Economics For Managers MODULE 3

Module 3: Consumer and Producer
Behaviour 12 Hours
3.1 Introduction to Consumer behaviour,
3.2 Utility, Cardinal approach, Ordinal approach,
3.3 Consumer’s equilibrium using Indifference
curve analysis and Consumer surplus,
3.4 Application of Indifference curve analyses
Market,
3.5 Production – Short-run and long-run
Production Function
3.6 Returns to scale – economies Vs
diseconomies of scale,
3.7 ISO-Quants & ISO-Cost line,
3.8 Analysis of cost – Short-run and long-run cost
function
3.9 Relation between Production and cost
function,
3.10 Break Even Analysis – Meaning,
Assumptions, Determination of BEA, Limitations,
Uses of BEA in Managerial decisions (with simple
Problems).
3.1 Introduction to Consumer behaviour:
Introduction :
Consumer behaviour can be defined as those acts of individuals (consumers) directly
involved in obtaining, using, and disposing of economic goods and services, including the
decision processes that precede and determine these acts. Understanding how consumers
make purchase decisions can help marketing managers in several ways. Consumer
behaviour, also called Buyer Behaviour is the process and act of decision-making of people
involved in buying and use products.
Consumer behaviour refers to human behaviours which go in making purchase decisions.

When consumers make decisions, they are engaged in a problem-solving talks, that is,
satisfying a perceived need. This is called Consumer Behaviour.
Consumer behaviour refers to the act of consuming a good or service. Consumer behaviour
is the study of how individuals, groups and organizations select, buy, use and dispose of
goods, services, ideas, and experiences to satisfy their needs and wants (Kotler).
Meaning of consumer behaviour:

Consumer behaviour can be defined as those acts of individuals (consumers) directly
involved in obtaining, using, and disposing of economic goods and services, including the
decision processes that precede and determine these acts. Understanding how consumers
make purchase decisions can help marketing managers in several ways.
One thing that we have in common is that we are all consumers. In fact, everybody in this
world is a consumer. Everyday of our life we are buying and consuming a different variety of
goods and services. However, we all have different tastes, likes and dislikes and adopt
different behaviour patterns while making purchase decisions.
Mr. ‘X’ may prefer to use Colgate toothpaste, Denim toilet soap and Halo shampoo while
Mrs. ‘X’, the spouse may prefer to use Pepsodent toothpaste, Lux soap and Sun silk
shampoo. Similarly, different types of people may have a different set of preferences in
food, clothing, books, magazines, recreational activities, forms of savings and the stores
from where one prefer to shop, which may be different not only from that of our family
members but also from our friends, neighbours and colleagues.
Each consumer is unique and this uniqueness is reflected in the consumption behaviour,
pattern and process of purchase. The study of consumer behaviour provides us with reasons
why consumers differ from one another in buying and using products and services.
‘What’ products and services do we buy, ‘why’ do we buy, “how often’ do we buy, from
‘where’ do we buy, ‘how’ we buy, etc., are the issues which are dealt within the discipline of
consumer behaviour.
For example, if a manager knows through research that gas mileage is the most important
attribute for a certain target market, the manufacturer can design the product to meet this
criterion. For example, an automobile manufacturer can advertise a car’s maintenance-free
features and sporty European style while downplaying gas mileage.
What do humans really want? And can these wants be satisfied or are human wants endless?
While these questions may seem philosophical, we actually study the economic wants of
humans in economics. It helps us explain consumer behavior and in turn demand and supply.
Let us take a look at the nature and classification of human wants.
Nature of Human Wants
All the desires and aspirations and motives of humans are known as human wants
in economics. And the wants that can be satisfied with goods and services of any kind are
economic wants. Like for example food, shelter, clothing, etc are economic human wants. And
those which cannot be bought are non-economic wants like peace, love, affection, etc.
All human wants to have some basic common characteristics. Let us have a look at the similar
nature of human wants.
 Wants are unlimited. A human is never truly satisfied, and so his wants to are
endless. We may temporarily satisfy some of our wants but they always reoccur.
 Different wants have varying degrees of intensity. Some wants are extremely
urgent, some are less intense.
 Human wants tend to be competitive. We have limited means and so we cannot

satisfy all of our wants. So they compete with each other. And the most urgent
want will be satisfied.
 Wants can be complementary as well. To satisfy our want for one good we have
to make arrangements for another. So now we have the want of two goods. For
example to run a car you need petrol.
 The wants of any person will constantly be changing according to the time and
place and situation of the person.
 Over time wants of a person can become his habits or customs.
Classification of Human Wants
We can classify wants into three broad categories in economics. These are Necessaries,
Comforts, and Luxuries. Let us take a look at all three.
1] Necessaries
These are the human wants absolutely essential for living and surviving. Further necessaries
will divide into necessaries for life, for efficiency and finally conventional necessaries. First and
most important wants are obviously necessaries for life. These include food, water, clothing,
shelter, etc.
And then there are necessaries that improve our efficiency and well being like comfortable
housing, nourishing foods, etc. Finally, there are conventional necessaries that arise out of
habits, customs or conventions.
2] Comforts
These are the extra wants of the human after necessaries. They are not as essential or urgent
as necessaries. Comforts are the wants that make the life of the human comfortable and
satisfying. Generally, these include items that save labour on behalf of the human or provide
comfort to him in his life. So items such as fans, furnished houses, special clothing for
occasions, etc fall under this category of human wants.
3] Luxuries
These are goods that give humans pleasure and prestige in society. They are not needed for
existence or comfort but provide happiness and acceptance in the world. These wants may be
called superfluous. And such items tend to be expensive.
Some examples of luxuries are cars, diamond jewelry, expensive designer clothing, ACs. As you
will notice all these items are not essential to our living. They are items of prestige.
What is Consumer Behaviour ?

Consumer Behaviour is a branch which deals with the various stages a consumer goes
through before purchasing products or services for his end use.
Why do you think an individual buys a product ?
 Need
 Social Status
 Gifting Purpose
Why do you think an individual does not buy a product ?
 No requirement
 Income/Budget/Financial constraints
 Taste
When do you think consumers purchase products ?
 Festive season
 Birthday
 Anniversary
 Marriage or other special occasions
There are infact several factors which influence buying decision of a consumer ranging from
psychological, social, economic and so on.
The study of consumer behaviour explains as to:
 Why and why not a consumer buys a product ?

 When a consumer buys a product ?
 How a consumer buys a product ?
During Christmas, the buying tendencies of consumers increase as compared to other

months. In the same way during Valentines week, individuals are often seen purchasing gifts
for their partners. Fluctuations in the financial markets and recession decrease the buying
capacity of individuals.
In a layman’s language consumer behaviour deals with the buying behaviour of individuals.
The main catalyst which triggers the buying decision of an individual is need for a particular
product/service. Consumers purchase products and services as and when need arises.
According to Belch and Belch, whenever need arises; a consumer searches for several
information which would help him in his purchase.
Following are the sources of information:
 Personal Sources
 Commercial Sources
 Public Sources
 Personal Experience
Perception also plays an important role in influencing the buying decision of consumers.
Buying decisions of consumers also depend on the following factors:
 Messages, advertisements, promotional materials, a consumer goes through also

called selective exposure.
 Not all promotional materials and advertisements excite a consumer. A consumer
does not pay attention to everything he sees. He is interested in only what he wants to
see. Such behaviour is called selective attention.
 Consumer interpretation refers to how an individual perceives a particular message.
 A consumer would certainly buy something which appeals him the most. He would
remember the most relevant and meaningful message also called as selective
retention. He would obviously not remember something which has nothing to do with
his need.
3.2 Utility, Cardinal approach, Ordinal approach:
In practice, every individual tries to satisfy his wants with available resources. It is
true that all human wants cannot be satisfied fully at a specific time. Utility analysis explains
a consumer’s behaviour in relation to maximization of satisfaction.
Features of Utility :
Following are the features of utility :
1) Relative concept : Utility is related to time and place. It varies from time to time
and place to place. For example, (i) woollen clothes have a greater utility in the
winter. (ii) sand has greater utility at the construction site than at the sea shore.
2) Subjective concept : It is a psychological concept. Utility differs from person to
person. This is due to differences in taste, preferences, likes, dislikes, nature, habits,
profession etc. For example, stethoscope has utility to a doctor but not to a
layman.
3) Ethically neutral concept : The concept of utility has no ethical consideration. It is a
morally colourless concept. The commodity should satisfy any want of a person
without consideration of what is good or bad, desirable or undesirable. For
example, a knife has utility to cut fruits and vegetables as well as it can be used to
harm someone. Both wants are of different nature but are satisfied by the same
commodity. Thus, utility is ethically neutral.
4) Utility differs from usefulness : Utility is the capacity of a commodity to satisfy
human wants, whereas usefulness indicates value in use of the commodity. For
example, milk has both utility as well as usefulness to a consumer, while liquor has
utility only to an addict, but has no usefulness.
5) Utility differs from pleasure : A commodity may possess utility but it may not give
any pleasure to the consumer. For example, injection for a patient has utility
because it cures the ailment but it hardly gives any enjoyment or pleasure to him.
Utility differs from satisfaction : Utility is a cause of consumption, satisfaction is the end
result of consumption. They are interrelated but still different concepts. For example, a
thirsty person drinks a glass of water since water has the capacity to satisfy thirst. Utility
of water is the cause of consumption and the satisfaction derived is the end result of
consumption.
6) Measurement of utility is hypothetical : Utility is an abstract concept. Cardinal or

numerical measurement of utility is not possible. For example, a thirsty person after
drinking water, may derive higher or lower level of utility. Thus, utility can only be
experienced and found either positive, zero or negative. Negative utility is called
disutility.
7) Utility is multi-purpose : A commodity can satisfy the want of more than one
person, it can also be put to several uses. For example, electricity can be used to
serve many purposes and for many people at some point of time.
8) Utility depends on the intensity of want : Utility depends on the intensity of a want.
More intense the want, greater will be the utility. As and when the urgency of want
declines, utility diminishes. For example, a hungry person finds more utility in
food, than a person who is not hungry.
9) Utility is the basis of demand : A person will demand a commodity only if it gives
utility to him. For example, a sick person has utility in medicines hence, he demands
medicines.
Types of Utility :
Following are some of the different types of utility
1) Form utility : When utility is created due to a change in the shape or structure of an
existing material, it is called form utility. For example, toys made of clay, furniture
from wood
etc.
Fig. 2.1
Place utility : When utility of a commodity increases due to a change in its place, it is
called place utilities. For example, woollen clothes have more utility at cold places
than at warm places. Transport creates place utility.
1) Service utility : Service utility arises when personal services are rendered by various
professionals. For example, services of doctors, teachers, lawyers etc.
1) Knowledge utility : When a consumer acquires knowledge about a particular
product, it is called knowled uitility. For example, utility of a mobile phone or a
computer increases when a person knows about its various functions.
Possession utility : Possession utility arises when the ownership of goods is

transferred from one person to another. For example, transfer of goods from the sellers to
the buyers.
2) Time utility : When the utility of a commodity increases with a change in its time of
utilization, it is called time utility. For example, a student has more utility for text
books during examinations than in the vacations. Time utility is also observed when
goods are stored and used at the time of scarcity. For example, Blood bank.
Try this :
Following are the various types of utility and their respective examples. Arrange the information
in the form of pairs:
Types of utility : Time utility, possession utility, service utility and place utility.
Examples : 1) A dentist giving dental treatment to a patient.
2) A mountaineer using oxygen cylinder at a high altitude.

3) A farmer selling rice stored in the warehouse at the end of the season.
4) A retail trader purchasing 100 chairs from the wholesale trader.
Concepts of Utility :
Following are the two main concepts of utility :
1) Total Utility (TU) : Total utility refers to the aggregate of utility derived by the
consumer from all units of a commodity consumed. It is an aggregate of utilities
from all successive units of a commodity consumed.
2) Marginal Utility (MU) : Marginal utility refers to the additional utility derived
by a consumer from an additional unit of a commodity consumed. In other
words, it is the addition made by the last unit of a commodity consumed.
Fig. 2.6 B Fig. 2.6 C Fig. 2.6 D
You should know :
Formulaeexplainingtherelationship between
total utility and marginal utility : TU =  MU
or
TU = MU1 + MU2 + MU3+ MUn
MUn = TUn – TU(n–1)
Where TU = Total Utility MU =
Marginal Utility
MU1, MU2, MU3 = Marginal Utility of
each unit.
MU = Marginal Utility of nth unit.

n
TU = Total Utility at nth level.

n
TU(n–1) = Total Utility at previous level.
Relationship between Total Utility and Marginal Utility :

Marginal utility derived from various units of a commodity and its total utility are
interrelated. This can be easily followed from the hypothetical example given in the table
2.1
Table 2.1 Utility Schedule
Units of Total Marginal

x utility utility
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 28 –2
Table 2.1 explains the relationship between total utility and marginal utility.
On the basis of Table 2.1 Total utility and Marginal Utility curves (TU and MU) can be
derived with the following diagram.
Total and Marginal utility
Units of Commodity x
LAW OF DIMINISHING MARGINAL UTILITY:
The law of diminishing marginal utility is one of the most important laws
in economics. It states that as the quantity consumed of a commodity
continues to increase, the utility obtained from each successive unit goes
on diminishing, assuming that the consumption of all other commodities
remains the same. To put simply, when an individual continues to consume
more and more units of a commodity
per unit of time, the utility that he/she obtains from each successive unit
continues to diminish. For example, the utility derived from the first glass
of water is high, but with successive glasses of water, the utility would
keep diminishing. The law of diminishing marginal utility is applicable to
all kinds of goods such as consumer goods, durable goods, and non-
durable goods. Let us understand the law of diminishing marginal utility
with the help of an example.
An individual consumes only one commodity X and its utility is mea-
sured quantitatively. The total utility and marginal utility schedules are as
shown in Table 4.1:
TABLE 4.1: NUMBER OF UNITS OF COMMODITY

