managerial economics introduction
TRANSCRIPT
Economics of Managers
Economics – the science of scarcity Scarcity and Efficiency: the twin themes of
Economics. Society has insufficient productive resources
to fulfill all human wants Scarcity implies that not all of society's goals
can be pursued at the same time; Concept of price.
"the science which studies human behavior as a relationship between ends and scarce means which have alternative uses." -Lionel Robbins
Economics is the study of choice under conditions of scarcity
Economics is the social science that studies the choices that individuals, businesses, government and the society at large make as they cope with the scarcity and the incentives that influence and reconcile those choices.
Choices People have to make choices because of
scarcity. Because our unlimited wants are greater than our limited resources, some wants must go unsatisfied. We must choose
which wants we will satisfy and which we will not
Need for a Rationing Device A rationing device is a means of deciding who
gets what. It is scarcity that implies the need for a
rationing device. Price is a rationing device.
Micro Economics and Macro Economics
tools of microeconomics are microscopes, and the tools of macroeconomics are telescopes.
Macroeconomics stands back from the trees to see the forest.
Microeconomics gets up close and examines the tree itself, its branch, and its roots..
In microeconomics, economists discuss a single price; in macroeconomics, they discuss the price level.
Microeconomics deals with the demand for a particular good or service; macroeconomics deals with aggregate,or total, demand for goods and services.
Microeconomics examines how a tax change affects a single firm’s output; -macroeconomics looks at how a tax change
affects an entire economy’s output.
A micro economist might be interested in answering such questions as:
How does a market work? What level of output does a firm produce? What price does a firm charge for the good it
produces? How does a consumer determine how much of a
good he or she will buy? Can government policy affect business
behavior? Can government policy affect consumer
behavior?
A macroeconomist might be interested in answering such questions as: How does the economy work? Why is the unemployment rate sometimes high and
sometimes low? What causes inflation? Why do some national economies grow faster than other
national economies? What might cause interest rates to be low one year and
high the next? How do changes in the money supply affect the economy? How do changes in government spending and taxes affect
the economy?
Positive & Normative Economics
Positive question A question about the consequences of
specific policies.
Normative question A question about what policies lead to the
best outcomes
Positive economics attempts to determine what is.
Normative economics addresses what should be.
Positive economics is descriptive in nature. Normative economics is prescriptive nature.
Fundamental concepts in Economics
Production Possibility Curve -All combination of two goods that can be
produced with the resources and the technology currently available.
Operating Inside the PPF
We could move from point W to E and produce 2000 more tanks with no sacrifice of wheat.
W represents productive inefficiency. A firm or an industry is productively
inefficient if it could produce more of at least one good without pulling the resources from the production of any other good
Recession -Another reason why economy operates inside
PPF.-Idle resources-wide spread unemployment-End of the recession – movement to the point
on the PPF.
PPF and Economic Growth Economic growth is the result of increase in
either Physical Capital or Human Capital or technological progress.
Opportunity Cost
Opportunity costs are part of every decision and activity.
Because of our seemingly unlimited wants push up against limited resources, some wants must go unsatisfied.
The opportunity cost of the chosen item or activity is the value of the best alternative that is forgone.
Opportunity Cost Is Subjective It is subjective. Only the individual making the
choice can identify the most attractive alternative.
But the chooser seldom knows the exact value of the best alternative forgone, because that alternative is “the road not taken.”
The higher the opportunity cost of doing something, the less likely it will be done.
Marginal Principle
People think at margin. Two concepts -Marginal cost – addition to the total cost as
result of the production of one more unit. -Marginal benefit - Addition to the total
benefit as result of the production of one more unit or last unit.
Criterion of decision making - Marginal benefit should exceed marginal
cost.
Incremental principle
Most frequently used managerial economics.
Involves estimating the impact of decision alternatives
Calculating MC & MB is difficult many times.
Two basic concepts -Incremental cost – Change in the total cost
as a result of change in the output. -Incremental revenue - Change in the total
revenue as a resulting from the change in the level of output.
Criterion of decision making - incremental revenue should exceed
incremental cost.
Example : A firm gets an order which can get it an additional revenue of Rs.2000.The normal cost of production.
Labor - Rs.600 Materials – 800 Overheads – 720 Selling & admn expenditures – 280 Full cost - Rs.2400
If we go by the incremental principle the project will be accepted.
Labor - Rs.400 Materials – 800 Overheads – 200 Incremental cost - Rs.1400
Discounting Principle
Fundamental tool in decision making
Discounting principle is based on: Rupee tomorrow is worth less than today -To understand the feasibility of a project we have to understand the present value of
future amount.
Calculating the present value r V= --------- 1 + i V= present value of future amount r = the amount i = rate of interest.
Decision making criteria If a decision brings revenues at future dates, it
is necessary to discount those revenues to present values before a valid comparison of alternatives is possible.
Module II Consumer Behaviour -Utility Analysis -law of diminishing marginal utility -Indifference curve analysis -Consumers surplus
Utility Analysis -Cardinal utility analysis Assumes that utility is measurable.
Consumer would assign arbitrary numbers (utils) to measure the utility derived.
-Quantifiable -Jeavons,Menger, Alfred Marshal belongs to
this school of thought. -Diminishing marginal utility is the contribution.
-Ordinal Utility analysis -Utility can not be measured. It can only be
compared. -Comparable Allen,Hicks and samuelson belong to this
school of thought. -Indifference curve analysis is the contribution
of this school of thought.
Total Utility (TU) -Total satisfaction (utility) derived by the
consumer from the consumption.
- Marginal Utility (MU) - Extra utility received from consuming one
additional unit of the good.
Law of diminishing Marginal utility
“As the consumer goes on consuming more of a particular good marginal utility of successive units goes on decreasing”
Marshall “ the additional benefit which a person derives from a given a given increase of his stock of a thing diminishes with every increase of the stock that he already has”
Assumptions -Consumer is rational. -Various units of the good are homogenous -There is no time gap between consumptions. -Tastes & preferences remain unchanged. - Utility is measurable & additive
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Exception to the law
1.Rare collections2.Misers3.Drunkards4.Reading and writing5.Music and poetry.
Practical Importance 1.Basis of the law of demand -If a person wishes to increase the sale of a
commodity, he must lower its price so that the consumers are induced to buy large quantities and this is what is explained in the law of demand.
2.Consumer’s Surplus Concept. -A consumer while purchasing the commodity
compares the utility of the commodity with that of the price which he has to pay
3.Importance to public finance -Utility of money to a rich man is high and to a
poor man low bases the system of taxation in such a way that the rich persons are taxed at a progressive rate.
- The system of modern taxation is therefore, based on the law-of diminishing marginal utility.
Equating MU per dollar or Equimarginal principle
The Equimarginal Principle applies to problems in which a limited resource is to be distributed among a set of possible uses.
Such problems are ubiquitous.
Equating MU per dollar or Equimarginal principle
There are two goods in the world; apples and oranges
Consumer is spending his entire income consuming 10 apples and 10 oranges a week
Assume – For a particular week ,the MU and price of each are as follows
MUo = 30 utilsMUa = 20 utils Po = $ 1Pa = $ 1
So the consumer’s marginal (last) dollar spent on apples returns 20 utils per dollar, and his marginal (last) dollar spent on oranges returns 30 utils per dollar.
The ratio MUo/Po is greater than the ratio MUa/Pa :
-Consumer would redirect his purchases of apples and oranges.
-He would think if I buy an orange I receive more utility than an apple.
-Better to buy 1 more orange and 1less apple.
-Now MU of orange falls and apple goes up (Law of diminishing marginal utility)
Now,MUo = 25utilsMUa = 25utils Po = $ 1Pa = $ 1
So Consumer is in equilibrium when he or
she derives the same marginal utility per dollar for all goods. The condition of consumer equilibrium is,
Significance 1) Useful in consumption Helps to maximize our utility. 2) Helps in production -Optimum combination of inputs - a firm deciding how to proportion its (finite) labor and capital to
maximize its profits. 3)Helps in public Expenditure. 4) Helps in investment decisions.
Indifference Curve Analysis
Developed by ordinalists as an alternative to Marshal’s theory of consumer behavior.
Criticized unrealistic assumption of measurability of the utility.
Utility can not be measured numerically. It can be experienced and compared.
Every consumer possesses a definite scale of preference for goods and services.
Given any two combination of bundles, the consumer can rank them as to their desirability.
It’s possible to be indifferent between two bundles of goods.
Indifference curve An indifference curve represents all
combinations of goods that provide the same level of satisfaction to a person.
Indifference table
Indifference Curve
Characteristics of Indifferent curves 1. Indifference curves are downward sloping
(from left to right). -This represents the sacrifice. To have more
of one good consumer has to sacrifice another good (Resource being limited)
-Marginal Rate of Substitution.
IC can not be horizontal line
IC can not be vertical line
IC can not be upward sloping curve
2. Indifference curves are convex to the origin.
-As we move down and to the right along the indifference curve, it becomes flatter.
-the more of one good that an individual has, the more units he will give up to get an additional unit of another good; the less of one good that an individual has, the fewer units he will give up to get an additional unit of another good.
