DEPARTMENT OF MANAGEMENT STUDIES

SMS-5103
Managerial Economics
 Course Contents:

Demand and Supply analysis✔

Utility: Cardinal and ordinal ✔

Consumer Theory✔

Production and cost analysis

Theory of markets and pricing strategies

❖Perfect competition
❖Monopoly
❖Monopolistic competition
 Production and cost analysis
❖Production:
Introduction
Total product, marginal product and average product
Law of variable proportions
Law of returns to scale
Isoquants and marginal rate of technical substitution

❖Cost:
Concept and types of cost
Isocost and shifts in isocost
Equilibrium
Introduction:

•Production process

•Production function
 Production process

•Combination of factor inputs to produce one unit of output

Process 1 Process 2 Process 3

Labour units 2 3 1

Capital units 3 2 4
 Production function

•Relationship between factor inputs and outputs

Y= f (L,K)
Total product, marginal product, average product

Total product is the total amount of output produced by a given amount

of a factor of production/input

Marginal product is the addition in total product for employing one

additional unit of a factor/input:
MPL= dTP/dL or
MPK =dTP/dK

It is also the slope of the total product curve

Average product is the total product/output produced per unit of factor

employed:
AP= TP/Units of factor /input
= TP/L or TP/K
 Law of variable proportions
Assumptions:
•It assumes a short-run situation
•The price of the product is given and constant
•Only one factor is variable and others kept constant
•All units of the variable factor are homogeneous
•There is no change in technology

The law:
•The law of variable proportions state how the total product changes as the
variable input is changed (and hence the proportions of the factor inputs change).

•This law also establishes the relationship between total product, average product
and marginal product
Capital Labour TP AP MP
(K) (L)
4 1 8 8 8
4 2 20 10 12
4 3 36 12 16
4 4 48 12 12
4 5 55 11 7
4 6 60 10 5
4 7 60 8.6 0
4 8 56 7 -4
Stage 1: Stage of increasing returns

Stage 2: Stage of diminishing returns

Stage 3: Stage of negative returns

 Law of returns to scale
Assumptions:
•It assumes a long run
•All the factors are variable
•No change in technology
•There is perfect competition

The law:
•The law describes the relationship between outputs and the scale of inputs
in the long run when all the inputs are increased in the same proportion

•When all the inputs are increased in same proportion and the scale of
production is increased, the effect on output can occur in three stages:
•Increasing returns to scale
•Constant returns to scale
•Decreasing returns to scale
Labour Capital Total Marginal
returns returns
1 2 8 8
2 4 17 9
3 6 27 10
4 8 38 11
5 10 49 11
6 12 59 10
7 14 68 9
8 16 76 8
 Isoquants and marginal rate of technical substitution

Isoquant:
•Firm’s counterpart of a consumer’s indifference curve
•It is a curve showing locus/combinations of inputs that yield the same level
of output
•Also called equal product curve, production indifference curve or iso
product curve.

Isoquant map:
•Set of isoquants that shows different levels of output form given
combinations of inputs
•Higher isoquants represent higher output

Properties of isoquant:
•Higher isoquant represent higher levels of output
•Two isoquants cannot intersect each other
•Isoquants are convex to the origin (because of diminishing marginal rate of
technical substitution)
 Isoquants and marginal rate of technical substitution
(contd..)

•Marginal rate of technical substitution (MRTS): Slope of isoquant

MRTSLK- Amount of K given up to employ one extra unit of L so that the

output remains the same

MRTSKL - Amount of L given up to employ one extra unit of K so that the

output remains the same

•MRTS is diminishing
 Iso cost and its shifts
Iso Cost
•Possible combinations of two factors that can be employed/used at given
costs (prices of factors) and for a given producers budget (expenditure)

•Graphical representation of various combinations of two factors (L&K)

which the firm can afford with a given budget.

•C= wL+ rK
w= wages or price of labor
r= interest rate or price of capital

•Also called price line or outlay line

•X intercept= C/w
•Y intercept= C/r
•Slope= -w/r [ratio of prices of two inputs]
 Iso cost and its shifts

Shifts in the Iso Cost line:

Shift can happen due to:

•Changes in the prices of factors

•Changes in the total outlay/expenditure

 Iso cost and its shifts
Changes in prices of factors:
❖Change in prices of labour - Increase in w and decrease in w
❖Changes in prices of capital- increase in r and decrease in r

Increase in w
C=wL+rK
X intercept (C/w): decreases
Y intercept (C/r): same
Slope (-w/r): increases
Shift: Rotation of iso cost towards left
with fixed y intercept
Decrease in w
C=wL+rK
X intercept (C/w): increases
Y intercept (C/r): same
Slope (-w/r): decreases
Shift: Rotation of iso cost towards right
with fixed y intercept

Increase in r
C=wL+rK
X intercept (C/w): same
Y intercept (C/r): decreases
Slope (-w/r): decreases
Shift: Rotation of iso cost towards left
with fixed x intercept
Decrease in r
C=wL+rK
X intercept (C/w): same
Y intercept (C/r): increases
Slope (-w/r): increases
Shift: Rotation of iso cost towards right
with fixed x intercept
 Iso cost and its shifts
Changes in total outlay:
❖Increase in C
❖Decrease in C

Increase in C Decrease in C
C=wL+rK C=wL+rK
X intercept (C/w): increases X intercept (C/w): decreases

Y intercept (C/r): increases Y intercept (C/r): decreases

Slope (-w/r): same Slope (-w/r): same

Shift: parallel shift of isocost towards the Shift: parallel shift of isocost towards the
right left
 Equilibrium
•A producer is in equilibrium when he can attain maximum level of
output, given his constraints

•Graphically producer equilibrium is derived at the tangency of isocost

and the highest attainable isoquant

•Mathematically, consumer is in equilibrium where the slope of isocost

equals the slope of isoquant

w/r= MPL/MPK
 Concept and types of cost
Fixed cost- Cost that does not vary with the volume of production. It remains fixed
even if there is no production. It is also called unavoidable cost.

Variable cost- Costs that vary with the level of output.

 Concept and types of cost

Total cost: Total costs incurred for producing a given level of output.
TC= TFC or FC + TVC or VC
 Concept and types of cost

Average cost:
Average cost is the cost incurred per unit of output
It can also be calculated as the total of average fixed cost and average variable
cost.

AC= TC/Q
= (FC+VC)/Q
= FC/Q+ VC/Q
= AFC+AVC

Marginal Cost:
Additional cost incurred for producing an extra unit of output.

MC= dTC/dQ