Principles of Economics

Microeconomics-I

ADVANCED DIPLOMA IN BUSINESS MANAGEMENT

FULL TIME PROGRAM

1
Introduction, Basic Economic Problems and
Economic Systems

What is Economics?

Economics is the study of how societies use scare resources to produce valuable goods and

services and distribute them among different individuals. Economics is the study of how

humans make decisions in the face of scarcity. These can be individual decisions, family

decisions, business decisions or societal decisions.

Definition of Economics

“Economics is the study of mankind inthe ordinary business of life; it examines that part of

individual and social action which is most closely connected with the attainment and with the

use of the material requisites of well-being”. Alfred Marshall

“Economics is the science which studies human behavior as relationship between ends and

scarce means which have alternative uses”. Lionel Robbins

2
The Problem of Scarcity

We have already decided that economics is a study of choices, either collective societal

choices or more individualized choices. However, what is it about the real world that

requires that we make choices? A moment‘s thought about our individual lives, and the

choices that we face, reveals that we must make choices because we have limited

resources.

Scarcity is simply the concept that human wants exceed the resources available that are

necessary to produce the goods used to satisfy those wants.

Resources

Resources, such as labor, tools, land, and raw materials are necessary to produce the goods

and services we want but they exist in limited supply. Of course, the ultimate scarce resource

is time- everyone, rich or poor, has just 24 expendable hours in the day to earn income to

acquire goods and services, for leisure time, or for sleep.

Resources are divided into four broad categories.

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Land is an inclusive category that includes all kinds of natural resources (such as, rivers,

trees, minerals etc). The only condition that must be met is that the resource cannot be the

result of a production process, which would make the resource Capital rather than Land.

Labor is often referred to as "human capital," an acknowledgement that labor resources are

often made more productive through education or training.

Capital represents human creations that are used inthe production of goods and services.

This includes both human capital and physical capital.

Human Capital consists of knowledge and skills people develop through experience and

education.

Physical Capital consists of buildings, machinery, tools andother manufactured items.

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Entrepreneurial ability is really just a particular type of Labor, that type of labor that

organizes all of the other resources in a productive enterprise. As a result, Entrepreneurs

receive profit – the amount of money that is left after all other resources have been paid.

Resources owners are paid for the time their resources are employed by entrepreneurs.

Type of resource Return

Land Rent

Labor Wage

Capital Interest

Entrepreneurship Profit

Thus, scarcity is fundamentally the most important concept in economics. Without scarcity,

no need for choice, either individual or collective, exists. One need not make a choice between

buying a lunch at a restaurant and buying a new sweater because one will always have

enough resources to purchase both goods. Since economics is the study of how people make

choices, without scarcity there would exist no choice and, hence, no economics.

Scarcity, Choice and Opportunity Cost

Example:
Scarcity of
resources

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Suppose that you have Rs.1000 with you. With this limited financial resource, you may try to
satisfy lot of needs. Such as,

- Having a lunch
- Go for a movie
Alternative uses
- Buying a dress.

But, all these needs cannot be achieved at the same time with scare/limited resources.
Therefore, we have to take a decision in which we try to utilize our resources among different
alternatives. This is how the problem of choice arises. When we make a selection, the other
alternatives have to be sacrificed.

Among above alternatives,

nd
- Having a lunch = 2 priority
rd
- Go for a movie = 3 priority
st
- Buying a dress = 1 priority

st
Your 1 priority has gone for ‘buying a dress. Therefore, you have to sacrifice other two
alternatives to select the “buying a dress”.

The value of the next best alternative that sacrificed to select the best alternative is the
“Opportunity Cost”.

In the above example, the opportunity cost of buying a dress is the value of having a lunch.

What is Opportunity Cost?

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An opportunity cost equals the value of the next-best foregone alternative, whenever
a choice is made.

When you take a course of action, you use resources that cannot be applied to other options.
The opportunity costs the value of those foregone opportunities.

For example, if you decide to spend your money on a new bicycle, you cannot also spend it
on a new computer. Or if you spend an hour watching television, you cannot also spend that
time reading a book.

Opportunity cost- Example

When people choose between two alternatives, they select one and give up the other.

Hamburger or Spicy Chicken?

You want them both but can have only one

You choose the spicy chicken.

The cost of the choice is the hamburger; you gave it up!

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Microeconomics vs. Macroeconomics

Microeconomics and macroeconomics are the two main branches of economics. In each

branch, it remains the case that what is being studied is the choices that people make, and

the personal and social consequences of those choices. However, the particular types of

choices being studied vary between the two branches.

As the word implies, macroeconomics deals with the large, or aggregated, economic choices

faced by society. Thus, macroeconomics studies issues dealing with an aggregated, national

or regional economy such as matters of unemployment, inflation, levels of government

spending and taxation, and so forth.

In contrast, microeconomics deals with small, sometimes individual, economic choices faced

within any society. Thus, microeconomics studies issues dealing with smaller choices

including individual choice by consumers, the behavior of profit maximizing firms in

different types of market scenarios, and other types of non-market organizations, such as the

family.

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Basic Economics Problems

The choices we confront as a result of scarcity raise three sets of issues. Every economy must
answer the following questions:

1. What should be produced?

The problem of choice between commodities to be produced

This problem arises due to two reasons,

• Scarcity of resources does not permit production of all the goods and services that
people would like to consume

• All the goods and services are not equally important in terms of their utility for the
consumers.

Using the economy’s scarce resources to produce one thing requires giving up another.
Producing better education, for example, may require cutting back on other services, such as
health care. A decision to preserve a wilderness area requires giving up other uses of the
land. Every society must decide what it will produce with its scarce resources.

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2. How should goods and services be produced?

This question focuses on issues such as the type of technology to be used, whether the
production process should be labor intensive or capital intensive, and so forth. The most
important focus for economists is on the issue of producing output with the fewest resources
or the lowest costs

-Labor intensive technology

-Capital Intensive technology

3. For whom should goods and services be produced?

Once the goods have been produced, the next crucial question that remains deals with who,
specifically, will get these goods. A decision to have one person or group receives a good or
service usually means it will not be available to someone else. In a market economy, which
relies upon money for many transactions, this question is essentially one of determining the
distribution of income. Higher income, in a market economy, translates into the ability to
purchase more goods and services.

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Basic Economic Systems
Economic system is the set of mechanisms and institutions that resolves the fundamental
economic problems.

In a market economy, decision-making is decentralized. Market economies are based on

private enterprise: the private individuals or groups of private individuals own and operate
the means of production (resources and businesses). Businesses supply goods and services
based on demand. Supply of goods and services depends on what the demands. A person’s
income is based on his or her ability to convert resources (especially labor) into something
that society values. In this system, market forces, not governments, determine economic
decisions.

Ex: UK, USA, Canada etc

In a command economy, the government decides what goods and services will be produced
and what prices it will charge for them. The government decides what methods of production
to use and sets wages for workers. The government provides many necessities like
healthcare and education for free.

Ex: Cuba and North Korea.

In a mixed economy, they combine elements of command and market systems. Most
economies in the real world are mixed.

Ex: Sri Lanka, India

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Theory of Demand & Supply

Supply and demand is an economic model, designed to explain how prices are determined in
certain types of markets. It’s such an important model because prices themselves play such
an important role in the economy. In this chapter, you will learn how the model of supply
and demand works and how to use it.

Theory of Demand

What is Demand?

Economists use the term demand to refer to the amount of some good or service
consumers are willing and able to purchase at each price. Demand is fundamentally
based on needs and wants, if you have no need or want for something, you won't buy it.
Demand is also based on ability to pay. If you cannot pay for it, you have no effective demand.

Determinants of demand

1. Price of the product

2. The consumer’s Income
3. Tastes and preferences
4. Prices of related goods and services
Complementary goods -goods which are used jointly and consumed together
Substitute goods-goods which are perceived by the consumer to be alternatives to a
product
5. Consumers' expectations about future prices and incomes that can be checked
6. Number of potential consumers

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The quantity demanded means, the quantity of a good that all buyers in a market would
choose to buy during a period of time, given their constraints. A rise in price of a good or
service almost always decreases the quantity demanded of that good or service. Conversely,
a fall in price will increase the quantity demanded. When the price of a gallon of gasoline
increases, for example, people look for ways to reduce their consumption by combining
several errands, commuting by carpool or mass transit, or taking weekend or vacation trips
closer to home.

Economists identify this inverse relationship between price and quantity demanded as the
law of demand. The law of demand states that when the price of a good rises and everything
else remains the same, the quantity of the good demanded will fall.

The Demand Schedule and the Demand Curve

The Demand Schedule

The Demand Schedule showing the quantities of a good that consumers would choose to
purchase at different prices, with all other variables held constant.

The Demand Curve

The graphical representation of the demand schedule is the demand curve. Following the
law of demand, the demand curve is almost always represented as downward-sloping,
meaning that as price decreases, consumers will buy more of the good.

Example;
Below example shows the demand schedule and the demand curve for cornflakes. These are
two ways to describe the same relationship between price and quantity demanded.

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Demand Schedule for Cornflakes

Price($per Quantity Demanded

box) (millions of boxes per
year)
5 9
4 10
3 12
2 15
1 20

Demand Function

Demand Function
A demand function that represents the behavior of buyers can be constructed for an

individual or a group of buyers in a market.

Individual Demand Function

The behavior of a buyer is influenced by many factors: the price of the good, the prices of

related goods (compliments and substitutes), incomes of the buyer, the tastes and

preferences of the buyer, the period of time and a variety of other possible variables. The

quantity that a buyer is willing and able to purchase is a function of these variables.

An individual’s demand function for a good (Good X) might be written:

QX = fX(PX, Price of related goods, income (M), preferences, . . . )

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· QX = the quantity of good X

· PX = the price of good X

· Price of related goods = the prices of compliments or substitutes

· Income (M) = the income of the buyers

· Preferences = the preferences or tastes of the buyers

Qd = Quantity of Demand
a = Intercept( the demand at zero price)
b = relationship between Qd and P
P = Price of the concerned goods

EX:
Qd = 1300 – 20 P

Exercise
Suppose that the demand schedule for commodity x is as shown in the below table.
You are required to,
a. Draw the demand curve
b. Derive the demand function

Price QD
0 100
10 80
20 60
30 40
40 20
50 0

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Market Demand Function

The market demand function is the horizontal summation of the individuals’ demand

functions.

Horizontal summation of demands by different individuals

“Change in Quantity Demanded” Versus “Change in Demand”

Change in quantity demanded

A change in quantity demanded is a movement along a demand function caused by a change

in price while other variables (incomes, prices of related goods, preferences, number of

buyers, etc) are held constant.

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Change in demand

Change in demand is a “shift” or movement of the demand function. A shift of the demand

function can be caused by a change in: Income, the prices of related goods, preferences, the

number of buyers etc .

Law of Demand

• There is an inverse relationship between the price of a good and the quantity of the
good demanded per time period.

Factors affecting the law of demand

• Substitution Effect
When other factors remain constant including the price of substitute goods, due to
increase or decrease of the price of concerned goods, change of quantity demand
of the considering good as a result of increase or decrease in relative price of the
good is known as substitute effect.

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• Income Effect:
When other factors remain constant including the nominal income of consumers,
changes of the quantity demanded according to the changes of real income is called
income effect.

Theory of Supply

What is Supply?

Supply indicates how much of the good producers are both willing and able to offer
for sale in a given time period at each possible price, holding other conditions of
supply constant.

Determinants of Supply

• The price of the product

• The prices of factors of production
• Technology
• Government policy (Tax and Subsidies)
• Future Price Expectations

The supply Schedule and the supply Curve

The Supply Schedule

The supply schedule for a commodity shows the relationship between its market price
and the amount of that commodity that producers are willing to produce and sell, other
things held constant.

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The Supply Curve

The graphical representation of the supply schedule is the Supply Curve.

Example:

Supply schedule for

cornflakes

Price( $ per box) Quantity

Supplied(millions
of boxes per year

5 18
4 16
3 12
2 7
1 0

Supply Function

Qd = a + bp

Qs = Quantity supplied (dependent variable)

a = Horizontal intercept (Quantity supplied in price zero)
b = how change in quantity supplied when price change in one unit or price coefficient
P= Price of concerned good

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Supply Function-Exercise

Suppose that the supply schedule for commodity x is as shown in the below table.
You are required to,
a. Draw the supply curve
b. Derive the supply function

Price QS
5 100
10 200
15 300
20 400
25 500

Market Equilibrium

• Market equilibrium comes at the price at which quantity demand equals

quantity supply.
• The equilibrium price also called as the market clearing price

Representation of Market Equilibrium

1. Using a demand and supply Schedule

2. Using a Graph
3. Using Functions

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Representation of Market Equilibrium-1

Example: using a schedule

From the following hypothetical data, plot the supply and demand curves and determine the
market equilibrium price and Quantity.

Representation of Market Equilibrium-2

Example: using a Graph

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Representation of Market Equilibrium-3

Example: Using a function

You are given following hypothetical equations regarding product x.

Supply Qs = 300 + 3P
Demand Qd = 1,800 - 2P
Required:

Market equilibrium price and quantity.

Answer
We need to make these equations equal each other.

QS = QD

300 + 3P = 1,800 - 2P

3P + 2P = 1,800 -300

5P = 1,500

P = Rs.300

Now let's substitute this into the Supply equation.

Qs = 300 + 3P

Qs = 300 + 3*300

Q =1,200

The equilibrium price = Rs.300

The equilibrium quantity = 1,200

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Consumer Surplus and Producer Surplus

Consumer Surplus

This is the difference between what the consumer pays and what he would have been
willing to pay.

For example: If you would be willing to pay £50 for a ticket to see the F. A. Cup final, but you
can buy a ticket for £40. In this case, your consumer surplus is £10.

Producer surplus

This is the difference between the price a firm receives and the price it would be willing to
sell it at.

If a firm would sell a good at £4, but the market price is £7, the producer surplus is £3.

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Calculation of Consumer Surplus and producer surplus

Formula:

Area of the triangle =½ x base x height.

Example:

Suppose that the demand and supply of commodity x given by,

Qd = 250-5p

Qs = 50+5p
Find the equilibrium price and quantity.

a) Mathematically

b) Graphically
Calculate consumer surplus and producer surplus.

The concept of Elasticity

It is important to measure the extent of relationship between the price of a product and its
demand and supply.

The extent of relationship between the price and demand ( or supply) is measured by,
measuring the degree of responsiveness of demand or supply for a product to the change in
its price.

This is called the elasticity of demand and supply.

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Elasticity of Demand

Types of Elasticity of Demand

Price elasticity of demand

Price Elasticity: Response in quantity demanded to changes in price measured in

percentage units.

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There are two types of price elasticity of demand.

Point elasticity of demand

Point elasticity of demand measures the elasticity at a specific point on the demand curve.

Example:
Calculate the point elasticity of demand at the price 6$

P($) QD

6 150
10 100

Arc Elasticity of Demand

Arc Elasticity of demand measures the elasticity between two points on the demand curve.

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Example:
Below table shows data about demand for wheat.
What is the Ed if P increases from point C to B?
Classify the elasticity at each point as elastic, inelastic, or unit elastic.

Qd(bushels of
Points P ($)
wheat)
A 8 20

B 7 40

C 6 60

D 5 80

E 4 100

Interpretation of EOD
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Determinants of Price Elasticity of Demand
• The availability of substitutes
• Nature of commodity
• Number of uses
• The proportion of income spent on a good
• The time periods

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Income Elasticity of Demand

Measures the change in demand when income changes in percentage points.

Formula

Types of Income Elasticity of Demand

Cross Elasticity of Demand

Measures the change in demand when the price of other goods change, in percentage
points.

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Elasticity of supply

The elasticity of supply measures the responsiveness of supply to a change in price

Elasticity coefficient is positive to show the direct relationship between price and quantity
of supply.

Example:

Price QS

20 10

30 13

Calculate Elasticity of supply

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Determinants of Price elasticity of supply
• Time period
• In a very short period, the supply of most goods is fixed and inelastic.
• In the long run, the supply tends to become elastic.

• Law of diminishing returns

Theory of Consumer Behavior.

Consumer behavior is the study of individuals, groups, or organizations and the processes
they use to select, secure, and dispose of products, services, experiences, or ideas to satisfy
needs and the impacts that these processes have on the consumer and society. It attempts to
understand the decision-making processes of buyers, both individually and in groups. The
theory of consumer behavior examines consumer preferences and what influences their
economic behavior.

There are two approaches that may be used to explain consumer behavior.

Theories of Consumer Behavior

• Utility Theory
• Theory of Indifference curve

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Utility Theory

33
This theory is formulated by Alfred Marshall, a British Economist, seeks to explain how a
consumer spends his income on different goods and services so as to attain maximum satisfaction.
The satisfaction which a consumer gets by having or consuming goods or service is called utility.

Approaches of Utility
• Utility Theory
• Cardinal utility Approach

• Indifference curve analysis

• Ordinal Utility Approach

Utility Theory
Cardinal utility Approach

 The cardinalist school postulated that utility can be measured

 Utility can be measured by monetary units; utils, by the amount of money the consumer
is willing to sacrifice for another unit of a commodity

Total Utility (Tu) and Marginal Utility (Mu)

 Total utility (TU) is defined as the amount of satisfaction or utility that one derives
from a given quantity of a good

 Marginal utility: The change in total utility an individual obtains from consuming an
additional unit of a good or service.

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Example

The Law of diminishing marginal Utility

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“For any individual consumer the value that he attaches to successive units of a particular
commodity will diminish steadily as his total consumption of that commodity increase, the
consumption of all other goods beingheld constant”.(Lipsey).

In other words, as a person consumes more and more of a given commodity (the
consumption of other commodities being held constant), marginal utility of a commodity will
eventually tend to decline.

Graphical Representation

The consumer will maximize his/her total satisfaction derived from consumption of a
particular product when marginal utility from consumption of that product equals to zero.
For instance, the maximum point of total utility gained from the consumption of the product.
This can be depicted by the diagram below.

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In equilibrium, the consumer balances the utility of good against its cost.
MU = P

Derivation of Demand Curve

Assumptions of Cardinal utility Approach

• Consumer is rational
• Limited money income
• Maximization of satisfaction
• Utility is cardinally measurable.
• Diminishing MU
• Constant utility of money

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Indifference curve Analysis
Ordinal Utility Approach

Ordinal Utility Approach

• Ordinal approach: The ordinalist school postulated that utility is not
measurement.

• The consumer need not know in specific units the utility of various commodities
to make his choice. It is needed for him to rank the various commodities.

• He must be able to determine his order of preference among the different

bundles of goods.

Indifference Curve Analysis

Very popular, easier and scientific method of explaining consumer’s demand is the
indifference curve analysis. This approach to consumer behavior is based on consumer
preferences. Human satisfaction is psychological phenomenon which cannot be measured in
terms of monetary terms.

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An Indifference curve (IC) is the locus of all those combination of two goods which give the
same level of satisfaction to the consumer.

Thus consumer is indifferent towards all the combinations lying on the same indifference
curve. In other words, consumer gives equal preference to all such combinations.

Example:

The below indifference schedule shows combinations of apples and oranges that yield the
same level of satisfaction. Point A marks initial combination of 1 apple and 22 oranges. The
indifference curve shows that the person could obtain the same level of utility by moving to
point B, consuming 2 apples and 14 oranges. The person could also get the same level of
utility along point C, D and E under different combinations of apples and oranges.

Any point below and to the left of the indifference curve would produce a lower level of
utility; any point above and to the right of the indifference curve would produce a higher
level of utility.

Slope of the Indifference curve

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The slope of the indifference curve is called, Marginal Rate of Substitution (MRS.

The marginal rate of substitution of X for Y (MRS ) is defined as the amount of Y, the
xy

consumer is just willing to give up to get one more unitof X and maintain the same level of
satisfaction.

Formula:

The Law Diminishing Marginal Rate of Substitution

Combinations Apple Oranges MRS

A 1 22 ---

B 2 14 8:1

C 3 10 4:1

D 4 8 2:1

E 5 7 1:1

with reference to the above example, as the consumer increases the consumption of apples,
then for getting every additional unit of apples, he will give up less and less of oranges, that
is, 8:1, 4:1, 2:1, 1:1 respectively This is the Law of Diminishing MRS.

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Characteristics of the Indifference curve

 An Indifference curve has negative slope

 Indifference curve is always convex to the origin.

This implies that two goods are imperfect substitutes and MRS between two
goods decreases as a consumer move along an indifference curve.

 Two Indifference curves never intersect or become tangent to each other.

 Higher indifference curve represents higher satisfaction

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The Budget Constraints

The Consumer’s limited incomes and the prices of goods act as constraints on the utility
maximizing behavior of consumer. This is known as Budget Constraint.

Budget line:
Shows all possible combinations of two goods that the consumer can buy if he spends the
whole of his given sum of money on his purchases at the given prices.

Example:

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Budget Line corresponding to budget of Rs. 24

Slope of the Budget Line

Consumers choose a combination of goods that will maximize the satisfaction they can
achieve, given the limited budget available to them. The maximizing combination must satisfy
two conditions:

 It must be located on the budget line.

 Must give the consumer the most preferred combination of goods and services

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Shift in
Budget Line

Budget line is drawn with the assumptions of constant income of consumer and constant
prices of the commodities.

Shift caused by,

(a) Changes in the Income of the consumer

(b) Change of Price of the commodity

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Effect of Change in the Income

Income Consumption curve (ICC)

Income consumption curve shows the optimum combination of two commodities at different levels when
prices of the two commodities remain constant.

44
ICC for a Normal good

ICC for Inferior good

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effect Effect of
Change in
Price of a
Good

The price

The price effect may be defined as the change in the consumption of goods when the
price of either of the two goods changes while the price of the other good and the income
of the consumer remain constant.

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47
Price Effect

• The Substitution Effect • The Income Effect

Refers to change in the It is a change in the
amount of goods purchased consumption of a good
due to change in their resulting from the change in
relative prices alone, while the purchasing power of
real income of the money that occurs as a result
consumer remains of a price change.
constant

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The substitution and the income effect for a normal good
(Hicksian Approach)

Derivation of Demand Curve from PCC

49
Assumptionsof Ordinal Utility/Indifference Curve

1. Rational consumers.
2. Two commodities
3. Utility is ordinal
4. Diminishing marginal rate of substitution
5. Total utility of the consumer depends on the quantities of the commodities
consumed.

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Theory of Production

What is Production?

Production is the process of combining inputs to make goods and services. Before

goods can be distributed or sold, they must be produced. Production, more specifically, the

technology used in the production of a good (or service) and the prices of the inputs

determine the cost of production.

Inputs:
Land, Labour, Capital Outputs: Goods
Entrepreneurship Production:
The Firm

Example:

Consider pizza making. The pizza maker takes flour, water, and yeast to make dough.

Similarly, the pizza maker may take tomatoes, spices, and water to make pizza sauce. The

cook rolls out the dough, brushes on the pizza sauce, and adds cheese and other toppings.

The pizza maker uses a peel—the shovel-like wooden tool-- to put the pizza into the oven to

cook. Once baked, the pizza goes into a box (if it’s for takeout) and the customer pays for the

good.

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Factors of production

The inputs or resources used in the production process are called factors of production by

economists. These include the four resources (land, labor, capital, and entrepreneurship).

All these inputs can be identified as either fixed or variable.

Fixed inputs are those that can’t easily be increased or decreased in a short period of

time. As far as the pizza example is concerned, the building is a fixed input. Once the

entrepreneur signs the lease, he or she is stuck in the building until the lease expires. Fixed

inputs define the firm’s maximum output capacity.

Variable inputs are those that can easily be increased or decreased in a short period

of time. In the above pizza example, the pizza maker can order more ingredients, so

ingredients would be variable inputs. The owner could hire a new person to work the

counter pretty quickly as well.

Short-Run versus Long-Run Decisions

When a firm changes its level of production, it will want to adjust the amounts of inputs it

uses. But these adjustments depend on the time horizon the firm’s managers are thinking

about.

There are two categories of different time horizons.

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Short run

The short run is the period of time during which at least some factors of production

are fixed. For example, during the period of the pizza restaurant lease, the pizza restaurant

is operating in the short run, because it is limited to using the current building—the owner

can’t choose a larger or smaller building.

Long run

The long run is the period of time during which all factors are variable. Another way to

say this is that, over the long run, all the inputs the firm uses are viewed as variable inputs—

inputs that can be adjusted up or down as the quantity of output changes. In the above Pizza

example, once the lease expires for the pizza restaurant, the shop owner can move to a larger

or smaller place.

The production function shows the input-output relationship and the maximum

attainable output under a given technology.

Firm’s production function

Q = f(Ld, L, K, M, T,t)

Where Ld = land and building;

L = labour;

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K = capital;

M = materials; T

= technology; t =

time.

For sake of convenience, economists have reduced the number of variables used in a

production function to only two:

capital (K) and labour (L).

Q = f (K, L)

In the short run

In the short run, capital is fixed

Only changes in the variable labor

input can change the level of output

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Production in the Short Run

Number Total Average Marginal

of product (Q) product product
workers (AP=Q/ (MP)
(L) L)

0 0
-

1 3
3 3

2 10
Increasing returns to 5 7
la bour
3 24
8 14

4 36
9 12

5 40
8 4
Decreasing returns to
6 labour 42
7 2

7 42
6 0
N egative returns4t0o
8
labour 5 -2

Total Product: It gives maximum of output that can be produced at different levels of one input,
assuming that the other input is fixed at a particular level.

Marginal Product: Change in the output resulting from a very small change in one factor input,
keeping the other factor inputs constant. (MP = Q/ L)

Average Product: Total production for per unit of output.

(AP = Q/L)

Example: Wheat production per year from a particular farm (tonnes)

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Wheat production per year from a particular farm

TPP

30
20
Tonnes of wheat per year

10

0
6 7 Number of
1 2 3 4 5 8 farm workers (L)
14

12

10
Tonnes of wheat per year

8
6 APP

2 MPP
0
0 Number of
1 2 3 4 5 6 7 8 farm workers (L)
-2

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Law of Diminishing Returns

The law of diminishing (marginal) returns states that as we continue to add more of any one
input (holding the other inputs constant), its marginal product will eventually decline.

Ex: In the factory, when we add staff, we start to see queues forming at machines, it becomes
more difficult to coordinate work, machinery starts to break down though overuse and there
is not enough space to work efficiently.

The Three Stages of Production

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Stage I: Stage of Increasing Returns:

• AP is increasing and the MP is greater than the AP.Up to point B on the TP curve Stage I
exist.
• AP is increasing, but MP is increasing first up to point A then decreasing.

Stage II: Stage of Decreasing Returns

 Both AP and MP is decreasing. But MP ispositive.

 The portion of TP curve between B and C represents this stage.

Stage III: Stage of Negative Returns

• TP is diminishing and the MP is negative.

• The portion of TP curve which lies to the right of point C represents this stage.

• This implies that, TP declines because of overcrowding of labour. When this

occurs, profits will fall.

The optimum usage of labor (Short run equilibrium of the producer)

When the per unit cost of labor input is equal or less than the marginal product of labor, the
optimum use of labor is determined.

The equilibrium would show what the optimum level of labor to be used is in short
run for any business organization.

MP L = PL

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Example:

Assume,

Wage rate per labor: Rs. 100

Labour units (L) MP of labour

100 150
101 120
102 100
103 95

At the optimum level,

MP L = PL

100 = 100
Therefore, the optimum number of labor units = 102

Graphical Representation:

MPL/Rs

Wage rate
100

102 MP L

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Production in the Short Run

The firm’s production function tells how much output the firm will produce with given
amounts of inputs. For every factor of production (or input), there is an associated factor
payment. Factor payments are what the firm pays for the use of the factors of production.
From the firm’s perspective, factor payments are costs. From the owner of each factor’s
perspective, factor payments are income.

Managers must answer questions about costs over different time horizons. One question
might be, “How much will it cost to produce a given level of output this year?” Another might
be, “How much will it cost us to produce a given level of output three years from now and
beyond?”. This section explores managers’ view of costs over a short-run time horizon—a
time period during which at least one of the firm’s inputs is fixed. That is, we’ll be looking at
costs with a short-run planning horizon. Because the firm has these two different types of
inputs in the short run, it will also face two different types of costs.

The costs of a firm’s fixed inputs are called, not surprisingly, fixed costs. Like the fixed inputs
themselves, fixed costs must remain the same no matter what the level of output. Typically,
rent and interest considered as fixed costs, since producing more or less output in the short
run will not cause these costs to change. The costs of obtaining the firm’s variable inputs are
its variable costs. These costs, like the usage of variable inputs themselves, will rise as output
increases. Most businesses treat the wages of hourly employees and the costs of raw
materials as variable costs, because quantities of labor and raw materials can usually be
adjusted rather rapidly.

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The three concepts of costs to be considered in the short-run are:

• Total fixed costs = TFC

• Total variable costs = TVC
• Total costs = TFC + TVC

 Total fixed costs = TFC

The cost of all inputs that are fixed in the short run. One example is the rent. Once you
sign the lease, the rent is the same regardless of how much you produce, at least until the
lease expires. Fixed costs can take many other forms: for example, the cost of machinery or
equipment to produce the product, research and development costs to develop new products
etc.

 Total Variable Cost (TVC) –

The cost of all variable inputs used in producing a particular level of output. We treat
labor as a variable cost, since producing a greater quantity of a good or service typically
requires more workers or more work hours. Variable costs would also include raw materials.

 Total Cost (TC) –

Total Cost is the sum of fixed cost and variable cost incurred at each level of output.

TC = TFC + TVC

Example:

The data for output and costs are in the below table relate to the barber shop. The fixed costs
of operating the barber shop, including the space and equipment, are $160 per day. The
variable costs are the costs of hiring barbers, which in this example is $80 per barber each
day. The first two columns of the table show the quantity of haircuts the barbershop can

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produce as it hires additional barbers. The third column shows the fixed costs, which do not
change regardless of the level of production. The fourth column shows the variable costs at
each level of output. This can be calculating by taking the amount of labor hired and
multiplying by the wage. For example, two barbers cost: 2 × $80 = $160. Adding together the
fixed costs in the third column and the variable costs in the fourth column produces the total
costs in the fifth column. For example, with two barbers the total cost is: $160 + $160 = $320.

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According to the above graph, at zero production, the fixed cost of $160 are still present. As
production increases, variable costs are added to fixed costs, and the total costs is the sum of
the two.

Average Costs

While total costs are important, sometimes it is more useful to track a firm’s costs per unit
of output, which call its average cost. There are three different types of average cost, each
obtained from one of the total cost concepts just discussed.

Average Total Cost (ATC) - refers to total cost per unit of output.

• ATC = Total Cost (TC)

Output (Q)

Average Fixed Cost (AFC) - refers to fixed cost per unit of output.

• AFC = TFC

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Output (Q)

Average Variable Cost (AVC) - refers to the variable costs per unit of output.

• AVC = TVC
Output (Q)

Marginal Cost is an increase in total cost that results from a one unit change in output.

• MC =
ΔT
C
ΔQ

Example:

The first five columns of the above table duplicate the previous table, but the last three
columns show average total costs, average variable costs, and marginal costs. These new
measures analyze costs on a per-unit (rather than a total) basis and are reflected in the
curves in the below graph.

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According to the above graph,

 ATC - The U shape of the ATC curve results from the behavior of both AVC and AFC. At
low levels of output, AVC and AFC are both falling, so the ATC curve slopes downward. At
higher levels of output, rising AVC overcomes falling AFC, and the ATC curve slopes
upward.

 AFC - The average fixed cost begins to fall with the increase in the number of units
produced, but it never becomes zero.

 AVC - As firms increases output, the AVC cost decreases initially until it reaches a
minimum, then increases again. In the beginning, a firm is not producing at its full
capacity, but when the plant works to its full potential, the AVC is at its minimum. If the
production is pushed to more than the plant capacity, AVC rises because production is
no longer efficient.

 MC - The MC curve crosses both the AVC curve and the ATC curve at their respective
minimum points.

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Production in the Long Run

The period during where manager can vary all the inputs as such there are no fixed factors
in the long run.

Long run production function

Q = f (K, L)

The Isoquant curve

An isoquant is a curve showing all possible efficient combinations of inputs that may be
used to produce a same level of output.

Derivation of Isoquant curve

Example:

Below isoquant schedule shows different combinations of labor and capital for cloths.

Combinations of L Units of Units of Output of

and K Labor(L) Capital(K) cloths(meters)
A 5 9 100

B 10 6 100

C 15 4 100

D 20 3 100

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Isoquant curve

Capital

Labor

Properties of Isoquant curve

 An isoquant has a negative slope-
This is because when capital (K) increase, the quantity of labor (L) must be
reduced to keep the same level of output.

 Higher isoquants represent a higher level of output.

 Isoquants cannot cross over each other

Two isoquants cannot intersect each other.

 Isoquants are convex to the origin

Due to diminishing marginal rate of technical substitution (MRTS)
Therefore as more and more capital are used to produce x units of a product, less and
less labor is employed.

Slope of Isoquant

Marginal rate of technical substitution (MRTS) is the rate at which one input can be
substituted for another while holding the level of output constant.

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The slope of an isoquant represents this MRTS.
MRTS = ΔK = MPL
ΔL MPK

Law of diminishing MRTS

As the producer continuously substitute’s capital with labor, the availability of labor
increases while the availability of capital decreases. So the producer does not prefer to
sacrifice more capital to get less labor.

Isocost Line

• The level of production of the firm depends on,

• The firm’s cost of resources
• The amount of money they plan to spend.

• A producer selects an efficient combination of the inputs, by choosing that which has
the lowest cost of production.

• An isocost line, shows all the combinations of labour and capital that are
available for a given total cost to the producer.

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Assume that there are two resources, Labour (L) and Capital (K).

Formula:
P L + P K = TC/C
L K
where:
PL = price of input L
PK = price of input K
L = quantity of input L
K = quantity of input K
TC = isocost

Isocost Curves

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Slope of an Isocost Line

Example:

P L + P K = TC
L K

Assume,

PL=Rs. 2

PK=Rs 4

TC = Rs 100

• If L=0, then K = C/PK,= 100/4= 25

• If K=0, then L = C/PL, = 100/2 =50

Then slope of the line is –PL/PK

Long run firm equilibrium

• The optimum factors combination (least cost combination) at a particular cost

refers to the combination of factors with which a firm can produce a specific
quantity of output at the lowest possible cost.

• At this point,the slope of the isoquant (the marginal rate of technical substitution
between the inputs) equals the slope of the isocost (the relative price of the
inputs).

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• At the Producer Equilibrium,
Slope of the isoquant = Slope of the iso cost
MPL = PL
MPK PK

Production expansion path

Refers to a curve which connects all the long run produces equilibrium points due to the
increase of investment of production

Long Run Cost

It describes alternative scales of operation when all inputs are variable.

The long run ATC curve is U-shaped but is flatter than the short run curve. It shows the
minimum cost per unit of producing each output level at any scale of operation

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Economies of Scale

Economies of scale refers to the

cost advantages that a business obtains due to expansion, which result in significant
decreasing costs per unit.

Factors causes to Economies of scale

- Use of specialized machinery

- Division of labor

- Large scale selling of products

- Economies in large scale production

- Economies in advertising cost

- Efficiency through decentralization

Diseconomies of Scale

Diseconomies of scale are the opposite, where firms produce outputs at increasing costs,
Factors causes to Diseconomies of scale

- Poor communication

- Transportation costs

- Outdated technology

- Lack of control of production process

- Large scale waste

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