Efe Unit-2 Merged

Unit - II
MARKET STRUCTURES
Equilibrium of a firm
A firm is in equilibrium when it earns maximum profits or
minimum losses. This condition applies to all types of
market structure.
The Two methods of determining the equilibrium of a firm
are the:
1. Total approach
2. Marginal approach
Total approach is the simplest way to determine the
equilibrium of a firm.
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1. Total Approach
TR, TC
TC Total approach is the simplest way

TR to determine the equilibrium of a
firm.
Highest vertical Under Perfect Market:

differences
TR curve is straight line through origin.
The firm maximum profits at ON output
because the vertical distance between
Quantity TR and TC curve is maximum.
0 N
TR, TC
TC Under Imperfect Market:

TR Total revenue (TR) curve continues to rise
from left to right at a less than
proportionate
Highest vertical rate. A rational firm will choose the output
differences
when the vertical distance between TR
and
TC is at maximum, ON.
Quantity
O
N

2. Marginal Approach
MR, MC
MC
A firm is said to be in equilibrium when marginal
revenue is equal to marginal cost.
P* MR=AR MARGINAL REVENUE = MARGINAL COST
Under Perfect Market:

MR curve is horizontal.
Quantity When MR is equal to MC,
Q*
MR, MC a firm is in equilibrium
MC
Under Imperfect Market:

P* MR curve is downward
sloping. Same as perfect
AR=DD market, when MR is equal to
MC, a firm is in equilibrium.
MR
Quantity
Q*

Market
A particular place where goods are purchased and sold.
In eco.- It refers to the whole region in which the
buyers & sellers are in competition with one another.
Place is not essential for transactions – Imp. thing that
they should be in contact with each other through any
means of communication.

Market Structure
Market structure refers to the number and distribution size
of buyers and sellers in the market of a good and service.
Market structure is an indication of the number of buyers
and sellers; their market shares; the degree of product
standardization and the ease of market entry and exit.

Forms of market
Market structures fall into four categories:
1. No. of buyers and sellers
2. Nature / type of commodity – Homogeneous or
heterogeneous
3. Nature of competition- Number, size and
distribution of sellers
4. Freedom to enter & exit from the market

Four Types of Market Structures
Number of
Firms?
Man Large firms
yfirm
s
Type of
Products?
On Fe Differentiat Identic
e
fir w
firm edproduct al
product
m s s s
Monopolist Perfec
Monopol Oligopol ic
Competiti t
Competiti
y y on on
• Tap • Cars • Toothpast • Whea

water
• Electricity • Steel e
• Movie t
• Mil
s k

Perfect competition
Is a market situation in which no seller or a firm can
influence the prevailing price by his independent action.
FEATURES -
1. Large no. of buyers & sellers – Industry is price maker and
firm is price taker

The Competitive Industry and
Firm

2. Homogeneous product – Perfect substitutes (identical) -
Unbranded spices
3. Freedom of entry & exit of firms
4. Perfect mobility of factors of production
5. Perfect knowledge of market conditions – Zero
information cost
6. Absence of transport cost
7. Absence of govt. interference

Pure & perfect competition
1+2+3 = Pure competition
1+2+3+4+5+6 = Perfect competition

Examples of Perfect competition
Market for stocks and shares
Securities can be transported without difficulty
Stock brokers have a sound knowledge of market
conditions
Commodity markets – Raw materials, foodstuff (Same
grade)

Equilibrium of a Firm and
Industry

Equilibrium in the short run
ASSUMPTIONS:
1. MR = MC - NECESSARY
2. MC must intersect MR from the below - SUFFICIENT
15
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Profit Maximization
MC
40 D=
0 MR
1 2 3 4 5 6 7 8 9 1
0 16
Output
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Short run equilibrium
Short run - Three possibilities:
1. Case of supernormal profits
2. Case of normal profits
3. Case of loss/subnormal profit
Exit or shut down in short-run – AR < AVC
Long run equilibrium

Monopoly
A market situation in which there is a single firm producing
a commodity with no close substitutes.
Example: Government has the monopoly in providing water
supply, railways, etc.

