Assig- 3 GLOBAL BUSINESS ENVIRONMENT & ECONOMICS

Q.1. Write answers for any two questions from below. (5 marks each – Word limit – 500)
A. What is meant by returns to a factor? State the law of
diminishing returns to a factor?

Returns to a factor It refers to the behaviour of output when only one

variable factor of production is increased in short-run and fixed
factors remain constant.
Law of diminishing returns to a factor It refers to a situation in which
total output increases at a diminishing rate when more and more
variable factor is combined with the fixed factor of production. In this
situation, Marginal Product of the variable factor must be
diminishing.

Have you heard of the law of diminishing returns? It’s a concept

that I learned while studying Economics. I find the lessons
very applicable to personal growth.
Say you have a maize field. You want to increase your maize yield
using fertilizers. To achieve maximum return, you need to
understand 3 principles:
1. Not every unit of input will lead to a proportional increase of
output. For example, adding fertilizers to a maize field with no
fertilizers will initially lead to a big increase in yield. When there’s
already a moderate amount of fertilizers used though, adding
more will not give the same effect.

2. At one point, adding more input gives you a decreasing rate

of return. Perhaps adding a 10th pack of fertilizer gives a 1kg
increase in yield. But adding your 11th pack only gives 0.5kg
increase, while adding your 12th pack gives an even less yield
increase of 0.3kg. Subsequent packs bring you less returns.
 This is the law of diminishing returns at work. The law states
that in all productive processes, adding one additional factor of
production, while holding all others constant, will at some point
yield lower incremental per-unit returns.[1] The 10th pack is
the point of diminishing returns.
3. If you continue to add more input despite diminishing
returns, you will reach a stage where not only do you not get a
positive return for every extra input, but you decrease your
overall output! For example, perhaps after adding your 13th pack
of fertilizer, you get a decrease  of 0.3kg in overall yield, due to
over-fertilization of the soil which damages your crops. This is
known as negative returns.
I’ve created a graph to illustrate the concept:

(Image: Personal Excellence)

* Here, input = number of packs of fertilizer while output = total

maize yield. The point of diminishing returns here is 10 packs of
fertilizer. The point of maximum yield is 12 packs of fertilizer,
 where you get the most maize yield. Beyond that, you get less yield
due to negative returns caused by over-fertilization of soil.
This same pattern can be seen in other production processes. Say
you run a restaurant but you only have one chef. You hire more
chefs, which results in more meals prepared initially. Eventually,
you reach a point where the increase in total meals prepared
per new chef decreases, even though all the chefs are equally
skilled. Meaning…

 1 chef → 50 meals a day

 2 chefs → 100 meals a day (total). This is a marginal increase
of 50 meals (100-50) after hiring a 2nd chef.
 3 chefs → 150 meals a day (total). This is a marginal increase
of 50 meals (150-100) after hiring a 3rd chef.
 4 chefs → 180 meals a day (total). This is a marginal increase
of 30 meals (180-150) after hiring a 4th chef. As it’s less than your
previous marginal increase, you’ve hit diminishing returns!
* Assume unlimited orders coming in
Why does this happen? One possible reason is that by having
so many chefs in a fixed kitchen space, you create problems that
are originally not there. For example, chefs getting in each other’s
way, chefs having to compete with each other to use
pots/pans/ovens, and so on.
Continuing to hire new chefs, despite diminishing returns, will lead
to negative returns:

 5 chefs → 200 meals a day (total). This is a marginal increase

of 20 meals (200-180) after hiring a 5th chef
 6 chefs → 180 meals a day (total). This is a
marginal decrease of 20 meals (180-200) after hiring a 6th chef,
despite paying more money to hire a 6th person!!
The negative returns are because the earlier
problems causing diminishing returns are now aggravated. Firstly,
there are not enough stoves for every chef. Secondly, the chefs,
having even less space and resources, become frustrated and argue,
which prevents them from getting work done. Thirdly, some chefs
may be slower in their meal preparation due to the lack of space
and negative work environment.
By hiring so many chefs to the point of negative returns, you
negatively affect the productivity dynamics of the system, hence
leading to a decreasing output. As they say, “too many cooks spoil
the broth”! 🙂

1-C. What is the difference between returns to an input and

returns to scale?