X CONSUMED PER UNIT OF TIME
Units of Total Utility Marginal Utility
Commodity X (TUx) (MUx)
1 30 30
2 50 30
3 60 20
4 65 10
5 60 5
6 45 -5
Table 4.1 shows that as the number of units of commodity X consumed per unit of time
increases, TUx increases but at a diminishing rate while marginal utility MUx decreases
consistently. The rate of increase in TUx as a result of increase in the number of
units consumed has been de- picted through the MUx curve in the graph shown in
Figure 4.2:
3.3 Consumer’s equilibrium using Indifference curve analysis and Consumer surplus,
3.4 Application of Indifference curve analyses Market,
3.5 Production – Short-run and long-run Production Function
3.6 Returns to scale – economies Vs diseconomies of scale,
3.7 ISO-Quants & ISO-Cost line,
3.8 Analysis of cost – Short-run and long-run cost function
3.9 Relation between Production and cost function,
3.10 Break Even Analysis – Meaning, Assumptions, Determination of BEA, Limitations,
Uses of BEA in Managerial decisions (with simple Problems).
70
M
60
50
40 TUx
30
20
10
0
1 2 3 4 5 6 7
–10
Quantity MUx
In Figure 4.2, the downward sloping MUx curve shows that the marginal utility of a
commodity consistently decreases as its consumption increases. When the
consumption reaches to 4 units of commodity X, TUx reaches its maximum level
(the point of saturation) marked as M. Beyond the point of saturation, MUx be-
comes negative and TUx begins to decline consistently. The downward slope of
MUx explains the law of diminishing marginal utility. Therefore, according to the
law of diminishing marginal utility, the utility gained from a unit of a commodity is
dependent on the consumer’s desire for the commodity. When an individual
continues to consume additional units of a commodity, the satisfaction that he/she
derives from the consumption keeps decreasing. This is because his/ her need gets
satisfied in the process of consumption. Therefore, the utility derived from
successive units of the commodity decreases.
The law of diminishing marginal utility is based on certain assumptions, which are
as follows:
 Rationality: The law of marginal utility assumes that a consumer is a rational being
who aims at maximising his/her utility at the given income level and the market price.
 Measurement of utility: The utility of a commodity can be measured using
quantifiable standards like a cup of tea, a bag of sugar, a pair of socks, etc.
 Constant marginal utility of money: The marginal utility of consumer’s income is
constant.
 Homogeneity of commodity: The successive units of a commodity consumed are
homogenous or identical in shape, size, colour, taste, quality, etc.
 Continuity: The consumption of successive units of a commodity should be
continuous without intervals.
 Ceteris paribus: Factors, such as the income, tastes and preferences of consumers;
price of related goods; etc. remain unchanged.
However, the law of diminishing marginal utility does not hold true in some cases
called exceptions to the law of diminishing marginal util ity. For example, in cases,
such as individuals accumulating wealth, pursuing hobbies (such as collection of
stamps, coins, or antiques, songs, rare paintings, etc.), the marginal utility may
increase initially rather than decrease. Therefore, they violate the law of
diminishing marginal utility. However, eventually the marginal utility may slowly
begin to decrease.
The measurement of utility has always been a controversial issue. Different

economists have given different viewpoints on the measurement of utility. Neo-
classical economists have given cardinal utility concept to measure the utility
derived from a good. On the other hand, modern economists have given the concept
of ordinal utility for measuring utility. Let us discuss these two concepts in detail in
the next sections.
NOTE
Cardinal numbers are 1, 2, 3, 4, 5, and so on. On the other hand, ordinal numbers are used for
ranking like 1st, 2nd, 3rd, 4th, and so on.
CARDINAL UTILITY APPROACH - NEO CLASSICAL APPROACH:

The cardinal utility theory or approach was proposed by classical economists,
Gossen (Germany), William Stanley Jevons (England), Leon Walras (France), and Karl
Menger (Austria). Later on a neo-classical economist, Alfred Marshall brought
about significant refinement in the cardinal utility theory. Therefore, cardinal utility
theory is also known as neo-classical utility theory.
Neo-classical economists believed that utility is cardinal or quantitative like other

mathematical variables, such as height, weight, velocity, air pressure, and
temperature. They developed a unit of measuring utility called utils. For example,
according to the cardinal utility concept, an individual gains 20 utils from a pizza and
10 utils from coffee. In the measurement of utility, neo-classicists assumed that one
util equals one unit of money and the utility of money remains constant. The
assumptions of the cardinal utility approach are as follows:
 Utility is measurable: The basic assumption of the cardinal utility approach is that
utilities of commodities can be quantified. Ac- cording to Marshall, money is used to
measure the utilities of commodities. This implies that the amount of money that a
customer is willing to pay for a particular commodity is a measure of its utility.
 Marginal utility of money is constant: The cardinal utility approach assumes that
money must measure the same amount of utility under all circumstances. To put
simply, the utility derived from each unit of money remains constant.
 Utilities are additive: As per this assumption, the utility derived from various
commodities consumed by an individual can be added together to derive the total
utility. Suppose an individual consumes X1, X2, X3,….Xn units of commodity X
and derives U1, U2, U3,….Un utils respectively, the total utility that the individual
derives from n units of the commodity can be expressed as follows:
Un = U1(X1) + U2(X2) + … + Un (Xn)
 Diminishing marginal utility: The marginal utility of a commodity diminishes as an

individual consumes successive units of a commodity. This can be expressed as
follows:
MUx = f (Qx)
Where MUx is the marginal utility of commodity X, f is a function, and Qx is the
quantity of the commodity consumed.
 Rationality: Consumers are rational beings and aim to maximise their utility at the
given income level and market price.
According to the cardinal utility approach, a consumer reaches his/ her equilibrium
when the last unit of his/her money spent on each unit of the commodity yield the
same utility. Therefore, the consumer would spend his/her money income on
commodity X so long as:
MUx > Px (MUm)
Where Px is the price of the commodity, MU x is the marginal utility of the

commodity and MUm is the marginal utility of money.
A utility maximising consumer reaches the equilibrium when:

MUx = Px (MUm) or = 1
This equilibrium condition derives the consumer demand curve for commodity X,
which is shown in Figure 4.3:
E
Px Px(MUm)
N
MUx
O CQx
Quantity
The line parallel to the X-axis, Px (MUm) depicts the constant utility of money
weighed by the price of commodity X. MU x curve represents the diminishing
marginal utility of commodity X. Both the lines intersect at point E, which means
the consumer reaches equilibrium at point E. The effects of consumer equilibrium
on the consumer demand are discussed later in the chapter.
ORDINAL UTILITY APPROACH – INDIFFERENCE CURVE ANALYSIS:

In the 1930s, two English economists, John Hicks and R.J. Allen ar- gued that the
theory of consumer behaviour should be developed on the basis of ordinal utility.
According to the ordinal theory, utility is a psychological phenomenon like
happiness, satisfaction, etc. It is high- ly subjective in nature and varies across
individuals. Therefore, it cannot be measured in quantifiable terms.
As per the ordinal utility approach, utility can be measured in relative terms such as
less than and greater than. The approach advocates that consumer behaviour can
be explained in terms of preferences or rankings. For example, a consumer may
prefer ice-cream over soft drink. In such a case, ice-cream would have 1 st rank,
while 2nd rank would be given to soft drink.
Therefore, as per the ordinal utility approach, a consumer identifies several pairs of
two commodities which would provide him/her the same level of satisfaction. Among
these pairs, he/she may prefer one commodity over the other based on how he/she
ranks them in order of utility. This implies that utility can be ranked qualitatively and not
quantitatively. To better understand the ordinal utility approach, there are certain con-
cepts that need to be discussed. Figure 4.4 shows these concepts:
Assumptions of Ordinal Utility Meaning of Indifference Curve
Marginal Rate of Substitution Properties of Indifference Curve

Criticism of Indifference Curve
4.6.1 ASSUMPTIONS OF ORDINAL UTILITY
The ordinal utility approach is based on certain assumptions, which are as follows:
 Rationality: Consumers are rational beings and aim to maximise their utility at the
given income level and market price of commodities that they consume.
Ordinal utility: Utility cannot be measured in quantitative terms but in qualitative
terms. This is because a consumer expresses his/ her preference for a commodity out
of a collection of similar goods.
 Transitivity and uniformity of choice: It is assumed that a consumer’s choice is
always transitive. This implies that if a consumer prefers A to B and B to C, the
consumer would prefer A to C as well. On the other hand, if the consumer considers
A=B and B=C, he must consider A=C. On the other hand, uniformity of choice implies
that if a consumer prefers A to B at one time period, he/ she does not prefer B to A
in another time period or even does not consider A and B as equal.
 Non-satiety: The theory also assumes that a consumer is never oversupplied with
commodities. This means that a consumer does not reach a state of saturation in case
of any commodity. Thus, a consumer tends to prefer larger quantities of a
commodity over smaller.
 Diminishing marginal rate of substitution: The marginal rate of substitution refers to
the rate at which a consumer is willing to substitute one good (X) for another good
(Y) in order to maintain the level of satisfaction. The marginal rate of substitution is
represented as dY/dX. According to the ordinal utility approach, the marginal rate
of substitution goes on decreasing when a consumer continues to substitute X for Y.
The marginal rate of substitution has been discussed in the later sections of the
chapter.
4.6.2 MEANING OF INDIFFERENCE CURVE
An indifference curve can be defined as the locus of points each representing a
different combination of two substitutes, which yield the same level of utility to a
consumer. Therefore, the consumer is indifferent to any combination of two
commodities if he/she has to make a choice between them. This is because an
individual consumes a variety of goods over time and realises that one good can be
substituted with another without compromising on the satisfaction level. When
these combinations are plotted on the graph, the resulting curve is called
indifference curve. This curve is also called the iso-utility curve or equal utility curve.
Let us learn the indifference curve through a schedule. Assume that a consumer
consumes two commodities X and Y and makes five combinations for the two
commodities a, b, c, d, and e, which is shown in Table 4.2:
TABLE 4.2: INDIFFERENCE SCHEDULE F
OR SUBSTITUTES X AND Y
Combinatio Units of Units of Total
n Commodity Commodity Utility
Y X
a 25 3 U
b 15 5 U
c 8 9 U
d 4 17 U
2 30 U
e
When the indifference schedule for X and Y is plotted on a graph, a curve is

obtained, which is shown in Figure 4.5:
30 IC
25 a
20
15 b
10
8 c
6
5
d
4
e
Commodity X
On the indifference curve (IC), there can be several other points in

between the points a, b, c, d, and e, which would yield the same level of
satisfaction to the consumer. Therefore, the consumer remains
indifferent towards any combinations of two substitutes yielding the
same level of satisfaction.
When more than one indifference curve is plotted on the same graph, the
family of curves is called an indifference map.
4.6.1 MARGINAL RATE OF SUBSTITUTION
Marginal rate of substitution (MRS) refers to the rate at which one commodity can
be substituted for another commodity maintaining the same level of satisfaction. The
MRS for two substitute goods X and Y:
may be defined as the quantity of commodity X required to replace one nit of

commodity Y (or quantity of commodity Y required to replace one unit of X) such that
the utility derived from either combinations remains the same. This implies that the
utility of X (or Y) is equal to the utility of additional units of Y (or X) added to a
combination. MRS of X and Y is denoted as ΔY/ ΔX as it continues to diminish as the
consumer continues to substitute X for Y or vice versa. According to the ordinal utility
approach, MRSy, x (or MRSx, y) decreases which means that the quantity of a
commodity an individual is willing to give up for an additional unit of the other commodity
continues to decrease with each substitution. MRSy,x derived from different combinations
of commodities X and Y are given in Table 4.3:
TABLE 4.3: DIMINISHING MRS BETWEEN X AND Y

Indifferenc Combina- Change Change MRSy,
e points tions Y+X in Y in X
x (ΔY/
(ΔY) (ΔX)
ΔX)
a 25 + 3 - - -
b 15 + 5 -10 2 -
5.00
c 8+9 -7 4 -
1.75
d 4 + 17 -4 8 -
0.50
e 2 + 30 -2 13 -
0.15
As the consumer moves from combination a to b on IC, he/she sacrifices 10 units
of commodity Y and gets 2 units of commodity X. There- fore,
MRSy, x = –5
Similarly when the consumer moves from combination b to c, he/she sacrifices 7

units of Y and gets 4 units of X. Therefore,
MRSy, x = –1.75
This shows that as the consumer moves down the IC from point a to b to c, MRS
diminishes from -5 to -1.75.
4.6.3 PROPERTIES OF INDIFFERENCE CURVE
The indifference curve (IC) has certain definite properties or characteristics, which
are as follows:
 ICs are negatively sloped: The indifference curves are sloped downwards to the
right. The reason for the negative slope is that as a consumer increases the
consumption of commodity X, he/ she sacrifices some units of commodity Y in
order to maintain the same level of satisfaction.
 Higher IC represents higher satisfaction level: A higher IC lying above and to the
right of another IC implies a higher level of satisfaction and vice versa. In simple
words, the combination of commodities on the higher IC is preferred by a
consumer to the combination that lies on a lower IC.
 ICs are convex to the origin: ICs are curved inwards; thus they are convex to the
origin. This implies that as the consumer continues to substitute commodity X for
commodity Y, MRS of X for Y diminishes along the IC.
 ICs do not intersect: This can be explained by considering a hypothetical situation
where two indifference curves intersect. The point of intersection would then imply
that a combination of commodities on the higher curve would offer the same level
of satisfaction as that on the lower indifference curve, which violates the basic
assumption of ICs.
 CRITICISM OF INDIFFERENCE CURVE
Although the concept of IC is vital to explain the ordinal approach, it is criticised on

various grounds. The main points of criticism against IC are given in Figure 4.6:
1. Ignorance towards market behaviour
2. Two commodities model
3. Ignorance towards demonstration effect
4. Indifference towards risks and uncertainties
5. Unrealistic assumptions
Figure 4.6: Points of Criticism against Indifference Curve
Let us discuss these points of criticism in detail:

 Ignorance towards market behaviour: IC analysis considers only two commodities in
the market. However, the market is full of a large number of commodities. Thus, it
does not consider market behaviour in the analysis of consumer behaviour. For
example, a change in the price of other commodities in the market may affect the
purchase of the commodities being considered.
 Two commodities model: IC analysis is based on the combinations of two
commodities. Considering more than two commodities in IC analysis makes the
calculations more complex. This may further make it difficult to predict consumer
behaviour.
 Ignorance towards demonstration effect: James Stemble Duesen- berry (July 18,
1918- October 5, 2009), an American economist, proposed the concept of demonstration
effect. The demonstration effect states that an individual’s consumption pattern is affected
by the level of consumption of other individuals. This is ignored by IC analysis limiting its use
to understand consumer behaviour.
 Indifference towards risks and uncertainties: Risks and uncertainties in the
market and individual’s life are inevitable. John Von Neumann and Oskar Morgenstern,
authors of The Theory of Games and Economic Behaviour point out that IC analysis has no
ability to analyse consumer behaviour in the midst of several risks and uncertainties that
prevail in the market and real life.
 Unrealistic assumptions: IC is based on an assumption that a consumer is fully
aware of his/her preference for various commodities. However, this is an unrealistic
assumption as humans have their limitations. A human brain cannot take quick decisions by
analysing different combinations of several commodities available in the market.
3.3 Consumer’s equilibrium using Indifference curve analysis and Consumer surplus:
CONSUMER EQUILIBRIUM EFFECTS:

Now that you have studied about the indifference curve and budget line, let us
analyse consumer equilibrium further. A consumer reaches a state of equilibrium when
he/she attains maximum total utility at the given income level and market price of
commodities. The ordinal utility approach (which follows the two-commodity model
explanation) provides two conditions with respect to consumer equilibrium:
 First order condition
 Second order condition
The first order condition for consumer equilibrium in ordinal utility is the same as that
specified through cardinal utility. Therefore,
MUx Px

MUy Py
As MUx/MUy = MRSx,y, the first order condition in ordinal utility is given as follows:
MUx Px
MRS x, y  
MUy Py
The second order condition states that the first order condition must be satisfied at
the highest IC as shown in Figure 4.10:
In Figure 4.10, IC1, IC2, and IC3 represent the hypothetical indifference map of a
consumer. AB is the budget line that intersects IC 2 at point E. This implies that the
slope of IC2 and AB are equal. This sat- isfies both the first order condition and the
second order condition. In Figure 4.10, between any two points on an indifference
curve, IC1:
P M E
QY
IC 3
IC2
K IC1
O QXB
Quantity of X
Y. MUy  X. MUx
Therefore, the slope of the curve would be:

