Mangerialeconomics 150313132610 Conversion Gate01

Managerial Economics
Meaning
Managerial economics is defined as the
study of economic theories, logic and tools
of economic analysis that are used in
process of business decision-making.
In other words economic theories and
techniques of economic analysis are applied
to analyze business problems, evaluate
business opportunities with a view to arrive
at appropriate business decision.
.
Managerial Decision Areas

Assessment of Investible
funds
Selecting Business areas
Choice of Product
Determining optimum
Output
Determining inputCombination of the product
Sales promotion
Application of
Economic
Concepts and
Theories in
Decision
Making
Use of
Quantitative
Methods
Mathematical
tools
Statistical Tools
Econometrics
Application of Economic Concepts, Theories and

analytical Tools to find Optimum Solution to Business
Problems
Why Economics?
Biology
contributes
to
medical
profession.
Physics to Engineering.
Economics to Managerial profession.
Achieve objective of the firm
Constraints is limited resources
Application of Economics to
Decision Making
I.
Determining and defining the objective to be

achieved.
II. Collection and analysis of business related data

and other information(Economic, social, Political
and technological environment.).
III. Inventing the possible courses of action
IV. Select the possible
alternatives.
action
from
the
II and III are crucial in decision making
given
Example Launching a
product
Production Related issues and
Sales related issues.
Production Related issues
Available techniques of Production.

Cost of Production
Supply position of inputs
Price structure of inputs
Cost structure of competitive
products
Availability of foreign exchange if
inputs are available.
Sales related issues

Market size, general market trends and
demand prospectus for the product
Trends in Industry
Competitors
Pricing of product
Pricing strategy of competitors
Degree of competition
Supply position of complementary
goods
Scope of Managerial
Economics
Economics applied to the analysis of
business problems and decision making.
Area of business issues to which
economic theories can be directly
applied are broadly divided into
1.Micro Economics (Operational and
internal issues)
2.Macro Economics (Environmental and
external issues)
Operational or Internal
issues
What to produce Nature of product or
Business
How much to produce Size of firm
How to produce Choice of technology
How to price the commodity
How to promote sales
How to face price competition
How to manage profit and capital
How to manage an inventory
Environmental or External
issues
The type of economic system in the country
Trends in GDP, Prices, Saving and Investment
Employment, etc.
Trends in Financial System Banks, Financial and
Insurance companies
Trends in Foreign Trade
Government Economic policies
Social Factors like value system, property rights,
customs and habits.
Socio-economic organization like trade unions,
consumers associations, Consumer cooperatives and producers unions.
Political environment
Degree of Globalization and Influence of MNCs
Micro Economic Issues
What to produce
How much to produce
How to produce
How to price the commodity
How to promote sales
How to face competition
How to decide on new investment
How to manage profit and capital
How to manage an inventory
Examples of Economic
Theories
Theory of Demand
It deals with the consumer behaviour
How do the consumer decides to buy
the commodity
How do they decide on Quantity
When do they stop consuming
How consumer behave on Price
It helps in making choice in commodity,
optimum level of production and price
Theory of Production and

Decision Making
It explains the relationship between
inputs and output.
Under what conditions the cost increases
or decreases
Helps to decide the optimum size of the
firm
Size of total output and amt of capital and
labour to be employed given the objective
Market structure and Pricing

theory
How price is determined.
When price discrimination is
desirable, feasible and profitable.
How advertising will be helpful to
increase sales.
Thus pricing and production decision
will help to determine the optimum
size of the firm.
Profit analysis and

Management
Elements of risk is always there even
if most efficient techniques are used.
It guide the firm to measure and
manage profit, to make the
allowance of risk premium, to
calculate the pure return on capital
and also future profit.
Theory of Capital and

investment decision
It contribute to deciding choice of
project, maintaining capital, capital
budgeting, etc
Macro economic Issues

Trends in Economics:
Level of GDP
Investment climate
Trends in National Output and
employment
Price trends
Issues related to Foreign Trade

Trends in International Trade
Trends in International Prices
Exchange rates
Prospectus in International Market
Issues related to Government

Policies:
Monetary Policy
Fiscal Policy
Foreign Trade Policy
Environmental Policy etc
Other Topics related to

Managerial Economics
Mathematical Tools
Economic theories for Decision

Making
Economic concepts (Cost, Price,
Demand etc.)
Ascertaining the variables which is
relevant.
Relationship between the two or
more variables.
What is Demand ?
When the desire for a commodity is backed by
the willingness and the ability to spent adequate
sums of money, it becomes demand or effective
demand in the economic sense of the curve.
Only desire for commodity or having money for
the same cannot give rise to its demand
Marshall
Demand for a product refers the amount of it
which will be bought per unit of time at a
particular price.
05/25/15
group 2
sec
23
RELATIVE CONCEPT
Demand is the relative concept i.e. it
is related to price and time:
1.The demand for rice is 100Kg
2.The demand for rice at Rs 5/- per Kg
is 100Kg per day.
Second
statement
is
complete
because it mentions the price and
time period, becoz demand varies
from time and price.
The demand refers to the quantity of
it purchased at a given price, during
a specific time period.
Determinants of
Demand
1.Price of the product.

2.Income and wealth distribution.
3.Tastes, habits and preferences.
4.Relative prices of other goods
Substitute products.
Complementary products.
5.Consumers satisfaction.
6.Quantity of money in circulation.
7.Utility of the commodity.
8.Quality.
9.Expectation regarding future price.
10.Number consumers, time and place: Transport,
communication and market facilities will increase the
consumers
11. Advertisements effects.

12. Growth of population.
13. Level of taxation.
14. Climatic or weather conditions.
15. Special occasions.
16. Technology.
17. Psychology of the consumers:
Bandwagon effect: Demand arises becoz others
have it others,
Snob effect: Demand arises becoz when it is not
commonly demanded,
Demonstration effect: Copying the others.
INDIVIDUAL DEMAND
It is the tabular representation of the various
quantities of a commodity demanded by an
Individual at a different prices during a given
period
Price per of
unittime
Demand for commodity X
50
10
40
20
30
30
20
40
10
50
05
60
Individual Demand
MARKET DEMAND
Price per Unit
Qty Demanded
Total market
Demand(A + B
+ C)
50
10
12
15
37
40
20
22
25
67
30
30
32
35
97
20
40
42
45
127
10
50
52
55
157
Demand and Demand Curves (d)

The market demand curve is the horizontal sum of the
demand curves of all individuals.
Market dd curve is also negatively sloped because 1.
Individual dd curves are downward sloping 2. At high
prices some buyers will exit the market
MARKET DEMAND
Generalized demand
function
The generalized demand function just set forth is
expressed in the most mathematical form.
Economist and market researchers often expressed
generalized demand function in a linear functional
form.
The following equation is an example of a linear form
of the generalized demand function:
Qd = a + bP + cM + dPR + eT + fPe + gN
Where the Variables are (P,M,PR,T,Pe,N).
And a,b,c,d,e,f and g are parameters.
Generalized demand
function
The intercept a shows the value of Qd
when the variables P,M,PR,T,Pe,N are all
simultaneously equal to zero.
The other parameter a,b,c,d,e,f and g are
called slope parameters.
They measure the effect on quantity
demanded of changing one of the variables
while holding rest of it as constant.
E.g. b measures the change in Qty dd per
unit change in price
i.e b =
Qd/
P.
Summary of Generalized
demand function
Variable
Relation to quantity
demanded
Sign of Slope
parameter
INVERSE
Negative
Direct for normal goods

Inverse for inferior goods
Positive
Negative
PR
Direct for substitute

goods
Inverse for the
complementary goods
Positive
Negative
Direct
Positive
Pe
Direct
Positive
Direct
Positive
Demand functions
The relation between price and
quantity demanded per period of
time, when all other factors that
affect demand held constant is called
as demand function or simply
demand.
It can be expressed as
Qd = f (P)
illustration
Generalized demand function is
Qd = 1800 20P + 0.6M 50PR
To derive a demand functions
Qd = (P)
The variables M and PR must be
assigned fixed value.
Suppose M = 20000, PR = 250
Substitute the value in generalized
demand function.
Qd = 1800 20P- 0.6(20000) 50(250)

= 1800 20P + 12000 12500
= 1300 20P
The intercept parameter 1300 is the amount
of the good consumers would demand if price
is zero.
The slope of the demand function
is
-20 and indicates that a Rs 1 increase in price
causes qty dd to decrease by 20 units.
Qd = 1300 20 (1)
= 1300 -20 = 1280
Determinants of Demand
Determinants of
Demand
Dema
nd
Increa
ses
Demand
decreases
Sign of Slope
parameter
M rises
M Falls
M Falls
M rises
C>0
C<0
Substitute goods
Complement good
PR
rises
PR falls
PR falls
PR rises
d>0
d<0
Consumer Tastes (T)
T rises
T falls
e>0
Expected price (Pe)
Pe rises Pe Falls
f>0
Number of consumers
(N)
N rises
g>0
Income (M)
Normal Goods
Inferior goods
Price of related goods
(PR)
N Falls
Demand Schedule
The Law of Demand

Other factors remaining same (habits, tastes
etc.) as price decreases demand increases and
vice versa
Marshall
Ceteris paribus, higher the price of a commodity,
smaller is the quantity demanded and lower the
price, larger the quantity demanded.
Demand Schedule
(Hypothetical)
Price of commodity (in Quantity demanded
Rs)
(unit per week)
5
4
3
2
1
100
200
300
400
500
Demand Curve
D
E1
P1
Price(P)
P1 - old price
P2 - new price
E2
P2
D
0
Q1
Q2
Quantity
demanded (Q)
A Linear Demand Curve
Q1 old quantity
demanded
Q2 new quantity
demanded
DD demand curve
Characteristics of A Typical
Demand Curve
Drawn by joining different loci.
Downward sloping.
Reciprocal relationship between price and
quantity demanded
( P 1/Qd )
Linear
linear
Non -
Assumptions (Other
things)
No change in consumers income.
a)
b) No change in consumers preferences.
c) No change in the fashion.
d) No change in the price of related goods :
Substitute goods.
Complementary goods.
e) No expectation of future price changes or
shortages.
f) No change in size, age, composition and sex
ratio of the population.
g) No change in the range of goods available to
the consumers.
Contd
h) No change in the distribution of income
and wealth.
i) No change in the government policy.
j) No change in weather conditions.
EXCEPTION TO LAW OF
DEMAND
Giffens Paradox: Giffen gods are
inferior goods. When the price rises
the real income of the consumer rises
and he will move to a superior goods.
This is also called as Giffens paradox.
Qualitative changes: It may increase
qty with the increase in the price.
Price illusion: Higher the price better
is the quality.
Prestige goods: Purchased by the
rich people.
Demonstration effect: Imitating

others or Snob appeal
Fashion:
Necessaries:
Movement along the curve

OR
Change in quantity demanded
Extension of demand
With a decrease in price, there is
increase in the quantity demand of the
product.
D
P1
Price
E`
P2
D
Q1
Q2
Quantity
demanded
Contraction of demand
With a increase in price, there is a
decrease in quantity demanded.
P2
Price
E`
E
P1
Q2
Q1
Quantity
demanded
SOURCES OF SHIFTS IN THE DEMAND

CURVES
Tastes
Prices of related goods
Income
Demographics
Information
Availability of credit
Changes in expectations
Movement of Demand Curve

OR
Change in demand
Increase in demand:
a) More quantity demanded ------ at a
given price.
D` ------ at a
b) D`
Same quantity demanded
D
D
higher price.
b
P1
P2
Pric
e
Price
D`
P1
a
D
D
Q1
Quantity
Q2
D`
Q1
Quantity demanded
Decrease in demand :
a) Less quantity demanded ---- at
same price.
b) Same quantity demanded ---- lower
price.
D
D
D`
Price
P1
D`
P1
a
Price
b
D
P2
D
a
D`
D`
Q2
Q1
Quantity demanded
Q1
Quantity demanded
Factors And Effects of Change

(increase or decrease) in
demand
a) Change in income :
D`
Increase
Decrease
D`
Price
Price D
D`
Quantity
demanded
D
D`
Quantity
demanded
b) Change in taste, habit and

preference :
D`
Positive
Negativ
e
D`
Price
Price
D`
D
Quantity
demanded
D
D`
Quantity
demanded
c) Change in fashion and

customs :
Favorable
Unfavorable
D
D`
Price
D`
Price
D`
D`
Quantity
demanded
Quantity
demanded
g)Change in population :
Increase
Decrease
D
D`
D`
Price
Price
D`
D`
Quantity
demanded
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Quantity
demanded
group 2
sec
57
h) Advertisement and publicity

persuasion :
Aggressive
D`
Price
Docile
Price D`
D`
D`
Quantity
demanded
05/25/15
Quantity
demanded
group 2
sec
58
i) Change in value of money :