This is the reflection of the diminishing marginal utility at work.
the more of one good an individual has, the more units he can (and will) sacrifice to get an additional unit of another good and still maintain total utility
3. Indifference curves that are farther from the origin are preferable because they represent larger bundles of goods.
- Higher indifference curve represents more combinations of two goods hence higher satisfaction.
Budget Constraint(Budget Line)
A good is demanded by the consumer if he has;
i)Preference for that commodityii) Purchasing power to buy that commodity. - purchasing power depends on; a) Income & b) prices E = Qx.Px + Qy.Py – Budget constraint.
Budget Constraint(Budget Line)
Societies have production possibilities frontiers, and individuals have budget constraints.
All the combinations or bundles of two goods a person can purchase, given a certain money income and prices for the two goods.
let's consider a situation in which a consumer has a fixed amount of income, I, that can be spent on food and clothing.
Let F be the amount of food purchased, and C the amount of clothing.
We will denote the prices of the two goods Pf and Pc. Then;
Pf F is ….? PcC is….?
the combinations of food and clothing that she can buy will all lie on this line:
PfF + PcC = I suppose the consumer has a weekly income
of $80, the price of food is $1 per unit, and the price of clothing is $2 per unit
F + 2C = 80 = Budget Line.
What Will Change the Budget Constraint?
If any of the three variables changes—two prices and the individual’s income—the budget constraint changes.
Change in price will bring about change in the budget line.
Change in consumer’s income will also bring about change in the budget line
Effects of a Change in Income on the Budget Line.
A change in income - (with prices unchanged) causes the budget line to shift parallel to the original line .
When the income of $80 (on L1) is increased to $160, the budget line shifts outward to
L2. If the income falls to $40, the line shifts inward to L3.
Effects of a Change in Price on the Budget Line.
A change in the price of one good (with income unchanged) causes the budget line to rotate about one intercept.
When the-price of food falls from $1.00 to $0.50, the budget line rotates outward from L1,, to L2. However, when the price increases from $1.00 to $2.00, the line rotates inward from L1 to L3.
Combining IC & Budget Line - Consumer equilibrium We bring the indifference map and the budget
constraint together to illustrate consumer equilibrium.
We have the following facts: (1) The individual has a budget constraint. (2) The absolute value of the slope of the
budget constraint is the relative prices of the two goods under consideration, say, PX/PY.
(3) The individual has an indifference map.
(4) The absolute value of the slope of the indifference curve at any point is the marginal rate of substitution
Condition of equilibrium
A given price line should be tangent to an indifference curve or marginal rate of satisfaction of good X for good Y (MRSxy) must be equal to the price ratio of the two goods. i.e.
MRSxy = Px / Py
Geometrically, at tangency point A, the consumer’s substitution ratio is equal to price ratio Pf / Pc.
It implies that at point A, what the consumer is willing to pay i.e., his personal exchange rate between C and F (MRScf) is equal to what he actually pays i.e., the market exchange rate.
So the equilibrium condition being satisfied at the point A is:
Price of F / Price of C = MRSfc
Thus, the consumer can obtain maximum satisfaction by adjusting his consumption of
goods F and C, so that the MRS equals the price ratio.
Price Effect & derivation of demand Curve As the price of food comes down consumer
experiences increased real income – nominal income remaining constant.
With this increased real income he can (will) buy more of that commodity whose price has come down and hence moves to a higher indifference curve.
Income Effect
An increase in their income, with the prices of all goods fixed, causes consumers to alter their choice of market basket.
Income effect in case of inferior good
Income consumption Curve traces the impact of change in the income on the consumer’s equilibrium.
Substitution Effect
Price Effect is the combination of income effect and substitution effect.
When the price of a good falls consumer experiences increased income real)
The good becomes less expensive relative to other good(s).
So consumer substitutes toward the good whose price has decreased.
Substitution effect is the powerful force in the marketplace.
For instance –the price of cell phone calls has fallen recent years whereas the price of pay phones has remained more or less remained same…
3rd module
Market forces of Demand & Supply
Concept of Demand
Market is any arrangement that enables the buyers and sellers to get information and to do the business each other.
The buying side of the market is usually referred to as the demand side; the selling side of the market is usually referred to as the supply side.
The word demand has a precise meaning in economics
1. the willingness and ability of buyers to purchase different quantities of a good
2. at different prices3. during a specific time period (per day, week,
etc.)
Unless both willingness and ability to buy are present, there is no demand, and a person is not a buyer.
Law of Demand
States the relationship between price and quantity demanded.
Relationship is inverse.
Assumes other things constant.
Ceteris paribus, the higher the price of the good, the smaller is the quantity demanded and the lower the price of a good, the higher is the quantity demanded.
P ↑ Qd ↓ P ↓ Qd ↑ ceteris paribus
“As the price of Pepsi-Cola rises, the quantity demanded of Pepsi-Cola falls, ceteris paribus.”
Ceteris paribus -a Latin term that means all other things held constant or nothing else changes.
Four Ways to Represent the Law of Demand In Words In symbols In a demand Schedule –(Numerical) As a demand curve.
Why does lower price increases quantity demanded?
-Income Effect (real) -Substitution Effect
Demand Schedule
Demand Curve
Individual demand curve and Market demand curve An individual demand curve represents the
price-quantity combinations of a particular good for a single buyer.
A market demand curve is derived by “adding up” individual demand curves.
Individual & Market demand schedule
Individual demand curve and Market demand curve
A Change in Quantity Demanded Versus a Change in Demand Economics often talk about;(1) a change in quantity demanded and
(2) a change in demand.
- A change in quantity demanded refers to movement on the demand curve.
- Quantity demanded at various price levels.- Change in demand brought about by change
in price. A movement from one point to another point on the same demand curve caused by a
change in the price of the good
Change in demand refers to shift in the demand curve.
Demand can change in two ways: Demand can increase, and demand can decrease. Let’s look first at an increase in demand.
Change in demand refers a shift in the demand curve caused by the factors other than price.
Increase in demand = Rightward shift in the demand curve
Decrease in demand = Leftward shift in the demand curve
1.Income of the consumer -Key determinant of demand -positively related with the demand.
X is a normal good: If income ↑ then DX ↑ If income ↓ then DX ↓
Y is an inferior good: If income ↑ then Dy ↓ If income ↓ then Dy ↑
-If good is neutral good the income effect is neutral.
For a neutral good, as income rises or falls, the demand for the good does not change.
2.Prices of the related goods -Substitutes -Complementary goods.
X and Y are substitutes: If PX ↑ then DY ↑ If PX ↓ then DY ↓
X and Y are Complements: If PX ↑ then DY If PX ↓ then DY
3.Taste and preference of the consumer - Can have both positive and negative impact
on demand. - A change in preferences in favor of a good
shifts the demand curve rightward.
5.Advertisements -Influence taste and preference of the
consumers-This influences the demand.
6.Expectations -Related to their future income -Related to the prices of the good.
7.Cusoms and traditions -Put restriction son the consumption of certain
commodities. 8.Income distribution -Slow growth in consumption if income is
concentrated than if income is equally distributed.
9.Size of the Population
Supply
1. the willingness and ability of sellers to produce and offer to sell different quantities of
a good (Supply)2. at different prices3. during a specific time period (per day, week,
etc.). (Quantity Supplied)
Law of Supply
States the relationship between price and quantity supplied.
Relationship is direct.
Assumes other things constant.
Ceteris paribus, the higher the price of the good, the higher is the quantity supplied and the lower the price of a good, the lower is the quantity demanded.
P ↑ Qd P ↓ Qd ceteris paribus
Change in quantity supplied versus Change in Supply- A change in quantity supplied refers to
movement along the supply curve.- Quantity supplied at various price levels.- Variation in supply brought about by change
in price. A movement from one point to another point on the same supply curve caused by a
change in the price of the good
Change in supply refers to shift in the supply curve.
Supply can change in two ways: Supply can increase, and Supply can
decrease. Change in demand refers a shift in the
demand curve caused by the factors other than price.
Shift Factors (Determinants of Supply)
1.Prices of factors of production. When the price of factors comes down.. With lower costs and prices unchanged, the
profit from producing and selling good has increased; as a result, there is an increased (monetary) incentive to produce.
2.Technogical Development. -Due to technological development supply of
various goods is increasing even at lower prices.
- Technological development –lower per unit cost.
3.Price of other Good -Applicable to a multi-product firm. -Change in the price of one good may result
in the change in the supply of another good.
4.Expectations of future prices -If the price of a good is expected to be higher
in the future – seller may hold back some of the product.
-He actually reduces the supply even though price goes up
5.The Number of Suppliers If more sellers begin producing a particular
good, perhaps because of high profits, the supply curve will shift rightward and vice -versa
6.Change in Weather and other natural events
-Agriculture –Favorable weather – more supply and vice versa.
-Natural disasters -Hurricanes stuck USA Gulf Coast in 2005 –
20% of nation’s oil refining capacity was taken out for several week – leftward shift in the supply curve.
Market Equilibrium
Market equilibrium is brought about by the forces of demand and supply.
Determine equilibrium price and quantity.
E.P is the price which buyers are ready to pay and sellers are ready to accept.
Surplus (Excess Supply) - A condition in which quantity supplied is greater than quantity demanded
Shortage (Excess Demand) -A condition in which quantity demanded is greater than quantity supplied
Equilibrium Price -The price at which quantity demanded of the good equals quantity supplied
Equilibrium Quantity - The quantity that corresponds to equilibrium price.
What Can Change Equilibrium Price and Quantity?
Whenever demand changes, supply changes, or both change, equilibrium price and quantity change.
(a) Demand rises (the demand curve shifts rightward from D1 to D2), and supply is constant (the supply curve does not move)
(b) Demand falls (the demand curve shifts leftward from D1 to D2), and supply is constant.
(c) Supply rises (the supply curve shifts rightward from S1 to S2), and demand is constant.
(d) Supply falls (the supply curve shifts leftward from S1 to S2), and demand is constant.
(e) Demand rises (the demand curve shifts from D1 to D2) and supply falls (the supply curve shifts leftward from S1 to S2) by an equal amount.
(f) Demand falls (the demand curve shifts leftward from D1 to D2) and supply rises (the supply curve shifts rightward from S1 to S2) by an equal amount.
Elasticity of Demand
The law of demand states that price and quantity demanded are inversely related, ceteris paribus.
But it doesn’t tell us by what percentage the quantity demanded changes as price changes.
Elasticity provides a technique for estimating the response of one variable to changes in another.
Price elasticity of demand is a measure of the responsiveness of quantity demanded to changes in price.
More specifically, it addresses the percentage change in quantity demanded for a given percentage change in price.
We know that…
T o calculate elasticity, we express the changes in price and quantity as a percentage of average price and quantity.
Original price is $ 3.10 and new price is $ 2.90.Average price is $ 3.00.
P/Pavg = ($0.20/$3.00) x 100 = 6.67%
Original Quantity demanded is 9.New Quantity is 11 and average is 10.
Q/Qavg = (2/10) x 100 = 20% So the elasticity of demand is % Q /% P = 20% / 6.67% = 3
Types of Elasticity
Perfectly Inelastic Inelastic demand Perfectly Elastic demand Elastic demand Unit Elasticity of demand.
Perfectly Inelastic demand Ed = 0
Inelastic demand Ed < 1
Perfectly Elastic Demand Ed = infinite
Elastic Demand - Ed > 1
Unit Elastic Demand
A proportionate rise in the price result in same proportionate change in the demand.
Ex- 10% change in the price results in exactly 10% change in the demand.
Elasticity and Total Revenue
TR = P x Q
-When P goes up Q goes down. What happens to the total revenue?
-Depends on the type of elasticity.
Elastic demand
Determinants of elasticity
1.Availability of substitutes -When close substitutes are available for a
good, demand for it will be….
- The demand for soft drinks is more elastic than the demand for petrol.
2.Necesseties V/s Luxuries - Demand for necessities will tend to be less
elastic.- Demand for luxuries will tend to be more
elastic.
3.Importance in buyers’ budget -When a good takes up large part of your
budget – make demand more elastic for that good.
Ex –Vocation trip to Paris – A rise in the price will make you think of alternatives.
- When a good takes up small part of your budget – make demand inelastic for that good.
4.Time Horizon ( Short run and Long run) Studies showed that demand is more elastic in
the long run than in the short run.
Demand for gasoline (As price goes up)
Short run -Use public transit
more often -Eliminate
unnecessary trips- If there are two cars,
use the more fuel-efficient one.
Long Run-Buy a more fuel-
efficient car.-Move closer to your
job-Switch to a job closer
to home.-Switch to a city which
is fuel efficient.
Significance of elasticity
-Pricing decisions -Can charge high if the demand is inelastic. -Low if demand is elastic.
Demand estimation - Income elasticity helps in estimating future
demand -Influence of economic growth on the sale of a
particular good and accordingly plan for growth.
-Helps to find out propensity to consume.
Normal and Inferior good -Income elasticity of demand may also be used
define normal and inferior good. Income elasticity is positive .- Normal good - Income elasticity is negative – inferior good
Advertisement decisions - Helps to understand the extent of impact of
advertisement expenditure.
Module IV –Production and Cost of Production
-Production is an activity that creates utility or value.
- It includes any process which transforms input into outputs, thus, adding to the utility.
-Includes both goods and services
Production function – the physical or technological relationship between inputs and output.
Input output ratio. Shows the productive efficiency of the firm Q = f(L,L,C,R etc..)
Production function is divided into a) Short run Production function b) Long run Production function
The short run is a period of time in which at least one of the factors of production is fixed.
The fixed factors of production,, are the inputs that cannot be increased during the short-run productive process.
variable factors of production, or variable inputs, are those inputs that can be increased during production.
In economic theory we come across 3 types of production function
-production function with one variable input(law of diminishing marginal returns)
-production function with two variable input(Iso-quant analysis)
-production function with all variable input (Laws of returns to scale)
Law of diminishing marginal returns The British economist David Ricardo first
formulated the law of diminishing returns. Within a given area of land, he noted,
successive "doses" of labor and capital yielded smaller and smaller increases in crop output.