Returns to Scale and

Returns to Factor (With
Diagram)
In this article we will discuss about the
relationship between Returns to Scale and Returns
to Factor.
Returns to a factor and returns to scale are two important
laws of production. Both laws explain the relation between
inputs and output. Both laws have three stages of
increasing, decreasing and constant returns. Even then,
there are fundamental differences between the two laws.
Returns to a factor relate to the short period production
function when one factor is varied keeping the other factor
fixed in order to have more output, the marginal returns of
the Variable factor diminish. On the other hand, returns to
scale relate to the long period production function when a
firm changes its scale of production by changing one or
more of its factors.
Assumptions:
We discuss the relation between the returns to a
factor (law of diminishing returns) and returns to
scale (law of returns to scale) on the assumptions
that:
(1) There are only two factors of production, labour and
capital.
(2) Labour is the variable factor and capital is the fixed
factor.
ADVERTISEMENTS:

(3) Both factors are variable in returns to scale.

(4) The production function is homogeneous.
Explanation:
Given these assumptions, we first explain the relation
between constant return to scale and returns to a variable
factor in terms of Figure 14 where OS is the expansion path
which shows constant returns to scale because the
difference between the two isoquants 100 and 200 on the
expansion path is equal i.e.,
OM = MN. To produce 100 units, the firm uses ОС + OL
quantities of capital and labour and to double the output to
200 units, double the quantities of labour and capital are
required so that ОС2 + OL2 lead to this output level at point
N. Thus there are constant returns to scale because OM =
MN.
To prove that there are decreasing returns to the variable
factor, labour, we take ОС of capital as the fixed factor,
represented by the CC line which is parallel to the X-axis
relating to labour.
This is called the proportional line. Keeping С as constant,
if the amount of labour is doubled by LL2 we reach point Y
which lies on a lower isoquant 150 than the isoquant 200.
By keeping С constant, if the output is to be doubled from
100 to 200 units, then OL3 units of labour will be required.
But OL3 > OL2. Thus by doubling the units of labour from
OL to OL2 with constant C the output less than doubles.
It is 150 units at point K instead of 200 units at point P.
This shows that the marginal returns of the variable factor,
labour, have diminished when there are constant returns to
scale.
The relation between diminishing returns to scale and
returns to a variable factor is explained with the help of
Figure 15 where OS is the expansion path which depicts
diminishing returns to scale because the segment MN >
OM. It means that in order to double the output from 100
to 200, more than double the amounts of both factors are
required.

Alternatively, if both factors are doubled to ОС2 + OL2, they

lead to the lower output level isoquant 175 at point R than
the isoquant 200 which shows diminishing returns to scale.
If С is kept constant and the amount of variable factor,
labour, is doubled by LL2, we reach point K which lies on a
still lower level of output represented by the isoquant 140.
This proves that the marginal returns of the variable factor,
labour, and have diminished when there are diminishing
returns to scale.
Now we take the relation between increasing returns to
scale and returns to a variable factor. This is explained in
terms of figure 16 (A) and (B) In Panel (A), the expansion
path OS depicts increasing returns to scale because the
Segment ОМ > MN. It means that in older to double the
output from 100 to 200 less than double the amounts of
both factors will be required.
If С is kept constant and the amount of variable factor
labour is doubled by LL2 the level of output is reached at
point K which shows diminishing marginal return as
represented by the lower isoquant 160 than the isoquant
200 when returns to scale are increasing.

In case the returns to scale are increasing strongly, that is,

they are highly positive; they will offset the diminishing
marginal returns of the variable factor, labour. Such a
situation leads to increasing marginal returns. This is
explained in Panel (B) of Figure 16 where on the expansion
path OS the segment OM > MN, thereby showing
increasing returns to scale.
When the amount of the variable factor, labour, is doubled
by LL while keeping С as constant, we reach the output
level K represented by the isoquant 250 which is at a higher
level than the isoquant 200. This shows that the marginal
returns of the variable factor, labour, have increased even
when there are increasing returns to scale.
Conclusion:
It can be concluded from the above analysis that under a
homogeneous production function when a fixed factor is
combined with a variable factor, the marginal returns of the
variable factor diminish when there are constant,
diminishing and increasing returns to scale. However, if
there are strong increasing returns to scale, the marginal
returns of the variable factor increase instead of
diminishing.

