Micro Economics

Term 1
Academic Year 2022-24
Prof. Sumirtha Gandhi
Email: Sumirtha@gmail.com; sumirtha@base.ac.in
Why do firms exist?
Earlier: Farmers, Money Now: Kellogs, Banks
lenders (Barter System) etc.

 What happens if people work as individual producers? Why can’t all of us work independently.
 Why do we have markets, stores, schools, colleges, banks and so on..
 If all work at individual level: (i) Can’t carry out decision making (decision of inputs, outputs,
pricing etc)
(ii) Negotiation based payments for all services.
(iii) If any change in output – go back to revise cost and prices.

Thus, we need some system/mechanism – that works on co-ordination and on the basis of certain
behaviour and trends (we will cover in this chapter)
Why do firms exist?
Individual Production – Inefficient – Compromise on Costs and Quality.
Firms : Managers, who decide:
Labour decisions (no of workers to hire and their salary, what to do, when to do and so on..)
No need of negotiating for type of work and salary!
Disadvantages of Firms !
Firms: Also inefficient sometimes
Shirking (Information Asymmetry)
Take decisions according to their interest.

But we start with Producer theory considering it relatively efficient.

 Production (Chapter 6)
•Theory of firm: (i) Cost minimizing Production Decisions, (ii) How does this cost vary
with changes in production? (iii) Deciding Output to maximize Profit.
•This helps us analyse market supply. (just the way consumer behaviour helped us to
understand market demand)
• Helps managers to decide about the following and help solve business problems:
(i) What product to be produced ? (Also depends on consumer behaviour, remember
elasticity)
(ii) Which inputs to use and what technology to adopt ? (Cost decisions)
(iii) Quantity of product and Price of product (To cover up costs and maximize profit,
Marginal Revenue = Marginal Cost)
(iv) Allocate funds to various inputs (equi-marginal principle )
 Production (Chapter 6)
(v) Decisions on size and location of Plant.
(vi) Long run and Short run decisions.
Three components of Producer Theory :
1. Production Technology/production process : How inputs can be transformed into
outputs.
E.g. MNC: Labour  Consultancy Services
Bank: Labour, Deposits  Loans
Airlines: Crew, Fuel, Machinery, Capacity  Flight Frequency
So the firm makes decisions related to inputs.
Production (Chapter 6)
Inputs used are called the Factors of Production.
Examples: Land, Labour (skilled/unskilled), Capital (Machinery), Raw materials,
electricity, water, land etc.
Production Function: Function showing the highest amount of output that a firm can
produce for every combination of inputs. (For a given technology!!)
Mathematically, q=f(K*L)
NOTE: Inputs and Outputs are flow variables (measured over a period of time)
2. Cost Constraint
Cost depends on prices of the inputs and the firm aims to minimise costs to maximise
profits (=Total Revenue – Total Cost)
Production (Chapter 6)
3. Input Choice
Given 1 (Production Function) and 2 (Prices of inputs), the firm chooses the level of
inputs to be used. E.g. Developing countries (Cheap Labour), Developed countries (High
wage rates)
NOTE: Short Run Versus Long Run
Short Run : Unable to make changes in all inputs. (Lack of liquidity – land). At least one
input that can’t be adjusted.
Long Run: All inputs are variable. E.g. Constructing new plants.
No pre-defined threshold.
 Average and Marginal Product

Source: https://www.stlouisfed.org/on-the-economy/2015/november/india-labor-development-puzzling
Average and Marginal Product
What will you do to increase Production/Output?: Increase the level of inputs, right?
Thus, an analysis of how output changes as inputs are varied is required. For this
analysis, following concepts are useful:
Average Product: Output per unit of a particular input = q/L
Marginal Product: Additional output produced as an input is increased by one unit=
q/ L.
Average and Marginal Product
 Relation between Marginal
Product and Average Product.
 When Marginal Product >
Average Product, Average
Product is rising. (It might
happen that Marginal Product
is falling and MP>AP)
 When Marginal Product <
Average Product, Average
product falls.
 Only when Average Product
is at maximum, Marginal
Product=Average Product.
Total and Marginal Product
 When Marginal Product rises, initially
Output increases by large amount. (MP
is rising)
 Later, Output rises but in a smaller
magnitude. (MP starts falling).
 At MP=0, Output is maximum (AT M).
 If MP<0, TP starts falling.
Total, Average
and Marginal
Product
§ Average Product: Slope of the
line drawn from Origin to the
point on Total Product Curve.
§ Marginal Product: Slope of
Total Product Curve at a
particular point.
Why does Marginal Product fall? Law
of diminishing Marginal Returns
 According to the law, as the use of
one input rises (with other inputs
fixed), the resulting additions to
output will eventually fall.
 What happens to the Total Product
Curve with better technology?
Production with two inputs
(Isoquant)
 What is Isoquant? Curve showing all the possible
combination of inputs that yield same Output.
 Isoquant Map: Graph consisting of number of
Isoquants describing a production function.
 What is the slope of isoquant? Marginal Rate of
Technical Substitution. = Amount by which the
quantity of one input can be reduced when one
extra unit of another input is used, so that output
remains same.
Production with two inputs
(Isoquant)
 What happens to slope of Isoquant as we move
down the Isoquant?
 Role of Diminishing Marginal Returns
 K/ L= Marginal Product of L/Marginal
Product of K.
 Find out the Marginal Rate of Technical
Substitution for the following isoquants:
 Q= 3L+2K
 Q= (2L+2K)^1/2
Isoquant : Two Special cases
Returns to Scale
https://www.business-standard.com/article/current-affairs/wef-2022-every-dollar-invested-in-social-jobs-t
o-yield-2-3-return-122052601012_1.html
Short run : Output can’t be changes drastically (Why? Because at least one input would be fixed in
short run).
Long Run: All the inputs are variable, So what happens if all the inputs are changed by same
proportion ? What would happen if all inputs are doubled?
Output will rise for sure, But by how much?
Output can double, it can rise by more than double, it can rise by less than double: The rate at
which output increases as inputs increase proportionately is called Returns to Scale.
In case of complementary inputs – it would double. This is called Constant Returns to Scale. It is
a situation in which output rises by the same proportion in which all the variables are increased.
 Returns to Scale (Cont..)
 If output more than doubles when all inputs are doubled, it is a situation of Increasing Returns to Scale. It
is a situation in which output rises by a higher proportion vis-à-vis the proportion in which all the
variables are increased.
The idea of increasing returns first came from Adam Smith: by means of his famous pinmaking example, Adam Smith
illustrated how specialization or division of labour could lead to lower unit costs.
Why do increasing returns occur ? Large scale of Operation allows employees to specialise in their
respective tasks and make them efficient.
Example: Large scale Operations
If output less than doubles when all inputs are doubled, it is a situation of Decreasing Returns to Scale. It
is a situation in which output rises by a lesser proportion vis-à-vis the proportion in which all the variables
are increased.
Why do decreasing returns occur ? Small scale producers (farmers with small landholding), Sometimes it
can happen in case of extremely large-scale operations where co-ordination and communication eventually
becomes difficult.
Returns to Scale (Cont..)
Returns to Scale (Cont..)
Comment on the returns to scale of the following production functions: