Macro-economics

Page 1

A Hand Note for Department of Finance

Marginal utility (MU) =

đ??śđ?‘•đ?‘Žđ?‘›đ?‘”đ?‘’ đ?‘–đ?‘› đ?‘Ąđ?‘œđ?‘Ąđ?‘Žđ?‘™ đ?‘˘đ?‘Ąđ?‘–đ?‘™đ?‘–đ?‘Ąđ?‘Ś đ??śđ?‘•đ?‘Žđ?‘›đ?‘”đ?‘’ đ?‘–đ?‘› đ?‘žđ?‘˘đ?‘Žđ?‘›đ?‘Ąđ?‘–đ?‘Ąđ?‘Ś đ?‘?đ?‘œđ?‘›đ?‘ đ?‘˘đ?‘šđ?‘’đ?‘‘

=

∆đ?‘‡đ?‘ˆ ∆đ?‘„

∙

Prepared By Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

1|Page

Economics Economics Economics is a social science that studies individuals' economic behavior, economic phenomena, as well as how individual agents, such as consumers, firms, and government agencies, make tradeoff choices that allocate limited resources among competing uses. People's desires are unlimited, but resources are limited, therefore individuals must make trade-offs. We need economics to study this fundamental conflict and how these trade-offs are best made.

Modern Economic Modern economics mainly developed in last sixty years, systematically studies individuals' economic behavior and economic phenomena by a scientific studying method - observation→ theory →observation- and through the use of various analytical approaches.

Economic Theory An economic theory, which can be considered an axiomatic approach, consists of a set of assumptions and conditions, an analytical framework, and conclusions (explanations and/or predications) that are derived from the assumptions and the analytical framework. Like any science, economics is concerned with the explanation of observed phenomena and also makes economic predictions and assessments based on economic theories. Economic theories are developed to explain the observed phenomena in terms of a set of basic assumptions and rules.

Microeconomic theory Microeconomic theory aims to model economic activities as the interaction of individual economic agents pursuing their private interests.

Micro Economics Vs Macroeconomics Microeconomics is generally the study of individuals and business decisions, macroeconomics looks at higher up country and government decisions. Macroeconomics and microeconomics, and their wide array of underlying concepts, have been the subject of a great deal of writings. The field of study is vast; here is a brief summary of what each covers: Microeconomics is the study of decisions that people and businesses make regarding the allocation of resources and prices of goods and services. This means also taking into account taxes and regulations created by governments. Microeconomics focuses on supply and demand and other forces that determine the price levels seen in the economy. For example, microeconomics would look at how a specific company could maximize it's production and capacity so it could lower prices and better compete in its industry. (Find out more about microeconomics in Understanding Microeconomics.) Macroeconomics, on the other hand, is the field of economics that studies the behavior of the economy as a whole and not just on specific companies, but entire industries and economies. This looks at economy-wide phenomena, such as Gross National Product (GDP) and how it is affected by changes in unemployment, national income, rate of growth, and price levels. For example, macroeconomics would look at how an increase/decrease in net exports would affect a nation's capital account or how GDP would be affected by unemployment rate. (To keep reading on this subject, see Macroeconomic Analysis.) Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

2|Page

While these two studies of economics appear to be different, they are actually interdependent and complement one another since there are many overlapping issues between the two fields. For example, increased inflation (macro effect) would cause the price of raw materials to increase for companies and in turn affect the end product's price charged to the public. The bottom line is that microeconomics takes a bottoms-up approach to analyzing the economy while macroeconomics takes a top-down approach. Regardless, both micro- and macroeconomics provide fundamental tools for any finance professional and should be studied together in order to fully understand how companies operate and earn revenues and thus, how an entire economy is managed and sustained. 1.Microeconomics focuses on the markets supply and demand factors, and determines the economic price levels. 2.Macroeconomics is a vast field, which concentrates on two major areas, increasing economic growth and changes in the national income. 3.Microeconomics facilitates decision making for smaller business sectors. 4.Macroeconomics focuses on unemployment rates, GDP and price indices, of larger industries and entire economies.

Positive economics Positive economics is the branch of economics that concerns the description and explanation of economic phenomena. It focuses on facts and cause-and-effect behavioral relationships and includes the development and testing of economics theories. Earlier terms were value-free economics and its German counterpart wertfrei economics. Positive economics as science, concerns analysis of economic behavior. A standard theoretical statement of positive economics as operationally meaningful theorems is in Paul Samuelson's Foundations of Economic Analysis (1947). Positive economics as such avoids economic value judgments. For example, a positive economic theory might describe how money supply growth affects inflation, but it does not provide any instruction on what policy ought to be followed. Still, positive economics is commonly deemed necessary for the ranking of economic policies or outcomes as to acceptability, which is normative economics. Positive economics is sometimes defined as the economics of "what is", whereas normative economics discusses "what ought to be". Positive economics usually answers the question "why". To illustrate, an example of a positive economic statement is as follows: The price of milk has risen from $3 a gallon to $5 a gallon in the past five years. This is a positive statement because it can be proven true or false by comparison against real-world data. In this case, the statement focuses on facts.

Normative economics Normative economics is that part of economics that expresses value judgments (normative judgments) about economic fairness or what the economy ought to be like or what goals of public policy ought to be. Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

3|Page

It is common to distinguish normative economics ("what ought to be" in economic matters) from positive economics ("what is"). But many normative (value) judgments are held conditionally, to be given up if facts or knowledge of facts changes, so that a change of values may be purely scientific. This undermines the common distinction. But welfare economist Amartya Sen distinguishes basic (normative) judgments, which do not depend on such knowledge, from nonbasic judgments, which do. He finds it interesting to note that "no judgments are demonstrably basic" while some value judgments may be shown to be nonbasic. This leaves open the possibility of fruitful scientific discussion of value judgments. An example of a normative economic statement is as follows: The price of milk should be $6 a gallon to give dairy farmers a higher living standard and to save the family farm. This is a normative statement, because it reflects value judgments and cannot be proven true or false by comparison against real world data. This specific statement makes the judgment that farmers need a higher living standard and that family farms need to be saved.

Nature of Economic Theories Classical political economy Publication of Adam Smith's The Wealth of Nations in 1776, has been described as "the effective birth of economics as a separate discipline." The book identified land, labor, and capital as the three factors of production and the major contributors to a nation's wealth.

Adam Smith

Smith discusses the benefits of the specialization by division of labour. His "theorem" that "the division of labor is limited by the extent of the market" has been described as the "core of a theory of the functions of firm and industry" and a "fundamental principle of economic organization." To Smith has also been ascribed "the most important substantive proposition in all of economics" and foundation of resourceallocation theory – that, under competition, owners of resources (labor, land, and capital) will use them most profitably, resulting in an equal rate of return in equilibrium for all uses (adjusted for apparent differences arising from such factors as training and unemployment). In Smith's view, the ideal economy is a self-regulating market system that automatically satisfies the economic needs of the populace. He described the market mechanism as an "invisible hand" that leads all individuals, in pursuit of their own self-interests, to produce the greatest benefit for society as a whole. Smith incorporated some of the Physiocrats' ideas, including laissez-faire, into his own economic theories, but rejected the idea that only agriculture was productive. In his famous invisible-hand analogy, Smith argued for the seemingly paradoxical notion that competitive markets tended to advance broader social interests, although driven by narrower self-interest. The general Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

4|Page

approach that Smith helped initiate was called political economy and later classical economics. It included such notables as Thomas Malthus, David Ricardo, and John Stuart Mill writing from about 1770 to 1870. The period from 1815 to 1845 was one of the richest in the history of economic thought. While Adam Smith emphasized the production of income, David Ricardo focused on the distribution of income among landowners, workers, and capitalists. Ricardo saw an inherent conflict between landowners on the one hand and labor and capital on the other. He posited that the growth of population and capital, pressing against a fixed supply of land, pushes up rents and holds down wages and profits.

Malthus cautioned law makers on the effects of poverty reduction policies

Thomas Robert Malthus used the idea of diminishing returns to explain low living standards. Human population, he argued, tended to increase geometrically, outstripping the production of food, which increased arithmetically. The force of a rapidly growing population against a limited amount of land meant diminishing returns to labor. The result, he claimed, was chronically low wages, which prevented the standard of living for most of the population from rising above the subsistence level. Malthus also questioned the automatic tendency of a market economy to produce full employment. He blamed unemployment upon the economy's tendency to limit its spending by saving too much, a theme that lay forgotten until John Maynard Keynes revived it in the 1930s. Coming at the end of the Classical tradition, John Stuart Mill parted company with the earlier classical economists on the inevitability of the distribution of income produced by the market system. Mill pointed to a distinct difference between the market's two roles: allocation of resources and distribution of income. The market might be efficient in allocating resources but not in distributing income, he wrote, making it necessary for society to intervene. Value theory was important in classical theory. Smith wrote that the "real price of every thing ... is the toil and trouble of acquiring it" as influenced by its scarcity. Smith maintained that, with rent and profit, other costs besides wages also enter the price of a commodity. Other classical economists presented variations on Smith, termed the 'labour theory of value'. Classical economics focused on the tendency of markets to move to long-run equilibrium.

Marxism

The Marxist school of economic thought comes from the work of German economist Karl Marx. Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

5|Page

Marxist (later, Marxian) economics descends from classical economics. It derives from the work of Karl Marx. The first volume of Marx's major work, Das Kapital, was published in German in 1867. In it, Marx focused on the labour theory of value and what he considered to be the exploitation of labour by capital. The labour theory of value held that the value of an exchanged commodity was determined by the labor that went into its production.

Neoclassical economics A body of theory later termed 'neoclassical economics' or 'marginalism' formed from about 1870 to 1910. The term 'economics' was popularized by such neoclassical economists as Alfred Marshall as a concise synonym for 'economic science' and a substitute for the earlier, broader term 'political economy'. This corresponded to the influence on the subject of mathematical methods used in the natural sciences. Neoclassical economics systematized supply and demand as joint determinants of price and quantity in market equilibrium, affecting both the allocation of output and the distribution of income. It dispensed with the labour theory of value inherited from classical economics in favor of a marginal utility theory of value on the demand side and a more general theory of costs on the supply side. In the 20th century, neoclassical theorists moved away from an earlier notion suggesting that total utility for a society could be measured in favor of ordinal utility, which hypothesizes merely behavior-based relations across persons. In microeconomics, neoclassical economics represents incentives and costs as playing a pervasive role in shaping decision making. An immediate example of this is the consumer theory of individual demand, which isolates how prices (as costs) and income affect quantity demanded. In macroeconomics it is reflected in an early and lasting neoclassical synthesis with Keynesian macroeconomics. Neoclassical economics is occasionally referred as orthodox economics whether by its critics or sympathizers. Modern mainstream economics builds on neoclassical economics but with many refinements that either supplement or generalize earlier analysis, such as econometrics, game theory, analysis of market failure and imperfect competition, and the neoclassical model of economic growth for analyzing long-run variables affecting national income.

Keynesian economics

John Maynard Keynes (right), was a key theorist in economics.

Keynesian economics derives from John Maynard Keynes, in particular his book The General Theory of Employment, Interest and Money (1936), which ushered in contemporary macroeconomics as a distinct field. The book focused on determinants of national income in the short run when prices are relatively inflexible. Keynes attempted to explain in broad theoretical detail why high labour-market unemployment might not be self-correcting due to low "effective demand" and why even price flexibility and monetary policy might be unavailing. Such terms as "revolutionary" have been applied to the book in its impact on economic analysis. Keynesian economics has two successors. Post-Keynesian economics also concentrates on macroeconomic rigidities and adjustment processes. Research on micro foundations for their models is represented as based Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

6|Page

on real-life practices rather than simple optimizing models. It is generally associated with the University of Cambridge and the work of Joan Robinson. New-Keynesian economics is also associated with developments in the Keynesian fashion. Within this group researchers tend to share with other economists the emphasis on models employing micro foundations and optimizing behavior but with a narrower focus on standard Keynesian themes such as price and wage rigidity. These are usually made to be endogenous features of the models, rather than simply assumed as in older Keynesian-style ones.

Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

7|Page

Theory of Demand and Supply Demand: The term demand refers to the quantity of a given product that consumers will be willing and able to buy at a given price. In other words, The demand for anything at a given price is the amount of it which will be bought per unit of time at that price. ―By demand we mean the various quantities of a given commodity or service which consumers would buy in one market in a given period of time at various prices, or at various incomes, or at various prices of related goods.‖ - Bober

From the point of view of the seller, the demand price is the average revenue (revenue per unit) or income he expects to earn from the sale of a unit of commodity. Thus demand price is identical with average revenue (AR). That is why, the demand curve is also drawn as AR curve.

Types of Demand: There are three kinds of demands are discussed. a) Price Demand: Price demand refers to the various quantities of a commodity or service that a consumer would purchase at a given time in a market at various hypothetical prices. It is assumed that other things, such as consumer’s income, his tastes and prices of inter-related goods, remain unchanged. Price demand expresses relationship between prices and quantities. The demand of the individual consumer is called Individual Demand and the total demand of all the consumers combined for the commodity or service is called Industry Demand. The total demand for the product of an individual firm at various prices is known as firm’s demand or Individual seller’s Demand. b) Income demand: The income demand refers to the various quantities of goods and services which would be purchased by the consumers at various levels of incomes. Here we assume that the prices of the commodity or service as well as the prices of inter related goods and the tastes and desires of consumers do not change. The income demand shows the relationship between income and quantities demand. For example, Superior goods or high priced articles command brisk sales when income increases. On the other hand, inferior goods command large sales when incomes are at a lower level. c) Cross demand: The cross demand means the quantities of goods or services which will be purchased with reference to change in price not of this good but of other inter-related goods. These goods are either substitutes or complementary goods. For instance, A change in the price of tea will affect the demand for coffee. Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

8|Page

In economics the above types of demand are mostly discussed. Of these types of demand, Price demand is the most commonly spoken one.

Demand Function: Demand function is a function of Price. It varies with price and can be expressed as, đ?‘„đ?‘‘ = đ??š đ?‘ƒ . Here đ?‘„đ?‘‘ is the quantity demand and P is price. It may also be added that no proportionality in the change is implied. If the price falls by 10 percent, it does not follow that the demand will increase exactly by 10 percent. We can only say that the demand will extend when the price falls, but we cannot say how much. This will depend on the elasticity of demand.

Determinants of Demand: Quantity demanded (đ?‘„đ?‘‘ ) is the total amount of a good that buyers would choose to purchase under given conditions. The given conditions include: ďƒź Income and wealth: As people’s incomes rise, individuals tend to buy more of almost everything, even if prices don’t change. ďƒź Prices of substitutes and complements: Substitute and complement good’s price will highly affect the demand of particular goods. ďƒź Population: Population clearly affects the market demand curve. ďƒź Preferences (tastes): Tastes represent a variety of cultural and historical influences. ďƒź Expectations of future prices: Expectation also brings a change in demand. If prices are expected to rise in future, the demand for goods will increase now in the present. ďƒź Special influences: It will affect the demand for particular goods. The demand for umbrellas is high in rainy season but low in sunny phoenix. ď€ We refer to all of these things as determinants of demand.

The Law of Demand: The Law of Demand states that when the price of a good rises, and everything else remains the same, the quantity of the good demanded will fall. In other words, the higher the price, the lower the quantity demanded (đ?‘„đ?‘‘ ). The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more.ď€ ď€ In short, ď‚­P ď‚Žď€ ď‚Żđ?‘„đ?‘‘ ď€ Obviously, the law of demand is based on the law of diminishing marginal utility. In other words, it is the law of diminishing marginal utility which explains the law of demand.

Demand Curve or Demand Schedule: A Demand Curve or demand schedule is a graphical representation of the relationship between price and quantity demanded (ceteris paribus). It is a curve or line, each point of which is a priceđ?‘„đ?‘‘ pair. That point shows the amount of the good buyers would choose to buy at that price. The chart below shows that the demand curve is a downward slope.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

9|Page

A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation between quantities demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and the price will be P1, and so on. The demand relationship curve illustrates the negative relationship between price and quantity demanded. The higher the price of a good the lower the quantity demanded (A), and the lower the price, the more the good will be in demand (C).

Shifts vs. Movement in the demand curve: Changes in demand or shifts in demand occur when one of the determinants of demand other than price changes. For economics, the movements and shifts in relation to the demand curve represent very different market phenomena: 1. Movements: A movement refers to a change along a curve. On the demand curve, a movement denotes a change in both price and quantity demanded from one point to another on the curve. The movement implies that the demand relationship remains consistent. Therefore, a movement along the demand curve will occur when the price of the good changes and the quantity demanded changes in accordance to the original demand relationship. In other words, a movement occurs when a change in the quantity demanded is caused only by a change in price, and vice versa.

2. Shifts: A shift in a demand curve occurs when a good's quantity demanded changes even though price remains the same. For instance, if the price for a bottle of beer was $2 and the quantity of beer demanded increased from Q1 to Q2, then there would be a shift in the demand for beer. Shifts in the demand curve imply that the original demand relationship has changed, meaning that quantity demand is affected by a factor other than price. A shift in the demand relationship would occur if, for instance, beer suddenly became the only type of alcohol available for consumption.

Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

10 | P a g e

Supply: Supply represents how much the market can offer at a given price. The term supply refers to the quantity of a particular product that suppliers (producers and/or sellers) will make available to the market at a particular price. ―We may define supply as a schedule of the amount of a good that would be offered for sale at all possible prices at any one instant of time, or during any one period of time, for example, a day, a week, and so on, in which the conditions of supply remain the same‖ - Meyer

At last we can say that, Supply is not just the amount of something there, but the willingness and ability of potential sellers to produce and sell it.

Supply Function: A supply equation or supply function expresses supply đ?‘„đ?‘ (the number of items a supplier is willing to bring to the market) as a function of the unit price P (the price per item). It is usually the case that demand decreases and supply increases as the unit price increases. Mathematically, đ?‘„đ?‘ = đ?‘“(đ?‘ƒ), For example, Supply will increase 10% . The supply equation is the explicit mathematical expression of the functional relationship.

Determinants of Supply: Innumerable factors and circumstances could affect a seller’s willingness or ability to produce and sell a good. Some of the more common factors are: ďƒź Prices of factors of production (labor, capital): If the price of factor increases the supply curve will shift in as sellers are less willing or able to sell goods at existing prices. ďƒź Prices of alternative products the firm could produce: For purposes of supply analysis related goods refer to goods from which inputs are derived to be used in the production of the primary good. ďƒź Technology: A technological advance would cause the average cost of production to fall which would be reflected in an outward shift of the supply curve. ďƒź Cost of production: When production cost for a goods are low relative to the market price, it is profitable for producers to supply a great deal. ďƒź Government policy: Government intervention can take many forms including environmental and health regulations, hour and wage laws, taxes, electrical and natural gas rates and zoning and land use regulations. ďƒź Expectations of future prices: Sellers expectations concerning future market condition can directly affect supply. ďƒź Special influences: Special influences affect the supply curve. For example, the

weather exerts an important influence on farming and on the ski industry. Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

11 | P a g e

We refer to all of these as determinants of supply. It should be emphasized that this list is not exhaustive. All facts and circumstances that are relevant to a seller's willingness or ability to produce and sell goods can affect supply.

The Law of Supply: The Law of Supply states that, when the price of a good rises, and everything else remains the same, the quantity of the good supplied will also rise. In short, ↑P → ↑đ?‘„đ?‘ . But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue.

Supply Curve or Supply Schedule: A Supply Curve is a graphical representation of the relationship between price and quantity supplied (ceteris paribus). It is a curve or line, each point of which is a price-đ?‘„đ?‘ pair. That point shows the amount of the good sellers would choose to sell at that price. The chart below shows that the supply curve is a upward slope.

A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation between quantities supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2, and so on.

Shifts vs. Movement in the Supply curve: Changes in supply or shifts in supply occur when one of the determinants of supply other than price changes. For economics, the movements and shifts in relation to the supply curve represent very different market phenomena: 1. Movements: A movement refers to a change along a curve. A movement along the supply curve means that the supply relationship remains consistent. Therefore, a movement along the supply curve will occur when the price of the good changes and the quantity supplied changes in accordance to the original supply relationship. In other words, a movement occurs when a change in quantity supplied is caused only by a change in price, and vice versa.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

12 | P a g e

2. Shifts: A shift in a supply curve occurs when a good's quantity supplied changes even though price remains the same. For instance, if the price for a bottle of beer was $2 and the quantity supplied decreased from Q1 to Q2, then there would be a shift in the supply of beer. Like a shift in the demand curve, a shift in the supply curve implies that the original supply curve has changed, meaning that the quantity supplied is effected by a factor other than price. A shift in the supply curve would occur if, for instance, a natural disaster caused a mass shortage of hops; beer manufacturers would be forced to supply less beer for the same price.

Market and Customer: Markets consist of individual or groups of businesses that are prepared to supply a product, and customers who demand the product. Market price is determined by the interaction of the forces of demand and supply.

Equilibrium position: When supply and demand are equal (i.e. when the supply function and demand function intersect) the economy is said to be at equilibrium. The equilibrium position arises where the wishes of buyers and sellers match i.e. where there is no surplus or shortage. At this point, the allocation of goods is at its most efficient because the amount of goods being supplied is exactly the same as the amount of goods being demanded. For example, At 50 pence where 500,000 papers are demanded and supplied.

In the chart, equilibrium occurs at the intersection of the demand and supply curve, which indicates no allocative inefficiency. At this point, the price of the goods will be P* and the quantity will be Q*. These figures are referred to as equilibrium price and quantity.

Effect of Shift in Supply and Demand: Some events cause both the supply curve and the demand curve to shift. If both shift, then the qualitative effect on the equilibrium price and quantity may be difficult to predict, even if we know the direction in which each curve shifts. Changes in the equilibrium price and quantity depend on exactly how the curves shift.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

13 | P a g e

Effect of shift in Demand: Consider first a rightward shift in Demand. This could be caused by many things: an increase in income, higher price of substitute, lower price of complements, etc. Such a shift will tend to have two effects: raising equilibrium price, and raising equilibrium quantity. [↑P*, ↑Q*]

A leftward shift of demand would reverse the effects: a fall in both price and quantity. The general result is that Demand shifts cause price and quantity to move in the same direction. Effect of shift in Supply: Consider a rightward shift of supply (caused by lower factor price, better technology, or whatever). This will tend to have two effects: raising equilibrium quantity, and lowering equilibrium price. [↓P*, ↑Q*.]

A left shift of supply would reverse the effects, so the general result is that supply shifts tend to cause price and quantity to move in opposite directions. Now if both demand and supply both shift at once, the effect on price and quantity of different demand and supply shifts: Cause

Demand and Supply Shifts

Effect on price and quantity

If demand rises

The demand curve shifts to the right

 Price  Quantity 

If demand falls

The demand curve shifts to the left

 Price  Quantity 

If supply rises

The supply curve shifts to the right

 Price  Quantity 

If supply falls

The supply curve shifts to the left

 Price  Quantity 

At the end we can say that, the two changes have reinforcing effects on either price or quantity, and offsetting effects on the other.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

14 | P a g e

Disequilibrium: Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*. 1. Excess Supply: If the price is set too high, excess supply will be created within the economy and there will be allocative inefficiency.

At price P1 the quantity of goods that the producers wish to supply is indicated by Q2. At P1, however, the quantity that the consumers want to consume is at Q1, a quantity much less than Q2. Because Q2 is greater than Q1, too much is being produced and too little is being consumed. The suppliers are trying to produce more goods, which they hope to sell to increase profits, but those consuming the goods will find the product less attractive and purchase less because the price is too high. 2. Excess Demand: Excess demand is created when price is set below the equilibrium price. Because the price is so low, too many consumers want the good while producers are not making enough of it.

In this situation, at price P1, the quantity of goods demanded by consumers at this price is Q2. Conversely, the quantity of goods that producers are willing to produce at this price is Q1. Thus, there are too few goods being produced to satisfy the wants (demand) of the consumers. However, as consumers have to compete with one other to buy the good at this price, the demand will push the price up, making suppliers want to supply more and bringing the price closer to its equilibrium.

Elasticity: Elasticity is a central concept in the theory of supply and demand. In this context, elasticity refers to how strongly the quantities supplied and demanded respond to various factors, including price and other determinants. The quantity demanded of a good is affected by changes in the price of a good, change in price of other goods, changes in income and changes in other relevant factors. It may carefully noted that elasticity depends primarily on proportional or percentage changes not on absolute changes in price and quantity demanded.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

15 | P a g e

Types of Elasticity: Different elasticities of demand measures the responsiveness of quantity demanded to changes in variables which affect demand. We may distinguish between the three types of elasticities. They are, 1. Price elasticity of demand (PED): Price elasticity of demand measures the responsiveness of quantity demanded by changes in the price of the good. The formula for the coefficient of price elasticity of demand for a good is: Price Elasticity, đ??¸đ?‘? =

đ?‘ƒđ?‘’đ?‘&#x;đ?‘?đ?‘’đ?‘›đ?‘Ąđ?‘Žđ?‘”đ?‘’ đ?‘?đ?‘•đ?‘Žđ?‘›đ?‘”đ?‘’ đ?‘–đ?‘› đ?‘„đ?‘˘đ?‘Žđ?‘›đ?‘Ąđ?‘–đ?‘Ąđ?‘Ś đ??ˇđ?‘’đ?‘šđ?‘Žđ?‘›đ?‘‘đ?‘’đ?‘‘ đ?‘ƒđ?‘’đ?‘&#x;đ?‘?đ?‘’đ?‘›đ?‘Ąđ?‘Žđ?‘”đ?‘’ đ?‘?đ?‘•đ?‘Žđ?‘›đ?‘”đ?‘’ đ?‘–đ?‘› đ?‘ƒđ?‘&#x;đ?‘–đ?‘?đ?‘’

=

∆đ?‘„ Ă—100 đ?‘„ ∆đ?‘ƒ Ă—100 đ?‘ƒ

=

∆đ?‘„ đ?‘„

Ă—

đ?‘ƒ ∆đ?‘ƒ

=

đ?‘ƒ đ?‘„

Ă—

∆đ?‘„ ∆đ?‘ƒ

.

Positive Price Elasticity can be divided into 3 categories: Unit elastic demand: If the percentage change in the quantity demanded equals the percentage change in price is known as unit elastic demand. Symbolically, đ??¸đ?‘? = 1

Perfectly elastic demand: When the quantity demanded changes by a very large percentage in response to an almost zero percentage change in price is known as perfectly elastic demand. Symbolically, đ??¸đ?‘? = ∞

Perfectly inelastic demand: When the quantity demanded remains constant as the price changes is known as perfectly inelastic demand. Symbolically, đ??¸đ?‘? = 0

2. Income elasticity of demand: Income elasticity of demand measures the responsiveness of quantity demanded by changes in consumer incomes. The formula is equivalent to: Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

16 | P a g e

Income Elasticity, đ??¸đ?‘Ś =

đ?‘ƒđ?‘’đ?‘&#x;đ?‘?đ?‘’đ?‘›đ?‘Ąđ?‘Žđ?‘”đ?‘’ đ?‘?đ?‘•đ?‘Žđ?‘›đ?‘”đ?‘’ đ?‘–đ?‘› đ?‘„đ?‘˘đ?‘Žđ?‘›đ?‘Ąđ?‘–đ?‘Ąđ?‘Ś đ?‘?đ?‘˘đ?‘&#x;đ?‘? đ?‘•đ?‘Žđ?‘ đ?‘’đ?‘‘ đ?‘ƒđ?‘’đ?‘&#x;đ?‘?đ?‘’đ?‘›đ?‘Ąđ?‘Žđ?‘”đ?‘’ đ?‘?đ?‘•đ?‘Žđ?‘›đ?‘”đ?‘’ đ?‘–đ?‘› đ??źđ?‘›đ?‘?đ?‘œđ?‘šđ?‘’

=

∆đ?‘„ Ă—100 đ?‘„ ∆đ?‘Œ Ă—100 đ?‘Œ

=

∆đ?‘„ đ?‘„

Ă—

đ?‘Œ ∆đ?‘Œ

=

đ?‘Œ đ?‘„

∆đ?‘„

Ă—

∆đ?‘Œ

.

Positive Income Elasticity can be divided into 3 categories: Income inelastic: When the proportion of income spent on a good decreases a income increases. Symbolically, đ??¸đ?‘Ś < 1.

Unit income elasticity: When the proportion of income spent on a good remains the same even though income increases. Symbolically, đ??¸đ?‘Ś = 1.

Income elastic: When the proportion of income spent on a good increases as income increases. Symbolically, đ??¸đ?‘Ś > 1.

Normal goods: Any goods whose income elasticity of demand is greater than zero. Symbolically, đ??¸đ?‘Ś = 0. Inferior goods: any good in which consumers have negative income elasticity of demand. 3. Cross elasticity of demand: Cross elasticity of demand measures the responsiveness of quantity demanded by changes in price of another good. Two goods, which are substitutes, will have a positive cross elasticity while two goods, which are complements, will have a negative cross elasticity. As with price and income elasticity, it is sometimes more convenient to use alternative formulae for cross elasticity of demand. These are: Cross elasticity, X =

đ?‘ƒđ?‘’đ?‘&#x;đ?‘?đ?‘’đ?‘›đ?‘Ąđ?‘Žđ?‘”đ?‘’ đ?‘?đ?‘•đ?‘Žđ?‘›đ?‘”đ?‘’ đ?‘–đ?‘› đ?‘?đ?‘˘đ?‘&#x;đ?‘? đ?‘•đ?‘Žđ?‘ đ?‘’ đ?‘œđ?‘“ đ?‘?đ?‘œđ?‘šđ?‘šđ?‘œđ?‘‘đ?‘–đ?‘Ąđ?‘Ś đ?‘Ľ đ?‘ƒđ?‘’đ?‘&#x;đ?‘?đ?‘’đ?‘›đ?‘Ąđ?‘Žđ?‘”đ?‘’ đ?‘?đ?‘•đ?‘Žđ?‘›đ?‘”đ?‘’ đ?‘–đ?‘› đ?‘?đ?‘&#x;đ?‘–đ?‘?đ?‘’ đ?‘œđ?‘“ đ?‘?đ?‘œđ?‘šđ?‘šđ?‘œđ?‘‘đ?‘–đ?‘Ąđ?‘Ś đ?‘Ś

=

∆đ?‘„ đ?‘Ľ Ă—100 đ?‘„đ?‘Ľ ∆đ?‘ƒ đ?‘Ś Ă—100 đ?‘ƒđ?‘Ś

=

∆đ?‘„đ?‘Ľ đ?‘„đ?‘Ľ

Ă—

đ?‘ƒđ?‘Ś ∆đ?‘ƒđ?‘Ś

=

đ?‘ƒđ?‘Ś đ?‘„đ?‘Ľ

Ă—

∆đ?‘„đ?‘Ľ ∆đ?‘ƒđ?‘Ś

.

[Here ∆đ?‘„ stands for some increase in Q; Q is the quantity of commodity x, P is the commodity of y and ∆đ?‘ƒ is some proportional increase in personal disposable income.] For an example with a complement good, if, in response to a 10% increase in the price of fuel, the quantity of new cars demanded decreased by 20%, the cross elasticity of demand would be -2.0.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

17 | P a g e

Note: It should remembered that, cross elasticity will indicate complementarily or rivalry only if the commodities in question figure in the family budget in small proportions.

Point Elasticity of Demand: Point elasticity demand means the relatively responsiveness of a change in one variable to an infinitesimally small change in another variable. The notion of point elasticity typically comes into play when discussing the elasticity at a specific point on a curve. Point elasticity can be calculated in a number of different ways. Sophisticated economists, using sophisticated mathematical techniques (better known as calculus) can calculate point elasticity by taking derivatives of equations. Derivatives are fancy calculus talk for infinitesimally small changes. The formula is, đ?‘ƒ đ?‘‘đ?‘„đ?‘‘ đ??¸đ?‘‘ = Ă— đ?‘„đ?‘‘ đ?‘‘đ?‘ƒ In other words, it is equal to the absolute value of the first derivative of quantity with respect to price (dQd/dP) multiplied by the point's price (P) divided by its quantity (Qd).

In terms of partial-differential calculus, point-price elasticity of demand can be defined as follows: let đ?‘Ľ(đ?‘?, đ?‘¤) be the demand of goods đ?‘Ľ1 , đ?‘Ľ2 , ‌ ‌ đ?‘Ľđ??ż as a function of parameters price and wealth, and let đ?‘Ľđ?‘™ đ?‘?, đ?‘¤ be the demand for good đ?‘™. The elasticity of demand for good đ?‘Ľđ?‘™ đ?‘?, đ?‘¤ with respect to price pk is đ?œ•đ?‘Ľđ?‘™ (đ?‘?, đ?‘¤) đ?‘?đ?‘˜ đ?œ•đ?‘™đ?‘œđ?‘”đ?‘Ľđ?‘™ (đ?‘?, đ?‘¤) đ??¸đ?‘Ľ đ?‘™ ,đ?‘? đ?‘˜ = ∙ = đ?œ•đ?‘?đ?‘˜ đ?‘Ľđ?‘™ (đ?‘?, đ?‘¤) đ?œ•đ?‘™đ?‘œđ?‘”đ?‘?đ?‘˜ However, the point-price elasticity can be computed only if the formula for the demand function, Qd = f(P), is known so its derivative with respect to price, dQd / dP, can be determined.

Arc Elasticity of Demand: The arc elasticity of demand refers to the relationship between changes in price and the subsequent change in quantity demanded. Arc elasticity of demand measures elasticity between two points on a curve. This method for computing the price elasticity is also known as the "midpoints formula", because the average price and average quantity are the coordinates of the midpoint of the straight line between the two given points. The arc elasticity is defined mathematically as: đ??¸đ?‘‘ =

đ?‘ƒ 1 +đ?‘ƒ 2 2 đ?‘„ đ?‘‘ +đ?‘„ đ?‘‘ 1 2 2

Ă—

∆đ?‘„đ?‘‘ ∆đ?‘ƒ

=đ?‘„

đ?‘ƒ1 +đ?‘ƒ2 đ?‘‘ 1 +đ?‘„đ?‘‘ 2

Ă—

∆đ?‘„đ?‘‘ ∆đ?‘ƒ

[ where

means "VERY SMALL CHANGES IN"]

The arc elasticity formula is used if the change in price is relatively large. It is more accurate a measure of elasticity than simple ''price elasticity''. If the arc or price elasticity of demand is greater than 1, demand is said to be elastic. The demand curve has a ''flat'' appearance. If the arc or price elasticity of demand is less than 1, demand is said to be inelastic. The demand curve has a ''steep'' appearance. Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

18 | P a g e

Formula for Average of 'midpoint' elasticity of demand (change in Q / average Q ) (change in P / average P) Example: If the Price increases from 10p to 12p and Quantity falls from 40 to 20. Find the arc elasticity of demand. Solution: Arc elasticity of demand assumes that we should calculate using the midpoint between 40 and 20 which equals 30 and the midpoint between 10 and 12 which 11. Now, 20 The % change in quantity is = - 0.667 The % change in price is Therefore PED =

−0.667 0.18

30

2đ?‘?

= 0.18

11

= -3.7

Ans.

Example: If the price declines from $12 to $8, the quantity demanded increases from 4 to 6, from point X to point Z. Using this midpoint formula (with price designated as P and quantity designated as Q) average price elasticity of demand is: Solution: midpoint = elasticity midpoint = elasticity

đ?‘„đ?‘§ −đ?‘„đ?‘Ľ đ?‘„ đ?‘§ +đ?‘„ đ?‘Ľ 2

6−4 6+4 2

á

á

đ?‘ƒđ?‘§ −đ?‘ƒđ?‘Ľ đ?‘ƒ đ?‘§ +đ?‘ƒ đ?‘Ľ 2

8−12 8+12 2

2

−4

5

10

= á

midpoint = 0.4 á -0.4 = -1.0 elasticity

Elasticities of demand are interpreted as follows: Value Descriptive Terms Perfectly inelastic demand Ed = 0 Inelastic or relatively inelastic demand - 1 < Ed < 0 Unit elastic, unit elasticity, unitary elasticity, or unitarily elastic demand Ed = - 1 Elastic or relatively elastic demand - ∞ < Ed < - 1 Perfectly elastic demand Ed = - ∞

A decrease in the price of a good normally results in an increase in the quantity demanded by consumers because of the law of demand, and conversely, quantity demanded decreases when price rises. As summarized in the table above, the PED for a good or service is referred to by different descriptive terms depending on whether the elasticity coefficient is greater than, equal to, or less than −1.

Examples: 1. Cross elasticity of demand is measured as the percentage change in demand for the first good divided by the causative percentage change in the price of the other good. For an example with a complement good, if, in response to a 10% increase in the price of fuel, the quantity of new cars demanded decreased by 20%, the cross elasticity of demand would be -2.0. Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

19 | P a g e

2. If quantity demanded increases from 10 units to 15 units, the percentage change is 50%, i.e., (15 − 10) á 10 (converted to a percentage). But if quantity demanded decreases from 15 units to 10 units, the percentage change is −33.3%, i.e., (15 − 10) á 15. 3. If the price moves from $1.00 to $1.05, and as a result the quantity supplied goes from 100 pens to 102 pens, the quantity of pens increased by 2%, and the price increased by 5%, so the price elasticity of supply is 2%/5% or 0.4.

Note: 1. Wants: A want is simply a desire for a product; it is not the same thing as demand. 2. Effective demand: Effective demand refers to a desire for a product that is backed up by a purchasing decision. For demand to be effective the consumer needs to have the money required to make the purchase. 3. Price, therefore, is a reflection of supply and demand. The relationship between demand and supply underlie the forces behind the allocation of resources. In market economy theories, demand and supply theory will allocate resources in the most efficient way possible.

Price elasticity of supply (PES): Price elasticity of supply measures the responsiveness of quantity supplied to changes in price. Responsiveness of producers to changes in the price of their goods or services. As a general rule, if prices rise so does the supply. Elasticity of supply is measured as the ratio of proportionate change in the quantity supplied to the proportionate change in price. High elasticity indicates the supply is sensitive to changes in prices, low elasticity indicates little sensitivity to price changes, and no elasticity means no relationship with price. Also called price elasticity of supply. It is calculated as per the following formula: đ?‘ƒđ?‘’đ?‘&#x;đ?‘?đ?‘’đ?‘›đ?‘Ąđ?‘Žđ?‘”đ?‘’ đ?‘?đ?‘•đ?‘Žđ?‘›đ?‘”đ?‘’ đ?‘–đ?‘› đ?‘žđ?‘˘đ?‘Žđ?‘›đ?‘Ąđ?‘–đ?‘Ąđ?‘Ś đ?‘ đ?‘˘đ?‘?đ?‘?đ?‘™đ?‘–đ?‘’đ?‘‘ ∆đ?‘„ đ?‘ƒ Supply Elasticity đ??¸đ?‘ = = Ă— đ?‘?đ?‘’đ?‘&#x;đ?‘?đ?‘’đ?‘›đ?‘Ąđ?‘Žđ?‘”đ?‘’ đ?‘?đ?‘•đ?‘Žđ?‘›đ?‘”đ?‘’ đ?‘–đ?‘› đ?‘?đ?‘&#x;đ?‘–đ?‘?đ?‘’

đ?‘„

∆đ?‘ƒ

At last we can say that, Supply elasticity is defined as the percentage change in quantity supplied divided by the percentage change in price. The value of elasticity of supply is positive, because an increase in price is likely to increase the quantity supplied to the market and vice versa. Percentage change in quantity supplied divided by the percentage change in price: Value đ?‘Źđ?’” > 1 đ?‘Źđ?’” < 1 đ?‘Źđ?’” = đ?&#x;? đ?‘Źđ?’” = đ?&#x;Ž đ?‘Źđ?’” = ∞ Department Of Finance

Descriptive Terms supply is price elastic supply is price inelastic Supply is price unitary elastic supply is perfectly inelastic supply is perfectly elastic following a change in demand Jagannath University

Md. Mazharul Islam (Jony)

20 | P a g e

Examples: 1. Suppose the price of beer increases from 80c per gallon to 90c and the quantity supplied increases from 1304 to 2894. Then the elasticity of supply is (2894-1304)/1304 divided (90-80)/80. That is 1.22/0.125 = 9.76

Determinants: Price elasticity of demand The overriding factor in determining PED is the willingness and ability of consumers after a price change to postpone immediate consumption decisions concerning the good and to search for substitutes ("wait and look"). A number of factors can thus affect the elasticity of demand for a good: 

 

Availability of substitute goods: the more and closer the substitutes available, the higher the elasticity is likely to be, as people can easily switch from one good to another if an even minor price change is made; Percentage of income: the higher the percentage of the consumer's income that the product's price represents, the higher the elasticity tends to be, as people will pay more attention when purchasing the good because of its cost; Necessity: the more necessary a good is, the lower the elasticity, as people will attempt to buy it no matter the price, such as the case of insulin for those that need it. Duration: for most goods, the longer a price change holds, the higher the elasticity is likely to be, as more and more consumers find they have the time and inclination to search for substitutes. When fuel prices increase suddenly, for instance, consumers may still fill up their empty tanks in the short run, but when prices remain high over several years, more consumers will reduce their demand for fuel by switching to carpooling or public transportation, investing in vehicles with greater fuel economy or taking other measures. This does not hold for consumer durables such as the cars themselves, however; eventually, it may become necessary for consumers to replace their present cars, so one would expect demand to be less elastic. Breadth of definition of a good: the broader the definition of a good (or service), the lower the elasticity. For example, Company X's fish and chips would tend to have a relatively high elasticity of demand if a significant number of substitutes are available, whereas food in general would have an extremely low elasticity of demand because no substitutes exist. Brand loyalty: an attachment to a certain brand—either out of tradition or because of proprietary barriers—can override sensitivity to price changes, resulting in more inelastic demand. Who pays: where the purchaser does not directly pay for the good they consume, such as with corporate expense accounts, demand is likely to be more inelastic.

Price elasticity of Supply Significant determinants include: Reaction time: The PES coefficient will largely be determined by how quickly producers react to price changes by increasing (decreasing) production and delivering (cutting deliveries of) goods to the market.  Complexity of Production: Much depends on the complexity of the production process. Textile production is relatively simple. The labor is largely unskilled and production facilities are little more than buildings - no special structures are needed. Thus the PES for textiles is elastic. On the other hand, the PES for specific types of motor vehicles is

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

21 | P a g e

 

relatively inelastic. Auto manufacture is a multi-stage process that requires specialized equipment, skilled labor, a large suppliers network and large R&D costs. Time to respond: The more time a producer has to respond to price changes the more elastic the supply. For example, a cotton farmer cannot immediately respond to an increase in the price of soybeans. Excess capacity: A producer who has unused capacity can quickly respond to price changes in his market assuming that variable factors are readily available. Inventories: A producer who has a supply of goods or available storage capacity can quickly respond to price changes.

Other elasticities can be calculated for non-price determinants of supply. For example, the percentage change the amount of the good supplied caused by a one percent increase in the price of a related good is an input elasticity of supply if the related good is an input in the production process. An example would be the change in the supply for cookies caused by a one percent increase in the price of sugar.

Useful applications of price elasticity of demand and supply The key is to understand the various factors that determine the responsiveness of consumers and producers to changes in price. The elasticity will affect the ways in which price and output will change in a market. And elasticity is also significant in determining some of the effects of changes in government policy when the state chooses to intervene in the price mechanism. Some relevant issues that directly use elasticity of demand and supply include: 

 

Taxation: The effects of indirect taxes and subsidies on the level of demand and output in a market e.g. the effectiveness of the congestion charge in reducing road congestion; or the impact of higher duties on cigarettes on the demand for tobacco and associated externality effects Changes in the exchange rate: The impact of changes in the exchange rate on the demand for exports and imports Exploiting monopoly power in a market: The extent to which a firm or firms with monopoly power can raise prices in markets to extract consumer surplus and turn it into extra profit (producer surplus) Government intervention in the market: The effects of the government introducing a minimum price (price floor) or maximum price (price ceiling) into a market

Elasticity of demand and supply also affects the operation of the price mechanism as a means of rationing scarce goods and services among competing uses and in determining how producers respond to the incentive of a higher market price.

Total revenue: Total revenue is the total money received from the sale of any given quantity of output. The total revenue is calculated as the selling price of the firm's product times the quantity sold, i.e. total revenue = price × quantity; or letting TR be the total revenue function, TR(Q) = P(Q) × Q Where Q is the quantity of output sold, and P(Q) is the inverse demand function (the demand function solved out for price in terms of quantity demanded). Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

22 | P a g e

Example: A promoter has properly estimated the demand curve for seats at an event to be Q = 40,000 − 2000P where P is the price of a seat. The inverse demand curve, which determines price as a function of quantity, is therefore represented by P(Q) = 20 − Q / 2000. We therefore have TR(Q) = 20Q − Q2 / 2000

Effect on total revenue A set of graphs shows the relationship between demand and total revenue (TR). As price decreases in the elastic range, TR increases, but in the inelastic range, TR decreases. TR is maximized at the quantity where PED = 1.

Generally any change in price will have two effects in total revenue: ďƒź The price effect: an increase in unit price will tend to increase revenue, while a decrease in price will tend to decrease revenue. ďƒź The quantity effect: an increase in unit price will tend to lead to fewer units sold, while a decrease in unit price will tend to lead to more units sold. Because of the inverse nature of the relationship between price and quantity demanded (i.e., the law of demand), the two effects affect total revenue in opposite directions. But in determining whether to increase or decrease prices, a firm needs to know what the net effect will be. Elasticity provides the answer: The percentage change in total revenue is equal to the percentage change in quantity demanded plus the percentage change in price. (One change will be positive, the other negative.)

The relationship between the price elasticity of demand and total revenues: Price elasticity of demand and total revenue: 1. Elasticity of demand is important because it predicts what may happen to total revenue received when a company changes the price of a product. 2. When the price elasticity of demand for a good is inelastic (đ??¸đ?‘‘ < 1), the percentage change in quantity is smaller than that in price. Hence, when the price is raised, the total revenue of producers rises, and vice versa. 3. When the price elasticity of demand for a good is elastic (đ??¸đ?‘‘ > 1), the percentage change in quantity is greater than that in price. Hence, when the price is raised, the total revenue of producers falls, and vice versa. Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

23 | P a g e

4. When the price elasticity of demand for a good is unit elastic (or unitary elastic) (đ??¸đ?‘‘ = 1), the percentage change in quantity is equal to that in price. Hence, when the price is raised, the total revenue remains unchanged. The demand curve is a rectangular hyperbola. 5. When the price elasticity of demand for a good is perfectly elastic (đ??¸đ?‘‘ = ∞), any increase in the price, no matter how small, will cause demand for the good to drop to zero. Hence, when the price is raised, the total revenue of producers falls to zero. The demand curve is a horizontal straight line. A ten-dollar banknote is an example of a perfectly elastic good; nobody would pay $10.01, yet everyone will pay $9.99 for it. 6. When the price elasticity of demand for a good is perfectly inelastic (Ed = 0), changes in the price do not affect the quantity demanded for the good. The demand curve is a vertical straight line; this violates the law of demand. An example of a perfectly inelastic good is a human heart for someone who needs a transplant; neither increases nor decreases in price effect the quantity demanded (no matter what the price, a person will pay for one heart but only one; nobody would buy more than the exact amount of hearts demanded, no matter how low the price is).

Marginal Revenue: In microeconomics, marginal revenue (MR) is the extra revenue that an additional unit of product will bring. It is the additional income from selling one more unit of a good; sometimes equal to price. It can also be described as the change in total revenue divide the change in the number of units sold. More formally, marginal revenue is equal to the change in total revenue over the change in quantity when the change in quantity is equal to one unit. Change in total revenue Marginal Revenue = Change in sales

This can also be represented as a derivative when the units of output are arbitrarily small. (Total revenue) = (Price that can be charged consistent with selling a given quantity) times (Quantity) or đ?‘‡đ?‘… = đ?‘ƒ đ?‘„ . đ?‘„ . Thus, by the product rule: đ?‘‘đ?‘‡đ?‘… đ?‘‘đ?‘ƒ đ?‘‘đ?‘„ đ?‘‘đ?‘ƒ đ?‘€đ?‘… = = ∙đ?‘„+ ∙ đ?‘ƒ = đ?‘„. + đ?‘ƒ. đ?‘‘đ?‘„ đ?‘‘đ?‘„ đ?‘‘đ?‘„ đ?‘‘đ?‘„ For a firm facing perfectly competitive markets, price does not change with quantity sold (

đ?‘‘đ?‘ƒ đ?‘‘đ?‘„

= 0),

so marginal revenue is equal to price. For a monopoly, the price received will decline with quantity đ?‘‘đ?‘ƒ sold ( < 0), so marginal revenue is less than price. This means that the profit-maximizing đ?‘‘đ?‘„

quantity, for which marginal revenue is equal to marginal cost (MC) will be lower for a monopoly than for a competitive firm, while the profit-maximizing price will be higher. When demand is elastic, marginal revenue is positive, and when demand is inelastic, marginal revenue is negative. When the price elasticity of demand is equal to 1, marginal revenue is equal to zero. Example: A promoter has properly estimated the demand curve for seats at an event to be Q = 40,000 − 2000P Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

24 | P a g e

where P is the price of a seat. The inverse demand curve, which determines price as a function of quantity, is therefore represented by P(Q) = 20 − Q / 2000. We therefore have TR(Q) = 20Q − Q2 / 2000. Marginal revenue is the slope of total revenue: MR (Q) = 20 − Q / 1000.

Marginal Curve: Marginal revenue is commonly represented by a marginal revenue curve, such as the one labeled MR and displayed in the exhibit to the right. This particular marginal revenue curve is that for peer sales by Phil the peer grower, a presumed perfectly competitive firm. The vertical axis measures marginal revenue and the horizontal axis measures the quantity of output (pounds of peer). Although quantity on this particular graph stops at 10 pounds of peer, the nature of perfect competition indicates it could easily go higher.

Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University.

Relationship between marginal revenue with price elasticity of demand: Price elasticity of demand is defined as the measure of responsivenesses in the quantity demanded for a commodity as a result of change in price of the same commodity. In other words, it is percentage change in quantity demanded as per the percentage change in price of the same commodity. In economics and business studies, the price elasticity of demand (PED) is a measure of the sensitivity of quantity demanded to changes in price. It is measured as elasticity that is it measures the relationship as the ratio of percentage changes between quantity demanded of a good and changes in its price. Drinking water is a good example of a good that has inelastic characteristics in that people will pay anything for it (high or low prices with relatively equivalent quantity demanded), so it is not elastic. On the other hand, demand for sugar is very elastic because as the price of sugar increases, there are many substitutions which consumers may switch to. In microeconomics, Marginal Revenue (MR) is the extra revenue that an additional unit of product will bring. It can also be described as the change in total revenue/change in number of units sold. More formally, marginal revenue is equal to the change in total revenue over the change in quantity when the change in quantity is equal to one unit (or the change in output in the bracket where the change in revenue has occurred). This can also be represented as a derivative. (Total revenue) = (Price demanded) times (Quantity)

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

25 | P a g e

Theory of Consumer Behavior Utility analysis: Utility analysis is a quantitative method that estimates the dollar value of benefits generated by an intervention based on the improvement it produces in worker productivity. Utility analysis provides managers information they can use to evaluate the financial impact of an intervention, including computing a return on their investment in implementing it. . A generic utility function is described mathematically as follows, U = f(X1, DX2,..., Xn)

Utility concepts Cardinal utility approach: cardinal utility approach assumes that we can assign values for utility,. E.g. derive 100 utils from eating a slice of pizza (units  utils) Ordinal utility approach: ordinal utility approach does not assign values, instead works with a ranking of preferences.

Cardinal versus Ordinal utility Early economists assumed that people are able (perhaps only subliminally) to assign meaningful utility numbers (utils) to their satisfaction in one situation vis-à-vis their satisfaction in an alternative situation. For example, the utils generated by each brownie you eat or book you read would be recorded as if you have utilometer imbedded in your frontal lobe. Cardinal measurement of utility Satisfaction, like temperature or distance, is assumed measurable in meaningful, absolute numbers. Cardinal measures are possible when incremental units are constant and reasonably objective, but utility is roughly measurable at best. As far as we know no one is born equipped with a utilometer to precisely measure satisfaction. Utility measured by rank alone is known as ordinal utility. Ordinal measurement of utility Satisfaction is not cardinally measurable. Instead, relative numbers provide rankings like first, second, tied, etc. Ordinal analysis assumes that between any two bundles of goods, a person either prefers one to the other or is indifferent between the bundles—i.e., individuals can provide an ordering of bundles. Thus, ordinal utility analysis cannot tell us, for example, that one fried chicken yields 147 utils more satisfaction for the president than a few pieces of dry white toast—all that really matters is that he prefers the chicken to the toast. As long as people can consistently rank different bundles of goods by the satisfaction generated, ordinal utility is sufficient to model consumer behavior. At last we can say that, any cardinal measurement is also ordinal (fixed increments establish rank), but the reverse is not true. If we know rank, it does not follow that we know cardinal intervals between bundles A, B, C, etc. For example, if we know only the order of finish in a horse race, inferring that the winner beat the second place finisher by precisely as much time as the second horse beat the third would be an unjustified stretch.

Marginal utility: The last unit of commodity consumed at any particular time is known as final or marginal utility. In other words, Marginal utility can be defined as the change in the total utility resulting from a one-unit change in the consumption of a commodity per unit of time. Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

26 | P a g e

Marginal utility (MU) =

đ??śđ?‘•đ?‘Žđ?‘›đ?‘”đ?‘’ đ?‘–đ?‘› đ?‘Ąđ?‘œđ?‘Ąđ?‘Žđ?‘™ đ?‘˘đ?‘Ąđ?‘–đ?‘™đ?‘–đ?‘Ąđ?‘Ś đ??śđ?‘•đ?‘Žđ?‘›đ?‘”đ?‘’ đ?‘–đ?‘› đ?‘žđ?‘˘đ?‘Žđ?‘›đ?‘Ąđ?‘–đ?‘Ąđ?‘Ś đ?‘?đ?‘œđ?‘›đ?‘ đ?‘˘đ?‘šđ?‘’đ?‘‘

=

∆đ?‘‡đ?‘ˆ ∆đ?‘„

∙

Example: If a man takes two oranges at the time, yielding 10 and 9 units of utility respectively, the second unit is marginal unit and its utility namely 9, is the marginal utility of oranges.

Conditions of Marginal Utility: Marginal utility is based upon two essential conditions: 1. Consumption should take place at any particular time or the act o consumption should be regular and unbroken. For example, Suppose a big family consumes several kg of wheat at a time. If it purchases only one kg of wheat, then it would be the marginal unit, and its utility. 2. The utility in question should be the utility of the marginal or final unit that is consumed. For example, Suppose it is 100, could be the marginal utility. If it is purchase another kg of wheat then second kg becomes the marginal unit, and its utility becomes the marginal utility. If this family purchases 5 kg of wheat the marginal utility declines.

Law Of Diminishing Marginal Utility This law can be stated as the fall in marginal utility of any good due to successive consumption of that good. Satisfactions of human wants follow some very important laws and one of them in the law of diminishing marginal utility. The law refers to the common experience of every consumer. For example, Suppose a person start-eating piece of bread one after another. The first toast gives him great pleasure. By the time he start taking second, the edge of his appetite has been blunted, and the second toast, meeting with a less urgent want, yield less satisfaction, the satisfaction of third less than of the second, and soon. The additional satisfaction goes on decreasing with every successive toast till it drops down to zero. If the customer is forced to take more the satisfaction may become negative or the utility may change in disutility.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

27 | P a g e

Therefore, Law of diminishing utility may be stated as follow“Each unit of commodity gives, other things remaining the same, less utility to the consumer than the foregoing unit.”

Equi-marginal Utility: The principle of equal marginal utility occupies an important place in the cardinal utility analysis. According to this, a consumer is in equilibrium when he distributes his given money income among various goods in such a way that marginal utility derived from the last rupee spent on each good is the same. The Marshallian approach to consumer’s equilibrium is based on the following assumptions. Assumptions: The main assumptions of the law of equi-marginal utility are as under: 1. Independent utilities. The marginal utilities of different commodities are independent of each other and diminish with more and more purchases. 2. Constant marginal utility of money. The marginal utility of money remains constant to the consumer as he spends more and more of it on the purchases of goods. 3. Utility is cardinally measurable. 4. Every consumer is rational in the purchase of goods. 5. Limited money income. A consumer has limited amount of money income to spend. The law of equi-marginal utility can be explained with the help the diagrams.

In the diagram, MU is the marginal utility curve for tea and KL of cigarette. When a consumer spends OP amount (Rs.2) on tea and OC (Rs.3) on cigarettes, the marginal utility derived from the consumption of both the items (Tea and Cigarettes) is equal to 8 units (EP=NC). The consumer gets the maximum utility when he spends Rs. 2.00 on tea and Rs. 3.00 on cigarettes and by no other alteration in the expenditure. We now assume that the consumer spends Rs. 1.00 on tea (OC’ amount) and Rs. 4.00 (OQ’) on cigarettes. If CQ’ more amount is spent on cigarettes, the added utility is equal to the area CQ’ N’N. On the other hand, the expenditure on tea falls from OP amount (Rs.2) to OC’ amount (Rs. 1.00). There is a toss of utility equal to the area C’PEE’. The loss in utility (tea) is greater than that of its gain in cigarettes. The consumer is not deriving maximum satisfaction except the combination of expenditure of Rs. 2.00 on tea and Rs. 3.00 on cigarettes.

Indifference curve: In microeconomic theory, an indifference curve is a graph showing different bundles of goods, each measured as to quantity, between which a consumer is indifferent. That is, at each point on the curve, the consumer has no preference for one bundle over another. In other words, an indifference curve represents the possible combinations of (usually two)

goods that, when consumed, result in a given constant level of happiness or utility. Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

28 | P a g e

They are all equally preferred. One can equivalently refer to each point on the indifference curve as rendering the same level of utility (satisfaction) for the consumer. Utility is then a device to represent preferences rather than something from which preferences come. The main use of indifference curves is in the representation of potentially observable demand patterns for individual consumers over commodity bundles.

Properties of Indifference curves: Indifference curves are typically represented to be:  Positive quadrant: Defined only in the positive (+, +) quadrant of commodity-bundle quantities.  Negatively (Downward) sloped: That is, as quantity consumed of one good (X) increases, total satisfaction would increase if not offset by a decrease in the quantity consumed of the other good (Y). Equivalently, satiation, such that more of either good (or both) is equally preferred to no increase, is excluded. (If utility U = f(x, y), U, in the third dimension, does not have a local maximum for any x and y values.) The negative slope of the indifference curve reflects the law of diminishing marginal utility. That is as more of a good is consumed total utility increases at a decreasing rate - additions to utility per unit consumption are successively smaller.  Non-intersecting: Complete, such that all points on an indifference curve are ranked equally preferred and ranked either more or less preferred than every other point not on the curve. So, with (2), no two curves can intersect (otherwise non-satiation would be violated).  Higher IC: Transitive with respect to points on distinct indifference curves. That is, if each point on I2 is (strictly) preferred to each point on I1, and each point on I3 is preferred to each point on I2, each point on I3 is preferred to each point on I1. A negative slope and transitivity exclude indifference curves crossing, since straight lines from the origin on both sides of where they crossed would give opposite and intransitive preference rankings.  Convex (sagging from below): With (2), convex preferences imply a bulge toward the origin of the indifference curve. As a consumer decreases consumption of one good in successive units, successively larger doses of the other good are required to keep satisfaction unchanged.

Indifference Map: A graph of indifference curves for an individual consumer associated with different utility levels is called an indifference map. Points yielding different utility levels are each associated with distinct indifference curves. An indifference curve describes a set of personal preferences and so can vary from person to person. An indifference curve is like a contour line on a topographical map. Each point on the map represents the same elevation.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

29 | P a g e

Budget Line: If there are only two goods, the budget line expresses the maximum amount of a good that an individual can consume, given his budget or income, and a certain amount of the other good available that the consumer has decided to consume. More generally, the budget constraint states that, given the prices of goods, an individual consumer can consume only such amounts of the goods that his income allows. We can say that, M = đ?‘ƒ1 đ?‘„1 + đ?‘ƒ2 đ?‘„2 If we were to plot this line on a graph that has đ?‘„1 as the vertical axis and đ?‘„2 as the horizontal axis, the line traced would be the budget line of the individual. In a two good case, we can think of quantities of good X on the horizontal axis and quantities of good Y on the vertical axis. The term is often used when there are many goods, and without reference to any actual graph. Consumption bundle: Two numbers(đ?‘„1 ; đ?‘„2 ) that tell us how much the consumer is choosing to consume of good 1 and how much the consumer is choosing to consume of good 2. Suppose we observe prices of two goods, (đ?‘ƒ1 ; đ?‘ƒ2 ) and the amount of money a consumer has to spend, m. Budget constraint: đ?‘ƒ1 đ?‘„ 1 + đ?‘ƒ2 đ?‘„2 ≤ đ?‘š Where đ?‘ƒ1 đ?‘„1 is spending on good 1 and đ?‘ƒ2 đ?‘„2 is spending on good 2. The budget constraint tells us that total spending cannot exceed m. Affordable consumption bundles are those that don't cost any more than m. Budget set: Budget set is a set of affordable consumption bundles at prices (đ?‘ƒ1 ; đ?‘ƒ2 ) and income m. Example: Let good 2 be money that the consumer can use to spend on other goods. Note that then p2 = 1. So, we can write đ?‘ƒ1 đ?‘„ 1 + đ?‘„2 ≤ đ?‘š which we read as "the amount of money spent on good 1 plus the amount of money spent on all other goods must be no more than the total amount of money the consumer has to spend". Often we define good 2 as a "composite good" that stands for everything else that the consumer might want to consume other than good 1. Properties of the budget set (opportunity set): Budget line is the set of bundles that cost exactly m đ?‘ƒ1 đ?‘„ 1 + đ?‘ƒ2 đ?‘„2 = m All bundles (đ?‘„1 ; đ?‘„2 ) that solve the equation above just exhaust the consumer's income. Alternative representation of the budget line đ?‘š đ?‘ƒ1 đ?‘„2 = − đ?‘„1 đ?‘ƒ2 đ?‘ƒ2 Which tells us how many units of good 2 the consumer needs to consume in order to just satisfy the budget constraint given consumption of x1 units of good 1. Easy way to draw a budget line for given prices (đ?‘ƒ1 ; đ?‘ƒ2 ) and income m: 1. Calculate how much of good 2 the consumer could buy by spending all income on good 2: Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

30 | P a g e

đ?‘š đ?‘ƒ2 2. Calculate how much of good 1 the consumer could buy by spending all income on good 1: đ?‘š đ?‘„1 đ?‘šđ?‘Žđ?‘Ľ = đ?‘ƒ1 đ?‘„2 đ?‘šđ?‘Žđ?‘Ľ =

3. Plot these two points on the appropriate axes of the graph and connect them with a straight line �

Slope of the budget line ( đ?&#x;? ): đ?‘ˇđ?&#x;?

Slope of the budget line measures the rate at which the market is willing to substitute good 1 for good 2. đ?‘ƒ1 đ?‘„1 + đ?‘ƒ2 đ?‘„2 = m đ?‘ƒ1 (đ?‘„1 + ∆đ?‘„1 ) + đ?‘ƒ2 (đ?‘„2 + ∆đ?‘„2 ) = m by subtracting the _rst equation from the second we can get đ?‘ƒ1 ∆đ?‘„1 ) + đ?‘ƒ2 ∆đ?‘„2 ) = 0 and rearranging ∆đ?‘„2 đ?‘ƒ1 = ∆đ?‘„1 đ?‘ƒ2 ∆đ?‘„ Where 2 is the rate at which good 2 can be substituted for good 1. But this is just the slope of the ∆đ?‘„1

budget line. Note: Negative sign tells that ∆đ?‘„2 and ∆đ?‘„1 must always have opposite signs - to satisfy the budget constraint by consuming more of good 2 the consumer must sacrifice some of good 1.

Changes in the budget line: Clearly, as prices and income change, the set of goods that a consumer can afford changes as well. 1. Changes in income Recall alternative representation of the budget line đ?‘„2 =

đ?‘š đ?‘ƒ2

−

đ?‘ƒ1 đ?‘ƒ2

đ?‘„1 . Change in income affects only

the intercept and not the slope of the line. An increase in income from m to m’ results in a parallel shift outward of the budget line.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

31 | P a g e

2. Changes in prices Consider increasing price 1 while holding price 2 and income fixed. Vertical intercept is đ?‘ƒ unchanged, but the budget line becomes steeper since 1 will become larger. An easier way to see đ?‘ƒ2

how the budget line changes is to use the same approach as we used before to draw the budget line Intuitively: vertical intercept does not change because it does not depend on đ?‘ƒ1 (if all income is spent on good 2, price of good 1 is irrelevant). However, when all income is spent on good 1 then the horizontal intercept must shift inward. What happens to the budget line when we change the prices of good 1 and good 2 at the same time? ďƒź If we increase both prices by t the budget line becomes đ?‘š đ?‘Ąđ?‘ƒ1 đ?‘„1 + đ?‘Ąđ?‘ƒ2 đ?‘„2 = đ?‘š ⇔ đ?‘ƒ1 đ?‘„ 1 + đ?‘ƒ2 đ?‘„2 = đ?‘Ą so multiplying both prices by t is the same as dividing income by t. ďƒź Increase in both prices by the same amount shifts budget line inward ďƒź Decrease in both prices by the same amount shifts budget line outward đ?‘ƒ ďƒź If price 2 increases more than price 1 the absolute value of − 1 goes down, then the budget đ?‘ƒ2

line will be flatter ďƒź If price 2 increases less than price 1, the budget line will be steeper

The numeraire: The budget line, đ?‘ƒ1 đ?‘„1 + đ?‘ƒ2 đ?‘„2 = đ?‘š can be also written as, đ?‘ƒ1 đ?‘š đ?‘„1 + đ?‘„2 = đ?‘ƒ2 đ?‘ƒ2 đ?‘ƒ2 đ?‘š đ?‘„1 + đ?‘„2 = đ?‘ƒ1 đ?‘ƒ1 đ?‘ƒ1 đ?‘ƒ2 đ?‘„ + đ?‘„ =1 đ?‘ƒ2 1 đ?‘ƒ1 2 When we set one of the prices to 1, we often refer to that price as the numeraire price. The numeraire price is the price relative to which we are measuring the other price and income.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

32 | P a g e

Consumer Equilibrium When consumers make choices about the quantity of goods and services to consume, it is presumed that their objective is to maximize total utility. In maximizing total utility, the consumer faces a number of constraints, the most important of which are the consumer's income and the prices of the goods and services that the consumer wishes to consume. The consumer's effort to maximize total utility, subject to these constraints, is referred to as the consumer's problem. The solution to the consumer's problem, which entails decisions about how much the consumer will consume of a number of goods and services, is referred to as consumer equilibrium.

Effect of price, income and substitution effect: Price Effect (PE): The effect on consumer equilibrium when price of one commodity changes while price (s) of other commodity and income of the consumer remain the same. Income Effect (IC): The effect on consumer equilibrium when income of the consumer changes while prices remain the same. Substitution Effect (SE): The effect on consumer's equilibrium when price of a commodity falls/rises the consumer increases/decreases the purchase of the commodity, but it is assumed that there is no increase/decrease in his/her real income, so he/she remain on the same indifference curve.

Consumer and producer Surplus The term surplus is used in economics for several related quantities. The consumer surplus (sometimes named consumer's surplus or consumers' surplus) is the amount that consumers benefit by being able to purchase a product for a price that is less than the most that they would be willing to pay. In other words, Consumer surplus is the difference between the maximum price a consumer is willing to pay and the actual price they do pay. This measure is used as a tool in policy analysis. The producer surplus is the amount that producers benefit by selling at a market price mechanism that is higher than the least that they would be willing to sell for.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

33 | P a g e

Note that producer surplus generally flows through to the owners of the factors of production: in perfect competition, no producer surplus accrues to the individual firm. This is the same as saying that economic profit is driven to zero. Real-world businesses generally own or control some of their inputs, meaning that they receive the producer's surplus due to them: this is known as normal profit, and is a component of the firm's opportunity costs. If the markets for factors are perfectly competitive as well, producer surplus ultimately ends up as economic rent to the owners of scarce inputs such as land.

Engel curve An Engel curve describes how a consumer’s purchases of a good like food varies as the consumer’s total resources such as income or total expenditures vary. Engel curves may also depend on demographic variables and other consumer characteristics. A good’s Engel curve determines its income elasticity, and hence whether the good is an inferior, normal, or luxury good. Empirical Engel curves are close to linear for some goods, and highly nonlinear for others. Engel curves are used for equivalence scale calculations and related welfare comparisons, and determine properties of demand systems such as agreeability and rank. In economics, an Engel curve shows how the quantity demanded of a good or service changes as the consumer's income level changes. It is named after the 19th century German statistician Ernst Engel. Money Income Engel Curve

Quantity consumed of good X

Graphically Presentation: The Engel curve is represented in the first-quadrant of the Cartesian coordinate system. Income is shown on the Y-axis and the quantity demanded for the selected good or service is shown on the X-axis.

1. For normal goods, the Engel curve has a positive gradient. That is, as income increases, the quantity demanded increases. 2. For luxury goods, the Engel curve remains upward sloping in both cases, it bends toward the y-axis for necessities and towards the x-axis. 3. For inferior goods, the Engel curve has a negative gradient. That means that as the consumer has more income, they will buy less of the inferior good because they are able to purchase better goods. 4. For goods with Marshallian demand function generated by a utility in Gorman polar form, the Engel curve has a constant slope. Derivation of Demand and Engel Curve: The demand function is a relationship between the quantity of a good/service that an individual will consume at different prices, holding other prices and income constant. Every point on the demand function is a utility maximizing point. In effect, the demand curve is a translation from Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

34 | P a g e

utility metric space into dollar metric space. Thus, point 'e' in the diagram below is a point on the demand curve.

To construct the demand curve simply vary the price of one good holding the price of other goods and income constant. In graphical terms this is represented as in the diagrams below. Note that the equilibrium points in the upper diagram have their counterparts in 'quantity space' in the lower diagram. Therefore, this shows that prices or expenditure information provides a measure of people's preferences and can be used in making assessments with respect to valuation.

An Engel curve is also associated with the development of the demand curve from the utility maximizing framework. An Engel curve is the locus of combinations of goods that an individual would consume if they were faced with changes in income holding all prices constant. Pictorially this would mean a parallel shift in the budget constraint either up or down if income rises or falls, respectively. This Engel curve is also known as an income-consumption curve. Elasticity measurement along with Engel curve : The shape of Engel curve shows the degree of elasticity of demand, i.e., the elasticity is unitary, greater than one or less than one. When the price consumption is horizontal, i.e., parallel to X axis (i.e., has zero slope), the elasticity of demand for good X unitary, i.e., the total outlay on X remains the same even though price of X rises. If the Engel curve is upward sloping, the demand for good X is inelastic and if it is downloads sloping, the demand will be elastic.

Income and Substitution Effects The total effect of a price change is the summation of the substitution and income effect. The substitution and income effect can work in opposite direction of each other. The income effect defines whether the good is an inferior good or a normal good. In other words, Substitution Effect is the change in the quantity consumed due to a change in the price of the good, while holding other prices for goods constant and utility constant. Income Effect is the change in the quantity consumed due to a relative increase in a change of income while holding prices constant.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

35 | P a g e

Relative price: Relative price has meaning only when applied to two goods. It is the ratio between the money prices of the two goods. Money price is the price of a good expressed in monetary units.

Intersecting Substitution effect and Income Effect:

We know, Total Effect = Substitution Effect + Income Effect The substitution effect is always positive, as we saw from the diagram above. And the income effect is positive for a superior good. Therefore, the total effect is certainly positive. This means that all superior goods are normal (they have downward-sloping demand). For an inferior good, the total effect is usually positive. The substitution effect is positive as always. The income effect is negative for an inferior good, which means the effects work in opposite directions. But the substitution effect is almost always bigger than the income effect. Therefore, the total effect is usually positive. This means that most inferior goods are also normal (they have downward-sloping demand). But for some inferior goods, it is possible for the total effect to be negative. The income effect is large enough to swamp the substitution effect. These goods are called Giffen goods (which have upward-sloping demand). Giffen goods are extremely rare, and there is some debate as to whether they even exist. One example: Potatoes in Ireland during the potato famine of the 1840s. When the price of potatoes rose, that made the effective incomes of the Irish much smaller because potatoes were a staple of their diets. With their smaller incomes, the Irish cut back on their consumption of ―luxury‖ foods like meat and bought more potatoes (or so said Samuel Giffen).

CLASSIFICATIONS OF CONSUMER GOODS: Normal Goods: A normal good can be defined as a good whose consumption has a positive correlation with the income effect. Inferior Goods: An inferior good can be defined as a good whose consumption has a negative correlation with the income effect. Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

36 | P a g e

In both panels, X is an inferior good; that is, B is to the right of C. In the first panel, X is not giffen; that is, B is to the left of A. In the second panel, X is Giffen; that is, B is to the right of A Giffen goods: A Giffen good is a good whose consumption increases as its price increases. (For a normal good, as the price increases, consumption decreases.) Thus, the demand curve will be upward instead of downward sloping. Superior goods: Superior goods make up a larger proportion of consumption as income rises, and therefore are a type of normal goods in consumer theory. Such a good must possess two economic characteristics: it must be scarce, and, along with that, it must have a high price. A superior good also may be a luxury good that is not purchased at all below a certain level of income.

Income and Substitution effect of Normal, Inferior and Giffin Goods: When the price of X rises, the consumer moves from A to B. this move can be broken down into a substitution effect (from A t C) followed by an income effect (from C to B). This move from A to C is always leftward. If X is normal, the move from C to B is also leftward, so the move from A to B is leftward; therefore, X is not Giffen. If X is inferior, the move from C to B is rightward. This allows two possibilities; Either B is to the left of A ( this happens when the income effect is small), so that X is not Giffen, or B is to the right of A ( this happens when the income effect is large), so that X is Giffen.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

37 | P a g e

Distinguish between total utility and marginal utility: Total utility (TU): Total utility is the total satisfaction which a consumer derives from the consumption of a particular good over a period of time. For example, a person consumes five units of a commodity and derives đ?‘ˆ1 , đ?‘ˆ2 , đ?‘ˆ3 , đ?‘ˆ4 , đ?‘ˆ5 utility from the successive units of a good, his total utility will be, đ?‘‡đ?‘˘ = đ?‘ˆ1 + đ?‘ˆ2 + đ?‘ˆ3 + đ?‘ˆ4 + đ?‘ˆ5 Marginal Utility (MU): It can also be described as the extra satisfaction which a consumer gets from consuming additional unit of a good. More precisely, it is defined as the, addition to the total utility obtained from the consumption of one more unit. For example, the marginal utility of second glass of water is the change in total utility resulting from consuming the second glass of water. ∆đ?‘‡ Thus, đ?‘€đ?‘˘ = đ?‘˘ ∆đ?‘„

Here∆đ?‘‡đ?‘˘ = Change in total utility and ∆đ?‘„ = change in consuming an additional unit of a good. It can also be expressed as đ?‘€đ?‘˘ = đ?‘‡đ?‘˘ đ?‘› − đ?‘‡đ?‘˘ đ?‘Ľ −1 , đ?‘‡đ?‘˘ đ?‘› here means total utility derived from the consumption of n units of a good and đ?‘‡đ?‘˘ đ?‘› −1 is the total utility derived from the consumption of đ?‘› − 1units. For example, a chocolate bar. Let's say that after eating one chocolate bar your sweet tooth has been satisfied. Your marginal utility (and total utility) after eating one chocolate bar will be quite high. But if you eat more chocolate bars, the pleasure of each additional chocolate bar will be less than the pleasure you received from eating the one before - probably because you are starting to feel full or you have had too many sweets for one day.

This table shows that total utility will increase at a much slower rate as marginal utility diminishes with each additional bar. Notice how the first chocolate bar gives a total utility of 70 but the next three chocolate bars together increase total utility by only 18 additional units. It may here be noted that as a person consumes more and more units of a commodity, the marginal utility of the additional units begins to diminish but the total utility goes on increasing at a diminishing rate. When the marginal utility comes to zero or we say the point of satiety is reached, the total utility is the maximum. If consumption is increased further from this point of satiety, the marginal utility becomes negative and the total utility begins to diminish.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

38 | P a g e

Giffen Paradox Proposed by Scottish economist Sir Robert Giffen (1837-1910) from his observations of the purchasing habits of the Victorian poor, Giffen paradox states that demand for a commodity increases as its price rises. Giffen paradox is explained by the fact that if the poor rely heavily on basic commodities like bread or potatoes, when prices are low they might still have some disposable income for purchases of other items. As bread or corn prices rise, these other purchases are no longer possible, thereby forcing the poor to concentrate all their purchasing power on the bread or corn. It should not be confused with products bought as status symbols or for CONSPICUOUS CONSUMPTION.

Relation between Diminishing Marginal Utility and Law of Demand: The law of demand is the scientific relation between demand price and quantity demanded that captures the demand side of the market. When combined with the law of supply (or other relevant supply principles) the result is the market model. The market provides a powerful tool for analyzing exchanges, resource allocation, and efficiency. Diminishing Marginal Utility states that the extra satisfaction obtained from a good decline as larger amounts are consumed. If buyers receive less satisfaction, then they are willing to pay a lower price, which generates the law of demand. The downside of this explanation is the inability to measure the actual utility derived from consuming a good.

The reasons for a downward sloping demand curve Demand curve has a negative slope, i.e, it slopes downwards from left to right depicting that with increase in price, quantity demanded falls and vice versa. The reasons for a downward sloping demand curve can be explained as follows1. Income effect- With the fall in price of a commodity, the purchasing power of consumer increases. Thus, he can buy same quantity of commodity with less money or he can purchase greater quantities of same commodity with same money. Similarly, if the price of a commodity rises, it is equivalent to decrease in income of the consumer as now he has to spend more for buying the same quantity as before. This change in purchasing power due to price change is known as income effect. 2. Substitution effect- When price of a commodity falls, it becomes relatively cheaper compared to other commodities whose price have not changed. Thus, the consumer tend to consume more of the commodity whose price has fallen ,i.e, they tend to substitute that commodity for other commodities which have not become relatively dear. Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

39 | P a g e

3. Law of diminishing marginal utility– It is the basic cause of the law of demand. The law of diminishing marginal utility states that as an individual consumes more and more units of a commodity, the utility derived from it goes on decreasing. So as to get maximum satisfaction, an individual purchases in such a manner that the marginal utility of the commodity is equal to the price of the commodity. When the price of commodity falls, a rational consumer purchases more so as to equate the marginal utility and the price level. Thus, if a consumer wants to purchase larger quantities, then the price must be lowered. This is what the law of demand also states.

Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

40 | P a g e

Theory of Production Production Production is an economic activity that makes goods available for consumption. Production at times is also defined as all economic activities minus consumption. It is the process of creating goods or services using various available resources.

The Production Function: The production function refers to the physical relationship between the inputs or resources of a firm and their output of goods and services at a given period of time, ceteris paribus. In microeconomics and macroeconomics, a production function is a function that specifies the output of a firm, an industry, or an entire economy for all combinations of inputs. This function is an assumed technological relationship, based on the current state of engineering knowledge; it does not represent the result of economic choices, but rather is an externally given entity that influences economic decision-making. Almost all economic theories presuppose a production function, either on the firm level or the aggregate level. In this sense, the production function is one of the key concepts of mainstream neoclassical theories. There are several ways of specifying the production function. In a general mathematical form, a production function can be expressed as: � = �(�1 , �2 , �3 , ‌ . . �� ) Where: Q = quantity of output �1 , �2 , �3 , ‌ . . �� = quantities of factor inputs (such as capital, labor, land or raw materials). This general form does not encompass joint production; that is a production process that has multiple co-products or outputs.

Production function as a graph Any of these equations can be plotted on a graph. A typical (quadratic) production function is shown in the following diagram under the assumption of a single variable input (or fixed ratios of inputs so they can be treated as a single variable). All points above the production function are unobtainable with current technology, all points below are technically feasible, and all points on the function show the maximum quantity of output obtainable at the specified level of usage of the input. From the origin, through points A, B, and C, the production function is rising, indicating that as additional units of inputs are used, the quantity of outputs also increases. Beyond point C, the employment of additional units of inputs produces no additional outputs (in fact, total output starts to decline); the variable input is being used too intensively. With too much variable input use relative to the available fixed inputs, the company is experiencing negative returns to variable inputs, and diminishing total returns. In the diagram this is illustrated by the negative marginal physical product curve (MPP) beyond point Z, and the declining production function beyond point C.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

41 | P a g e

Quadratic Production Function

From the origin to point A, the firm is experiencing increasing returns to variable inputs. As additional inputs are employed, output increases at an increasing rate. Both marginal physical product (MPP, the derivative of the production function) and average physical product (APP, the ratio of output to the variable input) are rising. The inflection point A defines the point beyond which there is diminishing marginal returns, as can be seen from the declining MPP curve beyond point X. From point A to point C, the firm is experiencing positive but decreasing marginal returns to the variable input. As additional units of the input are employed, output increases but at a decreasing rate. Point B is the point beyond which there are diminishing average returns, as shown by the declining slope of the average physical product curve (APP) beyond point Y. Point B is just tangent to the steepest ray from the origin hence the average physical product is at a maximum. Beyond point B, mathematical necessity requires that the marginal curve must be below the average curve

Stages of production To simplify the interpretation of a production function, it is common to divide its range into 3 stages. In Stage 1 (from the origin to point B) the variable input is being used with increasing output per unit, the latter reaching a maximum at point B (since the average physical product is at its maximum at that point). Because the output per unit of the variable input is improving throughout stage 1, a price-taking firm will always operate beyond this stage. In Stage 2, output increases at a decreasing rate, and the average and marginal physical product are declining. However the average product of fixed inputs (not shown) is still rising, because output is rising while fixed input usage is constant. In this stage, the employment of additional variable inputs increases the output per unit of fixed input but decreases the output per unit of the variable input. The optimum input/output combination for the price-taking firm will be in stage 2, although a firm facing a downward-sloped demand curve might find it most profitable to operate in Stage 1. In Stage 3, too much variable input is being used relative to the available fixed inputs: variable inputs are over-utilized in the sense that their presence on the margin obstructs the production process rather than enhancing it. The output per unit of both the fixed and the variable input Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

42 | P a g e

declines throughout this stage. At the boundary between stage 2 and stage 3, the highest possible output is being obtained from the fixed input.

Factors of production Production function shows the relationship between the quantity of a good/service produced (output) and the factors or resources (inputs) used. The inputs used for producing these goods and services are called factors of production. 

Variable factor of Production: A variable factor of production is one whose input level can be varied in the short run. Raw material inputs are a variable factor and unskilled labor is usually thought of as a variable factor. Fixed factor of production: A fixed factor of production is one whose input level cannot be varied in the short run. Capital is usually a fixed factor. Capital refers to resources such as buildings and machinery etc.

Types of Production Functions 1. Linear Production Function (Long-run Production Function): A production function that assumes a perfect linear relationship between inputs & total output. 2. Leontief Production Function (Short-run Production Function): A production function that assumes that inputs are used in fixed proportions. 3. Cobb-Douglas Production Function: A production function that assumes some degree of substitutability between inputs.

The Short Run Production Function The short run is defined in economics as a period of time where at least one factor of production is assumed to be in fixed supply i.e. it cannot be changed. We normally assume that the quantity of capital inputs (e.g. plant and machinery) is fixed and that production can be altered by suppliers through changing the demand for variable inputs such as labor, components, raw materials and energy inputs. Often the amount of land available for production is also fixed. In the short run, the law of diminishing returns states that as we add more units of a variable input (i.e. labor or raw materials) to fixed amounts of land and capital, the change in total output will at first rise and then fall. Diminishing returns to labor occurs when marginal product of labor starts to fall. This means that total output will still be rising – but increasing at a decreasing rate as more workers are employed. As we shall see in the following numerical example, eventually a decline in marginal product leads to a fall in average product. A graphically presentation is given below-

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

43 | P a g e

Total product curve A curve that graphically represents the relation between total production by a firm in the short run and the quantity of a variable input added to a fixed input. When constructing this curve, it is assumed that total product changes from changes in the quantity of a variable input like labor, while we hold one or more other inputs, like capital, fixed. A more general mathematical concept capturing the relation between total product and it's assorted inputs, both variable and fixed, can be found in production function.

Average Physical Product The average physical product is the total production divided by the number of units of variable input employed. It is the output of each unit of input. If there are 10 employees working on a production process that manufactures 50 units per day, then the average product of variable labour input is 5 units per day.

Average and Marginal Physical Product Curves

The average product typically varies as more of the input is employed, so this relationship can also be expressed as a chart or as a graph. A typical average physical product curve is shown (APP). It can be obtained by drawing a vector from the origin to various points on the total product curve and plotting the slopes of these vectors.

Marginal Physical Product The marginal physical product of a variable input is the change in total output due to a one unit change in the variable input (called the discrete marginal product) or alternatively the rate of change in total output due to an infinitesimally small change in the variable input (called the continuous marginal product). The discrete marginal product of capital is the additional output resulting from the use of an additional unit of capital (assuming all other factors are fixed). The continuous marginal product of a variable input can be calculated as the derivative of quantity produced with respect to variable input employed. The marginal physical product curve is shown (MPP). It can be obtained from the slope of the total product curve.

Law of variable proportions This law is called law of variable proportions because output of firm changes with the variation in factor-proportions. In short run the output of goods and services is increased by introducing additional variable factor to the production process to a said quantity of fixed factors. Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

44 | P a g e

Law of variable proportions outlines the various possible output scenarios due to the change in the proportions of fixed and variable factors used for production. If we increase the number of a factor (labor) keeping all other factors fixed (capital), and then the proportion between the fixed and variable factors is changed. The law of variable proportions implies that as we keep on adding the variable factor of production the marginal product of that factor keeps on decreasing progressively. Thus after a point every additional unit of factor added will result in a smaller increase in output. The law of variable proportion is also known as law of diminishing marginal returns or law of diminishing returns. The law has several assumptions as below:  one input is variable while others are fixed in the short run  all units of the variable input are same and have equal efficiency  no change in production technology  factors of production like land and labor can be used in different proportions For instance, hiring additional employees (a variable resource) to work at a factory will initially increase output but eventually it will become more and more difficult to generate additional output from the fixed resources (due to plant size and equipment limitations) and thus the total output will increase at a decreasing rate and ultimately will start decreasing. To further understand this let us consider an example of production of shirts in a factory. Refer to the table below: Labour (workers/day)

Total Product (shirts per day)

1 2 3 4 5 6 7 8

2 5 9 12 14 15 15 14

Marginal product (shirts per additional worker) 3 4 3 2 1 0 -1

Average Product (shirts per worker) 2.00 2.50 3.00 3.00 2.80 2.50 2.14 1.75

The numbers in the above table shows that as additional number of workers are put on work the total production of shirts increases. Total product is the maximum output that a given quantity of input can produce. Marginal product is the increase in total output due to an increase in a unit of input (labor) with all other inputs remaining constant. ∆TP MP = ∆L Average product is the average quantity of shirts produced by each worker. This tells us how productive workers are on an average. TP AP = L

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

45 | P a g e

As we can see from the above table, marginal product at first increases and then starts decreasing. Average product also similarly first increases and then starts decreasing. The relationship between these 3 product concepts and input can be further explained using the three product curves below

In the figure above the input (labor) is shown on x axis while the output (shirts) are shown on the y axis. As we can see from the figure up to three input units the production increases at increasing rate and thus marginal product (MP) is highest. After this MP curve starts declining and intersects average product (AP) curve. At this point AP is highest and after this AP also starts to decline. At 7 input units the total product is maximum and MP is zero. Thereafter TP starts decreasing leading to negative marginal product The three stages of production as shown above in the figure above can be summarized as follows:

Stages Stage 1

Stage 2

Stage 3

Total Product(TP)

Marginal Product (MP)

Average product (AP)

Increase at increasing rate and then at diminishing rate Continues to increase and reaches its maximum Starts decreasing

Initially increases and reaches the maximum point, thereafter starts decreasing Continues to decrease and reaches to zero

Increases and reaches its maximum. At this stage AP=MP

Moves to negative territory

Continues to decrease but always remains above zero

Starts to diminish. Remains above the MP curve

Relationship between Marginal Product (MP) and Average Product (AP) We can observe the relationship between MP and AP as below, ďƒ˜ When the marginal is greater than the average, the average increases, MP>AP. Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

46 | P a g e

  

When the marginal is less than the average, the average decreases, MP<AP. When the marginal is equal to the average, the average does not change (it is either at maximum or minimum), AP=MP. MP can be zero or negative, but AP continues to be positive always.

Long run production Function Long run refers to that period of time in which all inputs are variable. In economic models, the long-run time frame assumes no fixed factors of production. Firms can enter or leave the marketplace, and the cost (and availability) of land, labor, raw materials, and capital goods can be assumed to vary. If the demand for the firm's product increases, the firm can increase its output by enlarging the size of its plant or increasing the scale of its operations.

On a curve we have different combinations of L and K that give the same amount of output. Curves farther out in the northeast direction have more output. Later we will say more about what the firm uses as a guide to choice of position in the graph. The position chosen will have implications for the amount of labor demanded.

So in the long run there is enough time to effect changes in the scale operations or to introduce other adjustment in the organization set- up of the firm. In fact the firm in the long period, can build any desired scale of plant. All factors are variable none is fixed. In the long run, then, there are number of decisions that a firm will have to make about the scale of its operations, the location of its operations and the techniques of production it will use. In this concept it explains the laws of return to scale.

Isoquants Isoquants are those combination of inputs or factors of production which provides an equal or same quantity of output. In other words, an isoquant is a curve (or locus of points) showing all possible combinations of the input physically capable of producing a given (fixed) level of output. Each point on an isoquant is technically efficient. Isoquant curves are also called Equal product or isoproduct curve. For a production function which denotes isoquant: Q=F(L,K), Where, Q is fixed level of production, L = labor and K = Capital are variable Different resources/ inputs are required for production of goods. Same number of outputs can be produced using different input combinations. Isoquant is the combination of all such combination of inputs which produces same output. Thus we have an isoquant curve for every level of output. Since the quantity produced will remain unchanged on an isoquant, the producer is indifferent for different input combinations.

Properties of isoquants We now set forth the typically assumed characteristics of isoquants when labor, capital, and output are continuously divisible. Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

47 | P a g e

 Isoquant slopes downwards from left to right. Because, when quantity of input labor is increased, the quantity of capital must be reduced so as to keep output constant.  Higher isoquant represents higher level of output. Because, higher isoquant consists of more of both labor and capital.  No two isoquants intersect each other. If two isoquants intersect each other it would mean that with the same unit of labor and capital, two different levels of output can be produced, which is absurd.  Isoquants are convex to the origin due to diminishing marginal rate of technical substitution.

Isoquant Q1 shows all technologically efficient combinations of labor and capital that can be used to produce 290 units of output. Isoquant Q2 is drawn for 415 units and Q3 for 475 units. Each isoquant has a negative slope and is convex to the origin.

Types of Isoquants There are three types of Isoquants, they are, 1. Linear isoquants: In linear isoquants there is perfect substitutability of inputs. For example, in a power plant equipped to burn oil or gas. Various amounts of electricity could be produced by burning gas, oil or combination i.e. oil and gas are perfect substitutes. Hence the isoquant would be a straight line. 2. Right-Angle isoquants: In right-angle isoquants there is complete non-substitutability between inputs. For example, two wheels and frame are required to produce a bicycle, these cannot be interchanged. This is also known as Leontief isoquant or input-output isoquant. 3. Convex isoquants: In convex isoquants there is substitutability between inputs but it is not perfect. For example, a) A shirt can be made with large amount of labor and small amount machinery. b) The same shirt can be made with less laborers, by increasing machinery. c) The same shirt can be made with less laborers but with a larger increase in machinery.

Isoquants for perfect substitutes and perfect compliments If the two inputs are perfect substitutes, the resulting isoquant map generated is represented in fig. A; with a given level of production Q3, input X can be replaced by input Y at an unchanging rate. The perfect substitute inputs do not experience decreasing marginal rates of return when they are substituted for each other in the production function. Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

48 | P a g e

If the two inputs are perfect complements, the isoquant map takes the form of fig. B; with a level of production Q3, input X and input Y can only be combined efficiently in the certain ratio occurring at the kink in the isoquant. The firm will combine the two inputs in the required ratio to maximize profit.

Isocost: Isocost is ratio of change of capital to labor. Line close to origin indicates lower cost outlay. In economics an isocost line shows all combinations of inputs which cost the same total amount. Although similar to the budget constraint in consumer theory, the use of the isocost line pertains to cost-minimization in production, as opposed to utility-maximization. For the two production inputs labor and capital, with fixed unit costs of the inputs, the equation of the isocost line is, đ?‘„ = đ?‘&#x;đ??ž + đ?‘¤đ??ż Where, w represents the wage rate of labor, r represents the rental rate of capital, K is the amount of capital used, L is the amount of labor used, and Q is the total cost of acquiring those quantities of the two inputs.

In diagram AB line is the isocost line, it shows all the pairs of K and L for which the cost of the firm remains same. A producer can purchase any of these pairs for given budget. A pair of capital and Labour on the right side of Isocost line e.g. Combination L is not Purchasable. Any pair below the isocost line is purchasable but with smaller cost. The absolute value of the slope of the isocost line, with capital plotted vertically and labor plotted đ?‘¤ horizontally, equals the ratio of unit costs of labor and capital. The slope is: − . đ?‘&#x;

The isocost line is combined with the isoquant map to determine the optimal production point at any given level of output. Specifically, the point of tangency between any isoquant and an isocost Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

49 | P a g e

line gives the lowest-cost combination of inputs that can produce the level of output associated with that isoquant. Equivalently, it gives the maximum level of output that can be produced for a given total cost of inputs.

Isocost curves Isocost curves are lines that show the various combinations of inputs that may be purchased for a given level of expenditure at given input price.

Properties of isocost curves: ďƒ˜ An infinite number of isocost curves exist. One for each level of total cost. đ?‘¤ ďƒ˜ The slope of the isocost curve is equal to the negative of the relative input price ratio, − . đ?‘&#x; This ratio is important because it tells the manager how much capital must be given up if 1 more unit of labor is purchased.

Shifts in isocost curves If the constant level of total cost associated with a particular isocost curve changes, the isocost curve shifts parallel. An increase in cost, holding input price constant, leads to a parallel upward shift in the isocost curve. A decrease in cost, holding input price constant, leads to a parallel downward shift in the isocost curve.

Law of Returns to Scale The law of return to scale is long run concept. In the long run volume if production can be changed by changing all factor of production. It shows the behavior of output when all factor are altered in the same proportion. Returns to scale are of three types, 1. Economies of scale: Economies of scale, in microeconomics, refers to the cost advantages that a business obtains due to expansion. There are factors that cause a producer’s average cost per unit to fall as the scale of output is increased. Economies of scale (also called increasing returns to scale) occur when long run average total cost declines as output rises. This is a property of the production function. Doubling all inputs results in more than double the output.

As quantity of production increases from Q to Q2, the average cost of each unit decreases from C to C1. 2. Diseconomies of scale: Diseconomies of scale are the forces that cause larger firms to produce goods and services at increased per-unit costs. Diseconomies of scale (also called decreasing returns to scale) occur when long run average Cost rises as output rises. Doubling all inputs leads to less than double the output.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

50 | P a g e

The rising part of the long-run average cost curve illustrates the effect of diseconomies of scale. Beyond Q1 (efficient output), additional production will increase per-unit costs 3. Constant returns to scale: Constant returns to scale are an attribute of a production function. Constant returns to scale occur when long run average total cost does not vary with output. If we increase all factors in a given proportion and the output increase in the same proportion, returns to scale are said to be constant. Thus, if a doubling or trebling of all factors causes a doubling or trebling of output, returns to scale are constant.

We can conceive of different returns to scale diagrammatically in the simplest case of a oneinput/one-output production function y = f (x) as in graph (note: this is not a total product curve!). As all our inputs (in this case, the only input, x) increase, output (y) increases, but at different rates. At low levels of output (around y1), the production function y = f(x) is convex, thus it exhibits increasing returns to scale (doubling inputs more than doubles output). At high levels of output (around y3), the production function y = f(x) is concave, thus it exhibits decreasing returns to scale (doubling inputs less than doubles output).

Note: the relationship between convexity and concave production functions and returns to scale can be violated unless the f (0) = 0 assumption is imposed.

Reasons for economies of scale:  Higher production allows for the employment of more workers, who can specialize in tasks they excel at. (Assembly line)  Larger batches allow for lower setup costs.  Some inputs only need to be used once, no matter how much output is produced, like programmers of computer software. Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

51 | P a g e

Reasons for diseconomies of scale: ďƒ˜ Coordination costs rise exponentially as the organization gets bigger. For intermediate levels of output, there are often constant returns to scale: duplicate what you are doing. Just build another factory, hire more workers and managers. If it is not a big deal to coordinate the two factories, then total costs and output should double.

Returns to Scale in isoquants:

Cost Function The cost function is a function of input prices and output quantity. Its value is the cost of making that output given those input prices. In other words, the term cost function is a financial term used by economists and mangers within businesses to understand how costs behave. The cost function shows how a cost changes as the levels of an activity relating to that cost change. There are three basic types of linear cost functions: fixed, variable, and total. In fixed functions, the cost is the same regardless of activity; variable functions change the cost depending on activity; and total functions combine the two — a cost will be fixed to a certain point, then can change based on related activity. Cost function is formed as, � = �0 + �1 � + �2 � 2 + �3 � 3 Total fixed cost

Total variable cost

where: Q – total production cost, y – production quantity

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

52 | P a g e

Equilibrium of Producer When a producer combines such a combination of two factors which yield maximum output for given cost or produces given output for minimum cost, it is called producers equilibrium or optimal combination of two factors of production. A combination of factors which makes a producer to be in equilibrium is called optimum combination. The equilibrium of producer is determined at a point where Isoquant is tangent to Isocost curve. Equilibrium of producer can be defined in following situations, 1. When output is given: A producer will be in equilibrium when given output is produced with minimum cost. In this situation equilibrium is at a point where IQ becomes tangent to lowest Isocost.

The equilibrium of the producer is at E where isocost line AB is tangent to given IQ. The output level shown by IQ can be produced at point L, but it shows higher cost for same output level. On the other hand this output level cannot be produced at CD isocost line. Therefore equilibrium of producer is at point E. 2. When cost is given: A producer is in equilibrium when maximum output is produced with given cost. In this case equilibrium is at a point where given is isocost is tangent to the highest IQ.

In this diagram cost or budget of the producer is given and shown by AB isocost line. Given this budget, a firm cannot produce IQ3 level of output as it is beyond the reach of the producer. On the other hand if firm produces at point K, it will only get output level of IQ1 which is not best level of output. Therefore equilibrium of producer is at point E.

Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University. Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

53 | P a g e

Marginal rate of technical substitution Since the two inputs can be substituted for one another to maintain a constant level of output, the rate at which one input is substituted for another along an isoquant is called the marginal rate of technical substitution MRTS  . In other words, the extra amount of one input which has to be added to compensate for an amount of another input which decreases, in order to keep up the same production levels is called MRTS . ∆đ??ž . The minus sign is added in order to make MRTS a positive MRTS is defined as: đ?‘€đ?‘…đ?‘‡đ?‘† = − ∆đ??ž

∆đ??ż

number, since , the slope of the isoquant, is negative. Over the relevant range of production the ∆đ??ż marginal rate of technical substitution diminishes. That is, as more and more labor is substituted for ∆đ??ž capital while holding output constant, the absolute value of decreases. ∆đ??ż

We can interpret the marginal rate of technical substitution (MRTS) graphically. The MRTS at point b on the q2 isoquant in the figure equals the absolute value of the slope of the straight line that is tangent to the isoquant at that point. The MRTS is approximately equal to the absolute value of the ∆đ??ž slope of the line from point b to point c, which equals (the rise divided by the run). As ∆đ??ż and ∆đ??ż ∆đ??ž become small, this approximation becomes exact.

Law of Diminishing Marginal Rate of Technical Substitution As less of one input is used, increasing amounts of another input must be used to produce the same level of output. The more of one input you use, the less productive it is relative to the other input. Yields typical ―bowed-in‖ isoquants. The MRTS falls as we move down along an isoquant. ďƒ˜ When more labor is added to the production process in place of capital, the productivity of labor falls. ďƒ˜ When more capital is added to the production process in place of labor, the productivity of capital falls. As more and more labor is added, the marginal product of labor is likely to diminish. Because capital has been reduced, each unit of capital remaining is likely to be more productive. Therefore, more units of labor will be required to replace each unit of capital. Alternatively, as we move down and to the right along an isoquant along which the MRTS is diminishing, we have to give up less capital for each unit of labor added to keep output constant.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

54 | P a g e

Output Maximization A process that companies undergo to determine the best output and price levels in order to maximize its return. The company will usually adjust influential factors such as production costs, sale prices, and output levels as a way of reaching its profit goal. There are two main profit maximization methods used, and they are Marginal Cost-Marginal Revenue Method and Total Cost-Total Revenue Method. Output maximization is a good thing for a company, but can be a bad thing for consumers if the company starts to use cheaper products or decides to raise prices.

Cost Minimization In case of cost minimization the process or goal of incurring the least possible opportunity cost in the pursuit of a given activity. Cost minimization is comparable to other objectives, including utility maximization and profit maximization. In other words, Cost minimization is the behavioral assumption that an individual or firm will seek to purchase a given amount of goods or inputs at the least cost, other things being equal. By making certain assumptions, there will exist a single cost-minimizing combination of inputs for any level of output. This goal, however, is generally used when circumstances constrain a decision. For example, a government agency has been assigned the task of building a bridge. It must now do so at the lowest cost possible.

Economic Efficiency Economic or Allocative efficiency is achieved when the value consumers place on a good or service (reflected in the price they are willing to pay) equals the cost of the resources used up in production. Condition required is that price equal to marginal cost. When this condition is satisfied, total economic welfare is maximized.

Production Efficiency Production efficiency measures whether the economy is producing as much as possible without wasting precious resources. Theoretically, production efficiency will include all of the points along the production possibility frontier, but this is difficult to measure in practice. Because resources are limited, being able to make products efficiently allows for higher levels of production. If the economy can't make more of a good without sacrificing the production of another, then a maximum level of production has been reached.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

55 | P a g e

In the producers' point of view, obviously, due to the lower price received by producers, producer surplus has been reduced. Without the tax, producers would be earning total rents (profits) equal to the area ACJ. At the lower domestic price, however, producers only earn rents equal to the area FGJ. The difference - the shaded area ACGF - represents the loss in producer surplus due to the tax. From the economy's point of view, the reduction in production from Q1 to Q2 is inefficient. In the absence of the tax, producers could produce the (Q1-Q2) amount of rice at a cost equal to the area Q1Q2GC; yet with the policy the government has to import this amount of rice at the world price at a total cost equal to Q1Q2BC. The difference, the triangular area BCG, is the additional cost to the economy of importing rice at a higher opportunity cost than domestic production. This triangle is commonly labeled the "production efficiency loss" of the rice subsidy.

Production-Possibility Frontier (PPF) In economics, a production-possibility frontier (PPF), sometimes called a production-possibility curve or product transformation curve, is a graph that shows the different rates of production of two goods and/or services that an economy can produce efficiently during a specified period of time with a limited quantity of productive resources, or factors of production. The PPF shows the maximum amount of one commodity that can be obtained for any specified production level of the other commodity (or composite of all other commodities), given the society's technology and the amount of factors of production available. The production efficiency locus can be translated to a diagram for goods X and Y. Points along the locus represent different combinations of X and Y produced. In Point A, a small amount of X is produced, a lot of Y. In Point B, more X and less Y. In Point C, even more X and Less Y.

If opportunity cost of producing more and more of a particular good increases, then the highest combination of output occurs near the middle of the ppf. As production of one good (say X) increases at the expense of good Y, the amount of extra good X that can be produced with each additional unit of inputs (factors) is less than the previous extra good X.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

56 | P a g e

Cobb–Douglas production function and Its Properties In economics, the Cobb–Douglas functional form of production functions is widely used to represent the relationship of an output to inputs. Cobb-Douglas production function which has the form đ?‘„ = đ??´đ??ž đ?›ź đ??żđ?›˝ where: Q = total production (the monetary value of all goods produced in a year) L = labor input K = capital input A = total factor productivity Îą and β are the output elasticities of labor and capital, respectively. These values are constants determined by available technology. Let đ??žâ€˛ = đ?‘?đ??ž and đ??żâ€˛ = đ?‘?đ??ż. Then, đ?‘„′ = đ??´đ??žâ€˛đ?›ź đ??żâ€˛đ?›˝ By substitution, đ?‘„′ = đ??´ đ?‘?đ??ž đ?›ź (đ?‘?đ??ż)đ?›˝ Which reduces to đ?‘? đ?›ź+đ?›˝ đ??´đ??ž đ?›ź đ??żđ?›˝ or đ?‘„′ = đ?‘? đ?›ź +đ?›˝ đ?‘„ . If đ?›ź + đ?›˝ <1, then đ?‘? đ?›ź+đ?›˝ < c, so this is a case of decreasing returns to scale. Alternatively, đ?›ź + đ?›˝ >1 indicates increasing returns to scale, and đ?›ź + đ?›˝ =1 indicates constant returns to scale.

Elasticity of Substitution Elasticity of substitution is the elasticity of the ratio of two inputs to a production (or utility) function with respect to the ratio of their marginal products (or utilities). Responsiveness of the buyers of a good or service to the price changes in its substitutes. It is measured as the ratio of proportionate change in the relative demand for two goods to the proportionate change in their relative prices. Elasticity of substitution shows to what degree two goods or services can be substitutes for one another. See also elasticity of technical substitution. It measures the curvature of an isoquant. The elasticity of substitution between factors of production is a measure of how easily one factor can be substituted for another. With two factors of production, say, K and L, it is a measure of the curvature of a production isoquant. The mathematical definition is: đ??ż −1 đ?œ• đ?‘ đ?‘™đ?‘œđ?‘?đ?‘’ đ??ž đ??¸= đ??ż đ?œ• đ?‘ đ?‘™đ?‘œđ?‘?đ?‘’ đ??ž where "slope" denotes the slope of the isoquant, given by: đ?‘ đ?‘™đ?‘œđ?‘?đ?‘’ = −

đ?œ•đ?‘“ (đ??ž ,đ??ż) đ?œ•đ??ž đ?œ•đ?‘“ (đ??ž ,đ??ż) đ?œ•đ??ż

.

Constant Elasticity of Substitution In economics, Constant elasticity of substitution (CES) is a property of some production functions and utility functions. More precisely, it refers to a particular type of aggregator function which combines two or more types of consumption, or two or more types of productive inputs into an aggregate quantity. This aggregator function exhibits constant elasticity of substitution. 

The CES production function is a type of production function that displays constant elasticity of substitution. In other words, the production technology has a constant percentage change in factor Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

57 | P a g e

(e.g. labour and capital) proportions due to a percentage change in marginal rate of technical substitution. The two factor (Capital, Labor) CES production function is: 1

đ?‘„ = đ?‘“(đ?‘Žđ??ž đ?‘&#x; + 1 − đ?‘Ž đ??żđ?‘&#x; )đ?‘&#x;

Where Q = Output, f = Factor productivity, a = Share parameter; K, L = Primary production factors (đ?‘ −1) 1 (Capital and Labor); r = ;s= = Elasticity of substitution. đ?‘

(1−đ?‘&#x;)

The CES production function exhibits constant elasticity of substitution between capital and labor. Leontief, linear and Cobb-Douglas production functions are special cases of the CES production function. That is, in the limit as s approaches 1, we get the Cobb-Douglas function; as s approaches 0 we get the linear (perfect substitutes) function; and for s approaching infinity, we get the Leontief (perfect complements) function. The general form of the CES production function is: đ?‘›

đ?‘„=đ?‘“

1 (đ?‘ −1) đ?‘Žđ?‘– đ?‘ đ?‘Ľđ?‘– đ?‘

đ?‘ (đ?‘ −1)

đ?‘–=0

Where Q = Output; f = Factor productivity; a = Share parameter; x = Production factors (i = 1,2...n); s = Elasticity of substitution.

Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

58 | P a g e

LAWS OF RETURNS Law of Increasing Returns Law of increasing return discusses initial changes in production when units of variable factors are applied to a fixed factor. This law can be stated in the following words: ―If Successive units of variable factors are applied to a fixed factor then up to a point the marginal product of the factor will increase, this is called law of increasing return.‖ FF 10 10 10 VF 1 2 3 MP 10 20 30

10 10 4 5 40 50

This table explains the law of increasing return. According to this table when first unit of variable factor is applied to the 10 units of fixed factor, its marginal product is 10 but when 2nd unit of the variable factor is applied then this produces additional 20 units thus marginal product of every next unit of variable factor goes on increasing under the law of increasing return.

Law of Diminishing Returns The law of diminishing returns simply refers to a principle of combination of the factors. In a general way, it can be stated that if a variable factor is combined with some fixed factors, the average and the marginal return for that variable factor will diminish, Benham states the law thus: "As the proportion of one factor in a combination of factors is increased, after a point the average and marginal product of that factor will diminish." This is due to the fact that the combination does not represent a correct proportion of the factors. There is too much of one factor in relation to others. When proper balance is restored the law of diminishing returns will no longer operate. FF 10 10 10 10 10 VF 1 2 3 4 5 MP 50 40 30 20 10

This table explains the law of diminishing returns. In this table we assume that law of diminishing returns starts from the very first unit of variable factor although in practice its application starts beyond the optimal combination of fixed and variable factors. According to this table when first unit of variable factor is applied to the 10 units of fixed factor, its marginal product is 50 but when 2nd unit of the variable factor is applied then this produces additional 40 units thus marginal product of every next unit of variable factor goes on decreasing under the law of decreasing returns CAUSES OF DIMINISHING RETURNS

There are many causes which are responsible for the law of diminishing returns.  Fixed productive capacity: The fertility of land and the productive capacity of machinery have fixed maxima. Employment beyond a point overstrains the fixed factor (land or machinery). This results in diminishing returns.  Scarcity of the factors: The supply of the various factors of production beyond a point becomes relatively inelastic and if demand continues to increase the prices of these factors will rise. In the words of Chapman, "The expansion of an industry, provided that additional Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

59 | P a g e

supplies of some agent in production which is essential cannot be obtained, is invariably accompanied at once or eventually by decreasing returns, other things being equal."  Limited capacity for organization and supervision: Even if it were possible to increase productive capacity indefinitely and to substitute one factor for another, the diminishing returns would still ultimately set in. This is so, because the work of supervision and organization, after a point, would become so heavy and cumbersome that it becomes difficult for a single farmer or entrepreneur to manage.  Defective combination of factor: Beyond a point of optimum combination, diminishing returns set in.  Imperfect substitutes: Factors of production cannot be substituted for one another. As Mrs. Robinson says, "What the law of diminishing returns really states is that there is a limit to the extent to which one factor of production can be substituted for another. That is why beyond a point law of diminishing returns sets in. The additional supply of factors cannot be arranged.

Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

60 | P a g e

COSTS OF PRODUCTION Cost Analysis: Cost Analysis refers to the Study of Behavior of Cost in relation to one or more Production Criteria like size of Output, Scale of Operations, Prices of Factors of Production. In other words, Cost Analysis related to the Financial Aspects of Production Relations against Physical Aspects.

Cost Function: The cost function refers to the mathematical relation between cost of a product and the various Determinants of costs. đ??ś = đ?‘“(đ?‘„, đ?‘‡, đ?‘ƒ, đ??ž) Here, Q = Quantity produced or output, T = Technology, P = Factor Price, K = Capital.

Opportunity Cost Principle The economic cost of an input used in a production process is the value of output sacrificed elsewhere. The opportunity cost of an input is the value of foregone income in best alternative employment. In other words, If there is no increase in productive resources, increasing production of a first good entails decreasing production of a second, because resources must be transferred to the first and away from the second. Points along the curve describe the trade-off between the goods. The sacrifice in the production of the second good is called the opportunity cost (because increasing production of the first good entails losing the opportunity to produce some amount of the second). Opportunity cost is measured in the number of units of the second good forgone for one or more units of the first good.

Explicit Costs: Explicit costs, is that, costs paid in cash. Explicit cost refers to the out of pocket or cash expenditures a firm makes to outsiders to supply resources. Wages paid to workers, payments to suppliers of raw materials, and fees paid to bankers and lawyers are all included among the firm's explicit costs. Implicit Costs: Implicit cost imputed cost of self-owned or self employed resources based on their opportunity costs .In other words, implicit cost refers to the money payments the self-employed resources could have earned in their best alternative employment. For example, a firm that uses its own building for production purposes forgoes the income that it might receive from renting the building out. Outlay Costs:Involves Actual Expenditure of Funds.e.g. Wages, Rent, Interest, etc.Outlay Co

sts are recorded in the Books of Accounts as it involves Financial Expenditure at some Time. Direct Costs & Indirect Costs Direct Costs are Costs that are readily identified and are Traceable to a particular Product, Operation or Plant. E.g., Manufacturing Costs to a Product Line. Indirect Costs are Costs that are not readily identified and are not Traceable to a particular Product, Operation or Plant. E.g., Electric Power, Salary to Gatekeeper, etc. Although not traceable but bears Functional Relationship to Production. Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

61 | P a g e

Fixed Costs & Variable Costs Fixed Costs require a Fixed Expenditure of Funds irrespective of the Level of Output e.g. Rent, Interest on Loans, Depreciation, etc.Fixed Cost does not vary with the Volume of Output within a Capacity Level. Fixed Cost may disappear on the Complete Shut Down of Business. Variable Costs are costs that are a Function of Output in the Production Period e.g. Wages & Cost of Raw Materials. Variable Costs vary Directly or sometimes Proportionately with Output.

Types of Profit The difference between explicit and implicit costs is crucial to understanding the difference between accounting profits and economic profits. Accounting profits: Accounting profits are the firm's total revenues from sales of its output, minus the firm's explicit costs. Economic profits: Economic profits are total revenues minus explicit and implicit costs. Alternatively stated, economic profits are accounting profits minus implicit costs. Thus, the difference between economic profits and accounting profits is that economic profits include the firm's implicit costs and accounting profits do not. Normal profits: A firm is said to make normal profits when its economic profits are zero. The fact that economic profits are zero implies that the firm's reserves are enough to cover the firm's explicit costs and all of its implicit costs, such as the rent that could be earned on the firm's building or the salary the owner of the firm could earn elsewhere. These implicit costs add up to the profits the firm would normally receive if it were properly compensated for the use of its own resources— hence the name, normal profits. Normal profit is an implicit cost TECHNICAL EFFICIENCY: Generally Technical efficiency refers to obtaining the greatest possible production of goods and services from available resources and should be contrasted with economic or allocative efficiency. In a broad sense, Technical efficiency means that natural resources are transformed into goods and services without waste, that producers are doing the best job possible of combining resources to make goods and services. There is no waste of material inputs. There are no workers standing idly around waiting for spare parts. The maximum amount of physical production is obtained from the given resource inputs. In essence, production is achieved at the lowest possible opportunity cost. Technical efficiency is a prerequisite for allocative or economic efficiency. Economic efficiency is achieved if the highest possible level of satisfaction is obtained from given resources. Because satisfaction is derived from consuming goods and services, economic efficiency requires the greatest possible level of production, that is, technical efficiency. ECONOMIC EFFICIENCY: Generally Economic efficiency refers to obtaining the most consumer satisfaction from available resources. In other words, resources are allocated in such a way that consumer satisfaction is at its highest possible level. This is also termed either efficiency or allocative efficiency. In a broad sense, Economic efficiency means the economy is doing the best job possible of satisfying unlimited wants and needs with limited resources, that is, of addressing the problem of Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

62 | P a g e

scarcity. To achieve economic efficiency, however, the economy must first achieve technical efficiency. However, while technical efficiency is necessary for economic efficiency, it does not guarantee economic efficiency. While technical efficiency might be achieved in the production of purple spotted stuffed animals, allocative or economic efficiency is not achieved if no one actually wants purple spotted stuffed animals and they remain stored in a big purple warehouse.

Short run cost The Short Run is a period of time too brief for an enterprise to alter its plant capacity. This means that we can change the intensity at which the fixed plant is used. Short run cost function: đ??ś = đ?‘“(đ?‘„) Total Cost, Average Cost, and Marginal Cost can be divided into 2 components --fixed costs and variable costs. ďƒ˜ Fixed Cost: In the short-run, some of the input factors the firm uses in production are fixed. Even if production is zero, the cost of these fixed factors is the firm's fixed costs. Fixed costs cannot be changed in the short run. Total fixed cost(TFC) are the sum of all of the fixed cost. Total fixed cost is more commonly referred to as "sunk cost" or "overhead cost." Graphically, depicted as a horizontal line. ďƒź Beyond current control ďƒź Examples: Rental payments, interest on a firm's debts, insurance premiums, and a portion of deprecation on equipment and buildings, insurance premiums, Salaries to top management ďƒ˜ Variable Cost: The firm also employs a number of variable factors of production. The cost of these variable factors of production is the firm's variable costs. In order to increase output, the firm must increase the number of variable factors of production that it employs. Therefore, as firm output increases, the firm's variable costs must also increase. Total Variable Costs (TVC) is the sum of all of the variable costs, and costs that change with level of output. Variable costs can be changed in the short run. ďƒź Variable costs first increase by a decreasing amount, but later it increase by increasing amounts (due to MP curve) ďƒź Examples: payments for materials, fuel, power, cost of ingredients, transportation services, labor, etc. ďƒź Can be controlled in the short run by changing production levels Total variable cost increases as the amount of output increases. ďƒź If no output is produced, then total variable cost is zero; ďƒź The larger the output, the greater the total variable cost. Total Cost (TC): The sum of fixed cost and variable cost at each level of output. In economics, total cost (TC) describes the total economic cost of production and is made up of variable costs, which vary according to the quantity of a good produced and include inputs such as labor and raw materials, plus fixed costs, which are independent of the quantity of a good produced and include inputs (capital) that cannot be varied in the short term, such as buildings and machinery. Total cost in Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

63 | P a g e

economics includes the total opportunity cost of each factor of production as part of its fixed or variable costs. Characteristics.. ďƒź increases by the same amount as variable cost ďƒź Because the total cost is simply the variable cost + fixed cost, it is a graphically simple curve to outline. TC = TFC + TVC The rate at which total cost changes as the amount produced changes is called marginal cost. This is also known as the marginal unit variable cost. Note: Area between TC (total cost) and TVC (total variable cost) equals the TFC (total fixed costs), since TC-TVC=TFC.

Average cost In economics, average cost or unit cost is equal to total cost divided by the number of goods produced (the output quantity, Q). It is also equal to the sum of average variable costs (total variable costs divided by Q) plus average fixed costs (total fixed costs divided by Q). Average costs may be dependent on the time period considered (increasing production may be expensive or impossible in the short term, for example). Average costs affect the supply curve and are a fundamental component of supply and demand. đ?‘‡đ??ś đ??´đ??ś = đ?‘„ Per Unit Cost or Average Costs  AFC: average fixed costs which is the total fixed cost divided by the quantity ďƒź AFC = TFC/Q ďƒź declines as output increases (spreading the overhead)  AVC: average variable costs which is the total variable cost divided by the quantity ďƒź AVC = TVC/Q ďƒź declines as variable resources (labor) increase output, reaches a minimum, and then increases again as the Law of Diminishing Returns sets in ďƒź at the low levels of output production is relatively inefficient and costly.  ATC: Average Total Cost ďƒź ATC = TC/Q = TFC/Q + TVC/Q = AFC + AVC ďƒź Can be found graphically by adding vertically the AFC and AVC curves ďƒź Vertical distance between ATC and AVC curves measures AFC at any level of output ďƒź The vertical distance between ATC and AVC curves will continue to decrease, as the AFC continues to decrease.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

64 | P a g e

Marginal cost In economics and finance, marginal cost is the change in total cost that arises when the quantity produced changes by one unit. That is, it is the cost of producing one more unit of a good. Mathematically, the marginal cost (MC) function is expressed as the first (order) derivative of the total cost (TC) function with respect to quantity (Q). Note that the marginal cost will change with volume, as a non-linear and non-proportional cost function includes ďƒź variable terms dependent to volume, ďƒź constant terms independent to volume and occurring with the respective lot size, ďƒź jump fix cost increase or decrease dependent to steps of volume increase. So at each level of production, the marginal cost is the cost of the next unit produced referring to the basic volume. đ?‘‘đ?‘‡đ??ś đ?‘€đ??ś = đ?‘‘đ?‘„ In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit. If producing additional vehicles requires, for example, building a new factory, the marginal cost of those extra vehicles includes the cost of the new factory. In practice, the analysis is segregated into short and long-run cases, and over the longest run, all costs are marginal. At each level of production and time period being considered, marginal costs include all costs which vary with the level of production, and other costs are considered fixed costs.

Relationship between Marginal cost and Marginal product The firm's marginal cost is related to its marginal product. If one calculates the change in total cost for each different level of total product reported and divides by the corresponding marginal product of labor reported, one arrives at the marginal cost figure. The marginal cost falls at first, then starts to rise. This behavior is a consequence of the relationship between marginal cost and marginal product and the law of diminishing returns. As the marginal product of the variable input, labor rises, the firm's total product increases at a rate that is greater than the rate of new workers hired. Consequently, the firm's marginal costs will be decreasing. Eventually, however, by the law of diminishing returns, the marginal product of the variable factor will begin to decline; the firm's total product will increase at a rate less than the rate at which new workers are hired. The result is that the firm's marginal costs will begin rising. Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

65 | P a g e

Relationship between Average Cost and Marginal Cost When average cost is declining as output increases, marginal cost is less than average cost. When average cost is rising, marginal cost is greater than average cost. When average cost is neither rising nor falling (at a minimum or maximum), marginal cost equals average cost. Other special cases for average cost and marginal cost appear frequently: ďƒź

ďƒź

ďƒź

Constant marginal cost/high fixed costs: each additional unit of production is produced at constant additional expense per unit. The average cost curve slopes down continuously, approaching marginal cost. An example may be hydroelectric generation, which has no fuel expense, limited maintenance expenses and a high up-front fixed cost (ignoring irregular maintenance costs or useful lifespan). Industries where fixed marginal costs obtain, such as electrical transmission networks, may meet the conditions for a natural monopoly, because once capacity is built, the marginal cost to the incumbent of serving an additional customer is always lower than the average cost for a potential competitor. The high fixed capital costs are a barrier to entry. Minimum efficient scale / maximum efficient scale: marginal or average costs may be non-linear, or have discontinuities. Average cost curves may therefore only be shown over a limited scale of production for a given technology. For example, a nuclear plant would be extremely inefficient (very high average cost) for production in small quantities; similarly, its maximum output for any given time period may essentially be fixed, and production above that level may be technically impossible, dangerous or extremely costly. The long run elasticity of supply will be higher, as new plants could be built and brought on-line. Zero fixed costs (long-run analysis) / constant marginal cost: since there are no economies of scale, average cost will be equal to the constant marginal cost.

Long Run The Long Run is extensive enough for firms to change quantities of all resources employed. The means that we can change capacity and intensity. Long run production function: đ??ś = đ?‘“(đ?‘„, đ?‘‡, đ?‘ƒ, đ??ž) Here, Q = Quantity produced or output, T = Technology, P = Factor Price, K = Capital.

Long-run cost curves Cost curves appropriate for long-run analysis are more varied in shape than short-run cost curves and fall into three broad classes.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

66 | P a g e

In constant-cost industries, average cost is about the same at all levels of output except the very lowest. Constant costs prevail in manufacturing industries in which capacity is expanded by replicating facilities without changing the technique of production, as a cotton mill expands by increasing the number of spindles. In decreasing-cost industries, average cost declines as the rate of output grows, at least until the plant is large enough to supply an appreciable fraction of its market. Decreasing costs are characteristic of manufacturing in which heavy, automated machinery is economical for large volumes of output. Automobile and steel manufacturing are leading examples. Decreasing costs are inconsistent with competitive conditions, since they permit a few large firms to drive all smaller competitors out of business. Finally, in increasing-cost industries average costs rise with the volume of output generally because the firm cannot obtain additional fixed capacity that is as efficient as the plant it already has. The most important examples are agriculture and extractive industries.

Cost curve In economics, a cost curve is a graph of the costs of production as a function of total quantity produced. In a free market economy, productively efficient firms use these curves to find the optimal point of production, where they make the most profits. There are various types of cost curves, all related to each other. The two basic categories of cost curves are total and per unit or average cost curves.

Reasons for Shifts of the Cost Curves:  Change

in resource cost

 Change in technology  When the price of labor

or some other variable input rise, AVC, ATC, and MC would rise and those cost curves would all shift upward.  The MC curve and the AVC curve are mirror images of the MP and AP curves.  When MP rises, MC falls, and vice versa.  When AP rises, AVC falls, and vice versa.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

67 | P a g e

7 Cost Concepts (Short-run): 1. 2. 3. 4. 5. 6. 7.

Total Fixed Cost Total Variable Cost Total Cost Average Fixed Cost Average Variable Cost Average Total Cost Marginal Cost

(TFC) (TVC) (TC=TVC+TFC) (AFC=TFC/Q) (AVC=TVC/Q) (AC=AFC+AVC) (MC= ∆AVC/∆Q

Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

68 | P a g e

Market Market Economy The market is a system where buyers and sellers exchange goods or services. Market is actually a very logical mechanism that helps answer the basic economic questions of what, how much and for whom to produce different commodities. System continually allocates goods and services to various units with the help of a pricing mechanism.

Perfect competition In economic theory, perfect competition describes markets such that no participants are large enough to have the market power to set the price of a homogeneous product. Because the conditions for perfect competition are strict, there are few if any perfectly competitive markets. Still, buyers and sellers in some auction-type markets, say for commodities or some financial assets, may approximate the concept. Perfect competition serves as a benchmark against which to measure real-life and imperfectly competitive markets. Economists have become more interested in pure competition partly because of the rapid growth of e-commerce in domestic and international markets as a means of buying and selling goods and services. And also because of the popularity of auctions as a rationing device for allocating scarce resources among competing ends.

Basic assumptions required for conditions of Perfect competition to exist Generally, a perfectly competitive market exists when every participant is a "price taker", and no participant influences the price of the product it buys or sells. Following are some of the features of a perfect market.  Infinite buyers and sellers: Infinite consumers with the willingness and ability to buy the product at a certain price, and infinite producers with the willingness and ability to supply the product at a certain price.  Zero entry and exit barriers: It is relatively easy for a business to enter or exit in a perfectly competitive market.  Perfect factor mobility: In the long run factors of production are perfectly mobile allowing free long term adjustments to changing market conditions.  Perfect information: Prices and quality of products are assumed to be known to all consumers and producers.  Zero transaction costs: Buyers and sellers incur no costs in making an exchange (perfect mobility).  Profit maximization: Firms aim to sell where marginal costs meet marginal revenue, where they generate the most profit.  Homogeneous products: The characteristics of any given market good or service do not vary across suppliers.  Constant returns to scale: Constant returns to scale ensure that there are sufficient firms in the industry.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

69 | P a g e

Determining Price of Commodity for the Perfectly Competitive Industry and Firm In the short run the equilibrium market price is determined by the interaction between market demand and market supply. In the diagram shown above, price P1 is the market-clearing price and this price is then taken by each of the firms. Because the market price is constant for each unit sold, the AR curve also becomes the Marginal Revenue curve (MR). A firm maximises profits when marginal revenue = marginal cost. In the diagram above, the profit-maximising output is Q1. The firm sells Q1 at price P1. The area shaded is the economic (supernormal profit) made in the short run because the ruling market price P1 is greater than average total cost.

Not all firms make supernormal profits in the short run. Their profits depend on the position of their short run cost curves. Some firms may be experiencing sub-normal profits because their average total costs exceed the current market price. Other firms may be making normal profits where total revenue equals total cost (i.e. they are at the break-even output). In the diagram below, the firm shown has high short run costs such that the ruling market price is below the average total cost curve. At the profit maximising level of output, the firm is making an economic loss (or subnormal profits)

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

70 | P a g e

Firm Firm refers to a production unit which employs factors of production to produce goods and services for the market .There are some features of a firm which are as follows:  Firm is a single unit engaged in production and sale of goods  It is a decision making entity. It takes decision regarding reduction and sales of goods.  It always attempt to maximize profit and minimize costs  A firm will be in equilibrium when it maximizes its profits.  A firm may be in the form of sole proprietorships, partnership or Joint Stock Company. Equilibrium: It indicates a situation or a point of rest .It refers to a stage of no change from where a firm does not want to move into any of the directions. Equilibrium of the Firm: Whenever a firm attains the stage from where it does not want to move forward or backward it is said to be in equilibrium. A firm would not like to change its level of output only when it is earning maximum profit. Determination of Firm’s Equilibrium: There are two methods for the determination of firm’s equilibrium: 1. Total revenue and total cost approach 2. Marginal revenue and marginal cost approach.

Profit Maximization under Perfect Competition To maximize profit, we need to know the revenue and costs of the business. Profit is maximized, 1. When marginal revenue = marginal cost (MR=MC), and marginal cost is rising. If marginal revenue is the additional revenue from 1 additional unit, Marginal cost is the additional cost from 1 additional unit. 2. When MR > MC, revenue is increasing faster than costs and the firm should increase production. 3. When MR < MC, revenue from the additional unit is less than additional cost, and the firm should decrease production. As such, A firm maximizes profits when MR = MC. 4. By the relationship between marginal revenue and price, however, we can see that the perfectly competitive firm achieves this condition by setting output where marginal cost equals price. Since MR=P(1-1/ep), and with a horizontal demand curve ep equals infinity, the profit maximizing firm in perfect competition produces where P=MC.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

71 | P a g e

A firm's production decision can be found by superimposing marginal cost, average cost, and average variable cost curves on the firm's demand curve, as shown in figure 10.2. The figure uses short run cost curves because production decisions occur in a short run environment.

Shut Down in the Short Run under Perfect Competition Shutting down is a short-run decision. A firm that has shut down is not producing. The firm still retains its capital assets. A company is considered to have shut down, if it temporary ceases production but keeps fixed capital. A company has exit the industry when it has made a permanent decision to leave the industry. The decision to temporarily shut down a business depends on a few factors. Where ATC = AVC + AFC. So average fixed cost is the vertical distance between average variable cost and average total cost. Now if a business shuts down, its total revenue becomes zero, and its total cost equals the fixed cost. So the company should continue producing its product, as long as it covers its variable costs. This way, total revenue is greater than total variable cost, because losses are then less than TFC. Basically, shut down when P (AR = MR) < AVC, to minimize the losses and so the company's short-run supply curve = MC curve above AVC. The firm therefore produces where profit equals marginal cost. In the short run, a firm operating at a loss [R < TC (revenue less than total cost) or P < ATC (price less than unit cost)] must decide whether to continue to operate or temporarily shutdown. The Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

72 | P a g e

shutdown rule states, ―In the short run a firm should continue to operate if price exceeds average variable costs‖. Restated, the rule is that for a firm to continue producing in the short run it must earn sufficient revenue to cover its variable costs. The rationale for the rule is straightforward. By shutting down a firm avoids all variable costs. However, the firm must still pay fixed costs. Because fixed cost must be paid regardless of whether a firm operates they should not be considered in deciding whether to produce or shutdown. Thus in determining whether to shut down a firm should compare total revenue to total variable costs (VC) rather than total costs (FC + VC). If the revenue the firm is receiving is greater than its total variable cost (R > VC) then the firm is covering all variable cost plus there is additional revenue (contribution), which can be applied to fixed costs. On the other hand if VC > R then the firm is not even covering its production costs and it should immediately shut down. The rule is conventionally stated in terms of price (average revenue) and average variable costs. Another way to state the rule is that a firm should compare the profits from operating to those realized if it shutdown and select the option that produces the greater profit. A firm that is shutdown is generating zero revenue and incurring no variable costs. However the firm still has to pay fixed cost. So the firm’s profit equals fixed costs or (- FC). An operating firm is generating revenue, incurring variable costs and paying fixed costs. The operating firm's profit is R - VC - FC. The firm should continue to operate if R - VC - FC ≥ - FC which simplified is R ≥ VC. At last it can be finalized here that, the difference between revenue, R, and variable costs, VC, is the contribution to fixed costs and any contribution is better than none. Thus, if R ≥ VC then firm should operate. If R < VC the firm should shut down. A decision to shut down means that the firm is temporarily suspending production. It does not mean that the firm is going out of business (exiting the industry). If market conditions improve, and prices increase, the firm can resume production.

When to Leave An Industry (permanent) A business should leave the industry when revenue is less than cost of operating in the long run. In other words, exit if total revenue is less than total cost (P < ATC). In competitive markets, a company will make zero economic profits in the long run. If companies are making more than zero economic profits, it will encourage other firms to enter the industry to share in these profits. In other words, enter if total revenue is greater than total cost (P > AC). If companies are making zero economic profits, there is no entry and no exit, which is a long run condition.

Long run equilibrium Long run equilibrium in a competitive market means existing firms have no ability to expand or contract to increase profits, no reason to exit the industry, and gives new investors no incentive to enter. Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

73 | P a g e

Assuming the representative firm has a u-shaped long run average cost curve, competitive market long run equilibrium is reached when price equals minimum long run average cost, an output of qm in figure 10.17. Market short run supply (SRS) and demand (D) establish a market price of Pm. At that price the firm maximizes profit at qm, where short run marginal cost, SMC, equals Pm and both short run average cost and long run average cost are at their minimum values. Since price equals average cost, profit is zero. Thus, there is no incentive for entry or exit. Moreover, because the firm is at its minimum long run average cost, there is no change in investment that can increase profit. We find the interesting paradox that the drive to make above normal returns (profits) results in a zero profit equilibrium in the competitive market. Firms make a normal return, but no more.

Market Equilibrium in the Long Run In the long run, the market price is determined solely by cost considerations, P = min(ATC). If we have P > min(ATC), there are profit opportunities, new firms would enter, and market forces will push down the price until P = min(ATC). If we have P < min(ATC), firms are making losses, firms would exit, and market forces will push up the price until P = min(ATC). If we have P = min(ATC), then whatever quantity is demanded would be willingly supplied, and we are in equilibrium. The demand curve only determines the equilibrium quantity and not the price in the long run.

A market reaches a long-run equilibrium when three conditions hold: 1. The quantity of the product supplied equals the quantity demanded 2. Each firm in the market maximizes its profit, given the market price 3. Each firm in the market earns zero economic profit, so there is no incentive for other firms to enter the market In addition to the conditions above, in long-run equilibrium the typical firm earns zero economic profit so there is no further incentive for firms to enter the market. ďƒ„ In long-run equilibrium, price equals marginal cost (the profit-maximizing rule), and price equals short-run average total cost (zero economic profit).

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

74 | P a g e

Monopoly In economics, a monopoly exists when a specific individual or an enterprise has sufficient control over a particular product or service to determine significantly the terms on which other individuals shall have access to it. Monopolies are thus characterized by a lack of economic competition for the good or service that they provide and a lack of viable substitute goods. Monopoly is mitigated only by competition from substitutes. In a monopoly market, the entire market supply is accounted by one firm. Therefore, equilibrium points for the market and for the firm are the same. The firm is able to choose the price-quantity combination to maximize its profits. The monopolist producer tends equates marginal revenue and marginal cost rather than price equal to marginal cost. In theory the monopolist is considered inefficient because the quantity supplied is less and the price higher than under perfect competition. The inverse of a monopoly or monophony can also exist, i.e. market power exercised by a single buyer facing many producers. Monopoly exists for one or more of four reasons.  First, one firm may control the entire supply of a basic input.  Second, a firm may become a monopolist because the average cost of producing the product reaches a minimum at an output sufficient to supply the entire market - a natural monopoly.  Third, a firm may acquire control over product through a patent on a basic process of production or the product itself, e.g. IPRs like a drug patent.  Fourth, a firm may become a monopolist because government awards an exclusive market franchise, e.g. electric power, water supply, etc.

Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University.

Department Of Finance

Jagannath University

Md. Mazharul Islam (Jony)

75 | P a g e

Issuu converts static files into: digital portfolios, online yearbooks, online catalogs, digital photo albums and more. Sign up and create your flipbook.