Short run production function
production function with one variable factor while other factors are kept constant.
states that after a certain point, when additional units of a variable input are added to fixed inputs, the marginal product of the variable input declines.
As more and more units of variable factor is applied over other fixed factors the marginal productivity will eventually decline.
Law does not say that each and every increase in the amount of variable factor will yield diminishing returns.
Initially MP will go up but after certain point it will decline.
Assumptions - One variable factor and all other factors are
kept constant.(short run production function) - Constant Technology. -Homogenous Inputs – The variable input as
applied unit by unit should by and large be homogenous in amount and quality.
TP curve is steeper in the beginning Becomes less steeper The steeper is the TP curve, the greater is
the MP.
Marginal Product
Increasing Marginal return -Occurs when the MR of a worker exceeds the
MR of previous worker.-Initially occurs due to specialization and
division of labor.
Diminishing MR-All production process eventually reach
diminishing MR-More and more workers use the same fixed
plant.-The gains of specialization and division of labor
exhausts.
Stage I -Segment from the origin to point L2 -Production function is characterized first by
increasing marginal returns and then by diminishing marginal returns
-At point X MR is equal to AR and AR is maximized.
-irrational stage.
Stage II -Segment L2 to L3 -MR continues to decline. -It touches the x axis or MR becomes 0.-TP is maximum when MR is 0.-MP becomes negative beyond this point.-Rational producer should stop here.
Stage III -Segment beyond L3 -MR becomes negative -TP starts declining -Irrational stage.
Production Function with two variable inputs.(Isoquant Analysis)
Isoquant – Two variable inputs resulting in the same level of output.
A graph that shows all the combinations of capital and labor that can be used to produce a given amount of output is called an isoquant
Isoquant Table
As we move along the isoquant the output remains same.
An increase in one input requires decrease in other input to keep total output unchanged.
More specifically as we move along the curve we are substituting one input for other.
Marginal Rate of Technical Substitution. -Slope of the isoquant curve. -Rate at which one variable input is substituted
for other variable input keeping total output constant.
-Rate at which labor is substituted for capital. -MRTS is decreasing due to the operation of
law diminishing returns.MRTS = - K/ L
Iso –Cost Line -A graph that shows all the combinations of
capital and labor that are available for a given total cost is called an isocost line.
-To choose a production technique, the firm must look to input markets to learn the current
market prices of labor and capital.
Iso –cost is downward sloping because producer must use less of other input to use more of one input to keep total cost unchanged.
The Slope of the Iso cost line represents the price ratios of the inputs.
- K/ L = PL/PK
Least Cost Input Combination -Combining IQ &Iso- Cost Line We bring the isoquant map and the iso-cost
line together to illustrate least cost input combination.
We have the following facts: (1) The producer has an iso-cost line (2) The slope of the budget constraint is the
relative prices of the two inputs under consideration, say, PL/PK.
(3) The individual has an isoquant map.
(4) The slope of the isoquant at any point is the marginal rate of technical substitution
Condition of equilibrium
A given isocost line should be tangent to an isoquant or marginal rate of technical substitution of input L for input K (MRTSLK) must be equal to the price ratio of the two inputs. i.e.
MRTSLK = PL / PK
At point C isocost line is tangent to IQ curve. Slope of the isocost line is equal to slope of
IQ curve. Hence at point C, MRTSLK = PL / PK
-Production function with all variable input (Laws of returns to scale)
Law of returns to scale -When all the inputs are increased firm
experiences following possibilities -Increasing returns to scale -Constant returns to scale -Decreasing returns to scale.
Increasing returns to scale -long run production function -Given percentage of increase inputs results
in larger percentage of output. -Suppose if firm doubled or tripled output, it
would more than double or triple output.-Increasing returns to scale implies that LAC
declines.
Constant returns to scale -Technically the quantitative relationship
between input and output remains constant. -If a firm doubles the input, it doubles the
output, if it triples the input, it triples the output and so on.
-Constant returns to scale implies that LAC remains same.
Decreasing returns to scale - Given percentage of increase inputs results in
smaller percentage of output. -Suppose if firm doubled or tripled output, it
would less than double or triple output.-Decreasing returns to scale implies that LAC
increases.
Cost Analysis
Cost can be broadly divided into;-Explicit Cost (Accounting Costs)-Implicit Costs (Economic Costs) -Explicit Costs – involves actual payments. -Implicit costs –opportunity cost of owner’s
resources
Costs in the short run
In the short run firm has two costs -Fixed Costs -Variable Cost
TC = TFC + TVC
Fixed Costs -Total fixed cost is sometimes called overhead. - Costs that firms must bear regardless of their
output.- Fixed costs represent a larger portion of total
costs for some firms than for others.
Total fixed costs (TFC) Those costs that do not change with output
even if output is zero
Average Fixed Cost (AFC) AFC is total fixed cost (TFC) divided by the number of units of output (q).
AFC = TFC/Q
Variable costs -Those costs that vary with the level of output. - Total Variable Cost Sum of those costs that vary with the level of
output. To produce more output, a firm uses more inputs.
The cost of additional output depends directly on what additional inputs are required and how much they cost.
Average Variable Cost -Cost of variable inputs per units of output. -total variable cost divided by no.of outputs
produced. AVC = TVC/Q
Average Total cost (ATC) -Total cost divided total output. -Cost per unit of output
ATC = TC/QATC first falls and then rises.
Why ATC is U-shaped -Spreading of fixed costs -eventually diminishing marginal returns.
Marginal Cost -MC tells how cost changes when output
changes at the margin. -Cost of producing one more unit at the margin -MC is change in total cost divided by change
in output.
MC first declines and then rises. Eventually diminishing marginal returns set in
and MPL declines and MC rises.
Relationship between AC & MC -All three curves ATC,AVC and MC first falls
and then rise. -MC curve bottoms out before either AVC or
ATC. -MC curve intersects both average costs at
their lowest point.
In the beginning marginal cost decreases; it is lower than the AVC.
Eventually MC rises above average pulling AVC up; AVC increases.
Similar relationship between MC and ATC ATC includes AFC also. ATC decreases more rapidly than AVC. When AVC start to rise, the rising AVC and
Falling AFC compete with each other. Eventually AVC wins and ATC starts to rise
as well.
Long Run Cost curve -In the long run there are no fixed inputs &
hence no fixed costs.-In the short run variations in output are
possible within the range of existing plants; in the long run firm can build new plants.
Long run costs refers to the cost of producing different levels of output by changes in the size of the plant or scale of production.
Long run Average Cost(LAC) -Called “Envelope Curve” -Tangential to various SAC curves
-LAC curve is U shaped. Implies lower average cost in the beginning until the optimum scale.
Economies of scale in the beginning and eventually diseconomies of scale.
Do firms operate at optimum scale? -Many firms may not be operating at optimum
scale due to following reasonsa) In many cases the market is not big enough
to permit all firms to operate at optimal scale. So firms may operate at lower level.
b) Firms may become “over- expanded” to attain a dominance in the market.
Fear of government action may hold back firms from profitable expansion.(Ex-MRTP Act)
Learning Curve and costs -Practice makes a man perfect. -With the passage of time workers become
skilful.-Output is produced with more efficiency.
Learning curve pricing -Company’s cost production falls as it
increases the volume of production-hence the firm should set its price at a
relatively low level to stimulate demand.-The greater demand will accelerate the
learning effects.(through further learning and innovation)
Japanese companies manufacturing such products as copiers, televisions and computer chips used this strategy to their advantage when entering the US market.
Profit Maximization
The Firm’s Constraint -if the firm is free to earn whatever level of
profit it wanted, it would earn virtually infinite profit.
a) Demand Curve facing the firm -Tells us the quantity of output which the
customer choose to purchase from that firm for different prices.
- Shows the quantity of output that the firm can sell at different prices.
- It also shows the maximum price which the firm can charge to sell any given amount of output.
Firm can freely determine either price or output. But once it makes the choice, the other variable is automatically determined by the demand curve.
Demand and Total Revenue-total inflow of receipts-Each time a firm chooses level of output, it also
determines its TR-TR follows automatically
b) The cost constraint -Every firm struggles to reduce costs. -But there is a limit to how low costs can go. -Firstly, the firm has a given technology which
determines the least cost combination of inputs.
-Secondly, the input prices
Profit Maximization output
Total Revenue and Total Cost Approach. -Firm’s profit is the difference between total
cost and total revenue at each level of output.-Firm chooses the output where profit is the
greatest.
Marginal Cost and Marginal Revenue Approach
- MC is the cost of producing additional unit of output at the margin or change in the total cost divided by change in total output.
- MR is the revenue from producing additional unit of output at the margin or change in total revenue divided by change in total output.
MC tells us how much cost increases per unit increase in output
MR tells us how much revenue rises per unit increase in output
- As long as MR is positive TR increases.
When MR is negative TR declines.
Two points of intersection- MC should cut MR from below
A firm maximizes its profit at the point where MR equals MC.
An increase in output will always raise profit as long as MR is greater than MC
An increase in output will always lower profit whenever MR is lesser than MC
5th module
Market Structures
By market structure we mean all characteristics that influence the behavior of buyers and sellers when they come together to trade.