Y MUx
  MRSy, x
X MUy
The slope of budget line is given as:
OA Px

OB Py
At point E where MRSy, x  Px / Py

Therefore, the consumer is at equilibrium at point E. As the IC2 curve is tangent to
the budget line AB, IC2 is the highest indifference curve that a consumer can attain
at the given income level and market price of commodities. At point E, the
consumer consumes quantities OQx of X and OQy of Y to yield maximum
satisfaction. In Figure 4.10, when the consumer is at point J and moves to point
M, there is no difference in the satisfaction level at both points that lie on the
same curve IC1. However, as point E is the point of equilibrium, a consumer would
tend to reach point E from J or M. The other point to note here is that the
indifference curve IC3 is impossible to reach for the consumer due to budgetary
constraints. His/her income does not permit the consumer to purchase any
combination of commodities X and Y on indifference curve IC3.
The above explanation of the consumer equilibrium is based on an assumption that

the income of the consumer and the market price of commodities remain
unchanged. However, this is not always the case as both income and market price
may vary at different time periods. The change in these variables results in an
upward or downward shift in the consumer’s budget line. The effects of these
changes are shown in Figure 4.11:
Income Effect on Consumer’s Equilibrium
Substitution Effect on Consumer’s Equilibrium
Price Effect on Consumer’s Equilibrium
Figure 4.11 Effects on Consumer Equilibrium
4.8.1 INCOME EFFECT ON CONSUMER EQUILIBRIUM
Income effect on consumer’s equilibrium can be defined as the effect caused by

changes in consumer’s income on his/her purchases while the prices of
commodities remain unchanged. Figure 4.12 illustrates the effect of change in the
consumer’s income on his/her equilibrium:
M2
ICC
M1
Quantity of Y
M
E2
E1
E
IC3
IC2
IC1
N N1 N2
Quantity of X
Figure 4.12: Effect of Change in Income on Consumer’s Equilibrium
Point E is the original point of consumer’s equilibrium. At point E, the indifference

curve IC1 is tangent to the budget line MN. In case the consumer’s income
increases, the budget line would shift from MN to M1N1 and then to M2N2. As a
result, the point of equilibrium shifts from E to E1 and then to E2. The ICC line on the
graph represents the Income Consumption Curve. The ICC can be obtained by
joining all the points of consumer’s equilibrium E, E1 and E2.
4.8.1 SUBSTITUTION EFFECT ON CONSUMER EQUILIBRIUM
Suppose a consumer’s money income is ` 15000. He/she needs to purchase two
commodities X and Y. Assume that the price of commodity Y increases and the price
of commodity X decreases. In such a case, the consumer would tend to purchase
more units of commodity X and fewer units of commodity Y, which implies that the
consumer substitutes commodity X for Y. This is known as the substitution effect. The
substitution effect occurs because of the following:
The relative prices of commodities change. In such a case, one commodity
becomes more affordable than the other.
The income of the consumer remains unchanged. In this case, the consumer needs
to substitute commodities in order to satisfy his/her needs.
Let us understand this with the help of Figure 4.13:
N Q
B1
Q1
N1
IC
O M M1
Quantity of X
Line AB represents the original budget line. Q is the original point of consumer’s
equilibrium, where AB is tangent to IC. At Q, the consumer purchases OM quantity of
commodity X and ON quantity of commodity
Y. If the price of commodity Y increases and the price of commodity X decreases,
the new budget line would shift to B 1A1. This new budget line is tangent to IC at Q1.
Therefore, the new equilibrium position of the consumer changes to Q1 from Q
when the price of a commodity changes. At Q1, the consumer cuts down the units
of commodity Y from ON to ON1 and purchases more units of X, OM to OM 1.
However, the indifference curve remains the same. This movement along the indif-
ference curve from Q to Q1 is known as the substitution effect.
4.8.2 PRICE EFFECT ON CONSUMER EQUILIBRIUM
As discussed in the substitution effect, the prices of both the commodities change
(Py increases and Px decreases). However, while considering the effect of price on
consumer equilibrium, the price of only one commodity changes. Therefore, the
price effect is the change in the price of any one of the commodities due to which
the quantity of commodities or services purchased changes. Assume that the
consumer purchases two commodities, X and Y. The price of commodity X
decreases while the price of commodity Y and consumer’s money income remain
constant. Let us understand this with the help of Figure 4.14:
PCC
Quantity of Y
C4
C2 C3
C1
O X1 X2 B X13 X4B 2 B3 B4
Quantity of X
Figure 4.14: Effect of Price on Consumer’s Equilibrium

In Figure 4.14, the drop in the price of commodity X is denoted by the
corresponding shifts of budget line from AB 1 to AB2, AB2 to AB3 and AB3 to AB4.
C1, C2, C3, and C4 represent a shift in consumer’s equilibrium. As the price of
commodity X decreases, the consumer’s real income increases. As a result, the
consumer is able to purchase more units of both commodities X and Y. The curve
PCC represents the Price Consumption Curve, which can be obtained by joining all
equilibrium points C1, C2, C3, and C4.
3.4 Application of Indifference curve analysis:

Indifference Curve Analysis

Definition and Explanation:

The indifference curve indicates the various combinations of two goods which yield equal
satisfaction to the consumer. By definition:
"An indifference curve shows all the various combinations of two goods that give an equal
amount of satisfaction to a consumer".
The indifference curve analysis approach was first introduced by Slustsky, a Russian
Economist in 1915. Later it was developed by J.R. Hicks and R.G.D. Allen in the year
1928.These economist are the of view that it is wrong to base the theory of consumption on
two assumptions:
(i) That there is only one commodity which a person will buy at one time.
(ii) The utility can be measured.
Their point of view is that utility is purely subjective and is immeasurable. Moreover an
individual is interested in a combination of related goods and in the purchase of one
commodity at one time. So they base the theory of consumption on the scale of preference
and the ordinal ranks or orders his preferences.
Example:

For example, a person has a limited amount of income which he wishes to spend on two
commodities, rice and wheat. Let us suppose that the following commodities are equally
valued by him:

Various Combinations:

a) 16 Kilograms of Rice Plus 2 Kilograms of Wheat
b) 12 Kilograms of Rice Plus 5 Kilograms of Wheat
c) 11 Kilograms of Rice Plus 7 Kilograms of Wheat
d) 10 Kilograms of Rice Plus 10 Kilograms of Wheat
e) 9 Kilograms of Rice Plus 15 Kilograms of Wheat
It is matter of indifference for the consumer as to which combination he buys. He may buy
16 kilograms of rice and 2 kilograms of wheat or 9 kilograms of rice and 15 kilograms of
wheat. All these combinations are equally preferred by him.
An indifference curve thus is composed of a set of consumption alternatives each of which
yields the same total amount of satisfaction. These combinations can also be shown by an
indifference curve.
An Indifference Schedule:
An indifference curve is drawn on the basis of indifference schedule. An indifference
schedule can be defined as an imaginary schedule of various combinations of two goods
that will equally satisfy the consumer.
An indifference schedule is a list of different combinations of two goods which will give
equal level of satisfaction to the consumer.
Combination Rice Wheat
a 16 2
b 12 5
c 11 7
d 10 10
E 9 15
Figure/Diagram of Indifference Curve:

The consumer’s preferences can be shown in a diagram with an indifference curve. The
indifference showing nothing about the absolute amounts of satisfaction obtained. It merely
indicates a set of consumption bundles that the consumer views as being equally
satisfactory.

In fig. 3.1 we measure the quantity of wheat along X-axis (in kilograms) and along Y-axis, the
quantity of rice (in kilograms). IC is an indifference curve.It is shown in the diagram that a
consumer may buy 12 kilograms of rice and 5 kilograms of wheat or 9 kilograms of rice and
15 kilogram of wheat. Both these combinations are equally preferred by him and he is
indifferent to these two combinations. When the scale of preference of the consumer is
graphed, by joining the points a, b, c, d, e, we obtain an Indifference Curve IC. Every point on
indifference curve represents a different combination of the two goods and the consumer is
indifferent between any two points on the indifference curve. All the combinations are
equally desirable to the consumer. The consumer is indifferent as to which combination he
receives. The Indifference Curve IC thus is a locus of different combinations of two goods
which yield the same level of satisfaction.
An Indifference Map:

A graph showing a whole set of indifference curves is called an indifference map. An
indifference map, in other words, is comprised of a set of indifference curves. Each
successive curve further from the original curve indicates a higher level of total satisfaction.

In the fig. 3.2 three indifference curves IC 1, IC2 and IC3 have been shown. The various
combinations of goods of wheat and rice lying on IC 1 yield the same level of satisfaction to
the consumer. The combinations of goods lying on higher indifference curve IC 2 contain
more both the goods wheat and rice. The indifference curve IC 2 gives more satisfaction to
the consumer than IC1. Similarly, the set of combinations of two goods on IC 3 yields still
higher satisfaction to the consumer than IC 2. In short, the further away a particular curve is
from the origin, the higher level of satisfaction it represents.
It may here be noted that while an indifference curve shows all those combinations of
wheat and rice which provide equal satisfaction to the consumer but it does not indicate
exactly how much satisfaction is derived by the consumer from these combinations. It is
because of the fact that the concept of ordinal utility does not involve the qualitative
measurement of utility.
Assumptions:

The ordinal utility theory or the indifference curve analysis is based on following
assumptions:

(i) Rational behavior of the consumer: It is assumed that individuals are rational in making
decisions from their expenditures on consumer goods.

(ii) Utility is ordinal: Utility cannot be measured cardinally. It can be, however, expressed
ordinally. In other words, the consumer can rank the basket of goods according to the
satisfaction or utility of each basket.

(iii) Diminishing marginal rate of substitution: In the indifference curve analysis, the
principle of diminishing marginal rate of substitution is assumed.

(iv) Consistency in choice: The consumer, it is assumed, is consistent in his behavior during
a period of time. For insistence, if the consumer prefers combinations of A of good to the
combinations B of goods, he then remains consistent in his choice. His preference, during
another period of time does not change. Symbolically, it can be expressed as:

If A > B, then B > A

(v) Consumer’s preference not self contradictory: The consumer’s preferences are not self
contradictory. It means that if combinations A is preferred over combination B is preferred
over C, then combination A is preferred over combination A is preferred over C. Symbolically
it can be expressed:

If A > B and B > C, then A > C

(vi)Goods consumed are substitutable: The goods consumed by the consumer are
substitutable. The utility can be maintained at the same level by consuming more of some
goods and less of the other. There are many combinations of the two commodities which
are equally preferred by a consumer and he is indifferent as to which of the two he receives.
Properties/Characteristics of Indifference Curve:

Definition, Explanation and Diagram:

An indifference curve shows combination of goods between which a person is indifferent.
The main attributes or properties or characteristics of indifference curves are as follows:

(1) Indifference Curves are Negatively Sloped:

The indifference curves must slope down from left to right. This means that an indifference
curve is negatively sloped. It slopes downward because as the consumer increases the
consumption of X commodity, he has to give up certain units of Y commodity in order to
maintain the same level of satisfaction.

In fig. 3.4 the two combinations of commodity cooking oil and commodity wheat is shown
by the points a and b on the same indifference curve. The consumer is indifferent towards
points a and b as they represent equal level of satisfaction.

At point (a) on the indifference curve, the consumer is satisfied with OE units of ghee and
OD units of wheat. He is equally satisfied with OF units of ghee and OK units of wheat shown
by point b on the indifference curve. It is only on the negatively sloped curve that different
points representing different combinations of goods X and Y give the same level of
satisfaction to make the consumer indifferent.

(2) Higher Indifference Curve Represents Higher Level:

A higher indifference curve that lies above and to the right of another indifference curve
represents a higher level of satisfaction and combination on a lower indifference curve
yields a lower satisfaction.

In other words, we can say that the combination of goods which lies on a higher indifference
curve will be preferred by a consumer to the combination which lies on a lower indifference
curve.

In this diagram (3.5) there are three indifference curves, IC 1, IC2 and IC3 which represents
different levels of satisfaction. The indifference curve IC 3 shows greater amount of
satisfaction and it contains more of both goods than IC2 and IC1 (IC3 > IC2 > IC1).

(3) Indifference Curve are Convex to the Origin:

This is an important property of indifference curves. They are convex to the origin (bowed
inward). This is equivalent to saying that as the consumer substitutes commodity X for
commodity Y, the marginal rate of substitution diminishes of X for Y along an indifference
curve.

In this figure (3.6) as the consumer moves from A to B to C to D, the willingness to substitute
good X for good Y diminishes. This means that as the amount of good X is increased by equal
amounts, that of good Y diminishes by smaller amounts. The marginal rate of substitution of
X for Y is the quantity of Y good that the consumer is willing to give up to gain a marginal
unit of good X. The slope of IC is negative. It is convex to the origin.
(4) Indifference Curve Cannot Intersect Each Other:

Given the definition of indifference curve and the assumptions behind it, the indifference
curves cannot intersect each other. It is because at the point of tangency, the higher curve
will give as much as of the two commodities as is given by the lower indifference curve. This
is absurd and impossible.

In fig 3.7, two indifference curves are showing cutting each other at point B. The
combinations represented by points B and F given equal satisfaction to the consumer
because both lie on the same indifference curve IC 2. Similarly the combinations shows by
points B and E on indifference curve IC1 give equal satisfaction top the consumer.
If combination F is equal to combination B in terms of satisfaction and combination E
is equal to combination B in satisfaction. It follows that the combination F will be equivalent
to E in terms of satisfaction. This conclusion looks quite funny because combination F on IC 2
contains more of good Y (wheat) than combination which gives more satisfaction to the
consumer. We, therefore, conclude that indifference curves cannot cut each other.
(5) Indifference Curves do not Touch the Horizontal or Vertical Axis:

One of the basic assumptions of indifference curves is that the consumer purchases
combinations of different commodities. He is not supposed to purchase only one
commodity. In that case indifference curve will touch one axis. This violates the basic
assumption of indifference curves.