Inflationary
Deflationary
D
D`
Price
Pric
e
D`
D`
D
D`
Quantity
demanded
( Value of
money)
Quantity
demanded
( Value of
money)
j) Change in level of taxation :

High
Low
D
D`
Price
Price
D`
D`
D
Quantity
demanded
D
D`
Quantity
demanded
k)Expectation of future changes

in prices :
D`
Price
Rise
Fall
Price D`
D
D`
D`
Quantity
demanded
Quantity
demanded
Shift in Demand
Price
Qd = 1300
Qd = 1600
Qd = 1000
20P
20P
20P
(M = 20000) D0 (M = 20500) D1 (M = 19500) D2
65
300
60
100
400
50
300
600
40
500
800
200
30
700
1000
400
20
900
1200
600
10
1100
1400
800
Shift in Demand
Determinants of Demand
Determinants of
Demand
Dema
nd
Increa
ses
Demand
decreases
Sign of Slope
parameter
M rises
M Falls
M Falls
M rises
C>0
C<0
Substitute goods
Complement good
PR
rises
PR falls
PR falls
PR rises
d>0
d<0
Consumer Tastes (T)
T rises
T falls
e>0
Expected price (Pe)
Pe rises Pe Falls
f>0
Number of consumers
(N)
N rises
g>0
Income (M)
Normal Goods
Inferior goods
Price of related goods
(PR)
N Falls
Supply
The amount of a good or service
offered for sale in a market during a
given period of time (e.g a week, a
month) is called quantity supplied.
Concept of Supply
Supply is defined as the various
amounts of goods and services which
the sellers are willing and able to sell at
any given price during a specific period
of time
It is related to time, place and person
The supply of sugar is 50 kg is not a
complete sentence
The supply of a sugar at price Rs 5/- is
50kg. Per day is the complete sentence
Factors affecting Supply
Price
Price of other commodities
Goals of the producer
State of technology
Cost of production
Climate and forces of Nature
Transport facilities
Taxation: Heavy taxes supply will
reduce
Expectation regarding future prices
Self-consumption
Time element: Short period the
supply is fixed and vice
Individual Supply Schedule

Individual
supply
schedule
is
a
tabular
representation of the various quantities of
commodity offered for sale by an individual seller
at different prices during given period of time
Price Per Unit of X
Qty. supplied of X
10
10
20
15
30
20
40
25
50
30
60
Individual Supply Curve
Market supply schedule

It is the tabular representation of the
various qty. of a commodity offered
for sale by all the sellers at different
prices during a given period of time.
It is the total supply of a commodity
by all the sellers at different prices
Market supply schedule

Price( Rs
Qty. supplied of X
)
Seller I
Seller II
Seller III
Market
supply (I
+ II+ III)
10
20
30
60
10
20
25
40
85
15
30
30
50
110
20
40
35
60
135
25
50
40
70
160
30
60
45
80
185
Market supply Curve
Law of Supply
Others things remaining the same ,
qty. supplied of a commodity directly
varies with its price. i.e. S= f (p)
SUPPLY SCHEDULE
Price Per Unit of X
Qty. supplied of X
10
10
20
15
30
20
40
25
50
30
60
Supply Curve
Assumption
Price of other commodities remains the same

The cost of production remains the same
The method of production remains the same
No change in the availability of goods
No change in transport facilities
No change in weather condition
No change in tax structure and govt. policies
Goals of producer remains the same
No change in expectation about the price
No natural calamities and no self
consumption
Exceptions to the law of

supply
Backward bending supply curve

Wage rate
( Rs.)
Hours of work
Daily Income
(Rs.)
40
10
70
10
12
120
12
10
120
Fixed income groups: If person

expects the income of Rs.20 he will
save 500 Rs at 4% rate of interest and
at 5% rate he will save Rs. 400 Rs.
Expectation regarding future prices
Need for cash by the seller
Rare collection the supply is
permanently fixed whatever the
price.
Self consumption
Movements or variation in
Supply
When there is change in supply
exclusively due to change in Price
Shift in supply
When there is a change in supply due to change
in factors other than the Price
Generalized supply function

It shows how the different variables jointly
determine the quantity supplied.
The generalized supply function is expressed
mathematically as
Qs = g(P, Pi, Pr, T, Pe, F)
Qs = Qty of goods and service offered for sale
P = Price of goods or service.
Pi = Price of inputs
Pr = Price of goods that are related to production.
T = Level of available technology.
Pr = Expected price of the producer
F = No. of firms in the industry
Generalized supply function

As in case of demand, economists often
find itself to express the generalised
supply function in linear functional form:
Qs = h + kP + lPi+ mPr + nT + rPe +
sF
Where P, Pi, Pr, T, Pe, F is a variables
affecting the supply, h is the intercept
parameter, and k, l, m, n, r, and s are
the slope parameters.
Relation to Generalised demand

function
Variable
Relation to
Quantity supplied
Sign of slope
parameter
Direct
K=
Pi
Inverse
L=
Negative
Pr
Inverse for substitute

in production (Wheat
and Corn)
Direct for
complement in
production(Oil and
Gas)
m=
Negative
Direct
n=
Positive
Pe
Inverse
r=
Negative
is
Direct
S=
is
m=
Positive
is Positive
is
is
is
is
Supply function
Supply function is derived from generalised supply
function.
A supply function shows the relation between supply
and price.
Qs = g(P, Pi, Pr, T, Pe, F) = g (P)

Illustration
Qs = 50 + 10P 8pi + 5F
Suppose the price of the input is Rs. 50 and there are
90 firms then the supply function will be
Qs = 50 + 10P -8(50) + 5(90)
= 100 + 10P
The supply schedule with equation can be drawn and is
given in next slide
Qs = 100
+10P
Price
Quantity Supplied
schedule
65
750
60
700
50
600
40
500
30
400
20
300
10
200
Shift in Supply
Price
Qs = 100 +
10P
Pi = 50, F =
90
Qs = 250 +
10P
Pi = 31.25, F
= 90
Qs = -200 +
10P
Pi = 50, F =
30
65
750
900
450
60
700
850
400
50
600
750
300
40
500
650
200
30
400
550
100
20
300
450
10
200
350
Shift in Supply
Determinants
of supply
Supply
Increases
Supply
Decreases
Sign of Slope
parameter
Price of inputs
(Pi)
Pi falls
Pi rises
I<0
Pr falls
Pr rises
Pr rises
Pr falls
M<0
M>0
State of
technology (T)
T rises
T falls
n>0
Expected Price
(Pe)
Pe falls
Pe rises
r<0
F falls
S>0
Price of goods
related in
Production (Pr)
Substitute good
Complement
good
Number of firms F rises

or productive
capacity in
Market Equilibrium
Demand and supply provide an analytical framework
for the analysis of the behaviour of buyers and sellers
in markets.
Demand shows how buyers respond to changes in
price and other variables that determine quantities,
buyers are willing to purchase.
Supply shows how sellers respond to changes in price
and other variables that determine quantities offered
for sale.
The interaction of buyers and sellers in the market
place leads to market equilibrium.
Market Equilibrium
Market equilibrium is a situation
which at the prevailing price,
consumers can buy all of a good they
wish and producers can sell all of
good they wish.
Market Equilibrium
Price
Qs = 100 + 10P
S0
Qd = 1300
20P
D0
Excess
supply
( +)
Excess
Demand
( -)
65
750
+750
60
700
100
+600
50
600
300
+300
40
500
500
30
400
700
-300
20
10
300
900
-600
Qd = Qs
200
1100
-900
1300 20 P = 100 + 10P
Solving this equation for the equilibrium price,
1200 = 30P
P = 40
Market Equilibrium
Market Equilibrium
At Market clearing price of 40
Qd = 1300 (20 * 40) = 500
Qs = 100 + (10 * 40) = 500
If the price is Rs 50 there is a surplus of 300 units.
Using the demand and supply. equations, when P =
50,
Therefore, When price is Rs 50.
Qd = 1300 (20 * 50) = 300
Qs = 100 + (10 * 50) = 600
There fore when the price is Rs 50
Qs Qd = 600 300 = 300
Changes in Market Equilibrium

Demand Shifts (Supply remains constant)
Supply Shifts (Demand

Remains constant)
Simultaneous Shift in Demand

and Supply
Simultaneous Shift in Demand

and Supply
Predicting the Direction of

change in Airfares (Qualitative
analysis)
Suppose you manage a travel department for a U.S.
corporation and your sales force makes heavy use of air travel
to call on customers.
The president of the corporation to reduce travel expenditures

for 2004.
You need to predict what will happen in future price of airfares
in 2004.
The wall street journal recently came with the news.
A number of new, small airlines have recently entered the
industry and others are expected to enter in 2004.
Video-conferencing is becoming a popular, cost effective
alternative to business travel for many U.S. corporation. The
trend will cut the price on teleconferencing rates.
Direction of change in Airfares:

Qualitative Analysis
ELASTICITY OF DEMAND
The degree of responsiveness of Qty.
demanded of a commodity to a change
in its price is known as elasticity of
demand.
Ed = % change in qty. dd /%
change in determinant
Elastic: Small change in price brings
big change in demand
Inelastic: Big change in price brings
small change in demand
Kinds of Elasticity
Price Elasticity
Income Elasticity
Cross Elasticity
Arc Elasticity
PRICE EASTICITY OF
DEMAND
IT is the degree of responsiveness of qty.
demanded of a commodity to a change
in its price.
Ed = % change in qty. dd /% change
in P
Ed = proportionate change in qty.
dd /Proportionate change in P
Ed =
Q/Q =
Q/Q * P/
P
P/P
Definition: Elasticity of
Demand
Price elasticity of demand is defined as
the percentage change in quantity
demanded divided by the percentage
change in price.
% change in Qd
Equation:
Elasticity of Demand =
% change in
Price
Example
Suppose Monginis cake is originally priced at Rs.
10 and the amount sold is 50 cakes per week. If
the price is increased to Rs. 11, then 40 cakes are
sold per week. What is the price elasticity of
demand?
% Change in Price = [(11-10)/10]*100 = 10%
% Change in Quantity Demanded = [(4050)/50]*100 = 20 % (ignoring the negative sign)
Elasticity = 20/10 = 2
Even a very small change in price has lead a highproportional fall in quantity demanded.
TYPES OF PRICE ELASTICITY

OF DEMAND
TYPES OF PRICE ELASTICITY

OF DEMAND
The Farmers Dilemma

For many crops, a strange situation arises a bad crop
year results in a good year for farm incomes, and a good
crop year results in a bad year for farm incomes. How
can this be?
Price elasticity gives us the answer:
Bad crop year: supply decreases, prices for farm products rise,
but quantity demanded doesnt fall very much. The quantity
demanded of farm products is not very responsive to changes
in prices
Good crop year: supply increases, prices for farm products fall,
but quantity demanded doesnt increase very much. The
quantity demanded of farm products is not very responsive to
changes in prices
It is easy to show this with a graph. But first we need yet

another concept: Total Revenue = Price x Quantity
Measurement of price elasticity

of demand
Percentage Method
Total outlay Method
Geometric Method
Percentage Method or Ratio

Method
It is the ratio of % change in Demand to a %
change in Price.
Ed = %
OR
Q *
P *
P
Unit elastic Ed =1
Relatively Elastic Ed >1
Relatively Inelastic Ed <1
Total Outlay Method or Revenue Or

Expenditure Method
Price (Rs)
QTY. DD
(units)
Total Outlay
(Rs)
Elasticity
50
250
40
10
400
Relatively
elastic Ed > 1
30
20
600
20
30
600
10
40
400
50
250
Unit Elastic Ed
=1
Relatively
inelastic Ed <
1
Geometric Method Or Exact

Method
Ed = Lower segment of demand
curve
Upper segment of demand curve
Ed at pt A = DA/DA = 1
Ed at pt B = DB/DB = 1/3 < 1
Ed at pt C = DC/DC =9/3 > 1
Other concepts of Elasticity of

Demand
Income Elasticity of Demand =
Q *
Y
Y
Q
Ed = % change in qty. dd /% change in Y
Cross Elasticity of Demand =
Qx
* Py
Py
Qx
Arc elasticity of Demand =
Qx
P
Q1+ Q2
P1+ P2
Factors Influencing Elasticity

Nature of commodity: Necessary or luxurious
goods
Availability of substitutes:
Number of Uses of a commodity:
Multipurpose elastic and vice-versa.
Income:
Proportion of Expenditure:
A small prop. Of exp demand is elastic.
Time period:
Height of Price and Range of Price change:

Very low or very High price demand is inelastic;
Diamonds or salt but moderately priced goods
have elastic demand.
Urgent or postponement:
Durability of commodity:
Short run Inelastic , but
Perishable goods is elastic.
long
Habits and customs:

Complementary goods: Inelastic
run
elastic
Recurring Demand: Relatively

elastic
Demonstration effect:
Significance of elasticity of
Demand
Useful to Producer
and monopolist:
Useful to the govt.

Factor pricing:
Importance to trade unionist:
International Trade:
Useful to policy Makers: Prices of agricultural
goods , Fiscal and monetary policies etc.
THEORY OF PRODUCTION
The fundamental questions that managers are faced with
are
How can production optimized or cost minimize?
How does output respond to change in quantity of inputs?
How does technology matter in reducing the cost of
production?
How can the least- cost combination of inputs be achieved?
Given the technology, what happens to the rate of return
when more plants are added to the firm?
Input and output

An input is simply anything which the firm buys for
in its production or other processes.
Inputs are classified as
1) Fixed inputs: A fixed input is one whose supply is
inelastic in the short-run. In technical sense, a
fixed factor is one that remains fixed (or constant)
for a certain level of output.
2) Variable inputs: A variable input is defined as
one whose supply in the short-run is elastic, e.g.,
labour and raw material, etc. all the users of such
factors can employ a larger quantity in the shortrun as well as in the long-run.
Short-run and Long-run

Production
The short-run refers to a period of time in which the supply of
certain inputs (e.g. plant, building, machinery etc.) is fixed or

inelastic.
In the short-run therefore, production of a commodity can be

increased by increasing the use of only variable inputs like labour
and raw materials.
Variable Input: labor force, Fixed Input: machinery, plant size,
raw materials.
Long-run refers to a period of time in which the supply of all the
inputs is elastic, but not enough to permit a change in technology.
That is, in the long-run, all the inputs are variable.
Corresponds to the planning stage
Production Function
The total amount of output produced by a firm is
a function of the levels of input usage by the firm.
Relation Between Input and Output the
maximum amount of output that can be obtained
per period of time given the factor inputs is
captured by the production function.
Describes purely Technological Relationship.
Flow Concept.
Production Function
A real-life production function is generally very
complex.
Q = f(LB, L, K, M, T, t)
Where LB = land and building L= labour,
K= capital, M= raw materials, T=
technology and t= time.
The economists have however reduced the
number of input variables used in a production
function to only two, viz., capital(K) and
labour(L), for the sake of convenience and
simplicity in the analysis of input-output
relations.
Production Function
Also, technology (T) of production remains constant
over a period of time.
That is why, in most production functions, only

labour and capital are include
As such, the general form of its production function

for coal mining firm may be expressed as
Qc = f (K, L)
Where Qc = the quantity of coal produced per time
unit,
K = capital, and L = labour.
Production Function
The short-run production function or what may
also be termed as single variable input
production function, can be expressed as
Q = f (K, L) where K is a constant (1a)
For example, suppose a production function is
expressed as
Q = bL
Where b =
gives constant returns to labour.
Total, Average and Marginal

Product
Total Product: Total Output Produced
during some period of time by all
factors of Production employed during
that Period.
Total Product (TP) function In the
Short
Run
captures
relationship
between the amount of labor and the
level of output, ceteris paribus
Total Product
Variation of Output (One
fixed, one variable factor),
with Capital fixed at say 5
Units
Quantity of Total
Labour
Product
0
0
5
50
10
120
15
180
20
220
25
250
30
270
35
275
40
275
45
270
Average Product
AP is merely the Total product per
Unit of the Variable Factor
AP = TP / L
Average Product
Quantity of Total Average
Labour
Product Product
0
0
5
50
10.00
10
120
12.00
15
180
12.00
20
220
11.00
25
250
10.00
30
270
9.00
35
275
7.86
40
275
6.88
45
270
6.00
Marginal Product (MP)

The additional output that results from
the use of an additional unit of a variable
input, holding other inputs constant.
Measured as the ratio of the change in
output (TP) to the change in the quantity
of labor (or other variable input) used
MP = in Output / in Labour
Marginal Product
Quantity of Total Change Marginal
Labour
Product in TP
Product
0
0
5
50
50
10
10
120
70
14
15
180
60
12
20
220
40
8
25
250
30
6
30
270
20
4
35
275
5
1
40
275
0
0
45
270
-5
-1
Marginal Product
(Continued)
Note that the MP is positive when an
increase in labor results in an
increase in output;
A negative MP occurs when output

falls when additional labor is used.
Production Function
In the long -term production function, both K and L
are included and the function takes the following
form.
Q = f (K, L)
(1b)
Consider, for example, the Cobb-Douglas production

function-the most famous and widely used
production function given in the form of an
equation as
Q=
(1.2)
(where K= capital, L= Labour, and A , a and b, are

parameters and b =1 a).
and are the output elasticities of capital and

labor, respectively.
These values are constants determined by available
technology.
Output elasticity measures the responsiveness of
output to a change in levels of either labor or
capital used in production, ceteris paribus.
For example if = 0.45, a 1% increase in capital
usage would lead to approximately a 0.45%
increase in output.
Production Function
Production function (1.2) gives the general form
of Cobb-Douglas production function.
The numerical values of parameters A, a and b,

can be estimated by using actual factory data on
production, capital and labour.
Suppose numerical values of parameters are

estimated as A=50, a=0.5 and b=0.5.
Once numerical values are known, the CobbDouglas production function can be expressed in
its specific form as follows.
Production Function
This production function can be used
to obtain the maximum quantity (Q)
that can be produced with different
combinations of capital (K) and
Labour (L).
The maximum quantity of output that
can be produced from different
combinations of K and L can be
worked out by using the following
formula.
Production Function
For example, suppose K = 2 and L = 5. Then
And if K = 5 and L = 5, then
Similarly, by assigning different numerical

values to K and L, the resulting output can be
worked out for different combinations of K and
L and a tabular form of production function can
be prepared.
Similarly, by assigning different numerical values to K and L, the

resulting output can be worked out for different combinations of K
and L and a tabular form of production function can be prepared.
It is important to note that the four combinations of K and L

10K + 1L
5K + 5L
2K + 5L and
1K + 10L produces the same output
Production with one variable

input
The law of diminishing returns states that
when more and more units of a variable input
are used with a given quantity of fixed inputs,
The total output may initially increase or
increasing rate, but it will eventually increase at
increasing rate.
That is, marginal increase in total output
decreases eventually when additional units of a
variable factor are used, given quantity of fixed
factors.
Assumptions:
The law of diminishing returns is
based on the following assumptions:
Labor is the only variable input,
capital remaining constant;
Labour is homogeneous;
Input prices are given.
To illustrate the law

returns, we assume
of
diminishing
i) That a firm (say, the coal mining firm in

our earlier example) as a set of mining
machinery as its capital (K) fixed in the
short-run and
ii) It can employ only more mine workers to

increase its coal production.
Thus, the short run production

function for the firm will take the
following form.
Q c f(L), K constant
Let us assume also that the labour output relationship in
coal production is given by a hypothetical production
function of the following form.
Q c L3 15L2 10 L,
K constant
Given the production function, we may

substitute different numerical values of L in the
function and work out a series of Q c i.e.
The quantity of coal that is produced with

different number of workers.
For example, if L = 5, then by substitution, we

get
Qc= -53 + 15 x 52 + 10 x 5 = -125 + 375 + 50 =
300
What we need now is to work out marginal

productivity of labour (MPL) to find the trend in
the contribution of the marginal labour and
average productivity of labour (APL) to find the
average contribution of labour.
Marginal Productivity of Labour (MPL) can be
obtained by differentiating the production
function.
Thus,
(Q c L3 15L2 10 L), K constant
Q
2
MP
3
L
30 L 10
can be written as L L
Alternatively,
where
labour
can
be
increased at least by one unit (MPL) can be
obtained as
MPL = TPL - TPL-1
Average Productivity of Labour (APL)
can be obtained by dividing the production
function by L. Thus,
L3 15 L2 10 L
APL
L2 15 L 10
L
No of Workers
(N)
Total Product
(TPL) (tones)
Marginal
Product* (MPL)
Average product
(APL)
Stages of
production(based on
MPL)
1
2
3
4
5
6
24
72
138
216
300
384
24
48
66
78
84
84
24
36
46
54
60
64
I
Increasing
returns
7
8
9
10
462
528
576
600
78
66
48
24
66
66
64
60
II
Diminishing
Returns
11
12
594
552
-6
-42
54
46
III
Negative returns
SHORT-RUN THEORY OF
PRODUCTION
Long-run and short-run production:
fixed and variable factors
The law of diminishing returns

The short-run production function:
total physical product (TPP)

average physical product (APP)
marginal physical product (MPP)
the graphical relationship between TPP, APP and
MPP
Wheat production per year from a particular farm

(tonnes)
Tonnes of wheat produced per year

Number of
workers
TPP
0
0
1
3
2
10
3
24
4
36
5
40
6
42
7
42
8
40
Number of farm workers
TPP
TPP
Diminishing returns
set in here
b

d
TPP
Maximum output
Tonnes of wheat per year

TPP
TPP = 7
Number of
farm workers (L
L = 1
MPP = TPP / L = 7
Number of
farm workers (L
TPP
Number of
farm workers (L)
MPP
Number of
farm workers (L)

TPP
Number of
farm workers (L
APP = TPP / L
APP
MPP
Number of
farm workers (L

TPP
Diminishing returns
set in here
Number of
farm workers (L)
APP
MPP
Number of
farm workers (L)

d
TPP
Maximum
output
Number of
farm workers (L)
APP
d
MPP
Number of
farm workers (L)

d
Slope = TPP / L
= APP
TPP
Number of
farm workers (L)
APP
d
MPP
Number of
farm workers (L)
Iso-quants
An iso-quant is a curve or line
that has various combinations
of inputs that yield the same
amount of output.
Production function
Here we will assume output is made with the inputs capital and
labor. K = amount of capital used and L = amount of labor.
The production function is written in general as Q = F(K, L)
sometimes we put a y instead of Q, where Q = output, and F and the
parentheses are general symbols that mean output is a function of
capital and labor.
The output, Q, from the production function is the maximum output
that can be obtained form the inputs.
On the next screen we will see some isoquants.
Note: on a given curve L and K change while Q is fixed.
ISOQUANT- ISOCOST
ANALYSIS
Iso-quants
their shape
diminishing marginal rate of substitution
isoquants and returns to scale
isoquants and marginal returns
Iso-costs
slope and position of the isocost
shifts in the isocost
An isoquant
Units of capital (K)
Units
of K
40
20
10
6
4
Units
of L
5
12
20
30
50
Units of labour (L)
Point on
diagram
a
b
c
d
e
An isoquant
Units
of K
40
20
10
6
4
Units
of L
5
12
20
30
50
Units of labour (L)
Point on
diagram
a
b
c
d
e
An isoquant
Units
of K
40
20
10
6
4
Units
of L
5
12
20
30
50
Point on
diagram
a
b
c
d
e
c
d
e
Units of labour (L)
MRTS
The slope of the isoquant defines the substitutability

between two factors of inputs (capital and labor).
This is known as the marginal rate of technical

substitution (MRTS) and is presented mathematically
as:
Diminishing marginal rate of factor substitution
g
K = 2
MRS = 2
MRS = K / L
L = 1
isoquant
Units of labour (L)
Diminishing marginal rate of factor substitution
g
MRS = 2
K = 2
MRS = K / L
L = 1
j
K = 1
MRS = 1
k
L = 1
isoquant
Units of labour (L)
An isoquant map
I1
Units of labour (L)
An isoquant map
I1
Units of labour (L)
I2
An isoquant map
I1
Units of labour (L)
I2
I3
An isoquant map
I1
Units of labour (L)
I2
I3
I4
An isoquant map
I5
I1
Units of labour (L)
I2
I3
I4
A Cost Function: Two Resources

