Chapter-2.new.ppt

UNIT II: DEMAND AND SUPPLY ANALYSIS
Demand Analysis; Law of Demand, Exceptions to the law of
Demand, Determinants of Demand. Elasticity of Demand-
Price, Income, Cross and Advertising Elasticity;
measurement of Elasticity of Demand.; Law of Supply,
Supply Elasticity; Analysis and its uses for managerial
decision making- Pricing methods.

Market
• Market refers to the interaction between sellers
and buyers of good (or service) at a mutually
agreed upon price.

Demand
Demand is defined as that want, need or desire
which is backed by willingness and ability to buy
a particular commodity, in a given period of
time.

Types of Demand (DD)
i. Individual and Market Demand
ii. Organization and Industry Demand
iii. Autonomous and Derived Demand
iv. Demand for Perishable and Durable Goods
v. Short-term and Long-term Demand

Individual and Market Demand
• Individual demand can be defined as a quantity
demanded by an individual for a product at a
particular price and within the specific period of
time. For example, Mr. X demands 200 units of a
product at Rs. 50 per unit in a week.
• The total quantity demanded for a product by all
individuals at a given price and time is regarded
as market demand.
• Market demand is the aggregate of individual
demands of all the consumers of a product over a
period of time at a specific price, while other
factors are constant.

Organization and Industry Demand
• The demand for the products of an organization
at given price over a point of time is known as
organization demand.
• For example, the demand for Toyota cars is
organization demand. The sum total of demand
for products of all organizations in a particular
industry is known as industry demand.
• For example, the demand for cars of various
brands, such as Toyota, Maruti Suzuki, Tata, and
Hyundai, in India constitutes the industry’
demand. The distinction between organization
demand and industry demand is not so useful in
a highly competitive market.

Autonomous and Derived Demand
• The demand for a product that is not associated
with the demand of other products is known as
autonomous or direct demand. The autonomous
demand arises due to the natural desire of an
individual to consume the product.
• For example, the demand for food, shelter,
clothes, and vehicles is autonomous as it arises
due to biological, physical, and other personal
needs of consumers. On the other hand, derived
demand refers to the demand for a product that
arises due to the demand for other products.

Demand for Perishable and Durable
Goods
• The goods are divided into two categories,
perishable goods and durable goods. Perishable
or non-durable goods refer to the goods that have
a single use. For example, cement, coal, fuel, and
eatables. On the other hand, durable goods refer
to goods that can be used repeatedly,
• durable goods need replacement because of their
continuous use. The demand for perishable goods
depends on the current price of goods and
customers’ income, tastes, and preferences and
changes frequently

Short-term and Long-term Demand
• Short-term demand refers to the demand for
products that are used for a shorter duration of
time or for current period. This demand
depends on the current tastes and preferences of
consumers.
• The long-term demand of a product depends on
a number of factors, such as change in
technology, type of competition, promotional
activities, and availability of substitutes.

Determinants of Demand
• Price of the product
• Income of the consumer
• Price of related goods
• Taste and preferences
• Advertising
• Consumer expectation of future Income and
price
• Population
• Growth of economy
• Consumer Credit

Demand Function
When we express the relation between demand
and its determinants mathematically, the
relationship is known as demand function.
It can be said that demand for a product X (Dx)
is a function of :
Dx= f (Px, Y, P0, T, A, E, N)
• Dx= Demand for commodity x;
• Px= Price of the given commodity x;
• Y= Income of the individual consumer;
• T= Tastes and preferences;
• F= Expectation of change in price in the future;

Law of Demand
• Other things remaining constant, when price of a
commodity rises, the demand for that
commodity falls and when the price of a
commodity falls, the demand for that
commodity rises.

Demand Schedule
Demand schedule is the list or tabular statement
of the different combinations of price and
quantity demanded of a commodity.
Demand schedule for Apple:
Price (per kg) Demand P.kg
150 20
200 15
250 10
300 5

Exceptions to the law of Demand
Giffen Goods: Display direct price demand
relationship
Snob Appeal: Veblen goods have snob value for
which the consumer measures the satisfaction
derived not by their utility value, but by their
social status.