In fig. 3.8, it is shown that the in difference IC touches Y axis at point C and X axis at point E.
At point C, the consumer purchase only OC commodity of rice and no commodity of wheat,
similarly at point E, he buys OE quantity of wheat and no amount of rice. Such indifference
curves are against our basic assumption. Our basic assumption is that the consumer buys
two goods in combination.
3.5 Market Production – Short-run and long-run Production Function
Meaning of Production
In economics, production theory explains the principles in which the business has to take
decisions on how much of each commodity it sells and how much it produces and also how
much of raw material ie.,fixed capital and labor it employs and how much it will use. It
defines the relationships between the prices of the commodities and productive factors on
one hand and the quantities of these commodities and productive factors that are produced
on the other hand.
Production refers to the creation of value .
Concept
Production is a process of combining various inputs to produce an output for consumption.
It is the act of creating output in the form of a commodity or a service which contributes to
the utility of individuals. In other words, it is a process in which the inputs are converted
into outputs.
Production Analysis
Production analysis basically is concerned with the analysis in which the resources such as
land, labor, and capital are employed to produce a firm’s final product. To produce these
goods the basic inputs are classified into two divisions −
Variable Inputs
Inputs those change or are variable in the short run or long run are variable inputs.
Fixed Inputs
Inputs that remain constant in the short term are fixed inputs.
3.1.1 Definitions:
“The production function is a technical or engineering relation between input and output.
As long as the natural laws of technology remain unchanged, the production function
remains unchanged.” Prof. L.R. Klein
“Production function is the relationship between inputs of productive services per unit of
time and outputs of product per unit of time.” Prof. George J. Stigler
“The relationship between inputs and outputs is summarized in what is called the
production function. This is a technological relation showing for a given state of
technological knowledge how much can be produced with given amounts of inputs.” Prof.
Richard J. Lipsey
Thus, from the above definitions, we can conclude that production function shows for a
given state of technological knowledge, the relation between physical quantities of inputs
and outputs achieved per period of time.
3.2) PRODUCTION FUNCTION
The production function shows a technical or engineering relationship between the physical
inputs and physical outputs of a firm, for a given state of technology. A production function
has the following attributes:
1. It indicates the functional relationship between physical inputs and physical outputs of
the firm, i.e. X=f (L,K)
2. The production function is always in relation to a period of time. This is because a firm
can increase output either by employing some additional factors of production or increasing
all the factors of production depending whether its short run or long run.
3. The production function shows either the maximum output that can be produced from a
given set of inputs or the minimum quantity of inputs required to produce a given level of
output.
4. The production function includes all the technically efficient methods of production as it
is a purely technical relationship.
5. Output in production function is the result of joint use of factors of production. Thus, the
productivity of a factor is always measured in the context of this factor being employed in
combination with other factors.
3.2.1 Types of production function

Leontief Production Function
1. It implies that a fixed proportion in which factor inputs are to be used
X = Minimum (K/a, L/b)
Empirical Production Function:-
1. Linear Production Function
Q = a + bL
2. Quadratic Production Function
Q = a + bL - cL2
3. Cubic Production Function
Q = a + bL - cL2 – dL3 4.
4. Power Production Function
Q = a + aLb
There are three types of production function:

1) Fixed proportion and variable proportion production function
Fixed Proportion Production Function
Definition: The Fixed Proportion Production Function, also known as a Leontief
Production Function implies that fixed factors of production such as land, labor, raw
materials are used to produce a fixed quantity of an output and these production factors
cannot be substituted for the other factors.
In other words, fixed quantity of inputs is used to produce the fixed quantity of output.
All the factors of production are fixed and cannot be substituted for one another.
Suppose there are 50 workers required to produce 500 units of a product, then the
technical Coefficient of production will be 1/10. In the case of a fixed proportion
production function, this one tenth of labor must be employed for the production of
fixed output and no other factors of production can be substituted in place of labor.
The concept of fixed proportion production function can be further understood with the
help of a figure as shown below:
In the given figure, OR shows the fixed labor-capital ratio, if a firm wants to produce 100
units of a product, then 2 units of capital and 3 units of labor must be employed to attain
this output.
Similarly, for the production of 300 and 500 units of a product, 5 units of capital and 6
units of labor and 7 units of capital and 9 units of labor must be employed respectively.
It may be noticed that along the isoquant curve the marginal product of a factor is zero,
lets say, for the production of 300 units of a product, the capital is fixed (say 5 units),
then any additional units of a labor won’t make any difference in the total production,
hence, the marginal product of labor is zero.
Variable Proportion Production Function
Definition: The Variable Proportion Production Function implies that the ratio in which
the factors of production such as labor and capital are used is not fixed, and it is variable.
Also, the different combinations of factors can be used to produce the given quantity,
thus, one factor can be substituted for the other.
In the case of variable proportion production function, the technical Coefficient of

production is variable, i.e. the required 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 other factor/ factors in its place.
Suppose 40 workers are required to produce 200 units of a product, then technical
Coefficient of production will be 1/5. In the case of a variable proportion production
function, one fifth of labor is not necessarily to be employed, but however, the different
combinations of factors of production can be used to produce a given level of output.
Thus, the labor can be substituted for any other factors.
The concept of variable proportion production function can be further understood from
an isoquant curve, as shown in the figure below:
In the figure, the isoquant curves show that the different combinations of factors of
technical substitution can be employed to get the required amount of output. Thus, for
the production of a given level of product, the input factors can be substituted for the
other.
2) Short period and long period production function
The Short Run and Long Run Production Function in the Market Structures
The production function provides information about the quantity of factor inputs as to
the result of the quantity of outputs and this is measured by total product; average
product; and marginal product
1. The total product is generated from the total output from the factors of production
employed by the firm. It is the quantity of output produced per time period given the inputs.
The total product can easily be determined when applied to manufacturing industries for
the production of cars, appliances, cellphones and other products because of clear cut
measure as to the volume of production as to the tangible costs on labor and capital inputs.
2. The average product is computed through the total output divided by the number of
units of the variables of the factor of production. For example, the 10 factory workers
produce 1000 units of electronic components of a computer, therefore the average product
of labor is 10 units of electronic components per worker. This example is generated by the
output per worker employed in the factory.
3. The marginal product is the change of the total product when there is an additional unit
of the input in the factors of production. The additional labor (increased in the number of
workers) as an input product may increase the total product. For example, the factory
intends to hire two additional workers then the 10 workers with a product of 1000 units
may now increase to 1200 units. Therefore , the marginal product is computed by the one-
unit change may result to the increase of the total product.
The Period of Production

1. Short Run Production
The short run is a period in which at least one input of the factors of production is fixed.
It should be noted that usually factory facilities, equipment and machinery including land
are fixed, however, the supply can be altered by changing the demand for labor, raw
material, factory components and etc.
Usually a firm or producers have to pay certain production cost form the expenses such
as the construction of building for the management office, manufacturing facilities, salaries
or wages of the labor and other overhead costs. In the short run,the firm cost structure has
to consider the fixed costs (FC) in a given period of time regardless of production level. The
variable cost is associated with the production cost.
1. Fixed Costs- The cost of production of the investment utilized by the firm.
The fixed cost does not vary regardless of the production output. These are
overhead cost, rent of offices and buildings, property tax, amortization and
interest.
1. Variable Cost- This indicates cost of the direct labor, raw materials, supplies
and materials. The variable cost is associated in the production of goods.
It must be noted that the Total Costs (TC) presents the sum of the of Total Variable Costs
(TVC) and Total Variable Costs (TVC). This is the economic calculation of this presentation
and the average cost with that of the Total Costs:
AC=(TFC+TVC)/Q=AFC+AVC
AC: average costs
TFC: total fixed costs
TVC: total variable costs
AFC: average fixed costs
AVC: average variable costs
In the short run, the total product usually responds to the increase on the use of a
variable input. However, you cannot simply add factory workers just to increase the
production output. There is a certain point when the marginal product could no longer
increase the production output because there are too many workers to work on a fixed
capital input just like machinery, equipment and facilities.
This is the reason why the Law of Diminishing Returns is present in the study of
production function because the additional units of a variable inputs such as labor and raw
material with a fixed land and capital may have consequence on the initial change in total
output will at first rise and then fall. The marginal product of labor starts to fall when there
are already so many workers producing products with fixed land, capital, equipment and
etc. It can reduce the diminishing returns once there is an expansion of the land, equipment,
machinery and even the increase of capital, however, we must always consider the average
product and marginal product with the standard workers needed in a given number of
production output.
The concept of law of diminishing returns is shown above with the production function
variables of capital outlay, labor input, total output, marginal product and average product
of labor. Let us assume that the fixed capital input in the short run analysis is 30 units
available for the production of certain product. There is a certain point of the capital input
that could maximized the marginal product, however, once it reaches the peak point the
marginal product falls which may show the sign of diminishing return.
Let us take this example in the production function, the fixed capital input of 30 units
may need a labor input of 6 workers that may produce 233 for the total output with a
marginal product of 60 and average product of labor of 39. The marginal product of 60 is the
maximize change of product for 6 workers, however, an additional workers may result to
diminishing return to marginal product and eventually to the average product output.
2. Long Run Production
The period of production in the long run shows the production operation of a certain
period of time. Normally, the firm expansion on the average cost of production may result
the increase of production inputs. However, there are some conditions that:
a) If the firm increases or expand its production operation, is it always increases its
production output.
b) Is it possible that the average cost of production may follow the same increase (to let say
50-50%) in the production input and output.
c) If the firm increases by its production input, however, the production output decreases.
The long run production for the expansion of the firm through the economies of scale
illustrates the importance of capital intensive ( more equipment per worker) in mass
production; increased specialization and division of labor .
Three (3) Possible Cases in Long Run Period of Production

The long run period of production usually analyzes the economies of scale which studies
the increasing returns to scale or economies of mass production. It tends to provided
information about the unit cost and the size of operation in the production of goods. The
economies of scale primarily directed to reduce the unit costs from the increasing size of the
operation. That is why the larger firms are more economically viable in the long run
production as it diminishes the production cost. Take note that the economies of scale tends
to increase in specialization and division of labor. This may lead to increase production
inputs and expands the production output.
1. Decreasing Returns to Scale (Increasing Cost)
When the firm becomes large it is likely to encounter problem in the production of a
particular product because of the increase average cost of operation. This is the problem of
management when increase of production input by 60% the production output reaches only
to 40%. In this notion the production is less cheap at a certain scale when it is already large
in scale. It requires large-scale machinery or division of labor to produce greater production
output.Hence, the Decreasing Returns to scale occur when the percent change in output is
greater in percent for the change in inputs.
2. Constant Returns to Scale (Constant Cost)
There is a time for a firm to enjoy a long range of production output for which the
average cost is the same proportion to both production input and output. If there is an
increase of the number of machines by 50% then there is also an increase of the number of
units produced by 50%. This is a constant returns in machinery production.Hence,
the Constant Returns to scale occur when the average cost do not increase as a result of
diseconomies of scale.
3. Increasing Return to Scale ( Decreasing Cost)
This is known as the economies of scale wherein the firm’s increase in all production
inputs and outputs. Supposing a firm increases the inputs by 50% the return of scale
increases to 60%.The economies scale expands productive capacity in the long run as it
operated by machines and other sophisticated technology that may reduce the overhead
cost in producing the products. This is more on capital-intensive production wherein there
are more equipment utilize than workers in the production process. In the long run, the
manufacturing sectors with high capital investment of equipment results to higher
production output that expands the profitability of the firms.The economies of scale is the
reduction of unit cost in the long run of operation. The expansion of the firm through a mass
production provides greater units of output.
Cobb-Douglas Production Function
Definition: The Cobb-Douglas Production Function, given by Charles W. Cobb and Paul H.
Douglas is a linear homogeneous production function, which implies, that the factors of
production can be substituted for one another up to a certain extent only.
With the proportionate increase in the input factors, the output also increases in the
same proportion. Thus, there are constant returns to a scale. In Cobb-Douglas production
function, only two input factors, labor, and capital are taken into the consideration, and
the elasticity of substitution is equal to one. It is also assumed that, if any, of the inputs,
is zero, the output is also zero.
Likewise, in the linear homogeneous production function, the expansion path generated
by the cobb-Douglas function is also a straight line passing through the origin. The CD
function can be expressed as follows:
Q = ALαKβ
Where, Q = output
A = positive constant
K = capital employed
L = Labor employed
α and β = positive fractions shows the elasticity coefficients of outputs for inputs labor
and capital, respectively.
Β = 1-α
This algebraic form of Cobb-Douglas function can be changed in a log linear form, with
the help of regression analysis:
Log Q = log A + α log L + β log K
The homogeneity of the Cobb-Douglas production function can be checked by adding the
values of α and β. If the sum of these parameters is equal to one, then it shows that the
production function is linearly homogeneous, and there are constant returns to a scale. If
the sum of these parameters is less or more than one, then there is a decreasing and
increasing returns to a scale respectively.
3.6 Returns to scale – economies Vs diseconomies of scale