Monopoly
1. Single seller
2. Single product – NO close substitute
3. No difference between firm & industry - Firm is
price maker
4. Independent decision making
5. Restricted entry
6. Price discrimination can be practiced

Example
No perfect example of monopoly
De Beers in the diamond market
Gas pipelines can be economic monopolies
VSNL from 1995- 1998
Indian Railways – Bulk Carrier
Prior to 1984 American Telephones and Telegraph company
(AT & T)
Microsoft virtual monopoly

AR and MR curves for a
Monopoly

AR and MR curves for a
Monopoly - Profit maximization
MR curve under imperfect market is downward sloping as
the output increases.
The profit maximization rule, MR = MC, where the MC curve
intersect with the MR curve.
MR, MC
MC
P*
AR=P
MR
Quantity
Q*

Price and output decisions in
short run and long run
1. Case of normal profits/supernormal profits

Imperfect competition
markets

Monopolistic competition
market
It refers to a market structure in which many / large
number of sellers sell differentiated products which are
close substitutes of each other.
Monopolistic competition combines the basic elements of
both perfect competition and monopoly.
Ex- Tooth paste, shampoo, hair oil, beauty soaps,
restaurants, apparels, detergents, education boards in
India, IT companies in India.

Monopolistic competition -
features
1. Many / Large number of firms are operating
2. Product differentiation / heterogeneous products
3. Free / unrestricted entry and exit
4. Selling cost
5. Independent decision making and multiplicity of prices
6. Imperfect knowledge – Information about cost, quality,
price etc. is not uniformly available to all buyers and
sellers in the market.

Concept of industry &
product groups
Industry is defined as group of firms producing a
homogeneous product in case of perfect competition.
But, under monopolistic competition product is
heterogeneous.
Therefore, Chamberlin defines the monopolistically
competitive industry as a ‘group’ of firms producing a
‘closely related’ commodity but not perfect substitutes of
each other are called product group.
Ex- Ariel, Surf, Nirma can be clubbed in the product group
of detergents.

AR & MR curve under
Monopolistic competition
market

Short run equilibrium

Oligopoly
A market where few dominant sellers sell differentiated or
homogeneous products under consciousness of rivals
actions.
Ex- Newspapers, Oil companies, automobile, computers,
credit cards.

Features of oligopoly
1. Few sellers
2. Product may be differentiated – Impure oligopoly and
selling cost

Pure / collusive oligopoly
1. Few sellers and the transaction unit is homogeneous.
2. Tendency to form a cartel and dictate price.
EXAMPLE – Oil, Steel, Copper etc.

3. Interdependence of decision making - Cars
4. Price rigidity and kinked demand curve

Price rigidity and kinked
demand curve
Since there is mutual interdependence between oligopoly
firms, the prices in the market are more stable. This is
called price rigidity in oligopoly market.
The price rigidity explains the behaviour of an oligopoly firm
that has no incentive to increase or decrease the price.
The theory of the kinked demand curve is based on two
assumptions.

Assumptions
1. First assumption: If an oligopolist reduces its price, its
rivals will follow and cut their prices to prevent losing
the customers.
2. Second assumption: If an oligopolist increases its price,
its rivals do not increase the price and keep their prices
the same, thereby they gain customers from the firm
that increases the price.

Kinked demand for a firm
under oligopoly

5. Knowledge is imperfect
6. Advertising and sales promotion
7. Entry barriers – Huge investment (cement, petroleum
product, cars), consumer loyalty (Godrej almirah, Xerox
for photocopying), economies of scale (HP printers).
EXAMPLE – Automobiles, Cameras, Telecom

Duopoly
1. Only two firms
2. Knowledge is imperfect
EXAMPLE – Pepsi and Coke in carbonated soft drink
market, CDMA firms in India, Premier and Hindustan
Motors before Maruti Udoyg Ltd.

SUMMARY OF MARKET STRUCTURE
Perfect Monopolistic
Characteristics Monopoly Oligopoly
competition competition
Number of sellers
Large One Many Few
Identical or Unique or no close Homogenous or

Type of product Differentiated
homogenous substitution differentiated
Entry condition Very easy Impossible Easy Difficult
Control over price None Some Some Considerable
Local phone Automobiles,

Examples Wheat, corn Food, clothing
service, electricity cigarettes
Profit maximization MR = MC MR = MC MR = MC MR = MC

SUMMARY OF MARKET STRUCTURE (cont.)
Monopolistic
Characteristics Perfect competition Monopoly Oligopoly
competition
Subnormal, Subnormal, Subnormal, Subnormal,
Short run
supernormal or supernormal or supernormal or supernormal or
equilibrium
normal profit normal profit normal profit normal profit
Normal/Supernorm Supernormal profit
Long run Normal profit due to Normal profit due to
al profit because of because of barriers
equilibrium free entry and exit free entry and exit
barriers to entry to entry
Production
efficiency (at Yes No No No
minimum AC)
S/run: AR<AVC S/run AR<AVC S/run: AR<AVC S/run: AR<AVC
Shut down
L/run: AR< AC L/run: AR< AC L/run: AR< AC L/run: AR< AC

Review questions

The fact that Pepsi uses a predominantly blue can, while
Coke uses a red and white one is an example of:
1. Collusion
2. Product choice
3. Product differentiation
4. Price competition

Which of the following firms belong to an oligopolistic
market?
1. McDonalds
2. Kellogg’s food products
3. Essar steel
4. All of the above

Which of the following is not a type of market structure?
a. Competitive monopoly
b. Oligopoly
c. Perfect competition
d. All of the above are types of market structures

Which of the following industries is most likely to be
monopolistically competitive?
a. The automobile industry
b. The steel industry
c. The car repair industry
d. The electrical generating industry

If a firm sells its output in a market that is characterized by
many sellers and buyers, a differentiated product, then the
firm is:
a. a monopolist
b. an oligopolist
c. a perfect competitor
d. a monopolistic competitor

Which of the following markets comes close to satisfying
the assumptions of a perfectly competitive market
structure?
a. The stock market
b. The market for agricultural commodities such as wheat or
corn
c. The market for dairy products such as milk
d. All of the above come close to satisfying the assumptions
of perfect competition

Unit - II
THEORY OF PRODUCTION AND COSTS
Production function
A producer/economy is faced with the problem of ‘how to
produce?’
He has to take a decision about the combination of fixed
and variable factors should be employed.
He has to decide about the input combination.

Production and Production function
Production refers to the process by which man utilizes or
converts the resources of nature, so as to satisfy human
wants.
Production function means transformation of physical
inputs into outputs.
Refers to the functional relationship between inputs &
output under given technology.
Mathematically,
Q=f (f1, f2……….fn)
Q= physical qty. of a certain product.
f1, f2= various inputs needed to produce Q.

Factors affecting production function
1. Technology
2. Inputs – Land, labour, capital, entrepreneur
Inputs are divided into fixed and variable.
3. Time period of production – Short run and long run

Fixed and variable factors
The inputs or factors of production are classified as fixed
and variable.
Variable factors / inputs - can be changed in the short-run
Ex- labour, electricity, fuel, transportation.
Fixed factors / inputs - Cannot be changed during short-run
Ex- land, capital, buildings, tools, machinery.
Both short run & long run actually depends on the inputs,
which can vary in production.

Short-run and Long-run
Production Function
Short-run Production Function: It refers to production in
the short-run where there is at least one factor in fixed
supply and other factors are in variable supply.
For example, land, plant, factory building, minimum
electricity bill, etc.
Long-run Production Function: It refers to production in the
long-run where all factors are in variable supply.
For example, raw materials, daily wages, etc.

Production function with one fixed
input & one variable input
We assume at least one input is fixed.
Q = f(Labour, K) K is fixed here
OR
Q = f(K, Labour) L is fixed here

Law of diminishing marginal
returns / Law of variable
proportion
The law basically explains the behaviour of production
functions in the short run.
“As the proportion of one factor in a combination of factors
is increased after a point, the AVERAGE & MARGINAL
production of that factor will diminish.”
When more units of variable factors used with the fixed
factors a point is reached first MP falls, then the AP & finally
the TP will diminish.
This law is also called the law of variable proportions
because it shows how output varies with variable and fixed
inputs.
Concept of production
1. Total product -Total volume of goods & services produced.
2. Average product - Per unit product of a variable product.

3. Marginal product - Net addition to total product.

Assumptions
1. Technology will remain constant.
2. Quantity of at least one factor input is constant and one
factor input is variable.
3. Variable factors are homogeneous.
4. The various factors are not to be used in rigidly fixed
proportions but the law is based upon the possibility of
varying proportions.
5. Addition to the variable input is made in equal
increment.

Law of variable proportion schedule
No. of TP AP MP Stage
workers
0 0 0 0
1 2 2 2
2 6 3 4 I stage
3 12 4 6
4 16 4 4
5 18 3.6 2
II stage
6 18 3 0
7 14 2 -4
III stage
8 8 1 -6

Stages
Stage -1 (IRRATIONAL) Stage –II (RATIONAL)
TP increases at an increasing rate TP rises but at a diminishing rate
–Maximum
MP also rises
MP falls-Becomes zero
AP also increases but lies below MP
AP also diminish –AP>MP
1. Indivisible fixed factors
1. Optimum utilization of
2. Division of labour & resources.
specialization

Stages contd…..
Stage-III (IRRATIONAL) Universality of law-
TP starts declining Applies to every industry & firm
MP becomes negative Operates in agriculture
AP also diminish Negative MP in PSU - SAIL
1. Excess variable factor with
fixed factors

Law of variable proportion and
capacity planning
Total output decisions of a firm depend on the demand
made by the consumers.
Production decisions in turn influence the selection of the
plant capacity in the short run.
To operate in the second stage of increasing returns, the
firm has to select the best combination of fixed inputs and
variable inputs.
Ex – Birla copper and rise in demand for furnaces for
power.

Review question
Which of the following is most likely an example of
production inputs that can be adjusted in the long run, but
not in the short run?
a. Amount of wood used to make a desk.
b. Number of pickles put on a sandwich.
c. The size of a McDonald’s kitchen.
d. The amount of electricity consumed by a
manufacturing plant.

Review question
The relationship between hours spent studying (input) and
knowledge of economics (output) is positive. However,
once you have done 20 hours of studying, an additional
hour does not add as much to your knowledge as the first
hour did. When you graph the relationship between
studying and knowledge, is the resulting line straight or
curved? Why?

Review question
A shoe factory has 500 employees and produces a thousand
pairs of shoes per hour.
The factory hires one new worker. Now, the factory
produces 1,002 shoes per hour. Then the factory hires one
S NEHRA EFE UNIT II

more worker. Production rises to 1,004 per hour. Does the
factory have diminishing, constant, or increasing marginal
returns at this level of production?
20
Long-run production function
In the long run, inputs-output relations are studied by the
laws of returns to scale.
These are long-run laws of production.
The laws of returns to scale functional can be explained
with the help of the isoquant curve.

Isoquant
An isoquant or iso-product represents all the possible
combination of two factor inputs, which gives the same
level of output (total product).
Represents all the possible combinations of variable
inputs that used to generate the same level of output
(total product).

Isoquant Schedule
Capital Labour
1 2 3 4 5
1 250 450 550 700 800
2 450 650 800 900 950
3 600 800 950 1050 1100
4 700 900 1050 1150 1200
5 800 950 1100 1200 1250

Isoquant Curve
Properties:
1. Isoquant curves slope downwards.
2. Isoquant curves are convex to origin.
3. The higher the isoquant the higher the output.

Isoquant Map
Refers to a number of isoquants that are combined in a
single graph.
Can be used to estimate the maximum attainable
output from different combinations of inputs.
Higher isoquant curve represents a higher level of
output.

Isoquant Map

Marginal Rate of Technical
Substitution
The slope of the isoquant curve is the rate of substitution
that shows how one input can be substituted for another
while holding the output constant. This is called marginal
rate of technical substitution (MRTS).
MRTS = - Change in Capital /

Change in Labour
MRTS = - Δ K / Δ L
The slope is negative, the MRTS itself is positive.

Law of Returns to Scale
Scale of production relates to size of plant.
Every entrepreneur has to decide about the size of his plant
or business.
The study of changes in output as a result of changes
(increase or decrease) in the scale is the subject matter of
returns to scale.
Returns to scale describes the relationship between outputs
and scale of inputs in the long run when all the inputs are
increased in the same proportion.

Three Possibilities
1. Increasing returns to scale
2. Constant returns to scale
3. Decreasing returns to scale

Increasing returns to scale
Increasing returns to scale refers to a situation in which output increase

by a greater proportion than increase in factor inputs. This is increasing
returns to scale, which occurs because of economies of scale.

Constant returns to scale
A constant return to scale implies the situation in which an increase in

output is equal to the increase in factor inputs. 6

Decreasing returns to scale
Diminishing returns to scale refers to a situation in which output

increases in lesser proportion than increase in factor inputs. Internal
and external diseconomies of scale contribute to decreasing returns
to scale.

Costs of Production
In producing a commodity, a firm has to employ an
aggregate of various factors of production like land, labour,
capital, producer.
These factors are to be compensated by the firm for their
efforts.
This compensation in terms of factor price is called as cost.
Cost of production, denotes the value of factors of
production employed.

Cost – Output relationship
Determinants of a cost function –
1. Size of plant – Cost depends on size of relevant plant
2. Output level – TC increases with the output
3. Price of inputs – Change in price of inputs influence costs
4. Technology – Modern technology is cost saving
5. Managerial efficiency – Managerial efficiency difficult to be
quantified
Most important determinant is output, other factors are assumed to
be constant while analyzing cost and cost curves.

Cost function
A cost function shows the functional relationship between
output and cost of production.
It gives the least cost combinations of inputs corresponding
to different levels of output.
Cost function is given as:
C = f (Q), ceteris paribus

Cost and decision making
Study of costs is essential for making a choice from the
competing production plants.
Since the productive resources are scarce with any firm and
also since these have alternative uses, the uses of these
resources involves sacrifice and, therefore,
The firm will have to analyze these sacrifices or costs
whenever it decides to use the resources.
Cost and revenue are the two major factors with which a
firm can maximize the profits.
A firm can influence cost more easily than revenue.

Cost concepts
1. Explicit cost (Paid out) and Implicit cost (Imputed) OR
Accounting and Economic cost
2. Actual cost and Opportunity cost
3. Short run & long run cost - Fixed cost and variable cost

1. Explicit cost and Implicit
cost
Explicit cost is the monetary payment made by the
entrepreneur for purchasing or hiring the services of
various productive factors, which do not belong to him.
This cost is in the nature of contractual payment and
includes rent for land, wages to the labour.
This cost is called out of pocket cost and is recorded in
firm’s account book. As accountant takes into account his
cost, it is also called accounting cost.

Accountants cost
An accountant include the cost of production only the cash
payments to the factors of production, made by the
entrepreneur, for the services rendered by these factors in
the productive process.
These cash payments are called explicit cost.
Ex – Wage, Interest, Rent

Implicit cost
Implicit cost arises in the case of those factors, which are
possessed and supplied by the entrepreneur himself.
There is no contractual obligation for payment to anyone
else in order to obtain these factor units.
Implicit cost is also known as imputed cost, as it is not
possible to assign exact money value to it.
It is worked out or imputed on the basis of potential
earnings, which the factors of production owned by the
firm could get in the next best alternative use.

Economic cost
In economics, the cost of production consists of
remuneration to all the factors of production.
Ex – Wages to labour, rent to land, interest to capital
It includes explicit and implicit cost.
A firm gets economic profits, if its revenue exceeds the sum
of explicit and implicit cost.

Review question
Mr. Suresh Ramchandran, an executive employed with
Ranbaxy India drives his car himself and hence is not paid
by the company for doing the work of a driver. This is:
1. Explicit cost
2. Implicit cost
3. Both of the above
4. None of the above

2. Actual cost and
Opportunity cost
Actual or historical cost refers to the actual expenditure
incurred for acquiring or producing a good or service.
Such cost is popularly known as absolute cost or outlay
cost.
Actual wages, rent or interest paid are some examples of
actual or absolute cost.

Opportunity cost
Opportunity cost is the cost which is not actually incurred,
but would have been incurred in the absence of
employment of self-owned factors.
As expenditure is not currently incurred, this cost is often
ignored and not recorded in the books of accounts.
However, producer should never ignore it while taking
business decision.
Implicit cost incurred by a firm is actually the opportunity
cost of the factor owned by him.

Cost curves in the short-run

Short run cost and long run
cost
Short run is defined as a period in which the supply of at
least one of the inputs cannot be changed by the firm.
Ex – Machinery, Buildings etc.
Short run costs are of two types – Fixed and Variable cost

Short run cost curves
Short run total cost – (on the basis of total)
1. Total Fixed cost (TFC)
2. Total Variable cost (TVC)
3. Total Cost (TC) = TFC + TVC
Short run per unit cost - (based on per unit)
1. Average Fixed cost (AFC) =TFC/Q
2. Average Variable cost (AVC) = TVC /Q
3. Average Cost (AC) = AFC + AVC
4. Marginal Cost (MC) = TC n – TC n-1

Total Fixed Cost
Fixed costs are those costs that do not change with a

change in level of output.
Ex - Wages/salaries of permanents workers.

Total Variable cost
Variable costs are those costs which vary with the quantity of
output produced.
Examples of variable costs are (i) cost of direct labour, (ii) running
expenses like cost of raw materials, fuel, etc. Variable costs are
also called Prime cost.
TVC curve is an inverse S-shaped curve. The reason behind its shape
is the law of variable proportion.

Total Cost (TC) = TFC + TVC
Total Cost (TC) is defined as the sum total of all costs of producing
any given level of output.
TFC is a horizontal line and TVC is an inverse S-shaped starting from
the origin. TC curve is an inverse S-shaped curve.
The reason behind the shape of TC curve is the law of variable
proportion.
The vertical distance between TVC and TC curves measures TFC.

Average Fixed cost
AFC is defined as the fixed cost of producing per unit of the
commodity.
It is obtained by dividing TFC by the level of output.
The AFC curve derived from TFC curve is a rectangular
hyperbola.
It shows declining values of fixed cost per unit of output
produced. The downward sloping AFC curve can never
touch either the x-axis or the y-axis.

Average Fixed cost

Average Variable cost
AVC is defined as the variable cost of producing per unit of
the commodity. It is obtained by dividing TVC by the level of
output.
The AVC curve is derived from TVC curve and is U-shaped. It
shows that as output increases, the value of AVC falls
continuously till it reaches a minimum point.
Beyond this point, the AVC starts rising. The reason behind
the U-shape of AVC curve is the law of variable proportion.

Average Cost (AC) = AFC +
AVC
The AC curve as derived from TC curve is U-shaped.

It shows that as output increases the value of AC falls continuously till it
reaches a minimum point. Beyond this point, the AC starts rising. The
reason behind the U-shape of AC curve is the law of variable
proportion.

Marginal Cost
Marginal cost is defined as addition made to total variable
cost or total cost when one more unit of output is
produced.
MC = Δ TVC / Δ X or Δ TC / Δ X
MC = TCn - TCn-1
MC is an additional cost. BY definition, additional cost
cannot be fixed cost; it can be only variable cost.
Accordingly sum total of MC becomes TVC.
ΣMC = TVC

MC curve, as derived from the TVC curve, is U-shaped. The reason
behind its shape is the law of Variable Proportion.

Short-run cost curves
COST
STAGE I STAGE III

STAGE II
SATC
SAVC
SAFC
QUANITTY
ATC curve is “U-Shaped” because of the combined influences of AFC

and AVC.
Stages and description
STAGE I
AFC begins to fall with an increase in output and AVC decreases.
As long as the falling effect of AFC is higher than the rising effect of AVC, the
ATC tends to decrease.
STAGE II
AFC continuous to decline and SATC will become minimum.
ATC remains constant at this stage since the falling effect of AFC and rising
effect of AVC is balanced.
STAGE III
The falling effect of AFC is lower than rising effect of AVC, therefore ATC
begins to increase.

Relationship between MC and ATC
Cost
MC
ATC
Quantity
ATC falling, MC curve lies below ATC curve.

ATC is at minimum point, ATC curve and MC curve are equal.
ATC starts to increase, MC curve lies above ATC curve.