Law of diminishing Marginal Utility
As per law of
diminishing marginal
utility, the utility
derived from every
next unit (marginal
unit) of a commodity
consumed goes on
falling.

Supply
Supply refers to the quantities of a good or
service that the seller is willing and able to
provide at a price , at a given point of time.

Determinants of Supply
• Price of Commodity
• Cost of Production
• State of Technology
• Number of Firms
• Government Policies

Law of Supply
Other things remaining same, the higher the
price of a commodity, the greater is the quantity
supplied.

Market Equilibrium
• Equilibrium refers to a state of balance that can
occur in a model showing a tendency of no
change. The point on which market demand and
market supply intersects is known as Market
Equilibrium.

• Consumers and producers react differently to
price changes. Higher prices tend to reduce
demand while encouraging supply, and lower
prices increase demand while discouraging
supply.
• Economic theory suggests that, in a free market
there will be a single price which brings demand
and supply into balance, called equilibrium
price. Both parties require the scarce resource
that the other has and hence there is a
considerable incentive to engage in an exchange.

• Equilibrium price is also called market clearing
price because at this price the exact quantity that
producers take to market will be bought by
consumers.

Example
The weekly demand and supply schedule for a brand of soft drink at
various prices (between 30p and Rs.1.10p) is shown opposite.
PRICE (Rs)
QUANTITY
DEMANDED
QUANTITY
SUPPLIED
1.10 0 1000
1.00 100 900
90 200 800
80 300 700
70 400 600
60 500 500
50 600 400
40 700 300
30 800 200

Equilibrium
• As can be seen, this market will be in
equilibrium at a price of 60p per soft drink. At
this price the demand for drinks by students
equals the supply, and the market will clear. 500
drinks will be offered for sale at 60p and 500
will be bought - there will be no excess demand
or supply at 60p.

• Demand contracts because at the higher price, the income
effect and substitution effect combine to discourage
demand, and demand extends at lower prices because the
income and substitution effect combine to encourage
demand.
• In terms of supply, higher prices encourage supply, given
the supplier's expectation of higher revenue and profits,
and hence higher prices reduce the opportunity cost of
supplying more. Lower prices discourage supply because
of the increased opportunity cost of supplying more.
• The opportunity cost of supply relates to the possible
alternative of the factors of production. In the case of a
college canteen which supplies cola, other drinks or other
products become more or less attractive to supply
whenever the price of cola changes. Changes in demand
and supply in response to changes in price are referred to
as the signaling and incentive effects of price changes.

Elasticity of Demand
Elasticity of demand measures the degree of
responsiveness of the quantity demanded of a
commodity to a given change in any of the
determinants of demand.
change in quantity demanded due to a
change in price is large. An inelastic demand is
one in which the change in quantity demanded due
to a change in price is small
Proportionate change in quantity demanded of commodity X
Elasticity of Demand: -------------------------------------------------------------------
Proportionate change in demand determinants

Types of Elasticity of demand
1. Price elasticity of demand
2. Income elasticity of demand
3. Cross elasticity of demand
4. Promotional elasticity of demand

1. Price Elasticity of Demand
Price elasticity of demand measures the
proportionate change in quantity demanded of a
commodity to a given change in its price.
Proportionate changes in quantity demanded
= ----------------------------------------------------
Proportionate changes in Price

Types of Price Elasticity Demand

1. Perfectly Elastic Demand:
• When a small change in price of a product
causes a major change in its demand, it is said to
be perfectly elastic demand.
• In perfectly elastic demand, a small rise in price
results in fall in demand to zero, while a small
fall in price causes increase in demand to
infinity.