3.7 ISO-Quants & ISO-Cost line:
Production function through ISO-QUANT analysis.
Iso-Quant Curve: Definitions, Assumptions and Properties!
The term Iso-quant or Iso-product is composed of two words, Iso = equal, quant = quantity
or product = output.
Thus it means equal quantity or equal product. Different factors are needed to produce a
good. These factors may be substituted for one another.
A given quantity of output may be produced with different combinations of factors. Iso-
quant curves are also known as Equal-product or Iso-product or Production Indifference
curves. Since it is an extension of Indifference curve analysis from the theory of
consumption to the theory of production.
Thus, an Iso-product or Iso-quant curve is that curve which shows the different
combinations of two factors yielding the same total product. Like, indifference curves, Iso-
quant curves also slope downward from left to right. The slope of an Iso-quant curve
expresses the marginal rate of technical substitution (MRTS).
Definitions:
“The Iso-product curves show the different combinations of two resources with which a firm
can produce equal amount of product.” Bilas
“Iso-product curve shows the different input combinations that will produce a given
output.” Samuelson
“An Iso-quant curve may be defined as a curve showing the possible combinations of two
variable factors that can be used to produce the same total product.” Peterson
“An Iso-quant is a curve showing all possible combinations of inputs physically capable of
producing a given level of output.”
Assumptions:
The main assumptions of Iso-quant curves are as follows:
1. Two Factors of Production:
Only two factors are used to produce a commodity.
2. Divisible Factor:
Factors of production can be divided into small parts.
3. Constant Technique:
Technique of production is constant or is known before hand.
4. Possibility of Technical Substitution:
The substitution between the two factors is technically possible. That is, production function
is of ‘variable proportion’ type rather than fixed proportion.
5. Efficient Combinations:
Under the given technique, factors of production can be used with maximum efficiency.
Iso-Product Schedule:
Let us suppose that there are two factor inputs—labour and capital. An Iso-product
schedule shows the different combination of these two inputs that yield the same level of
output as shown in table 1.
The table 1 shows that the five combinations of labour units and units of capital yield the
same level of output, i.e., 200 metres of cloth. Thus, 200 metre cloth can be produced by
combining.
(a) 1 units of labour and 15 units of capital
(b) 2 units of labour and 11 units of capital
(c) 3 units of labour and 8 units of capital
(d) 4 units of labour and 6 units of capital
(e) 5 units of labour and 5 units of capital
Iso-Product Curve:
From the above schedule iso-product curve can be drawn with the help of a diagram. An.
equal product curve represents all those combinations of two inputs which are capable of
producing the same level of output. The Fig. 1 shows the various combinations of labour and
capital which give the same amount of output. A, B, C, D and E.
Iso-Product Map or Equal Product Map:
An Iso-product map shows a set of iso-product curves. They are just like contour lines which
show the different levels of output. A higher iso-product curve represents a higher level of
output. In Fig. 2 we have family iso-product curves, each representing a particular level of
output.
The iso-product map looks like the indifference of consumer behaviour analysis. Each
indifference curve represents particular level of satisfaction which cannot be quantified. A
higher indifference curve represents a higher level of satisfaction but we cannot say by how
much the satisfaction is more or less. Satisfaction or utility cannot be measured.
An iso-product curve, on the other hand, represents a particular level of output. The level of
output being a physical magnitude is measurable. We can therefore know the distance
between two equal product curves. While indifference curves are labeled as IC 1, IC2, IC3, etc.,
the iso-product curves are labelled by the units of output they represent -100 metres, 200
metres, 300 metres of cloth and so on.
Properties of Iso-Product Curves:
The properties of Iso-product curves are summarized below:
1. Iso-Product Curves Slope Downward from Left to Right:
They slope downward because MTRS of labour for capital diminishes. When we increase
labour, we have to decrease capital to produce a given level of output.
The downward sloping iso-product curve can be explained with the help of the following
figure:
The Fig. 3 shows that when the amount of labour is increased from OL to OL 1, the amount of
capital has to be decreased from OK to OK 1, The iso-product curve (IQ) is falling as shown in
the figure.
The possibilities of horizontal, vertical, upward sloping curves can be ruled out with the
help of the following figure 4:
(i) The figure (A) shows that the amounts of both the factors of production are increased-
labour from L to Li and capital from K to K 1. When the amounts of both factors increase, the
output must increase. Hence the IQ curve cannot slope upward from left to right.
(ii) The figure (B) shows that the amount of labour is kept constant while the amount of
capital is increased. The amount of capital is increased from K to K 1. Then the output must
increase. So IQ curve cannot be a vertical straight line.
(iii) The figure (C) shows a horizontal curve. If it is horizontal the quantity of labour
increases, although the quantity of capital remains constant. When the amount of capital is
increased, the level of output must increase. Thus, an IQ curve cannot be a horizontal line.
2. Isoquants are Convex to the Origin:
Like indifference curves, isoquants are convex to the origin. In order to understand this fact,
we have to understand the concept of diminishing marginal rate of technical substitution
(MRTS), because convexity of an isoquant implies that the MRTS diminishes along the
isoquant. The marginal rate of technical substitution between L and K is defined as the
quantity of K which can be given up in exchange for an additional unit of L. It can also be
defined as the slope of an isoquant.
It can be expressed as:
MRTSLK = – ∆K/∆L = dK/ dL
Where ∆K is the change in capital and AL is the change in labour.
Equation (1) states that for an increase in the use of labour, fewer units of capital will be
used. In other words, a declining MRTS refers to the falling marginal product of labour in
relation to capital. To put it differently, as more units of labour are used, and as certain units
of capital are given up, the marginal productivity of labour in relation to capital will decline.
This fact can be explained in Fig. 5. As we move from point A to B, from B to C and from C to
D along an isoquant, the marginal rate of technical substitution (MRTS) of capital for labour
diminishes. Everytime labour units are increasing by an equal amount (AL) but the
corresponding decrease in the units of capital (AK) decreases.
Thus it may be observed that due to falling MRTS, the isoquant is always convex to the
origin.
3. Two Iso-Product Curves Never Cut Each Other:
As two indifference curves cannot cut each other, two iso-product curves cannot cut each
other. In Fig. 6, two Iso-product curves intersect each other. Both curves IQ1 and IQ2
represent two levels of output. But they intersect each other at point A. Then combination A
= B and combination A= C. Therefore B must be equal to C. This is absurd. B and C lie on two
different iso-product curves. Therefore two curves which represent two levels of output
cannot intersect each other.
4. Higher Iso-Product Curves Represent Higher Level of Output:
A higher iso-product curve represents a higher level of output as shown in the figure 7
given below:
In the Fig. 7, units of labour have been taken on OX axis while on OY, units of capital.
IQ1 represents an output level of 100 units whereas IQ2 represents 200 units of output.
5. Isoquants Need Not be Parallel to Each Other:
It so happens because the rate of substitution in different isoquant schedules need not be
necessarily equal. Usually they are found different and, therefore, isoquants may not be
parallel as shown in Fig. 8. We may note that the isoquants Iq 1 and Iq2 are parallel but the
isoquants Iq3 and Iq4 are not parallel to each other.
6. No Isoquant can Touch Either Axis:
If an isoquant touches X-axis, it would mean that the product is being produced with the
help of labour alone without using capital at all. These logical absurdities for OL units of
labour alone are unable to produce anything. Similarly, OC units of capital alone cannot
produce anything without the use of labour. Therefore as seen in figure 9, IQ and IQ 1 cannot
be isoquants.
7. Each Isoquant is Oval-Shaped.
It means that at some point it begins to recede from each axis. This shape is a consequence
of the fact that if a producer uses more of capital or more of labour or more of both than is
necessary, the total product will eventually decline. The firm will produce only in those
segments of the isoquants which are convex to the origin and lie between the ridge lines.
This is the economic region of production. In Figure 10, oval shaped isoquants are shown.
Curves OA and OB are the ridge lines and in between them only feasible units of capital and
labour can be employed to produce 100, 200, 300 and 400 units of the product. For
example, OT 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 T and less
quantity of capital VT.
Thus only an unwise entrepreneur will produce in the dotted region of the iso-quant 100.
The dotted segments of an isoquant are the waste- bearing segments. They form the
uneconomic regions of production. In the up dotted portion, more capital and in the lower
dotted portion more labour than necessary is employed. Hence GH, JK, LM, and NP
segments of the elliptical curves are the isoquants.
Difference between Indifference Curve and Iso-Quant Curve:
The main points of difference between indifference curve and Iso-quant curve are
explained below:
1. Iso-quant curve expresses the quantity of output. Each curve refers to given quantity of
output while an indifference curve to the quantity of satisfaction. It simply tells that the
combinations on a given indifference curve yield more satisfaction than the combination on
a lower indifference curve of production.
2. Iso-quant curve represents the combinations of the factors whereas indifference curve
represents the combinations of the goods.
3. Iso-quant curve gives information regarding the economic and uneconomic region of
production. Indifference curve provides no information regarding the economic and
uneconomic region of consumption.
4. Slope of an iso-quant curve is influenced by the technical possibility of substitution

between factors of production. It depends on marginal rate of technical substitution (MRTS)
whereas slope of an indifference curve depends on marginal rate of substitution (MRS)
between two commodities consumed by the consumer.
Principle of Marginal Rate of Technical Substitution [June-2005]:
The principle of marginal rate of technical substitution (MRTS or MRS) is based on the
production function where two factors can be substituted in variable proportions in such a
way as to produce a constant level of output. The marginal rate of technical substitution
between two factors C (capital) and L (labour), MRTS LC is the rate at which L can be
substituted for C in the production of good X without changing the quantity of output.
As we move along an isoquant downward to the right each point on it represents the
substitution of labour for capital. MRTS is the loss of certain units of capital which will just
be compensated for by additional units of labour at that point. In other words, the marginal
rate of technical substitution of labour for capital is the slope or gradient of the isoquant at
a point. Accordingly, slope = MRTS LC = AC/AL. This can be understood with the aid of the
isoquant schedule, in Table 2.
The above table 2 shows that in the second combination to keep output constant at 100
units, the reduction of 3 units of capital requires the addition of 5 units of labour, MRTS LC =
3 : 5. In the third combination, the loss of 2 units of capital is compensated for by 5 more
units of labour, and so on.
In Fig. 11 at point B, the marginal rate of technical substitution is AS/SB, t point G, it is BT/TG
and at H, it is GR/RH. The isoquant AH reveals that as the units of labour are successively
increased into the factor- combination to produce 100 units of good X, the reduction in the
units of capital becomes smaller and smaller.
It means that the marginal rate of technical substitution is diminishing. This concept of the
diminishing marginal rate of technical substitution (DMRTS) is parallel to the principle of
diminishing marginal rate of substitution in the indifference curve technique. This tendency
of diminishing marginal substitutability of factors is apparent from Table 2 and Figure 11.
The MRTSLc continues to decline from 3: 5 to 1: 5 whereas in the Figure 11 the vertical lines
below the triangles on the isoquant become smaller and smaller as we move downward so
that GR < BT < AS. Thus, the marginal rate of technical substitution diminishes as labour is
substituted for capital. It means that the isoquant must be convex to the origin at every
point.
Iso-Cost Line:
The iso-cost line is similar to the price or budget line of the indifference curve analysis. 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. Just as there are various isoquant curves, so there are various iso-cost lines,
corresponding to different levels of total output.
Definition:
Iso-cost line may be defined as the line which shows different possible combinations of two
factors that the producer can afford to buy given his total expenditure to be incurred on
these factors and price of the factors.
Explanation:
The concept of iso-cost line can be explained with the help of the following table 3 and Fig.
12. Suppose the producer’s budget for the purchase of labour and capital is fixed at Rs. 100.
Further suppose that a unit of labour cost the producer Rs. 10 while a unit of capital Rs. 20.
From the table cited above, the producer can adopt the following options:
(i) Spending all the money on the purchase of labour, he can hire 10 units of labour (100/10
= 10)
(ii) Spending all the money on the capital he may buy 5 units of capital.
(iii) Spending the money on both labour and capital, he can choose between various
possible combinations of labour and capital such as (4, 3) (2, 4) etc.
Diagram Representation:
In Fig. 12, labour is given on OX-axis and capital on OY-axis. The points A, B, C and D convey
the different combinations of two factors, capital and labour which can be purchased by
spending Rs. 100. Point A indicates 5 units of capital and no unit of labour, while point D
represents 10 units of labour and no unit of capital. Point B indicates 4 units of capital and 2
units of labour. Likewise, point C represents 4 units of labour and 3 units of capital.
Iso-Cost Curves:
After knowing the nature of isoquants which represent the output possibilities of a firm
from a given combination of two inputs. We further extend it to the prices of the inputs as
represented on the isoquant map by the iso-cost curves.
These curves are also known as outlay lines, price lines, input-price lines, factor-cost lines,
constant-outlay lines, etc. Each iso-cost curve represents the different combinations of two
inputs that a firm can buy for a given sum of money at the given price of each input.
Figure 13 (A) shows three iso-cost curves each represents a total outlay of 50, 75 and 100
respectively. The firm can hire OC of capital or OD of labour with Rs. 75. OC is 2/3 of OD
which means that the price of a unit of labour is 1/2 times less than that of a unit of capital.
The line CD represents the price ratio of capital and labour. Prices of factors remaining the
same, if the total outlay is raised, the iso-cost curve will shift upward to the right as EF
parallel to CD, and if the total outlay is reduced it will shift downwards to the left as AB.
The iso-costs are straight lines because factor prices remain the same whatever the outlay
of the firm on the two factors.
The iso-cost curves represent the locus of all combinations of the two input factors which
result in the same total cost. If the unit cost of labour (L) is w and the unit cost of capital (C)
is r, then the total cost: TC = wL + rC. The slope of the iso-cost line is the ratio of prices of
labour and capital i.e., w/r.
The point where the iso-cost line is tangent to an isoquant shows the least cost combination
of the two factors for producing a given output. If all points of tangency like LMN are joined
by a line, it is known as an output-factor curve or least-outlay curve or the expansion path of
a firm.
It shows how the proportions of the two factors used might be changed as the firm expands.
For example, in Figure 13 (A) the proportions of capital and labour used to produce 200 (IQ 1)
units of the product are different from the proportions of these factors used to produce 300
(IQ2) units or 100 units at the lowest cost.
Like the price-income line in the indifference curve analysis, a relative cheapening of one of
the factors to that of another will extend the iso-cost line to the right. If one of the factors
becomes relatively dearer, the iso-cost line will contract inward to the left.
Given the price of capital, if the price of labour falls, the isocost line EF in Panel (B) of figure
13 will extend to the right as EG and if the price of labour rises, the iso-cost line EF will
contract inward to the left as EH, if the equilibrium points L, M, and N are joined by a line. It
will be called the price-factor curve.
Ridge Lines:
One knows from the iso-quant curves the extent to which production should be carried out.
Lines which represent the limits of the economic region of production are called ridge lines.
Ridge lines join those points on different iso-quant curves which determine the economic
limits of production. The importance of ridge lines is explained with the help of Figure 14.
Iso-quant curves at point A and D; B and E; and C and F begin to recede from each axes. The
segments above or below these points A B C and D E F, one gets OL and OR lines. OR and OL
lines are called Ridge Lines. These ridge lines show the economical limits for the firm to
produce only in those segments of the iso-quants which lie between the ridge lines.
It can be explained with the help of an example. In fig. 14, combination of OL3 units of
labour and ON3 units of land can produce 60 quintals of wheat, ON3 amount of land is the
minimum required to produce 60 quintals of wheat.
While using ON3 amount of land, at point C, if more than OL 3 units of labour are used, total
output will be less than 60 quintals of wheat. It means beyond OL3 units of labour, their
marginal productivity will become negative causing total output to be less than 60 quintals.
In other words, after OL3, marginal productivity of labour will be zero.
If at point ‘C’ more than OL 3 units of labour are used then to keep the total output of 60
quintals of wheat constant, more than ON3 units of land will have to be used. It will be
unwise and irrational decision. It will unnecessarily increase the cost of production. Thus to
produce outside point ‘C’ will be uneconomic. At point ‘C’ marginal productivity of labour
will be zero.
In the same way, we can find out point A and B on iso-quant curves IP) and IP2 where
marginal productivity of labour will be zero. The lines joining these points are called ridge
lines. Ridge line OL, therefore, is the locus of points where marginal productivity of labour is
zero. Point F of IP3 indicates that to produce 60 quintals of wheat, OR3 units of labour and
OM3 units of land are required. OR3 units of labour are the minimum units to produce this
level of output. If keeping OR3 units of labour constant, more than OM3 units of labour are
used, the total output will be less than 60 quintals of wheat. It implies that after point ‘F’.
Accordingly, points ‘D’ and ‘E’ on IPi and IP2 curves represent zero marginal productivity of
land. Production thus, will be done on the segment below point ‘D’, ‘E’ and ‘F’. These points
have been joined by OR ridge line.
Economies of Scale: Internal and External
Prof. Stigler defines economies of scale as synonyms with returns to scale.
As the scale of production is increased, up to a certain point, one gets economies of scale.
Beyond that, there are its diseconomies to scale Marshall has classified economies to scale
into two parts as under:
I. Internal Economies:
As a firm increases its scale of production, the firm enjoys several economies named as
internal economies. Basically, internal economies are those which are special to each firm.
For example, one firm will enjoy the advantage of good management; the other may have
the advantage of specialisation in the techniques of production and so on.
“Internal economies are those which are open to a single factory, or a single firm
independently of the action of other firms. These result from an increase in the scale of
output of a firm and cannot be achieved unless output increases.” Cairncross
Prof. Koutsoyannis has divided the internal economies into two parts:
A. Real Economies
B. Pecuniary Economies
A. Real Economies:
Real economies are those which are associated with the reduction of physical quantity of
inputs, raw materials, various types of labour and capital etc.
These economies are of the following types:
1. Technical Economies:
Technical economies have their influence on the size of the firm. Generally, these
economies accrue to large firms which enjoy higher efficiency from capital goods or
machinery. Bigger firms having more resources at their disposal are able to install the most
suitable machinery.
Therefore, a firm producing on large scale can enjoy economies by the use of superior
techniques.
Technical economies are of three kinds:
(i) Economies of Dimension:
A firm by increasing the scale of production can enjoy the technical economies. When a firm
increases its scale of production, average cost of production falls but its average return will
be more.
(ii) Economies of Linked Process:
A big firm can also enjoy the economies of linked process. A big firm carries all productive
activities. These activities get economies. These linked activities save time and transport
costs to the firm.
(iii) Economies of the Use of By-Products:
All the large sized firms are in a position to use its by-products and waste-material to
produce another material and thus, supplement to their income. For instance, sugar
industries make power, alcohol out of the molasses.
2. Marketing Economies:
When the scale of production of a firm is increased, it enjoys numerous selling or marketing
economies. In the marketing economies, we include advertisement economies, opening up
of show rooms, appointment of sole distributors etc. Moreover, a large firm can conduct its
own research to effect improvement in the quality of the product and to reduce the cost of
production. The other economies of scale are advertising economies, economies from
special arrangements with exclusive dealers. In this way, all these acts lead to economies of
large scale production.
3. Labour Economies:
As the scale of production is expanded their accrue many labour economies, like new
inventions, specialization, time saving production etc. A large firm employs large number of
workers. Each worker is given the kind of job he is fit for. The personnel .officer evaluates
the working efficiency of the labour if possible. Workers are skilled in their operations which
save production, time and simultaneously encourage new ideas.
4. Managerial Economies:
Managerial economies refer to production in managerial costs and proper management of