Assume that there are two resources, Labor (L)
and Capital (K).
The money payments to these resources are
Wages (W) and Rent (R).
An isocost line is similar to the budget line. Its a

set of points with the same cost, C. Lets plot K on
the y axis and L on the x axis.
WL + RK = C; solve for K by first subtracting WL from both sides.
RK = C - WL; next divide both sides by R.
K = C/R (W/R)L; note that C/R is the y intercept and W/R is the
slope.
An isocost line
K (machines rented)
C/R
Absolute value of slope equals

The relative price of Labor, W/R.
C/W Labor hours used in

production
A Numerical Example
Bundles of:
Labor
Machine rental
with C = Rs30 (Rs6 per labor hour)

hour)
(Rs3 per machine
10
Points a through f lie on the isocost line for C = Rs30/hour.
Capital, K (machines rented)
The Isocost Line

10
a
b
8
c
6
d
4
e
2
f
0
6 7 8 9 10
Labor, L (worker-hours employed)
The Isocost Line

Wage-rental ratio
With K on the y axis and L on the x axis, the
slope of any isocost line equals W/R, the wagerental ratio. It is also the relative price of labor.
The y-intercept shows the number of units

of K that could be rented for Rs.C.
The x-intercept shows the number of units
of L that could be hired for Rs.C.
Changes in One Resource

Price
10
Cost = Rs30; R = Rs3/machine

The money wage, W = ...
8
6
A Change
in W
4
Rs6
2
Rs10
0
h
2
f
4
7 8 9 10
Changes in Cost
10
A Change
in Cost; every point
between g and h costs Rs18.
8
6
4
2
W = Rs6; R = Rs3;C = Rs30
h
0
7 8 9 10
Cost
Minimization
Choose the recipe where the

desired isoquant is tangent to
the lowest isocost.
12
10
8
C = Rs36
6
4
W = Rs6; R = Rs3;C = Rs30
equ.
2
C = Rs18
7 8 9 10
Conclusion: Buy resources such

that the last dollar spent on K
adds the same amount to
output as the last dollar spent
on
L.
The |slope| of the isocost line = W/R.
The |slope| of the isoquant =
MPL/MPK
This will be demonstrated on the board.
An isocost
Assumptions
PK = Rs20 000
W = Rs10 000
TC = Rs300 000
a
TC = Rs300 000
Units of labour (L)
An isocost
Assumptions
PK = Rs20 000
W = Rs10 000
TC = Rs300 000
a
b
TC = Rs300 000
Units of labour (L)
An isocost
Assumptions
PK = Rs20 000
W = Rs10 000
TC = Rs300 000
a
b
c
TC = Rs300 000
Units of labour (L)
An isocost
Assumptions
PK = Rs20 000
W = Rs10 000
TC = Rs300 000
a
b
c
TC = Rs300 000
d
Units of labour (L)
ISOQUANT- ISOCOST
ANALYSIS
Least-cost combination of factors for
a given output
point of tangency
comparison with marginal productivity
approach
Highest output for a given cost of

production
Finding the least-cost method of production

Assumptions
PK = Rs20 000
W = Rs10 000
TC = Rs200
000
TC = Rs300 000
TC = Rs400 000
TC = Rs500 000
Units of labour (L)
TPP1
Units of labour (L)
TC = Rs400 000
TPP1
Units of labour (L)
TC = Rs500 000
TC = Rs400 000
Units of labour (L)
TPP1
Finding the maximum output for a given total cost
TPP5
TPP1
O
Units of labour (L)
TPP4
TPP3
TPP2
Isocost
TPP5
TPP1
O
Units of labour (L)
TPP4
TPP3
TPP2
TPP5
v
TPP1
O
Units of labour (L)
TPP4
TPP3
TPP2

r
TPP5
v
TPP1
O
Units of labour (L)
TPP4
TPP3
TPP2

r
TPP5
v
TPP1
O
Units of labour (L)
TPP4
TPP3
TPP2

r
K1
TPP5
v
TPP1
O
L1
Units of labour (L)
TPP4
TPP3
TPP2
Properties of Iso-Quant
An isoquant has a negative slope in the
economic region and in the economic range of
isoquant.
Economic region is also known as the product
maximizing region.
The negative slope of the isoquant
substitutability between the inputs.
implies
It means that if one of the inputs is reduced, the

other input has to be so increased that the total
output remains unaffected.
Isoquants are convex to the origin

Convexity of isoquants implies two things.
I) substitution between the two inputs, and
II) diminishing marginal rate of technical substitution
(MRTS) between the inputs in the economic region.
K
MRTS
LK
III)The MRTS is defined as,

L
the isoquant.
= slope of
IV)MRTS is the rate at which a marginal unit of labour

can substitute a marginal unit of capital (moving
downward on the isoquant) without affecting the
total output.
This rate is indicated by the slope of the isoquant.

The MRTS decreases for two reason:
i) no factor is a perfect substitute for another, and
ii)inputs are subject to diminishing marginal returns.
Therefore, more and more units of an input are
needed to replace each successive unit of the
other input.
the corresponding units of

L substituting K go (in fig.) on increasing
i.e.
K 1 K 2 K 3
L1 L2 L3
K
MRTS=
L
As a result,
decreasing i.e.,
goes on
Isoquants are non-intersecting and

non-tangential. This implies that in
terms of output.
Capital (K)
Q2 = 200
J
Q1 = 200
O
L1
L2
Fig. Intersecting Isoquants
Labour (L)
OL 2 (L) JL 2 (K) OL 2 (L) KL 2 (K)
Since OL2 is common to both the

sides, it means,
J L2 (K) = K L2 (K)
But it can be seen in fig that J L2 < K
L2(K)but the intersection of the two
isoquants means that JL2 and KL2 are
equal in terms of isoquants will not
intersect or be tangent to each other.
Upper isoquants represent

higher level
of output.
Quality of K
a
b
c
IQ2 = 200
IQ1 = 200
O
Fig. Comparison of Output at Two Isoquaqnts
Quality of L
Economic region
Economic region is that area
of production plane in which
substitution
between
two
inputs is technically feasible
without affecting the output.
Capital (K)
Upper ridge line
d
Lower ridge
line
This area is marked by

locating the points on the
isoquants at which MRTS = 0.
h
Q4
g
Q3
Q2
A zero MRTS implies that

further substitution between
inputs
is
technically
not
feasible.
It
also
determines
the
minimum quantity of an input
that
must
be
used
to
production a given output.
Q1
Labour
(L)
Beyond this point, an additional

employment of one input will
necessitates employing additional
units of the other input.
By joining the resulting

points a, b, c and d we get a
line called the upper ridge
line, Od, similarly by joining
the points e, f, f and h we
get the lower ridge line, Oh.
Capital (K)
Upper ridge line
d
Lower ridge
line
h
Q4
g
Q3
f
Q2
Labour
(L)
The ridge lines are locus of

points on the isoquants
where
the
marginal
products (MP) of the inputs
are equal to zero.
The upper ridge line implies
that MP of capital is zero
along the line, Od. The
lower ridge line implies that
MP of labour is zero along
the line, Oh.
The area between the two
ridge lines, Od, and Oh, is
called Economic Region
or
technically
efficient
region of production.
The laws of returns to

scale
The laws of returns to scale explain
the behavior of output in response to
a proportional and simultaneous
change in inputs, increasing inputs
proportionately and simultaneously
is, in fact, an expansion of the scale
of production.
Three technical possibilities

Total output may increase more than
proportionately.
Total
output
may
proportionately and
increase
Total output may increase less than

proportionately
kinds of returns to scale

Increasing returns to scale;
Constant returns to scale, and
Diminishing returns to scale.
Increasing returns to scale

When inputs, K and L are increased
at a certain proportion and output
increase
more
than
proportionately,
it
exhibits
increasing returns to scale.
The increasing returns to scale is
illustrated in fig.

The movement from point a to b
on the line OB means doubling
the inputs.
It can be seen in fig that input
combination increases from 1K +
1L to 2K + 2L.
As a result of doubling the
inputs, output is more than
doubled; it increases from 10 to
25 units e.g. an increase of
150%.
Similarly, the movement from
point b to point c indicates 50%
increase in inputs as a result of
which the output increases from
25 units to 50 units i.e. by 100%.
Capital (K)
B
4K
Product lines
c
3K
C
Q = 50
2K
1K
Q = 25
Q = 10
1L
2L
3L
4L
Fig. Increasing Returns to Scale
Labour (L)
Economies of scale
The scale of production has an very important
bearing on the cost of production.
It is the manufacturers common experience
that larger the scale of production, the lower
generally is the average cost of production.
That is why the entrepreneur is tempted to
enlarge the scale of production so that he
benefit from the resulting economies of scale.
There are two types
External Economies.
of
Internal
and
Internal Economies of Scale

These are those economies in production, those in
production costs, which accrue to the firm itself
when it expands its output or enlarges its scale of
production.
The internal economies arise within a firm as a
result of its own expansion of the industry.
The internal economies are simply due to the
increase in the scale of production.
They arise from the use of the methods which
small firms do not find it worthwhile to employ.
Three reasons for increasing

returns to scale
Technical and managerial indivisibilities:

Certain inputs, particularly mechanical equipments and
managers, used in the process of production are
available in a given size.
Such inputs cannot be divided into parts to suit small

scale of production.
Because of indivisibility of machinery and managers,

given the state of technology, they have to be
employed in a minimum quantity even if scale of
production is much less than the capacity output.
Therefore, when scale of production is expanded by

increasing all the inputs, the productivity of indivisible
factors increases exponentially because of technological
advantage. This results in increasing returns to scale.
Internal Economies
Labour Economies: Division of Labour, this will
increase the efficiency, saves time and promote skill
information.
Technical economies: Modern machinery.
Marketing Economies: Buying inputs at large qty
when it expands the output. Small firms are deprived
of these benefits.
The cost of marketing the product is also reduced
providing thereby the economies of large scale
transportation.
Per unit advertisement cost is reduced.
Higher degree of specialization (Managerial

economies)
The use of specialized labour suitable to a particular
job and of a composite machinery increases
productivity of both labour and capital per unit of
inputs.
Financial economies: The finance will be available

at competitive rate and at easy terms. Can also raise
money from the market, because of its goodwill.
Risk Bearing Economies: Can diversify the risk by

selling products in different parts of the world.
Dimensional relations
For example, when the length and breadth of
a room (15 x 10 =- 150 Sq. ft.) are doubled
then the size of the room is more than
doubled; it increases to 30 x 20 = 600 sq. ft.
In
accordance
with
this
dimensional
relationship, when the labour and capital are
doubled, the output is more than doubled
and so on.
External Economies
These are those economies which
accrue to each member firm as a
result of the expansion of the
industry as a whole.
External Economies
Availability of raw-material and machineries at lower
price: Expansion of the industry may results in the availability of
inputs like raw-material and other equipments at lower prices.
Technical external economies: Since the growth of industry
enables the firm to use the new technical know-how employing
thereby improved machinery and other inputs.
Development of Skill labour: By training and development of
the industry.
The growth of subsidiary industry:
material.
Will supply the raw-
Transport and marketing facilities:

Information Service: Will disseminate information, technical
knowledge and R and D
Constant returns to scale

When the increase in output is proportionate to the
increase in inputs it exhibits constant returns to
scale.
Capital (K)
1K 1L 10
2 K 2 L 20
3K 3L 30
4K
Product lines
c
3K
Q = 30
2K
a
1K
Q = 20
Q = 10
1L
2L
3L
4L
Fig. Constant Return to Scale
Labour (L)
Decreasing Return to Scale
When economies of scale reach their

limits and diseconomies are yet to begin,
returns to scale become constant.
For example, doubling of coal mining plant

may not double the coal deposits.
Similarly doubling the fishing fleet may not
double the fish output because availability
of fish may decrease in the ocean when
fishing is carried out on an increased scale.
Decreasing Return to Scale

Capital (K)
B
4K
c
Product lines
3K
C
2K
1K
Q = 24
Q = 18
Q = 10
1L
2L
3L
Fig. Decreasing Return to Scale Scale
4L
Labour (L)
INTERNAL DISECONOMIES
Large scale production firms faces a problem of
management and control over the production unit.
Lack of proper coordination and supervision of
different departments.
So growth of the firm beyond the limit will bring

more problems.
The increase in the scale of output beyond its

optimum size creates the managerial structure
inflexible and cumbersome which ultimately
reduces efficiency of the management
External Diseconomies
Constraints in the Supply of rawmaterial.
Demand for labour will increase due
to growth of industry.
Instabilities
product
of
demand
for
the
Economies of Scope
When
the
cost
efficiencies
in
production allow the firm to produce a
variety of products rather than a single
product in large volume, it can be
referred to the Economies of Scope.
This allows product diversification in
the same scale of plant and with the
same technology.
Returns to Scale (Summary)

