Micro Economics

Definition of Economics

Economics is the “Science of Wealth”. (Adam Smith). Economics is concerned with “An inquiry into the Nature and Causes of Wealth of Nations.” (Adam Smith)

“Political Economy or Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of material requisites of well-being.” (Marshall)

“Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses.” (Robbins)

According to Keynes, Economics studies how the levels of income and employment in a community are determined. Economics is “a study of the factors affecting the size, distribution and stability of a country’s national income.” 

Key Issues on the definition of Economics:

• Science of wealth
• Science of material welfare
• Science of scarcity and science of choice
• Study of income and employment
• Distribution, stability and growth of national income

Subject Matter of Economics (scope)

Economics studies human being’s life and work, not the whole of it, but only one aspect of it. This “one aspect of life and work” deal with the cycle called “Wants-Efforts-Satisfaction”. That way the subject matters of economics are production, consumption, exchange, and distribution. However the modern approach on the subject matter of economics divides it into two parts: Micro-economics and Macro-economics

Micro and Macro Economics (Subject Matter of Economics)

Micro-economics: Micro means the smallest or the millionth part of the whole. Micro economics is that part of economics that studies the behavior of any economic decision making unit such as a firm, an industry, a consumer. Micro economics is also called Price Theory. Macro economics is the analysis of the behavior of the economy as a whole. It is the study of the economic system as a whole. Macro economics is also called Income Theory. “Price theory explains the consumption, or allocation, of total production – why more of something is produced than others.” The micro approach assumes that full employment in the economy prevails. “Income theory explains the level of total production and why the level rises and falls.” Macro economics deals also with how an economy grows.

Nature of Economics

Economics as an “Art”. (BS)

Economics as a “Science”. (BS)

Economics as a “Social Science”. (BS)

Economics and “Ethics”. (BS)

Positive and Normative Economics:

Positive science only explains “what is” (as it is). Normative science tells us “what ought to be” (right or wrong of a thing). Positive science describes, while normative science evaluates and prescribes. Classical economists were of the view “that the science of economics should be concerned only with what is and not what ought to be.” They were of the view that it was none of the functions of the economists to comment on the rightness or wrongness of an economic situation.  It is said that the function of the economist is to explore and explain and not to advocate and condemn. Others say that there is an “economic ought”. For example, in the case of mal-distribution of wealth, economist must say that it “ought to be better distributed.” Economics, therefore, is both positive and normative science.

Basis assumptions in economics

1. Behavior of individuals:

A) Consumers act in a rational manner.

B) There is absolute mobility of labor in search of higher wages.

C) Entrepreneurs seek maximum profit.

2. Social, economic, and political institutions:

A) Existence of private property and capitalistic order in the society.

B) Stable law and order and political system.

3. Law of geography and biology:

A) One must base conclusions on what is physically and/or climatically possible. 

Central Problem (Law of Scarcity)

“Wants are unlimited, but mean (resources) are limited.” We would not have been locked in battle against each other had there been enough resources. We struggle for resources to meet our ends. So the Central Problems of every economic society are:

What to produce

How to produce

For whom to produce

(How much to produce)

(When to produce)

Utility Analysis: Consumer Behavior

Utility: The capacity to satisfy human needs. “Utility is the quality or capacity of a good (or service) which enables it to satisfy human wants.” (Meyers) “Utility is the property of a commodity that satisfies a want or need of a consumer.” (D. Salvator)

Need Vs. Want (BS)

Total Utility: A sum total of utility gained from a number of units of a good or service.

Average Utility: Total utility divided by number of units used or consumed.

Marginal Utility: Utility gained from an extra, additional or marginal unit. It is defined as the change in the total utility resulting from one-unit change in the consumption or use of a commodity per unit of time.

Law of Diminishing Marginal Utility

The Law of Diminishing Marginal Utility states that as a person keeps on using or consuming a good or service, the utility from subsequent units will keep on decreasing. Suppose a person starts eating pieces of bread one after another. The first gives him/her great pleasure or satisfaction. The second piece gives lesser satisfaction than the first one as appetite decreases. The satisfaction of the third will be less than that of the second. The fourth piece will give lesser satisfaction than the previous one, and so on. The additional satisfaction will go on decreasing with every successive piece till it drops down to zero. And if the person is forced to take more, the satisfaction may become negative.

Unit	Total Utility	Marginal Utility
1	20	20
2	38	18
3	53	15
4	64	11
5	70	6
6	70	0
7	62	- 8
8	46	- 16

The above table shows that as the consumer goes on taking bread (in pieces), the extra satisfaction that s/he gets from successive units goes on decreasing till it goes down to zero (6th unit). Then it become negative (7th, 8th ). The total utility, however, goes on increasing until the consumption of the 5th unit. It may be noted that it (utility or satisfaction) it increases at a diminishing rate.

In the words of Chapman, “The more we have of a thing the less we want additional increment of it, or the more we want not to have additional increments of it.”

According to Marshall, “The additional benefit which a person derives from a given increase of his/her stock of a thing diminishes with every increase in stock that s/he already has.”

Two reasons as to why this theory works:

1. Each particular want is satiable.

2. Goods are imperfect substitutes for one another and they tend to be consumed in appropriate proportions.

Limitations of the law

In the previous discussion we have found as to why the law operates. The application of the Law of Diminishing Marginal Utility is based on certain assumptions. The assumptions are:

1. It is assumed that the commodity is taken in suitable units. Let us take the case of a thirsty person taking a drop of water instead of a full jug. Or the case of a hungry person consuming some pieces of rice. In such cases, thirst or hunger can not be mitigated, rather these will be stimulated. But sooner or later, a point will be reached when utility will begin to diminish. Therefore, unless the units are of a suitable size, the law will not operate.

2. It is further assumed that the commodity is taken within a certain time, otherwise the law will not apply. If one takes lunch at 1 pm. And dinner at 9 pm., there is no reason why the utility of the second meal will be less. But in case one is compelled to take the second mill within an hour of taking the first, the law will apply, and the utility of the second meal will be less.

3. Another assumption is that the character of the consumer does not change. The consumer must not have developed craving or greed. The more music one listens, the more literature one reads, or the more money a miser or a greedy person gets, the more will be the utility in each case. Enough is enough!!! Thus the low applies to a normal (rational) person, not to eccentric or abnormal persons like misers.

4. It is also essential that the income of the consumer remains the same. Any change in income will falsify the law. A rise in a person’s income may raise his/her longing for more land or houses.

5. In case of rare collections the law does not hold good. For a person collecting ancient coins or other antics, the more s/he is able to collect the greater will be his/her satisfaction.

6. There is another exception: The law says that the utility decreases when there is an increase in our stock. But in some cases the utility changes, not because of a change in what we have but because of a change in other people’s stock. One rival collector loses coins, utility of my coins will increase. More telephone connections, or more mobile phones with others, the utility of my land phone or mobile phone increases. More costly sharee or ornaments with the neighbor, more utility for the woman who does not have much?

7. The utility also depends on our other possessions. My printer may be lying idle, but as soon as I am able purchase a computer, the utility of my printer goes up.

8. Utility depends on fashion. The utility of my dress goes up when that dress comes in fashion. On the other hand, if it goes out of fashion, the utility goes down.

Law of Equi-Marginal Utility (Law of Maximum Satisfaction)

Wants are competitive (BS). We want to maximize our satisfaction. So, we have to make a choice between the more urgent and less urgent wants. We want to take more of one thing by sacrificing some part of the other. In economic terms, in order to maximize our satisfaction, we are really balancing the marginal utility of two commodities.  The law suggests that we sacrifice one commodity to get more of the other. Here, money (resource or means) is the determining or bridging factor. We spend more money on one commodity by saving from the other commodity. This way we go on sacrificing one commodity (and money) for the other (spending more money) in order to get maximum satisfaction from both the commodities with our limited resources (here, money). To get the maximum satisfaction we substitute the more useful for the less useful thing. This is all about the law of Equi-Marginal Utility.

Now, let us take the case of our hypothetical consumer (student). We assume that:

1. Our hypothetical consumer needs both Pen (commodity – X), and Paper (commodity – Y) at the same time.

2. S/he has a limited amount of resource/s (money) to spend on those. That means the consumer has a given income to spend.

3. And the resource (money) is the deciding or bridging factor.

4. His/her taste and preferences are given and constant.

5. But, s/he wants to get maximum satisfaction by using those with his/her limited money.

6. The value of money remains constant during successive purchases.

7. The law of diminishing marginal utility operates.

Application of the law:

So long as the Marginal Utility (MU) of money spent on good – X is not equal to the MU of money spent on good – Y, the consumer will increase satisfaction by substituting one good (for example – X) for the other (for example – Y) until the MU of the other is equal. Once the MU of money spent on one commodity (X) is equal to the MU of money spent on another commodity (Y), the consumer will get maximum satisfaction. It looks as if we are giving more emphasis on the MU of money, but in fact we are giving more emphasis on the MU of the commodities. This law may be called by various names:

Law of substitution (BS)

Law of indifference (BS)

Law of economy of expenditure (BS)

Law of maximum satisfaction (BS)

(Consumer’s Equilibrium) – (BS)

Limitations of the Law

The assumptions cited earlier do not always remain valid in our real life (other things do not remain the same).

1. The law requires a very careful and meticulous calculation of satisfaction (MU), many of us are not capable of such fine calculations.

2. Sometimes we act based on whims not on rational judgment.

3. Most of our expenditure is governed by habit.

4. Ignorance of consumers imposes another limitation. (may not be aware of other alternatives)

5. People are sometimes slaves of customs or fashion, and are incapable of rational consumption.

6. Some commodities are not divisible into smaller units to enable consumers to equalize marginal utilities.

Practical Importance of the Law

Despite several limitations, the law of equi-marginal utility has a very wide application.

1. It is applicable to the utilization of time.

2. It can be applied for distribution of assets in various forms and allocation of resources among various uses.

3. It also applies the use of money now and its use in the future.

Other application:

Applies to consumption (discussed)

Applies to production (BS)

Applies to exchange (BS)

Applies to the determination of value (BS)

Applies to distribution (BS)

Consumer’s Surplus: Consumer’s surplus is the extra satisfaction we derive from consumption of a good or availing a service. Marshall, “The excess of the price which he (the consumer) would be willing to pay rather than go without the thing over which he actually does pay is the economic measure of this surplus satisfaction … It may be called Consumer’s Surplus.”

It is the difference between the marginal valuation of a unit and the price which is actually paid for it. In short, consumer’s surplus is what we are prepared to pay minus what we actually pay. It is the excess between ‘what we are prepared to pay’ and ‘what we really pay’.

Utility Analysis of Demand: Need: Lack of something. Desire: The intention to have something. Willingness: A mental set to acquire something in exchange for something.

Demand: Is the desire for a thing backed by purchasing power and the willingness to purchase it. “The demand for anything at a given price is the amount of it which will be bought per unit of time at that price.” – Dewett.

“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.” (Bober)

Conditions for Demand

1. Desire for a thing. 2. Existence of Purchasing Power, 3. Willingness to use the purchasing power (willingness to spend) for the desired thing.

Cases: A person not having the need for a commodity (student). A person having the need for the commodity, but does not have money (purchasing power). (BS)

A person having the desire for the commodity, has the purchasing power, but not willing to use the purchasing power for that particular commodity. (BS)

Demand Function: Demand function is the nature or behavior of demand that is influenced by the factors affecting it. In other words, demand function shows the functional relationship between demand (quantity demanded) and the factors affecting it.

Classification of Demand (Kinds of Demand):

Price Demand: The 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 prices.

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 income.

Cross Demand: The cross demand refers to the quantities of a good or service which will be purchased with reference to changes (in price or quality) not of the particular good (or service) but other interrelated goods or services. Reference: Complementary goods vs. substitute goods.

Demand Curve and Demand Schedule

Demand Curve: The curve showing the nature or behavioral (hypothetical) tendency of demand. It is the graphical representation of the nature of demand (or graphicalrepresentation of the demand schedule).

Demand Schedule: A list of quantities purchased or demanded at various prices is called a demand schedule.

Determinants of Demand (Factors)

1. The income of the individual (consumer). BS

2. The individual’s (consumer’s) tastes and preferences. BS

3. The price level. BS

4. The prices of substitutes. BS

5. Social conventions (customs). BS

6. Whims. BS

7. Climate or weather change. BS

8. Changes in income distribution. BS

9. Conditions of trade. BS

The Law of Demand (the nature or characteristics of the demand curve)

“The Demand Curve Slopes Downward to the Right.” The law of demand expresses the relationship between the quantity demanded and the price. “All other things remaining constant, the quantity demanded of a commodity increases when its price decreases, and decreases when its price increases”.

It is convex to the origin.

Generally the demand curve slopes downward to the right. It means that “demand varies inversely with price.” (Inverse relationship between price and demand - Negative slope). “A rise in the price of a commodity or service is followed by a reduction in demand, and a fall in price is followed by an increase in demand, if the conditions (assumptions) of demand remain constant”.

Assumptions (on the operation or behavior of demand)

1. The consumer’s tastes do not undergo any change in fashion or on account of season or weather.

2. The consumer’s income remains constant during the period under consideration.

3. The prices of other goods (substitutes) remain constant.

4. The individual does not have the power to influence (manipulate) the price.

5. The consumer behaves rationally (rational being).

6. Certain period of time.

Why does the law of demand operate?

1. A consumer tries to maximize his/her satisfaction.

2. Operation of the law of diminishing marginal utility.

3. A unit of money goes further and one can afford to buy more (purchasing power).

4. When a thing becomes cheaper one naturally likes to buy more of it (human nature).

5. A commodity tends to be put to more uses when it becomes cheaper.

6. Income effect, Price effect, Substitution effect, Law of diminishing marginal utility

Exceptional demand curves or Exceptions to the law of demand

Instead of sloping to the right, the demand curve moves otherwise. It goes upward to the right. It becomes horizontal. It becomes vertical. It becomes concave to the origin.

Reasons

1. In case a serious shortage is feared or apprehended.

2. Speculations regarding future prices.

3. When a commodity represents distinction (status symbol – or prestigious goods)

4. Sometimes people buy more at a higher price in sheer ignorance.

5. If the price of necessity goes up, the consumer tends to buy more (or same amount) by readjusting the whole expenditure.

6. Giffen goods (British Economist – Sir Robert Giffen). Example: Potato (inferior good) and Rice (superior good).

Limitations of the law of demand: (Why the Law of Demand does not always operate?)

The conditions (assumptions) do not always remain the same.

1. Change in taste and fashion. (BS)

2. Change in income. (BS)

3. Change in prices of other goods. (BS)

4. Emergence or Discovery of substitutes. (BS)

5. Speculation or anticipation of changes in price. (BS)

Movement Along the Demand Curve: Movement along the demand curve means increase and/or decrease in the quantity demanded due to change in price. It shows the relationship between price and quantity demanded (inverse relationship between price and quantity). The consumer moves along the same demand curve (from one point to another point of the demand curve) depending on the price of a particular commodity. It is also called extension and contraction of demand.

Shift of the Demand Curve: Shift of the demand curve means the original demand curve shifts (changes its position) either to the right or to the left due to change in the factors (other  than price) affecting demand. Shift of the demand curve represents changes in demand due to change in factors (affecting it) other than price. The factors are income, price of other goods, etc. The shift of the demand curve is also called increase and decrease in demand with price remaining the same.

Example: Price of a commodity remains the same, but the amount of the commodity increases or decreases. (BS)

The fundamental difference between “Movement along the demand curve (extension and contraction of demand)” and “Shift of the demand curve (increase and decrease in demand)” is that the former is caused by change in price, and the other is caused by changes in the factors other than price.

Elasticity of Demand: The law of demand states the nature of relationship between price and quantity demanded. It tells us that as the price of a commodity falls, the quantity demanded increases, and vice versa. In other words, the law of demand tells us only the direction of change (increase or decrease) in the quantity demanded due to change in price. But, the law of demand does not state by how much of the quantity demanded changes as a result of certain change in price. It does not state how much the quantity demanded increases as a result of certain fall in price or by how much the quantity demanded decreases as a result of a rise in price. It does not state the rate at which the change (increase/decrease) takes place. This question is answered by the measure of responsiveness of demand to changes in price. This measure is called elasticity of demand. “The term elasticity expresses the degree of correlation between demand and price.” It is the rate at which the quantity demanded varies with a change in price. It indicates the relative responsiveness of demand to changing prices. Thus, Elasticity of demand can be defined as “the degree of responsiveness of quantity demanded to a change in price.” To be more exact, “The elasticity of demand is a measure of the relative change in amount purchased in response to a relative change in price on a given demand curve.” (Meyers) Elasticity depends primarily on proportional or percentage changes not on absolute changes           in priced and quantity demanded. Thus, the fundamental difference between the Law of demand and Elasticity of demand is that the Law of demand indicates the nature or direction of change in demand as a result of change in price, and Elasticity of demand indicates the degree of change in demand due to a certain change in price.  Elasticity of demand does not only happen due to price changes, it may happen due to other factors affecting demand.

Types of Elasticity of Demand: Price elasticity of demand, Income elasticity of demand, and Cross elasticity of demand.

Price Elasticity of Demand: The proportion or degree of change in quantity demanded due to certain change in price of a commodity.

Income Elasticity of Demand: The proportion or degree of change in quantity demanded due to certain change in income of the consumer (the price remaining the same).

Cross Elasticity of Demand: The proportion or degree of change in quantity demanded due to certain change in prices of other commodities (the price of the original commodity remaining the same).

The Formula of Measuring Price Elasticity of Demand: The price elasticity of demand can be measured by the following formula:

Proportionate change in the quantity demanded

      Ep =    ---------------------------------------------------------

                  Proportionate change in price

Or

                  Change in quantity demanded

                  Quantity demanded

      Ep =    ------------------------------------- 

                  Change in price

                        Price

Or

Ep = [(Q2 – Q1) ÷ Q1] ÷ [(P2 – P1) ÷ P1]

Where:       Q1 stands for quantity demanded before price change

                   Q2 stands for quantity demanded after price change

                   P1 stands for price charged before price change

                   P2 stands for price charged after price change

Illustration:

If  Q1 = 2,000 Q2 = 2,500                  P1 = 10/-          P2 = 9 

then

Ep = [ (2,500 – 2,000) ÷ 2,000] ÷ [(9/- - 10/-) ÷ 10]  = - 2.5

The price elasticity is negative emphasizing the inverse relationship between price and demand. In practice, the minus sign is omitted from the final result as the inverse relationship is implied. This can be a little modified by taking the average of Q1 and  Q2, and P1 and P2. Like (Q2 + Q1) ÷ 2, and (P2 + P1) ÷ 2

The interpretation of the above is “a one percent reduction in price will result in a 2.5 percent increase in the quantity demanded.

Types of Price Elasticity (Five cases of Elasticity – representing the degree):

Five different types of price elasticity can be found:

1. Perfect elasticity (Perfectly elastic demand – infinite elasticity): In this case, a firm can sell the quantity it wants at the prevailing price but none at all even at a slightly higher price. The shape of the demand curve here is horizontal.
2. Perfect inelasticity (Perfectly inelastic demand – zero elasticity): In this case, a change in price causes no change in the quantity demanded. The shape of the demand curve here is vertical.

It may be noted that both perfect elasticity and infinite elasticity are seldom found in real life situations. In actual life, we come across such elasticity of demand which is somewhere between these two limits i. e., it is more than zero but less than infinity.

3. Unit elasticity (Demand with unity elasticity): In this case, a given proportionate change in price causes exactly an equal proportionate change in the quantity demanded. Here the shape of the demand curve is that of rectangular hyperbola. The size of OX axis equals to the size of OY axis, with a constant area.
4. Relative elasticity (Relatively elastic demand): In this case, a reduction in price results in more than proportionate change in demand. Here the shape of the demand curve is relatively flat.
5. Relative inelasticity (Relatively inelastic demand): In this case, a reduction in price results in less than proportionate change (increase) in demand. Here the shape of the demand curve is relatively steep.

 Factors Determining Price Elasticity of Demand:

1. Nature of the commodity (necessities and conventional necessities): The demand for necessities is generally inelastic because the consumption of a necessary article does not change much with the change in prices. We must buy fixed quantities of such goods whatever the price. But the demand for luxuries is elastic (refrigerators, televisions, cars, air conditioners, computer, digital camera, etc.) However, the demand for such luxuries for the rich people is not elastic (enough is enough). For them these things are conventional necessaries. They must buy them and having purchased one, they will not purchase another, whatever the price. However, luxury is a relative term. A high priced luxury for a poor is a low priced necessary for a rich. It is said that a luxury of yesterday has become a necessary of today.
2. Extent of Use or Goods having several uses: A commodity having a variety of uses has a comparatively elastic demand. On the other hand, a commodity having a limited use will have a comparatively inelastic demand. Examples are – coal, even water, gas, wheat, etc.
3. Range of substitutes: A commodity a number of substitutes has relatively elastic demand because if its price rises, its consumption can be curtailed in favor of substitutes. For example, if CNG autorickshow or taxicab fare rises, people will go for public bus or paddle rickshow. (other examples such as for students). However, very few things can serve as real substitutes. Explanation expected.
4. Income level: People with high income are less affected by price changes than people with low income. A rich person will not curtail his/her consumption of fruits or milk even if their prices rise significantly and will continue to purchase the same quantity as before. But a poor person can not do so. The demand on the part of poor is more sensitive to price changes. Thus, the demand for such goods is inelastic for the rich but elastic for the poor.
5. Proportion of income spent on the commodity or proportion of expenditure: If consumption of a good absorbs only a small proportion of the total expenditure, the demand will not be much affected by a change in price. Or where an individual spends only a small part of his/her income on a commodity the price change will not significantly affect the demand for that commodity. Here, the demand is inelastic. Examples: Match box, salt, chocolate, pencil, etc.
6. Urgency of demand: If the demand for a good is very urgent for a particular person, a rise in price will not affect the demand for that good significantly. Whatever the causes, the urgency of demand tends to cause inelastic demand. Examples: Emergency or life saving medicine or treatment, wedding, fuel for a car on the road, umbrella during rain, etc.
7. Durability of a commodity or goods whose use can be postponed: In case the commodity is durable or repairable, one is likely to use that commodity for a longer time, the demand will be elastic. Examples: Shoe, old machine, CI sheet, etc.
8. Purchase frequency of a good: If the frequency of purchase of a product is very high, its demand is likely to be more price elastic than in the case of a product which is purchased less often.
9. Joint demand: The demand for jointly demanded goods is less elastic. If the price of carriage is cheap but the price of horse continues to increase, the demand for carriage will be less elastic. Ink – pen.
10. Level of prices: If a thing is very expensive, or very cheap, the demand will be inelastic. If the price is too high, a fall in it will not increase the demand much. On the other hand, if the price is too low (most people have already purchased what they needed or wanted), any further fall (in price) will not increase the demand.

Arc vs. Point Elasticity

There are two approaches to computing price elasticity. These are:

• Arc Elasticity, and
• Point Elasticity

However, the choice between the two (approaches), depends on the available data and intended use. Arc elasticities are appropriate for analyzing the effect of discrete (measurable) changes in price. Point elasticity is computed at a particular point of the demand curve (or at a particular price). When price elasticity of demand is measured between any two points on a demand curve, it is called arc elasticity. When elasticity of demand is at a point of the demand curve, it is called point elasticity.

We know that, the elasticity of demand measures the percentage (or proportionate) change in quantity demanded due to certain percentage change in price. The percentage change in price may be considerably high (say 10%, 20% or more) or it may be very small – so small that it is not significantly different from zero. The price elasticity measured for a considerably high change in price is called arc elasticity of demand. And, when price elasticity is measured for a very small change in price (not significantly different from zero), it is called point elasticity. In actual practice, most elasticity computations involve the arc method. Point elasticity is important only in theoretical economics. Recall the formula of elasticity measurement we discussed earlier.

Measuring Arc Elasticity

Arc elasticity: Ep = - ▲Q/Qo

                                   ▲ P/Po

                    Ep = - ▲Q . Po

                               ▲ P  Qo

 Example follows

Original Price: Tk. 25

Changed (new) Price: Tk. 15

Original Demand: 30 units

Changed (new) demand: 50 units

Calculation:

• Changed Price = 25 – 15 = (10)
• Changed demand = 30 – 50 = (- 20)
• = - 20/10 x 25/30 = 1.66

Interpretation: The elasticity coefficient is 1.66, meaning one percent decrease in price results in a 1.66 percent increase in the quantity demanded.

(Caveat = If we experience the reverse direction of change, the result will be different). For measuring point elasticity pls. refer to the book (Microeconomics) by D. N. Dwivedi

Elasticity of demand from Two or more demand curves with different slopes

Same elasticity (Ref. – Dwivedi) Figures have been shown in the slides.

Elasticity with parallel demand curves (having same slope)

Different degrees of elasticity (Ref. Dwivedi) Figures have been shown in the slides.

Same slope and different slopes

Concluding remarks:

It may be concluded that demand curves having the same slope may have different elasticities, and demand curves having different slopes may have the same elasticities, both at a given price.

Practical Application of Elasticity of Demand

Public Finance: Those in charge of public finance can take appropriate decisions regarding govt. revenue collection and expenditure. Imposing taxes on those commodities that have relatively inelastic demand. Taxes will increase the price no doubt, but people will buy (have to) those (necessities). However, on humanitarian grounds, such taxes are generally avoided (to ensure public welfare).

Monopoly Price: If the price is relatively inelastic, the monopolist may charge higher price (though small quantity may be sold). But, is the demand is elastic, the monopolist will lower the price to stimulate demand and to generate maximum revenue. But if it is a competitive industry, the demand for a firm’s product is elastic. So a single producer or seller can not increase the price (no control over price).

Joint Products: In case of joint products, if the price is elastic, the producer will lower the price to earn maximum profit. The producer will be guided mostly by demand and its nature while fixing the price. The producer will follow the principle of what the “traffic will bear”.

Increasing Returns: When an industry is subject to increasing returns, the manufacturer lowers the price increase the market share. Eventually, this will bring the economies of large-scale production.

Consumers and Outputs: In case of products for individual consumption, the demand is relatively inelastic. A newspaper reader will not purchase the same copy (of the daily newspaper) even if the seller reduces its price. But if there are numerous consumers (readers), a decrease in the price of the newspaper will bring more customers (relatively elastic).

Wages: Elasticity of demand also exerts its influence on wages. If demand for labor is relatively elastic, it is easy to raise wages, but not otherwise.

Poverty in plenty: A bumper crop may bring disaster than prosperity, if the demand is inelastic. This is especially true in case of perishable goods. But, if the produce can be stored (durable good), the price is relatively elastic.

Indifference Curve Analysis: Our previous analysis of consumer behavior dealt with utility analysis of consumer behavior. The utility analysis of consumer behavior focuses on the assumption that utility can be measured in quantitative terms. That is, utility can be expressed in numerical terms. For example, utility 10 is greater than utility 9 or 8, and so and on. . This approach is called cardinal approach of utility measurement. There are, however, others who believe that utility can not be measured in numerical terms. That is, utility is not quantifiable. According to them, utility can be measured only in relative terms. This is ordinal approach. Ordinal utility is not a quantity or a numerical value. It is only an expression of the consumer’s preference for one commodity over another or one packet/basket of goods over another. The concept of ordinal utility is based on the following axioms:

1. It may not be possible for the consumer to express his/her utility in quantitative terms. But, it is always possible for her/him to tell which of any two goods s/he prefers. For example, an individual may not be able to specify how much utility s/he derives by eating a chocolate. But, s/he can always tell what s/he prefers between chocolate and ice-cream, a pair of shoes and trousers, and so on.
2. A consumer can list all the commodities s/he consumes in order of preference.

According to the ordinal approach, absolute measurement of utility is neither feasible nor necessary for analyzing consumer behavior. This approach suggests the indifference curve analysis.

Indifference Curve:  An indifference curve represents satisfaction of a consumer from two commodities. An indifference curve is the curve that shows at any point of the curve, consumer’s satisfaction is the same. That is, the consumer remains indifferent (in terms of satisfaction) at various points of the curve. “An indifference curve can be defined as the locus of points each representing a different combination of two goods yielding the same utility or level of satisfaction. Therefore, a consumer is indifferent between any two combinations of goods when it comes to making a choice between them.” – Dwivedi.

Indifference Map: An indifference map is a pictorial or graphical representation of different indifference curves in one setting.

Indifference Schedule: An indifference schedule is the list of various combinations of goods yielding the same level of satisfaction.

Marginal Rate of Substitution: The marginal rate of substitution (MRS) is the rate at which one commodity can be substituted for another, the level of satisfaction remaining the same. The MRS shows how much of one commodity is substituted for how much of another or at what rate a consumer is willing to substitute one commodity for another in her/her consumption pattern. The concept of MRS is a tool of indifference curve technique and is parallel to the concept of marginal utility.

Combination	Apples	Mangoes	MRS of Ms. for As.
1	15	0	-
2	11	1	4:1
3	8	2	3:1
4	6	3	2:1
5	5	4	1:1

 Properties of Indifference Curves:

1. Downward sloping: An indifference curve slopes downward to the right.
2. Convexity: It is convex to the origin. The implication of this convexity is that as we have more and more of one good (Mango) and less and less of another (Apple), the MRS of M for A goes on falling.
3. Higher the indifference curve, the higher the satisfaction and vice versa.
4. Non-intersecting: Two indifference curves never intersect with each other. This is because of the operation of the 3^rd property.

Assumptions underlying the (Ordinal Utility) Indifference Curve Analysis:

1. Rationality: A consumer is assumed to be a rational being. S/he wants to maximize her/his satisfaction.
2. Completeness: The consumer’s scale of preference is so complete that s/he is able to choose any one of the combinations presented to him/her. Also, s/he has full knowledge of the circumstances and conditions required for taking rational decision.
3. Non-satiation: The consumer has not reached the saturation point (full satisfaction). The consumer, thus, prefers more to less.
4. Consistency and Transitivity of choice: The consumer’s choice or preference remains consistent. Transitivity of choice means that if a consumer prefers A to B, and B to C, s/he must prefer A to C. Or if a consumer treats A = B, and B = C, s/he must treat A = C.
5. Continuity or Substitutability: Unless the one combination can be substitutes or replaced for another, the consumer’s preference will not be possible.
6. Convexity: The law of diminishing rate of MRS will operate.
   
   Indifference Curve Analysis of Demand:
   Price line or Budget Line: The price line is the line that shows a consumer can purchase different combinations of goods at given prices with certain amount of money. It is also called the budget line in the sense that the consumer has a limited amount of money to spend on different combinations of goods.
   Suppose that our hypothetical consumer (A student, for example) has Tk. 20/- to spend for break fast. And the consumer decides to take break fast with loops of bread and/or bananas. The price of a piece of banana is Tk. 4/- and that of bread is Tk. 2/-. The options open to the consumer are:
   It must be kept in mind that the consumer is governed by the money or income s/he has to spend on goods, and the prices of the goods in the market.
   Consumer’s Equilibrium Through Indifference Curve: Consumer’s equilibrium means maximum satisfaction of the consumer. The consumer is said to be in equilibrium when s/he obtains the maximum possible satisfaction from the purchases and consumption, given the prices in the market and the amount of money s/he has to spend. In order to explain how a consumer reaches the equilibrium, we will have to make certain assumptions. These are:
   1. Our consumer has an indifference map showing his/her scale of preferences for various combinations of goods. This scale of preferences remains the same throughout the analysis.
   2. The consumer has a given (and constant) amount of money to spend on goods.
   3. The prices of the goods are given and constant.
   4. Each of the goods is homogenous and perfectly divisible.
   5. The consumer acts rationally. (End)
   Cost and Cost Concepts
   In economic terms, cost is the expenditure made for production or consumption (use) of goods and services.
   Actual Cost: Actual costs mean the expenditure incurred/made for producing or acquiring a good or service.
   Opportunity Cost: The opportunity cost of a good or service is measured in terms of revenue which could have been earned by that good or service in some other alternative uses. Opportunity cost can be defined as the cost of the best alternative foregone.
   Explicit Cost: Explicit costs are those costs that involve an actual payment to other parties.
   Implicit Cost: Implicit costs represent the value of foregone opportunities but do not involve an actual cash payment. For example, a manager who runs his/her own business foregoes the salary that could have been earned by working for someone else. This type of cost is not generally reflected in accounting systems, but it is important for rational decision making.
   Past Cost: Past costs are actual costs incurred in the past and are generally recorded in financial statements.
   Future Cost: Future costs are costs that are reasonably expected to be incurred in some future period/s. Their actual incurrence is a forecast, and, unlike the past costs, they can be planned and managed (be kept or avoided).
   Short-run Costs: Short-run costs are costs that vary with output when fixed plant and capital equipment remain the same.
   Long-run Costs: Long-run costs are those which vary with output when all inputs factors including plant and equipment vary.
   Short-run Cost: Capital cost remains the same.
   Long-run Cost: Capital cost varies or can be varied.
   Fixed Cost: Fixed cost is the cost that remains the same regardless of the amount of output up to a certain point. They are not affected by changes in the volume of production. There is an inverse relationship between the volume and fixed costs per unit. (BS)
   Variable Cost: Variable cost varies with the amount of output. They are affected by changes in the volume of production. There is a positive relationship between total variable cost and the volume of output.
   Total Cost: Total cost is the sum of all costs (fixed and variable) incurred to produce a certain level of output.
   Average Cost: Average cost is the total cost divided by the number of units produced.
   Marginal Cost: Marginal cost is the additional cost incurred for producing an additional unit of output. It is the cost of producing an extra or marginal unit.
   Incremental Cost: Incremental cost is the additional cost due to change in the level or nature of business activity. The change may take place different forms like: - a new product line, adding a new machine, change in channel of distribution.
   Sunk Cost: Sunk cost is the one which is not affected by a change in the level or nature of business activity. (depreciation) Sunk costs are the costs that have been made in the past or need to be made in future as a part of contractual arrangements. Rent for warehouse (space) that must be paid as a part of long-term lease.
   Nominal Cost: Nominal cost is the money cost of production.
   Real Cost: Real cost is the cost a community bears due to operation of business. Adam Smith regarded “pains and sacrifices” of labor as the real cost. The “cost of waiting” is also said to be a real cost. Some also term the real cost as “social cost”. The cost of constructing the “Jamuna Bridge”. BS
   The cost of a tannery factory in Hazaribagh. BS
   Cost and Output Relationship: Here, we will discuss the behavior of total, average and marginal costs in relation to volume of output. The total cost increases with the increase in the volume of output. The fixed cost remains the same throughout the level of output. The variable cost varies with the volume of output. The marginal cost also varies depending on the behaviors of fixed and variable costs.  The average fixed cost (AFC) decreases with the increase in output. The average cost (AC) first decreases, then after certain point increases with the increase in output. That is why the AC curve is “U” shaped. The average variable cost (AVC) follows the similar pattern. Like the AC, the marginal cost (MC) also initially declines, but after certain point (of output) it goes upward.
   Why is the AC curve “U” shaped?
   At first the average cost is high due to large fixed cost and small output. As output increases, the fixed cost is evenly shared by the additional outputs, and the average cost falls accordingly. But after a certain point of output, the average cost start increasing due to addition of new facilities, limits of other factors of production. Operation of the law of diminishing marginal rate of return.
   Relation Between AC and MC
   As we know, marginal cost is the addition to the total cost due to increase in an extra or additional unit of output. Like the AC, the MC also falls at first due to more efficient use of variable factors as output increases. Then it slopes upward (like AC) as further additions to output interfere with the most efficient use of variable factors. The average variable cost continues to decline so long as the MC is below it. But it starts rising at a point where MC crosses AVC. While falling the MC will lie below the AC and while rising the MC will lie above the AC.
   Equilibrium of the Firm: The first and foremost aim of a firm is to earn profits. And firms try to maximize their profits. The concept of “Equilibrium of the Firm” is all about when a firm maximizes its profits. So, “equilibrium of the firm” is the point at which it maximizes its profit. “A firm is in equilibrium when it has no incentive either to expand or to contract its outputs.” Dewett. (BS)  Before we discuss about the equilibrium of the firm, let us about various concepts of revenue. Revenue is the money received by a firm by selling its goods and/or services. The term “revenue” should not be confused with the term “profit”. (BS)
   Total Revenue: It is the sum total of money received by selling goods and services (sales proceeds).
   Average Revenue: It is total revenue divided by number of units (of goods and services) sold.
   Marginal Revenue: It is the extra/additional revenue earned by selling an additional (or extra) unit of goods and services.
   Average Revenue and Marginal Revenue Relationship: When price is falling, the additional revenue (MR) for the extra unit sold will be less than the revenue (MR) from the previous unit. It is also obvious that when price is falling, a firm experiences a declining AR curve. It is also true that in a condition of falling price, the MR curve lies below the AR curve. But when the price is constant the MR equals AR. Here, the MR curve is the same as the AR curve. (Same straight lines)
   Equilibrium of the Firm (contd.): The equilibrium of the firm can be explained by two methods or ways:
   A) With the help of total revenue and total cost curves.
   B) With the help of marginal revenue and marginal cost curves.
   Assumptions:
   Equilibrium of the Firm (TR and TC method): We already know that a prudent entrepreneur will expand output if s/he can increase his/her profits. And will contract output to avoid losses (when the cost is greater than the revenue). The profit is the difference between total revenue and total cost. The entrepreneur will be in equilibrium position at the level of output where the money profits are maximum. At the equilibrium position the entrepreneur will have no intention or inducement either to expand or contract the output.
   Break-even Point: Break-even point is the point of output (or sale) where a firm neither earns profit, nor incurs loss. At the break-even point, the total revenue equals total cost. The break-even point may occur in two different scenarios:
   Equilibrium of the Firm (MR and MC method): We know that a firm will be in equilibrium when it earns maximum profits. Under the MR and MC method, the following TWO conditions must be fulfilled:
   1) Marginal Revenue = Marginal Cost.
   2) The MC curve must cut the MR curve from below at the equilibrium point.
   That means, the MC will be less than MR before the equilibrium point. If MC is greater than MR, it implies that the firm incurs more cost than earning revenue by producing even a single unit of output.
   The Concept of Market and Market Forms: In economic terms a “Market” is a place or region where the “buyer/s” and “sellers” come into an agreement that affect exchange of goods and services. A market is not necessarily market place where goods are bought and sold. A market may be whole of any region where buyers and sellers interact with each other to affect/perform the exchange.
   Examples: (Marketing) Buyers’ market, Sellers’ market, children's’ market, adults’ market, the “Rich's market, “low income-groups market”, or the market targeting on some special-category customers.
   The Essential Conditions of a Market
   1. A commodity that is bought and sold.
   2. The existence of buyers and sellers.
   3. A place, be it a certain region, a country or the entire world.
   4. Interaction with or bargaining of buyers and sellers over price of the commodity.
   5. Only one price will prevail for the same commodity at any certain point of time as a result of such interaction or bargaining.
   Classification of Markets: Markets can be classified on the basis of:
   1. Area – as local, regional, national, and world markets.
   2. Time – as market price on any particular day or moment, short-term price, long-term price, or secular markets covering a generation.
   3. Nature of competition – as perfect markets and imperfect markets.
   Perfect and Imperfect Markets: Perfect Market: A market is said to be perfect when all potential sellers and buyers are clearly aware of the price, and no single buyer or seller can influence the price.
   Imperfect Market: A market is said to be imperfect when some buyers or sellers or both are not fully aware of the offers being made (price and quantity) by others.
   Nature of Competition:
   The type of market depends on the degree of competition prevailing in the market.
   The degree of competition may be classified as:
   1. Pure Competition
   2. Perfect Competition
   3. Imperfect Competition
   Sometimes Pure competition and Perfect competition are brought under the category of Perfect Competition. However, Perfect competition is broader than Pure competition. Imperfect competition consists of Monopolistic competition, Oligopoly, Duopoly, and Monopoly.
   Pure Competition: Pure Competition is said to exist when the following conditions are fulfilled:
   1. Large number of buyers and sellers: The number of buyers and sellers is so large that no single buyer and seller can influence the price.
   2. Homogenous Products: The second condition is that the commodity produced by all firms should be standardized and absolutely identical. This condition ensures that the same price rule in the market for the same commodity. (No matter who purchase from whom). This, again, implies that AR = MR = Price.
   Perfect Competition: Perfect competition is wider than Pure competition. Besides the two conditions mentioned for Pure competition, Perfect competition must also fulfill other conditions: Thus, the conditions of perfect competition are:
   i) Large number of buyers and sellers; ii) Homogenous product; iii) Free entry and exit; iv) Perfect knowledge; v) Absence of transport costs; vi) Perfect mobility of factors of production.  In Perfect Competition, firms only make normal profits. 
   Imperfect Competition: Imperfect competition may be of three (some say four) types:
   A) Monopolistic Competition: Large number of buyers and sellers, not as large as that of perfect competition. Individual sellers can have influence over price, products are not exactly similar, product differentiation, competitive advantage.
   B) Oligopoly: Few sellers, they can exert significant influence over price.
   C) Monopoly: Single producer or seller, absolute or indefinite influence over price and supply.
   D) Duopoly: Only two producers or sellers, significant influence over price and supply. Sellers (or Producers) under all these forms of imperfect competition face a downward sloping demand curve. (BS) Or Declining AR and MR curves. (BS)
   A monopolistic competition contains the conditions of both Perfect competition and Monopoly. – Explain (BS)
   “Theoretically, a Monopolist can charge as much high price as s/he wishes, but does not always do so.” Why? (BS)
   Supply Side of the Market: Supply means the amount offered for sale at a given price. “Supply means the quantity of a commodity which its producers or sellers offer for sale at a given price, per unit of time.” (Dwivedi)
   “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.” (Meyers)
   The term supply should not be confused with the term “stock”. Stock is the total volume of a commodity which can be brought into the market for sale at a short notice and supply means the quantity which is actually brought in the market. Stock is potential supply and supply is actual supply. Market supply is the sum of supplies of a commodity made by all individual firms at a given period of time.
   The Law of Supply: Supply has a functional relationship with price. The law of supply states this relationship. The law of supply states that “Other things remaining the same, as the price of a commodity rises its supply is extended, and as the price falls its supply is contracted.” According to Dwivedi, “The supply of a product increases with the increase in its price and decreases with decrease in its price, other things remaining constant.” That means supply has a positive relationship with price. We can say that supply and price are positively related, other things remaining the same. The ‘other things’ include factors (other than price) that affect supply. Movement along the supply curve and Shift of the supply curve: Movement along the supply curve states the relationship between price and quantity supplied (the law of supply). Shift of the supply curve states the relationship between quantity supplied and the factors, other than price, affecting supply. They include technology, cost, price of related goods, nature and size of industry, government policy, transport and communication system, and other non-economic factors like strikes, lockouts, war, drought, flood, epidemics, etc.
   Price Determination (General): The market price of a commodity or service is determined by the interaction between the demand and supply curves. It is called the equilibrium price. At this (equilibrium) price both consumers or customers and sellers are ready to purchase and sell a certain quantity of a product or service. It may be noted that any shift of either the demand curve or the supply curve or both will cause a change in the equilibrium price.
   Shift of the Demand Curve (Supply Curve remaining constant: A right-ward shift of the demand curve will cause an increase in quantity demanded followed by a rise in price. But a left-ward shift of the demand curve will result in decrease in price as well as in quantity demanded.
   Shift of the Supply Curve (Demand Curve remaining constant): The right-ward shift of the supply curve will result in an increase in the quantity demanded, but will cause a reduction in price.
   Parallel shift of both the Demand Curve and the Supply Curve will not cause a change in price but will cause a change in quantity demanded and supplied.
   Equilibrium of the Firm Under Different Market Conditions (Price-Output Determination):
   Under Perfect Condition: We know a firm under perfect condition faces a horizontal demand curve where price = AR = MC.
   A firm under perfect competition earns only normal profit. But, in the short-run, a firm may earn abnormal profit. The abnormal profit is said to exist when MR is greater than the short-run average cost (SAC). Graph
   Price Output Determination under Monopoly: We know a monopoly firm faces a downward sloping demand curve or average revenue curve (AR) curve. That is a monopoly firm can increase sale by reducing the price. A monopoly firm is likely to earn abnormal profit.
   Monopoly equilibrium and Competitive equilibrium compared: The similarity is that under both market conditions a firm is in equilibrium (maximum profit) when marginal revenue (MR) equals marginal cost (MC).
   Differences: There are several differences between a firm under perfect competition and a monopoly firm at the equilibrium point. These are:
    Price Discrimination: A monopolist firm is usually blamed for exercising price discrimination. Price discrimination means charging different prices for the same product from different people. According to Robbins, price discrimination is “charging different price for the same product, same price for the differentiated product.” The product may be differentiated by time, appearance or place. Stigler defines price discrimination “as the sale of various products at prices which are not proportional to their marginal costs.”
   Price discrimination may be personal (charging different prices from different persons), local (charging different prices at different locations, or according to trade or use (charging different prices for business-use or for household consumption).
   Price Output Determination under Monopoly
   We know a monopoly firm faces a downward sloping demand curve or average revenue curve (AR) curve. That is a monopoly firm can increase sale by reducing the price. A monopoly firm will be in equilibrium at the price-output level at which the profits are maximum. The monopolist will go on increasing output so long as additional units add more to the revenue than to cost. In other words, it will be in equilibrium level of output at which MR equals MC. Before this point the MR will be greater than the MC (there still exists the possibility of adding more profit). But, beyond this point, the MC will be greater than MR (implying the reduction in the total profit). A monopoly firm is likely to earn abnormal profits.
   Monopoly equilibrium and Competitive equilibrium compared
   Similarity: The similarity is that under both market conditions a firm is in equilibrium (maximum profit) when marginal revenue (MR) equals marginal cost (MC).
   Differences: There are several differences between a firm under perfect competition and a monopoly firm at the equilibrium point. These are: Under perfect competition the demand curve or the average revenue curve is horizontal (parallel to the horizontal axis or perfect price elasticity). Bur under monopoly, the demand curve (or the average revenue curve) slopes downward to the right.  It implies that the AR is greater than MR. Both under perfect competition and monopoly, the firm is in equilibrium at the level of output where MC is equal to MR. Under perfect competition, MC = MR = AR or price. But this is not so under monopoly. Under monopoly MR is always less than AR or price at the equilibrium point. Under perfect competition a firm is in long-run equilibrium at the lowest point of the AC curve. But in monopoly, a firm is in equilibrium at a point where the AC is still declining and has not reached the minimum. The reason is that as output is increased, MR drops below the AR, where as the MC is likely to increase. In the long-run a firm under perfect competition only earns normal profit at the equilibrium point, but a firm under monopoly still earns super-normal profit at the equilibrium point.
   Monopoly Power: The monopoly power is the power a monopoly firm enjoys to charge different prices at will and to produce different levels of output. The bases of monopoly power are:
   1. Barriers to entry of other firms (by government regulations).
   2. Exclusive ownership or control of raw materials.
   3. Patent right or innovation.
   4. Aggressive cut-throat tactics by the monopolist.
   It may be noted here that the above barriers are seldom cent percent effective.
   Price Discrimination: A monopolist firm is usually blamed for exercising price discrimination. Price discrimination means charging different prices for the same product from different people. When the same product is sold at different prices to different buyers, it is called price discrimination. According to Robbins, price discrimination is “charging different price for the same product, same price for the differentiated product.”
   The product may be differentiated by time, appearance or place.
   Stigler defines price discrimination “as the sale of various products at prices which are not proportional to their marginal costs.”
   Price discrimination may be personal (charging different prices from different persons), local (charging different prices at different locations), or according to trade or use (charging different prices for business-use or for household consumption).
   Degrees of Price Discrimination: The degree of price discrimination refers to the extent to which a seller can divide the market and can take advantage of market division in extracting the consumer’s surplus.
   According to Pigou, there are three degrees of price discrimination practiced by a monopolist.
   1. First Degree Price Discrimination
   2. Second Degree Price Discrimination
   3. Third Degree Price Discrimination
   The First Degree Price Discrimination:
   The discriminatory pricing that attempts to take away the entire consumer surplus is called the First Degree Price Discrimination. Here the seller is in a position to know the price each buyer is willing to pay. A doctor charging different fees from different types of patients.
   Second Degree Price Discrimination:
   The second degree of discriminatory pricing is to charge different prices for different quantities purchased. This is popularly known as quantity discount.
   Third Degree Price Discrimination:
   When a monopolist sets different prices in different markets having demand curves with different elasticities, it is using the third degree. It is possible when the markets are separated (in different locations) that resale is not possible or feasible. Local and foreign markets, geographical distance, transport barriers, transportation costs, etc.
   Is Price Discrimination Beneficial to Society?
   Price discrimination has had a bad reputation. The term itself is self-explanatory (favoring some and disfavoring others). In certain cases price discrimination may be to the advantage of the society or a particular community.
   Theory of Production: Production is an activity of transforming inputs into outputs. Production is sometimes defined as the creation of utility or the creation of want – satisfying goods and services. (Time utility, place utility, ownership utility, form utility). Production is basically concerned with creation of form utility (value addition). The laws of production are also called as laws of return or the theory of production.
   The theory of production states the quantitative relationship between inputs and output.
   Factors of Production: They are the inputs used in the process of production. The factors of production are the productive resources that are used to produce a given product or service. In economics, the factors of production are classified as land, labor, capital and organization (or entrepreneurship). These factors may be fixed or variable for a certain level of output during a certain period.
   Production Function: The term “Production Function” refers to the relationship between inputs and outputs produced by them. It states the functional relationship between inputs and outputs. The production function, however, ignores the prices of inputs and outputs. The production function shows the maximum amount of output which can be produced with a given set of inputs and with a given state of technology. The output will change when the quantity of any inputs is changed. To understand the nature of production function, the following points need to be emphasized:
   1. It represents a purely technical relationship in physical quantities between inputs and outputs. It has no reference to price.
   2. The output is the result of a joint use of the factors of production.
   3. The nature of combination of various factors (quantity to be used) will depend on the state of technology.
   4. In specifying the production function of a firm, we have to take into account the variability and divisibility of the factors.
   A production function is based on following assumptions:
   A) Perfect divisibility of both inputs and outputs.
   B) There are only two factors of production – labor and capital.
   C) Labor and capital are imperfect substitutes (limited substitution of one factor for another)
   D) A given technology.
   E) Inelastic supply of fixed factors in the short-run.
   Laws of Return: There are three laws of returns in economics – (a) the law diminishing return; (b) the law of constant return; and (c) the law of increasing return. These three laws are only three aspects of one law, called “The Law of Variable Proportions”. The law of variable proportions suggests that if the proportions of inputs are changed, they will result in increasing, constant, and diminishing outputs.
   The Law of Diminishing (Marginal) Returns: The application of the law is the most appropriate in the case of agriculture. The law suggests that successive increase of inputs (say labor and capital) in a particular land will ultimately result in proportionate decrease in return/yield. If the law does not operate a particular plot of land would have been sufficient to feed the entire population. The following table will explain this.
   
   
   # Worker        Total Return              Marginal Return       Average Return
   Three Aspects of the Law
   Law of Increasing Returns: Another aspect of the Law of Variable Proportions is the “Law of Increasing Returns”. If an extra amount of investment (increase in factors or inputs) is followed by more than proportionate increase in return (output) the law is said to operate. That means the rate of increase in marginal product/return is greater than marginal increase in input.
   Why does the law operate?
   Several factors are responsible for the operation of this law.
   1. Economies of mass production (specialization, division of labor, etc.).
   2. Technological Advancement.
   3. No scarcity of factors.
   4. Right combination.
   5. Full use of invisible factors (full capacity utilization).
   Law of Constant Returns: There may be a situation where neither the law of diminishing return nor the law of increasing return operates. An industry or a production unit is subject to the law of constant returns when, the cost per unit is unaltered or increased investment of labor and capital results in a proportionate increase in the output. Here neither the nature (diminishing return) nor the human being (increasing return) has any influence on the output (or both effects are neutralized).
   Returns to Scale: Returns to scale explains the behavior of production or returns when all the productive factors are increased or decreased simultaneously in the same ratio. In returns to scale we attempt to analyze the effects of doubling, trebling (and so on) of all inputs on the output of a product. The law of variable proportions explains the behavior of returns when proportions or combinations of factors are changed. On the other hand, the returns to scale explain the behavior of returns when the factor inputs are changed in same proportions.
   Three Phases of Returns to Scale: Normally, one would expect that by doubling the scale of production would exactly double the production and so on. In reality, however, this is not so. In reality, the marginal product increases up to a certain point, remains constant for certain point, then decline after a certain point. That is, like the law of variable proportions, returns to scale also has three phases – increasing rate, constant rate, and decreasing rate.
   Numerical Representation
   Case                            Scale               TP/TR                        MP/MR
   1                                  1W+3L            2 Units                        2 Units
   2.                                 2W+6L            5 Units                        3 Units (In.)
   3.                                 3W+9L            9 Units                        4 Units (In.)
   4.                                 4W+12L          14 Units          5 Units (In.)
   5.                                 5W+15L          19 Units          5 Units (Cons.)
   6.                                 6W+18L          24 Units          5 Units (Cons.)
   7.                                 7W+21L          28 Units          4 Units (Dec.)
   8.                                 8W+24L          31 Units          3 Units (Dec.)
   9.                                 9W+27L          33 Units          2 Units (Dec.)
   Note: W = Number of Worker/s or Laborer/s; L = Amount of Land (may be acre/s); TP/TR = Total Production or Total Return; MP/MR = Marginal Production/Return.
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   Economy of Scale
   
   
   Equal Product Curves: A new technique has been developed to study the theory of production and to show the equilibrium of a producer with factor combination. This technique is called as iso-product or iso-quant or equal product curves. Just as indifference curve represents various combinations of two goods giving the consumer equal satisfaction; The iso-product curve also shows all possible combinations of two inputs producing exactly the same level of output.
   Similarities and Differences between Indifference Curve and Iso-product Curve
   The similarity is that both the curves deal with combination of two variables producing the same effect (satisfaction or output).
   Differences: Indifference curve deals with satisfaction, the iso-quant curve deals with production. Indifference curve can not quantify the outcome, but the iso-quant curve can accurately quantify the outcome. The indifference map shows only higher the IC higher the satisfaction, but the iso-product map shows how much (with figures) higher is the output or product.
   Marginal Rate of Technical Substitution (MRTS): Like MRS, MRTS is the number of units of one factor (Y) which can be substituted by one unit of another factor (X).
   This also represents the diminishing rate of MRTS.
   Properties of Iso-product Curve: 1. Downward sloping, 2. Convex to the origin, 3. Non-intersecting, 4. Higher –lower principle
   Iso-cost Curve: The Iso-cost curve or line is the line that represents same costs with different factor combinations. The Iso-cost line represents two things:
   The Iso-cost curve also represents Price Line or Budget Line, the total amount a producer can spend on various combinations of two factors.
   Theory of Distribution: Generally, by distribution we mean the activities aimed at distribution of goods and services by the producers and their agents. In economics, by distribution we mean determining or evaluating the services of productive agents or factors. It is the share of income earned by the factors of production (land, labor, capital, organization) for their contribution in the production of goods and services.
   Functional Distribution and Personal Distribution
   Marginal Productivity Theory of Distribution: Marginal Productivity theory of distribution provides explanations how the services of factors of production are evaluated. By marginal productivity of a factor, we mean the addition made to total production by employing an extra unit. We know an entrepreneur works for profit. The entrepreneur will not engage an extra unit of a factor if it does not add to the total production. In employing various factors of production, the entrepreneur act on the principle of substitution. S/he substitutes one factor for another till the marginal productivities of all factors are equal. That is how marginal productivity determines the remuneration of a factor of production. It may also be noted that the marginal productivity of a factor should be equal to its price or remuneration. If the marginal productivity of a factor is more than its price, the entrepreneur will employ more of that factor. Again, if the marginal productivity of a factor is less than its price, the entrepreneur will be discouraged to add more of that factor. So, the entrepreneur will stop employing any particular factor where its marginal productivity equals its price.
   Assumptions of MP Theory
   1. All units of a factor are homogenous (any one unit is as same as other).
   2. Different factors are capable of being substituted for one another.
   3. The amount of a factor can be continuously varied (a little more or a little less).
   4. Mobility of factors for various uses.
   5. The law of diminishing marginal return operates.
   6. MP and reward are independent from each other.
   7. All factor contributions can be equally calculated.
   8. All factors are independent of each other.
   Equilibrium of the Firm in a Factor Market: By Equilibrium in the factor market means the maximum number of a factor the firm uses with minimum possible costs. The maximum number of a factors (or a combination of factors) used with minimum possible costs also means that a firm reaches the maximum profit position. To reach the equilibrium position, a firm must fulfill certain conditions.
   Conditions of General Equilibrium in a Factor Market: The conditions are: 1. The Marginal Revenue Productivity (MRP) should be equal to the Marginal Factor Cost (MFC) or the remuneration of a marginal factor. 2. The MRP curve must cut the MFC curve from above.
   Wages: The term wages means payments made for the services of labor. According to Benham wages mean “ a sum of money paid under contract by an employer to a worker for services rendered.
   Nominal Wages: Are money wages paid to workers.
   Real Wages: Are the purchasing powers a worker receives for the services rendered.
   Theories of wages: Subsistence Theory, Wages fund Theory, Residual Claimant Theory, Marginal Productivity Theory, Modern Theory (Demand and Supply)
   Subsistence Theory: According to this theory, wages tend to settle at a level just sufficient to maintain the worker and his/her family at subsistence level.
   Wages Fund Theory: According this theory, wages depend upon two quantities:
   1. The wages fund or the circulating capital set aside for the purchase of labor.
   2. The number of workers seeking employment.
   If the number of workers seeking employment is low, the wage per head will be high and vice versa. Or if the wages fund is smaller, the wage per head is lower and vice versa.
   Residual Claimant Theory: According to this theory, wages are residue left over, after the other factors of production have been paid. According to this theory, rent and interest are governed by contracts, and profit is determined by definite principles. But there are no principles operating with regard to wage. So, after rent, interest, and profit have been paid, the reminder goes to the workers as wages. 
   Reasons for Differences in Wages
   Rent: Rent is payment made for the use of land. Ricardo defined rent as “the portion of the produce of earth which is paid to the landlord for the original and indestructible power of soil”. According to Ricardo, rent arises due to differences in surplus accruing to the cultivators and resulting from the differences in fertility of soil of different grades of land.
   Ricardian Theory of Rent: Ricardian theory of rent is based on the principles of demand and supply. If supply of land in a country exceeds the total demand for land, no rent will be paid, like nothing is paid for the use of air. According to Ricardo, “If all lands had same properties, if it were unlimited in quantity, and uniform in quality, no charge could be made for its use, unless where it possessed peculiar advantages of situation.” Rent is chargeable – because land is not unlimited in quantity and uniform in quality and because (due to increase in population) land of inferior quality, or less advantageously situated, is called into cultivation. Ricardo has shown that rent arises in both extensive and intensive cultivation of land.
   Extensive Cultivation: It means extending cultivation to different grades of land with same amount of capital and labor applied to all grades of land. When land is cultivated extensively, rent on superior land equals the excess of its produce over that of the most inferior land.
   Intensive Cultivation: It means putting more and more of labor and capital on the use of land. For example, before land ‘B’ is brought under cultivation, additional capital is employed more productively on land ‘A’. But it is quite likely that doubling the amount of capital would not double the output.
   Transfer Earning and Economic Rent: Transfer Earning: It is also called opportunity cost and “Reservation Price”. Assuming that a factor has alternative uses, transfer earning has been defined as the amount a factor must earn to remain in its present occupation. It is the minimum amount that must be paid to a factor to avail of its services. Alternatively, the transfer earning can be defined as the amount that a factor expects to earn if transferred to its second best use.
   Economic Rent: It is the excess of actual earning of a factor over its transfer earning.
   Interest Interest is the amount paid to the owner for the use of the services of capital. The lender charges an extra amount form the borrower of capital for the services used – it is called interest.
   Theories of Interest
   Bohm-Bawerk/s Theory of Interest: According to Bohm-Bawerk, “interest is paid in the process of lending present income against the promise of future income”. Interest arises because people prefer present consumption of goods to their future consumption. It is discount for future goods. Bohm-Bawerk gave three reasons why people prefer present consumption to future.
   1. The circumstances of wants and provision for the present wants and future wants are different.
   2. People underestimate future because of (a) deficiency of imagination, (b) limited will power, and (c) the shortness and uncertainty of life.
   3. Present goods are economically superior to future ones. (money in hand today is more than the money in hand tomorrow).
   Fisher’s Liquidity Preference Theory: Fisher’s notion of interest is the same as that of Bohm-Bawerk. According to Fisher, interest arises because people prefer present to future income. The rate of interest equals the price that people are willing to pay for income now rather than income at some future date. The price (interest) is determined by the interaction of “willingness to give up present consumption in favor of a larger consumption in future, and opportunity to invest”.