large scale firm. Under this, work is divided and subdivided into different departments. Each
department is headed by an expert who keeps a vigil on the minute details of his
department. A small firm cannot afford this specialisation. Experts are able to reduce the
costs of production under their supervision. These also arise due to specialization of
management and mechanisation of managerial functions.
5. Economies of Transport and Storage:
A firm producing on large scale enjoys the economies of transport and storage. A big firm
can have its own means of transportation to carry finished as well as raw material from one
place to another. Moreover, big firms also enjoy the economies of storage facilities. The big
firm also has its own storage and go down facilities. Therefore, these firms can store their
products when prices are unfavorable in the market.
B. Pecuniary Economies:
Pecuniary economies are those which can be had after paying less prices for the factors
used in the process of production and distribution. Big firms can get raw material at the low
price because they buy the same in the large bulk. In the same way, they enjoy a lot of
concessions in bank borrowing and advertisements.
These economies occur to a large firm in the following:
(i) The firms producing output on a large scale purchase raw material in bulk quantity. As a
result of this, the firms get a special discount from suppliers. This is a monetary gain to the
firms.
These economies occur to a large firm in the following:
(i) The firms producing output on a large scale purchase raw material in bulk quantity. As a
result of this, the firms get a special discount from suppliers. This is a monetary gain to the
firms.
(ii) The large-scale firms are offered loans by the banks at a low interest rate and other
favourable terms.
(iii) The large-scale firms are offered concessional transportation facilities by the transport
companies because of the large-scale transportation handling.
(iv) The large-scale firms advertise their products on large scales and they are offered
advertising facilities at lower prices by advertising firms and newspapers.
3.7) External Economies:
External economies refer to all those benefits which accrue to all the firms operating in a
given industry. Generally, these economies accrue due to the expansion of industry and
other facilities expanded by the Government. According to Cairncross, “External economies
are those benefits which are shared in by a number of firms or industries when the scale of
production in any industry increases.” Moreover, the simplest case of an external economy
arises when the scale of production function of a firm contains as an implicit variable the
output of the industry. A good example is that of coal mines in a locality.
Prof. Cairncross has divided the external economies into the following parts as:
1. Economies of Concentration:
As the number of firms in an area increases each firm enjoys some benefits like, transport
and communication, availability of raw materials, research and invention etc. Further,
financial assistance from banks and non-bank institutions easily accrue to firm.
We can, therefore, conclude that concentration of industries lead to economies of

concentration.
2. Economies of Information:
When the number of firms in an industry expands they become mutually dependent on
each other. In other words, they do not feel the need of independent research on individual
basis. Many scientific and trade journals are published. These journals provide information
to all the firms which relates to new markets, sources of raw materials, latest techniques of
production etc.
3. Economies of Disintegration:
As an industry develops, all the firms engaged in it decide to divide and sub-divide the
process of production among themselves. Each firm specializes in its own process. For
instance, in case of moped industry, some firms specialize in rims, hubs and still others in
chains, pedals, tires etc. It is of two types-horizontal disintegration and vertical
disintegration.
In case of horizontal disintegration each firm in the industry tries to specialize in one
particular item whereas, under vertical disintegration every firm endeavors to specialize in
different types of items. Material of one firm may be available and useable as raw materials
in the other firms. Thus, wastes are converted into by-products.
The selling firms reduce their costs of production by realizing something for their wastes.
The buying firms gain by getting other firms’ wastes as raw materials at cheaper rates. As a
result of this, the average cost of production declines.
Significance of Economies of Scale:
The significance of economies of scale is discussed as under:
(a). Nature of the Industry:
The foremost significance of economies of scale is that it plays an important role in

determining the nature of the industry i.e. increasing cost industry, constant cost industry or
decreasing cost industry.
(b). Analysis of Cost of Production:
When an industry expands in response to an increase in demand for its products, it

experiences some external economies as well as some external diseconomies. The external
economies tend to reduce the costs of production and thereby causing an upward shift in
the long period average cost curve, whereas the external diseconomies tend to raise the
costs and thereby causing an upward shift in the long period average cost curve. If external
diseconomies outweigh the external economies, that is, when there are net external
diseconomies, the industry would be an Increasing cost industry.
3.8 Analysis of cost – Short-run and long-run cost function :
Concept of Cost Function:

The relationship between output and costs is expressed in terms of cost function. By
incorporating prices of inputs into the production function, one obtains the cost function
since cost function is derived from production function. However, the nature of cost
function depends on the time horizon. In microeconomic theory, we deal with short run and
long run time.
A cost function may be written as:
Cq = f(Qf Pf)
Where Cq is the total production cost, Qf is the quantities of inputs employed by the firm,
and Pf is the prices of relevant inputs. This cost equation says that cost of production
depends on prices of inputs and quantities of inputs used by the firm.
Importance of Cost Function:

The study of business behaviour concentrates on the production process—the conversion of
inputs into outputs—and the relationship between output and costs of production.
We have already studied a firm’s production technology and how inputs are combined to
produce output. The production function is just a starting point for the supply decisions of a
firm. For any business decision, cost considerations play a great role.
Cost function is a derived function. It is derived from the production function which captures
the technology of a firm. The theory of cost is a concern of managerial economics. Cost
analysis helps allocation of resources among various alternatives. In fact, knowledge of cost
theory is essential for making decisions relating to price and output.
Whether production of a new product is a wiser one on the part of a firm greatly depends
on the evaluation of costs associated with it and the possibility of earning revenue from it.
Decisions on capital investment (e.g., new machines) are made by comparing the rate of
return from such investment with the opportunity cost of the funds used.
The relevance of cost analysis in decision-making is usually couched in terms of short and
long periods of time by economists. In all market structures, short run costs are crucial in
the determination of price and output. This is due to the fact that the basis for cost function
is production and the prices of inputs that a firm pays.
On the other hand, long run cost analysis is used for planning the optimal scale of plant size.
In other words, long run cost functions provide useful information for planning the growth
as well as the investment policies of a firm. Growth of a firm largely depends on cost
considerations.
The position of the U-shaped long run AC of a firm is suggestive of the direction of the
growth of a firm. That is to say, a firm can take a decision whether to build up a new plant or
to look for diversification in other markets by studying its existence on the long run AC
curve. Further, it is the cost that decides the merger and takeover of a sick firm.
Non-profit sector or the government sector must also have a knowledge of cost function for
decision-making. Whether the Narmada Dam is to be built or not, it should evaluate the
costs and benefits ‘flowing’ from the dam.
Profit Function
Economics – profit and revenue
Total revenue (TR): This is the total income a firm receives. This will equal price × quantity
Average revenue (AR) = TR / Q
Marginal revenue (MR) = the extra revenue gained from selling an extra unit of a good
Profit = Total revenue (TR) – total costs (TC) or (AR – AC) × Q

Profit maximisation
 In classical economics it is assumed that firms will seek to maximise their profits. This
occurs when the difference between TR – TC is the greatest.
 Profit maximisation will also occur at an output where MR = MC
 When MR> MC the firms is increasing its profits and Total Profit is increasing.
 When MR< MC total profit starts to fall
 Therefore profit is maximised where MR = MC
Definition normal profit
This occurs when TR = TC. This is the break-even point for a firm (P2). It is the minimum
profit level to keep the firm in the industry in the long run.
Definition supernormal profit
This occurs when total revenue > total cost.
Whether to produce at all

 If AR > ATC The firm is making supernormal profits
 If AR= ATC The firm is making normal profits. This is the ‘break-even’ price.
 If AR< ATC but AR > AVC. it is making an operating profit, and is covering its variable costs.
However it is making an economic loss because it can not cover its fixed costs as well. At this
level (P1-P2) In the short run it is best to keep producing because it has already paid for its
fixed costs. It is at least making a contribution to its fixed costs
 If AR < AVC The firm is likely to shut down in the short run.
Evaluation
 In the real world it is more difficult for firms to maximise profits because they do not have
access to costs and marginal revenue data easily, it is difficult to predict.
 The firm may not close down at price of less than P1 – if they expect fall in demand to be
temporary and they are hopeful that they can cut costs. A firm will try to avoid shutting
down, because it will lose market share and long-term customers.
Short Run Production Function: In the short run, some inputs (land, capital) are fixed in
quantity. The output depends on how much of other variable inputs are used. For example if
we change the variable input namely (labour) the production function shows how much
output changes when more labour is used. In the short run producers are faced with the
problem that some input factors are fixed. The firms can make the workers work for longer
hours and also can buy more raw materials. In that case, labour and raw material are
considered as variable input factors. But the number of machines and the size of the
building are fixed. Therefore it has its own constraints in producing more goods. 50 In the
long run all input factors are variable. The producer can appoint more workers, purchase
more machines and use more raw materials. Initially output per worker will increase up to
an extent. This is known as the Law of Diminishing Returns or the Law of Variable
Proportion. To understand the law of diminishing returns it is essential to know the basic
concepts of production.
Measures Of Productivity
Total production (TP): the maximum level of output that can be produced with a given
amount of input.
Average Production (AP): output produced per unit of input AP = Q/L
Marginal Production (MP): the change in total output produced by the last unit of an input
Marginal production of labour = Δ Q / Δ L (i.e. change in the quantity produced to a given
change in the labour)
Marginal production of capital = Δ Q / Δ K (i.e. change in the quantity produced to a given
change in the capital)
Labour TP AP MP
1 20 20 0
2 54 27 34
3 81 27 27
4 104 26 23
5 125 25 21
6 138 23 13
7 147 21 9
8 152 19 5
9 153 17 1
10 150 15 -3
The firm has a set of fixed variables. As long with that it increases the labour force from 1
unit to 10 units. The increase in input factor leads to increase in the output up to an extent.
After that it start declining. Marginal production increases in the initial period and then it
starts declining and it become negative. The firm should stop increasing labour force if the
marginal production is zero- that is the maximum output that can be derived with the
available fixed factors. The 9th labour does not contribute to any output. In case the firm
wants to increase the output beyond 153 units it has to improve its fixed variable. That
means purchase of new machinery or building is essential. Therefore the firm understands
that the maximum output is 153 units with the given set of input factors.
The graphical representations of the production function are as shown in the following
graph.
The graphical presentations of the values are shown in the graph. The ‘X” axis denotes the
labour and the ‘Y’ axis indicates the total production (TP), average production (AP) and
marginal production (MP). From the given table and graph we can understand all the three
curves in the graph increased in the beginning and the marginal product (MP) first fell, then
the average product (AP) finally total production (TP). The marginal production curve MP
cuts the AP at its highest point. Total production TP falls when marginal production curve
cuts the ‘X’ axis. The law of diminishing returns states that if increasing quantity of a variable
input are combined with fixed, eventually the marginal product and then average product
will decline.
When the production function is expressed as an equation it shall be as follows:
Q = f (Ld, L, K, M, T )
It can be expressed as Q = f1, f2, f3, f4, f5 > 0
Where,
Q = output in physical units of good X
Ld = land units employed in the production of Q
L = Labour units employed in the production of Q
K = Capital units employed in the production of Q
M = Managerial Units employed in the production of Q
T = Technology employed in the production of Q
f = unspecified function
fi = Partial derivative of Q with respect to ith input.
This equation assumes that output is an increasing function of all inputs.
The Law Of Diminishing Returns
In the combination of input factors when one particular factor is increased continuously
without changing other factors the output will increase in a diminishing manner. Let us
assume that a person preparing for an examination continuously prepares without any
break. The output or the understanding and the coverage of the syllabus will be more in the
beginning rather than in the later stages. There is a limit to the extent to which one factor of
production can be substituted for another. The total production increases up to an extent
and it gets saturated or there won’t be any change in the output due to the addition of the
input factor and further it leads to negative impact on the output. That means the marginal
production declines up to an extent and it reaches zero and becomes negative. The point at
which the MP becomes zero is the maximum output of the firm with the given set of input
factors. This law is applicable in all human activities and business activities.
For example with two sewing machines and two tailors, a firm can produce a maximum of
14 pairs of curtains per day. The machines are used only from 9 AM to 5 PM and the
machines lie idle from 5 pm onwards. Therefore the firm appoints 2 more tailors for the
second shift and the production goes up to 28 units. Then adding two more labour to assist
these people will increase the output to 30 units. When the firm appoints two more people,
then there won’t be any change in their production because their Marginal productivity is
zero. There is no addition in the total production. That means there is no use of appointing
two more 54 tailors. Therefore, there is a limit for output from a fixed input factors but in
the long run purchase of one more sewing machine alone will help the firm to increase the
production more than 30 units.
The Law Of Returns To Scale
In the long run the fixed inputs like machinery, building and other factors will change along
with the variable factors like labour, raw material etc. With the equal percentage of increase
in input factors various combinations of returns occur in an organization. Returns to scale:
the change in percentage output resulting from a percentage change in all the factors of
production. They are increasing, constant and diminishing returns to scale. Increasing
returns to scale may arise: if the output of a firm increases more than in proportionate to an
increase in all inputs. For example the input factors are increased by 50% but the output has
doubled (100%). Constant returns to scale: when all inputs are increased by a certain
percentage the output increases by the same percentage. For example input factors are
increased by 50% then the output has also increased by 50 percentages. Let us assume that
a laptop consists of 50 components we call it as a set. In case the firm purchases 100 sets
they can assemble 100
laptops but it is not possible to produce more than 100 units.
Diminishing returns to scale: when output increases in a smaller proportion than the
increase in inputs it is known as diminishing return to scale. For example 50% increment in
input factors lead to only 20% increment in the output. From the graph given below we can
see the total production (TP) curve and the marginal production curve (MP) and average
production curve (AP). It is classified into three stages; let us understand the stages in terms
of returns to scale
Stage I: The total production increased at an increasing rate. We refer to this as increasing
stage where the total product, marginal product and average production are increasing.
Stage II: The total production continues to increase but at a diminishing rate until it reaches
the next stage. Marginal product, average product are declining but are positive. The total
production is at the maximum level at the end of the second stage with a zero marginal
product.
Stage III: In this third stage total production declines and marginal product becomes
negative. And the average production also started decline. Which implies that the change in
input factors there is a decline in the over all production along with the average and
marginal. In economics, the production function with one variable input is illustrated with
the well known law of variable proportions. (below graph) it shows the input-output
relationship or production function with one factor variable while other factors of
production are kept constant. To understand a production function with two variable inputs,
it is necessary know the concept iso-quant or iso-product curve.
Definition and Meaning:

By "Cost of Production" is meant the total sum of money required for the production of a
specific quantity of output. In the word of Gulhrie and Wallace:

"In Economics, cost of production has a special meaning. It is all of the payments or
expenditures necessary to obtain the factors of production of land, labor, capital and
management required to produce a commodity. It represents money costs which we want
to incur in order to acquire the factors of production".

In the words of Campbell:

"Production costs are those which must be received by resource owners in order to assume
that they will continue to supply them in a particular time of production".

Elements of Cost of Production:

The following elements are included in the cost of production:

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

Normal Profit:

By normal profit of the entrepreneur is meant in economics the sum of money which is
necessary to keep an entrepreneur employed in a business. This remuneration should be
equal to the amount which he can earn in some other alternative occupation. If this
alternative return is not met, he will leave the enterprise and join alternative line of
production.

Types/Classifications of Cost of Production:

Prof, Mead in his book, "Economic Analysis and Policy" has classified these costs into three
main sections:

(1) Production Costs:

It includes material costs, rent cost, wage cost, interest cost and normal profit of the
entrepreneur.

(2) Selling Costs:

It includes transportation, marketing and selling costs.

(3) Sundry Costs:

It includes other costs such as insurance charges, payment of taxes and rate, etc., etc.
Concept of Economic Costs:

We have discussed the important types of cost which a firm has to face. The cost of
production from the point of view of an individual firm is split up into the following parts.

(1) Explicit Cost:

Explicit cost is also called money cost or accounting cost. Explicit cost represents all such
expenditure which are incurred by an entrepreneur to pay for the hired services of factors
of production and in buying goods and services directly. In other words, we can say that
they are the expenses which the business manager must take into account of because they
must actually be paid by the firm.

Example:

The explicit cost includes wages and salary payments, expenses on the purchase of raw
material, light, fuel, advertisements, transportation, taxes and depreciation charges.

(2) Implicit Cost:

The implicit costs are the imputed value of the entrepreneur's own resources and services.
Implicit costs can be defined as:

"Expenses that an entrepreneur does not have to pay out of his own pocket but are costs to
the firm because they represent an opportunity cost".

Example:

For instance, if a person is working as a manager in his own firm or has invested his own
capital or has built the factory at his own land, the reward of all these factors of production
at least equal to their transfer prices is, included in the expenses of a business.

Implicit costs, thus, are the alternative costs of the self-owned and self-employed resources
of a firm. The total costs of a business enterprise is the sum total of explicit and implicit
costs. If the implicit costs are not included in the firm's total cost, the cost of the firm will be
understated and it will result in serious error.

(3) Real Cost:

Real costs are the pains and inconveniences experienced by labor to produce a commodity.
These costs are not taken in the costing of a commodity by the firm. Real cost has been
defined differently by different economists.

Classical economists understood by real costs the pains and sacrifices of labor.
Alfred Marshall calls real cost as social cost and describes it:

"Real costs of efforts of various qualities and real costs of waiting".

The Austrian School of Economists have criticized the meaning given to real cost by the
classical economists and new classical economists. They say that to give a subjective value
to cost is a hopeless task as when real cost is expressed in terms of sacrifices or pains, it is
not amenable to precise measurement and thus it fails to explain the phenomenon of
prices.

(4) Opportunity Cost:

The concept of opportunity cost has a very important place in economic analysis. It is
defined as:

"The value of a resource in its next best use. It is the amount of income or yield that could
have been earned by investing in the next best alternative".

Example:

The opportunity cost of a good can be given a money value. For instance, a labor is working
in a factory and is getting $2000 P.M. The entrepreneur is paying him this amount because
he can earn this amount in the next best alternative employment. If he pays less than this
amount, he will move to next best alternative occupation, where he can get $2000 P.M.

So in order to obtain a productive service say labor in the present occupation, the cost
should be equal to the amount which he can get in some alternative occupation. Similarly, a
piece of land or capital must be paid as much as they could earn in their next best
alternative use. The total alternative earnings of the various factors employed in the
production of a good constitute the opportunity cost of a good. In a money economy,
opportunity or transfer cost is defined as the amount of money which a firm must make to
resource suppliers m order to attract these resources away from alternative lines of
production. In the words of Lipsay:

"The opportunity cost of using any factor is what is currently foregone by using it".

The idea of opportunity cost has an important bearing on the decisions involving scarcity of
resources, their alternative uses and the choice.
Analysis of Short Run Cost of Production:

Definition of Short Run:

Short run is a period of time over which at least one factor must remain fixed. For most of
the firms, the fixed resource or factors which cannot be increased to meet the rising
demand of the good is capital i.e., plant and machinery.

Short run, then, is a period of time over which output can be changed by adjusting the
quantities of resources such as labor, raw material, fuel but the size or scale of the firm
remains fixed.

Definition of Long Run:

In the long run there is no fixed resource. All the factors of production are variable. The
length of the long run differs from industry to industry depending upon the nature of
production.

For example, a balloon making firm can change the size of firm more quickly than a car
manufacturing firm.

Categories/Types of Costs in the Short Run:

The total cost of a firm in the short run is divided into two categories (1) Fixed cost and (2)
Variable cost. The two types of economic costs are now discussed in brief.

(1) Total Fixed Cost (TFC):

Total fixed cost occur only in the short run. Total Fixed cost as the name implies is the cost
of the firm's fixed resources, Fixed cost remains the same in the short run regardless of how
many units of output are produced. We can say that fixed cost of a firm is that part of total
cost which does not vary with changes in output per period of time. Fixed cost is to be
incurred even if the output of the firm is zero.

For example, the firm's resources which remain fixed in the short run are building,
machinery and even staff employed on contract for work over a particular period.

(2) Total Variable Cost (TVC):

Total variable cost as the name signifies is the cost of variable resources of a firm that are
used along with the firm's existing fixed resources. Total variable cost is linked with the level
of output. When output is zero, variable cost is zero. When output increases, variable cost
also increases and it decreases with the decrease in output. So any resource which can be
varied to increase or decrease with the rate of output is variable cost of the firm.

For example, wages paid to the labor engaged in production, prices of raw material which a
firm. incurs on the production of output are variable costs. A firm can reduce its variable
cost by lowering output but it cannot decrease its fixed cost. These expenses remain fixed in
the short run. In the long run there are no fixed resources. All resources are variable.
Therefore, a firm has no fixed cost in the long run. All long run costs are variable costs.

(3) Total Cost (TC):

Total cost is the sum of fixed cost and variable cost incurred at each level of output. Total
cost of production of a firm equals its fixed cost plus its:

Formula:

TC = TFC + TVC

Where:

TC = Total cost.

TFC = Total fixed cost.

TVC = Total variable cost.

Explanation:

Short run costs of a firm is now explained with the help of a schedule and diagrams.
Units of Output (in Total

Total Variable Cost Total Cost
Hundred) Fixed Cost
0 1000 0 1000
1 1000 60 1060
2 1000 100 1100
3 1000 150 1150
4 1000 200 1200
5 1000 400 1400
6 1000 700 1700
7 1000 1100 2100
The short run cost data of the firm shows that total fixed cost TFC (column 2) remains
constant at $1000/- regardless of the level of output.

The column 3 indicates variable cost which is associated with the level of output. Total
variable cost is zero when production is zero. Total variable cost increases with the increase
in output. The variable does not increase by the same amount for each increase in output.
Initially the variable cost increases by a smaller amount up to 3 rd unit of output and after
which it increases by larger amounts.

Column (4) indicates total cost which is the sum of TFC + TVC. The total cost increases for
each level of output. The rise in total cost is more sharp after the 4 th level of output.
The concepts of costs, i.e., (1) total fixed cost (2) total variable cost and (3) total cost can be
illustrated graphically.

In this diagram (13.1) the total fixed cost of a firm is assumed to be $1000 at various levels
of output. It remains the same even if the firm's output is zero.

(ii) Total Variable Cost Curve/Diagram:
In the figure (13.2), the total variable cost curve (TVC) increases with the higher level of
output. It starts from the origin. Then increases at a diminishing rate up to the 4th units of
output. It then begins to rise at an increasing rate.

Total Cost Curve Curve/Diagram:
In the figure (13.3), total cost curve which is the sum of the total fixed cost and variable cost
at various levels of output has nearly the same shape. The difference between the two is by
only a fixed amount of $1,000. The total variable cost curve and the total cost curve begin to
rise more rapidly as production is increased. The reason for this is that after a certain
output, the business has passed its most efficient use of its fixed costs machinery, building
etc., and its diminishing return begins to set in.

Average Cost:

Definition and Explanation:

The entrepreneurs are no doubt interested in the total costs but they are equally concerned
in knowing the cost per unit of the product. The unit cost figures can be derived from
the total fixed cost, total variable cost and total cost by dividing each of them with
corresponding output.

Types/Classifications:

(1) Average Fixed Cost (AFC):

Average fixed cost refers to fixed cost per unit of output. Average fixed Cost is found out by
dividing the total fixed cost by the corresponding output.
Formula:AFC = TFC
Output (Q)
For instance, if the total fixed cost of a shoes factory is $5,000 and it produces 500 pairs of
shoes, then the average fixed cost is equal to $10 per unit. If it produces 1,000 pairs of
shoes, the average fixed cost is $5 and if the total output is 5,000 pairs of shoes, then the
average fixed cost is $1 pair of shoe.

From the above example, it is clear, that the fixed cost, i.e., $5,000 remains the same
whether the output is 1,000 or 5,000 units.

Behavior of Average Fixed Cost (AFC):

The average fixed cost begins to fall with the increase in the number of units produced, In
our example stated above, average fixed cost in the beginning was $10. As the output of the
firm increased, it gradually came down to $1. The AFC diminishes with every increase in the
quantity of output produced but it never becomes zero.

Diagram/Curve
The concept of average fixed cost can be explained with the help of the curve, in the
diagram (13.4) the average fixed cost curve gradually falls from left to right showing the
level of output. The larger the level of output, the lower is the average fixed cost and
smaller the level of output, the greater is the average fixed cost. The AFC never becomes
zero.

(2) Average Variable Cost (AVC):

Average variable cost refers to the variable expenses per unit of output Average variable
cost is obtained by dividing the total variable cost by the total output.

For instance, the total variable cost for producing 100 meters of cloth is $800, the average
variable cost will be $8 per meter.

Formula:
AVC = TVC
(Q)

Behavior of Average Variable Cost:

When a firm increases its output, the average variable cost decreases in the beginning,
reaches a minimum and then increases. Here, a question can be asked as to why AVC
decreases in the beginning reaches a minimum and then increases. The answer to this
question is very simple.

When in the beginning, a firm is not producing to its full capacity, then the various factors of
production employed for the manufacture of a particular commodity remain partially
absorbed. As the output of the firm is increased, they are used to its fullest extent. So the
AVC begins to decrease. When the plant works to its full capacity, the AVC is at its minimum.
If the production is pushed further from the plant capacity, then less efficient machinery
and less, efficient labour may have to be employed. This results in the rise of AVC. It is in this
way we say that as the output of a firm increases, the AVC decreases in the beginning,
reaches a minimum and then increases. The AVC can also be represented in the form of a
curve.

Diagram/Curve:
The shape of the average variable cost curve (Fig. 13.5) is like a flat U-shaped curve. It shows
that when the output is increased, there is a steady fall in the average variable cost due to
increasing returns to variable factor. It is minimum when 500 meters of doth are produced.
When production is increased to 600 meters, of cloth or more, the average variable cost
begins to increase due to diminishing returns to the variable factor.

(3) Average Total Cost (ATC):

Average total cost refers to cost (both fixed and variable) per unit of output. Average total
cost is obtained by dividing the total cost by the total number of commodities produced by
the firm or when the total sum of average variable cost and average fixed cost is added
together, it becomes equal to average total cost.

Formula:

ATC = Total Cost (TC)
Output (Q)

Behavior of Average Total Cost:

As the output of a firm increases, average total cost like the average variable cost decreases
in the beginning reaches a minimum and then it increases. The reasons for decline of ATC in
the beginning are that it is the sum of AFC and AVC.

Average fixed cost and average variable costs have both the tendency to fall as output is
increased. Average total cost will continue falling so long average variable cost does not rise.
Even if average variable cost continues rising, it is not necessary that the average total cost
will rise. It can be due to the fact that the increase in average variable cost is less than the
fall in average fixed cost. The increase in average variable cost is counterbalanced by a rapid
fall of average fixed cost. If the rise in the average variable cost is greater than the fall in
average fixed cost, then the average total cost will rise.

The tendency to rise on the part of average total cost-in the beginning is slow, after a
certain point it begins to increase rapidly.

Diagram/Curve:
Short Run and Long Run Average Cost Curves:

Relationship and Difference:

Short Run Average Cost Curve:

In the short run, the shape of the average total cost curve (ATC) is U-shaped. The, short
run average cost curve falls in the beginning, reaches a minimum and then begins to rise.
The reasons for the average cost to fall in the beginning of production are that the fixed
factors of a firm remain the same. The change only takes place in the variable factors such
as raw material, labor, etc.

As the fixed cost gets distributed over the output as production is expanded, the average
cost, therefore, begins to fall. When a firm fully utilizes its scale of operation (plant size), the
average cost is then at its minimum. The firm is then operating to its optimum capacity. If a
firm in the short-run increases its level of output with the same fixed plant; the economies
of that scale of production change into diseconomies and the average cost then begins to
rise sharply.

Long Run Average Cost Curve:

In the long run, all costs of a firm are variable. The factors of production can be used in
varying proportions to deal with an increased output. The firm having time-period long
enough can build larger scale or type of plant to produce the anticipated output. The shape
of the long run average cost curve is also U-shaped but is flatter that the short run curve as
is illustrated in the following diagram:

Diagram/Figure:
In the diagram 13.7 given above, there are five alternative scales of plant SAC 1 SAC2, SAC3,
SAC4 and, SAC5. In the long run, the firm will operate the scale of plant which is most
profitable to it.

For example, if the anticipated rate of output is 200 units per unit of time, the firm will
choose the smallest plant It will build the scale of plant given by SAC 1 and operate it at point
A. This is because of the fact that at the output of 200 units, the cost per unit is lowest with
the plant size 1 which is the smallest of all the four plants. In case, the volume of sales
expands to 400, units, the size of the plant will be increased and the desired output will be
attained by the scale of plant represented by SAC 2 at point B, If the anticipated output rate
is 600 units, the firm will build the size of plant given by SAC 3 and operate it at point C where
the average cost is $26 and also the lowest The optimum output of the firm is obtained at
point C on the medium size plant SAC3.

If the anticipated output rate is 1000 per unit of time the firm would build the scale of plant
given by SAC5 and operate it at point E. If we draw a tangent to each of the short run cost
curves, we get the long average cost (LAC) curve. The LAC is U-shaped but is flatter than tile
short run cost curves. Mathematically expressed, the long-run average cost curve is the
envelope of the SAC curves.

In this figure 13.7, the long-run average cost curve of the firm is lowest at point C. CM is the
minimum cost at which optimum output OM can be, obtained.
Marginal Cost (MC):

Definition:

Marginal Cost is an increase in total cost that results from a one unit increase in output. It is
defined as:

"The cost that results from a one unit change in the production rate".

Example:

For example, the total cost of producing one pen is $5 and the total cost of producing two
pens is $9, then the marginal cost of expanding output by one unit is $4 only (9 - 5 = 4).

The marginal cost of the second unit is the difference between the total cost of the second
unit and total cost of the first unit. The marginal cost of the 5th unit is $5. It is the difference
between the total cost of the 6th unit and the total cost of the, 5th unit and so forth.

Marginal Cost is governed only by variable cost which changes with changes in output.
Marginal cost which is really an incremental cost can be expressed in symbols.

Formula:
Marginal Cost = Change in Total Cost = ΔTC
Change in Output Δq

The readers can easily understand from the table given below as to how the marginal cost is
computed:

Schedule:

Units of Output Total Cost (Dollars) Marginal Cost (Dollars)
1 5 5
2 9 4
3 12 3
4 16 4
5 21 5
6 29 8

Graph/Diagram:

MC curve, can also be plotted graphically. The marginal cost curve in fig. (13.8) decreases
sharply with smaller Q output and reaches a minimum. As production is expanded to a
higher level, it begins to rise at a rapid rate.

Long Run Marginal Cost Curve:

The long run marginal cost curve like the long run average cost curve is U-shaped. As
production expands, the marginal cost falls sharply in the beginning, reaches a minimum
and then rises sharply.

Relationship Between Log Run Average Cost and Marginal Cost:

The relationship between the long run average total cost and log run marginal cost can be
understood better with the help of following diagram:

t is clear from the diagram (13.9), that the long run marginal cost curve and the long run
average total cost curve show the same behavior as the short run marginal cost curve
express with the short run average total cost curve. So long as the average cost curve is
falling with the increase in output, the marginal cost curve lies below the average cost
curve.

When average total cost curve begins to rise, marginal cost curve also rises, passes through
the minimum point of the average cost and then rises. The only difference between the
short run and long run marginal cost and average cost is that in the short run, the fall and
rise of curves LRMC is sharp. Whereas In the long run, the cost curves falls and rises
steadily.
3.9 Break Even Analysis – Meaning, Assumptions, Determination of BEA,
Limitations, Uses of BEA in Managerial decisions (with simple Problems).
Break-Even Point
Contents:
1. Definition of Break-Even Point
2. Determination of the Break-Even Point
3. Break-Even Point Charts
4. Assumptions Underlying Break-Even Point
5. Managerial Uses of Break-Even Point
6. Limitations of Break-Even Point
1. Definition of Break-Even Point:

Break-even analysis involves the study of revenues and costs of a firm in relation to its
volume of sales and specifically the determination of that volume at which the firm’s costs
and revenues will be equal. The break-even point (BEP) maybe defined as that level of sales
at which total revenues equal total costs and the net income is equal to zero. This is also
known as no-profit no-loss point.
The main objective of the break-even analysis is not simply to spot the BEP, but to develop
an understanding of the relationship of cost, price, and volume within a company’s practical
range of operations. The break-even chart is an “excellent instrument panel for your
guidance in controlling your business.”
2. Determination of the Break-Even Point:

Break-even point may be determined either in terms of physical units or in money terms,
i.e., sales value in rupees.
1. Break-Even Point in Terms of Physical Units:
This method is convenient for the single-product firm. The break-even volume is the number
of units of the product which must be sold to earn enough revenue just to cover all
expenses—both fixed and variable. The selling price of a unit covers not only its variable
cost but also leaves a margin (contribution margin) to contribute toward the fixed costs
(costs remaining fixed irrespective of the volume).
The breakeven point is reached when sufficient numbers of units have been sold so that the
total contribution margin of the units sold is equal to the fixed costs. The formula for
calculating the break-even point is as follows –
BEP = Fixed cost/Contribution margin per unit
Where the contribution margin is selling price-variable costs per unit.
2. Break-Even Point in Terms of Sales Value:
Multi-product firms are not in a position to measure the break-even point in terms of any
common unit of product. They find it convenient to determine their breakeven point in
terms of total rupee sales. Here, again, the break-even point would be the point where the
contribution margin (Sales value – Variable costs) would equal the fixed costs. The
contribution margin, however, is expressed as a ratio to sales. For example, if the sales are
Rs.200 and the variable cost of these sales is Rs.140, the contribution margin ratio is (200 –
140)/200, i.e., 0.3.
BEP = Fixed cost/Contribution ratio
3. Break-Even Charts:
Break-even analysis is very commonly presented by means of break-even charts, also known
as profit-graphs. A break-even chart prepared on the basis of Example I is represented in Fig.
3.19. Units of product are shown on the horizontal axis OX, and revenues and costs are
shown on the vertical axis OY. The fixed costs are shown on the vertical axis OY. The fixed
costs of Rs.10,000 are represented by a straight line parallel to the horizontal axis.
Variable costs are then plotted over and above the fixed costs. The resultant line is the total
cost line, combining both variable cost lines in the graph; variable costs are represented by
the vertical distance between the fixed cost and the total cost lines. The total cost at any
point is the sum of Rs.10,000 plus Rs.2.00 per unit of variable cost multiplied by the number
of units sold at that point.
Total revenue at any point is the unit price of Rs.4.00 multiplied by the number of units sold.
The break-even point corresponds to the point of intersection of the total revenue and the
total cost lines.
Projecting a perpendicular from the BEP to the horizontal axis shows the break-even point in
units of the product. Dropping a perpendicular from BEP (or to the left of it), total costs are
more than total revenue and the firm would suffer a loss. Above BEP (or to its right), total
revenue exceeds total costs and the firm would be making profits. Since profit or loss occurs
between costs and revenue lines, the space between them is known as the profit zone (to
the right of the BEP) and the loss zone (to the left of the BEP).
Where the BEP is measured in terms of sales rupee value rather than in physical units, the
break-even chart remains basically the same as in Fig. 3.20. The only difference is that the
volume on the X-axis is measured in terms of sales value. In that case, a perpendicular from
the point BEP to either axis would show the break-even rupee sales value. The same type of
chart can be used to depict the BEP in relation to full capacity: in this case, the horizontal
axis would represent the percentage of full capacity, instead of physical units or the sale
value.
Break-Even Chart—A Variation:

The adjoining chart is a variation of the traditional break-even graph. This graph is prepared
with the variable cost line (instead of fixed cost line) starting at the zero axis. It is
superimposed the total cost line which includes the fixed cost and is, therefore, parallel to
the variable cost line. This graph is more useful as much as the contribution to fixed cost and
profit is more clearly shown.
4. Assumptions Underlying Break-Even Point:
1. All costs are either perfectly variable or absolutely fixed over the entire range of the
volume of production. In practice, however, this assumption may not hold true over the
entire range of production.
2. All revenue is perfectly variable with the physical volume of production. This assumption
may not be valid in all cases, e.g., lower prices may be charged to large customers.
3. The volume of sales and the volume of production are equal. Everything produced is sold
and there is no change in the closing inventory. In practice, sales and production volumes
may differ significantly.
4. However, these assumptions are not so unrealistic as to impair the validity of the break-
even analysis.
5. In the case of multi-product firms, the product-mix should be stable. For a multi-product
firm, the BEP is determined by dividing total fixed costs by an average ratio of variable profit
(contribution) to sales. If each product has the same contribution ratio, the BEP is
unaffected by changes in the product-mix.
However, if different products have different contribution ratios, a shift in the product-mix
may cause a shift in the break-even point. In real life, the assumption of stable product-mix
is somewhat unrealistic.
5. Managerial Uses of Break-Even Point:
To the management, the utility of break-even analysis lies in the fact that it presents a
microscopic picture of the profit structure of a business enterprise. Break-even analysis not
only highlights the areas of economic strength and weaknesses in the firm but also sharpens
the focus on certain leverages which can be operated upon to enhance its profitability.
Ever changing contributions are characteristics of modern business life, and through break-
even analysis, it is possible for the management to examine the profit vulnerability of a
business firm to the possible changes in business conditions, for example, sales prospects,
changes in cost structure, etc. Through break-even analysis, it is possible to devise
managerial actions to maintain and enhance profitability of the firm.
The break-even analysis can be used for the following purposes:
1. Margin of Safety:
The break-even chart can help the management to know at a glance the profits generated at
the various levels of sales. But while deciding upon the volume at which the firm would
operate, apart from the demand, the management should consider the “safety margin”
associated with the proposed volume. The safety margin refers to the extent to which the
firm can afford a decline in sales before it starts incurring losses. The formula to determine
the safety margin is
Margin of safety = [(Actual Sales – BEP)/Actual sales] x 100
Margin of safety = [(8,000 – 80,000)/8,000] x 100 = 37.5%
That is, we can afford to lose sales up to 37.5 per cent of the present level before incurring a
loss. If the safety margin is dropping over a period of time, it would mean that the firm’s
resistance capacity to avoid losses has become poorer. A margin of safety can be negative as
well. In that case, it reveals the percentage increase in sales necessary to reach the BEP so
as to avoid losses at least.
Thus, it reveals the minimum extent of sales effort expected of the management. Suppose in
our example, sales are as low as 4,000 units. The safety margin would be –
Margin of safety = (4000 – 5,000)/4,000 = – 25%
In other words, the management must strive to increase sales at least by 25 per cent to
avoid losses.
2. Drop and/or Add Decision:
A business manager is often confronted with the following questions:
(a) Should a new product be added in view of its estimated revenue and cost?
(b) Should a particular item be dropped from the product line and what would be its
consequent effects on revenue and cost?
Break-even analysis is quite useful in deciding the question of product planning.
3. Make or Buy Decision:
Many business firms often have the option of making certain components or ingredients,
which are part of their finished products, or purchasing them from outside suppliers. For
instance, an automobile manufacturer can make spark plugs or buy them. Break-even
analysis can enable the manufacturer to decide whether to make or buy.
4. Choosing Promotion-Mix:
Sellers often use several modes of sales promotion, e.g., personal selling, advertising, and
the like. However, the proportion of various modes in the promotion-mix varies from seller
to seller. A retail shop may have to consider whether to employ a certain number, say five,
of additional salesmen.
A manufacturer may have to decide if he should spend an additional sum of Rs.20,000 on
advertising his product. Break-even analysis enables him to take appropriate decisions by
showing how these additional fixed costs would influence the break-even points.
6. Limitations of Break-Even Point:
We may now mention certain important limitations which ought to be kept in mind while
using break-even analysis:
1. When break-even analysis is based on accounting data, as it usually happens, it may suffer
from various limitations of such data. For example, neglect of imputed costs, arbitrary
depreciation estimates, and inappropriate allocation of overhead costs. Break-even analysis,
therefore, can be sound and useful only if the firm in question maintains a good accounting
system and uses proper managerial accounting techniques and procedures. The figures
must be adequate and sound. If break-even analysis is based on past data, the same should
be adjusted for changes in wages and price of raw materials.
2. Break-even analysis is static in character. It is based on the assumption of given

relationship between costs and revenues, on the one hand, and input, on the other.
However, costs and revenues may change over time making the projection based on past
data wrong. As such, break-even analysis is more useful in situations relatively stable and
slow-moving rather than extremely volatile, erratic, and widely changing ones.
3. Costs in a particular period may not be caused entirely by the output in that period. For
example, maintenance expenses may be the result of past output or a preparation for
future output; it may, therefore, be difficult to attribute them to a particular period.
4. Selling costs are especially difficult to handle in break-even analysis. This is because
changes in selling costs are a cause and not a result of changes in output and sales. Besides,
the relationship between output and selling expenses is unstable over time, rendering the
projection of past relationship into future inaccurate.
5. A straight-line total revenue curve presumes that any quantity might be sold at that one
price. This implies a horizontal demand curve and can be true only under conditions
approximating perfect competition. Hence, to be realistic, calculations are often made at
several price levels.
Several total revenue curves are required instead of just one, because, in real world, perfect
competition is rare; or else demand and demand schedules will not get the weight and
respect due to them.
6. A basic assumption in break-even analysis is that the cost-revenue-volume relationship is
linear. This is realistic only over narrow ranges of output. For example, this type of analysis
is worthwhile in deciding whether- (a) selling price should be 50 or 60 paise, (b) volume
should be attempted at 80 per cent of capacity rather than 85 per cent, (c) advertising
expenditure should total Rs.1,00,000 or Rs.1,15,000, or (d) the product should be put in a
package costing 70 paise rather than 90 paise.
7. Break-even analysis is not an effective tool for long-range use and its use should be
restricted to the short run only. The break-even analysis should better be limited to the
budget period of the firm which is usually the calendar year.
8. The area included in the break-even analysis should be limited. If too many products, too
many departments, or too many plants are lumped together and graphed on a single break-
even chart, both good and bad performances can easily be buried in the total picture of the
group. While the above limitation is valid, the job of getting data by product or by brand
(and this is often what management requires) can be quite difficult.
9. Break-even analysis assumes that profits are a function of output ignoring the parent fact
that they are also caused by other factors such as technological change, improved
management, changes in the scale of the fixed factors of production, and so on.
In view of the limitations, doubts have sometimes been raised about the utility of break-
even analysis unless it is made complex. The truth, however, remains that break-even
analysis is a device, simple, easy to understand, and inexpensive and hence quite useful to
management whose primary concern is to cut through the complexity of real world and
focus attention on basic relationships.
Of course, its usefulness buries from industry. Industries suffering from frequent, volatile
changes in input prices, rapid technological changes, and constant shifts in product-mix will
not benefit much from break-even analysis. Finally, break-even analysis should be viewed as
a guide to decision making and not as a substitute for judgment, logical thinking, or common
sense.

Economics For Managers MODULE 3

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Module 3: Consumer and Producer

Consumer behaviour refers to human behaviours which go in making purchase decisions.

Meaning of consumer behaviour:

Nature of Human Wants

 Human wants tend to be competitive. We have limited means and so we cannot

 Over time wants of a person can become his habits or customs.

Classification of Human Wants

What is Consumer Behaviour ?

Why do you think an individual buys a product ?

Why do you think an individual does not buy a product ?

The study of consumer behaviour explains as to:

 Why and why not a consumer buys a product ?

During Christmas, the buying tendencies of consumers increase as compared to other

Following are the sources of information:

Buying decisions of consumers also depend on the following factors:

 Messages, advertisements, promotional materials, a consumer goes through also

6) Measurement of utility is hypothetical : Utility is an abstract concept. Cardinal or

Possession utility : Possession utility arises when the ownership of goods is

Examples : 1) A dentist giving dental treatment to a patient.

2) A mountaineer using oxygen cylinder at a high altitude.

MU = Marginal Utility of nth unit.

TU = Total Utility at nth level.

Relationship between Total Utility and Marginal Utility :

Units of Total Marginal

TABLE 4.1: NUMBER OF UNITS OF COMMODITY

The measurement of utility has always been a controversial issue. Different

CARDINAL UTILITY APPROACH - NEO CLASSICAL APPROACH:

Neo-classical economists believed that utility is cardinal or quantitative like other

 Diminishing marginal utility: The marginal utility of a commodity diminishes as an

Where Px is the price of the commodity, MU x is the marginal utility of the

A utility maximising consumer reaches the equilibrium when:

ORDINAL UTILITY APPROACH – INDIFFERENCE CURVE ANALYSIS:

Assumptions of Ordinal Utility Meaning of Indifference Curve

Marginal Rate of Substitution Properties of Indifference Curve

4.6.1 ASSUMPTIONS OF ORDINAL UTILITY

4.6.2 MEANING OF INDIFFERENCE CURVE

When the indifference schedule for X and Y is plotted on a graph, a curve is

On the indifference curve (IC), there can be several other points in

4.6.1 MARGINAL RATE OF SUBSTITUTION

may be defined as the quantity of commodity X required to replace one nit of

TABLE 4.3: DIMINISHING MRS BETWEEN X AND Y

Similarly when the consumer moves from combination b to c, he/she sacrifices 7

4.6.3 PROPERTIES OF INDIFFERENCE CURVE

 CRITICISM OF INDIFFERENCE CURVE

Although the concept of IC is vital to explain the ordinal approach, it is criticised on

Figure 4.6: Points of Criticism against Indifference Curve

Let us discuss these points of criticism in detail:

CONSUMER EQUILIBRIUM EFFECTS:

Therefore, the slope of the curve would be:

At point E where MRSy, x  Px / Py

The above explanation of the consumer equilibrium is based on an assumption that

Substitution Effect on Consumer’s Equilibrium

Price Effect on Consumer’s Equilibrium

Figure 4.11 Effects on Consumer Equilibrium

4.8.1 INCOME EFFECT ON CONSUMER EQUILIBRIUM

Income effect on consumer’s equilibrium can be defined as the effect caused by

Figure 4.12: Effect of Change in Income on Consumer’s Equilibrium

Point E is the original point of consumer’s equilibrium. At point E, the indifference

Let us understand this with the help of Figure 4.13:

4.8.2 PRICE EFFECT ON CONSUMER EQUILIBRIUM

Figure 4.14: Effect of Price on Consumer’s Equilibrium

3.4 Application of Indifference curve analysis: