finance a company with debt

over issuing stock.

3. Differentiate between total utility & marginal utility.

Ans . "Total utility is the total satisfaction obtained from all units of a particular

commodity consumed over a period of time".

"Marginal utility means an additional or incremental utility. Marginal utility is the

change in the total utility that results from unit one unit change in consumption of

the commodity within a given period of time".

4. Write 2 exceptions of Law of Demand.

Ans. Inferior goods

The law of demand does not apply in case of inferior goods. When price of inferior

commodity decreases and its demand also decrease and amount so saved in spent

on superior commodity. The wheat and rice are superior food grains while maize is

inferior food grain.

Demonstration effect

The law of demand does not apply in case of diamond and jewelry. There is more

demand when prices are high. There is less demand due to low prices. The rich

people like to demonstrate such items that only they have such commodities.

5. Define Budget line.

Ans. A graphical depiction of the various combinations of two selected products

that a consumer can afford at specified prices for the products given their particular

income level. When a typical business is analyzing a two product budget line, the

amounts of the first product are plotted on the horizontal X axis and the amounts of

the second product are plotted on the vertical Y axis.

Read more: http://www.businessdictionary.com/definition/budget-line.html

Q. 2 Short answer type questions. (2*5=10 marks)

1. Explain 5 properties of Indifference Curve along with diagrams.

Ans. Properties of Indifference Curve:

1. Indifference curves are always convex to the origin:

An indifference curve is convex to the origin because of diminishing MRS. MRS

declines continuously because of the law of diminishing marginal utility. As seen

in Table 2.6, when the consumer consumes more and more of apples, his marginal

utility from apples keeps on declining and he is willing to give up less and less of

bananas for each apple. Therefore, indifference curves are convex to the origin (see

Fig. 2.6). It must be noted that MRS indicates the slope of indifference curve.

2. Indifference curve slope downwards:

It implies that as a consumer consumes more of one good, he must consume less of

the other good. It happens because if the consumer decides to have more units of

one good (say apples), he will have to reduce the number of units of another good

(say bananas), so that total utility remains the same.

3. Higher Indifference curves represent higher levels of satisfaction:

Higher indifference curve represents large bundle of goods, which means more

utility because of monotonic preference. Consider point „A‟ on ICX and point „B‟

on IC2 in Fig. 2.5. At „A‟, consumer gets the combination (OR, OP) of the two

commodities X and Y. At „B‟, consumer gets the combination (OS, OP). As OS >

OR, the consumer gets more satisfaction at IC2.

4. Indifference curves can never intersect each other:

As two indifference curves cannot represent the same level of satisfaction, they

cannot intersect each other. It means, only one indifference curve will pass through

a given point on an indifference map. In Fig. 2.7, satisfaction from point A and

from B on IC1 will be the same.

Similarly, points A and C on IC2 also give the same level of satisfaction. It means,

points B and C should also give the same level of satisfaction. However, this is not

possible, as B and C lie on two different indifference curves, IC1 and

IC2 respectively and represent different levels of satisfaction. Therefore, two indif-

ference curves cannot intersect each other.

2. Explain Price & Income effect by the application of Indifference curve.

Ans.

Q.3 Long answer type questions. (2*10=20 marks)

1. Explain law of DMU along with diagram.

Ans. Law of Diminishing Marginal Utility:

Definition of the Law:

"Other things remaining the same when a person takes successive units of a

commodity, the marginal utility diminishes constantly".

The marginal utility of a commodity diminishes at the consumer gets larger

quantities of it. Marginal utility is the change in the total utility resulting from one

unit change in the consumption of a commodity per unit of time.

Assumptions:

Following are the assumptions of the law of diminishing marginal utility.

1. The utility is measurable and a person can express the utility derived from a

commodity in qualitative terms such as 2 units, 4 units and 7 units etc.

2. A rational consumer aims at the maximization of his utility.

3. It is necessary that a standard unit of measurement is constant

4. A commodity is being taken continuously. Any gap between the

consumption of a commodity should be suitable.

5. There should be proper units of a good consumed by the consumer.

6. It is assumed that various units of commodity homogeneous in

characteristics.

7. The taste of the consumer remains same during the consumption o the

successive units of commodity.

8. Income of the consumer remains constant during the operation of the law of

diminishing marginal utility.

9. It is assumed that the commodity is divisible.

10. There should be not change in fashion. For example, if there is a fashion of

lifted shirts, then the consumer may have no utility in open shirts.

11. It is assumed that the prices of the substitutes do not change. For example,

the demand for CNG increases due to rise in the prices of petroleum and

these price changes effect the utility of CNG.

Explanation With Schedule and Diagram:

We assume that a man is very thirsty. He takes the glasses of water successively.

The marginal utility of the successive glasses of water decreases, ultimately, he

reaches the point of satiety. After this point the marginal utility becomes negative,

if he is forced further to take a glass of water. The behavior of the consumer is

indicated in the following schedule:

Units of commodity Marginal utility Total utility

1st glass 10 10

2nd glass 8 18

3rd glass 6 24

4th glass 4 28

5th glass 2 30

6th glass 0 30

7th glass -2 28

On taking the 1st glass of water, the consumer gets 10 units of utility, because he is

very thirsty. When he takes 2nd glass of water, his marginal utility goes down to 8

units because his thirst has been partly satisfied. This process continues until the

marginal utility drops down to zero which is the saturation point. By taking the

seventh glass of water, the marginal utility becomes negative because the thirst of

the consumer has already been fully satisfied.

The law of diminishing marginal utility can be explained by the following diagram

drawn with the help of above schedule:

In the above figure, the marginal utility of different glasses of water is measured on

the y-axis and the units (glasses of water) on X-axis. With the help of the schedule,

the points A, B, C, D, E, F and G are derived by the different combinations of units

of the commodity (glasses of water) and the marginal utility gained by different

units of commodity. By joining these points, we get the marginal utility curve. The

marginal utility curve has the downward negative slope. It intersects the X-axis at

the point of 6th unit of the commodity. At this point "F" the marginal utility

becomes zero. When the MU curve goes beyond this point, the MU becomes

negative. So there is an inverse functional relationship between the units of a

commodity and the marginal utility of that commodity.

Exceptions or Limitations:

The limitations or exceptions of the law of diminishing marginal utility are as

follows:

1. The law does not hold well in the rare collections. For example, collection of

ancient coins, stamps etc.

2. The law is not fully applicable to money. The marginal utility of money

declines with richness but never falls to zero.

3. It does not apply to the knowledge, art and innovations.

4. The law is not applicable for precious goods.

5. Historical things are also included in exceptions to the law.

6. Law does not operate if consumer behaves in irrational manner. For

example, drunkard is said to enjoy each successive peg more than the

previous one.

7. Man is fond of beauty and decoration. He gets more satisfaction by getting

the above merits of the commodities.

8. If a dress comes in fashion, its utility goes up. On the other hand its utility

goes down if it goes out of fashion.

9. The utility increases due to demonstration. It is a natural element.

Importance of the Law of Diminishing Marginal Utility:

The importance or the role of the law of diminishing marginal utility is as follows:

1. By purchasing more of a commodity the marginal utility decreases. Due to

this behaviour, the consumer cuts his expenditures to that commodity.

2. In the field of public finance, this law has a practical application, imposing a

heavier burden on the rich people.

3. This law is the base of some other economic laws such as law of demand,

elasticity of demand, consumer surplus and the law of substitution etc.

4. The value of commodity falls by increasing the supply of a commodity. It

forms a basis of the theory of value. In this way prices are determined

2. Define Production. Explain Law of Variable proportion.

Ans.

Law of Variable Proportions:

"in a given state of technology, when the units of variable factor of production (L)

are increased within the units of other fixed factors, the marginal productivity

increases at increasing rate up to a point, after this point. it will become less and

less"

Assumptions:

The assumptions of the law of variable proportion are given as below:

1. It is assumed that the technique of production should remain constant during

production.

