E-LESSON-7 MICRO ECONOMICS-1 ENG

IDOL Institute of Distance and Online Learning ENHANCE YOUR QUALIFICATION, ADVANCE YOUR CAREER.

B.A.English 2 All right are reserved with CU-IDOL Microeconomics Course Code: BAQ108 Semester: First e-Lesson: 7 SLM Unit: 7 www.cuidol.in Unit-7(BAQ108)

MICRO ECONOMICS 33 OBJECTIVES INTRODUCTION In this unit we are going to study Student will be able to understand the concept of about Production Function. Production and various production functions. Student will be able to understand the concept of Under this you will be explain the TP,MP,AP law of variable proportions and returns to scale. Student will be able to understand the laws of return to scale. Students will be able to understand the concept of cost. Students will be able to understand the concept of Cost Analysis. INSTITUTE OF DISTANACEll ArNigDhtOaNrLeINreEsLeErAvRedNIwNiGth CU-IDOL www.cuidol.in Unit-7(BAQ108)

TOPICS TO BE COVERED 4 Production Function and its types. Law of Variable Proportion Laws of Return to Scale. Concept of Cost and its types. Short Run cost curve and Long run cost curve. Relationship between Cost and production curves. www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

Production Function 5  Production: Combining inputs in order to get the output is production. It is the conversion of inputs into output.  Production Function: It is the functional relationship between inputs and output in a given state of technology. Q= f(L,K) Q is the output, L: Labor, K: Capital www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

PRODUCTION FUNCTION 6 A production function can be represented in the form of a mathematical model of equation as Q = f ( a,b,c,…… etc.) where Q stands for quantity of output per unit of time and a, b, c, etc are the various factor inputs like land, capital, labour etc, which are used in the production of output. Technically production function can be written as Qx = f (L, N, K, R, E, T) It means quantity or output of x commodity depends upon the various factors such as land, labour, capital, raw material, efficiency parameter and technology. Qx = Quantity of x commodity L= Land N= Labour K= Capital R= Raw Material E= Efficiency Parameter T= Technology www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

TWO TYPES OF FACTOR INPUTS 7 FIXED INPUTS :  Fixed inputs are those factors the quantity of which remains constant irrespective of the level of output produced by a firm. For example, land, buildings, machines, tools, equipments, superior types of labour, top management etc. VARIABLE INPUTS :  Variable inputs are those factors the quantity of which varies with variations in the levels of output produced by a firm for example, raw materials, power fuel, water, transport, labour and communication etc. www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

TWO TYPES OF PRODUCTION 8 FUNCTIONS  SHORT RUN In this case, the producer will keep all fixed factors as constant and changes only a few variable factor inputs. For example, Law of Variable Proportions.  LONG RUN In this case, the producer will vary the quantities of all factor inputs both fixed as well as variable in the same proportion. For example, the laws of returns to scale. www.cuidol.in Unit-7(BAQ108) 8All right are reserved with CU-IDOL

Difference between short run & 9 long run : Basis Short Run Long Run Only variable factors are All factors are Meaning changed changed Both demand & supply play Price Determination Demand is active. an important role. Classification Factors are classified as fixed All factors are variable & variable www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

Iso-Quant The term Iso-quant or Iso-product is composed of two 10 words, All right are reserved with CU-IDOL Iso = equal, quant = quantity or product = output. Thus it means equal quantity or equal product. Different factors are needed to produce a good. These factors may be substituted for one another. “An Iso-quant curve may be defined as a curve showing the possible combinations of two variable factors that can be used to produce the same total product.” Peterson www.cuidol.in Unit-7(BAQ108)

Properties of Iso-Quant 11 (i) Iso-quants have a Negative Slope: This means that in order to maintain a given level of output, when the amount of one factor input is increased that of the other must be decreased. At each point on a iso-quant term we get factor-combination which produces the same level of output. (ii) Iso-quants are Convex to Origin: The slope of the iso-quant measures, the marginal rate of technical substitution of one factor input (say labour) for the other factor-input (say, capital). The convexity of iso-quant suggests that MRTS is diminishing which means that as quantities of one factor-labour is increased, the less of another factor-capital will be given up. If output level is to be kept constant. (iii) The Iso-quant is an Oval-Shape Curve: It must be noted that one iso-quant may have a positive slope at their ends. When with relatively small amount of a factor, relatively large amount of another factor is combined, in such a manner that the marginal productivity of this abundant factor tends to be negative and as such resulting in a decline in a total output.. (iv) Iso-quants do not Intersect: This is necessary because by definition each iso-quant represents a specific quantum of output. Therefore, if two iso-quants intersect each other it would involve logical contradiction as to a particular iso-quant at a time may be representing a small as well as a large quantity of output. (v) Iso-quants do not Intercept either Axis: If an iso-quant is drawn touching the x-axis, it means output is possible even by using a single factor (e.g., labour alone without using capital). Both the factors (labour and capital) are essential in some proportion to produce a commodity. Similarly, if an iso-quant touches y-axis, it means that only capital www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

THE LAW OF VARIABLE 12 PROPORTIONS In the short-run the level of production can be changed by changing the factor proportions. This law examines the production function with on factor variable, keeping the other factors quantities fixed. The law explains the short-run production function. When the quantity of one input is varied, keeping other inputs constant, the proportion between factors changes. When the proportion of variable factors increases, the total output does not always increase in the same proportion, but in varying proportion. www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

ASSUMPTIONS OF THE LAW 13  Only one factor is variable while other factors are constant.  All units of variable factors are homogeneous.  Technology is constant  Factors of production can be used in different proportions.  This law is applicable in short time period.  Methods of production are constant. www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

PRODUCTION SCHEDULE 14 Units of Fixed Input Units of Variable TP (Total AP (Average MP Description (Land) Inputs (Labour) Product) Product) (Marginal Product) 2 1 3 3 3 2 2 8 4 2 3 15 5 IRTF 2 4 24 6 2 5 28 5.6 5 2 6 31 5.1 2 7 32 4.6 (1st Stage) 2 8 32 4 2 9 31 3.4 7 www.cuidol.in 9 4 CRTF 3 (2nd Stage) 1 0 -1 DRTF (3rd Stage) Unit-7(BAQ108) 1A4ll right are reserved with CU-IDOL

TP, AP AND MP 15 Total Product or Output (TP)  It refers to the total volume of goods produced during a specified period of time.  Total product (TP)can be raised only by increasing the quantity of variable factors employed in production. Average product  Average product can be known by dividing total product by the total number of units of the variable factor.  TP/Q Marginal Product or Output (MP)  It is output derived from the employment of an additional unit of variable factor unit.  The rate at which total product increases is known as marginal product.  Addition to the total product resulting from a unit increase in the quantity of the  variable factor. www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

RELATIONSHIP BETWEEN AP AND 16 MP  When AP rises as a result of an increase in the quantity of variable input, MP is more then the average product.  When AP are maximum then MP is equal to AP. The MP curve cuts the AP curve at its maximum.  When AP falls as a result of decrease in quantity of variable input, MP is less than the AP. Three stages of production.  Stage 1- THE LAW ON INCREASING RETURNS.  Stage 2- THE LAW OF DIMINSHING RETURNS.  Stage 3- THE STATE OF NAGATIVE RETURNS www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

STAGE 1- THE LAW 17 ON INCREASING RETURNS  TP increases at an increasing rate up to a point F.  MP also rises and is maximum at point F.  AP goes on rising.  After point F , TP rises but at diminishing rate.  MP falls but is positive.  Stage 1 ends where AP reaches its highest point. www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

STAGE 2- THE LAW OF 18 DIMINSHING RETURNS.  TP continues to increase at a diminishing rate, until it reaches it maximum point H.  Both MP and AP continuously fall during this stage.  Stage ends when TP reaches its maximum point H. www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

STAGE 3- 19 THE STATE OF NAGATIVE RETURNS  TP declines.  MP negative.  AP is diminishing. www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

CONCLUSION 20  A rational producer will never produce in stage 3, where MP is negative.  A rational producer will also not produce in stage 1, where the MP of fixed factor is negative.  The producer producing in stage 1 will not be making best use of fixed factor and he will not be utilizing fully the opportunity of increasing production by increasing quantity of variable factor.  A rational producer will produce in stage 2, where both MP and AP of variable factors are diminishing. www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

LAW OF RETURNS TO SCALE 21 Law of Returns to scale is applicable in long run. In long run all factors of productions are considered to be changeable. It means in order to increase the scale of production; various units of factors of production are enhanced. Algebraically, the long run production function can be stated as under:- Qx = f (L, N, K, R, E, T) It means to enhance the quantity of X commodity, the quality of inputs such as land (L) capital (K) Raw-material (R) Efficiency parameter (E) and Technology (T) can also increase in the same proportion. www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

EXPLANATION 22 Assumptions: - • Returns are measured in physical terms. • All units of factors are homogeneous. Explanation:- Law of returns to scale refers to increase in production as the result of increase in all inputs in the same proportion. Let consider initial production function is Q = f (L, K) ............. (1) If both factors of production i.e. Land (L) and Capital (K) are increased in the same proportion (n), then new production function will be written as – Q1=f (nL, nK) www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

EXPLANATION 23  If Q1, increases more than proportionate increase in factors of production i.e. then it will be an example of increasing returns to scale.  If Q1 increases in the same proportion as increases in factors of production i.e. then it will be an example of constant returns to scale.  If Q1 increases less then proportionate increase in factors of production i.e. then it will be an example of decreasing returns to scale. www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

INCREASING RETURNS TO SCALE 24 If the proportional change in the output of an Y Increasing Returns to Scale organization is greater than the proportional change in Q inputs, the production is said to reflect increasing 25 returns to scale. Output 20 15 For example, to produce a particular product, if the 10 quantity of inputs is doubled and the increase in output 5 is more than double, it is said to be an increasing returns to scale. When there is an increase in the scale 0 5 10 15 20 25 X of production, the average cost per unit produced is Labour and Capital lower. This is because at this stage an organization enjoys high economies of scale. www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

CONSTANT RETURNS TO SCALE: 25 Constant returns to scale refers to the production Y situation where if all factors / inputs are increased Constant Returns to Scale in a given proportion, output increase in a same Q 25 proportion. 20 15 Output 10 5 For example, when inputs are doubled, so output 0 5 10 15 20 25 should also be doubled, then it is a case of Labour and Capital constant returns to scale X www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

DECREASING RETURNS TO SCALE 26 • Decreasing returns to scale refers to the Y production situation where all factors are / inputs Decreasing Returns to Scale are increased in a given proportions, output Q increase in a smaller proportion. • For example, when capital and labor is doubled Output 25 20 but the output generated is less than doubled, 15 X the returns to scale would be termed as 10 diminishing returns to scale. 5 0 5 10 15 20 25 Labour and Capital www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

Meaning of Cost 27 The term ‘cost’ is most widely used as the ‘money cost’ of production which relates to the money expenditure of a firm on: (i) Wages and salaries paid to the labour. (ii) Payment incurred on machinery and equipment. (iii) Payment for materials, power, light, fuel, transportation etc. (iv) Payments for rent and insurance. (v) Payments to Government by way of taxes. Money costs therefore relate to money outlays by a firm or factors of a production which enable the firm to produce and sell a product. It should be remembered that every producer is interested in money costs. Besides money cost there are other costs that are equally important to take decisions on various matters. www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

Types of Cost 28  Fixed Costs (FC) The costs which don’t vary with changing output. Fixed costs might include the cost of building a factory, insurance and legal bills. Even if your output changes or you don’t produce anything, your fixed costs stay the same.  Variable Costs (VC) Costs which depend on the output produced. For example, if you produce more cars, you have to use more raw materials such as metal. This is a variable cost  Semi-Variable Cost. Labour might be a semi-variable cost. If you produce more cars, you need to employ more workers; this is a variable cost. However, even if you didn’t produce any cars, you may still need some workers to look after an empty factory.  Total Costs (TC) = Fixed + Variable Costs. www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

Types of Cost 29  Marginal Costs – Marginal cost is the cost of producing an extra unit. If the total cost of 3 units is 1550, and the total cost of 4 units is 1900. The marginal cost of the 4th unit is 350  Opportunity Cost – Opportunity cost is the next best alternative foregone. If you invest £1million in developing a cure for pancreatic cancer, the opportunity cost is that you can’t use that money to invest in developing a cure for skin cancer.  Economic Cost. Economic cost includes both the actual direct costs (accounting costs) plus the opportunity cost. For example, if you take time off work to a training scheme. You may lose a weeks pay of £350, plus also have to pay the direct cost of £200. Thus the total economic cost = £550.  Accounting Costs – this is the monetary outlay for producing a certain good. Accounting costs will include your variable and fixed costs you have to pay. www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

Determinant to Cost 30 The cost of producing any given amount of output by a firm depends on two main factors: (a) The Quantities of Resources and Their Combinations: The cost to the firm of producing any output evidently depends upon the physical quantities of actual resources or services—labour, material, machine hours, and so forth—used in production. Thus, the cost of producing a tons of steel depends upon the quantities of iron ore, limestone, coal, blast-furnace, etc. used in the production. (b) Techniques of Productions: A firm can produce at low cost when it produces with the new and improved techniques of production. Production with the old and out-dated technique involves higher cost. The profit maximisation requires the use of the particular technique of production which would allow the optimum combination of factors. In the short period the optimum combination for any given level of output is the least-cost combination possible with the fixed factor units. But this may not be the absolute optimum combination if all the factors could be adjusted. Over the longer period, all factors can be varied, and so the firm is free to select the production technique of factors. www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

Short Run Cost 31  The Short Run cost  The short run is a time frame in which the quantity of one or more resources used in production is fixed.  For most firms, the capital, is fixed in the short run.  Other resources used by the firm (such as labor, raw materials, and energy) can be changed in the short run.  Total Costs  The sum of total fixed costs and total variable costs  Fixed Costs  Costs that do not vary with output  Variable Costs  Costs that vary with the rate of production TC = TFC+TVC www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

SHORT RUN COST 32 • Average Total Costs (ATC) • Average Variable Costs (AVC) Total variable costs (TVC) Output (Q) Average variable costs (AVC) = • Average Fixed Costs (AFC) www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

Marginal Cost 33  It is the addition to total cost incurred by increasing output by one unit. In other words, it is the extra cost of producing on extra unit of output.  Marginal cost represents the incremental costs incurred when producing additional units of a good or service. It is calculated by taking the total change in the cost of producing more goods and dividing that by the change in the number of goods produced.  The usual variable costs included in the calculation are labor and materials, plus the estimated increases in fixed costs (if any), such as administration, overhead, and selling expenses.  The marginal cost formula can be used in financial modeling to optimize the generation of cash flow .  The Marginal Cost Formula is: Marginal Cost = (Change in Costs) / (Change in Quantity) www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

Total cost curve 34 www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

Marginal cost and average 35 cost curves www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

Long run Average cost curves 36 www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

Long –run average 37 cost curves www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

Long –run marginal 38 cost curves www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

Relationship between Cost and 39 production curves. www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

Multiple Choice Questions 40 1. ______ shows the overall output generated at a given level of input: (a) Cost function (b) Production function (c) Iso cost (d) Marginal rate of technical substitution. 2. Increasing returns to scale can be explained in terms of: (a) External and internal economies (b) External and internal diseconomies (c) External economics and internal diseconomies (d) All of these 3. The transformation of resources into economic goods and series is called: (a) Technical efficiency (b ) Input (c) Production (d) Increasing returns. 4.Laws of return apply to firms working in: (a) Perfect competition (b)Monopoly (c) Small firm (d) All kinds of market situations Answers: 1.(b) 2.(a) 3.( c) 4.(d) www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

SUMMARY 41  Law of variable proportion of says that as more and more of the factor input is employed, all other input quantities remaining constant, a point will eventually be reached where additional quantities of varying input will yield diminishing marginal contributions to total product.  Increasing Returns to Scale occurs if a proportional increase in all inputs under the control of a firm results in a greater than proportional increase in production..  Constant Returns to Scale occurs if a proportional increase in all inputs under the control of a firm results in an equal proportional increase in production.  Decreasing Returns to Scale occurs if a proportional increase in all inputs under the control of a firm results in a less than proportional increase in production.  Production function: A function that states the maximum amount of an output that can be produced with a certain combination of inputs, within a given period of time and with a given level of technology.  Costs enter into almost every business decision and it is important to use the right analysis of cost. Different business problems call for different kinds of costs such as future and past costs, incremental and sunk cost, out of pocket and book costs, replacement and historical cost etc. www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

Frequently Asked Questions 42 Q 1. Difference between short run & long run? Ans:-In short run only variable factor is changed whereas in long run all varibles are changed. For More details refer SLM. Q 2. Define Law of variable proportion? Ans: Law of variable proportion of says that as more and more of the factor input is employed, all other input quantities remaining constant, a point will eventually be reached where additional quantities of varying input will yield diminishing marginal contributions to total product. For More details refer SLM. Q 3.Explain Law of return to scale? Ans: Law of returns to scale refers to increase in production as the result of increase in all inputs in the same proportion. For More details refer SLM. Q4. Why is Average cost curve U shaped ? Ans :Average total cost is U-shaped. At low output: fixed costs are high and variable costs are low per unit. At high output: fixed costs are low and variable costs are relatively higher per unit. www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

REFERENCES 43 1. Ahuja, H.L.(1999). Advanced Economic Theory. New Delhi: S.Chand&Co. 2. Chopra,P.N.(1998). Micro Economic Theory and Welfare Economics. New Delhi: Kalyani Publishers. 3. Chopra,P.N.(2006). Advanced Economic Theory. New Delhi: Kalyani Publishers. 4. Lekhi, R.K., Walia, H.S. & Talwar,S.J.(2003).Micro Economics. New Delhi: Kalyani Publishers. 5. Lipsey,R.G. & Chrystal, K.A.(2004). Economics. New Delhi: Oxford University Press. 6. Mandal,R.K.(2007). Micro Economics Theory. New Delhi: Atlantic Publishers. 7. Ray, N.C.(1980). An introduction to Micro Economics. New Delhi: The Macmillan Company of India. 8. Salvatore,D. (2003). Micro Economics: Theory & Applications. New York: Oxford University Press. 9. Singh,M. (1971). MangSidhant Ate Mishrat Arth-VivsthaVich Arthik Ganana. Patiala: Punjabi University. 10. Vohra, P.& Mehta,R. (2007). Micro Economics. New Delhi: Commonwealth Publishers. www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL

44 THANK YOU For queries Email: [email protected] www.cuidol.in Unit-7(BAQ108) All right are reserved with CU-IDOL