Relationship between productivity and cost
Production
When its AP is equal to MP,

MP AP curve is at maximum.
AP
When its AVC is equal to MC,
Labour AVC curve is at minimum.
Cost
MC AVC
Quantity

Relationship between
different cost curves

Relationship
Output TFC TVC TC AFC AVC AC MC
0 10 0 10 - - - -
1 10 4 14 10 4 14 4
2 10 7 17 5 3.5 8.5 3
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3 10 9 19 3.3 3 6.3 2
4 10 11 21 2.5 2.7 5.2 2
5 10 14 24 2 2.8 4.8 3
6 10 19 29 1.6 3.1 4.7 5
64
Review question
Output TFC TVC TC AFC AVC AC MC
0 60 60
1 60 90
2 60 100
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3 60 105
4 60 115
5 60 135
6 60 180
65
Review question
Engineers for The All-Terrain Bike Company have determined
that a 15% increase in all inputs will cause a 15% increase in
output. Assuming that input prices remain constant, you
correctly deduce that such a change will cause _________ as
output increases.
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1. average costs to decrease
2. average costs to remain constant
3. marginal costs to increase
4. average costs to increase
66
Isocost analysis

Isocost Line
The Isocost line is similar to the budget line in the
Indifference Curve analysis.
An Isocost line shows various combinations of two inputs,
that is capital and labour used in the production and the
given total cost by a firm.

Isocost Line
Slope of Isocost line is: Price of Labour (w) / Price of Capital (r)

Iso-cost Map
An Isocost map is a number of Isocost lines that shows different

levels of TC.

Cost-Minimizing Technique
The cost minimizing technique is selecting combinations of
inputs that minimize the total cost at the given level of
output.
Slope of Isoquant curve is equal to Isocost line (Tangent)
At equilibrium, MRTSLK = w/r

Cost Curves in the Long Run
Long run is defined as a period in which all inputs can be
changed as desired.
In the long run all costs are variable.
Firm’s long-run decisions are called planning decisions.
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A firm attempts to maximize long run profits by selecting a
short-run scale of plant that minimizes cost.
In the long run we are interested only in –
1. Long run average cost (LRAC)
2. Long run marginal cost (LRMC)
73
Long-run Average Cost Curve
Long run total cost (LRTC) starts from origin because of the
absence of total fixed cost.
LRAC is a curve that shows the minimum cost of producing
any given output, when all the inputs are variable.
The LRAAC curve is derived from a series of Short-run
average cost (SRAC) curves. Tangential points of these
curves are joined to form the LRAC curve.

LONG-RUN PRODUCTION COST
LRAC curve are derived by a series of short run average cost curves
COST
SRAC1
SRAC5
SRAC2
SRAC4 LRAC
SRAC3
Tangential point of the SAC

are joined and made up the LRAC.
QUANTITY

Long run average cost curve (LRAC) is “U–Shaped” due to the Law of
Returns to Scale.
Law of Returns to Scale states that as the firm expand its size or scale of
production, its long run average cost (LRAC) will decrease and increase
at later stage.
Cost
LRAC
Increasing Constant Decreasing

Return to Return to Return to
Scale Scale Scale
Quantity

WHY firms are not in a position
to operate at the optimum level
?
1. Create artificial scarcity so as to get higher price in the
future.
2. Set up industrial empire often produce beyond full
capacity.
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3. Government’s regulation stipulates the level of output –
MRTP Act
4. Unable to reach optimal level due to adjustments to the
changes in market conditions, technology and the price
of factor inputs.
5. Optimal scale is only lowest cost scale of enterprise. It is
not necessary the most profitable scale. 77
LAC & LMC
In the figure, LAC curve is U-shaped. The reason behind the

U-shape of the LAC is the law of returns to scale.

Review question
You are the owner of the firm. In long run the firm is
currently losing Rs. 1000 per month, with fixed costs per
month of Rs. 800 per month. A consultant advises you to
stop production. Should you accept the advice. Why or why
not?
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Importance of cost curves
1. Equilibrium of firm – A firm reach the equilibrium
position when its MC = MR.
2. Optimum output – Optimum output is determined by
the costs – When MC cuts AC from below.
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3. Estimate of profit and loss – AR and AC
4. Choice of plants – In the long run a firm can choice a
plant and scale of production, on the basis of long run
average cost.
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Economies of Scale
Anything that serves to minimize average cost of
production in the long run as scale of output increases is
referred to as “economies of scale”.
TYPES –
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1. Internal Economies – Open to an individual firm when
its size expands.
2. External Economies – Shared by all the firms in an
industry.
81
Forms of Internal Economies
1. Labour economies – Division of labour – Greater specialization-
Productivity rises.
2. Technical Economies– Automatic machines are quicker and
efficient.
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3. Managerial economies – Large output can be managed with the
same skill & efficiency.
4. Marketing economies – Raw material at a cheaper rate –Large
scale marketing.
5. Financial economies – Loans at a cheaper rate .
6. Risk bearing economies –Diversification of output, market, sources
of supply.
82
Form of External Economies
1. Economies of localization / concentration - Skilled
labour, transport facilities, maintenance services.
2. Economies of information -Trade and technical,
publications – Seminar, workshops.
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3. Economies of vertical disintegration - Split up
production Ex- Textile industry – Color, thread.
4. Economies of by-products - Waste material for
manufacturing new products.
83
Internal diseconomies of
scale
1. Labour diseconomies – Indivisibility of factors occur –
Disinterest.
2. Management problems – Miscommunication, lack of
cooperation, coordination and supervision of the work of
different departments.
3. Technical difficulties – Machinery has an optimum
capacity limits – Breakdown of machinery.

External Diseconomies of
scale
1. Scarcity of raw material – Cost rises
2. Rise in Wages – Attrition problem
3. Concentration problem – Cost of transportation
increases due to congestion.

Economies of scope
Economies of scope appear when an individual firm’s
output for two different products is higher than the output
reached by two different firms each produce a single
product.
The theory of an economy of scope states the average total
cost of a company's production decreases when there is an
increasing variety of goods produced.
A firm can gain efficiencies from producing a wider variety
of products.
These efficiencies can involve lower average costs.

Economy of Scope
Economy of scope is to imagine that it's cheaper for two
products to share the same resource inputs (if possible)
than for each of them to have separate inputs.
A single train can carry both passengers and freight more
cheaply than having separate trains, one for passengers and
another for freight. In this case, joint production reduces
total input costs.
Netflix
Amazon

Example
Company ABC is the leading desktop computer producer in
the industry. Company ABC wants to increase its product
line and remodels its manufacturing building to produce a
variety of electronic devices, such as laptops, tablets and
phones.
Since the cost of operating the manufacturing building is
spread out across a variety of products, the average total
cost of production decreases.
The costs of producing each electronic device in another
building would be greater than just using a single
manufacturing building to produce multiple products.

Diseconomies of Scope
The diseconomies of scope appear in the productions of an
individual firm’s because the production of one product might
inconsistent with the production of another product.
There might be a situation in which the combined production of
two goods escalate the costs such that the combined cost of the
two products is higher than the sum of the stand-alone costs of
each product.
When firms diversify into new businesses, they actually do more
harm than good.
Example - Additional advertising expenditure on new products
may become less effective - Passenger vehicles and Commercial
vehicles.

Concept of Revenue
Revenue is the money payment received from the sale of a
commodity.
The terms mostly used with revenue are:
1. Total Revenue (TR)
2. Average Revenue (AR) and
3. Marginal Revenue (MR)

Total Revenue
TR is defined as the total or aggregate of proceeds to the
firm from the sale of a commodity.
It is calculated by multiplying price (P) by the quantity sold
(Q).
TR = P.Q

Average Revenue
AR is revenue per unit of output sold.
It is obtained by dividing total revenue by the number of
units sold.
AR is always identical with the price.

Marginal Revenue
MR is addition made to total revenue when one more unit
of output is sold.
MR = Δ TR / Δ Q
MRn = TRn – TRn–1

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Unit - II

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TC Total approach is the simplest way

Highest vertical Under Perfect Market:

TC Under Imperfect Market:

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Under Perfect Market:

Under Imperfect Market:

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• Tap • Cars • Toothpast • Whea

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Identical or Unique or no close Homogenous or

Entry condition Very easy Impossible Easy Difficult

Control over price None Some Some Considerable

Local phone Automobiles,

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