When the % change in output > % change in inputs
E.g. a 30% rise in factor inputs leads to a 50% rise in output
Long run average total cost will be falling
Decreasing returns to scale

When the % change in output < % change in inputs
E.g when a 60% rise in factor inputs raises output by only 20%
Long run average total cost will be rising
Constant returns to scale

When the % change in output = % change in inputs
E.g when a 10% increase in all factor inputs leads to a 10% rise in
total output
Long run average total cost will be constant
Consumer Surplus
The concept was formulated by Dupuit in
1844 to measure the social benefits of
Public goods such as canals, bridges,
national highways etc,
Marshall further popularized the concept
The concept was based on cardinal
measurability
and
interpersonal
comparison of utility
Concept or Defination
It is simply the difference between the
price that one is willing to pay and the
price one actually pays pays for a
particular product.
It is also used in policy formulation by
government
and
price
policy
purchased by the monopolistic seller
of a product.
People generally get more utility

from the consumption of goods than
the price they actually pay for them.
This extra satisfaction which the
consumer obtains from buying a
good is called as consumer surplus.
The amount of money which a person is

willing to pay for a good indicates the
amount of utility he derives from that good.
Marginal utility of a unit of a good
determines the price a consumer will be
prepared to pay for that unit.
The total utility which a person gets from a
good is given by the sum of marginal utilities
( MU) of the units of a good purchased.
The total price the consumer actually

pays is equal to the price per unit of
the good multiplied by the number of
units of it purchased.
Consumers surplus = MU (Price *
No. of units of a commodity
purchased.)
Consumer Surplus and DMU

The concept of consumer surplus is derived from the
law of diminishing marginal utility.
As the consumer purchase more units of a good its
MU diminishes and the consumers willingness to pay
for additional units of commodity declines.
The consumer is in equilibrium when MU from a
commodity becomes equal too its price.
That is consumer purchases the number of units of
commodity at which MU equals price.
This means willingness to pay and

actually pays are equal but rest previous
units there is a consumer surplus.
But for the previous units customers
willingness to is greater than the price
he actually pays for them.
Because the price of all units are same.
Consumer Surplus
It measures extra utility or satisfaction which a
consumer obtains from the consumption of a
certain amount of a commodity over and above
the utility of its market value.
The total utility obtained from consuming water
is immense while its market value is negligible.
It is due to the occurrence of DMU that a
consumer
gets
total
utility
from
the
consumption of a commodity greater than its
market value
Marshall tried to obtain the monetary

measure of this surplus, i.e. how
many rupees this surplus of utility is
worth to consumer.
It is the monetary value of this
surplus
that
Marshall
called
Consumer surplus.
Determine Monetary value

of Surplus
Total utility of money in terms of money
that consumer expects to get from
consumption of a certain amount of
commodity.
The total market value of the amount of
commodity consumed by him.
It is easy to find out market value i.e. P*Q
Marginal Utility and Consumer

Surplus
No. Marginal Price Net Marginal
of Utility
Benefit
Unit
s
1
20
12
2
18
12
3
16
12
4
14
12
5
12
12
6
10
12
Consumer Surplus
(from 5 Units) =
8
6
4
2
0
-2
20
Consumer Surplus - Example

Price
(Rs)
The consumer surplus

of purchasing 5 units is
the sum of the
surplus derived from
each one individually.
20
18
16
14
12
10
14
Market Price
Consumer Surplus
8 + 6 + 4 + 2 + 0 + -2 = 20
13
Will not buy more than 5

because surplus from
additional units is negative
1
Price of X
Consumer Surplus
The stepladder demand curve can be converted into a
straight-line demand curve by making the units of the good
smaller.
Consumer surplus measures the total net benefit to
consumers =
total benefits from consumption (-)the total expenses.
Thus, consumer surplus is area under the demand curve and
above the price.
Note that the area under the demand curve up to the level of
consumption measures the total benefits.
Consumer Surplus
Price
(Rs.)
20
Consumer
Surplus
12
Market Price
Demand Curve
Actual
Expenditure
0
Price of X
Consumer Surplus and Market Price

A lower market price will usually increase
consumer surplus.
A higher market price will usually reduce
consumer surplus.
Consumer surplus will be smaller when the demand
curve is more elastic and larger when the demand
curve is inelastic.
How the Price Affects Consumer Surplus?

Price
Consumer Surplus at Price P2

vs. at Price P1
Initial
consumer
surplus
P1
P2
Consumer surplus
to new consumers
F
D
Additional consumer
surplus to initial
consumers
E
Demand
Q1
Q2
Quantity
Consumer Surplus
Price
Consumer Surplus
Maximum Willingness to Pay for Qo
Po
What is paid
D
Qo
Quantity
Change in Consumer Surplus: Price

Increase
Price
New Consumer Surplus
Original Consumer
Surplus
Loss in Surplus: Consumers paying more

P1
Po
Loss in Surplus: Consumers

buying less
Q1
Qo
Quantity
PRODUCER SURPLUS
The revenue that producers obtain from
a good over and above the price paid.
This is the difference between the
minimum supply price that sellers are
willing to accept and the price that they
actually receive.
A related notion from the demand side
of the market is consumer surplus.
Producers' surplus is the extra revenue

received when selling a good.
The supply price is less than the price
actually received.
Most producers under most circumstances
receive some surplus of revenue.
Even competitive markets overflowing
with efficiency generate an ample amount
of producer surplus.
Producer Surplus
The amount a seller is paid , minus the sellers cost.
It is the area above the supply curve, and below the
equilibrium price.
Producer Surplus
Price
Producer Surplus
Po
What is paid
Minimum Amount Needed to

Supply Qo
Qo
Quantity
Consumer and Producer Surplus

Price
Consumer
Surplus
Po
Producer Surplus
D
Qo
Quantity
The magic of perfectly competitive markets

At equilibrium, both consumer and producer surplus are at
their maximum
Any interference with the equilibrium price in perfectly
competitive markets will reduce total consumer and producer
surplus
Cost
By "Cost of Production" is meant the total sum

of money required for the production of a
specific quantity of output. In the word of
Gulhrie and Wallace:
"In Economics, cost of production has a special

meaning.
It is all of the payments or expenditures necessary

to obtain the factors of production of land, labor,
capital and management required to produce a
commodity.
It represents money costs which we want to incur in

order to acquire the factors of production".
Cost of Production
The following elements are included in the cost of

production:
(a) Purchase of raw machinery,

(b) Installation of plant and machinery,
(c) Wages of labor,
(d) Rent of Building,
(e) Interest on capital,
(f) Wear and tear of the machinery and building,
(g) Advertisement expenses,
(h) Insurance charges,
(i) Payment of taxes,
(j) In the cost of production, the imputed value of the factor of
production owned by the firm itself is also added,
(k) The normal profit of the entrepreneur is also included In
the cost of production.
FIXED, VARIABLE, AND

INCREMENTAL COSTS
Fixed costs: unaffected by changes in activity
level over a feasible range of operations for the
capacity or capability available.
Typical fixed costs include:
insurance and taxes on facilities
general management and administrative salaries
license fees
interest costs on borrowed capital.
Fixed costs will be affected When:

large changes in usage of resources occur
plant expansion or shutdown is involved
FIXED, VARIABLE AND

INCREMENTAL COSTS
Variable costs: associated with an
operation that vary in total with the
quantity of output or other measures of
activity level.
Example of variable costs include :
Costs of material and labor used in a
product or service.
FIXED,VARIABLE AND
INCREMENTAL COSTS
Incremental cost: additional cost that results from increasing
output of a system by one (or more) units.
Incremental cost is often associated with go / no go decisions
that involve a limited change in output or activity level.
A very simple example of incremental cost would be a factory producing

widgets where it takes one employee an hour to produce one widget.
the incremental cost of a widget would include the wages for an hour in
addition to the cost of materials used in production of a widget.
A more exact figure could comprise added costs, like electricity consumed if
the factory had to stay open for a longer duration, or the cost for shipping the
additional widget to a consumer.
SUNK COST AND

OPPORTUNITY COST
A sunk cost is one that has occurred in the past and has no
relevance to estimates of future costs and revenues related to
an alternative course of action;
Example : Product Research
Companies spend money each year for research and
development as they work to come up with new products and
services.
While the nature of research varies from business to business,
It's recognized as a sunk cost, since once the money is spent
on conducting a focus group or administering a survey, it's
gone.
Opportunity cost
An opportunity cost is the cost of
the best rejected ( i.e., foregone )
opportunity and is hidden or implied;
What is opportunity
cost?
Andy had $65.00
to spend at the
toy store. The
basketball net
cost $50.00, so
he had to buy
that instead of
the skateboard,
which cost
$75.00.
Sara had enough

money for either
the rabbit or the
bike. She decided
to buy the bike
because then she
could ride bikes
with her friends
after school.
Opportuni
ty Costs
Purchase
s
Opportunity cost
is the process of
choosing one good
or service over
another. The item
that you dont pick is
the opportunity
cost. The rabbit is
Saras opportunity
cost and the
skateboard is Andys
opportunity cost.
Social Cost
Building a new railway
$100
million
Creating pollution nearby (e.g.
cutting trees, noises)
$5
million
Social cost of building highway
= private cost + external cost
= $105 million
Historical Costs and

Replacement Costs.
Historical cost or original costs of an asset refers to the original
price paid by the management to purchase it in the past.
Whereas replacement costs refers to the cost that a firm incurs to
replace or acquire the same asset now.
The distinction between the historical cost and the replacement

cost result from the changes of prices over time.
In conventional financial accounts, the value of an asset is shown

at their historical costs but in decision-making the firm needs to
adjust them to reflect price level changes.
Example: If a firm acquires a machine for $20,000 in the year 1990 and the
same machine costs $40,000 now. The amount $20,000 is the historical cost
and the amount $40,000 is the replacement cost.
Money Cost
Money Cost of production is the actual monetary
expenditure made by company in the production
process.
Money cost thus includes all the business
expenses which involve outlay of money to
support business operations.
For example the monetary expenditure on

purchase of raw material, payment of wages and
salaries, payment of rent and other charges of
business etc can be termed as Money Cost.
Real Cost
Real Cost of production or business operation on
the other hand includes all such expenses/costs of
business which may or may not involve actual
monetary expenditure.
For example if owner of a business venture uses
his personal land and building for running the
business venture and
He/she does not charge any rent for the same
then such head will not be considered/included
while computing the Money Cost but this head will
be part of Real Cost computation.
Accounting Cost
Accounting Cost includes all such business expenses
that are recorded in the book of accounts of a business
firm as acceptable business expenses.
Such expenses include expenses like Cost of Raw

Material, Wages and Salaries, Various Direct and Indirect
business Overheads, Depreciation, Taxes etc.
When such business expenses or accounting expenses are

deducted from the Sales income of any firm the
accounting profit is obtained.
Such Accounting/Business expenses or costs are also

termed as Explicit Costs.
Accounting
Cost:
business expenses.
Various
allowed
Such as Cost of Raw Material, Salaries

and Wages, Electricity Bill, Telephone
Charges,
Various
Administrative
Expenses,
Selling
and
Distribution
Expenses,
Production
Overhead
Expenses,
Other
Indirect
Overhead
Expenses etc.
Accounting Profit
Accounting Cost
Sales
Income
Economic Cost
Economic Cost on the other hand includes all
the accounting expenses as well as the
Opportunity cost of a business firm.
Economic Cost and Economic Profit is thus
calculated as follows:
Economic Cost = Accounting Cost (Explicit
Costs) + Opportunity Cost.
Economic Profit = Total Revenues
(Accounting Cost + Opportunity Cost)
Private Cost and Social Cost

The actual expenses of individuals/ firms which are
borne or paid out by the individual or a firm can be
termed as Private Cost.
Thus for a business firm this may include expenses
like Cost of Raw Material, Salaries and Wages, Rent,
Various Overhead Expenses etc.
On the other hand Private Cost for an individual will

be his or her private expenses such as expense on
food, rent of house, expenses on clothing,
expenses on travel, expenses on entertainment
etc.
Social Cost
Social Cost on the other hand includes Private Cost
and also such costs which are not borne by the firm
but by the society at large.
Such Cost (that is cost not borne or paid out by the

firm) is also known as External Cost.
Another example of external cost can be the cost of

providing the basic infrastructure facilities like good
roads, sewage system or network, street lights etc.
Cost Concepts
I. Total Costs (TC)
whatever total cost is for any level of output
sum of all costs
Two Sub-Components:
(A)Total Fixed Costs TFC (Overhead
Costs)
do not vary with
output
come from fixed inputs
(B) Total Variable Costs TVC
vary with
output
Note:
variable inputs
TC = TFC + TVC
come from
Understanding Fixed, Variable,

Total cost
Numbe
r of
Units
Produc
ed
Fixe
d
Cos
t
Variabl
e Cost
Total
Cost
10
15
10
10
20
10
17
27
10
30
40
10
45
55
Cost Concepts
Graph of Total Cost Concepts
Cost(
Rs)
TC
TVC
(TFC)
TFC
Output (or
TP or Q)

d
Slope = TPP / L
= APP
TPP
Number of
farm workers (L)
APP
d
MPP
Number of
farm workers (L)
Cost Concepts
II. Average Total Costs (ATC)
Total Cost Per Unit of Output
TC
ATC
Q
Two
Average
Costs!!
Two Sub-Components:
(A) Average Fixed

Cost:
TFC
AFC
Q
(B) Average Variable AVC

Cost:
Note:
ATC = AFC + AVC
TVC
Q
Cost Concepts
III. Marginal Costs (MC) : Increase in Total Cost
that
results from an
increase in output
TC
MC
Q
The Short Run Cost Function

Add ATC = AFC + AVC to the
table

ATC = AFC + AVC
Cost Concepts
Graph of Average & Marginal Cost Concepts
Cost(
Rs)
MC
ATC
AVC
AFC
Q1 Q2
Output
Cost Concepts
Summary of Relationship Between Marginal Cost &
Average Cost
(1) When marginal is below average average
is falling.
(2) When marginal is above average average
is rising.
(3) When marginal is equal average average
is at its lowest
Note : There is a certain correspondence
point.
between product
concepts and cost
concepts.
When AVC is at its minimum, AP will be at its
maximum.
When MC is at a minimum, MP will be at its
maximum.
(See diagram in book.)
285

Production cost graph or map is

Important Map Observations
AFC declines steadily over the range
of production. Why?
In general, ATC is u-shaped. Why?
MC intersects the minimum point (q*)
on ATC. Why?

A change in input
prices will shift
the cost curves.
If fixed input costs
are reduced then
ATC
will
shift
downward.
AVC
and MC will remain
unaffected.
Computer Chip Case

A change in input
prices will shift
the cost curves.
If variable input
costs are reduced
then MC, AVC,
and AC will all
shift downward.
Airline Industry Case
Long-Run Average Cost Curve

(No distinction between fixed and variable in
Long-Run)
Plots the relationship between
the lowest attainable Average
Cost and output when both capital (or plant size) and labor
can be varied.
Total Costs
per
Unit(Rs)
LRAC
Attaina
ble
Costs
(LRAC)
C1
C2
Unattaina
ble Costs
Q1
Q2
Q
(Output)
Relationship Between SATC & LRAC

Short-Run & Long-Run
Costs
SATC 3
LMC
SATC 2
SATC 1
SMC 1
Average
Costs per
Unit (Rs)
LRAC
0
Q
(Output)
Relationship Between SATC & LRAC

Short-Run & Long-Run
Costs
Average
Costs per
Unit (Rs)
LRAC
Xmi
n
X = minimum point
Q
(Output)
Long-Run Average Cost Curve

Slope of LRAC
LRAC
Costs per
Unit
Qm
Q
(Outpu
t)
Qm Rightward: Diseconomies
of
0 to Qm: Economies of
Scale
Scale
* Qm is the most efficient point doubly efficient:
(1) It represents the lowest possible costs for its production
level (like all
points on LRAC curve).
(2) It is the output level that has absolutely lowest costs of
all output levels.
Other Possible Shapes for LRAC

Constant Returns to Scale
: LRAC curve is horizontal
Doubling Input spending
always leads to a
doubling of output.
Average
Cost per
Unit (Rs)
LRAC
0
OR
Average
Cost per
Unit (Rs)
Q
(Outpu
t)
LRAC
Q
(Outpu
Other Possible Shapes for LRAC

Continually Decreasing
Costs
Average
Cost per
Unit (Rs)
Decreasing
Cost!!!
LRAC
0
Q
(Outpu
t)
Minimum Efficient Scale
Definition :
The smallest quantity of output at
which long-run average cost reaches
its lowest level.
A Perfectly Competitive Market

A perfectly competitive market is a market in
which economic forces operate unimpeded
For a market to be perfectly competitive, six

conditions must be met:
1. Both buyers and sellers are price takers
a price taker is a firm or individual who
takes the price determined by market supply
and demand as given
2. The number of firms is large any one
firms output compared to the market output
is imperceptible and what one firm does has
no influence on other firms
A Perfectly Competitive Market

3. There are no barriers to entry barriers to
entry
are social, political, or economic
impediments that prevent firms from entering a
market.
3. Firms
products
are
identical
this
requirement means that each firms output is
indistinguishable from any other firms output
4. There is complete information all consumers
know all about the market such as prices,
products, and available technology
5. Selling
firms
are
profit-maximizing
entrepreneurial firms firms must seek
Total Revenue of a Competitive Firm

Total revenue for a firm is the selling
price times the quantity sold.
TR = P Q
Average Revenue of a Competitive

Firm
T o ta l re v e n u e
A v e ra g e R e v e n u e =
Q u a n tity
P ric e Q u a n tity
Q u a n tity
P ric e
Average revenue is the revenue per unit sold
P = AR.
This is simply because all units sold are sold at the
same price.
Marginal Revenue of a Competitive

Firm
Marginal Revenue is the increase
() in total revenue when an
additional unit is sold.
MR = TR / Q
Revenue of a Perfectly Competitive Firm

Total Revenue: The amount of money received when the
firm sells the product, i.e.,
Total Revenue = Price of the product Quantity of the product sold
TR = P Q
Since the firm is a price taker under perfect competition, it

sells each additional unit of the product for the same price.
Average Revenue = Total Revenue/Quantity sold
AR = TR/Q = P
Marginal Revenue = Additional revenue earned from

selling an additional unit of the product.
MR = TR/Q = P
Thus, for a competitive firm AR = P = MR
Total Revenue: PQ
TP = Q
TR
AR
MR
10
30
25
75
50
150
70
210
85
255
95
285
100
300
101
303
95
285
85
255
The Revenue of a Competitive Firm

In perfect competition, marginal
revenue equals price: P = MR.
We saw earlier that P = AR
Therefore, for all firms in perfect
competition, P = AR = MR
9.4 Profit Maximization (SR):

TR and TC approach
What Is Perfect
Competition?
Figure illustrates a firms revenue concepts.
Part (a) shows that market demand and market supply
determine the market price that the firm must take.
What Is Perfect
Competition?
A perfectly competitive firms goal is to
make maximum economic profit, given
the constraints it faces.
So the firm must decide:
1. How to produce at minimum cost
2. What quantity to produce
3. Whether to enter or exit a market
We start by looking at the firms output
decision.
Profit Maximization by the Competitive Firm:

Approach I: Total Profit = TR TC
TP = Q
TR
TC
Profit
80
-80
10
30
105
-75
25
75
130
-55
50
150
155
-5
70
210
180
30
85
255
205
50
95
285
235
50
100
300
255
45
101
303
280
23
95
285
305
-20
10
85
255
330
-75
On the Diagram, the profit maximizing level of output is the

level where the vertical difference between the TR and TC is
the largest.
The Firms Output Decision

Profit-Maximizing Output
A perfectly competitive firm chooses the
output that maximizes its economic profit.
One way to find the profit-maximizing
output is to look at the firms the total
revenue and total cost curves.
Figure on the next slide looks at these
curves along with the firms total profit
curve.

Part (a) shows the total
revenue, TR, curve.
Part (a) also shows the

total cost curve, TC,
which is like the one in
previous Slides.
Total revenue minus
total cost is economic
profit (or loss), shown
by the curve EP in part
(b).
The Firms Output

Decision
At low output levels,
the firm incurs an
economic lossit cant
cover its fixed costs.
At intermediate output
levels, the firm makes
an economic profit.
The Firms Output

Decision
At high output
levels, the firm again
incurs an economic
lossnow the firm
faces steeply rising
costs because of
diminishing returns.
The firm maximizes its

economic profit when
it produces 9 sweaters
a day.
Profit Maximization by the Competitive

Firm:
Approach I: Total Profit = TR TC
Max Profit
Max Output

Approach II: MR = MC
Most managers do not make decisions looking at TR and TC.
Most decisions are made at the margin.
The output level that will maximize profit is determined by
comparing the amount that each additional unit of output adds
to TR and TC.
Recall, Marginal Cost (MC) represents additional cost from
producing an additional unit of output; and Marginal Revenue
(MR) represents addition to TR from selling (producing) an
additional (one more) unit of output, which is equal to the
price of that output.
Thus, MC and MR can be used to determine profit maximizing
level of output.

Approach II: MR = MC
TR
MR
TC
MC Profit
10
30
105
2.50
-75
25
75
130
1.67
-55
50
150
155
1.00
-5
70
210
180
1.25
30
85
255
205
1.67
50
95
285
235
3.00
55
100
300
255
5.00
45
101
303
280
25.0
23
95
285
305
-4.17
-20
10
85
255
330
-2.50
-75
80
-80
The firm will continue to expand production until MR is equal to MC, i.e., profit
is maximized when MR = MC.
With P being Rs 3/unit, profits are maximized by producing 95 units of output.
The Firms Output

Decision
Marginal Analysis and Supply Decision
The firm can use marginal analysis to
determine the profit-maximizing output.
Because marginal revenue is constant and
marginal cost eventually increases as output
increases, profit is maximized by producing
the output at which marginal revenue, MR,
equals marginal cost, MC.
Figure on the next slide shows the marginal
analysis that determines the profit-maximizing
output.
The Firms Output

Decision
At high output
levels, the firm again
incurs an economic
lossnow the firm
faces steeply rising
costs because of
diminishing returns.
The firm maximizes its

economic profit when
it produces 9 sweaters
a day.

If MR > MC, economic
profit increases if
output increases.
If MR < MC, economic

profit decreases if
output increases.
If MR = MC, economic
profit decreases if
output changes in
either direction, so
economic profit is
maximized.
Determining Profits Graphically: A Firm with Profit

P
Find output where

MC = MR, this is the
profit maximizing Q
MC
MC = MR
ATC
P=D=
AVCMR
Profits
ATC
ATC at Qprofit max
Qprofit
max
Find profit per unit

where the profit max
Q intersects ATC
Since P>ATC at the
profit maximizing
quantity,
this firm is earning
profits
Determining Profits Graphically:

A Firm with Zero Profit or Losses
P
Find output where

profit maximizing Q
MC
ATC

Q intersects ATC
Since P=ATC at the
profit maximizing
quantity,
zero profit or loss
MC = MR
AVC
P
=AT
C
P=D=
MR
ATC at Qprofit max
Qprofit
max
Determining Profits Graphically: A Firm with Losses

P
Find output where

profit maximizing Q
MC
ATC at Qprofit max
ATC
P
ATC
AVC
P=D=
MR
Losse
s
MC = MR
Qprofit
max

Q intersects ATC
Since P<ATC at the
profit maximizing
quantity,
losses
Determining Profits Graphically:

The Shutdown Decision
P
The shutdown point is
the point below which
the firm will be better
off if it shuts down than
it will if it stays in
business
If P>min of AVC, then
the firm will still
produce, but earn a
PShut
loss
down
If P<min of AVC, the
firm will shut down
If a firm shuts down, it
still has to pay its fixed
costs
MC
ATC
AVC
P=D=
MR
Qprofit
max
Short-Run Market Supply and

Demand
While the firms demand curve is perfectly
elastic, the industrys demand curve is
downward sloping
The market (industry) supply curve is the horizontal
sum of all the firms marginal cost curves
The market supply curve takes into
account any changes in input prices that
might occur
Short-Run Market Supply and Demand Graph

P
Market
Firm
MC
Market
Supply
ATC
P
ATC
Market
Deman
d
P=D=
MR
Profits
Qprofit
max
Long-Run Competitive Equilibrium

At long run equilibrium, economic profits are zero
Profits create incentives for new firms to

enter, market supply will increase, and the
price will fall until zero profits are made
The existence of losses will cause firms to
leave the industry, market supply will
decrease, and the price will increase until
losses are zero

Zero profit does not mean that the
entrepreneur does not get anything for his
efforts
Normal profit is the amount the owners would
have received in their next best alternative
Economic profits are profits above normal profits

Graph
P
At long-run
equilibrium, economic
profits are zero
MC
LRAT
CSRAT
C
P = D = MR
Market Response to an Increase in Demand Graph

P
Market
Firm
MC
S0(SR)
P1
P0
2
1
S1(SR)
2
1
1
Q0 Q 1 Q 2
S(LR)
D1
D0
ATC
P1
P0
SR Profits
1
2
Q0,2Q1
Long-Run Market Supply

If the long-run industry supply curve is
perfectly elastic, the market is a constant-cost
industry
If the long-run industry supply curve is upward
sloping, the market is an increasing-cost industry
If the long-run industry supply curve is
downward sloping, the market is a
decreasing-cost industry
In the short run, the price does more of the
adjusting, and in the long run, more of the
adjustment is done by quantity
Monopoly
Only one seller of a particular
product
Characteristics of Monopoly
Single Producer
No close substitute
Inelastic demand curve
Price Maker
Barriers to entry
Legal restrictions or barriers to entry of
other firms
Control over key raw material
Examples: Public utilities telephones
and electricity etc.
Total Revenue
Price
6
5
4
3
2
1
0
Quantity
0
1
2
3
4
5
6
Total Revenue
0
5
8
9
8
5
0
Can you work out the demand, total revenue and marginal
revenue functions from this information?
Demand and Total Revenue

TR
Graph A
9
0
Price 6
TR
3
D
Graph B
AR = D
3
Marginal Revenue
TR
C
A
Graph A
TR
0
P,MR
Graph B
C
0
X
Q1
Q2
MR
AR = D
Q
Profit Maximizing Output Decision

under Monopoly in the Short-run
The Total Curves Approach
Profit maximization output decision
rule for a monopolist depends
on two considerations.
$
TR
TC
One, whether there is any

output level at which TR
exceeds the TVC. If not, the
profit maximizing strategy is to
shut down.
If there are output levels at

which TR > TVC, the
monopolist will produce where
the vertical distance between
TR and TC is at its maximum.
TVC
Profit Maximizing Output Decision

under Monopoly in the Short-run
The Total Curves Approach
In this case, the vertical

distance between TR and TC
is at maximum at the Q* level
of output.
Note that at Q* units of

output, TR and TC curves
have the same slope, i.e.,
MR = MC. (This is called
the Necessary Condition of
profit maximization)
Further, the slope of MC

exceeds that of the MR (MC
has a positive slope and MR
has a negative slope). (This
is called the Sufficient
Condition of profit
maximization)
$
TR
TC
TVC
Q*
Output and Price Determination

Steps for Graphically Determining the Profit-Maximizing Output, ProfitMaximizing Price, and Economic Profits (if Any) in Pure Monopoly
Step 1
Determine the profit-maximizing output by finding where

MR=MC.
Step 2
Determine the profit-maximizing price by extending a vertical

line upward from the output determined in step 1 to the pure
monopolists demand curve.
Step 3
Determine the pure monopolists economic profit by using

one of two methods:
Method 1. Find profit per unit by subtracting the average total
cost of the profit-maximizing output from the profitmaximizing price. Then multiply the difference by the profitmaximizing output to determine economic profit (if any).
Method 2. Find total cost by multiplying the average total cost
of the profit-maximizing output by that output. Find total
revenue by multiplying the profit-maximizing output by the
profit-maximizing price. Then subtract total cost from total
revenue to determine the economic profit (if any).
LO2
10-337
Finding Pm and Qm
Price
MC
Pm
Cost data will determine

a monopolists profit.
MC = MR
Market Demand
Qm
MR
Quantity of output
Price, Costs, and Revenue
Output and Price Determination

$200
175
Pm=$122
MC
150
125
100
75
Economic
Profit
ATC
D
A=$94
MR=MC
50
25
0
LO2
MR
1
5 6 7
Quantity
10
10-339
Misconceptions of Monopoly
Pricing
Not highest price

Total profit
Possibility of losses
LO2
10-340
Misconceptions of Monopoly
Pricing
MC
A
Pm
ATC
Loss
AVC
V
D
MR=MC
MR
0
LO2
Qm
10-341
Price Discrimination
It refers to discrimination of price for
different consumers on the basis of their
income or purchasing power,
geographical location, age, sex, colour,
marital status, quantity purchased, time
of purchase etc. for eg: Physicians and hospitals
Merchandise sellers
Railways and Airlines
Cinema shows or musical concerts
Domestic and foreign markets
Necessary conditions
Different Markets must be separable for
a seller
The Elasticity of demand must be
different in different markets
There must be imperfect competition in
the market
Profit maximizing output should be
larger than the quantity demanded in a

single market or section of consumers
First Degree of Price

Discrimination
Costs / Revenue
Output / Sales
Second Degree of Price

Discrimination
Costs / Revenue
S
P1
P2
P3
P
Q1
Q2
Q3
Output / Sales
Third Degree of Price

Discrimination
Costs / Revenue
Market B
Market A
Total Market
MC
PB
PA
AR=D
ARA
MRB
MRA
0
QA
Output / Sales
ARB
QB
Output / Sales
MR
0
Output / Sales
Four Market Models

Characteristics of the Four Basic Market Models
Characteristi
c
Number of
firms
Pure
Competitio
n
Oligopoly
Monopoly
Many
Few
One
Type of product Standardized
Differentiated
Standardized or
differentiated
Unique; no
close subs.
Control over
price
None
Some, but within

rather narrow limits
Limited by
mutual interdependence;
considerable
with collusion
Considerabl
e
Conditions of
entry
Very easy, no Relatively easy

obstacles
Significant
obstacles
Blocked
Nonprice
competition
None
Considerable
emphasis on
advertising, brand
names, trademarks
Typically a great
deal,
particularly with
product
differentiation
Mostly
public
relation
advertising
Examples
Agriculture
Retail trade, dresses,
Steel, auto, farm Local
LO1
A very large
number
Monopolistic
Competition
DEMAND FORECASTING
Demand forecasting means estimation of the
demand for the good in the forecast period.
It is a process of estimating a future event by
casting forward past data.
The past data are systematically combined in
a predetermined way to obtain the estimate
of future demand.
Why demand forecasting?
Planning and scheduling production

Acquiring inputs
Making provision for finances
Formulating pricing strategy
Planning advertisement
Criteria for selecting a good

forecasting method
1. Accuracy: Different methods of forecasting yield
accurate results under different circumstances. An
appropriate choice of method will ensure more accurate
results.
2. Reliability: A time tested method increases the
reliability of that method. If a particular method was
used to give reliable result in the past then the same
method can be reused for forecasting future.
3.
Economical: Although complete enumeration

method of forecasting demand would perhaps yield
more accurate result yet it would be a very expensive
method.
The team conducting forecast cannot afford to discuss the
economic aspect of forecasting and therefore should
select the least expensive of the methods which would
give some reliable forecasts.
Criteria for selecting a good

forecasting method
4. Data availability: Forecasting is made on the basis of
the availability of primary or secondary data and therefore
the required data should be easily available preferably in the
required form.
5. Flexibility: As the managerial economist is faced with a
number of uncontrollable variables, flexibility in using would
be a necessary condition for a good forecast.
6. Durability: The forecast that are made should be valid
in the long run because there is a certain time lag in
conducting the forecasts and the period when the product is
likely to enter the market.
7.
Simplicity: Depending upon the objective the

researcher should apply a simple and straightforward
method of forecasting
Consumer Surveys:
It involves gathering of information about
consumer behavior from a sample of
consumers which is analyzed and then
further projected onto the population.
Surveys are conducted to assess consumers
perception of various aspects, such as new
variations in products, variations in prices of
the product and related products, new
variations in services provided etc.
The drawback of this method is that the
consumer has to respond to hypothetical
situations.
Complete Enumeration
Method
Complete Enumeration Survey covers all the
consumers. It resembles the Census Data
Collection which considers the entire
population.
In this case all the consumers are covered and
information is obtained from all regarding the
prospective demand for the product under
consideration.
In this method the consumer is asked about the
future plan of purchasing product in question.
For Example if majority of households

in a city report the quantity (q) and
they are willing to purchase a
commodity then the total probable
demand (DP) may be calculated as
Advantages
(a)Quite accurate as it surveys all the
consumers of a product
(b)It is simple to use
(c)It is not affected by personal bias
(d)It is based on collected data
Disadvantages
(a)It is costly
(b)It is time consuming
(c)It is difficult and practically
impossible to survey all the
consumers
(d)Useful only for products with limited
consumers
Sample Survey:
In case of the sample survey
method, few consumers are selected
to represent the entire population of the
consumers of the commodity consumed.
The total demand for the product in the
market is then projected on the basis of
the opinion collected from the sample.
The most important advantage of this
method is that it is less expensive and
less tedious compared to the method of
complete enumeration.
On the basis of information collected the probable

demand is estimated through the following formula
D = Probable demand Forecast

H = census number of households from the
relevant market
= number of household reporting demand for

the product
= number of household surveyed.
= Average expected consumption by the

reporting household ( = total qty reported to be
consumed by the reporting household / no. of
households)
Sample Survey Method

Instead of surveying all the
consumers of a commodity, only a
few consumers are selected and their
views on the probable demand are
collected
Populatio
n
Sampl
e
Advantages
(a)It is simple and does not cost much
(b)Since only a few consumers are to
be approached, the methods works
quickly
(c)The risk of handling a large number
of data is reduced
(d)It gives excellent results, if used
carefully
Disadvantages
(a)The conclusions are based on the
view of only a few consumers and
not all of them
(b)The sample may not be a true
representation of the entire
population
End Use Method

A given product may have different end uses.
For example: milk may have different end uses
such as milk powder, chocolates, sweet -meats like
barfi etc.
Therefore the end users of milk are identified.
A survey is planned of the end users and the
estimated demands from all segments of end users
are added.
This method of demand forecasting is easy to
manage if the number of end-users is limited.
In this method the investigator expects the endusers to provide correct information well in advance
of their respective production schedules.
Advantages:
(a)The method yields accurate predictions
(b)It provides sector wise demand forecast
for different industries
Disadvantages:
(a)It requires complex and diverse
calculation
(b)It is costlier as compared to other survey
methods and is more time consuming
(c)Industry data may not be readily available
Opinion Poll Method

It aims at collecting opinions of those
who are supposed to possess knowledge
of the market, e.g sales representative,
sales executives, professional marketing
experts and consultants,
The opinion poll methods include:
Expert opinion method
Delphi method
Market studies and experiments
Expert Opinion
The expert opinion method, also known as
EXPERT CONSENSUS METHOD, is being widely
used for demand forecasting.
This method utilizes the findings of market
research and the opinions of management
executives, consultants, and trade association
officials, trade journal editors and sector analysts.
When done by
An expert, qualitative techniques provide
reasonably good forecasts for a short term
because of the experts familiarity with the
issues and the problems involved.
Expert Opinion
Salesmen are required to estimate expected sales in their territories.
Salesmen being the closest to the customers, have most intimate feel
of the market.
The estimates of individual salesmen are consolidated to find out
the total estimated sales.
These estimates are reviewed to eliminate the bias of optimism or
pessimism.
Thereafter they are further revised in the light of factors proposed
change in prices, product design, advertising budget, expected
change in competition, changes in purchasing power, income
distribution, employment, population etc.
The final forecast will emerge after all these factors are taken into
account.
The method is known as collective opinion as it takes advantage of
the collective wisdom of salesmen, departmental heads like
production manager, sales manager, marketing manager, managerial
economist and top executives, as well as dealers and distributors.
Advantages:
1. The method is simple and does not involve the use of
statistical techniques.
2. The forecasts are based on first-hand knowledge of salesmen
and others directly connected with sales.
3. The method is useful in predicting sales of new products.
Here, salesmen will have to depend more on their judgement
than in the case of existing products.
Disadvantages:
1. It is subjective. Salesmen may underestimate the forecast if it
is to be used to decide their quotas.
2. This method can only be used for short-term forecasting.
3. Focus of salesmen is centered round the present trend, and they
dont think about the future. They may even lack the breadth
of vision for looking into the future.
Delphi Method
This is a variant of the opinion poll or survey
method.
In Delphi Method, an attempt is made to arrive at a
consensus of opinion.
The participants are supplied with responses to
previous questions from others in the group by a
leader.
The leader provides each expert with opportunity to
react to the information given by others, including
reasons advanced, without disclosing the source.
The Delphi method is primarily used to
forecast the demand for NEW
PRODUCTS.
Advantages & Disadvantages of Delphi

Method:
Delphi method has some exclusive advantages:

a) It facilitates anonymity of the respondents identity. This enables
respondents to be frank and forthright in giving their views.
b) It facilitates posing the problem to the experts at one time and have their
response nearly as good as pooling the panelists together. In one case
620 experts from different background such as policy-makers,
technologists, scientists, economists, administrators and advisers were
consulted.
However, Delphi method presumes these two conditions: 1) panelists must be
rich in their expertise, having wide knowledge of the subject and are
sincere and earnest in their disposition towards the participants.
2) The conductors are objective in their job, possess skill to conceptualize the
problems for discussion to generate considerable thinking, stimulate
dialogue among panelists and make inferential analysis of the numerous
views of the participants.
Experimental Approaches
Customer Surveys are sometimes conducted
over the telephone or on street corners, at
shopping malls, and so forth.
The new product is displayed or described, and
potential customers are asked whether they would
be interested in purchasing the item.
While this approach can help to isolate attractive
or unattractive product features, experience has
shown that "intent to purchase" as measured in
this way is difficult to translate into a meaningful
demand forecast. This falls short of being a true
demand experiment.
Consumer Panels
Consumer Panels are also used in the early
phases of product development.
Here a small group of potential customers are
brought together in a room where they can use the
product and discuss it among themselves.
Panel members are often paid a nominal amount
for their participation.
Like surveys, these procedures are more useful
for analyzing product attributes than for estimating
demand, and they do not constitute true demand
experiments because no purchases take place
Market Experiment
Market Experiment can help to

overcome the survey problems as
they generate data before
introducing a product or
implementing a policy.
Market Experiments are two types:1) Test marketing:2) Controlled experiments:-
Test marketing
In this case, a test area is selected, which should be a
representative of the whole market in which the new product is
to be launched.
A test area may include several cities and towns,
particular
region of a country or even a sample of consumers.
or a
More than one test area can be selected if the firm wants
to
assess the effects on demand due to various alternative
marketing mix.
Advertising or packaging can be done in various market

areas.
Then the demand for the product can be compared at different
levels of price and advertising expenditure.
In this way, consumers response to change in price or

advertising can be judged.
Test Marketing
Test Marketing is often employed after new product
development but prior to a full-scale national launch of
a new brand or product.
The idea is to choose a relatively small, reasonably
isolated, yet somehow demographically "typical"
market area.
The total marketing plan for the item, including
advertising, promotions, and distribution tactics, is
"rolled out" and implemented in the test market, and
measurements of product awareness, market
penetration, and market share are made.
DRAWBACKS OF THE MARKET

EXPERIMENT
1)
2)
3)
The test experiments are that they are very

costly and much time consuming.
If in a test market prices are raised, consumer
may switch to the competitors products.
It may be difficult to regain lost customers
even if the price is reduced to the previous
level. Moreover, it is often difficult to select an
area, which accurately represents the
potential market.
Controlled experiments
Controlled experiments are conducted to the test
demand for a new product launched or to test
the demands for various brands of a product.
They are selected consumers.
DRAWBACKS OF THE CONTROLLED EXPERIMENTS
1) The consumers may be biased in the process of

selection of a sample of consumers on which
experiments is to be performed.
2)The selected consumers may not respond
accurately If they come to know that they are a
part of an experiment being conducted and their
behavior is being recorded.
Statistical Method
Statistical method is used for long run

forecasting.
Statistical & mathematical techniques are
used to forecast demand.
Statistical methods has been used to
explain time-series & cross-section data
for estimating long-term demand.
Statistical methods are considered to be
superior
techniques
of
demand
estimation.
The important statistical methods are
1. Trend Projection method/time series
2. Barometric methods
3. Econometric method
1. Trend project method
Trend project method are also called as time

series method therefore, it is also known as
time series analysis.
The data relating to sales over a period of time
is known as time series data (10 20 yrs).
On the basis of the past trend in demand,
forecasting the future demand trend is
possible.
Trend project method classified into 3 types
1. Graphical method
2. Fitting trend equation/least square method &
3. Box Jenkins method
1. Graphical Method
Annual data on sales are plotted on a graph paper

& a line is drawn through the plotted points.
This method is very simple & less expensive.
2. Fitting Trend Equation
A trend line (curve) is fitting to the time-series

sales data with the aid of statistical techniques.
3. Box Jenkins Method
This method of forecasting is used only for shortterm predictions.

This method is suitable for forecasting demand
with only stationary time series sales data.
Stationary time-series is one which does not
reveal a log term trend.
Graphical method:
The past data will be plotted on a graph
The identified trend will be extended
further in the same pattern to ascertain
the demand in the forecast period
In the figure trend 1 is linear, trend 2 is
non-linear
Demand
Trend 2
2. Barometric Method
Barometric method is an improvement
over trend projection method.
Under barometric method, present events
are used to predict the directions of
change in future.
This method done with the help of
economic & statistical indicators.
This method is also known as Economic
Indicators Methods. Under barometric
method, present events are used to
predict the directions of change in future.
Barometric Technique
The Bhuj earthquake in January 2001, lead
to a massive destruction of property &
buildings in Gujrat.
This necessitated construction of buildings
to rehabilitate the people of affected areas.
The construction was followed by a spurt in
the demand for cement, fans, tube lights,
etc.
Thus, construction of buildings leads to the
demand for cement.
Here, construction of buildings is the
leading indicator or the barometer
TREND PROJECTION
METHOD
Based on analysis of past sales
patterns
Shows effective demand for the
product for a specified time period
The trend can be estimated by using
the Least Square Method
A producer of soaps decides to

forecast the next years sales of his
product.
The data for the lastSALES
five IN
years
is as
YEARS
Rs.LAKHS
follows:
1996
45
1997
52
1998
48
1999
55
2000
60
The data is plotted on a

graph:
The equation for the straight line trend

is
Y = a + bx
a-intercept
b-shows impact of independent variable
The Y intercept and the slope of the line
are found by making substitutions in
the following normal equations:
Y = na + b x
XY = a x + b x2
YEARS
SALES Rs.
LAKHS (Y)
X2
XY
1996
45
45
1997
52
104
1998
48
144
1999
55
16
220
2000
60
25
300
N=5
Y=260
X=15
X2=55
XY=813
Substituting the above values in the normal

equations:
260=5a +15b (Eq.3)
813=15a + 55b (Eq.4)
solving the two equations,
a = 42.1 , b = 3.3
Therefore, the equation for the

straight line trend is
Y=42.1 + 3.3X
Using this equation we can find the trend

values for the previous years and estimate
the sales for the year 2001 as follows:
Y 1996
=
42.1+3.3(1)
=
45.4
Y 1997
=
42.1+3.3(2)
=
48.7
Y 1998
=
42.1+3.3(3)
=
52.0
Y 1999
=
42.1+3.3(4)
=
55.3
Y 2001
=
42.1+3.3(6)
=
61.9
Thus, the forecast sales for year 2001 is Rs.61.9

2000
42.1+3.3(5)
58.6
lakhs. Y
=
=
Estimation of Trend by the Method of Least Squares
Q. The annual sales of a company are as follows:

Year
1991
1992
1993
1994
1995
Sales 000
45
56
58
46
75
Using the method of least squares, fit a st. line trend and estimate the annual
sales of 1997.
Year
Sales
1990 = 0
x2
xy
Estimated
Trend000
Y=45 + 5x
TimeDeviation
x
1991
45
45
50
1992
56
112
55
1993
78
234
60
1994
46
16
184
65
1995
75
25
375
70
n=5
y = 300
x = 15
x2 = 55
xy = 950
n=5
y = 300
xy = 950
yn.a. + b x
xy = a x + b x2
. 2
Substituting the computed values

we have,
300 = 5a + 15b .3 (x 3)
950 = 15a + 55b . 4
Multiplying (3) by 3 we have
900 = 15a + 45b
950 = 15a + 55b
Therefore, 10b = 50,
b=5
Substituting b = 5 in (3)
300 = 5a + 15(5)
300 = 5a + 75
5a = 225
a = 45
x = 15
x2 = 55
St. line equation is Y = a + bx

Substituting the values of a and b,
Y = 45 + 5x
Therefore,
Y1991 (x=1) = 45 + 5(1) = 50
Y1992 (x=2) = 45 + 5(2) = 55
Y1993 (x=3) = 45 + 5(3) = 60
Y1994 (x=4) = 45 + 5(4) = 65
Y1995 (x=5) = 45 + 5(5) = 70
Y1996 (x=6) = 45 + 5(6) = 75
Forecast for the year 1997
Y1997 (x=7) = 45 + 5(7) = 80
i.e. Rs.80,000/-
Use of Economic Indicators

The use of this approach bases demand forecasting on
certain economic indicators following these steps:
1. See whether a relationship exists between demand for
the product and the economic indicator.
2. Establish the relationship through the method of least
squares and derive the regression equation. Assuming
the relationship to be linear, the equation will be Y = a +
bx
3. Once the regression equation is derived, the value of
Y i.e. demand can be estimated for any given value of x.
Draw back: Finding an appropriate economic indicator may
be difficult.
For new products it is inappropriate as no past data
exists.
Illustration: Suppose a company manufacturing tractors

finds that a relationship exists between sale of tractors
and Farm Income Index published by CSO. Table below
shows the number of tractors sold and
the corresponding farm income index 1988 through
Regression
is calculated
asx follows:
Year 1992.
Farm
Sales of equation
X
Y
y
x2
Income Tractors
Index (x)
(y)
1 = x/10
1 = y/10
1 1
1988
100
110
10
11
110
100
1989
110
130
11
13
143
121
1990
140
150
14
15
210
196
1991
150
160
15
16
240
225
1992
200
180
20
18
360
400
n=5
X1=70
Y1 =73 X1y1=1063 X12=1042
The equations to be solved simultaneously are:

y1 = n.a. + b x1 .(1)
x1y1 = a x1 + b x12(2)
Substituting the various values, we get,
73 = 5a + 70b
(x14)(3)
1063 =70a + 1042b
1022 =70a + 980b
62b = 41
b = 41/62 = 0.66
Substituting the value of b in (3)
73 = 5a + 70 (0.66) = 5a + 46.2
5a = 73 46.2 = 26.8
a = 26.8/5
= 5.36
a = 5.36
b = 0.66
y1 = 5.36 + 0.66x1
Y/10 = 5.36 + 0.66 (X/10)
Y = 10(5.36) + 0.66(x/10)10
= 53.6 + 0.66x
If the index of farm income becomes
210, sale of tractors will be
Y = 53.6 + 0.66(210)
= 53.6 + 138.6
= 192 tractors.

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Managerial Economics

Managerial Decision Areas

Application of Economic Concepts, Theories and

Determining and defining the objective to be

II. Collection and analysis of business related data

II and III are crucial in decision making

Production Related issues

Available techniques of Production.

Sales related issues

Micro Economic Issues

Theory of Production and

Market structure and Pricing

Profit analysis and

Theory of Capital and

Macro economic Issues

Issues related to Foreign Trade

Issues related to Government

Other Topics related to

Economic theories for Decision

1.Price of the product.

11. Advertisements effects.

Demand and Demand Curves (d)

Direct for normal goods

Direct for substitute

Qd = 1800 20P- 0.6(20000) 50(250)

Consumer Tastes (T)

Expected price (Pe)

The Law of Demand

Demonstration effect: Imitating

Movement along the curve

SOURCES OF SHIFTS IN THE DEMAND

Movement of Demand Curve

Factors And Effects of Change

b) Change in taste, habit and

c) Change in fashion and

h) Advertisement and publicity

i) Change in value of money :

j) Change in level of taxation :

k)Expectation of future changes

Consumer Tastes (T)

Expected price (Pe)

Factors affecting Supply

Individual Supply Schedule

Price Per Unit of X

Individual Supply Curve

Market supply schedule

Market supply schedule

Market supply Curve

Price of other commodities remains the same

Exceptions to the law of

Backward bending supply curve

Fixed income groups: If person

Generalized supply function

Generalized supply function

Relation to Generalised demand

Inverse for substitute

Qs = g(P, Pi, Pr, T, Pe, F) = g (P)

Number of firms F rises

Changes in Market Equilibrium

Supply Shifts (Demand

Simultaneous Shift in Demand

Simultaneous Shift in Demand

Predicting the Direction of

The president of the corporation to reduce travel expenditures