• From the Figure it can be interpreted
that at price OP, demand is infinite;
however, a slight rise in price would
result in fall in demand to zero. It can
also be interpreted from Figure that
at price P consumers are ready to buy
as much quantity of the product as
they want. However, a small rise in
price would resist consumers to buy
the product.
• Though, perfectly elastic demand is a
theoretical concept and cannot be
applied in the real situation.
However, it can be applied in cases,
such as perfectly competitive market
and homogeneity products. In such
cases, the demand for a product of an
organization is assumed to be
perfectly elastic.
From an organization’s point of view,
in a perfectly elastic demand
situation, the organization can sell as
much as much as it wants as
consumers are ready to purchase a
large quantity of product. However, a
slight increase in price would stop
the demand.

2. Perfectly Inelastic Demand
• It can be interpreted from Figure that
the movement in price from OP1 to
OP2 and OP2 to OP3 does not show
any change in the demand of a
product (OQ).
• The demand remains constant for any
value of price. Perfectly inelastic
demand is a theoretical concept and
cannot be applied in a practical
situation. However, in case of
essential goods, such as Salt, the
demand does not change with change
in price. Therefore, the demand for
essential goods is perfectly inelastic.

3.Relatively Elastic Demand
• Relatively elastic demand refers
to the demand when the
proportionate change produced
in demand is greater than the
proportionate change in price of
a product. The numerical value
of relatively elastic demand
ranges between one to infinity.
• Mathematically, relatively
elastic demand is known as
more than unit elastic demand
(ep>1). For example, a small
decrease in price from P1 to P2
leads to proportionately greater
increase in quantity demanded
from Q1 to Q2. (Luxuries)

4. Relatively Inelastic Demand
• Relatively inelastic demand is one
when the percentage change
produced in demand is less than
the percentage change in the price
of a product.
• For example, if the price of a
product increases by 30% and the
demand for the product decreases
only by 10%, then the demand
would be called relatively inelastic.
The numerical value of relatively
elastic demand ranges between
zero to one (ep<1). Marshall has
termed relatively inelastic demand
as elasticity being less than unity.

5. Unitary Elastic Demand
• When the proportionate change
in demand produces the same
change in the price of the
product, the demand is referred
as unitary elastic demand. The
numerical value for unitary
elastic demand is equal to one
(ep=1).
• From Figure, it can be
interpreted that change in price
OP1 to OP2 produces the same
change in demand from OQ1 to
OQ2. Therefore, the demand is
unitary elastic.

Income Elasticity of Demand
• Income elasticity of demand measures the
degree of responsiveness of demand for a
commodity to a given change in consumer’s
income.
Proportionate change in quantity demanded of commodity X
Ey = -------------------------------------------------------------------------
Proportionate change in Income of Consumer
Types:
Positive Income Elasticity, Zero Income Elasticity, Negative Income elasticity

Cross Elasticity
“Cross elasticity of demand is the rate of change
in quantity associated with change in the price
of related goods”
Proportionate change in the quantity
demanded of commodity X
Ec= -------------------------------------------
Proportionate change in the price of
commodity Y

Promotional Elasticity
• Advertising (or promotional) elasticity of
demand measures the effect of incurring an
“expenditure” on advertising, vis-a-vis.
Proportionate change in quantity demanded X
Ea = ---------------------------------------------------------
Proportionate change in advertising expenditure

Measuring Price Elasticity of
Demand
• The following points highlight the top four methods
used for measuring elasticity of demand. The methods
are:-
1. Total Outlay Method
2. Proportional Method
3. Geometric Method
4. Arc Method

Total Outlay Method
• The term ‘outlay’ means the amount expended
by the consumer and the outlay is the revenue of
the seller.
• This method envisages a measurement based
upon the total outlay of the consumer.
• If, for example, his total outlay on a particular
product P is Rs.X and if the management takes a
decision to reduce or increase the price, it would
be evident that there would be an increase or
decrease in the total revenue of the firm.

Sl.No Price of the
product (in Rs)
Number of
Units
bought
Total Outlay
In (Rs)
1 60 4 240
2 50 4 200
3 40 5 200
4 30 8 240
When the price was Rs.60, the consumer bought 4 units of x. When the
price was reduded to Rs.50, he still bought 4 units. In the first case, the
toal outlay was Rs.240. in the second case, it was Rs.200. In other
words, ther is fall in the total outlay, indicating that the elasticity is less
than unity. Betweeb 2 abd 3, the total outlay is Rs.200. this is a case of
unit elasticity. Between 3 and 4, the total outlay has increased from
Rs.200 to Rs.240; that is, more than unity.

Proportional Method
• This is refers to point elasticity. Under this method, the
percentage change is compared to the percentage
change in the quantity demanded; in other words, the
ratio is the change in the quantity demanded to the
change in the price. The formula is written as follows:
Proportionate change in the amount demanded
Price elasticity = -------------------------------------------------------
Proportionate change in price
Alternatively = Change in quantity demanded Change in price
------------------------------------ ÷ -----------
Amount demanded Price

The Percentage Method
The price elasticity of demand is measured by its
coefficient (Ep). This coefficient (Ep) measures
the percentage change in the quantity of a
commodity demanded resulting from a given
percentage change in its price.
• Where q refers to quantity demanded, p to price and Δ to change. If
EP>1, demand is elastic. If EP< 1, demand is inelastic, and Ep= 1,
demand is unitary elastic.
• With this formula, we can compute price elasticities of demand on
the basis of a demand schedule.

Let us first take combinations B and D.
(i) Suppose the price of commodity X falls from Rs. 5 per kg. to
Rs. 3 per kg. and its quantity demanded increases from 10
kgs.to 30 kgs.
Then
This shows elastic demand or elasticity of demand greater than
unitary.

2. The Point Method
Prof. Marshall devised a geometrical method for
measuring elasticity at a point on the demand curve. Let
RS be a straight line demand curve in Figure. 2. If the
price falls from PB ( = OA) to MD ( = OC), the quantity
demanded increases from OB to OD.
• Elasticity at point P on the RS demand curve
according to the formula is:
• EP = Δq/Δp x p/q
• Where Δq represents change in quantity demanded, Δp
changes in price level while p and q are initial price and
quantity levels.

• With the help of the point method, it is easy to
point out elasticity at any point along a demand
curve. Suppose that the straight line demand
curve DC in Figure. 3 is 6 centimeters. Five
points L, M, N, P and Q are taken on this
demand curve.
• The elasticity of demand at each point can be
known with the help of the above method.
• Let point N be in the middle of the demand
curve. So elasticity of demand at point

• We arrive at the conclusion that at the mid-
point on the demand curve, the elasticity of
demand is unity.
• Moving up the demand curve from the mid-
point, elasticity becomes greater. When the
demand curve touches the Y- axis, elasticity is
infinity.
• Ipso facto, any point below the mid-point
towards the A’-axis will show elastic demand.
Elasticity becomes zero when the demand curve
touches the X -axis.

3. The Arc Method:
• We have studied the measurement of elasticity at a point
on a demand curve. But when elasticity is measured
between two points on the same demand curve, it is
known as arc elasticity. In the words of Prof. Baumol,
“Arc elasticity is a measure of the average
responsiveness to price change exhibited by a
demand curve over some finite stretch of the
curve.”

• Any two points on a demand curve make an arc. The area between P
and M on the DD curve in Figure. 4 is an arc which measures
elasticity over a certain range of price and quantities. On any two
points of a demand curve, the elasticity coefficients are likely to be
different depending upon the method of computation. Consider the
price-quantity combinations P and Mas given in Table 2.
If we move in the reverse direction from M to P, then

• Thus the point method of measuring elasticity at two points on a
demand curve gives different elasticity coefficients because we used
a different base in computing the percentage change in each case.
To avoid this discrepancy, elasticity for
the arc (PM in Figure 4) is calculated by
taking the average of the two prices [(p1 +
p2 )½] and the average of the two
quantities [(q, +q2 )½]. The formula for
price elasticity of demand at the mid-
point (C in Figure 4) of the arc on the
demand curve is

• On the basis of this formula, we can measure arc
elasticity of demand when there is a movement either
from point P to M or from M to P.
• From P to M at point P, p1 =8, q1 = 10, and at point M,
p2 = 6, q2 = 12.
Applying these values, we get

• Thus whether we move from M to P or P to M
on the arc PM of the DD curve, the formula for
arc elasticity of demand gives the same
numerical value.
• The closer the two points P and M are, the more
accurate is the measure of elasticity on the basis
of this formula.
• If the two points which form the arc on the
demand curve are so close that they almost
merge into each other, the numerical value of
arc elasticity equals the numerical value of point
elasticity.

4. The Total Outlay Method
• Marshall evolved the total outlay, or total revenue or total
expenditure method as a measure of elasticity. By
comparing the total expenditure of a purchaser both
before and after the change in price, it can be known
whether his demand for a good is elastic, unity or less
elastic.
• Total outlay is price multiplied by the quantity of
a good purchased:
Total Outlay = Price x Quantity Demanded.
• This is explained with the help of the demand schedule in
Table.3.

i) Elastic Demand:
Demand is elastic, when with the fall in price the total expenditure
increases and with the rise in price the total expenditure decreases.
Table.3 shows that when the price falls from Rs. 9 to Rs. 8, the total
expenditure increases from Rs. 18 to Rs. 24 and when price rises from
Rs. 7 to Rs. 8, the total expenditure falls from Rs. 28 to Rs. 24.
Demand is elastic(Ep > 1) in this case.
(ii) Unitary Elastic Demand:
When with the fall or rise in price, the total expenditure remains
unchanged, the elasticity of demand is unity. This is shown in the
table when with the fall in price from Rs. 6 to Rs. 5 or with the rise in
price from Rs. 4 to Rs. 5, the total expenditure remains unchanged at
Rs. 30, i.e., Ep = 1.

(iii) Less Elastic Demand:
Demand is less elastic if with the fall in price,
the total expenditure falls and with the rise in
price the total expenditure rises. In Table 3
when the price falls from Rs. 3 to Rs. 2, total
expenditure falls from Rs. 24 to Rs 18, and when
the price rises from Re. 1 to Rs. 2. the total
expenditure also rises from Rs. 10 to Rs. 18. This
is the case of inelastic or less elastic demand, Ep
< 1.

Demand Forecasting-Definition
“ Demand Forecasting is an estimate of sales in
dollars or physical units for a specified future
period under a proposed marketing plan”
-American Marketing Association

Demand Forecasting
• Demand forecasting as the scientific and
analytical estimation of demand for a product
(good or service) for a particular period of time”
Categorisation by level of Forecasting:
• Firm (Micro) Level
• Industry Level
• Economy (Macro level)

Categorisation by Time Period:
1. Short term Forecasting
2. Long term Forecasting
Categorisation by Nature of Goods:
1. Consumer Goods
2. Capital Goods

Demand Forecasting
Subjective Methods of Demand forecasting :
• Consumer Opinion Survey
• Sales Force Composite
• Experts’ Opinion Method
- Group Discussion
- Delphi Technique
The Delphi method is a process used to arrive at a group opinion or decision by
surveying a panel of experts
• Market Stimulation

Market Morphology/ Market Structure
• Nature of competition
• Nature of product
• Number and size of buyers
• Freedom to Enter into or Exit from the market

Types of Market
• Perfect Competition
• Monopolistic Competition
• ligopoly
• Monopoly
• Monopsony

Perfect Competition
• Number of firms are Very large
• Nature of product is Homogeneous
(Undifferentiated)
• Number of buyers are very large
• Freedom of Entry and Exit is Unrestricted
Examples:
Agricultural commodities, shares, Unskilled
labour.

Monopolistic Competition
• Number of firms are many
• Nature of products are differentiated
• Number of buyers are many
• Freedom of entry and exit is unrestricted
Examples:
Retail stores, detergents

Oligopoly
• Number of firms are few
• Nature of products are undifferentiated or
differentiated
• Number of buyers are few
• Freedom of entry and exit is restricted
Examples:
Car, Computers, Universities

Monopoly
• Number of firm is single
• Nature of product is unique
• Number of buyers are many
• Freedom of entry and exit is restricted
Examples:
Indian Railways, Microsoft

Monopsony
• Number of firms are many
• Nature of products are undifferentiated or
differentiated
• Number of buyers are also single
• Freedom of entry and exit is Not applicable
Example:
Indian Defence Industry

Consumer behaviour
• Consumer behaviour is the study of how
individual customers, groups or organizations select,
buy, use, and dispose ideas, goods, and services to
satisfy their needs and wants. It refers to the actions
of the consumers in the marketplace and the
underlying motives for those actions.
• Marketers expect that by understanding what causes
the consumers to buy particular goods and services,
they will be able to determine—which products are
needed in the marketplace, which are obsolete, and
how best to present the goods to the consumers.

Consumer Equilibrium
• A consumer is said to be in
equilibrium when he feels that he
“cannot change his condition
either by earning more or by
spending more or by
changing the quantities of
thing he buys”. A rational
consumer will purchase a
commodity up to the point where
price of the commodity is equal to
the marginal utility obtained from
the thing.
• If this condition is not fulfilled the
consumer will either purchase
more or less. If he purchases
more, MU will go on falling and a
situation will develop where price
paid will exceed MU. In order to
avoid negative utility, i.e.,
dissatisfaction, he will reduce
consumption and MU will go on
increasing till P = MU.

Theoretical approaches to the study of consumer
behavior
• Economic Man
• Psychodynamic
• Behaviorist
• Cognitive
• Humanistic

Economic Man
• In order to behave rationally in the economic
sense, as this approach suggests, a consumer
would have to be aware of all the available
consumption options, be capable of correctly
rating each alternative and be available to select
the optimum course of action

Psychodynamic Approach :
• The psychodynamic tradition within
psychology is widely attributed to the work of
Sigmund Freud (1856-1939) (Stewart 1994).
• This view posits that behaviour is subject to
biological influence through ‘instinctive forces’
or ‘drives’ which act outside of conscious
thought (Arnold, Robert sonet al.1991).
• While Freud identified three facets of the
psyche, namely the Id, the Ego and the
Superego (Freud 1923)

• The id is the primitive and instinctual part of
the mind that contains sexual and aggressive
drives and hidden memories.
• The super-ego operates as a moral conscience;
and
• The ego is the realistic part that mediates
between the desires of the id and the super-ego.

Behavioural approach :
Human thoughts were regarded by Watson as ‘covert’
speech (Sternberg 1996), and strict monism was adhered
to (Foxall 1990). Between 1930 and 1950 Skinner
founded ‘Radical Behaviourism’ which acknowledges the
existence of feelings, states of mind and introspection,
however still regards these factors as epiphenomenal
• (Skinner 1938);(Nye 1979). The assumed role of
internal processes continued to evolve in subsequent
decades, leading to more cognitive approaches with a
new branch of study ‘Cognitive Behaviourism’
• claiming that intrapersonal cognitive events and
processes are causative and the primary irreducible
determinants of overt behaviour (Hillner 1984, p107).

Cognitive Approach:
• The cognitive approach ascribes observed action
(behaviour) to intrapersonal cognition. The
individual is viewed as an ‘information processor’
(Ribeaux AND Poppleton 1978).
• This intrapersonal causation clearly challenges the
explicative power of environmental variables
suggested in Behavioural approaches, however an
influential
• role of the environment and social experience is
acknowledged, with consumers actively seeking and
receiving environmental and social stimuli as
informational inputs aiding internal decision making
(Stewart 1994).

Humanistic Approach: start from the assumption that
every person has their own unique way of perceiving and
understanding the world and that the things they do only make
sense in this light.
• Consequently, the kinds of questions they ask about people
differ from those asked by psychologists from other
approaches.
• Whereas other approaches take an objective view of people,
in essence asking about them, ‘what is this person like?’
humanistic psychologists’ priority is understanding people’s
subjectivity, asking ‘what is it like to be this person?’ As a
result, they reject the objective scientific method as a way of
studying people.
• Humanistic psychologists explicitly endorse the idea that
people have free will and are capable of choosing their own
actions (although they may not always realize this). They also
take the view that all people have a tendency towards growth
and the fulfillment of their potential.

Production, Factors of Production,
Output
• The transformation of inputs into outputs.
• Factors of production refers to the goods and
services which assist the production process.
• Goods and services produced called ‘Output’.

Classification of factors of production
• Land: All natural resources such land area, air,
lakes, water and minerals.
• Labour: Physical or mental activities carried
out by human beings for monetary value.
• Capital: The part of man-made wealth which is
used to further produce wealth.
• Entrepreneurship: A person who combines
the three factors of production, initiates the
process of production and also bears the risk.

Production Functions
Production function refers to a statement of the
functional relationship between inputs (factors of
production) and output (goods and services).
Q= f (K,L,M, etc.)
Where,
Q= the amount of output per unit of time
K,L,M, = Land, Labour, Capital

Short-run and Long-run Production
Functions
Both short run and long run actually depends on the
inputs (factors of production) which can vary in
production. There are two types of inputs:
1. A fixed input is an input where the quantity does
not change according to output. E.g: Machinery,
land, buildings, tools, equipment, etc.
2. A variable input is an input where the quantity
changes according to output, e.g: raw materials,
electricity, fuel, transportation, communication, etc.

• The short run time frame has at least one input
which is fixed, but other inputs vary. The output
can be varied by changing the quantities of one
or a few inputs.
e.g: capital (buildings, equipment, tools, etc) is a
fixed resource. Output can be increased by
varying labour.
• The long run time frame, on the other hand, has
inputs which are all variable. In the long run,
firms can alter the inputs to increase the output.

Short-Run Production Function- One
fixed input and one variable
Suppose that only two inputs are used in
production: Capital and labour
Q= f (L,K) where K Quantity of capital is
fixed.
Law of Diminishing Marginal Returns:
States that as more of a variable input is used,
with other technology and input remaining
fixed, the marginal product of the variable input
will eventually decline.

• Total Product (TP): The amount of output
produced when a given amount of input is used.
• Average Product (AP): Obtained by dividing the
TP by the amount of input used.
• Marginal Product (MP): The change in the TP of
input, corresponding to an additional unit
change in its labour. Marginal product is the
additional to total product When one more unit
of labour is employed.

ISO Quant Analysis & ISO Quant Curves
• The term ‘ISO Quant’ is derived from ‘Iso’
(equal) and ‘Quant’ (quantity).
• An Isoquant or isoproduct represents all the
possible combinations of variable input
that are used to generate the same level of
output (Total Product)

ISOQUANT MAP
• An isoquant map is a number of isoquants that
are combined in a single graph.

Long-Run Production Function –All
Inputs are variables
• In the long run, all inputs are variables. A firm
can expand its scale of production by increasing
all inputs, such as more labour, equipment,
buildings, plants, machinery, etc.
• The law of returns to scale applies in the long
run. This law refers to the effects of changes in
the quantities of all inputs is called returns to
scale.

• Increasing Returns to Scale: Output
increased by greater proportion than input.
Fig:

• Constant Returns to Scale: Output increased
by same proportion with input.

• Decreasing Returns to Scale: Output
increased by lesser proportion than input.

Economies of Scale
• Economies of scale are benefits or advantages
a firm enjoys as it grows larger, whereas
diseconomies of scale are the problems or
disadvantages faced by the firm as it grows
larger.

Internal Economies of Scale:
1. Labour economies
2. Managerial economies
3. Marketing economies
4. Technical economies
5. Financial economies
6. Risk-bearing economies
7. Transport and storage economies

External economies of scale:
1. Economies of Govt., Action
2. Economies of Concentration
3. Economies of Information
4. Economies of Marketing

Internal & External Diseconomies
• Labour diseconomies
• Management problems
• Technical difficulties
• Scarcity of raw materials
• Wage Differentials
• Concentration problemsi

Cost Analysis
Implicit and Explicit costs:
Implicit cost is the value of input services that are
used in production which are not purchased in the
market.
Explicit cost is the value of resources purchased
for production( it includes both economic and
accounting costs)
Opportunity Cost of a particular product is the
value of the forgone alternative product.
Social cost is the total cost of production of a
product, and includes direct and indirect costs
incurred by society.
E.g: Contamination of rivers by industrial wastage

Sunk Cost refers to the cost that a firm cannot
recover from the expenditure it has made. Sunk
costs are only counted in accounting cost, not
economic cost.
E.g: A firm has purchased a specialized machine
for the purpose of production. The machine
purchased is designed only for specific work, with
no alternative use. The purchase of such
machinery is thus a sunk cost for the firm.

Cost curves in the Short Run
Short-run costs:
Total Fixed Cost (TFC) refers to the input that
are independent of output. TFC has no relationship
with output. Its remains constant throughout the
production period.
Total Variable Cost (TVC) refers to the cost of
input that changes with the output. TVC is incurred
on the purchase of variable inputs.
Total Cost (TC) is the sum of cost (all inputs)-
fixed and variable inputs used to produce goods
and services.

• Average Fixed Cost (AFC) is the fixed cost
per unit of out. It declines continuously as output
increases, due to the spreading of fixed costs.
• Average Variable Cost (AVC) is the variable
cost per unit of output. The average variable cost
is obtained when the total variable cost is divided
by the total output.
• Average Total Cost (ATC) is the total cost per
unit of output. The average total cost is also
obtained by adding the average fixed cost and
average variable cost

Marginal cost
• Marginal Cost (MC) refers to the change in
total cost (or total variable cost) that results
from producing another unit of output.
• In other words, the marginal cost is defined as
the additional cost incurred in producing an
additional unit.

Iso cost line
• The isocost is similar to the budget line in the
indifference curve analysis.
• An isocost line shows various combinations of
two inputs. i.e. Capital and labour, which can be
purchased with a given amount of money for a
given total cost.

Long-run Average cost Curve
• The long run is a period which involves only
variable factors and not fixed cost.
• In the long run the firm cannot adjust its fixed
cost, since there is no fixed cost.
• In the long run, only the average total cost is
important and considered by a firm during its
decision making process.
• The long run is the period where firms decide
and plan how to minimize the average total cost.

• A long-run average cost (LRAC) curve is a curve
that shows the minimum cost of producing any
given output, when all the inputs are variable.
• LRAC curve is derived from a series of short-run
average cost (SAC) curves.
• Tangential points of these SAC curves are joined
to form the LRAC curve.
• When the firm has a plant relating to SAC1, total
output is Q1, suppose the demand increases and
the firm wants to increase its output from Q1 to
Q2, the firm can still operate on the same plant
(SAC1) to produce Q2, but the average total cost
will increase from point A to point B

• However, by expanding the output as in SAC2,
the output of Q2 can be produced at a lower
average cost, at point C. SAC3 refer to plants of a
higher capacity.
• If the firm wants to produce an output of Q3, it
will face two possible options, either to use plant
SAC2 or plant SAC3.
• Plant SAC3 will be the better choice as the firm
will incur lower costs) In the long run, the firm
will select the plants which gives the lowest
average cost at a given output level.
• The LRAC curve is also U-shaped due to the law
of returns to scale.

• Price is the value that is put to a product or
service and is the result of a complex set of
calculations, research and understanding and
risk taking ability. A pricing strategy takes into
account segments, ability to pay, market
conditions, competitor actions, trade margins
and input costs, amongst others
• Economic pricing is a pricing strategy that
gives products that have low production
costs a lower price.

• Price Skimming
• Price skimming occurs when a company sets an artificially high
price for a product or service, but knows that competitors will soon
enter the product or service arena.
• Penetration Pricing
• Penetration pricing sees products or services priced much lower
than their actual value in order to make an entrance into the market
• Premium Pricing
• Premium pricing is used for products or services that are clearly of a
higher luxury value than anything else on the market.

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