2. It operates in the short-run because in the long run, fixed inputs become

variable.

3. Some inputs must be kept constant.

4. The various factors are not to be used in rigidly fixed proportions but the law

is based upon the possibility of varying proportions. It is also called the law

of proportionality.

5. It is assumed that all the units of variable factors of production are

homogeneous in amount and quality.

6. It is assumed that labor is a single variable factor.

Schedule:

The law of variable proportion is explained with the help of the following

schedule:

Units of

variable

factor (L)

Marginal

product

(MPL)

Total product

(TPL)

Average

product (APL) Stages

1 2 2 2

I 2 4 6 3

3 6 12 4

4 4 16 4

II

5 2 18 3.6

6 0 18 3

III

7 -2 16 2.28

In the above schedule, units of variable factor (labor) are employed with other

fixed factors of production. The marginal productivity of labor goes on increasing

up to the 3rd worker. This is so because the proportion of workers to other fixed

factors was at first insufficient. After 3rd worker the marginal productivity goes on

falling onwards till it drops down to zero at the 6th unit of labor. The 7th worker is

only a cause of obstruction to the others and is responsible in making the marginal

productivity negative. The marginal productivity (MPL) and the average

productivity (APL) equalize at 4the worker. Then the MPL falls more sharply

Diagram:

The number of workers are measured on X-axis while TPL, APL and MPL on Y-

axis. The above diagram shows the three stages also obtained from the schedule.

Stage I:

At this stage MPL increases up to 3rd worker and its curve is higher than the

average product, so that total product is increasing at increasing rate.

Stage II:

At this stage, MPL decreases up to 6th unit of labor where MPL curve intersects the

X-axis. At 4the unit of labor MPL = APL after this, MPL curve is lower than the

APL. TPL increases at decreasing rate.

Stage III:

At 6the unit of labor the MPL becomes negative, the APL continues falling but

remains positive. After the 6th unit, TPL declines with the employment of more

units of variable factor (L).

Relationship Among Total, Average and Marginal Product:

The relationship among total, average and marginal product of labor in the light of

the law of variable proportion is explained as under:

1. The marginal productivity of labor increases, the TPL also increases at

increasing rate. It is shown in the schedule up till 3rd unit of labor. The

MPL curve has positive slope and TPL curve has rising tendency towards Y-

axis.

2. When the MPL decreases onwards till it drops to zero, the TPL increases at

decreasing rate as shown in the stage II and the TPL curve has positive slope

but has rising tendency towards X-axis

3. When the MPL is equal to zero, the TPL is maximum as shown on the 6th

unit of labor.

4. When the MPL becomes negative, the MPL curves falls below the X-axis, the

TPL declines from its maximum position and its slope becomes negative as

shown in the stage III in the above diagram.

5. When the MPL increases, The APL also increases but at slow rate. The

MPL curve becomes above the APL curve. Both have positive slopes.

6. At some point, MPL = APL. At this point, MPL curve intersects the

APL curve as shown at the 4th unit of labor in the above diagram.

7. After intersecting point, MPL falls sharply. The MPL curve becomes below

the APL curve. Both curves have negative slope.

8. When MPL becomes negative, the APL never becomes negative because it is

calculated from the TPL. So MPL curve is below the X-axis but APL curve is

above the X-axis, having negative slope.

Biyani Girls College, Jaipur

I Internal Examination-2016

B Com I (P+H)

Subject: Business Economics

Time: 1.5 Hrs. SET-B M.M.40

Q.1 Very short answer type questions (2*5=10 marks)

1. Define Law of Equi-marginal Utility.

Ans. "A person can get maximum utility with his given income when it is spent

on different commodities in such a way that the marginal utility of money spent on

each item is equal"

2. Define Indifference Map.

Ans . The Indifference Map is the graphical representation of two or more

indifference curves showing the several combinations of different quantities of

commodities, which consumer consumes, given his income and the market price of

goods and services.

3. What is Iso-Product Curve.

Ans. so-product curve represents all possible combinations of the two factors

that will give the same total product”. According to K.J. Cohen and R.M. Cyert,

“An iso-product curve is a curve along which the maximum achievable production

is constant”.

4. Define Expansion Path.

Ans. an expansion path (also called a scale line[1]

) is a curve in a graph with

quantities of two inputs, typically capital and labor, plotted on the axes. The path

connects optimal input combinations as the scale of production expands.[2]

A

producer seeking to produce the most units of a product in the cheapest possible

way attempts to increase production along the expansion path.[3]

5. Write 2 exceptions of Law of DMU.

Ans.

1. The law does not hold well in the rare collections. For example, collection of

ancient coins, stamps etc.

2. The law is not fully applicable to money. The marginal utility of money

declines with richness but never falls to zero.

Q. 2 Short answer type questions. (2*5=10 marks)

1 Explain the reasons of Law of Demand.

Ans. Marginal utility decreases:

When a consumer buys more units of a commodity, the marginal utility of such

commodity continue to decline. The consumer can buy more units of commodity

when its price falls and vice versa. The demand curve falls because demand is

more at lower price.

Price effect:

When there is increase in price of commodity, the consumers reduce the

consumption of such commodity. The result is that there is decrease in demand for

that commodity. The consumers consume mo0re or less of a commodity due to

price effect. The demand curve slopes downward.

Income effect

Real income of consumer rises due to fall in prices. The consumer can buy more

quantity of same commodity. When there is increase in price, real income of

consumer falls. This is income effect that the consumer can spend increased

income on other commodities. The demand curve slopes downward due to positive

income effect.

Same price of substitutes

When the price of a commodity falls, the prices of substitutes remaining the same,

consumer can buy more of the commodity and vice versa. The demand curve

slopes downward due to substitution effect.

Demand of poor people

The income of people is not the same, The rich people have money to buy same

commodity at high prices. Large majority of people are poor, They buy more when

price fall and vice versa. The demand curve slopes due to poor people.

Different uses of goods

There are different uses of many goods. When prices of such goods increase these

goods are put into uses that are more important and their demand falls. The

demand curve slopes downward due to such goods.

Q.3 Long answer type questions. ( 2*10-20 marks)

1. Define Production.Explain Laws of Returns to Scale.

Ans. Laws of Returns to Scale: Long-Run Analysis of Production:

In the long run expansion of output may be achieved by varying all factors. In the

long run all factors are variable. The laws of returns to scale refer to the effects of

scale relationships. In the long run output may be increased by changing all factors

by the same proportion, or by different proportions. Traditional theory of

production concentrates on the first case, that is, the study of output as all inputs

change by the same proportion. The term „returns to scale‟ refers to the changes in

output as all factors change by the same proportion.

Suppose we start from an initial level of inputs and output

ADVERTISEMENTS:

X0 = ƒ(L, K)

and we increase all the factors by the same proportion k. We will clearly obtain a

new level of output X*, higher than the original level X0,

X = ƒ(kL, kK)

If X* increases by the same proportion k as the inputs, we say that there are

constant returns to scale.

If X* increases less than proportionally with the increase in the factors, we have

decreasing returns to scale.

If X* increases more than proportionally with the increase in the factors, we have

increasing returns to scale.

Returns to scale and homogeneity of the production function:

Suppose we increase both factors of the function

X0 = ƒ(L, K)

ADVERTISEMENTS:

by the same proportion k, and we observe the resulting new level of output X

X* = ƒ (kL, kK)

If k can be factored out (that is, may be taken out of the brackets as a common

factor), then the new level of output X* can be expressed as a function of k (to any

power v) and the initial level of output

X* = Kvƒ (L, K)

or

X* = kvX0

and the production function is called homogeneous. If k cannot be factored out, the

production function is non-homogeneous. Thus A homogeneous function is a

function such that if each of the inputs is multiplied by k, then k can be completely

factored out of the function. The power v of k is called the degree of homogeneity

of the function and is a measure of the returns to scale

If v = 1 we have constant returns to scale. This production function is sometimes

called linear homogeneous.

If v < 1 we have decreasing returns to scale.

If v > 1 we have increasing returns to scale.

Returns to scale are measured mathematically by the coefficients of the production

function. For example, in a Cobb-Douglas function

X = b0Lb1

Kb2

the returns to scale are measured by the sum (b1 + b2) = v.

For a homogeneous production function the returns to scale may be represented

graphically in an easy way. Before explaining the graphical presentation of the

returns to scale it is useful to introduce the concepts of product line and isocline.

Product lines:

To analyze the expansion of output we need a third dimension, since along the

two- dimensional diagram we can depict only the isoquant along which the level of

output is constant. Instead of introducing a third dimension it is easier to show the

change of output by shifts of the isoquant and use the concept of product lines to

describe the expansion of output.

A product line shows the (physical) movement from one isoquant to another as we

change both factors or a single factor. A product curve is drawn independently of

the prices of factors of production. It does not imply any actual choice of

expansion, which is based on the prices of factors and is shown by the expansion

path. The product line describes the technically possible alternative paths of

expanding output. What path will actually be chosen by the firm will depend on the

prices of factors.

The product curve passes through the origin if all factors are variable. If only one

factor is variable (the other being kept constant) the product line is a straight line

parallel to the axis of the variable factor (figure 3.15). The K/L ratio diminishes

along the product line.

Among all possible product lines of particular interest are the so-called

isoclines.An isocline is the locus of points of different isoquants at which the MRS

of factors is constant. If the production function is homogeneous the isoclines are

straight lines through the origin. Along any one isocline the K/L ratio is constant

(as is the MRS of the factors). Of course the K/L ratio (and the MRS) is different

for different isoclines (figure 3.16).

If the production function is non-homogeneous the isoclines will not be straight

lines, but their shape will be twiddly. The K/L ratio changes along each isocline (as

well as on different isoclines) (figure 3.17).

Graphical presentation of the returns to scale for a homogeneous production

function:

The returns to scale may be shown graphically by the distance (on an isocline)

between successive „multiple-level-of-output‟ isoquants, that is, isoquants that

show levels of output which are multiples of some base level of output, e.g., X, 2X,

3X, etc.

Constant returns to scale:

Along any isocline the distance between successive multiple- isoquants is constant.

Doubling the factor inputs achieves double the level of the initial output; trebling

inputs achieves treble output, and so on (figure 3.18).

Decreasing returns to scale:

The distance between consecutive multiple-isoquants increases. By doubling the

inputs, output increases by less than twice its original level. In figure 3.19 the point

a‟, defined by 2K and 2L, lies on an isoquant below the one showing 2X.

Increasing returns to scale:

The distance between consecutive multiple-isoquants decreases. By doubling the

inputs, output is more than doubled. In figure 3.20 doubling K and L leads to point

b‟ which lies on an isoquant above the one denoting 2X.

Returns to scale are usually assumed to be the same everywhere on the production

surface, that is, the same along all the expansion-product lines. All processes are

assumed to show the same returns over all ranges of output either constant returns

everywhere, decreasing returns everywhere, or increasing returns everywhere.

However, the technological conditions of production may be such that returns to

scale may vary over different ranges of output. Over some range we may have

constant returns to scale, while over another range we may have increasing or

decreasing returns to scale. In figure 3.21 we see that up to the level of output 4X

returns to scale are constant; beyond that level of output returns to scale are

decreasing. Production functions with varying returns to scale are difficult to

handle and economists usually ignore them for the analysis of production.

With a non-homogeneous production

function returns to scale may be increasing, constant or decreasing, but their

measurement and graphical presentation is not as straightforward as in the case of

the homogeneous production function. The isoclines will be curves over the

production surface and along each one of them the K/L ratio varies.

In most empirical studies of the laws of returns homogeneity is assumed in order to

simplify the statistical work. Homogeneity, however, is a special assumption, in

some cases a very restrictive one. When the technology shows increasing or

decreasing returns to scale it may or may not imply a homogeneous production

function.

Causes of increasing returns to scale:

The increasing returns to scale are due to technical and/or managerial

indivisibilities. Usually most processes can be duplicated, but it may not be

possible to halve them. One of the basic characteristics of advanced industrial

technology is the existence of „mass-production‟ methods over large sections of

manufacturing industry. „Mass- production‟ methods (like the assembly line in the

motor-car industry) are processes available only when the level of output is large.

They are more efficient than the best available processes for producing small levels

of output.

For example, assume that we have three processes:

The K/L ratio is the same for all processes and each process can be duplicated (but

not halved). Each process has a different „unit‟-level. The larger-scale processes

are technically more productive than the smaller-scale processes. Clearly if the

larger-scale processes were equally productive as the smaller-scale methods, no

firm would use them: the firm would prefer to duplicate the smaller scale already

used, with which it is already familiar. Although each process shows, taken by

itself, constant returns to scale, the indivisibilities will tend to lead to increasing

returns to scale.

For X < 50 the small-scale process would be used, and we would have constant

returns to scale. For 50 < X < 100 the medium-scale process would be used. The

switch from the smaller scale to the medium-scale process gives a discontinuous

increase in output (from 49 tons produced with 49 units of L and 49 units of K, to

100 tons produced with 50 men and 50 machines). If the demand in the market

required only 80 tons, the firm would still use the medium-scale process,

producing 100 units of X, selling 80 units, and throwing away 20 units (assuming

zero disposal costs).

This is one of the cases in which a process might be used inefficiently, because this

process operated inefficiently is still relatively efficient compared with the small-

scale process. Similarly, the switch from the medium-scale to the large-scale

process gives a discontinuous increase in output from 99 tons (produced with 99

men and 99 machines) to 400 tons (produced with 100 men and 100 machines).

If the demand absorbs only 350 tons, the firm would use the large-scale process

inefficiently (producing only 350 units, or producing 400 units and throwing away

the 50 units). This is because the large-scale process, even though inefficiently

used, is still more productive (relatively efficient) compared with the medium-scale

process.

Causes of decreasing returns to scale:

The most common causes are „diminishing returns to management‟. The

„management‟ is responsible for the co-ordination of the activities of the various

sections of the firm. Even when authority is delegated to individual managers

(production manager, sales manager, etc.) the final decisions have to be taken from

the final „centre of top management‟ (Board of Directors).

As the output grows, top management becomes eventually overburdened and hence

less efficient in its role as coordinator and ultimate decision-maker. Although

advances in management science have developed „plateaux‟ of management

techniques, it is still a commonly observed fact that as firms grows beyond the

appropriate optimal „plateaux‟, management diseconomies creep in.

Another cause for decreasing returns may be found in the exhaustible natural re-

sources: doubling the fishing fleet may not lead to a doubling of the catch of fish;

or doubling the plant in mining or on an oil-extraction field may not lead to a

doubling of output.

B. The Law of Variable Proportions: Short-Run Analysis of Production:

If one factor is variable while the other(s) is kept constant, the product line will be

a straight line parallel to the axis of the variable factor .

In general if one of the factors of production (usually capital K) is fixed, the

marginal product of the variable factor (labour) will diminish after a certain range

of production. We said that the traditional theory of production concentrates on the

ranges of output over which the marginal products of the factors are positive but

diminishing. The ranges of increasing returns (to a factor) and the range of

negative productivity are not equilibrium ranges of output.

If the production function is homogeneous with constant or decreasing returns to

scale everywhere on the production surface, the productivity of the variable factor

will necessarily be diminishing. If, however, the production function exhibits

increasing returns to scale, the diminishing returns arising from the decreasing

marginal product of the variable factor (labour) may be offset, if the returns to

scale are considerable. This, however, is rare. In general the productivity of a

single-variable factor (ceteris paribus) is diminishing.

Let us examine the law of variable proportions or the law of diminishing

productivity (returns) in some detail.

If the production function is homogeneous with constant returns to scale

everywhere, the returns to a single-variable factor will be diminishing. This is

implied by the negative slope and the convexity of the isoquants. With constant

returns to scale everywhere on the production surface, doubling both factors (2K,

2L) leads to a doubling of output.

In figure 3.22 point b on the isocline 0A lies on the isoquant 2X. However, if we

keep K constant (at the level K) and we double only the amount of L, we reach

point c, which clearly lies on a lower isoquant than 2X. If we wanted to double

output with the initial capital K, we would require L units of labour. Clearly L >

2L. Hence doubling L, with K constant, less than doubles output. The variable

factor L exhibits diminishing productivity (diminishing returns).

If the production function is homogeneous with decreasing returns to scale, the

returns to a single-variable factor will be, a fortiori, diminishing. Since returns to

scale are decreasing, doubling both factors will less than double output. In figure

3.23 we see that with 2L and 2K output reaches the level d which is on a lower

isoquant than 2X. If we double only labour while keeping capital constant, output

reaches the level c, which lies on a still lower isoquant.

If the production function shows increasing returns to scale, the returns to the

single- variable factor L will in general be diminishing (figure 3.24), unless the

positive returns to scale are so strong as to offset the diminishing marginal

productivity of the single- variable factor. Figure 3.25 shows the rare case of strong

returns to scale which offset the diminishing productivity of L.

2. Define Cost.Explain various short –run cost curves with the help of diagram.

Ans.

The Cost function

The cost function expresses a functional relationship amidst total cost and factors

that determine it. Usually the factors that determine total cost of production (C) of

a firm are the productivity (Q), the level of technology (T), the prices of factors

(Pt) and the fixed factors (F). It is expressed as follows.

C = f (Q, T, Pf, F)

Such a comprehensive cost function requires multi dimensional diagrams which

are hard to construct.

The Traditional Theory of Costs

The traditional theory of costs analyses the behaviour of cost curves in the short-

run and long run and arrives at the conclusion that both the short run and long run

cost curves are U shaped but the long run cost curves are flatter than the short run

cost curves.

A. Firm’s Short Run Cost Curves

The short run is an epoch in which the firm cannot change its plant, equipment and

the scale of organisation. To meet the amplified demand, it can raise output by

hiring more labour and raw materials or asking the existing labour force to work

overtime. The scale of organisation being fixed, the short run total costs TC are

divided into total fixed costs (TFC) and total variable costs (TVC), TC = TFC +

TVC.

1. Total Costs – These are those expenses incurred by a firm in producing a

given quantity or a commodity. They include payments for rent, interest,

wages, taxes and expenses on raw materials, electricity, water, advertising

etc.

2. Total Fixed Cost – These costs of production that do not change with output.

They are independent of the level of output.

3. Total Variable Costs – These costs of production that change directly with

productivity. They rise when output increases and fall when output declines.

4. Short-run average costs – In the short run analysis of the firm average costs

are more important than total costs. The units of productivity that a firm

produces do not cost the same amount to the firm.

5. Short run average variable Costs – These are equal total variable costs at

each level of output divided by the number of units produced. SAVC = TVC

/ Q.

6. Short Run Average Total Costs – These are the average costs of producing

any given output. They are arrived at by dividing the total costs at each level

of output by the number of units produced. The shape of these curves is U

shaped. SAC or SAVC = TC / Q = (TFC / Q) + TVC / Q = AFC + AVC

7. Short run Marginal Cost – A fundamental concept for the determination of

the exact level of output of a firm is the marginal cost. Marginal Cost is the

addition to total cost by producing an additional unit of output.

The curve will look like this: Diagram 1