Q.2. Write short notes on all of the following topics (1 mark each –
Word limit – 100)

A. Elasticity of demand

Elasticity of Demand
To begin with, let’s look at the definition of the elasticity of
demand: “Elasticity of demand is the responsiveness of the
quantity demanded of a commodity to changes in one of the
variables on which demand depends. In other words, it is
the percentage change in quantity demanded divided by
the percentage in one of the variables on which demand
depends.”

The variables on which demand can depend on are:

 Price of the commodity

 Prices of related commodities
 Consumer’s income, etc.
 2-B. Contraction and expansion of demand
We have studied under the law of demand that other things
remaining the same, if price of a commodity rises, its demand decreases
and if price of the commodity falls, its demand increases.
When quantity demanded of a commodity increases as a result of
the fall in the price, it is called extension (or expansion) in demand (a
movement down the demand curve) and when the quantity demanded
decreases as a result of an increase in the price of the commodity, it is
called contraction in demand (a movement up the demand curve). Thus,
extension and contraction in demand imply change in quantity demanded
due to change in the price of the commodity, other things remaining the
same.
Extension in demand is shown in Fig. 1.7. At price OP1,
OQ1 quantity of the commodity is demanded. If the price falls to OP 2,
quantity demanded of the commodity increases to OQ2 . Q1 Q2 is the
extension in demand, which results from a fall in the price of the
commodity from OP1 to OP2.

Contraction in demand is shown in Fig. 1.8. At price OP,, the

quantity demanded of the commodity is OQ,. When the price of the
commodity rises to OP2, the quantity demanded of the commodity falls to
OQ2. Q2 Q, is the contraction in demand resulting from an increase in the
price from OP, to OP2
 Both extension and contraction in demand are represented by a
movement (moving down and up respectively) along the same demand
curve. In these cases, there is no shift in the demand.

2-C. Fixed cost and variable cost

Variable Cost vs. Fixed Cost: An Overview
In economics, variable costs and fixed costs are the two main
costs a company has when producing goods and services. A
variable cost varies with the amount produced, while a fixed
cost remains the same no matter how much output a company
produces.
Variable Cost
A variable cost is a company's cost that is associated with the
number of goods or services it produces. A company's variable
cost increases and decreases with its production volume. When
production volume goes up, the variable costs will increase. On
the other hand, if the volume goes down, so too will the variable
costs.
Fixed Cost
A fixed cost is the other cost incurred by businesses and
corporations. Unlike the variable cost, a company's fixed cost does
not vary with the volume of production. It remains the same even if
no goods or services are produced, and therefore, cannot be
avoided.

2-D. Law of demand

Definition of 'Law Of Demand'

Definition: The law of demand states that other factors being constant

(cetris peribus), price and quantity demand of any good and service are
inversely related to each other. When the price of a product increases,
the demand for the same product will fall.

Description: Law of demand explains consumer choice behavior when

the price changes. In the market, assuming other factors affecting
demand being constant, when the price of a good rises, it leads to a fall
in the demand of that good. This is the natural consumer choice
behavior. This happens because a consumer hesitates to spend more for
the good with the fear of going out of cash.

The above diagram shows the demand curve which is downward sloping.
Clearly when the price of the commodity increases from price p3 to p2,
then its quantity demand comes down from Q3 to Q2 and then to Q3 and
vice versa.

2-E. Determinants of supply

The Five Determinants of Demand

The five determinants of demand are:

 1. The price of the good or service.
2. Income of buyers.
3. Prices of related goods or services. These are either
complementary, those purchased along with a particular good
or service, or substitutes, those purchased instead of a certain
good or service. 
4. Tastes or preferences of consumers.
5. Expectations. These are usually about whether the price will go
up.

For aggregate demand, the number of buyers in the market is the

sixth determinant.