CONTENTS
Unit No. Title Page No.
SEMESTER - I
UNIT 1
1. Introduction to Business Economics 1
1A. Market Demand and Market Supply 8
UNIT 2
2. Demand Analysis 17
2A. Demand Estimation and Forecasting 43
UNIT 3
3. Supply and Production Decisions 53
3A. Economies of Scale and Diseconomies of Scale 79
UNIT 4
4. Cost Concepts 85
4A. Extension of Cost Analysis 100
munotes.in
1
UNIT 1
Unit -1
INTRODUCTION TO BUSINESS
ECONOMICS
Unit Structure :
1.0 Objectives
1.1 Scope and Importance of Business Economics
1.2 Basic tools -Opportunity Cost principle -Incremental and
Marginal Concepts and Use of Marginal analysis in decision
making
1.3 Basic economic relations -functional relations: equations -
1.4 Total, Average and Marginal relations
1.5 Summary
1.6 Questions
1.0 OBJECTIVES
To understand Scope and Importance of Business Economics.
To study the basic tools of Economics.
To ex plore Basic economic and functional relations.
To understand use of Marginal analysis in decision making.
1.1 MEANING, SCOPE AND IMPORTANCE OF
BUSINESS ECONOMICS
1.1.1 MEANING
Business Economics is also called as Managerial
Economics. It involves applic ation of economic theory and practice
to business. In b usiness ,decision making is very important .
Decision making is aprocess of selecting one course of action out
ofavailable alternative s.Thus business economics serves as a link
between economic theor y and decision -making in the context of
business. Following are few definitions of Business Economics .
Spencer and Siegelman:
It is “the integration of economic theory with business
practice for the purpose of facilitating decision making and forward
planning by management.”munotes.in
2
Henry and Hayne:
“Business Economics is economics applied in decision
making. It is a special branch of economics. That bridges the gap
between abstract theory and managerial practice.”
Salvatore:
“Business Economics refers to the application of economic
theory and the tools of analysis of decision science to examine how
an organisation can achieve its objectives most effectively.”
1.1.2 SCOPE OF BUSINESS ECONOMICS
Scope is nothing but the subject matter of business
economics. Scop e of Business Economics is very wide.
1)Market Demand and Supply
In economics both demand and supply are the important
forces through which market economy functions. Individual demand
for a product is based on an individual’s choice / Preference s
among different products, price of the product, income etc.
Individual demand is nothing but desire backed by individual’s
ability and willingness to pay. By summing up the demand of all the
consumers or individuals for the product we get market demand for
thatparticular product. Individual Supply is the amount of a product
that producer is willing to sell at given prices. By summing up the
supply of all the producers for the product we get market supply for
that particular product. The market price where the qu antity of
goods supplied is equal to the quantity of goods demanded is
called as equilibrium price. Existence, growth and future of
business or firm depends on what price market determines for its
product.
2)Production and Cost Analysis
Knowledge of bus iness economics helps manager to do
production and cost analysis. Production analysis helps to
understand process of production and to make optimum utilisation
of available resources. Cost analysis on the other hand helps firm
to identify various costs and plan budget accordingly. Both
production and cost analysis will help firm to maximize profit.
3)Market structure and Pricing Techniques
Markets are very important in business economics. Study of
markets such as perfect completion, monopoly, oligopoly,
monopolistic market etc. is very significant for producers. It is very
imperative for manager or producer to identify type of market that
will be there for their products. Knowledge of markets and
competition will help them to take better decision regarding pricing
of the product, marketing strategies etc. Pricing techniques, on the
other hand, helps the firms to decide best remunerative price at
different kinds of markets.munotes.in
3
4)Forecasting and coverage of risk and uncertainty.
Knowledge of business economics helps manager to
forecast future. For example Demand forecasting. It means
estimation of demand for the product for a future period. Demand
forecasting enables an organization to take various decisions in
business, such as planning about production proces s, purchasing
of raw materials, managing funds in the business, and determining
the price of the commodity. Likewise forecasting future helps firm to
take important decisions and cover risk and uncertainty associated
with those decisions.
5)Inventory Man agement
Knowledge of business economics will help producer to
reduce costs associated with maintenance of inventory such as raw
materials, finished goods etc.
6)Allocation of resources
Business Economics provides advanced tools such as linear
programming which helps to achieve optimal utilisation of available
resources.
7)Capital Budgeting
Capital budgeting or investment appraisal is an official
procedure used by firms for assessing and evaluating possible
expenses or investments. It is a process of p lanning of expenditure
which involves current expenditure on fixed/durable assets in return
for estimated flow of benefits in the long run. Investment appraisal
is the procedure which involves planning for determining whether
firm’s long term investments s uch as heavy machinery, new plant,
research and development projects are worth the funding or not.
Knowledge of business economics helps producer to take
appropriate investment decisions with the help of capital budgeting.
1.1.3 IMPORTANCE OF BUSINESS EC ONOMICS
1.Knowledge of business economics helps business o rganization
to take important decisions as it deals with application of
economics inreal life situation.
2.It helps manager or owner of firm to design policies suitable for
their firm or business.
3.Business economics is useful in planning future course of
action.
4.It helps to control cost and monitor profit by doing cost benefit
analysis.
5.It helps in forecasting future for taking important decisions in
present.munotes.in
4
6.It helps to set appropriate prices for vari ous products by using
available pricing techniques.
7.It helps to analyse effects of various government policies on
business and take appropriate decision.
8.It helps to degree ofefficiency of firms by using various
economic tools.
1.2 BASIC TOOLS IN BUSINESS ECONOMICS
Opportunity cost
Individuals f ace Trade -offs in day to day life. It is a conflicting
situation where people have to make decision or make choice s
among available alternatives. The moment selection takes place,
the counterpart becomes opportuni ty cost. Opportunity lost is
nothing but opportunity cost. If you decide to attend lecture , then
you have to sacrifice on time that you could have spent otherwise .
If you plant potatoes in your field, you must forego the chance of
planting another crop because your resources are limited.
Opportunity cost plays very important role in decision making.
Doing one thing excludes doing something else. In other words,
when we select something , we pay a cost, which is the cost of not
being able to do the next best thing.
Marginalism
Rational decision makers will always think in terms of
marginal quantities. One should compare the cost of an additional
chocolate with the benefits of an extra chocolate in order to decide
whether to have it or not. Ifthe additional revenue that the producer
is going to get by producing one more car is greater than the cost of
producing the extra car, only then the sel ler will produce an extra
car.
Let us take one example, an additional car sells for Rs. 10
lacks while it costs onl y Rs. 8 lakhs to produce the additional car.
Clearly, a rational producer will decide to produce the carbecause
he will make profit of Rs. 2 lakhs per car . On the other hand, if the
price of car falls to Rs.7 lakhs while the co st of producing it remains
Rs. 8 lakh , it will not make sense to produce the additional car
since the cost surpasses the revenue to be earned from it. The cost
of producing the extra caris called asmarginal cost while the
revenue obtained from selling an extra caris called asmarg inal
revenue. If marginal revenue exceeds marginal cost, it obviously
makes sense to produce the extra car. If the marginal revenue is
less than marginal cost, it not advisable to produce the extra car.
Let us take another example from your day to day l ife.
Suppose you may score 10additional marks in economics bymunotes.in
5
studying for entire night . Getting the additional 10marks is
important because it makes you feel happy and proud . But suppose
staying up for entire night makes you feel really sleep y in the
morning hence makes you feel dull and unhappy. In this case,
whether you should study for entire night depends upon whether
the happiness that you get from the 10additional marks in
economics overshadows the unhappiness caused by the additional
sleeplessne ss.In this way individuals can make use of marginalism
principal in their day to day life for making appropriate decisions.
Incrementalism
Marginalism represents small unit change in the concerned
variables. But many times in real life situations change s takes place
in chunks or batches. For example firm producing car will not
generally increase its production by one unit, but by a batch of
additional units. Here we use concept of incrementalism instead of
marginalism and decision will be taken by compar ing incremental
cost and incremental revenue.
Check your progress :
1)What do you mean by Business Economics?
2)Why knowledge of Business Economics is important?
3)Define opportunity cost.
4)Distinguish between Marginalism & Incrementalism.
1.3 BASIC ECONOMIC RELATIONS -FUNCTIONAL
RELATIONS: EQUATIONS -TOTAL, AVERAGE AND
MARGINAL RELATIONS
The Relationship between Total, Average and Marginal can
be explained with the help of concepts like utility, cost, revenue etc.
Here we will take example of revenue concepts.
Where, P = Price & Q = Quantity
TR = Total Revenue
AR = Average Revenue
MR = Marginal Revenuemunotes.in
6
Quantity Price TR AR MR
1 30 30 30 30
2 28 56 28 26
3 26 78 26 22
4 24 96 24 18
5 22 110 22 14
6 20 120 20 10
7 18 126 18 6
8 16 128 16 2
9 14 126 14 -2
10 12 120 12 -6
Table 1.1
Total revenue is calculated by multiplying price and quantity.
As quantity increases TR increases initially then it decreases. AR is
same as price . MR decreases constantly and becomes negative
eventually.
Important concepts
1.Variables
A variable is magnitude of interest that can be measured.
Variables can be endogenous and exogenous variables. Variables
can be independent and dependent.
2.Functions
Function shows existence of relationship betwee n two or
more variables. It indicates how the value of one variable depends
on the value of another one. It does not give any direction of
relation.
3.Equations
An equation specifies the relationship between the
dependent and independent variables . It spec ifies the direction of
relation.
4.Graph
Graph is a geometric tool used to express the relationship
between variables. Itis a pictorial representation of data which
shows how two or more sets of data or variables are related to one
another.munotes.in
7
5.Curves
Thefunctional relationship between the variables specified in
the form of equatio ns can be shown by drawing line or outline
which gradually deviates from being straight for some or all of its
length in the graph.
6.Slopes
Slopes show how fast or at what rate , the dependant
variable is changing in response to a change in the independent
variable.
1.4SUMMARY
In this unit we have seen meaning, scope and importance of
business economics. Business Economics is also called as
Managerial Economics. It involves a pplication of economic theory
and practice to business. In business, decision making is very
important. Decision making is a process of selecting one course of
action out of available alternatives. Thus business economics
serves as a link between economic theory and decision -making in
the context of business. Scope of business economics involves
Market Demand and Supply, Production and Cost Analysis, Market
structure and Pricing Techniques, Forecasting and coverage of risk
and uncertainty, Inventory Managem ent, Allocation of resources,
Capital Budgeting etc. We have also discussed basic tools in
economics such as opportunity cost, marginalism and
incrementalism. Business economics deals with many economic
relations and various concepts such as variables, fun ctions,
equations, graph, curves and slopes.
1.5QUESTIONS
1)Discuss scope and importance of business economics.
2)Write short note on Opportunity Cost.
3)Write short note on Marginalism
4)Discuss use of marginal analysis in decision making.
5)Write short note on Incrementalism .
6)Explain following concepts -
a.Variables
b.Functions
c.Equations
d.Graph
e.Curves
f.Slopes
munotes.in
8
Unit –1A
MARKET DEMAND AND MARKET
SUPPLY
Unit Structure :
1A.0Objectives
1A.1The basics of market demand, mark et supply and
equilibrium price
1A.2Shifts in the demand and supply curves and equilibrium
1A.3Summary
1A.4Questions
1A.0 OBJE CTIVES
1)To study the basics of market demand, market supply and
equilibrium price.
2)To study shifts in the demand and supply curves and
equilibrium.
1A.1 MARKET DEMAND, MARKET SUPPLY AND
EQUILIBRIUM PRICE
In economics both demand and supply are the impo rtant
forces through which market economy functions. Individual’s
demand is desire backed by his / her ability and willingness to pay.
There is an indirect or negative relationship between price and
quantity demanded. Individual Supply is the amount of a p roduct
that producer is willing to sell at given prices. There is a direct or
positive relationship between price and quantity supplied.
Market Demand
Individual demand for a product is based on an individual’s
choice / Preference among different products , price of the product,
income etc. Individual demand is nothing but desire backed by
individual’s ability and willingness to pay. By summing up the
demand of all the consumers or individuals for the product we get
market demand for that particular product .munotes.in
9
Table 1A .1Market Demand Schedule
Price Demand of
Individual ADemand of
Individual
BMarket Demand
(Demand of Individual A +
Demand of Individual B)
10 5 7 12
20 4 6 10
30 3 5 8
40 2 4 6
50 1 3 4
The above table 1A .1 represents demand schedul eof
individual A, individual Band Market Demand. Same schedule can
be represented with the help of agraph.
Diagram 1A .1Market Demand Curve
Diagram 1A .1 represents demand curve of individual A, individual B
and Market Demand. DA is a demand curve of individual A. DB is
thedemand curve of individual B. DM isthemarket demand curve.
All curves are downward sloping indicating negative relationship
between price and quantity demanded.munotes.in
10
Market Supply
Individual Supply is the amount of a product that producer is
willing to sell at given prices. By summing up the supply of all the
producers for the product we get market supply for that particular
product.
Table 1A .2 Market Supply Schedule
Price Supply of
Producer ASupply of
Producer BMarket Supply
(Supply of Producer A +
Supply of Producer B)
10 1 3 4
20 2 4 6
30 3 5 8
40 4 6 10
50 5 7 12
The above table 1A .2 represents supply schedule of
producer A,producer B and Market supply . Same schedule can be
represented with the help of a graph.
Diag ram 1A .2 Market Supply Curve
munotes.in
11
Diagram 1A .2 represents supply curve of producer A,
producer B and Market supply. SA is a supply curve of producer A.
SB is the supply curve of producer B.SMisthemarket supply
curve. All curves are upward sloping indic ating positive relationship
between price and quantity demanded.
Equilibrium Price
The market price where the quantity of goods supplied is
equal to the quantity of goods demanded is called as equilibrium
price . This is the point at which the market deman d and market
supply curves intersect s.
Table 1A .3 Equilibrium Price Schedule
Price Market Demand Market Supply
10 12 4
20 10 6
30 8 8
40 6 10
50 4 12
The above table 1A .3 represents schedule of equilibrium
price. Same schedule can be represented wi th the help of a graph
to locate equilibrium price. Even in the table itself it is very clear
that 30 is equilibrium price as at this price ,market demand is equal
to market supply i.e. 8 units.
Diagram 1A .3 Equilibrium Price.
munotes.in
12
Diagram 1A .3 represents E quilibrium Price. DMis the
market demand curve. D Mis downward sloping curve indicating
inverse or negative relationship between price and quantity
demanded. S Mis the market supply curve. SMis upward sloping
curve indicating direct or positive relations hip between price and
quantity supplied. DM and SMcurves intersect each other at point
E where equilibrium price is 30 and equilibrium quantity demanded
and supplied is 8 units.
Check your Progress :
1)What do you mean by Individual Demand & Market Dem and?
2)What do you mean by Individual Supply & Market Supply?
3)Define Equilibrium Price.
1A.2 SHIFTS IN DEMAND AND SUPPLY CURVES AND
EQUILIBRIUM
1A.2.1 SHIFTS / CHANGES IN DEMAND :
Shifts in demand takes place due to changes in non-price
factors such as income, population, government policies, tastes,
preferences, habits, fashion etc. Whenever there are favourable
changes in these factors the n the demand curve shifts outward. It is
also known as Increase in Demand. Whenever there are
unfav ourable changes in these factors then the demand curve
shifts inward. It is also known as Decrease in demand .
Diagram 1A .4 Changes in Demand
munotes.in
13
In the above diagram D is the original demand curve. At
price P, OQ quantity is demanded. If there are favourab le changes
in the non -price factors affecting demand then the demand curve
shifts outward and becomes D1. Here we can see that at same
price P, now more quantity i.e. OQ1 quantity is demanded. If there
are unfavourable changes in the non -price factors affecting demand
then the demand curve shifts inward and becomes D2. Here we
can see that at same price P, now less quantity i.e. OQ2 quantity is
demanded. Shift from D to D1 is known as Increase in Demand and
shift from D to D2 is known as Decrease in Demand.
1A.2.2SHIFTS / CHANGES IN SUPPLY
Shifts in supply takes place due to changes in non -price
factors such as cost of production, government policies, state of
technology etc. Whenever there are favourable changes in these
factors then the supply curve shif ts outward. It is also known as
Increase in supply. Whenever there are unfavourable changes in
these factors then the supply curve shifts inward. It is also known
as Decrease in supply.
Diagram 1A .5 Changes in Supply
In the above diagram S is the orig inal supply curve. At price
P, OQ quantity is supplied. If there are favourable changes in the
non-price factors affecting supply then the supply curve shifts
outward and becomes S1. Here we can see that at same price P,
now more quantity i.e. OQ1 quantity isSupplied . If there are
unfavourable changes in the non -price factors affecting supply then
thesupply curve shifts inward and becomes S2. Here we can see
that at same price P, now less quantity i.e. OQ2 quantity is
supplied .Shift from S to S 1 is known as Increase in Supply and
shift from S to S 2 is known as Decrease in Supply .munotes.in
14
1A.2.3SHIFTS IN EQUILIBRIUM
The market price where the quantity of goods supplied is
equal to the quantity of goods demanded is called as equilibrium
price. This is the point at which the market demand and market
supply curves intersects. Whenever there are changes in demand
and supply, position of equilibrium will change.
Diagram 1A .6Effects of Changes in Demand on Equilibrium
In the above diagram D is the original dem and curve and S
is the original Supply curve. At equilibrium E, equilibrium price is P
and equilibrium quantity demanded and supplied is OQ. If there are
favourable changes in the non -price factors affecting demand then
the demand curve will shift outward and become D1. Now the new
equilibrium is atE1. At E1, equilibrium price is P1 and equilibrium
quantity demanded and supplied is OQ1. If there are unfavourable
changes in the non -price factors affecting demand then the demand
curve will shift inward and b ecome D2. Now the new equilibrium is
atE2. At E2, equilibrium price is P2 and equilibrium quantity
demanded and supplied is OQ2. Thus increase in demand leads to
higher price and decrease in demand leads to lower prices.munotes.in
15
Diagram 1A .7Effects of C hanges in Supply on Equilibrium
In the above diagram D is the original demand curve and S
is the original Supply curve. At equilibrium E, equilibrium price is P
and equilibrium quantity demanded and supplied is OQ. If there are
favourable changes in th e non -price factors affecting supply then
the supply curve will shift outward and become S1. Now the new
equilibrium is at E1. At E1, equilibrium price is P1 and equilibrium
quantity demanded and supplied is OQ1. If there are unfavourable
changes in the no n-price factors affecting supply then the supply
curve will shift inward and become S2. Now the new equilibrium is
at E2. At E2, equilibrium price is P2 and equilibrium quantity
demanded and supplied is OQ2. Thus increase in supply leads to
lower price and decrease in supply leads to higher prices.
Check you Progress :
1)List out the factors that lead to changes in demand.
2)List out the factors that lead to changes in supply.
1A.3SUMMARY
In economics both demand and supply are the import ant
forces through which market economy functions. Individual demand
for a product is based on an individual’s choice / Preference among
different products, price of the product, income etc. Individual
demand is nothing but desire backed by individual’s ab ility and
willingness to pay. By summing up the demand of all themunotes.in
16
consumers or individuals for the product we get market demand for
that particular product. Individual Supply is the amount of a product
that producer is willing to sell at given prices. By s umming up the
supply of all the producers for the product we get market supply for
that particular product. The market price where the quantity of
goods supplied is equal to the quantity of goods demanded is
called as equilibrium price. Existence, growth a nd future of
business or firm depend on what price market determines for its
product. In this unit we studied derivation of individual and market
demand and supply curves along with derivation of equilibrium
price and quantity. We have also seen how shifts in demand and
supply takes place along with their effect on equilibrium level of
price and quantity.
1A.4QUESTIONS
1)Write short note on Market Demand.
2)Write short note on Market Supply.
3)Write short note on Equilibrium Price.
4)Complete the following table and draw the graph.
Price Demand of Individual
ADemand of Individual
BMarket
Demand
10 15 10 ?
20 14 9 ?
30 13 8 ?
40 12 7 ?
50 11 6 ?
5)Complete the following table and draw the graph.
Price Supply of Producer A Supply of Producer B Market Supply
10 8 6 ?
20 9 7 ?
30 10 8 ?
40 11 9 ?
50 12 10 ?
6)Write short note on changes in Demand.
7)Write short note on changes in supply.
8)What are the effects of changes in Demand on equilibrium?
9)What are the effects of changes in Supply on equilibrium?
munotes.in
17
UNIT 2
Unit -2
DEMAND ANALYSIS
Unit Structure :
2.0 Objectives
2.1 Introduction
2.2 Demand function
2.3 Determinant of demand
2.4 Meaning of demand
2.5 Law of demand
2.6 Nature of deman d curve under different markets
2.7 Elasticity of demand
2.8 Price elasticity of demand
2.9 Factors affecting price elasticity
2.10 Measures of price elasticity
2.11 Degree s of price elasticity of demand
2.12 Income elasticity of demand.
2.13 Cross elasticity of demand.
2.14 Promotional elasticity of deman d
2.15 Concept s of revenue.
2.16 Summary
2.17Questions
2.0OBJECTIVES
To understand the demand and its function.
To study the various factors which determines the demand.
To familiarise with the various concepts of elasticities of
demand.
To understand with the con cepts of revenue.
2.1INTRODUCTION
In economics both demand and supply are the important
forces through which market economy functions. The demand
function shows the relationship between the quantity demanded
and its various determinants. In this chapter we will explain the
demand function in detail and the nature of demand curve under
different market situation. We will also explain the relationship
between elasticity of demand and revenue concepts.munotes.in
18
2.2 DEMAND FUNCTION
Demand function is an arithmetic expression that shows the
functional relationship between the demand for a commodity and
the various factors affecting it. This includes the income of a
consumer and the price of a commodity along with other various
determining factors affecting demand. Th e demand for a
commodity is the dependent variable, while its determinants factors
are the independent variables.
The demand for a commodity depends on various factors
which determines the quantity of a commodity demanded by
various individuals or a group of individuals. The following equation
shows the demand function which expresses the relationship
between the quantity demanded of a commodity X and its
determinants.
x x yQd = f P ,Y, P ,T, A
Where,
xQd= Quantity demanded of commodity X.
xP= Price of commodity X.
Y= income of a consumer.
yP= Price of related commodities.
T= Taste and Preference of an individual consumer.
A= Adverting expenditure made by producer.
2.3 DETERMINANTS OF DEMAND
The important determinants of demand for a commodity are
explained below:
1.Price of commodity (P x):The price of commodity is very
important determinants of demand for any commodity. Other
things remaining same, the rise in price of the commodity, the
demand for the commodity contracts, and with the fall in price,
its demand expands . So, the quantity demanded and price
shows an inverse relationship in thecase of no rmal goods. In
other word changes in price brings changes in the consumer’s
demand for that commodity.
2.Income (Y): Another important determinant of demand for a
commodity is consumer’s income. Change in consumer’s
income also influences the change in cons umer ’sdemand for a
commodities. The demand for normal goods increases with themunotes.in
19
increasing level of income and vice versa. it shows a direct
relationship between income and quantity demanded.
3.Price of related commodities (P y):The demand for a
commodity is also affected by the price of other commodities,
especially of substitute or complementary goods. A good may
have some related goods either substitute or complementary.
The relation between two may be different.
Substitute Goods :Substitute Goods arethose goods which can
be substituted from each other. For Instance Tea & Coffee .When
the rise in the price of Tea causes rise in demand for Coffee
because there is no change in price of coffee such goods are called
as substitute goods. In other words the relation between two
substitute goods are positive. An incase the price of one commodity
increase the demand for other.
Complementary Goods :Complementary goods are those goods
which one purchased together .For Instance Car & Petrol .when
their a rise in price of Petrol leads to fall in demand for Car such
goods are called complementary good. In other words, the relation
between two complementary goods are negative. An increase in
price of one commodity leads to decrease in demand for other.
4.Taste and Preference (T): The demand for a commodity also
depends on the consumer’s taste and preferences such as
change in fashion, culture, tradition etc. As the consumers taste
and preference for a particular commodity changes the demand
for that particular commo dity also changes. Therefore, Taste
and Preference of a consumer plays an important role.
5.Advertising expenditure (A): Advertising expenditure by a firm
influence the demand for a commodity. The advertisements by
the manufacturer and sellers attract more customers towards
the commodity. There exists positive relationship between
advertising expenditure and demand for the commodity.
2.4MEANING OF DEMAND
The demand in economics means the desires to purchase
the commodity backed by willingness and the ability to pay for it.
Demand= Desire + Willingness to buy + Ability to pay
2.5 THE LAW OF DEMAND
The law of demand was propounded by the famous
economist Alfred Marshall in early 1892. Due to the generalmunotes.in
20
observation of law, economists have come to ac cept the validity of
the law under most situations. The law of demand states that other
thing being equal the relationship between the price and the
quantity demanded of a commodity are inversely related to each
other. In other words, when the price of a c ommodity rises the
quantity demand for the commodity falls. The law of demand helps
to explain the consumer’s choice behaviour due to change in the
price of a commodity.
Assumptions:
The law of demand is based on the following assumption given
below:
1.No c hange in consumers income: There should not be any
change in the consumer income while operating under the law
of demand. If income of a consumer increase sthe consumer
may buy more goods at the same price or buy the same
quantity even if price increases. The income is assumed to be
constant, as it may lead to enticement tothe consumer to buy
more goods and raise thedemand for a commodity despite an
increase in the price of commodity.
2.No change in the price of other goods: The price of substitute
goods an d complimentary good should remain the same. If any
of the price changes may lead to change in the demand for the
other commodity and it will change the consumer preference will
affect the law of demand.
3.No change in taste and preference: The law assumes t hat the
consumer’s taste and preference for a commodity remains the
same. If there is a change in consumer’s taste and preferences
there will be a change in the demand for the commodity.
4.No expectation of change in the future price: The law of
demand rema ins valid if there is no change in future expectation
about price of commodities. If consumer is expecting rise in
price in future, he will buy more quantities even at a higher price
in present time and vice -versa.
5.No change in the size and composition of population: The
law also assumes that the size and composition of the total
population of a country should not change. That means, the
population must neither increase nor decrease. Because a rise
in the populations would increase the demand for commoditie s.
Along with the size of population, composition of population also
matters. If number of senior citizens is more then the demand
for medical care will be more. If female population is more then
the demand for cosmetics will be more.
6.No change in governme nt polices: The law assumes that
there is no change in the government policy which will either
increases or decreases the demand for the commodity.munotes.in
21
Demand Schedule and Demand Curve:
The law of demand can be simply explained through a
demand schedule and d emand curve. The demand schedule is a
tabular representation of the law of demand which is shown below:
Demand Schedule: Table 2 .1
Price (`) Quantity demanded of a commodity ‘X’
(Units)
50 10
40 20
30 30
20 40
10 50
Representation of table:
It can be seen from the above table, that when theprice of a
commodity ‘X’ is `50 per unit, the consumer purchases 10 units of
the commodity. Further when the price of the commodity falls to
`40, he purchases 20 units of commodity. Similarly, when the price
falls further the quantity demand by the consumer goes on
increasing by 30 units as so on. This demand schedule shows the
inverse relationship between the price and quantity demanded of a
commodity.
Demand curve:
Quantity Demand
Diagram 2.1
The demand sch edule can also be explained through
demand curve in a simpler way. The demand curve is a graphical
representation of the quantities of good demanded by the
consumer at various possible price in a period of time. The Diagram
shows quantity demanded on X -axis and the price of a commoditymunotes.in
22
on Y -axis. If the demand schedule is plotted on the demand curve,
we get the various price -quantity combination points and if we join
these points, we get the downward slopping demand curve. Thus,
the downward sloping demand curve according to law of demand
shows, the inverse relationship between price and quantity
demanded.
Exceptions to the Law of Demand: The law of demand is
generally valid in most of the cases but there are few cases where
the law is not applicable. Such cases are explained below:
1.Goods having prestige value (Veblen effect): This exception
to the law of demand was propounded by an economists
Thorstein Veblen in his work ‘conspicuous consumption’.
According to him, some consumer measures the utility of a
commodity by its price i.e., the higher the price of a commodity,
the higher its utility. For example, People sometimes buy certain
expensive or prestigious goods like diamonds at high prices not
due to their intrinsic value but only because it has snob val ue.
On the other hand, as price falls, they demand less due to the
loss of its snob value. This effect is called as Veblen effect or
Snob value.
2.Giffen goods: Another exception to the law of demand was put
forwarded by the economists Sir Robert Giffen. The re is a direct
price –demand relationship in case of giffen goods. When with
the rise in the price of a giffen goods, its quantity demand
increases and with the fall in its price its quantity demand
decreases, the demand curve will slope upward to the rig ht
hand side and not downward.
3.Price Expectations: When the consumer expects there is rise
in price of a commodity in future, he/she may purchase more of
commodity at present. Where the law of demand is not
applicable.
4.Emergencies: During the time of emer gencies such as natural
and man -made calamities, the law of demand becomes
ineffective. In such circumstances, people often fear the
shortage of the necessity goods and hence demand more
goods and services even at higher prices.
5.Change in fashion and taste &preferences: The change in
taste and preferences of the consumers denies the effect of law
of demand. The consumer tends to buy those commodities
which are in trends in the market even at higher prices. On the
other hand, when a product goes out of fashi on, a reduction in
the price of the product may not increases the demand for it.munotes.in
23
Check your Progress :
1)Who propounded the theory of law of demand?
2)What relationship does law of demand state between demand &
price?
3)What is Veblen effect?
2.6NATURE OF DEMAND CURVE UNDER DIFFERENT
MARKETS
Economist have classified the various markets prevailing in a
capitalist economy into (a) perfect competition or pure competition,
(b) monopolistic competition, (c) oligopoly and (d) monopoly.
Accor ding to Cournot, a French economist, “Economist understand
by the term market not any particular market place in which things
are bought and sold but the whole of any region in which buyers
and sellers are in such free interaction with one another that the
price of the same good tends to equality easily and quickly’’. The
type of different market depends on number of factors. Accordingly,
the nature of demand curve is different in different market. The
nature of demand curve under various market structure a re as
follows:
Demand Curve in Perfect Competition:
Perfect competition is said to prevail when there are large
number of producers (firms) producing and selling homogenous
product. The maximum output produce by the individual firm is very
small relative ly to the total demand to the industry product so that
firm cannot affect the price by varying its supply of output. The
seller is the price taker he accepts the price determined in the
market by market demand and market supply. Thus, the individual
price under perfect competition is determine by the market demand
and market supply.
Market Demand Curve: The market demand curve under perfect
competition is downward sloping. Because price and quantity
demand are inversely related to each other as the price o f a
commodity increases the demand for that good decreases. The
market price at which the firms will sell their commodity is
determined by the interaction of market demand and market supply.
Once the market determines the price for the commodity all firms
will fix their price equals to market price as they are price takermunotes.in
24
under the perfect competition. Thus, the individual demand curve is
equal to the equilibrium price of the market. The Diagram 2.2.
shows the market demand curve which is downward sloping a nd P 0
is the equilibrium market price which is followed by all the individual
firm and the individual firm is facing the horizontal demand curve.
Diagram 2 .2
Individual Firm demand curve: Demand curve facing an
individual firm working under prefect competition is perfectly elastic
i.e. a horizontal straight line parallel to X axis at a given price which
is determined by the market demand sand market supply. The
Diagram 2.3 shows Qty demanded on X axis and Price of the
commodity on Y axis. Where OP 1is the price determined by the
interaction of market demand and market supply curve. It shows if
firm tries to lower the price, he will get negative profit.
Diagram 2.3
Demand Curve under Monopoly: Monopoly is a market where
there is single firm produci ng and selling product which has no
close substitute. As being the single seller monopoly has a control
on supply and he can also decide the price of a commodity. But
however, a rational monopolist who aim at maximum profit willmunotes.in
25
control either price or sup ply. As monopolists is the only single
seller in the market, he constitutes the whole industry. Therefore,
the demand curve under monopoly market is downward sloping
and has a steeper slope as shown in the Diagram 2.4. below:
Diagram 2.4
Thus, in mono poly there is a strong barrier to entry new firm
in the industry. If the monopolist firm wants to increases the sale in
the market, he has to lower the price of its commodity.
Demand curve under Monopolistic competition: In the
monopolistic market there is a large number of firms producing or
selling somewhat differentiated product which have close
substitute. As a result, demand curve facing a firm under
monopolistic competition is sloping downward and has a flatter
shape which is highly elastic and this indicate that a firm enjoy
some control over the price of a commodity. The demand curve
facing an individual firm under monopolistic competition is shown in
the following Diagram 2.5.
Diagram 2.5munotes.in
26
Demand curve under oligopoly market :Oligopoly is a m arket
where there are few firms or sellers producing or selling
differentiated products. The fewness of firm ensures that each of
them will have some control over the price of the product and the
demand curve facing each other will be downward sloping whic h
indicates the price elasticity of demand for each firm will not be
infinite. As there are interdependence of firm. Any decision
regarding change in the price of output attracts reaction from the
rival firms. Therefore, the demand curve for an oligopoly f irm is
indeterminate, i.e. it cannot be drawn accurately as exact behaviour
pattern of a producer with certainty.
The demand curve faced by the firm under oligopoly is
shown in the following Diagram 2.6:
Diagram 2.6
The demand curve facing an oligop olist is kinked in nature.
The kink is formed at a prevailing level the point K because the
segment of the demand curve above the prevailing price level i.e.
Kd is highly elastic and the segment the segment below the
prevailing price level i.e. Kd 1is inel astic. This is due to different
reaction of the different firm.
2.7ELASTICITY OF DEMAND
Elasticity of demand helps us to estimate the level of change
in demand with respect to a change in any of the determinants of
demand. The concept of elasticity of demand helps the firm or
manager in decision making with respect to pricing, promotion and
production polices. It has a very great importance in economic
theory ss well for formulation of suitable economic policy.munotes.in
27
Meaning of elasticity:
Elasticity is th e measure of the degree of responsiveness of
change in one variable to the degree of responsiveness change in
another variable.
Thus, Elasticity =% change in A
% change in B
The concept of elasticity of demand therefore refers to the
degree of responsiv eness of quantity demanded of a good to the
change in its price, consumers income and price of related goods.
Check your Progress :
1)In which market condition market demand & market supply
determines the price of commodity?
2)Why Oligopoly demand Curv e is kinked?
3)What is Elasticity?
2.8PRICE ELASTICITY OF DEMAND
Price elasticity of demand shows the degree of
responsiveness of quantity demanded of a good to the change in its
price, other factors such as income, prices of related commodi ties
that determines demand for the commodity which are held
constant. In other words, price elasticity of demand is defined as
the ratio ofthe percentage change in quantity demanded of a
commodity to a percentage change in price of the commodity.
Thus,
ep=Percentage change in quantity demanded
Percentage change in price
The demand curve for most of the commodities, is
downward sloping due to the inverse relationship between quantity
demanded and price of the commodity, the value of the price
elasticit y ofdemand will always be negative. While interpreting the
price elasticity of demand the negative sign is ignored or omitted.
This is because we are interested in measuring the magnitude of
responsiveness of quantity demanded of a good to changes in its
prices.munotes.in
28
2.9 FACTORS AFFEC TING PRICE ELASTICITY OF
DEMAND
The price elasticity of demand depends upon number of
factors which affects its elasticity. They are as follows:
a.Nature of goods or commodity: The elasticity of demand for a
commodity depends upo n the nature of the commodity, i.e.,
whether the commodity is a necessary, comfort or luxury good.
The elasticity of demand for a necessary commodity is relatively
small. For example, if the price of such a good rise, its buyers
generally are not able to r educe its demand as its necessity
commodity.
The elasticity of demand for a luxury good is usually high.
This is because the consump tion of a such good, unlike that of a
necessary commodity, can be delayed. That is why if the price of
such a commodity in crease, the demand for the good can be
significantly reduced.
b.Availability of Substitute Goods: The price elasticity of
demand also depends upon the substitution of goods. If there is
a close substitute for a particular commodity in the market, then
the d emand for such commodity would be relatively more
elastic. For example, since tea and coffee are close substitute
for each other in the commodity market, a rise in the price of
coffee will result in a considerable fall in its demand and a
consequent rise i n the demand for tea. Therefore, a demand for
coffee will be relatively more elastic because of the availability
of tea in the market.
c.Alternative and Variety of Uses of the Product: as we know
that the resources have an alternative use. The demand for
such goods has many uses. The more the alternative and
variety of uses of a good, the more would be its elasticity of
demand. For example, Electricity is used for many purposes
such as lighting, heating, cooking, ironing and also use as a
source of power in many industries & households . That is why
when the price of electricity increases, its demand will decrease
and vice versa.
d.Role of Habits and custom: i f the consumer has a habit of
something, he will not reduce his consumption even if the price
of such c ommodity increases thedemand for them do not
decreases considerably and so their elasticity of demand will be
inelastic. Ex; Alcohol, Cigarettes which are injurious for health
but people still consume it because of their habit.munotes.in
29
e.Income Level of the consu mer: The elasticity of demand
differs due to the change in the income level of the households.
Elasticity of demand for a commodity is low for higher income
level groups then the people with low incomes. This is because
rich people are not influenced much by changes in the price of
goods. Poor people are highly affected by the increase or
decrease in the price of goods. As a result, demand for the
lower income group is highly elastic in demand.
f.Postponement of Consumption: if the consumer postponed
the con sumption of commodity in future the demand is relatively
elastic. For example, commodities whose demand is not urgent,
have highly elastic demand as their consumption can be
postponed if there is an increase in their prices. However,
commodities with urgen t demand like medicines have inelastic
demand because it is an essential commodity whose
consumption cannot be post pended.
g.Time Period: Price elasticity of demand is related to a period of
time. The elasticity of demand varies directly with the time
period. In the short run the demand is generally inelastic and in
long-run it becomes relatively elastic. This is because
consumers find it difficult to change their habits, in the short run,
in order to response to the change in the price of the
commodity. However, demand is more elastic in long run as
their other substitutes available in the market, if the price of the
given commodity rises.
2.10 MEASUREMENTS OF PRICE ELASTICITY OF
DEMAND
There are various methods of measuring price elasticity of
demand s ome of the important methods are explained below:
A.Percentage method: This method is associated with the name
of Dr Alfred Marshall. This method is known by various names
such as Proportionate method, Ratio method, Arithmetic
method, and Flux method. The p rice elasticity of demand in this
method is measured by dividing percentage change in quantity
demanded by the percentage change in the price. In other it is
the ratio of the percentage change in quantity demanded of a
commodity by the percentage change in the price of the
commodity itself.
Thus,
Ep= Percentage change in quantity demanded
Percentage change in pricemunotes.in
30
Symbolically, Ep = ÷
=
Where, q = original quantity demanded.
p = original price.
Δq = change in quantity demanded.
Δ p= change in price.
As mentioned above, the price elasticity of demand has a
negative sign this is due to inverse relationship between price and
quantity demanded. But for simplicity in understanding the
magnitude or the degree of responsiveness we ignore the negative
sign and take only numerical value of elasticity.
B.Point method: Prof. Marshall devised a geometrical method
for measuring the elasticity of demand at a point on the demand
curve. In o ther word, the point elasticity of demand measures
the elasticity of demand at the point on the demand curve.
This can be illustrated by the following given example:
Table 2 .2
Price of
commodity XQuantity
demanded of XPoint
20
1560
90A
B
The above table is represented in the following Diagram 3.7.
Diagram 2.7munotes.in
31
The elasticity is at point A & B
Elasticity at point A =/
/q q
p p
30 / 60
5 / 20
30 10
5 60
1.10
Elasticity at point B
30 / 90
5 / 5
30 5
5 90
0.33
C.Arc ela sticity of demand: In the above measure we have
studied the measurement of elasticity at a point on a demand
curve. When elasticity is measured between two points on the
same demand curve, it is known as arc elasticity. According to
Prof. Baumol, “Arc elas ticity is a measure of the average
responsiveness to the change in price exhibited by a demand
curve over some finite stretch of the demand curve.”. Any two
points on the same demand curve make an arc shows the arc
elasticity of demand. In other words, arc price elasticity of
demand measures elasticity of demand at two points on the
demand curve.
1 2 1 2
2 2q pEpq q p p
2 1 2 1
2 1 2 1
2 1 2 1
2 1 2 1
90 60 15 20
15 20 90 60
30 35
5 150
1.39
q q p p
q q p p
q q p p
p p q q
D.Geometrical measure of elasticity of demand: If there is a
linear demand curve the point elasticity of demand is measured
by geometrical method i.e. it is the ratio of lower segment of themunotes.in
32
demand curve below the point to the upper segment of the
demand curve above the point on the demand curve.
Symbolically,
Ep = Lower segment of the de mand curve below the point
Upper segment of the demand curve above the point
The geometric method can be explained through the
Diagram 3.8 given below:
Diagram 2.8
2.11DEGREES OF ELASTICITY OF DEMAND
Different commodities have d ifferent elasticities of demand.
Some commodities have more elastic demand then others, while
other commodities have relative elastic demand. The elasticity of
demand ranges from zero to infinity (0 -∞). It can be equal to zero,
one, less than one, greater than one and equal to unity.
“The degree of responsiveness to the change in demand in a
market for a commodity is great or small, as the amount demanded
increases much or little for a given fall in price and diminishes much
or little for a given rise in p rice of the commodity”.
The various level or the degree of elasticity of demand is
explained in brief below:
1.Perfectly elastic demand (E p=∞):The demand is said to be
perfectly elastic, if slight change in price leads to infinite change
in the quantity demanded of the commodity. In other words, it is
the level of responses where the consumer is able to buy all the
available commodity at a particular price where the demand is
elastic. The demand curve under this situation is horizontal
straight line parallel to X axis shown in the Diagram 3.9 below.munotes.in
33
This type of demand curve is relevant in perfect competition. But
in the real world, this cas e is exceptionally rare and are not of
any practical interest.
Diagram 2.9
2.Perfectly inelastic demand (E p= 0): The demand is said to be
perfectly inelastic, if the demand for a commodity does not
change with a change in price of the commodity. In o ther words,
the perfectly inelastic demand of a commodity is opposite to the
perfectly elastic demand. Under the perfectly inelastic demand,
a rise or fall in price of a commodity the quantity demanded for a
commodity remains the same. The elasticity of de mand will be
equal to zero. The demand curve is vertical straight line parallel
to Y-axis shown in the Diagram 2.10.
Diagram 2.10munotes.in
34
3.Unitary elastic demand (E p= 1): Demand is said to be unitary
elastic when the percentage change in the quantity demanded
for a commodity is equal to the percentage change in its price.
The numerical value of unitary elastic of demand is exactly
equal to one i.e. Marshall calls it as unit elastic. The demand
curve is rectangular hyperbola shown in the Diagram 2.11.
Diag ram 2.11
4.Relatively Elastic demand (E p> 1): Demand is said to be
relatively elastic, when the percentage change in quantity
demanded of a commodity is greater than the percentage
change in its price. In other words, it refers to a situation in
which a sm all change in price leads to a great change in
quantity demanded. The demand curve under this situation is
flatter as shown in Diagram 2.12.Such demand curve is seen
under monopolistic competition.
Diagram 2.12munotes.in
35
5.Relatively Inelastic demand (E p< 1): Dem and is relatively
inelastic when the percentage change in the quantity demanded
of a commodity is less than the percentage change in the price
of the commodity. The demand curve under this situation is
steeper shown in Diagram 2.13. Such demand curve is
observed under monopoly market.
Diagram 2.13
Check your Progress :
1)What is the nature elasticity of demand for luxurious good?
2)List down the degrees of Elasticity of Demand.
2.12 INCOME ELASTICITY OF DEMAND
As we have discussed earlier the factor which determines
elasticity of demand for a commodity. The consumer’s income is
one of the important determinants of demand for a commodity. The
demand for a commodity and consumer’s income is directly related
to each other, unlike pric e-demand relationship.
Income elasticity of demand shows the degree of
responsiveness of quantity demanded of a commodity to a small
change in the income of a consumer. In other words, the degree of
responsiveness of quantity demanded to a change in incom e is
measured by dividing the proportionate change in quantitymunotes.in
36
demanded of a commodity by the proportionate change in the
income of a consumer.
Percentage change in purchases of a comm odityIncome Elasticity =Percentage change in income
2.12.1 MEASUREMENT OF INCOME ELASTICITY OF DEMAND
The income elasticity of demand can be calculated by either
point method or arc method.
Point income elasticity of demand is measured by following
formula:/
/yQ QEY Y
Q Y
Y Q
Q Y
Y Q
Where, Q = Origin al Quantity Demanded.
Y= Original Income.
ΔQ= Change in Quantity Demanded.
ΔY= Change in Income.
Arc income elasticity of demand is measured by following formula:
2 1 2 1
2 1 2 1yQ Q Y YEY Y Q Q
Income elasticity of demand being zero is a great
significance. It implies that a given increase in the income of a
consumer does not at all lead to any increase in quantity demanded
of a commodity or expenditure on it.
Classification of goods based on income elasticity of
demand: We can broadly classify the various goods on the bas is of
value of income elasticity of demand.
1.Normal Goods: Normal goods are those goods which are
usually purchased by consumer as his income increases. In
other words, normal good means an increase in income causes
an increase in the demand for a commodity . It has a positive
income elasticity of demand. Normal goods are further classified
as:
a.Necessity goods: A good with an income elasticity less
than one and which claims declining proportion of
consumers income as he becomes richer is called a
necessity go od. Necessity goods are those goods where anmunotes.in
37
increase in income of a consumer leads to less than
proportionate increases in the demand for a commodity. For
example, daily used goods, basic goods etc. the income
elasticity of demand for such goods positive and less then
unity. i.e. E y< 1.
b.Luxuries goods: A good having income elasticity more than
one and which therefore bulks larger in consumers budget
as he becomes richer is called a luxury good. Luxuries
goods are those goods where a change in income leads to
direct and more than proportionate change in quantity
demand for a commodity. For example, diamonds,
expensive cars, etc. Thus, income elasticity of demand for
such goods is positive and greater than one i.e. E y> 1.
c.Comfort goods: Comfort goods are those goods where
change in income leads to direct and proportionate change
in quantity demanded. For example, semi -luxury goods and
comfort items. Income elasticity of such goods are positive
and unity. i.e. E y= 1.
2.Inferior goods: Inferior goods are thos e goods are where
consumer buys less of goods as his income increases. Goods
having negative income elasticity are known as inferior goods.
As income of a consumer increases his demand for goods shifts
from inferior to superior. The income elasticity for s uch goods
are 0yE.
3.Neutral goods: when a change in income of a consumer brings
no change in the quantity demanded of a commodity. For
example, salt, rice, pulses etc. elasticity for such goods are
0yE.
2.13CROSS ELASTICITY OF DEMAND
Sometimes we find two goods are inter -related to each other
either they are substitute goods or commentary goods. Cross
elasticity of demand measures the degree of responsiveness of
demand for one good in responsive to the chang e in the price of
another good.
cPercentage change in quantity demanded o f commodity 'X'E =Percentage change in the price of commod ity 'Y'
Classification of goods based on value of cross elasticity of
demand:munotes.in
38
a.Substitution: If the value of elasticity between two goods are
positive the goods are said to be substitute to each other. For
example, Tea and coffee, if the price of tea increases the
demand for coffee increases.
b.Complementary: if the value of elasticity between two goods
are negative the goods are said to be complementary. For
example, car and petrol, if the price of petr ol increases the
demand for car decreases.
c.Unrelated: if the value of elasticity between two goods are zero
then the goods are said to be unrelated to each other. For
example, table and car, if the price of table increases there is no
change in the deman d for car.
2.14 PROMOTIONAL ELASTICITY OF DEMAND
It is also known as ‘Advertisement elasticity’. In modern
times an increase in expenditure on advertisement or promotion
leads to an increase in the demand for a commodity Promotional
elasticity of deman d is the proportional change in quantity demand
due to proportionate change in promotional expenditure. In other
words, percentage change in the quantity of demand for a
commodity divided by the percentage change in promotional
expenditure shows the promot ional elasticity of demand.
APercentage change in quantity demandedEPercentage change in advertisement expen diture
The greater the elasticity of demand, its better for a firm to
spend more on promotional activities. The pro motional elasticity of
demand is usually positive.
Check your Progress :
1)How income of a Consumer related to the demand of the
commodity?
2)If the Consumer income increase. What will be the elasticity of
demand for necessity goods?munotes.in
39
2.15 CONCEPTS OF REVENUE
The term revenue refers to the income obtained by a firm or
a seller through the sale of commodity at different prices. The
revenue is classified as:
1.Total revenue: The total revenue or income earned by a firm or
producer from the sale of the output he produced is called the
total revenue. Thus, the total revenue is the price multiply the
quantity of output.
TR = P×Q
Where,
TR = Total Revenue.
P = Price of a commodity.
Q = Total Output sold.
Thus, Total revenue is the sum of all sales, receipts or
income of a firm in the market.
2.Average revenue: The average re venue refers to the revenue
obtained by the firm by selling the per unit of output of a
commodity. It is obtained by dividing the total revenue by total
unit of output sold in the market.
AR = TR
Q
Or
AR = P
Where, AR= Average revenue.
The average revenue curve shows that the price of the firm’s
product is the same at each level of output. In other words, the
average revenue curve of a firm is al so the demand curve of the
consumer.
3.Marginal revenue: Marginal revenue is the additional revenue
earned by selling an additional unit of the commodity. In other
words, Marginal revenue is the change in total revenue due to
the sale of one additional un it of output. Thus, marginal revenue
is the addition commodity made to the total revenue by selling
one more unit of the commodity. In algebraic terms, marginal
revenue is the net addition to the total revenue by selling n units
of a commodity instead of n –1.
Thus, MR n= TR n-TRn-1
Or
MR = ΔTR
ΔQmunotes.in
40
Relationship between price elasticity and total revenue:
Elasticities of demand can be divided into three broad categories:
elastic, inelastic, and unitary. An elastic demand is one in which the
elasticity is greater than one, indicating a high responsiveness to
changes in price. Elasticities that are less than one indicates low
responsiveness to price changes and correspond to inelastic
demand. Unitary elasticities indicate proportional responsiveness of
either demand or supply, as summarized in the following table:
Total
revenueChange in
priceElasticity Reasons
Increase
DecreaseFall
RiseEp> 1 Percentage
change in
quantity
demanded is
greater than the
percentage
change in price.
Decrease
IncreaseFall
RiseEp<1 Percentage
change in
quantity
demanded is
smaller than
percentage
change in price.
Unchanged
UnchangedFall
RiseEp= 1 Percentage
change in
quantity
demanded is
equal to
percentage
change in price.
Table 2 .3
The relationship between the price elasti city and total revenue
shows the following analysis from the above table.
A.When demand is elastic, price and total revenue move in
opposite directions.
B.When demand is inelastic, price and total revenue moves in
same direction.
C.When demand is unitary elasti c, total revenue remains
unchanged with the price changes.
This relationship can be easily understood by the following
diagram: 2.14munotes.in
41
Relationship between price elasticity and Average revenue
and Marginal revenue: The relationship between AR, MR and
elast icity of demand is very useful to understand at any level of
output.
This relationship is also very useful to understand the price -
determination under different market conditions. It has been
discussed that average revenue curve of a firm is the same thin g as
the demand curve of the consumer for the product of the firm under
market.
This relationship can be explained with the following diagram: 2.14
Diagram 2 .14
2.16SUMMARY
In this unit we have analysed the demand concept and its
various function al ong with the law of demand. Ineconomics both
demand and supply are the important forces through which market
economy functions. But in this unit, we will focus more on demand
side. The demand function shows the relationship between the
quantity demanded a nd its various determinants. In this chapter we
will explain the demand function in detail. Demand function is an
arithmetic expression that shows the functional relationship
between the demand for a commodity and the various factors
affecting it. It has a lso explained he nature of demand curve under
different market situation. We have also discussed the nature of
demand curve under different market conditions with the various
elasticity concepts and its measures in detail. Elasticity of demand
helps us to estimate the level of change in demand with respect to
a change in any of the determinants of demand. The concept of
elasticity of demand helps the firm or manager in decision making
with respect to pricing, promotion and production polices. Themunotes.in
42
elasticity of demand measures the elasticity of four important
factors i.e. price, income, cross and promotional with three
important measures of point, arc and geometric measures of
elasticity. The unit also deals with the various revenue of the firm in
business a ndtheir relationship in detail.
2.17QUESTIONS
1.Explain the law of demand and the factors with determines the
demand.
2.Explain the nature of demand curve under different markets.
3.What is demand function? Explain in detail.
4.What is elasticity? Explain pric e elasticity of demand in detail.
5.Explain the measurements of price elasticity of demand.
6.Discuss the different degrees of elasticity of demand.
7.What are the factors affecting price elasticity of demand?
8.Write a note on:
a)Income elasticity of demand.
b)Cross elasticity of demand.
c)Promotional elasticity of demand.
9.Explain the concepts of revenue in detail.
munotes.in
43
Unit –2A
DEMAND ESTIMATION AND
FORECASTING
Unit structure:
2A.0Objectives
2A.1Introduction
2A.2Meaning
2A.3Significance of d emand forecasting
2A.4Steps in demand forecasting
2A.5Methods in demand forecasting
2A.6Summary
2A.7Question
2A.0 OBJECTIVE S
To understand the meaning and sig nificance of demand
forecasting
To learn the steps, involve i n estimating demand forecas ting
To understand th e methods of demand forecasting
2A.1INTRODUCTION
Business is a serious job. Manager or the business firms has
to take certain decision to run their business smoothly without any
disturbance in his business. Demand forecasting play a vital role in
business planning. Business enterprises need to plan their
activities. Most of the business decisions of a firm under an
organization are made under the conditions of risk and uncertainty.
Demand forecasting is a systematic process that inv olves
anticipating the demand for the product and services of an
organization in future under a set of uncontrollable and competitive
forces in the economy.
Demand forecasting helps the business firms to take
appropriate decision about the production and the use of factors of
production to fulfil the future demand of the commodity.munotes.in
44
2A.2MEANING
Demand forecasting means estimation of demand for the
product for a future period. Demand forecasting enables an
organization to take various decisions in busin ess, such as
planning about production process, purchasing of raw materials,
managing funds in the business, and determining the price of the
commodity. A business organization can forecast demand for his
product by making own estimations called guess or b y taking the
help of specialized consultants or market research agencies.
2A.3SIGNIFICANCE OF DEMAND FORECASTING
Demand forecasting plays an important function in the
management of various business decision. Forecasting help the
business firm to know w hat is likely to happened in future and to
reduce the degree of risk and uncertainty in business and to make
various business policy decision and action of the future. Thus, a
demand forecasting is meant to guide business policy decision.
The significa nce of demand forecasting are as follows:
1)Fulfils the s objective: Demand forecasting implies that every
business unit starts with certain pre -determined objectives.
Demand forecasting helps in fulfilling these objectives. An
organization estimates the cu rrent demand for its products and
services in the market and move forward to achieve the set
goals.
For example, an organization has set a target of selling 60, 000
units of its products. In such a case, the organization would
make demand forecasting for its products. If the demand for the
organization’s products is low, the organization would take
remedial actions, so that the set objective can be achieved.
2)Production planning: Demand forecasting is important to
forecast the future production plan of bu siness firm. There is a
gestation period between production of goods and services and
demand for it. Demand forecasting help to eliminate those gaps
between demand and supply of goods preventing shortages and
surplus.
3)Distribution and avoidance of wastag e of resources
planning: The business firm has to take decision regarding the
distribution of capital, machinery, raw material in the production
process. So that if there is any shortage of those resources can
be arranged prior through estimation. Making a right and correct
estimation of using resources reduces the usage of it.munotes.in
45
4)Sales distribution policy: Sales of goods and service gives
revenue to the firm’s demand. Forecasting is nothing but
estimating the sales of the product. To formulate realistic sales
targets and to make arrangements for the movement of
production for the movement of product region wise, demand
forecasting is very essential. This can help to formulate an
effective sales policy, and therefore, to increase sales revenue.
5)Price policy: The firm has to make decision regarding the price
of goods and services which is a critical job. The firm has to
make appropriate price policy so that there is no price
fluctuation in the future.
6)Reduce business risk: Every business has certain risk.
Dema nd forecasting help the business firm to make appropriate
business decision to reduce such risk and uncertainty to a
certain extent.
7)Inventory planning: Inventories are goods and raw materials
held by the firm future sale. Demand forecasting helps in
devising appropriate inventory management policies.
Check your Progress :
1)How demand forecasting health business firm in predicating
future demand for his product?
2)List down the factors determining nature of demand forecasting.
2A.4STEPS IN DEMAND FORECASTING
The demand forecasting finds its significance during large -
scale production of goods and services. During such period of time
firms may often face difficulties in obtaining a fairly accurate
estimation of future demand. Thus, it is essential for a firm to
forecast demand systematically and scientifically to arrive at
desired objective. Therefore, the following steps are to be taken to
facilitate a systematic demand forecasting:
1.Determining the objective: The very first step in demand
forecasting is to determine its objective of forecasting. The
objective for which the demand forecasting is to be done must
be clearly specified. The objective of forecasting may be defined
in terms of; long -term or short -term demand, the whole or onlymunotes.in
46
the segment of a market for a firm’s product, overall demand for
a product or only for a firm’s own product, firm’s overall market
share in the industry, etc. The objective of the demand must be
determined prior in the process of demand forecasting begins
asit will give direction to the whole research.
2.Nature of forecast: After determining the objective of
forecasting the second important step is to identified the nature
of demand forecasting. Its based on the nature of forecasting.
3.Nature of commodity: While forecasting it is important to
understand the nature of the product whether it is consumer
goods or producer goods, perishable goods or durable goods. If
the good is perishable the forecasting is to be done in a short
period of time and for durable goods it may be done in long run.
4.Determinants of demand: Determinants of demand play an
important role in determining the forecasting as different
commodity have different factor determination of demand which
depends upon the nature of commodity and nature of
forecasting. The important determinants are price of the
commodity, price of related goods, income of a consumer etc.
5.Identifying the relevant data: Necessary data for the
forecasting are collected, then tabulated, analysed and cross -
checked by the firm. The data are interpreted by applying
various statistical or graphical techniques, and then to draw
necessary deductions there from. The forecaster has to decide
whether to choose primary or secondary data. The primary data
are the first -hand data which has never been collected before.
While the secondary data are the data already available. Often,
data required is not available and hence the data are to be
adjusted, even manipulated, if necessary, with a purpose to
build a data consistent with the data requ ired. Then after
collecting the relevant data from different sources and proceed
for the further step.
6.Selecting the method: After collecting the relevant data the
firm choose the appropriate method of forecasting the demand.
Appropriate method of sales f orecasting is selected by the
company considering the relevant information, purpose of
forecasting and the degree of accuracy required. The choice of
method has to be appropriate and logical. If the required data is
not available toward the method, the for ecaster may force to
use less reliable method. The forecaster should use a method
which should not be too time consuming and it should be
reliable for long term.
7.Testing accuracy: After making a choice of method the
forecaster needs to test the accuracy of it. There are variousmunotes.in
47
methods choose to test the accuracy. This testing helps to
reduce the margin of error and thereby helps to improve its
validity for the purpose of decision making
8.Evaluation and conclusion: the last and final step are to
evaluate th e forecasting and to draw a conclusion from it.
2A.5METHODS OF DEMAND FORECASTING
The main challenge to the forecaster while forecasting the
demand is to select an effective technique or method. Broadly
speaking methods of demand forecasting are class ified into
Qualitative methods and Quantitative methods. Which can also be
classified as Survey method and Statistical method. The forecaster
may choose any of the method depending upon the data which is
available. Under these two broad categories, there a re other
specific methods which is been choose to analysis the data. These
two methods will be discussed below:
A.Survey method: This method is also called as qualitative
method of demand forecasting. This method is one of the most
common and direct method of demand forecasting in the short
run. In this method the future purchase plans of the consumers
and their aims are included. An organization conducts these
surveys with consumers to determine the demand of their
existing products and services and forecas t the future demand
of their product accordingly.
The forecaster may undertake the following survey methods:
a)Expert’s opinion: This method is based on the opinion of
expert who predict the demand for a product based on his
experiences and his knowledge in the particular specialised
field. The expert may be from the same organisation or may be
hired from outside. They may be salesman, sales manager,
marketing expert, market consultant etc they act as experts who
can assess the demand for the product in di fferent areas,
regions, or cities. This method involves the opinion of three or
four experts. Each expert will be asked about his opinion
regarding the demand for the product and the expert through his
personal experience give his opinion for the product a nd
forecast the demand. This method is very simple to use and it
requires less statistical work. Due to expert’s personal views the
time for forecasting is short and the cost involve is also low. On
the other side as its expert’s personal opinion or guess where its
likely to be biased.
b)Delphi method: Delphi method is a group decision -making
technique of forecasting demand. In Delphi method, a group ofmunotes.in
48
experts gives their opinion on the demand for the products of
individual firm in future based on question s which have been
asked by the firm. These questions are repeatedly asked until a
result is obtained. In addition, each and every expert is provided
information regarding the estimates made by other experts in
the group, so that he/she can revise his/her e stimations with
respect to others’ estimates. In this way, the forecasters cross
check among experts to reach more accurate decision making.
The main advantage of this method is that it is time and cost
effective as a number of experts are approached in a short time
without spending much time on other resources. However, this
method may lead to appropriate decision making. This method
allows the forecaster to solve the problem to the experts at once
and have instant response. But the success of this method
depends upon the skills, experience, knowledge, and aptitude of
the expert.
c)Consumer survey method: In this method, the consumers are
directly approached to unveil their future purchase plans. This
method is the most direct method because forecasting is done
by interviewing all consumers or a selected group of consumers
out of the relevant population through various other methods of
survey. The firm may choose for complete enumeration method,
sample survey method and end use method for sample surveys
depe nding upon the nature of forecasting. The following
methods are described in brief below:
i.Complete enumeration method: Under the Complete
Enumeration Survey, the forecaster undertakes the survey of
the whole population who demand for the commodity. The fi rm
may go for a door to door survey by making questionnaire to get
the data requires. This method has an advantage of first hand
data, unbiased information, yet it has its share of disadvantages
also. The major limitation of this method is that it requires lot of
resources, manpower and time period. There may be a chance
where the consumer or the population may give false statement
or may deliberately misguide the investigators due to which
there may be chance of data error. In this method, consumers
may be unwilling to reveal their purchase plans due to personal
privacy or commercial secrecy.
ii.Sample survey method: This method is also known as test
market. In this method the forecaster selects the samples of
consumer from the relevant population instead of considering
the whole population. If sample is the true representative of
data, there is likely to be no significant difference in the results
obtained by the survey. Apart from that, this method is less
tedious and less costly then the complete enumeratio n method.
A sample survey technique is a variant of test marketing.munotes.in
49
Product testing basically involves employing the product with a
number of users for a set of periods of time. Their reactions to
the product are noted after a period of time and an estimat e of
likely demand is made from the result. These are suitable for
new products or for completely modified old products for which
there is no prior data available. It is a more scientific method of
estimating like demand because it stimulates the national
launch in a very closely defined geo graphical area. Their can be
a sampling error in this method as the size of sample is small
i.e. smaller the size of sample larger the sampling error.
iii.End-use method: This method is quite useful for industries
which a re mainly producer’s goods and when a product is used
for more than one use. In this method, the sale of the product is
projected on the basis of demand survey of the industries which
are using this product as an intermediate product, that is, the
demand f or the final product is the end user demand of the
intermediate product which are used in the production of this
final product is considered. The end use method of demand
estimation of an intermediate product may involve many final
good industries using th is product at home and abroad. It helps
us to understand inter -industry’ relations. The major efforts
required by this type of method are not in its operation but in the
collection and presentation of data. This will help the forecaster
to manipulate the f uture demand. This policy helps the
government to frame many of its policies. Its major limitations
are that it requires every firm to have a plan of production
correctly for the future period.
d)Market experiments: This method involves collecting
necessar y information regarding the current and future demand
for a product in the market. This method carries out the studies
and experiments on consumer behaviour under actual market
conditions. In this method, some areas of markets are selected
with similar fea tures, such as income level , population, cultural
and political background, and tastes of consumers. The market
experiments are carried out with the help of changing prices and
expenditure, so that the resultant changes in the demand are
recorded. These results help in forecasting future demand.
i.Actual market experiment: This method is conducted in the
actual market place in several ways. One method is to select
several market or stores with similar characteristics. This
method is very useful in the proc ess of introducing a product
for which no other data exist.
ii.Simulated market experiment: This method is also called
as consumer clinic or laboratory experiment. Under this
method the firm make a set of consumers and give them amunotes.in
50
sum of money and asked the m to shop in a stimulated store.
While shopping the consumer reaction towards the change
in price of a product, packaging, advertisement etc are taken
into consideration.
B.Statistical methods: This method is also called as quantitative
method. Statistical method is most useful in demand
forecasting. In order to key objectivity, that is, by consideration
of all implications and viewing the problem from an external
point of view, the statistical methods are used to forecast the
demand of the product to get th e accurate solution to the
problems. The following are some statistical methods which are
been used now a day:
I.Trend method: A firm existing for a long time will have its
own data regarding sales for past years. Such data when
arranged in a chronologicall y manner will yield what is
referred to as ‘time series. Time series method shows the
past sales with effective demand for a particular product
under normal conditions. Such data can be given in a tabular
or graphic form for further analysis. This is the m ost popular
method among business firms, partly because it is simple
and cheap and partly because time series data often show a
persistent growth trend. Time series has got four types of
components namely, Secular Trend (T), Secular Variation
(S), Cyclical Element (C), and an Irregular or Random
Variation (I). These time elements are expressed by the
equation O = TSCI. Secular trend refers to the long run
changes that occur as a result of general tendency.
Seasonal variations refer to the changes in the sho rt run
weather pattern or the social habits. Cyclical variations refer
to the changes that occur in industry during a depression
and boom period. Random variation refers to the factors
which are generally able such as wars, strikes, natural
calamities such as flood, famine and so on. When a
prediction is made the seasonal, cyclical and random
variations are removed from the observed data. Thus, only
the secular trend is left. This trend is then projected. Trend
projection fits a trend line into a mathematic al equation. The
trend can be estimated by using any one of the following
methods:
(a) The Graphical Method: Graphical method is the
simplest technique to determine the trend analysis. All
values of output or sale of product for different years are
plotte d on a graph and a smooth free hand curve is drawn
passing through as many points as possible on the graph.munotes.in
51
The direction of this free hand curve is either upward or
downward and shows the possible trend.
(b) The Least Square Method: Under the least squar e
method of forecasting, a trend line can be fitted to the time
series data with the help of statistical techniques such as
least square method of regression. When the trend in sales
over time is given by straight line, the equation of this line is
in the form of: y = a + bx. Where ‘a’ is the intercept and ‘b’
shows the impact of the independent variable. We have
taken two variables i.e. the independent variable x and the
dependent variable y. The line of best fit establishes a kind
of mathematical relation ship between the two variables v
and y. This is expressed by the regression у on x.
In order to solve the equation v = a + bx, we have to make
use of the following normal equations:
Σy = na + b ΣX
Σxy =aΣx+bΣx2
II.Regression method: regression metho ds attempts to
assess the relationship between at least two variables (one
or more independent and one dependent), the purpose is to
predict the value of the dependent variable from the specific
value of the independent variable. The foundation of this
prediction generally is historical data. This method starts
from the assumption that a basic relationship exists between
two variables. An interactive statistical analysis computer
package is used to formulate this mathematical relationship.
Check your Progr ess :
1)List down the steps of demand forecasting.
2)Define survey method of demand forecasting.
3)Define Delphi method of demand forecasting.
2A.6SUMMARY
This unit study the demand estimation and its forecasting.
Demand forecasting pl ay a vital role in business planning. Business
enterprises need to plan their activities. Most of the businessmunotes.in
52
decisions of a firm under an organization are made under the
conditions of risk and uncertainty. Demand forecasting is a
systematic process that involves anticipating the demand for the
product and services of an organization in future under a set of
uncontrollable and competitive forces in the economy. Demand
forecasting helps the business firms to take appropriate decision
about the production an d the use of factors of production to fulfil the
future demand of the commodity. It had studied the importance or
significance of demand forecasting. Demand forecasting plays an
important function in the management of various business decision.
Forecasting help the business firm to know what is likely to
happened in future and to reduce the degree of risk and uncertainty
in business and to make various business policy decision and
action of the future. The unit explains the various steps in
forecasting dema nd. It has also explained the two major methods of
demand forecasting in detail.
2A.7QUESTIONS
1. What is demand forecasting? Explain its importance.
2. Discuss the steps to be taken to estimate demand forecasting.
3. Explain the survey methods of deman d forecasting.
4. Examine the statistical methods of demand forecasting.
munotes.in
53
UNIT -3
Unit -3
SUPPLY AND PRODUCTION DECISIONS
Unit Structure :
3.0 Objectives
3.1 Meaning of production
3.2 Production function
3.3 Types of production function
3.4 Law of variable proportion
3.5 Law of returns to scale
3.6 Isoquants
3.7 Properties of isoquants
3.8 Types of isoquants
3.9 Ridge lines
3.10 Producer’s equilibrium
3.11Expansion path
3.12Summary
3.13 Questions
3.0 OBJECTIVES
To study the meaning, functions a nd types of production
function
To understand the law of variabl e proportion and law of returns
to scale
To study the concept isoquants and its property and types
To understand the producer’s equilibrium and expansion path
3.1 MEANING OF PRODUCTION
The term ‘production’ is very important and broader concept
in econom ics. To meet the daily demand of a c onsumer production
is essential part.Production is a process by which various inputs
are combined and transformed into output of goods and services,
for which there is a demand in the market. In other words,
Production is a process of combining various material inputs and
immaterial inputs in order to make something for consumption. The
essences of production are the creation of utilities and themunotes.in
54
transformation of inputs or resources into output. Inputs are the
resources used in the production of goods and services the
important resources or input in production are land, labour, capital,
and entrepreneur. Production process creates economic well -being
into the nation. Thus, production is a process which creates utility
and value in exchange.
The theory of production function is concern with the
problem in the production process in a certain level of output. It
analyses the relation between cost and output and help the firm to
determine its profit. All firms that aims at m aximising their profit
must make their decision regarding production on the bases of the
following three decision:
a.How much output to produce and supply in the market?
b.How to produce the product, i.e. which technique of production
or combination of produ ction to used have to be decided?
c.How much quantity of input is demanded to produce the output
of the product?
Thus, the above three decisions are interrelated and have to
be taken by the firm during the production process.
3.2PRODUCTION FUNCTION
In e conomics, a production function is the functional
relationship between physical output of a production process to
physical inputs or factors of production . In other words, production
function denotes an efficient combination of input and output. The
factor s which are used in the production of goods and services are
also called as agents of production. Production function of a
business firm is determined by the state of technology. More
specifically, production function shows the maximum volume of
physical o utput available from a given set of inputs, or the minimum
set of inputs necessary to produce any given level of output.
Definition: With the above statements we can define the
production function as: “Aproduction function refers to the
functional rela tionship, under the given technology, between
physical rates of input and output of firm, per unit of time”.
Mathematically, production function can be express as : Q = f (N, L,
K, E, T, etc.)munotes.in
55
3.3 TYPES OF PRODUCTION FUNCTION
I.The production functi on can be broadly categorised into two
based on the time period i.e. a) Short run production function and
b) long run production function.
A) Short run production function: The short run is defined as the
period during which at least one of the input is fixed. According to
the following short -run production function, labour is the only
variable factor input while the rest of the inputs are regarded as
fixed. In other words, the short run is a period in which the firm can
adjust production by changing var iable factors such as materials
and labour but cannot change fixed factors such as land, capital,
etc. Thus, in short -run some factors are fixed and some are
variable.
B) Long run production function: The long run production
function is defined as the pe riod of time in which all factors of
production are variable. In the long run there is no distinction
between the fixed or variable factor as all factors in the long runare
variable.
II.The production function can also be classified on the basis
of fac tor proportion i.e.
a)Fixed proportion production function and b)Variable proportion
production function .
A.Fixed proportion production function :The fixed proportion
production function , also known as a Leontief Production
Function which implies thefixed factors of production function
such as land, labour, raw materials are used to produce a fixed
quantity of an output and these factors of production function
cannot be substituted for the other factors. In other words, in
such factors of production func tion fixed quantity of inputs is
used to produce the fixed quantity of output. All factors of
production are fixed and cannot be substituted for one another.
The concept of fixed proportion production function can be
further expained with the help of a Diagram 5.1as shown
below:munotes.in
56
Diagram 3.1
B.Variable proportion production function :The variable
proportion production function supposes that the ratio in which
the factors of production such as labour and capital are used i n
avariable proportion . Also, the different combinations of factors
can be used to produce the given quantity, thus, one factor can
be substituted for the other factor . In the case of variable
proportion production function, the technical Coefficient of
production function is variable , i.e. the important quantity of
output can be achieved through the combination of different
quantities of factors of production, such as these factors can be
varied by substituting one facto rs to the other / factors in its
place.
The concept of variable p roportion production function can
be further explained from an isoquant curve, as shown in the
Diagram 5.2below:
Diagram 3.2munotes.in
57
In the above diagram , the isoquant curves show that the
different combinations of factors of technical substitution shows that
itcan be employed to get the required amount of output in the
production process . Thus, for the production of a given level of
product, the input factors can be substituted f rom another factor
input .
3.4 LAW OF VARIABLE PROPORTION
The law of variable p roportion is a short run production
function theory. This law plays a very important role in the
economic theory, which examines the production function with
which one variable factor keeping the other factors input fixed. This
law is explained by the clas sical economists to explain the
behaviour of agricultural output. In other words, it examines the
behaviour of the production in the short -run when the quantity of
one factor is varied, keeping the quantity of another factor’s
constant. Thus, the law of variable proportion is the new name for
the famous theory “The Law of Diminishing Marginal Returns” of
classical economist.
Alfred Marshall, had discussed the law in relation to
agriculture, according to him, “an increase in the capital and labour
applied in the cultivation of land causes in general a less than
proportionate increase in the amount of product raised unless it
happens to coincide with an improvement in the art of agriculture”.
Marginal productivity of labour in agriculture is zero.
Assumpti ons:The law of variable proportion is based on the
following assumptions:
a.The state of technology is assumed to be given and constant.
b.There must be some inputs whose quantity must be kept as
fixed or constant. Such input factors are called fixed fact ors.
c.All units of variable factors inputs are homogenous.
d.The law is based upon the possibility of varying the proportions
in which the various factors can be combined to produce the
level of output. Let us assume the labour is the variable factor in
ourexplanation.
Change in output due to increase in variable factors can be
explain with the table given below:munotes.in
58
Units of Variable
factor (LABOUR)Total Product
(TP)Average
Product (AP)Marginal
Product (MP)
0 0 0 -
1 5 5 5
2 12 6 7
3 27 9 15
4 48 12 21
5 75 15 27
6 80 13.33 15
7 91 13 11
8 98 12.5 7
9 98 10.8 0
10 92 9.2 -6
Table 3 .1
Explanation of the table:
In the above table the labour is consider as a variable factor
and all other factors are assumed to be constant according to the
law. With the increase in the variable factor i.e. labour there is a
change in the level of TP, AP, and MP.
Total product: The total product is the total amount of output
produced by using all the variable input in a fixed proportion in
production. The to tal product increases with the increase in the unit
of labour and reaches to the maximum and they’re after decline
with further more increase in the variable factor.
Average product: The average product is the per unit of product
produced by the firm wit h the per unit of variable factor inputs. It is
obtained by dividing the total product by the unit of total variable
factor. The average product increases initially and then declines.
Marginal product: Marginal product is the additional output
produced by an additional unit of variable factor. Marginal product
increases and thereafter falls when TU becomes maximum MU
becomes zero and further becomes negative.
Diagram: the law of diminishing marginal returns can be explained
with the following diagram:munotes.in
59
Diagram 3.3
The above diagrams show three phases with the changes in the
output can be explained below:
Phase 1: In phase 1the total product is increasing at increasing
rate where average product is also increases at a diminishing rate
and reaches at its maximum and marginal product increases
initially and then decreases.
Phase 2: In phase 2the total product increases at a diminishing
rate and reaches its maximum point. Where the average product is
starts declining and the marginal product diminishes and become
zero.
Phase 3: In this phase total product starts declining. Where
average product is continuously declining and marginal product
becomes negative.
3.5 LAW OF RETURNS TO SCALE
As the law of variable proportion is a short run production
function theory, law of returns to scale is a long run production
function theory. In this theory all factors of production are variable
no factors are fixed. With the change in the factors of production
scale of production will change accordingly.munotes.in
60
According to Koutsoyiannis “The term returns to scale refers to
the changes in output as all factors change by the same
proportion.”
Types of return to scale:
The concept of returns to scale assumes only two factors of
productions i.e. capital and labour t his analysis enables us to
understand the change or scale in production due to change in the
factors of production in terms of isoquants or equal product curves.
Increasing returns to scale: Increasing returns to scale means an
increase in a level of out put more than the increase in the inputs.
Forexample, if an output increases by 35% with an increase in all
inputs by only 15% increasing returns to scale prevails . In other
words, a proportionate change in output brings about less
proportionate change in inputs it is called increasing returns to
scale. Where, OA>AB>BC.
Diagram 3.4
Decreasing returns to scale: Decreasing returns to scale means
an increase in a level of output less that the increase in the inputs.
For example, if an output increase by25% with an increase in all
inputs by 35% decrease in returns to scale prevails. In other words,
a proportionate change in output brings more proportionate change
in inputs it is called decreasing returns to scale. Where
OA
61
Diagram 3.5
Constant r eturns to scale: Constant returns to scale means an
increase in a level of output is constant that the increase in the
inputs. For example, if an output increase by 25% with an increase
in all inputs by 25% constant in returns to scale prevails. In other
words, a proportionate change in output brings constant change in
inputs it is called constant returns to scale. Where OA=AB=BC.
Diagram 3.6munotes.in
62
Check your Progress :
1)Define Production Functions.
2)Define total product, average product & marginal pr oduct.
3)Explain constant returns to scale.
3.6ISOQUANTS
Meaning: The term “iso -quants” is derived from Greek word iso
means “equal” and quants means “quantity”. Thus, iso -quant
means equal quantity. An iso -quant is also known as iso-produ ction
curve, iso -indifference, equal production curve by various
economists . The isoquants have its properties which are similar to
those generally assumed for indifference curve theory of the theory
of consumer’s behaviour analysis .Iso-quant is defined a s “a locus
of all the combination of two factors of production that yields that
yield the same level of output.”
Thus, an iso -quant is a combination of any two factor inputs
that represents and produce the same level of output. Any two
combinations of inp ut factors e.g. Labour and capital are used in
which one factor is increased by decreasing the other factor of input
to maintain the same level of production.
Iso-quant can be explained with the schedule and graph
given below:
Factor combinations to prod uce a given level of output.
Factor combination Labour Capital Output
A 1 150 500
B 2 100 500
C 3 75 500
D 4 50 500
E 5 25 500
Table 3 .2
The above table shows the five combination of inputs i.e.
Labour and Factor unit which yield the same level of output of 500munotes.in
63
units. Which says any point on the iso -quant will give the same
level of output. To show this we draw the iso -quant drawn below:
Diagram 3.7
Iso-quant map:
An iso -quant map represents a set of iso -quant curves
shows the combination o f input factor at the various level of output.
A higher level of iso -quant represents the higher level of output.
Thus, in simple word, iso -quant map is a family of iso -quant
representing the various iso -quant curve at a particular level of
output. The iso -quant map can be represented with the diagram
given below:
Diagram 3.8
The fig above shows the various iso -quants representing the
various level of output at different combination of input factors. IQ 1,
IQ2and IQ 3shows the iso -quant which produce s 100,200 and 300munotes.in
64
units of output respectively with the various combination of input
factors which provides the same level of output at different level of
Iso-quant.as we had said higher the Iso -quant represents higher
the value of output.
3.7 PROPERTIES OF ISO -QUANTS
1.Iso-quant curve slopes downwards: The iso-quant curve
slopes downwards from left to right i.e. it has a negative slope. The
slope is downward because it operates under law of MRTS , when
we increase labour as a factor, we have to decrease c apital factor
to produce a same level of output. The downward sloping iso -quant
curve can be explaining the help of following Diagram 3.9.
Diagram 3.9
Thus, the iso -quant can be downward sloping from left to right.
There can’t be an upward slop ing iso -quant curve because it shows
that a given product can be produce by using less of both the input
factor. Similarly, an iso -quant cannot be horizontal or vertical
because it also doesn’t represent the equilibrium position of a firm.
Only the downwar d sloping supply curve represents the
characteristics of iso -quant.
2.Iso-quant are convex to the origin: As we had discussed in
the above propert ythat the iso -quant curve is downward sloping
and it has a negative slope and it operates under law of Margin al
rate of Technical Substitution ( MRTS ). It says that it equals the ratio
of the marginal product if labour and marginal product of capital i.e.
one factor is given up to get one additional unit of other factor to
produce the same of output which creates a convexity of iso -quant
curve.munotes.in
65
Thus, the slope of iso -quant can be represented by,
L
LK
KMP KMRTSL MP
The above equation represents ratio of change in capital and
labour should be equal to the ratio of the marginal rate of technical
substit ution of labour and capital which is equal to the ratio of
marginal product of labour and capital.
The convexity of iso -quant means that as we move down the
curve less and less of capital given up for an additional unit of
labour so to produce the same le vel of output. The convexity of iso -
quant can be observed from the Diagram 5.10.Given below
Fig 3 .10
Thus, the iso -quant can be convex to the origin but not the
concave because it would mean that MRTS will increase instead of
decreasing i.e. labour w ill increase at a constant rate the amount of
capital given up will goes on increasing.
3.Iso-quants do not intersect: The properties of iso -quants say
that two iso -quant will never intersect each other. To explain this,
we will take a help of following Diagram 3.11:munotes.in
66
Diagram 3.11
The above fig represents two different iso -quant IQ 1and IQ 2,
where it represents the level of output 100 and 200 units
respectively. Point a represents 100 units of output on IQ 1and point
c represents 200 units of output on IQ2. The point b shows the
intersection of both the iso -quants where is logically not possible to
identify the level of output.
4.Iso-quant cannot touch either of the axis: an iso -quant
cannot only touch x axis or y axis or any either axis because it wil l
represent that the iso -quant only produce goods by using one
factors of production either by using only capital or only labour
which is practically not possible and which is unrealistic.
Diagram 3.12munotes.in
67
5. Higher the iso -quant higher the level of product ion: if
there is a multiple iso -quant showing different level of production in
one diagram. Where the higher the iso -quant i.e. the iso -quant far
from the origin indicates higher level of output and the iso -quant
close to the origin indicates lower level o f output.
Diagram 3.13
3.8TYPES OF ISO -QUANT
The iso -quant have various shapes which depend supon the
degree of substitutability of factors in production. On the bases of
that the types of iso -quant are derive. The following are the various
types of iso -quant based on the degree of substitutability of
substitution:
1.Liner iso -quant: if the iso -quant is liner one i.e. downward
sloping straight line it assumes that there is a perfect substitutability
of the factors of productions. It means thatcapital and labour can
be easily substitute from each other. i.e. the rate atwhich labour
can be substituted for capital in production (i.e. MRTS LK) is
constant. This can be seen from the following Diagram 3.14given
below:munotes.in
68
Diagram 3.14
The above diagram shows that there is a perfect
substitutability of labour and capital at the points A & B where point
A on iso -quant represents the level of output can be produce with
capital alone i.e. without using any labour on the other hand point B
represents the sam e level of output can be produce with labour
alone i.e. without any use of capital. This in reality is not possible
because no production can be done with using any of the factor
alone.
2.Right angled iso -quant: if the iso -quant is right angled it
assumes t hat there is a perfect complementarily i.e. it assumes that
there is a perfect substitutability of factors of production. This
shows that there is only one method is used for production of the
commodity. In this type the iso -quant is formed as right angled as
shown in the following fig. which shows labour and capital are used
in a fixed proportion i.e. output can be increased by increasing
labour and capital in fixed proportion. This type of iso -quant is
known by many names such as input -output iso -quant an d Leontief
iso-quant.munotes.in
69
Diagram 3.15
3.Kinked iso -quant: This type of iso -quant assumes only limited
substitutability only at the kinked of the iso -quant. That means the
substitutability of labour and capital is only possible at the kinked of
the iso -quant in the production. i.e. in the fig. the substitutability is
possible at the point A, B, C and D. This type of iso -quant is also
called as ‘liner programming iso -quant” and it is used in liner
programming.
Diagram 3.16
4.Smooth convex iso -quant: Theclassical economic theory has
adopted this type of iso -quant for analysis as its simpler to
understand. This iso -quant assumes the continuous substitutability
of labour and capital over a certain range beyond which there ismunotes.in
70
zero substitutability of factor s in production. This iso -quant fulfils all
the criteria of iso -quant. The derivation of this smooth convex iso -
quant is explained below:
To explain the derivation of iso -quant we assume that there
is a various combination of factor inputs of labour and c apital used
to produce 100 units of output. The combination is a such where
one factor is increased by reducing the other factor input to produce
the same level of output in production. All this combination is
technically efficient in production.
Various combinations of labour and capital to produce 100
units of output.
Factor combination Labour Capital
A 10 60
B 20 50
C 30 40
D 40 30
Table 3 .3
If we plot all this combination on a graph, we obtain an IQ
curve.
Diagram 3.17
3.9 RIDGE LINES
The ridge lines are the locus of points of an iso -quants
where the marginal product of factors is zero. An isoquant is oval -munotes.in
71
shaped as shown in diagram but its area of rational operation lies
between the ridge lines. The firm will produce only in those
segmen ts of isoquants which are convex to the origin and lie
between the ridge lines. The ridge lines are the locus of points of
isoquants where the marginal products (MP) of factors are zero.
The upper ridge line implies zero MP of capital and the lower ridge
line implies zero MP of labour. Production techniques are only
efficient inside the ridge lines. The marginal products of factors are
negative and the methods of production are inefficient outside the
ridge lines. The ridge lines can be explained through th e help of
following diagram:
Diagram 3.18
In the above Diagram curves ОA and OB are the ridge lines
on the oval -shaped iso -quants and in between these lines on points
G, J, L and N and H, К, M and P economically feasible units of
capital and labour can be employed to produce 100, 200, 300 and
400 units of the product.
For example, ОТ units of labour and ST units of the capital
can produce 100 units of the product, but the same output can be
obtained by using the same quantity of labour ОТ and lessquantity
of capital VT. Thus, only an unwise producer will produce in the
dotted region of the iso -quant 100.
The dotted segments of isoquants form the uneconomic
regions of production because they require an increase in the use
of both factors with no c orresponding increase in output. If points
G, J, L, N, H, К, M and P are connected with the lines OA and OB,
they are the ridge lines. On both sides of the ridge lines, it is
uneconomic for the firm to produce while it is economically feasible
to produce inside the ridge lines.munotes.in
72
Check your Progress :
1)Define isoquant.
2)Why isoquant cannot intersect each other.
3)Define ridge lines.
3.10 PRODUCER’S EQUILIBRIUM
Producer’s equilibrium is also known as least cost
combination of inputs and o ptimal combination of inputs. The main
aim of any firm or a producer is to maximise his profit either by
increasing the level of output or sale or by producing the output at
lower cost. A firm by analysing its production function can choose
the combination of factors inputs which cost him least in his
production which is technically efficient. In this way a firm can
maximise its profit. There are two ways to determine the least cost
combination of factors to produce the given output. i.e.
a)Finding the Tota l cost of Factor combinations.
b)Geometrical method.
a)Finding the Total cost of factor combination: This method
helps the producer to choose the combination by finding the total
cost of production. The cost of each factor combination is found by
multiplying the price of each factor by its quantity and then
summing it for all inputs. The firm will choose those combination of
inputs of which total cost is least. To explain this in detail we will
explain it with the help of following illustration.
Least cost p roduction technique
Method Labour
(units)Capital
(units)Labour cost
(100 per unit)Capital cost
(200 per unit)Total
cost
A 8 10 8×100 = 800 10×200 = 2000 2800
B 6 15 6×100 = 600 15×200 = 3000 3600
Table 3 .4
The above table shows two methods of pr oduction A and B.
There are two factors of production labour and capital. The
producer has to choose any to the combination or method where
the cost of labour per unit is 100 Rs and cost of capital per is 200munotes.in
73
Rs. If the firm choose method A where he can us e 8 units of labour
and 10 units of capital where the total cost of production is 2800
Rs. And if he chooses method B where he can 6 units of labour and
15 units of capita to produce the same level of output and where
the cost of production is 3600 Rs. It is efficient for the firm to
choose method A then B because the same level of output can be
produced at a leaser cost with method A.
b)Geometrical method: Another important method to determine
the least cost combination of factors is geometrical method. It is the
easiest method to explain with the help of iso -quant map and iso -
cost line. We explain both this method in detail below:
Iso-quant map: As we have already explained what iso -quant map
is. It shows all the possible combination of factors that can b e
produce at different level of output. This is shown in fig. higher the
iso-quant represents higher the level of output. In other words, iso -
quant closer to the origin denotes a lower level of output.
Diagram 3.19
Iso-cost line: The iso -cost line is similar to as budget line or price
line of consumer theory. Iso -cost line may be defined as the line
which shows different possible combinations of labour and capital
that a producer can afford to buy given his total expenditure to be
incurred on these fa ctors and price of the factors. In other , it is the
line which shows the various combinations of factors that will result
in the same level of total cost. It refers to those different
combinations of two factors that a firm can obtain at the same cost.
Iso-cost line can be explained with following Diagram 5.20munotes.in
74
Diagram 3.20
In the above fig the line AB is the iso -cost line which shows a
firm can hire OA of capital OB of labour or any combination of
capital and labour on AB curve. Thus, iso -cost line is the locus of all
those combinations of labour and capital which, given the prices of
labour and capital, could be brought for a given amount of money.
The slope of the iso -cost line is equal to the ratio of the factor
prices, that is, the slope of the iso -cost lineK
LP
P.
Where, P Lis the price of labour and P kis the price of capital.
If the money to be spend on the factors increases the iso -
cost line will shift to the right and it denotes that, with the given
factor prices, the fir m could buy more of the factors. The iso -cost
lines closer to the origin show a lower total cost outlay.
Optimal input combination for minimising cost:
Ifthe firm has to produce a product with the given output by
the minimum cost, he will choose optima l minimising cost method.
In this method the firm will minimise its cost at the point where the
iso quant is tangent to the iso cost line. To explain this, we will take
a help of the following Diagram 3.21given below:munotes.in
75
Diagram 3.21
Explanation of the diagram:
Labour is taken on X axis where the capital on Y IC, I1C1,
and I2C2 are the family of Iso -cost lines. IQ denotes the single iso -
quant which produces the desired level of output. The iso cost line
having a same slope because the factor price isassumed to be
constant. The firm minimises its cost at the point ‘E’ where the iso -
quant IQ and Iso cost I1C1 are tangent. It shows the producer can
produce the given output by using minimum quantity of input at
minimum or least cost.
Thus, at the point ‘ E ’at the point of tangency the ratio of the
marginal product of two factors i.e. labour and capital is equal to the
ratio of their factor prices. To illustrate,
MPL
MPKSlope of isoquant.
PL
PKSlope of iso -cost line
Optimal input combination for maximisation of output:
In this method the firm has to maximise its output for a given
cost. The equilibrium condition is this method is a s same as the
minimisation method of output. But the maximisation of output
meth od is conceptually different then the minimisation method. The
following concept can be explained by the given diagram below:munotes.in
76
Diagram 3.22
Explanation of the diagram:
Labour is taken on the X axis and capital on Y axis. AB is the
firms Iso -cost lin e. Q, Q1, Q2 is the iso -quant.
The maximum level of output a firm can produce is at the
point ‘E’ where the isoquant Q1 is tangent to the iso -cost line AB.
The point above the ‘E’ will be on the Iso -quant Q2 which is higher
but nit attainable for the fi rm and iso -quant Below the point ‘E’ is
less productive.
Thus, the above two analysis minimisation output and
maximisation of output helps the firm to maximise their profits
according to the factor cost or factor prices.
3.11 EXPANSION PATH
Expansion path is also called scale line. The expansion path
is so called because if the firm decides to expand its operations, it
would have to move along this path. The expansion path in simple
word is defined as the locus of the points of tangency between the
isoquants and iso -cost lines. The expansion paths show how a
business firm tries to expand his output in the long run with the
given factor prices and the given various factor combinations. This
can be explained with the following diagram given below:munotes.in
77
Diagram 3.23
Explanation of the diagram:
X axis examines Labour and Y axis Capital. IC, I1C1 and
I2C2 are the iso -cost line parallel to each other which shows factor
prices are assumed to be constant. Q, Q1 and Q2 are the Iso -
quant. ‘e’ is the point of tan gency which shows a firm can produce
Q level quantity of output with least cost and least combination of
factors of production. Similarly, if firms want to increase his level of
output, he will be on point e1 and point e2 for the maximum level of
output at minimum cost and minimum level of factor inputs. If we
join all this tangency point E, E1 and E2 we will get a line OE called
as expansion path or scale line. It is important to note that at the
tangency point e, e1 and e2 the marginal rate of technical
substitution of labour for capital is equal to the ratio of factor prices.
Expansion path helps the business firm to find the cheapest way to
produce each level of output with given factor price. It helps the firm
to produce those level of output with the least cost and by using the
least factor combination of input.
3.12SUMMARY
The current unit had studied the production function and
various concepts of production decision which helps the firm to take
the appropriate production and supply decision. The term
‘production’ is very important and broader concept in economics.
To meet the daily demand of a consumer production is essential
part. Production is a process by which various inputs are combined
and transformed into output of goods and services, for which there
is a demand in the market. It has discussed two very important
theory of production function. The law of variable proportion is amunotes.in
78
short run production function theory. This law plays a very
important role in the economic theory, which examines the
production function with one variable factor keeping the other
factors input fixed. Law of returns to scale is a long run production
function theory. In this theory all factors of production are variable
no factors are fixed. With the change in the fac tors of production
scale of production will change accordingly. The unit has also
discussed the concept of iso -quant and its properties in detail and
concluded with producer’s equilibrium and expansion path.
3.13QUESTIONS
1)Explain the law of variable pro portion in detail.
2)Explain the law of returns to scale.
3)What is isoquant? Discuss its properties in detail.
4)Define isoquant. Explain the different types of isoquants.
5)Write a short note on:
a.Ridge lines
b.Expansion path
c.Producers behaviour
munotes.in
79
Unit –3A
ECONOMIES OF SCALE AND
DISECONOMIES OF SCALE
Unit Structure :
3A.0Objectives
3A.1Introduction
3A.2Economies of scale
3A.3Internal economies of scale
3A.4Internal diseconomies of scale
3A.5External economies of scale
3A.6External diseconomies of scale
3A.7Economies of scope
3A.8Summary
3A.9Questions
3A.0 OBJECTIVES
To study the internal and external econ omies and diseconomies
of scale
To understand the economies of scope
3A.1 INTRODUCTION
Adam smith in his fa mous book ‘Wealth of the Nation’ 1776
analyse the advantages of Division of labour which is capable of
generating economies of scale in static as well as in dynamic
sense. Economies of scale is a real phenomenon to the real -world
situation which helps to u nderstand the real situation in the world
economy. In microeconomics, economies of scale is a cost
advantage method of production where the firm operates its level of
output by producing the scale of operation with cost per unit of
output decreases with th e increasing scale of output. Where the
diseconomies of scale are the opposite of economies of scale.
3A.2 ECONOMIES OF SCALE
According to Alfred Marshal lEconomies of scale are broadly
classif iedinto Internal economies of scale and external economies
of scale. In the large -scale production, the cost of production should
be low which is called as economies of scale. A firm enjoy internal
economies of scale when he expands his size or scale ofmunotes.in
80
production in economy by making changes in the internal facto rs of
production. Where on the other hand a firm enjoy internal
economies of scale when he expands his size of production in
economy by making changes in the external factors of production.
So now we will explain both internal and external economies of
scale in details.
3A.3 INTERNAL ECONOMIES OF SCALE
Internal economies of scale arean increase in the scale or
size of production or output of a firm these are solely enjoyable by
firm independently by making changes in the input factors of
production into his business. The internal economies of scale have
various different types which are as follows:
1)Labour economies: Adam smith in this book “An inquiry into
the nature and causes of the wealth of the nation” 1776
emphasised on the division of labour. Econ omies of labour also
implies the benefit which is arising in the scale of economy due to
division of labour. Division of labour increases the efficiency in
production which leads to increase in the size of output. Division of
labour bring specialisation in labour skills and also saves time
which in turn increases the level or scale of output. Thus, with the
specialisation of division of labour the firm produces large scale of
production.
2)Technical economies: technique of production also increases
the scal e of production. In other words, technical economies refer
to increase in the scale of production due to change in technical or
methods of production which reduces the cost of production.
Technical economies increase the dimension of firms where the
averag e cost of production decreases and average revenue will be
high.
3)Managerial economies: Manager plays an important role in
managing business activities. Managerial economies refer to the
specialisation of managerial function which increases the level of
output. It is a mangers duty to carry out all the managerial decision
efficiently and effectively in the business organisation. Division of
managerial activities increases the management of the business
efficiently.
4)Financial economies: finance plays and important role in
process of production. It is one of the important and essential
factors of production. It is always observed that the large firms
enjoy the benefit of better credit facility from banks then the small -
scale firm. They also get the credit quickly and easily then the small
firm or producer.munotes.in
81
5)Marketing economies: marketing economies deals with the
process of buying raw materials and selling of finished goods. A
large firm have a great bargaining power .By using firm raw
material at cheaper c ost because it buys in bulk then the small firm.
This in turn helps him to produce more at less cost and sell large
amount of output in the market th an the small firm.
6)Transport and storage: The large -scale firm have its own
transport and storage facility which reduces his transportation and
storage cost. This reduces the average cost of large -scale firm and
increase the scale of output or revenue. Where the small -scale
firms hire or pay rent for the use of transport and storage facility.
3A.4 INTERNAL DISECONOMIES OF SCALE
If the firm isunable to manage the level of output or the
scale of operation diseconomies of scale occurs. If firm do not
understand the importance of the specialisation of division of labour
and specialisation of division manageme nt activities the level of
output or scale of operation decreases leads to diseconomies of
scale in economy. Suppose a firm take huge amount of loan from a
financial institution or banks to expand his level of output. Such
loan increases the burden on firm to prove their credit leads to
financial diseconomies of scale.
Check your Progress :
1)What are Internal Economies of Scale?
2)What are Internal Diseconomies of Scale?
3A.5 EXTERNAL ECONOMIES OF SCALE
External economies of scale refer to those economies which
provides benefits and facilities to all firms of given industry. It is an
economy which is enjoyed by all firms of industry irrespective of
their size of operation. External economies of scale are also of
various types which are fo llows:
1)Localisation economies: when a number of firms are located
on one place with an objective of deriving the mutual benefits of
training of skilled labour, provision of better transport facility etc. all
these advantage helps the firm to reduce cost o f production. Thus,munotes.in
82
localisation economies refer to concentration of a particular industry
in one area which results in the development of conditions of
industry which will reap the mutual benefits of all firms in the
economy.
2)Disintegration economies: disintegration means firms splitting
up its operation and the process of manufacture and handing over
the specialised agency and institution is called economies of
disintegration. There are two types of disintegration such as vertical
and horizontal disinteg ration of economies. The firm which operates
on disintegration of economies of scale will be able to get
economies of scale when it operates on a large scale.
3)Information economies: proper information in economy plays
an important role for the producer t o grow his economy. Networking
with each other enables firms to make marketing and technical
information easily.
4)By-product economies: to manufacture by -products a large -
scale firmmake use of waste material. This will help all the firm in
the industry to reduce the waste in the economy and make efficient
use of resources. This will ultimately reduce the cost of production
and increase the level of output.
3A.6 EXTERNAL DISECONOMIES OF SCALE
External diseconomies of scale result s when there is an
increa sing in the total cost of production beyond the control of a
company and it reduces the level of output . The increase in costs
can be due to increase in the market price of factors of production.
The external diseconomies are not suffered by a single firm but by
whole firms operating in a given industry. These diseconomies
arise due to much concentration and localization of industries
beyond a certain stage. For example, Localization may lead to
increase in the demand for transport and, therefore, transport costs
rise and it leads to diseconomies of scale in the economy.
3A.7 ECONOMIES OF SC OPE
Economies of sc operefer to a situation where in the long -run
afirm tries to reduce average and marginal cost of production by
producing large varieties of output . In other words, economies of
means a firm produces multiple products instead of producing one
single product to increases his scope of output by using the same
equipment’s and machine as a result of this average cost
decreases.munotes.in
83
Economies of scope is d ifferent from economies of scale, in
that where the former means producing a variety of different
products or multiple of product together to reduce costs while the
latter means producing more of the same product in order to reduce
the costs by increasing the efficiency in production.
Economies of scope can arise from the co -production
relationships between the final products or the actual products. In
economic terms these goods are complements in production. This
is when the production of one good automa tically produces another
good as a by -product or a kind of side -effect in the production
process. Sometimes one product might be a by -product of another,
but have value for use by the producer or for sale. Finding a
productive use or market for the co -products can reduce costs or
increase revenue.
For example, dairy farmers separate milk into whey and
curds, with the curds going on to become cheese. In the process
they also end up with a lot of whey, which they can use as a high
protein feed for livestock to reduce their feed costs or sell as a
nutritional product to fitness enthusiasts and weightlifters for
additional revenue. Another example of this is the black liquor
produced by the processing of wood into paper pulp. Instead of
being just a waste product that might be costly to dispose of , black
liquor is burned as an energy source to fuel and heat the plant,
saving money on other fuels, or can even be processed into more
advanced bio -fuels for use on -site or for sale. Producing and using
the black liquor saves costs on producing the paper .
Check your Progress :
1)What do you mean by Economies of scope?
2)What is by product economies?
3A.8SUMMARY
The current unit studied the concept of economies and
diseconomies of scale in detail. According to Alfred Marshal l
Economies of scale are broadly classif iedinto Internal economies
of scale and external economies of scale. In the large -scale
production, the cost of production should be low which is called asmunotes.in
84
economies of scale. Internal economies of scale are an increase in
thescale or size of production or output of a firm these are solely
enjoyable by firm independently by making changes in the input
factors of production into his business.
External economies of scale refer to those economies which
provides benefits and facil ities to all firms of given industry. It is an
economy which is enjoyed by all firms of industry irrespective of
their size of operation. It also discuss the internal factors and
external factors of scale in details.
3A.9QUESTIONS
1)Explain the internal and external economies of scale.
2)Explain in brief external economies and diseconomies of scale.
3)Write a short note on: Economies of scope.
munotes.in
85
UNIT -4
Unit -4
COST CONCEPTS
Unit Structure :
4.0 Objectives
4.1 Concepts of cost
4.2 Cost and output relationship in the short run and in the long
run
4.3 Short run and long run cost curves and numerical problems
4.4 Long run average cost and Lear ning curve
4.5 Summary
4.6 Questions
4.0 OBJECTIVES
To study various concepts of cost
To understand the relationship between short run and long run
cost curves
To study the concept of break -even analysis and understand its
application in busines s
4.1 CONCEPTS OF COST
A firm who wants to maximize their profit concentrates on
revenue and cost of the firm. Profit of the firm can be increased
either by increasing revenue or by reducing cost. Firm generally
cannot influence revenue because it is det ermined by the market
forces but it is possible for the firm to reduce cost by producing
maximum output or by increasing efficiency of the organization.
For managerial decision -making ,cost is very important
because it helps to decide price for the commod ity. It also helps to
decide whether to increase the production or not. Therefore,
understanding of cost concepts is very important.
a.Private cost and Social cost:
Costs which are directly incurred by the individual or firm
producing good or service is cal led private cost. This cost gives
private benefit to an individual or firm engaged in relevant activity.
Some of the examples of private cost are firm’s expenditure on
purchase of raw material, payment of rent, wages and salaries,
interest, insurance, depr eciation etc. Similarly company’smunotes.in
86
expenditure for its labor, advertising cost for the promotion of
goods, transportation cost to carry goods from company to the
market are also considered as private cost.
Social cost on the other hand is bared by the soci ety as a
result of production of commodity. Even though social cost occurs
due to production of a commodity it is not bared by the producer. It
consists of external cost. E.g.: If a factory is located in a residential
area causes air pollution. Due to poll ution as the health of the
people living in that area affects, they have to spend money on
medical facilities. Even though this cost occurs due to the factory, it
is passed on to the society at large.
Externalities are included in the social cost.
b.Histo rical cost and Replacement cost:
The original money value spent at the time of purchasing of
anasset is called historical cost. Most of the assets in the balance
sheet are at the historical cost. One of the advantages of historical
cost is that records ma intained on the basis of historical cost are
considered to be reliable, consistent, comparable and verifiable.
Historical cost does not reflect current market valuation.
The amount which has to be spent at the time of replacing of
the existing asset is ca lled the replacement cost. This cost reflects
the current market prices. If we consider an increase in prices over
the years, replacement cost will be greater than historical cost. If
we consider fall in prices over the years, replacement cost will be
less than historical cost and if we consider prices to be constant
over the years, replacement cost and historical costs are the same.
c.Fixed cost and Variable cost:
Fixed cost refers to the firm’s expenditure on fixed factors of
production. Even if no output is produced, fixed cost needs to be
paid. Even if output increases in the short run, fixed cost remains
constant. E.g.: If a businessman borrows money from a bank to
start his business. Initially even if his output is zero, he has to pay
the interest on b orrowed capital. Rent on land, insurance premium,
tax payment aresome of the examples of fixed cost. Addition of all
fixed cost gives Total Fixed Cost.
Variable cost on the other hand refers to the firm’s
expenditure on variable factors of production. Wh en no output is
produced, variable cost is zero. As output increases, variable cost
also increases. Payment for raw material, wages and salaries of the
workers are some of the examples of variable cost. Addition of all
variable costs gives the Total Variab le Cost.munotes.in
87
d.Total cost, Average cost and Marginal cost:
Total cost (TC) –Firms total expenditure on all fixed and variable
factors for producing a commodity is called the Total cost of
production.
Therefore TC= TFC+TVC
For zero level of output there is so me total cost. It increases with an
increase in the level of output.
Average Cost (AC) or Average Total Cost (ATC) –It refers to the
per unit cost of producing a commodity. It is calculated by the
following formula
AC = TC/Q
Where AC = Avera ge cost TC = Total cost Q = Number of units
produced
Average cost can also be calculated by using following formula -
AC or ATC = AFC+AVC
Where AC -Average Cost AFC -Average Fixed Cost
AVC-Average Variable Cost
Average Fixed Cost (AFC) -It is the per unit fixed cost of
production. It can be calculated by the following formula
AFC= TFC/Q
Where TFC= Total Fixed Cost Q = Number of units produced
Average Variable Cost (AVC) -It is the per unit variable cost of
produ ction. It can be calculated by the following formula
AVC= TVC/Q
Where TVC= Total Variable Cost Q= Number of units produced
Marginal Cost (MC) -It is the addition made to the total cost. Or
cost of producing an additional unit of output is ca lled asthe
marginal cost. It can be calculated by using following formula
MC = Change in total cost/ change in outputTC
Q
Where, TC = Change in Total Cost
Q= Change in Output
OR
MC= TCn -TCn-1munotes.in
88
Eg: If total cost of producing 2 cars is Rs. 3, 00,000 and the total
cost of producing 3 cars is Rs. 4, 50,000. Then the marginal cost is
Rs. 1, 50,000 i.e. the cost of producing an additional unit of output.
e.Sunk Cost and Incremental Cost:
In order to enter in to the market certain costs are incurred
by the firm. These costs are known as Sunk cost. It includes the
cost by the firm for setting up the business, advertisement etc.
These costs cannot be recovered by the firm if they decide to exit
the market.
Incremental cost refers to a change in total coat as a result
of policy change or a change in managerial decision. The concept
of incremental cost is broader as compared to marginal cost.
Marginal cost considers a change in total cost due to a unit
change in output whereas incremental cost considers a change in
total cost due to an introduction of new product, change in
advertising strategy, additional batch of output etc. The concept of
incremental cost is more relevant as compared to marginal cost
because the firm increases its output in batches and not by unit
only.
f.Implicit Cost and Explicit Cost:
Implicit cost refers to the cost of all own factors which the
entrepreneur employs in the business. It includes salary and wages
for the service of entrepreneur, interest on capital invested by the
entrepreneur etc. Implicit costs are also called indirect cost
because direct cash payment is not made to own factors of
production.
If entrepreneur sold th ese services to others, he would have
earned money. Therefore, implicit cost is also the opportunity cost
of factors owned by him.
Explicit cost on the other hand is the direct cash payment
made by the firm for purchasing or hiring of various factors of
production. E.g. rent paid for hiring of land, money spent for
purchasing for raw material, wages and salaries paid to the
employees, expenditure on transport, power, advertising etc.
g.Accounting and Economic Cost:
Accounting cost includes only explicit cos t i.e. the firm’s
expenditure on purchasing of various factors of production. For
financial purpose and tax purpose, accounting cost is important.
Economic cost on the other hand includes both explicit and
implicit cost. This cost is important for manager ial decision making .munotes.in
89
Therefore an economist who wants to take any decision consider s
both explicit and implicit cost.
Check your Progress :
1)Give two examples of Private Cost & Social Cost.
2)Explain concepts of total fixed cost & total variable cost .
3)Consider a firm who is producing a truck. What are the various
fixed and variable factors of production it require? Make a list of
all those factors.
4)The total cost of producing 5 TV Sets is Rs. 1,00,000 if the firm
produces 6 TV sets its total c osts increases to Rs. 1,35,000.
What is the marginal cost for 6thTV Sets.
4.2 COST AND OUTPUT RELATIONSHIP IN THE
SHORT RUN AND IN THE LONG RUN
Relationship between TFC, TVC and TC in the short run
TFC is the firm’s total expenditure on fix ed factors of
production. For zero level of output TFC is zero. It remains constant
for all the levels of output.
TVC on the other hand is the firm’s total expenditure on
variable factors of production. For zero level output TVC is zero. It
increases with an increase in the level of output.
Total cost is the additional of Total Fixed Cost and Total
Variable Cost. In the following table relationship between TFC, TVC
and TC is discussed for different units of output
Table 4 .1
Output TFC TVC TC
0 50 0 50
1 50 20 70
2 50 35 85
3 50 45 95
4 50 65 115
5 50 95 145
6 50 140 190
7 50 200 250
8 50 280 330
(All Cost sin Rupees)munotes.in
90
Explanation –In table 4 .1 First column shows various levels of
output starting from zero units to 8 units. Second column shows
TFC. As fixed factors of production are constant for certain level of
output TFC is also constant for all level of output. For zero level of
output also TFC is Rs. 50. Third column shows TVC which is zero
for zero level of output. With an increase level of output TVC initially
increases at decreasing rate then increases at an increasing rate.
This is because of the law of variable proportions. Forth column
shows TC which is the addition of TFC and TVC. TC increases with
an increase level in the output. TC increases in the same
proportions as increased in TVC.
This relation between TFC, TVC and TC can be explained with the
help of following diagram.
Two curves are parallel to each other.
Diagram 4.1
By plotting different combinations of output and TF C, TVC
and TC, we have TFC curve, TVC curve and TC curves.
Diagram shows that TFC curve is a straight -line curve
parallel to X axis. This is because when output is zero, some fixed
cost has to be paid and this cost remains constant for all the levels
of output. TFC curve is horizontal.
TVC curve starts at the point of origin because when output
is zero, TVC is also zero. TVC curve initially increases at a
diminishing rate with an increase in the level of output and then
increases at an increasing rate.munotes.in
91
As TC is the addition of TFC and TVC, TC curve is above
TFC and TVC curves. The shape of TC curve is same as the TVC
curve. The gap between TC and TVC curve measures TFC.
Cost and output relationship:
Cost Function
Production function gives the functiona l relationship between
the level of output and the various factor inputs (land, labor, capital
and entrepreneur). The cost of production depends on the level of
output produced, nature of technology used, prices of factors of
production. Thus, the cost fun ction is derived from the production
function. The cost function is given as -
C = f (Q, T, Pf)
Where C = total cost Q = Level of output produced T = Technology
Pf = Prices of factors f = Functional relationship
If we assume that technol ogy, prices of factors are constant,
total cost increases with an increase in the level of output i.e. C =
f(Q).
Any change in production function will shift cost function
either up or down. E.g. Use of better techniques of production, use
of better -quali ty raw material, use of efficient labors etc. will
improve the production function and thus reduce the cost function.
Similarly use of poor -quality raw material, inefficient techniques of
production, unskilled labor will shift the production function up.
The relationship between cost and output needs to be
studied in the short run and in the long run.
4.3 SHORT RUN COST -OUTPUT RELATIONSHIP
As the name suggests short run is a very short period where
the firm produces its output by changing only variabl e factors of
production. This is because in the short run fixed factors of
production remain constant for all the levels of output. Following
table shows the behavior of output and various costs in the short
run.munotes.in
92
(Table 4 .2)
Output TFC TVC TC AFC AVC AC MC
0 50 0 50 - - - -
1 50 20 70 50 20 70 20
2 50 35 85 25 17.5 42.5 15
3 50 45 95 16.66 15 31.66 10
4 50 65 115 12.5 16.25 28.75 20
5 50 95 145 10 19 29 30
6 50 140 190 8.33 23.33 31.66 45
7 50 200 250 7.14 28.57 35.71 60
8 50 280 330 6.25 35 41.25 80
(All costs in Rupees)
In the above table output is shown in the (1st) column, which
increases from 0 units to 8units. For all the levels of output TFC in
column (2) remain constant i.e. Rs. 50. TVC in the (3rd) column is
zero for zero level of output. And then increases with an increase in
the level of output. In column (4) TC is calculated by adding TFC
and TVC.
AFC in column (5) is calculated by using the formula TFC/Q.
As TFC remain constant for all the levels of outp ut, AFC
continuously declines with an increase in the level of output.
AVC in column (6) is calculated by using formula TVC/Q.
Initially AVC declines. At third level of output it reaches to the
minimum and then increases with an increase with an increase in
the level of output.
AC in column (7) is calculated by using the formula TC/Q.
AC also declines initially reaches to the minimum point at 4thunit of
output and then increases with an increase in the level of output.
MC in column (8) is the cost of producing an additional unit
of output. It is calculated by the formulaTC
Q
orTVC
Q
. This is
because TC increases by the same amount as increase in TVC.
MC initially declines, reaches to minimum and increases th ereafter.
Diagrammatic relationship between AFC, AVC, AC and MC is as
follows -munotes.in
93
Diagram 4.2
Explanation:
1.As AFC is continuously declining. AFC curve slopes downward
from left to right.
2.Initially AVC curve is declining, reaches to a minimum and then
increases with an increase in the level of output. AVC curve
starts increasing after a normal capacity level of output is
produced. More intensive use of various factors of production
leads to an increase in AVC.
3.AC curve lies above AFC and AVC cu rves because AC is the
addition of AFC and AVC. AC curve initially declines due to fall
in AFC curve. AC curve reaches to minimum point and then
increases due to an increase in AVC curve. AC curve is a U -
shaped curve.
4.MC curve is also a U -shaped curve. MC curve also falls in the
beginning, reaches to the minimum and then increases. When
MC curve starts rising, it intersects the AVC curve and AC curve
at their minimum point.
Relationship between AC and MC:
AC is the per unit cost of production and marg inal cost is the
cost of producing an additional unit of output. Relationship between
AC and MC can be discussed with the help of following diagram.munotes.in
94
Diagram 4.3
•For initial levels of output AC and MC both curves are declining,
but MC is less than AC. W hen MC is less than AC it means that
cost of producing an additional unit of output is less than per
unit cost of production. As MC
•At a certain level of output (optimum level of output ) AC is
minimum. At this point MC curve intersects AC curve. Thus
AC=MC. It means that cost of producing an additional unit of
output is exactly equal to the average cost of production. As
AC=MC, new AC must be equal to the old average cost.
•At higher leve ls of output AC and MC both are increasing but
MC>AC. It means that the cost of producing an additional unit of
output is greater than the average cost of production. As
MC>AC, new average cost must be greater than old average
cost. Therefore, AC curve is rising.
From the above explanation we can conclude that when
•MC
•MC>AC, MC pulls the AC curve up.
•Long run cost and output relationship
As the name suggests long run refer s to a sufficiently long
period. As the long period is available, firm can make necessary
change in all factors of production as per the changes in demand.
Thus, in long run all factors of production are variable. Hence there
are no fixed cost in the long run. Depending on the type of industry
the length of long run can differ. For a firm producing a particular
product, long run may be years.
In the long run firm can make proper planning and build that
size of plant which will minimize the cost of product ion for
producing optimum level of output. Once the particular plant has
been built, the firm operates in the short run. This means that even
though firm operates in the short run, it plans in the long run.munotes.in
95
Check your Progress :
1)Is it possible to have a straight line TVC and TC curves? Justify.
2)On the basis of following data calculate TVC, AVC and MC
Output 0 1 2 3 4
TC 70 100 150 220 300
3)Discuss Relationship between AC & MC.
4.4 LONG RUN AVERAGE COST CURVE
Different plant siz es are available to the firm to operate in the
long run. For a specific level of output, the plant of specific size is
more suitable. For every size of plant there will be a specific
average cost and thus a specific average cost curve. In the long run
different short run average cost curves are available for different
sizes of plant. The firm has to choose the specific size of plant for
its operation.
Derivation of Long run average cost curve with a number of
short run average cost curves can be discussed with the help of
following diagrams -
Diagram 4.4munotes.in
96
Here we assume that there are three sizes of plant.
Above figure shows that there are three plants available to
the firm and are shown by three different cost curves -SAC1, SAC2
and SAC3. For a particul ar level of output, a specific plant is most
suited.
Above diagram shows that for producing OQ level of output
on plant SAC1, cost is BQ and on plant SAC2 cost is AQ. This
shows that OQ level of output can be produced with lower cost QB
with SAC1 as comp ared to plant SAC2.
If the firm wants to produce OQ1 level of output, it can be
produced either with plant SAC1 or SAC2. But it is better for the
firm to go with plant SAC2 because as shown in the diagram higher
level of output OQ2 can be produced with mu ch lower cost on
SAC2. With plant SAC2, output greater than OQ1 and less than
OQ3 can be produced at lower average cost.
For output greater than OQ3 firm will use plant SAC3
because the average cost with SAC2 will be greater as compared
to average cost w ith SAC 3.
Derivation of LAC
Diagram 4.5
From the above explanation it is clear that in the long run the
firm has alternative plant sizes available for the production and the
firm will choose that plant size which gives minimum average cost
for produ cing a given leve l of output. Accordingly ( Fig 4 .4) with
three short run average cost curves the Long run Average Cost
curve is HBCEGI.
If we assume that there are infinite plant sizes available,
there are number of short run average cost curves corresponding tomunotes.in
97
each plant size. Therefore, the LAC will be a smooth U -shaped
curve as shown in ( Diagram 4.5) above.
As LAC curve is a locus of points of the lowest average cost
of producing different levels of output. Every point of LAC will have
a tang ency point with SAC curve. It can be seen from the above
diagram that LAC curve is tangent to the minimum point of SAC3
curve only at the optimum level of output OQ. Plant SAC3 is
considered as the optimum size of plant because it produces
optimum level of output OQ with minimum cost CQ.
For any output less than OQ, LAC curve is tangent to SAC
curve on its declining part ie. at point A and B on SAC1 and SAC2.
For any output greater than OQ, LAC curve is tangent to SAC curve
on its increasing part i.e. At p oint D and E on SAC4 and SAC5.
It can be seen from ( Diagram 4.5) that LAC curve initially
declines, reaches to minimum and again increases with an increase
in the level of output. LAC curve is much flatter than SAC curves.
LAC curve declines due to e conomies of scale and increases due
to diseconomies of scale.
As the LAC curve includes the family of short run average
cost curves, it is called an Envelop curve. In the long run firm can
also plan to increase its scale of production and therefore LAC
curve is also called the Planning Curve.
Learning curve:
The learning curve shows an inverse relationship between
an average cost of production and the level of output. This means
that as firm produces more and more output, its average cost of
product ion declines. Therefore, the learning curve slopes
downward from left to right. Following diagram explains the learning
curve effect.
Diagram 4.6munotes.in
98
In the above diagram X axis represents total output and Y
axis represents the average cost. It shows that a verage cost is
RS.6000 for producing 10 units of output. As output increases to
20, 30 and 40 units, average cost declines to 4000, Rs. 3000 and
Rs. 2000 respectively. Points P, Q, R and S shows different
combinations of output and average cost.
Learning curve effect is a result of an experience which the
firm gains during the process of production. When the firm is new, it
takes time for the firm to produce the output. Thus, the costs are
high. As firm becomes older, it learns to use new techniques of
production, efficient way of using raw material and skills. Workers
also become efficient over a period of time. All this will help to
reduce the average cost of production. Firm learn to reduce cost
through experience. Therefore, learning curve is also calle d an
Experience curve . The effect of learning curve applies to the
manufacturing and service sector.
As shown in the diagram learning curve initially declines
faster and then declines at a slower rate. This means that when the
production process is new, average cost declines much faster as
compared to the old production process.
Check your Progress :
1)What do you mean by Envelope Curve?
2)What do you mean by Learning Curve?
4.5SUMMARY
This unit studies the cost function which is being derived
from the production function. It discusses different concepts of
costs with examples and explains the behaviour of cost cu rves in
the short run andlong run. It also includes calculations of vario us
costs like T FC, TVC, TC, AFC , AVC, AC and MC.
This unit explains how firm learns to reduce their average
cost of production through experience over a period of time through
the concept of learning curve or experience curve.munotes.in
99
4.5QUESTIONS
Q.1 Explain the following concepts -
a)Implicit cost and Explici t cost
b)Private cost and Social cost
c)Historical cost and Replacement cost
d)Total cost, Average cost and Marginal cost
e)Fixed cost and Variable cost
f)Opportunity cost
Q.2 Explain the relationship between TFC, TVC and TC with the
help of diagram.
Q.3 Define AC ,AFC, AVC and MC and also discuss the relationship
between them.
Q.4 Bring out the relationship between AC and MC.
Q.5 Explain the derivation of Long run Average Cost curve.
Q.6 Discuss the Learning curve effect.
Q.7 If the Total fixed cost of production is rs.75, with the help of
following data, calculates TC, AC, AFC, AVC, MC.
Output 0 1 2 3 4 5
TVC 0 35 50 70 100 160
Q.8 With the help of following information, complete the table given
below.
Output TFC TVC TC AFC AVC AC MC
0 80 0
1 80 40
2 80 70
3 80 120
4 80 190
5 80 290
6 80 420
munotes.in
100
Unit –4A
EXTENSION OF COST ANALYSIS
Unit Structure :
4A.0Objectives
4A.1 Concept of break -even point
4A.2 Changes in break -even point due to price, fixed cost and
variable cost
4A.3 Application of break -even analysis
4A.4 Limitations
4A.5 Case study
4A.6 Summary
4A.7 Questions
4A.0 OBJECTIVES
To understand the concept of break -even point
To understand the effects of change in price, fixed cost and
variable cost on break -even point
To study the actual application of break -even analys is in
business
To study the limitations of break -even analysis
4A.1 CONCEPT OF BREAK -EVEN POINT
Break -even analysis studies the relationship between total
cost, total revenue, total profits and losses over a range of output.
Break -even point is a point w here the total revenue of the firm is
equal to total cost. Therefore, at break -even point there is no profit,
no loss.
Break -even analysis technique is used in the business to
determine the level of production or sales volume which is
necessary for the bu siness to cover its cost of doing a business. In
financial analysis the concept of break -even point is most
commonly used. The concept of break -even point can be explained
with the help of following table -8.1munotes.in
101
Output TR TC Profit/ Loss
0 0 1200 -1200
1 1000 1500 -500
2 1400 1800 -400
3 2000 2000 0
4 2600 2200 400
5 3500 3000 500
Table 4A .1
Above table shows that break -even level of output is 3 units
because, firms TR and TC are equal at 3 units of output and
therefore there is no profit, no loss .
Break -even point can also be explained with the help of
following diagram
Diagram 4A.1
Above diagram is drawn on the basis of the assumption that
TR and TC curves are linear i.e. TR and TC increases at aconstant
rate with an increase in the level o f output. Therefore, TR and TC
curves are straight lines.
For initial levels of output total cost is greater than total
revenue therefore the firm is making loss. At output OQ, firm stops
making loss, TR=TC therefore there is no profit no loss. Thus, OQ
is the break -even output and B1 is the break -even point. After OQmunotes.in
102
level of output total revenue is greater than total cost and thus firm
starts making profit.
When TR and TC curves are linear, there is only one break -
even point. According to above diagram entire output after break -
even output gives profit. However, this may not be true because of
changes in price and cost.
If we do not consider constant change in TR and TC, TR and
TC curves are non -linear. In this case we have more than one
break -even poi nt as shown in the following diagram -
Diagram 4A.2
In the above diagram on the Y axis we measure cost and
revenue and on the X axis we measure output.
In case of non -linear TR and TC curves there two break -
even points P and Q, indicating lower level o f output OM and higher
level of output ON respectively. For any output less than OM and
greater than ON, firm makes losses because TC>TR. Between the
range of output M and N, TR>TC and thus firm makes profit.
4A.2 CHANGES IN BREAK -EVEN POINT DUE TO
PRICE , FIXED COST AND VARIABLE COST
Break -even point or break -even quantity changes due to
change in following factors -
•Changes in price
•Changes in fixed cost
•Changes in variable costmunotes.in
103
Changes in break -even quantity and break -even point due to
above factors ca n be discussed with the help of following example -
•Changes in price
Any change in price will have an effect on total revenue and
therefore also on break -even point.
If we consider the same example 1 and consider an increase
in price to Rs.17, and keep fix ed cost and average variable cost
constant, break -even quantity is -
QB = FC/ P -AVC
= 4000/17 -7
= 4000/10
= 400 units.
If we consider fall in price to Rs. 12, keeping fixed cost and
average variable cost constant, break -even quantity is-
QB = FC/P -AVC
= 4000/12 -7
= 4000/5
= 800 units.
This shows that with an increase in price, break -even
quantity falls and with a fall in price, break -even quantity increases.
Effect of changes in price on break -even point and break -
even quantity can be explained with the help of following diagram.
Diagram 4A.3munotes.in
104
In the above diagram X axis measures output and Y axis
measures cost and revenue. With an initial TR and TC curves A is
the break -even point, where TR and TC curves inters ects. If price
increases, TR curve shifts upward from TR to TR1. This will bring
down the break -even point from A to A1. Similarly, with a fall in
price, TR curve shifts downward to TR 2and thus break -even point
also shifts to A 2.
•Changes in fixed cost
For the same mathematical example 1 if we change the fixed
cost and keep price and average variable cost constant, we have
changes in breakeven quantity.
Suppose fixed cost increases to Rs. 5000, break -even
quantity is -
QB = FC/P -AVC
= 5000/1 5-7
= 5000/8
= 625 units.
If fixed cost falls to Rs. 3600, break -even quantity is -
QB = FC/P -AVC
= 3600/15 -7
= 3600/8
= 450 units.
This shows that with an increase in fixed cost, break -even
quantity incre ases and with a fall in fixed cost, break -even quantity
falls.
Changes in break -even point due to changes in fixed cost
can be explained with the help of following diagram -munotes.in
105
Diagram 4A.4
On the X axis we measure output and on the Y axis we
measure cos t and revenue. With an initial TR and TC curves initial
break -even point is B initial break even quantity is OQ if fixed cost
increases, TFC curve shifts upward to TFC1. As total cost is the
addition of TFC and TVC, TC curve will also shift upward to TC1.
This shifts the break -even point at higher level to B1. Break even
quantity has also increased from OQ to OQ 1.
On the other hand, if TFC falls, TFC curve will shift
downward to TFC 2. This will shift the TC curve down to TC 2.
Therefore, new break -even poin t is B 2& new break e ven quantity
falls from OQ to OQ 2.
•Changes in variable cost per unit
Using the same mathematical problem if we keep price and
fixed cost constant and change the variable cost per unit, we have
a change in break -even quantity.
Suppos e the average variable cost per unit increases to Rs.
10, break -even quantity is
QB = FC/P -AVC
= 4000/15 -10
= 4000/5
= 800 units.munotes.in
106
If variable cost per unit falls to Rs. 5, break -even quantity is
QB = FC/P -AVC
= 4000/15 -5
= 4000/10
= 400 units.
This shows that with an increase in per unit variable cost,
break -even quantity increases and with a fall in average variable
cost, break -even quantity falls.
This can be discussed with the help of following diagram -
Diagram 4A.5
In the above diagram X axis measures output and Y axis
measures cost and revenue. Initial break -even point is C where TR
and TC curves intersect. Initial break even quantity is OQ .With an
increase in TVC, TVC curve shifts to TVC1. This also shi fts TC
curve to TC1. TVC1 and TC are parallel to each other. Thus, the
new break -even point shifts upward to C 1& break even quantity
increases from OQ to OQ 1.
With a fall in TVC, TVC curve shifts to TVC 2, shifting down
TC curve to TC 2. Thus, the new bre ak-even point also shifts down
to C 2. Again, TVC2 and TC2 are parallel to each other. New break
even quantity falls from OQ to OQ 2.munotes.in
107
Check your Progress :
1)What is the important of Break -Even Point?
2)If FC = 2000, Price per unit = Rs. 12 & AVC = Rs. 8 Calculate
Break -even Quantity.
3)Find out the Break -even Point for the firms having following
data.
Output 0 1 2 3 4 5 6
TR 0 150 180 270 350 400 560
TC 120 150 170 250 340 390 500
4A.3 APPLICATION OF BREAK -EVEN ANALYSIS
Business fir ms are interested in understanding break -even
analysis because it helps to determine that level of output which will
help the firm to cover its entire cost and thus to make profit. Break -
even point is the point where the firm starts making profit. Break -
even analysis is used in the business for following purposes.
•Targeting profits -Firm has to target the level of profit for short
run and long run. Break -even point gives the level of output
where the firm starts making profit. Thus, for setting profit
targets, break -even analysis is important.
•Recovery of cost -At break -even point firm covers its entire
cost of production (including fixed and variable cost).
Understanding of break -even can help the firm to manage its
costs in a better manner ie. the firm ca n try to reduce cost in
order to have early break -even.
•Helps in deciding techniques of production -different
techniques of production are available to the firm. Each
technique differs in efficiency and cost. Break -even analysis
helps in deciding a proper technique of production.
•Effects of changes -in order to be competitive, firm needs to
make changes in their pricing, marketing and other policies. Any
change in this policy will have an effect on revenue and cost of
the firm and thereby on break -even poi nt. Any change in break -
even point will finally have an effect on profitability of the firm.
•Deciding sales and marketing policies -it is possible for the
firm to lower break -even point by using new marketingmunotes.in
108
strategies. But an increase in marketing cost w ill increase the
cost of production and thus will increase the break -even point.
Therefore, it is necessary for the firm to find proper sales and
marketing policies to achieve its break -even point.
•Utilization of capacity -it is possible for the firm to r educe its
average cost when it uses its full capacity and thereby reduces
wastages and improves efficiency of resources. This will help to
reach break -even point quickly.
•Capital raising capacity -once the break -even point is
reached, it is possible for th e firm to raise capital for its future
expansion. Possibility of making profit for those firms is high
who have reached their break -even and therefore financial
institutions are also ready to give loans to these firms. On the
other hand, firms who have not reached their break -even finds it
difficult to raise loans from the financial institutions.
4A.4 LIMITATIONS OF BREAK -EVEN ANALYSIS
Various limitations of break -even are as follows -
•Linear TR and TC curves gives wrong impression that the entire
outpu t after break -even point is profitable. But this is not always
true.
•In case of single product unit, break -even analysis can be
applied. But in case of multiple or joint products it is difficult to
apply break -even analysis as long as cost cannot be determ ined
for each of the product.
•The data required for break -even analysis including costs, price
etc. is generally historical. If historical data is not proper for
estimating future costs and prices, break -even analysis cannot
be usefully applied.
•If it is possible to clearly classify costs as fixed and variable
costs, break -even analysis is more useful. But sometimes it is
not possible to have such classification of costs.
Even though there are various limitations of break -even
analysis, it is useful in pr oduction planning if proper data is
obtained.
4A.5 CASE STUDY
Break -even level of output can be algebraically determined
by using following formula
BQ = FC/Fixed cost/ Price -Average variable cost i.e. BQ = FC/
P-AVCmunotes.in
109
Where BQ = Break -even quanti tyP= Price per unit AVC=
Average Variable Cost
Example 1 -
Suppose fixed cost for the firm is Rs. 4000, price per unit of
output is Rs. 15 and the Average Variable Cost is Rs. 7, its break -
even quantity is -
BQ = FC/ P -AVC
4000/15 -7
4000/8
BQ= 500 units
Break -even sales volume can be calculated by multiplying
break -even quantity by the price per unit of output.
BS = BQ*P
Where BS= Break -even sales volume
BQ= Break even quantity P= Price pe r unit
BS= 500*15
= Rs.7500
4A.6SUMMARY
Extension of cost analysis introduce the concept of break -
even point. Here the concept of break -even point is studied with the
help of linear and nonlinear TR and TC curves. The calculation of
break-even sales volume in units and break even sales volume in
amount is also studied with the help of numerical examples this
unit also explains changes in break -even point due to change in
TFC or TVC for price per unit of a commodity.
In the last part of this unit application of break -even analysis
and limitations of break -even analysis are studied
4A.7QUESTIONS
1.Explain the concept of break -even point with the help of
diagram.
2.Discuss with the help of diagram how break -even point changes
due to change in price and fixed cost.
3.Explain changes in break -even point due to change in total
variable cost.
4.Discuss the implications and limitations of break -even analysis.
5.Suppose the TFC of the firm is rs.5000, AVC is rs.25 and price
per unit is rs.40, calculate break -even quantity and break -even
sales volume.munotes.in
110
i.If TFC increases to rs.6000, what will happen to break -even
quantity and sales volume?
ii.If price per unit reduces to rs.35, what will happen to break -
even quantity and sales volume?
6.With the help of following data find out lower and upper level of
break -even quantity.
Output TR TC
0 2500 3500
1 2200 3000
2 2000 2000
3 1800 1500
4 1500 1300
5 1000 1000
munotes.in
Question Paper Pattern
(Business Economics Paper I & II)
Maximum Marks: 100
Questions to be set: 06
Duration: 03Hrs.
Question
No Particula r Marks
Q-1 Objective Questions
A) Sub Questions to be asked 07 and to be a nswered any 05
B) Sub Questions to be asked 12 and to be answered any 10
(*Multiple choice / True or False / Match the columns/Fill in the blanks) 20
Q-2
Q-2 Full Length Question
OR
Full Length Question
15
Q-3
Q-3 Full Length Question
OR
Full Length Question
15
Q-4
Q-4 Full Length Question
OR
Full Length Question
15
Q-5
Q-5 Full Length Question
OR
Full Length Question
15
Q-6 Short Notes
To be asked 06 To be answered 04
20
Note - Theory questions of 15 marks may be divided into tw o sub questions of 7/8 and 10/5.
munotes.in