Four basic market structures -Perfect Competition-Monopoly-Monopolistic competition-Oligopoly
Perfect Competition
a) A large no. of buyers and sellers. -So large that each firm produces a tiny
fraction of total output. Hence individual firm can not influence the market price.
-A firm can sell any amount of output at the prevailing price.
b) Standardized(homogenous) products offered by the sellers
-Buyers do not perceive the difference between the products of one seller and another.
-For ex- Buyers of wheat.
c) Free entry and exit from the market -Perfectly competitive market has no
significant entry barriers or special costs to discourage new entrants.
-Firm wishing to do the business can do so on the same terms.
-Perfect competition also requires easy exit in the long run.
d) Well informed buyers and sellers Buyers and sellers have relevant information
to their decision to buy and sell.
Short run Price and output determination In the short run firm maximizes its profit by
equalizing MC and MR. Three possible outcomes in the short run -Normal Profit -Super normal profit and -loss.
Firm earning Normal Profit
Firm earning Supernormal Profit
Firm incurring Loss
Long run equilibrium
-In the long run super normal profit attracts new firms in to the industry. Price comes down hence supernormal profit goes.
-Loss making firms in the short run exit in the long run
Long run equilibrium
Shut down point
- In the short run firm must pay its fixed inputs.
- At first glance one would say that loss making firm should always shut down in the short run.
- Firm can continue to operate as long as TR >TVC.
-So it can cover some fixed cost as well.
Shut down decision.
Shut down point
Shut Down Rule : In the short run the firm should continue to produce if total revenue exceeds total variable costs; otherwise it should shut down.
Perfect Competition and Economic efficiency
Monopoly
Monopoly is the market with just one seller selling a good for which there are no close substitutes.
Pure monopoly is an industry (1) with a single firm that produces a product
for which there are no close substitutes and (2) in which significant barriers to entry
prevent other firms from entering the industry to compete for profits.
How monopolies arise?
Economies of scale (Natural Monopoly) -A firm may be enjoying economies of scale
and thus prevents the new firms from entering into the market.
Legal Barriers-Many monopolies arise due to legal barriers-Protection of intellectual properties.-A firm can enjoy monopoly for a certain no.of
years.-Government restriction for entry in certain
sectors.
High costs of entry. -Economic barrier.-Cost of entry simply may be very high.
Control over key raw materials- Monopoly power over certain key and scarce
raw materials.- Raw material monopolies- Aluminum company of America had
monopolized the industry before world war II
Price and output determination under monopoly Profit maximizing monopolist continues to
produce as long as MR exceeds MC. A monopolist faces relatively inelastic
demand.
Monopolist is a price maker.
Monopolist enjoys market power unlike perfect competition.
He has the ability to raise the price without causing the quantity demanded to go to zero.
Hence Monopolist is the price maker and firm in perfectly competitive market is a price taker.
Short run equilibrium In the short run firm maximizes its profit by
equalizing MC and MR. Three possible outcomes in the short run -Normal Profit -Super normal profit and -loss.
Monopolist earning economic profit
Monopolist incurring loss
Long run equilibrium
In the long run monopolist earns either normal profits or supernormal profit
Monopoly and P.Competition compared
Monopoly is a price maker and a firm in perfect competition is price taker.
Monopolist faces downward sloping demand curve and MR curve. Whereas firm in PC faces horizontal MR and demand curve.
Monopolist may earn economic profit in the long run also.
Monopolist may not operate at the lowest point of average cost curve. Whereas firm in PC operates at the lowest point of average cost curve.
Monopolistic Competition
Monopolistic Market is market structure in which;
-large no. of firms operate -Each firm produces a differentiated product. -Firms are free to enter and exit.
Large no of firms -Limited market power -Demand is highly elastic-Close substitutes-Independent decisions.
Product Differentiation -A differentiated product is one which is a close
substitute but not a perfect substitute.-Differentiated by quality, brand etc..-So when its price rises demand falls but does
not become zero. - Importance of advertisement. - non-price
competition
Free entry and exit-In the long run firms can freely enter and exit
from the industry.
Price and output determination
Profit maximizing firm in Monopolistic Comp. continues to produce as long as MR exceeds MC.
A firm in monopolistic competition faces relatively elastic demand.
Zero economic profit in the short run
Profit in the short run
Loss in the shortrun
Long run Equilibrium –Zero economic profit
Oligopoly
Features UK definition of an oligopoly is a five firm
concentration ratio of more than 50%. Interdependence of Firms, firms will be
effected by how other firms set price and output
Barriers To Entry, but less than Monopoly Differentiated Products, advertising is often
important Most Common Market Structure
Kinked demand curve model