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Thinking Like an Economist

Thinking Like an EconomistEvery field of study has its own terminologyMathematicsintegrals axioms vector spacesPsychologyego id cognitive dissonanceLawpromissory estoppel torts venuesEconomicssupply opportunity cost elasticity consumer surplus demand comparative advantage deadweight lossThinking Like an EconomistEconomics trains you to. . . . Think in terms of alternatives.Evaluate the cost of individual and social choices.Examine and understand how certain events and issues are related.32THE ECONOMIST AS A SCIENTISTThe economic way of thinking . . .Involves thinking analytically and objectively.Makes use of the scientific method.43The Scientific Method: Observation, Theory, and More ObservationUses abstract models to help explain how a complex, real world operates.

Develops theories, collects, and analyzes data to evaluate the theories.54The Role of Assumptions Economists make assumptions in order to make the world easier to understand. The art in scientific thinking is deciding which assumptions to make. Economists use different assumptions to answer different questions.Economic Models Economists use models to simplify reality in order to improve our understanding of the world Two of the most basic economic models include:The Circular Flow DiagramThe Production Possibilities Frontier

ProductionTo match the limited resources with the unlimited want every society must make choices about the economy inputs and outputsInputs: There are the commodities/services that are used to produce goods and services.Outputs: These are the various useful goods or services that results from the production process and are either consumed or employed in further production.Inputs can further be understood in terms of factors of production. These can further be classified into three broad categories:

Opportunity CostDefinition the cost expressed in terms of the next best alternative sacrificedHelps us view the true cost of decision makingImplies valuing different choices

9This is a key concept and one that often causes problems and misunderstanding but is central to students thinking like an economist. The crucial thing to knock out of students is their thinking that everything costs money. Because we have to make choices there are issues surrounding value judgements about what is important and what is not it should not be difficult to stimulate discussion about what issues of government spending are important and what are not!What is opportunity cost?Andy had $65.00 to spend at the toy store. The basketball net cost $50.00, so he had to buy that instead of the skateboard, which cost $75.00. Sara had enough money for either the rabbit or the bike. She decided to buy the bike because then she could ride bikes with her friends after school. Opportunity cost is the process of choosing one good or service over another. The item that you dont pick is the opportunity cost. The rabbit is Saras opportunity cost and the skateboard is Andys opportunity cost.

Opportunity Costs

Purchases

Our Second Model: The Production Possibilities FrontierThe production possibilities frontier is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology.8. Production Possibility Curve1214Production Possibility FrontierThis explains the number of possibilities for production keep certain factors as unchanged.

Assumptions:Scarce input and technologyConsidering an economy which produces only two economic goodsEconomy is having full employment

The production possibility frontier shows the maximum amounts of production that can be obtained by an economy, given its technological knowledge and quantity of inputs available. The PPF represents the menu of goods and services available to society.

Units of clothing (millions)Units of food (millions)Units of food Units of clothing (millions) (millions)

8m 0.0 7m 2.2m 6m 4.0m 5m 5.0m 4m 5.6m 3m 6.0m 2m 6.4m 1m 6.7m 0 7.0mA production possibility curve14

Units of clothing (millions)Units of food (millions)Units of food Units of clothing (millions) (millions)

a 8m 0.0 7m 2.2m 6m 4.0m 5m 5.0m 4m 5.6m 3m 6.0m 2m 6.4m 1m 6.7m 0 7.0maA production possibility curve15

Units of clothing (millions)Units of food (millions)Units of food Units of clothing (millions) (millions)

8m 0.0b 7m 2.2m 6m 4.0m 5m 5.0m 4m 5.6m 3m 6.0m 2m 6.4m 1m 6.7m 0 7.0mbA production possibility curve16

Units of clothing (millions)Units of food (millions)Units of food Units of clothing (millions) (millions)

8m 0.0 7m 2.2mc 6m 4.0m 5m 5.0m 4m 5.6m 3m 6.0m 2m 6.4m 1m 6.7m 0 7.0mcA production possibility curve17

Units of clothing (millions)Units of food (millions)Units of food Units of clothing (millions) (millions)

8m 0.0 7m 2.2m 6m 4.0m 5m 5.0m 4m 5.6m 3m 6.0m 2m 6.4m 1m 6.7m 0 7.0mA production possibility curve18

Units of clothing (millions)Units of food (millions)A production possibility curve19

Units of clothing (millions)Units of food (millions)xA production possibility curvew20The Economic ProblemThe production possibility curvewhat the curve showsmicroeconomics and the p.p. curve:214The Economic ProblemThe production possibility curvewhat the curve showsmicroeconomics and the p.p. curve:choices and opportunity cost224The Economic ProblemThe production possibility curvewhat the curve showsmicroeconomics and the p.p. curve:choices and opportunity costincreasing opportunity cost234Units of clothing (millions)Units of food (millions)Increasing opportunity costsxy

11z1224The Economic ProblemThe production possibility curvewhat the curve showsmicroeconomics and the p.p. curve:choices and opportunity costincreasing opportunity costmacroeconomics and the p.p. curve:254The Economic ProblemThe production possibility curvewhat the curve showsmicroeconomics and the p.p. curve:choices and opportunity costincreasing opportunity costmacroeconomics and the p.p. curve:production within the curve264vxyOMaking a fuller use of resourcesFoodClothingProduction insidethe productionpossibility curve27The Economic ProblemThe production possibility curvewhat the curve showsmicroeconomics and the p.p. curve:choices and opportunity costincreasing opportunity costmacroeconomics and the p.p. curve:production within the curveshifts in the curve284OGrowth in potential outputFoodClothingNow29OFoodClothingNowGrowth in potential output5 years time30OFoodClothingGrowth in potential and actual output31OFoodClothingGrowth in potential and actual outputxy32The Economic ProblemThe circular flow of incomefirms and householdsThe circular flow of goods and incomes

34The Economic ProblemThe circular flow of incomefirms and householdsgoods marketsreal flows: goods and servicesThe circular flow of goods and incomes

36The circular flow of goods and incomesGoods and services

37The Economic ProblemThe circular flow of incomefirms and householdsgoods marketsreal flows: goods and servicesmoney flows: consumer expenditureThe circular flow of goods and incomesGoods and services

39Goods and services

ConsumerexpenditureThe circular flow of goods and incomes40The Economic ProblemThe circular flow of incomefirms and householdsgoods marketsreal flows: goods and servicesmoney flows: consumer expenditurefactor marketsThe Economic ProblemThe circular flow of incomefirms and householdsgoods marketsreal flows: goods and servicesmoney flows: consumer expenditurefactor marketsreal flows: services of labour and other factorsGoods and services

ConsumerexpenditureThe circular flow of goods and incomes43Goods and services

ConsumerexpenditureServices of factors of production (labour, etc)The circular flow of goods and incomes44The Economic ProblemThe circular flow of incomefirms and householdsgoods marketsreal flows: goods and servicesmoney flows: consumer expenditurefactor marketsreal flows: services of labour and other factorsmoney flows: wages and other incomesGoods and services

ConsumerexpenditureServices of factors of production (labour, etc)The circular flow of goods and incomes46Goods and services

ConsumerexpenditureWages, rentdividends, etc.Services of factors of production (labour, etc)The circular flow of goods and incomes47The Economic ProblemThe circular flow of income (cont.)macroeconomic issuesthe size of total flowsmicroeconomic issuesindividual marketschoices within goods and factor markets49Circular Flow Between Firms and Households(real resources)Goods and servicesFactor InputHouseholdsFirmsHousehold includes workers, managers, entrepreneurs etc4950Circular Flow Between Firms and Households(corresponding flow of payments)Spending ongoods and servicesFactor incomesHouseholdsFirms5051Circular Flow Between Firms and HouseholdsSpending ongoods and servicesGoods and servicesServices of productive factorsFactor incomesHouseholdsFirms5152Circular Flow Between Firms and HouseholdsSpending ongoods and servicesGoods and servicesServices of productive factorsFactor incomesHouseholdsFirmsExpenditureOutputIncome3 different way of measuring the economic activity in the economy5253Three measures of national outputExpenditurethe sum of expenditures in the economyIncomethe sum of incomes all factor incomesOutputthe sum of output (value added) produced in the economy

All three approaches are should give you the same final figure for national output

5354Leakages from the Circular Flow Leakages (in terms of flow of payment)money paid to the households but not returned to firmOr flow of payments that started from firms but did not return back to firmse.g. household savings, net taxes and imports5455Circular Flow Between Firms and Households(corresponding flow of payments)Spending ongoods and servicesFactor incomesHouseholdsFirmsLeakages5556Injections into the Circular Flow Injections (in terms of flow of payment)are revenue for firms not from sales to household

e.g. investment by firms, government purchases and exports5657Circular Flow Between Firms and Households(corresponding flow of payments)Spending ongoods and servicesFactor incomesHouseholdsFirmsInjections57

Figure 2-2 Introduction of Saving and Investment to the Circular Flow DiagramFactorpaymentsConsumption ofdomesticallyproduced goodsand services (Cd)The circular flow of incomeFactorpaymentsConsumption ofdomesticallyproduced goodsand services (Cd)BANKS, etcNetsaving (S)The circular flow of incomeFactorpaymentsConsumption ofdomesticallyproduced goodsand services (Cd)BANKS, etcInvestment (I)Netsaving (S)The circular flow of incomeFactorpaymentsConsumption ofdomesticallyproduced goodsand services (Cd)BANKS, etcGOV.Investment (I)Netsaving (S)Nettaxes (T)The circular flow of incomeFactorpaymentsConsumption ofdomesticallyproduced goodsand services (Cd)BANKS, etcGOV.Investment (I)Governmentexpenditure (G)Netsaving (S)Nettaxes (T)The circular flow of incomeFactorpaymentsConsumption ofdomesticallyproduced goodsand services (Cd)BANKS, etcGOV.ABROAD Investment (I)Governmentexpenditure (G)Netsaving (S)Nettaxes (T)Importexpenditure (M)The circular flow of incomeFactorpaymentsConsumption ofdomesticallyproduced goodsand services (Cd)BANKS, etcGOV.ABROAD Investment (I)Governmentexpenditure (G)Exportexpenditure (X)Netsaving (S)Nettaxes (T)Importexpenditure (M)The circular flow of incomeFactorpaymentsConsumption ofdomesticallyproduced goodsand services (Cd)BANKS, etcGOV.ABROAD Investment (I)Governmentexpenditure (G)Exportexpenditure (X)Netsaving (S)Nettaxes (T)Importexpenditure (M)WITHDRAWALSThe circular flow of incomeFactorpaymentsConsumption ofdomesticallyproduced goodsand services (Cd)BANKS, etcGOV.ABROAD Investment (I)Governmentexpenditure (G)Exportexpenditure (X)Netsaving (S)Nettaxes (T)Importexpenditure (M)The circular flow of incomeWITHDRAWALSINJECTIONSFactorpaymentsRegional Purchases ofregionally produced goodsand services OUTSIDE OF REGION Exportexpenditure (X)Importexpenditure (M)Economic Base Model Collapses All Spending into Regional and Non-Regional WITHDRAWALINJECTIONTransactions with foreign sectorIncludes sales of goods and services, assets, and transfersExports - sales of domestically produced goods to other countries Imports - goods bought from other countries69Demand in economics means effective demand, that is one which meets with all its three crucial characteristics; desire to have a good, willingness to pay for that good & ability to pay for that good.

In absence of any of these three characteristics, there is no demand.WHAT IS DEMAND?70Demand forecasting means estimation of the demand for the good in the forecast period.

It is a process of estimating a future event by casting forward past data.

The past data are systematically combined in a predetermined way to obtain the estimate of future demand.DEMAND FORECASTING71Why demand forecasting?Planning and scheduling productionAcquiring inputsMaking provision for financesFormulating pricing strategyPlanning advertisement

Criteria for selecting a good forecasting method

Accuracy: Different methods of forecasting yield accurate results under different circumstances. An appropriate choice of method will ensure more accurate results.

2. Reliability: A time tested method increases the reliability of that method. If a particular method was used to give reliable result in the past then the same method can be reused for forecasting future.

3. Economical: Although complete enumeration method of forecasting demand would perhaps yield more accurate result yet it would be a very expensive method. The team conducting forecast cannot afford to discuss the economic aspect of forecasting and therefore should select the least expensive of the methods which would give some reliable forecasts.

4. Data availability: Forecasting is made on the basis of the availability of primary or secondary data and therefore the required data should be easily available preferably in the required form.

5. Flexibility: As the managerial economist is faced with a number of uncontrollable variables, flexibility in using would be a necessary condition for a good forecast.

6. Durability: The forecast that are made should be valid in the long run because there is a certain time lag in conducting the forecasts and the period when the product is likely to enter the market.

7. Simplicity: Depending upon the objective the researcher should apply a simple and straightforward method of forecasting

Criteria for selecting a good forecasting method

Steps Specifying the objective:Determinants of Demand1. Non-durable consumer goods:Purchasing power disposable personal income (personal income direct taxes and other deductions). Published by C.S.O. Price.Demography:

2. Durable consumer goods:Choice between using the goods longer by repairing it, or disposing it off and replacing it with a new one. Require special facilities for their use, eg., roads for automobiles. Household demand vis--vis individual demand. Family characteristics. Total demand consists of a. New-owner demand and, b. Replacement demand. Price and credit conditions.

Determinants of Demand3. Capital goods: used for further production. Demand will depend upon the specific markets they serve and the end uses for which they are bought.Data required for estimating the demand for capital goods:The growth prospects of the user industries.The norm of consumption of capital goods per unit of installed capacity.The velocity of their use.Other objectivesThe overall demand for product or firms own product.The whole or only segment.Firms market share.

Determining the time perspective

Short Term forecast (2 to 3 years) Scheduling of production to avoid problems of over production and under- production.Proper management of inventoriesEvolving suitable price strategy to maintain consistent salesFormulating a suitable sales strategy in accordance with the changing pattern of demand and extent of competition among the firms.Forecasting financial requirements for the short period.

Long Term ForecastPlanning for a new project, expansion and modernization of an existing unit, diversification and technological up gradation.Assessing long term financial needs. It takes time to raise financial resources.Arranging suitable manpower. It can help a firm to arrange for specialized labour force and personnel.Evolving a suitable strategy for changing pattern of consumption.

More StepsMaking choice of methodCollection of dataEstimation and interpretation of results

Consumer Surveys: It involves gathering of information about consumer behavior from a sample of consumers which is analyzed and then further projected onto the population. Surveys are conducted to assess consumers perception of various aspects, such as new variations in products, variations in prices of the product and related products, new variations in services provided etc. The drawback of this method is that the consumer has to respond to hypothetical situations.

Complete Enumeration MethodComplete Enumeration Survey covers all the consumers. It resembles the Census Data Collection which considers the entire population. In this case all the consumers are covered and information is obtained from all regarding the prospective demand for the product under consideration.In this method the consumer is asked about the future plan of purchasing product in question.For Example if majority of households in a city report the quantity (q) and they are willing to purchase a commodity then the total probable demand (DP) may be calculated as

AdvantagesQuite accurate as it surveys all the consumers of a productIt is simple to useIt is not affected by personal biasIt is based on collected data DisadvantagesIt is costlyIt is time consumingIt is difficult and practically impossible to survey all the consumersUseful only for products with limited consumersSample Survey:In case of the sample survey method, few consumers are selected to represent the entire population of the consumers of the commodity consumed. The total demand for the product in the market is then projected on the basis of the opinion collected from the sample. The most important advantage of this method is that it is less expensive and less tedious compared to the method of complete enumeration.On the basis of information collected the probable demand is estimated through the following formula

D = Probable demand ForecastH = census number of households from the relevant market = number of household reporting demand for the product = number of household surveyed.

= Average expected consumption by the reporting household ( = total qty reported to be consumed by the reporting household / no. of households)

Sample Survey Method

Instead of surveying all the consumers of a commodity, only a few consumers are selected and their views on the probable demand are collected

PopulationSampleAdvantagesIt is simple and does not cost muchSince only a few consumers are to be approached, the methods works quicklyThe risk of handling a large number of data is reducedIt gives excellent results, if used carefully DisadvantagesThe conclusions are based on the view of only a few consumers and not all of themThe sample may not be a true representation of the entire populationEnd Use Method A given product may have different end uses. For example: milk may have different end uses such as milk powder, chocolates, sweet -meats like barfi etc. Therefore the end users of milk are identified. A survey is planned of the end users and the estimated demands from all segments of end users are added. This method of demand forecasting is easy to manage if the number of end-users is limited. In this method the investigator expects the end- users to provide correct information well in advance of their respective production schedules.Advantages:The method yields accurate predictionsIt provides sector wise demand forecast for different industriesDisadvantages:It requires complex and diverse calculationIt is costlier as compared to other survey methods and is more time consumingIndustry data may not be readily availableOpinion Poll MethodIt aims at collecting opinions of those who are supposed to possess knowledge of the market, e.g sales representative, sales executives, professional marketing experts and consultants,The opinion poll methods include:Expert opinion methodDelphi methodMarket studies and experimentsExpert OpinionThe expert opinion method, also known as EXPERT CONSENSUS METHOD, is being widely used for demand forecasting.

This method utilizes the findings of market research and the opinions of management executives, consultants, and trade association officials, trade journal editors and sector analysts. When done by

An expert, qualitative techniques provide reasonably good forecasts for a short term because of the experts familiarity with the issues and the problems involved.

Expert OpinionSalesmen are required to estimate expected sales in their territories. Salesmen being the closest to the customers, have most intimate feel of the market. The estimates of individual salesmen are consolidated to find out the total estimated sales. These estimates are reviewed to eliminate the bias of optimism or pessimism. Thereafter they are further revised in the light of factors proposed change in prices, product design, advertising budget, expected change in competition, changes in purchasing power, income distribution, employment, population etc.The final forecast will emerge after all these factors are taken into account. The method is known as collective opinion as it takes advantage of the collective wisdom of salesmen, departmental heads like production manager, sales manager, marketing manager, managerial economist and top executives, as well as dealers and distributors.Advantages: The method is simple and does not involve the use of statistical techniques.The forecasts are based on first-hand knowledge of salesmenand others directly connected with sales.3.The method is useful in predicting sales of new products.Here, salesmen will have to depend more on their judgementthan in the case of existing products.

Disadvantages:It is subjective. Salesmen may underestimate the forecast if itis to be used to decide their quotas.2. This method can only be used for short-term forecasting.Focus of salesmen is centered round the present trend, and they dont think about the future. They may even lack the breadth of vision for looking into the future. Delphi MethodThis is a variant of the opinion poll or survey method. In Delphi Method, an attempt is made to arrive at a consensus of opinion. The participants are supplied with responses to previous questions from others in the group by a leader. The leader provides each expert with opportunity to react to the information given by others, including reasons advanced, without disclosing the source.The Delphi method is primarily used to forecast the demand for NEW PRODUCTS.Advantages & Disadvantages of Delphi Method:Delphi method has some exclusive advantages: It facilitates anonymity of the respondents identity. This enables respondents to be frank and forthright in giving their views. It facilitates posing the problem to the experts at one time and have their response nearly as good as pooling the panelists together. In one case 620 experts from different background such as policy-makers, technologists, scientists, economists, administrators and advisers were consulted.

However, Delphi method presumes these two conditions: 1) panelists must be rich in their expertise, having wide knowledge of the subject and are sincere and earnest in their disposition towards the participants.

2) The conductors are objective in their job, possess skill to conceptualize the problems for discussion to generate considerable thinking, stimulate dialogue among panelists and make inferential analysis of the numerous views of the participants.

Customer Surveys are sometimes conducted over the telephone or on street corners, at shopping malls, and so forth. The new product is displayed or described, and potential customers are asked whether they would be interested in purchasing the item. While this approach can help to isolate attractive or unattractive product features, experience has shown that "intent to purchase" as measured in this way is difficult to translate into a meaningful demand forecast. This falls short of being a true demand experiment.

Experimental Approaches 103Consumer Panels are also used in the early phases of product development. Here a small group of potential customers are brought together in a room where they can use the product and discuss it among themselves. Panel members are often paid a nominal amount for their participation. Like surveys, these procedures are more useful for analyzing product attributes than for estimating demand, and they do not constitute true demand experiments because no purchases take placeConsumer Panels 104Market Experiment Market Experiment can help to overcome the survey problems as they generate data before introducing a product or implementing a policy.

Market Experiments are two types:-1) Test marketing:-2) Controlled experiments:-

Test marketing In this case, a test area is selected, which should be a representative of the whole market in which the new product is to be launched.

A test area may include several cities and towns, or a particular region of a country or even a sample of consumers.

More than one test area can be selected if the firm wants to assess the effects on demand due to various alternative marketing mix.

Advertising or packaging can be done in various market areas. Then the demand for the product can be compared at different levels of price and advertising expenditure.

In this way, consumers response to change in price or advertising can be judged.Test Marketing is often employed after new product development but prior to a full-scale national launch of a new brand or product.

The idea is to choose a relatively small, reasonably isolated, yet somehow demographically "typical" market area.

The total marketing plan for the item, including advertising, promotions, and distribution tactics, is "rolled out" and implemented in the test market, and measurements of product awareness, market penetration, and market share are made.Test Marketing107DRAWBACKS OF THE MARKET EXPERIMENTThe test experiments are that they are very costly and much time consuming.If in a test market prices are raised, consumer may switch to the competitors products. It may be difficult to regain lost customers even if the price is reduced to the previous level. Moreover, it is often difficult to select an area, which accurately represents the potential market.Controlled experimentsControlled experiments are conducted to the test demand for a new product launched or to test the demands for various brands of a product.They are selected consumers.DRAWBACKS OF THE CONTROLLED EXPERIMENTS1) The consumers may be biased in the process of selection of a sample of consumers on which experiments is to be performed.

2)The selected consumers may not respond accurately If they come to know that they are a part of an experiment being conducted and their behavior is being recorded.Statistical MethodStatistical method is used for long run forecasting.Statistical & mathematical techniques are used to forecast demand.Statistical methods has been used to explain time-series & cross-section data for estimating long-term demand.Statistical methods are considered to be superior techniques of demand estimation.The important statistical methods are Trend Projection method/time seriesBarometric methodsEconometric method1. Trend project methodTrend project method are also called as time series method therefore, it is also known as time series analysis.The data relating to sales over a period of time is known as time series data (10 20 yrs).On the basis of the past trend in demand, forecasting the future demand trend is possible.Trend project method classified into 3 types Graphical methodFitting trend equation/least square method &Box Jenkins method1. Graphical MethodAnnual data on sales are plotted on a graph paper & a line is drawn through the plotted points.This method is very simple & less expensive.2. Fitting Trend EquationA trend line (curve) is fitting to the time-series sales data with the aid of statistical techniques.3. Box Jenkins MethodThis method of forecasting is used only for short-term predictions.This method is suitable for forecasting demand with only stationary time series sales data.Stationary time-series is one which does not reveal a log term trend.

Graphical method: The past data will be plotted on a graph

The identified trend will be extended further in the same pattern to ascertain the demand in the forecast period

In the figure trend 1 is linear, trend 2 is non-linear

DemandTrend 22. Barometric MethodBarometric method is an improvement over trend projection method.Under barometric method, present events are used to predict the directions of change in future.This method done with the help of economic & statistical indicators.This method is also known as Economic Indicators Methods. Under barometric method, present events are used to predict the directions of change in future. Barometric Technique

The Bhuj earthquake in January 2001, lead to a massive destruction of property & buildings in Gujrat.This necessitated construction of buildings to rehabilitate the people of affected areas.The construction was followed by a spurt in the demand for cement, fans, tube lights, etc.Thus, construction of buildings leads to the demand for cement.Here, construction of buildings is the leading indicator or the barometer TREND PROJECTION METHODBased on analysis of past sales patternsShows effective demand for the product for a specified time periodThe trend can be estimated by using the Least Square MethodA producer of soaps decides to forecast the next years sales of his product.The data for the last five years is as follows:YEARSSALES IN Rs.LAKHS199645199752199848199955200060The data is plotted on a graph:

The equation for the straight line trend is Y = a + bxa-interceptb-shows impact of independent variableThe Y intercept and the slope of the line are found by making substitutions in the following normal equations:Y = na + b xXY = a x + b x2Substituting the above values in the normal equations:260=5a +15b (Eq.3)813=15a + 55b (Eq.4)solving the two equations, a = 42.1 , b = 3.3YEARSSALES Rs. LAKHS (Y)XX2XY19964511451997522410419984839144199955416220200060525300N=5Y=260X=15X2=55XY=813Therefore, the equation for the straight line trend is Y=42.1 + 3.3XUsing this equation we can find the trend values for the previous years and estimate the sales for the year 2001 as follows:

Thus, the forecast sales for year 2001 is Rs.61.9 lakhs.Y 1996 =42.1+3.3(1) = 45.4Y 1997 =42.1+3.3(2) =48.7 Y 1998 =42.1+3.3(3) =52.0Y 1999 =42.1+3.3(4) =55.3Y 2000 =42.1+3.3(5) =58.6Y 2001 =42.1+3.3(6) =61.9Estimation of Trend by the Method of Least SquaresQ. The annual sales of a company are as follows:Year19911992199319941995Sales 000 45 56 58 46 75Using the method of least squares, fit a st. line trend and estimate the annual sales of 1997.

YearSales

y1990 = 0Time-Deviationxx2xyEstimated Trend000Y=45 + 5x199145114550199256241125519937839234601994464161846519957552537570 n = 5 y = 300 x = 15 x2 = 55 xy = 950 n = 5 y = 300 x = 15 x2 = 55 xy = 950

y = n.a. + b x 1xy = a x + b x2 . 2

Substituting the computed valueswe have,300 = 5a + 15b .3 (x 3)950 = 15a + 55b . 4Multiplying (3) by 3 we have900 = 15a + 45b950 = 15a + 55b Therefore, 10b = 50, b = 5Substituting b = 5 in (3)300 = 5a + 15(5)300 = 5a + 755a = 225 a = 45

St. line equation is Y = a + bxSubstituting the values of a and b,Y = 45 + 5xTherefore,Y1991 (x=1) = 45 + 5(1) = 50Y1992 (x=2) = 45 + 5(2) = 55Y1993 (x=3) = 45 + 5(3) = 60Y1994 (x=4) = 45 + 5(4) = 65Y1995 (x=5) = 45 + 5(5) = 70Y1996 (x=6) = 45 + 5(6) = 75Forecast for the year 1997Y1997 (x=7) = 45 + 5(7) = 80i.e. Rs.80,000/-Use of Economic IndicatorsThe use of this approach bases demand forecasting on certain economic indicators following these steps:See whether a relationship exists between demand for the product and the economic indicator.Establish the relationship through the method of least squares and derive the regression equation. Assuming the relationship to be linear, the equation will be Y = a + bxOnce the regression equation is derived, the value of Y i.e. demand can be estimated for any given value of x.Draw back: Finding an appropriate economic indicator may be difficult. For new products it is inappropriate as no past data exists.Illustration: Suppose a company manufacturing tractors finds that a relationship exists between sale of tractors and Farm Income Index published by CSO. Table below shows the number of tractors sold and the corresponding farm income index 1988 through 1992. Regression equation is calculated as follows:YearFarm IncomeIndex (x)Sales ofTractors(y)X1 = x/10Y1 = y/10x1y1x121988100110101111010019891101301113143121199014015014152101961991150160151624022519922001802018360400n = 5X1=70 Y1 =73X1y1=1063X12=1042The equations to be solved simultaneously are: y1 = n.a. + b x1 .(1) x1y1 = a x1 + b x12(2)Substituting the various values, we get,

73 = 5a + 70b (x14)(3)1063 =70a + 1042b1022 =70a + 980b 62b = 41 b = 41/62 = 0.66

Substituting the value of b in (3) 73 = 5a + 70 (0.66) = 5a + 46.2 5a = 73 46.2 = 26.8 a = 26.8/5 = 5.36 a = 5.36 b = 0.66y1 = 5.36 + 0.66x1 Y/10 = 5.36 + 0.66 (X/10) Y = 10(5.36) + 0.66(x/10)10 = 53.6 + 0.66xIf the index of farm income becomes 210, sale of tractors will beY = 53.6 + 0.66(210) = 53.6 + 138.6 = 192 tractors.MOVING AVERAGES METHODMoving averages method can be used when the forecast period is either odd or even.

These are the annual sales of goods during the period of 1993-2003. We have to find out the trend of the sales using (1) 3 yearly moving averages and (2) 4 yearly moving averages and forecast the value for 2005.YEARSALES IN Rs.LAKHS1993121994151995141996161997181998171999192000202001222002252003243 yearly period:The value of 1993 + 1994 +199512 +15+14 = 41 written at the capital period 1994 of the years 1993, 1994 and 1995YEARSALES (Rs. LAKHS)3 YEARLY MOVING TOTAL3 YEARLY MOVING AVG. TREND VALUES199312--94154141/3= 13.795144545/3= 1596164848/3 =1697185151/3 =1798175454/3 = 1899195656/3 = 18.72000206161/3 = 20.201226767/3 = 22.302257171/3 = 23.70324--4 YEARLY MOVING AVERAGESYEAR. SALES (Rs. LAKHS)4 YEARLY MOVING TOTALMOVING TOTAL OF PAIRS OF YEARLY TOTAL4 YEARLY MOVING AVG. TREND VALUES9312---9415---9514120120/8 = 159616128128/8 = 169718135135/8 = 16.99817144144/8 = 189919152152/8 = 190020164164/8 = 20.50122177177/8 = 22.10225--0324---57 = 93 + 94 +95 + 96 = 12 + 15 + 14 + 16 120= 57 +63, 128 = 63 +65 and so on.120 is total of 8 years and so the avg. is calculated by dividing 120 by 85763657074788691The trend values from the previous tables can be plotted on a graph as follows:

Time Series AnalysisThe time series analysis is one of the most common quantitative method used to predict the future demand for a product. Here the past sales and demand are taken into considerations.

TIME SERIES ANALYSIS IS DIVIDED INTO FOUR CATEGORIES:1)TREND2)SEASONAL VARIATIONS.3)CYCLICAL VARIATIONS.4)RANDOM FLUCTUATIONS.METHODS OF TIME SERIES ANALYSIS 1)TREND:- Past data is used to predict the future sales of firm trend is a long term increase or decrease in the variable.2)SEASONAL VARIATIONS:- It is taken into account the Variations in demand during different seasons.Eg:- The sale of cotton dresses increases in summer. The sale of Woolen clothes increases in winter.3)CYCLICAL VARIATIONS:- This variations in demand due to the fluctuations in the business cycle Boom, recession and depression.4) RANDOM FLUCTUATIONS:- It may happen due to Natural calamities like flood, earthquake, etc. Which cannot be predicted accurately.

3. Econometric MethodsThe econometric methods combine statistical tools with economic theories to estimate economic variables & to forecast economic events.Demand forecasting made through econometric methods are much more reliable than those made through any other method.The econometric methods are of two types 1. Regression Method2. Simultaneous Equations MethodsRegression method Refers to those methods by which the relationship between quantity demanded & one or more independent variable (like income, price of commodity & advertisement cost) is estimated.It consists 2 methods 1. Simple Regression Analysis used when the quantity demanded is estimated as a function of a single independent variable such as price.2. Multiple Regression Analysis used to estimate demand as a function of two or more independent variables2. Simultaneous Equation MethodThis method is also known as the complete system approach.It involves simultaneous considerations of all variables.

THEORY OF PRODUCTION

The fundamental questions that managers are faced with areHow can production optimized or cost minimize?How does output respond to change in quantity of inputs?How does technology matter in reducing the cost of production?How can the least- cost combination of inputs be achieved?Given the technology, what happens to the rate of return when more plants are added to the firm?

Input and outputAn input is simply anything which the firm buys for in its production or other processes.Inputs are classified as 1) Fixed inputs: A fixed input is one whose supply is inelastic in the short-run. In technical sense, a fixed factor is one that remains fixed (or constant) for a certain level of output.

2) Variable inputs: A variable input is defined as one whose supply in the short-run is elastic, e.g., labour and raw material, etc. all the users of such factors can employ a larger quantity in the short-run as well as in the long-run.

Short-run and Long-run ProductionThe short-run refers to a period of time in which the supply of certain inputs (e.g. plant, building, machinery etc.) is fixed or inelastic. In the short-run therefore, production of a commodity can be increased by increasing the use of only variable inputs like labour and raw materials. Variable Input: labor force, Fixed Input: machinery, plant size, raw materials.

Long-run refers to a period of time in which the supply of all the inputs is elastic, but not enough to permit a change in technology. That is, in the long-run, all the inputs are variable. Corresponds to the planning stageProduction FunctionThe total amount of output produced by a firm is a function of the levels of input usage by the firmRelation Between Input and Output the maximum amount of output that can be obtained per period of time given the factor inputs is captured by the production functionDescribes purely Technological RelationshipFlow Concept

142Production Function

143Production FunctionInputsProcessOutputLandLabourCapitalProduct or service generated value added

144A real-life production function is generally very complex.Q = f(LB, L, K, M, T, t)where LB = land and building L= labour, K= capital, M= raw materials, T= technology and t= time.

The economists have however reduced the number of input variables used in a production function to only two, viz., capital(K) and labour(L), for the sake of convenience and simplicity in the analysis of input-output relations.

Production FunctionLand and building (LB), as inputs, are constant for the economy as a whole, and hence they do not enter into the aggregate production function.However, land and building are not a constant variable for an individual firm or industry. In the case of individual firms, land and building are lumped with capital.

In case of raw materials it has been observed that this input bears a constant relation to output at all levels of production.

For example, cloth bears a constant relation to the number of garments. Similarly, for a given size of a house, the quantity of bricks, cement steel etc. remains constant, irrespective of number of houses constructed. Production FunctionAlso, technology (T) of production remains constant over a period of time. That is why, in most production functions, only labour and capital are include As such, the general form of its production function for coal mining firm may be expressed as Qc = f (K, L) Where Qc = the quantity of coal produced per time unit,K = capital, and L = labour.

Production FunctionThe short-run production function or what may also be termed as single variable input production function, can be expressed as Q = f (K, L) where K is a constant (1a)For example, suppose a production function is expressed asQ = bLWhere b = gives constant returns to labour.

Production FunctionIn the long -term production function, both K and L are included and the function takes the following form.Q = f (K, L)(1b)Consider, for example, the Cobb-Douglas production function-the most famous and widely used production function given in the form of an equation as Q =(1.2)(where K= capital, L= Labour, and A , a and b, are perameters and b =1 a).

Production FunctionProduction function (1.2) gives the general form of Cobb-Douglas production function. The numerical values of parameters A, a and b, can be estimated by using actual factory data on production, capital and labour. Suppose numerical values of parameters are estimated as A=50, a=0.5 and b=0.5. Once numerical values are known, the Cobb-Douglas production function can be expressed in its specific form as follows.

Production FunctionThis production function can be used to obtain the maximum quantity (Q) that can be produced with different combinations of capital (K) and Labour (L). The maximum quantity of output that can be produced from different combinations of K and L can be worked out by using the following formula.

Production FunctionFor example, suppose K = 2 and L = 5. Then

And if K = 5 and L = 5, then

Similarly, by assigning different numerical values to K and L, the resulting output can be worked out for different combinations of K and L and a tabular form of production function can be prepared.

Production FunctionSimilarly, by assigning different numerical values to K and L, the resulting output can be worked out for different combinations of K and L and a tabular form of production function can be prepared.It is important to note that the four combinations of K and L 10K + 1L5K + 5L2K + 5L and1K + 10L produces the same output

Production with one variable inputThe law of diminishing returns states that when more and more units of a variable input are used with a given quantity of fixed inputs, the total output may initially increase or increasing rate, but it will eventually increase at increasing rate.

That is, marginal increase in total output decreases eventually when additional units of a variable factor are used, given quantity of fixed factors.

Assumptions:

The law of diminishing returns is based on the following assumptions:Labor is the only variable input, capital remaining constant;Labour is homogeneous;Input prices are given.

To illustrate the law of diminishing returns, let us assume that a firm (say, the coal mining firm in our earlier example) as a set of mining machinery as its capital (K) fixed in the short-run andii) It can employ only more mine workers to increase its coal production.Thus, the short run production function for the firm will take the following form.

Let us assume also that the labour output relationship in coal production is given by a hypothetical production function of the following form.

Given the production function, we may substitute different numerical values of L in the function and work out a series of Qc i.e. The quantity of coal that is produced with different number of workers. For example, if L = 5, then by substitution, we get Qc= -53 + 15 x 52 + 10 x 5 = -125 + 375 + 50 = 300

What we need now is to work out marginal productivity of labour (MPL) to find the trend in the contribution of the marginal labour and average productivity of labour (APL) to find the average contribution of labour.

Marginal Productivity of Labour (MPL) can be obtained by differentiating the production function. Thus, can be written as

Alternatively, where labour can be increased at least by one unit (MPL) can be obtained asMPL = TPL - TPL-1Average Productivity of Labour (APL) can be obtained by dividing the production function by L. Thus,

No of Workers (N)Total Product (TPL) (tones)Marginal Product* (MPL)Average product (APL)Stages of production(based on MPL)123451234562472138216300384244866788484243646546064IIncreasingreturns789104625285766007866482466666460IIDiminishingReturns1112594552-6-425446IIINegative returnsWheat production per year from a particular farm (tonnes)

163

Wheat production per year from a particular farmNumber of farm workersTonnes of wheat produced per yearNumber of workers 012345678 TPP 0 310243640424240164Wheat production per year from a particular farm

Number of farm workersTonnes of wheat produced per yearTPP165Wheat production per year from a particular farm

Number of farm workersTonnes of wheat produced per yearTPPabDiminishing returnsset in here166Wheat production per year from a particular farm

Number of farm workersTonnes of wheat produced per yearTPPabdMaximum output167

Wheat production per year from a particular farmNumber offarm workers (L)Tonnes of wheat per yearTPP

Tonnes of wheat per yearNumber offarm workers (L)DTPP = 7DL = 1MPP = DTPP / DL = 7168

Wheat production per year from a particular farmTonnes of wheat per yearTPP

Tonnes of wheat per yearMPPNumber offarm workers (L)Number offarm workers (L)169

Wheat production per year from a particular farmTonnes of wheat per yearTPP

Tonnes of wheat per yearAPPMPPAPP = TPP / LNumber offarm workers (L)Number offarm workers (L)170

Wheat production per year from a particular farmTonnes of wheat per yearTPP

Tonnes of wheat per yearAPPMPPbDiminishing returnsset in hereNumber offarm workers (L)Number offarm workers (L)b171

Wheat production per year from a particular farmTonnes of wheat per yearTPP

Tonnes of wheat per yearAPPMPPbddNumber offarm workers (L)Number offarm workers (L)Maximumoutputb172

Wheat production per year from a particular farmTonnes of wheat per yearTPP

Tonnes of wheat per yearAPPMPPbbddNumber offarm workers (L)Number offarm workers (L)Slope = TPP / L= APPcc173IsoquantsAn isoquant is a curve or line that has various combinations of inputs that yield the same amount of output.174Production functionHere we will assume output is made with the inputs capital and labor. K = amount of capital used and L = amount of labor. The production function is written in general as Q = F(K, L) sometimes I put a y instead of Q, where Q = output,and F and the parentheses are general symbols that mean output is a function of capital and labor.The output, Q, from the production function is the maximum output that can be obtained form the inputs.

On the next screen we will see some isoquants. Note: on a given curve L and K change while Q is fixed.175ISOQUANT- ISOCOST ANALYSISIsoquantstheir shapediminishing marginal rate of substitutionisoquants and returns to scaleisoquants and marginal returnsIsocostsslope and position of the isocostshifts in the isocost1767Unitsof K402010 6 4Unitsof L 512203050Point ondiagramabcdeaUnits of labour (L)Units of capital (K)An isoquant

177Unitsof K402010 6 4Unitsof L 512203050Point ondiagramabcdeabUnits of labour (L)Units of capital (K)An isoquant

178An isoquantUnitsof K402010 6 4Unitsof L 512203050Point ondiagramabcdeabcdeUnits of labour (L)Units of capital (K)

179MRTS The slope of the isoquant defines the substitutability between two factors of inputs (capital and labor). This is known as the marginal rate of technical substitution (MRTS) and is presented mathematically as:

Units of capital (K)Units of labour (L)ghDK = 2DL = 1isoquantMRS = 2MRS = DK / DLDiminishing marginal rate of factor substitution181

Units of capital (K)Units of labour (L)ghjkDK = 2DL = 1DK = 1DL = 1Diminishing marginal rate of factor substitutionisoquantMRS = 2MRS = 1MRS = DK / DL182

An isoquant mapUnits of capital (K)Units of labour (L)I1183

I2Units of capital (K)Units of labour (L)An isoquant mapI1184

I2I3Units of capital (K)Units of labour (L)An isoquant mapI1185

I2I3I4Units of capital (K)Units of labour (L)An isoquant mapI1186

I1I2I3I4I5Units of capital (K)Units of labour (L)An isoquant map187188Assume that there are two resources, Labor (L) and Capital (K).The money payments to these resources are Wages (W) and Rent (R). An isocost line is similar to the budget line. Its a set of points with the same cost, C. Lets plot K on the y axis and L on the x axis.WL + RK = C; solve for K by first subtracting WL from both sides.RK = C - WL; next divide both sides by R.K = C/R (W/R)L; note that C/R is the y intercept and W/R is the slope.A Cost Function: Two ResourcesEastwood's ECO 486 NotesIsocost lines, isoquant curves, and the HO model188189C/RC/WAbsolute value of slope equalsThe relative price of Labor, W/R.K (machines rented)

Labor hours used in productionAn isocost lineEastwood's ECO 486 NotesIsocost lines, isoquant curves, and the HO model189190Bundles of: Labor Machine rental with C = Rs30 (Rs6 per labor hour) (Rs3 per machine hour)a0 10b1 8c2 6d3 4e4 2f5 0A Numerical ExamplePoints a through f lie on the isocost line for C = Rs30/hour.Eastwood's ECO 486 NotesIsocost lines, isoquant curves, and the HO model190Instructor Notes:1) The rows of the table list combinations of labor and capital costing $30, rent is $3 per machine hour, and the wage is $6 per hour.2) For example, row shows us that how much K could be hired for $30: 10 machine hours but no labor.191The Isocost Line0 1 2 3 4 5 6 7 8 9 10246810Labor, L (worker-hours employed)Capital, K (machines rented)abcdefEastwood's ECO 486 NotesIsocost lines, isoquant curves, and the HO model191192The Isocost Line0 1 2 3 4 5 6 7 8 9 10Labor, L (worker-hours employed)Capital, K (machines rented)Cost = Rs30R = Rs3/machineW = Rs6/hour246810abcdefEastwood's ECO 486 NotesIsocost lines, isoquant curves, and the HO model192Instructor Points:1) The isocost line is the continuous line af.2) To calculate the equation, start with expenditure equal to C:$3K + $6L = $30

Divide by $3 to obtain K + 2L= 10

Subtract 2L from both sides to obtain

K = 10 2L193Learning ObjectivesCalculate and graph a firms isocost lineWork out how the isocost line changes when resource prices or total cost changeMake a map of production recipes (technology) using isoquantsExplain the choices that firms makeEastwood's ECO 486 NotesIsocost lines, isoquant curves, and the HO model193194The Isocost LineWage-rental ratioWith K on the y axis and L on the x axis, the slope of any isocost line equals W/R, the wage-rental ratio. It is also the relative price of labor.The y-intercept shows the number of units of K that could be rented for Rs.C.The x-intercept shows the number of units of L that could be hired for Rs.C.Eastwood's ECO 486 NotesIsocost lines, isoquant curves, and the HO model194195Changes in One Resource Price0 1 2 3 4 5 6 7 8 9 10Capital, K (machines rented)246810Labor, L (worker-hours employed)afCost = Rs30; R = Rs3/machineThe money wage, W = ...Rs6Rs10A Change in WhEastwood's ECO 486 NotesIsocost lines, isoquant curves, and the HO model195196Changes in One Resource Price0 1 2 3 4 5 6 7 8 9 10Capital, K (machines rented)246810Labor, L (worker-hours employed)aCost = Rs30; R = Rs3/machineThe money wage, W = ...A Change in WfRs6Rs10Rs3hEastwood's ECO 486 NotesIsocost lines, isoquant curves, and the HO model196197Changes in Cost0 1 2 3 4 5 6 7 8 9 10Capital, K (machines rented)

246810Labor, L (worker-hours employed)ghA Change in Cost; every pointbetween g and h costs Rs18.W = Rs6; R = Rs3;C = Rs30Eastwood's ECO 486 NotesIsocost lines, isoquant curves, and the HO model197Instructor Notes:1) Lisas income falls from $30 to $15 while the prices of movies and soda remain constant.2) The budget line shifts leftward, but its slope does not change.198Changes in Cost0 1 2 3 4 5 6 7 8 9 10Capital, K (machines rented)

246810Labor, L (worker-hours employed)ghA Change in Cost; every pointbetween g and h costs Rs18.C = Rs18W = Rs6; R = Rs3;C = Rs30Eastwood's ECO 486 NotesIsocost lines, isoquant curves, and the HO model198Instructor Notes:1) Cost, C, falls from $30 to $15 while the prices of labor and capital remain constant.2) The isocost line shifts leftward, but its slope does not change.199Cost Minimization0 1 2 3 4 5 6 7 8 9 10Capital, K (machines rented)

246810Labor, L (worker-hours employed)aequ.W = Rs6; R = Rs3;C = Rs30Choose the recipe where thedesired isoquant is tangent tothe lowest isocost.C = Rs1812C = Rs36Eastwood's ECO 486 NotesIsocost lines, isoquant curves, and the HO model199200Conclusion: Buy resources such that the last dollar spent on K adds the same amount to output as the last dollar spent on L.The |slope| of the isocost line = W/R.The |slope| of the isoquant = MPL/MPKThis will be demonstrated on the board.Eastwood's ECO 486 NotesIsocost lines, isoquant curves, and the HO model200

An isocostUnits of labour (L)Units of capital (K)Assumptions

PK = Rs20 000 W = Rs10 000TC = Rs300 000TC = Rs300 000a201

Units of labour (L)Units of capital (K)TC = Rs300 000abAssumptions

PK = Rs20 000 W = Rs10 000TC = Rs300 000An isocost202

Units of labour (L)Units of capital (K)TC = Rs300 000abcAssumptions

PK = Rs20 000 W = Rs10 000TC = Rs300 000An isocost203

Units of labour (L)Units of capital (K)TC = Rs300 000abcdAssumptions

PK = Rs20 000 W = Rs10 000TC = Rs300 000An isocost204ISOQUANT- ISOCOST ANALYSISLeast-cost combination of factors for a given outputpoint of tangencycomparison with marginal productivity approachHighest output for a given cost of production2058

Finding the least-cost method of productionUnits of labour (L)Units of capital (K)AssumptionsPK = Rs20 000W = Rs10 000TC = Rs200 000TC = Rs300 000TC = Rs400 000TC = Rs500 000206

Units of labour (L)Units of capital (K)Finding the least-cost method of productionTPP1207

Units of labour (L)Units of capital (K)Finding the least-cost method of productionTC = Rs400 000rTPP1208

Units of labour (L)Units of capital (K)Finding the least-cost method of productionTC = Rs400 000TC = Rs500 000srtTPP1209Finding the maximum output for a given total costTPP1TPP2TPP3TPP4TPP5Units of capital (K)Units of labour (L)O210OIsocostUnits of capital (K)Units of labour (L)TPP1TPP2TPP3TPP4TPP5Finding the maximum output for a given total cost211OrvUnits of capital (K)Units of labour (L)TPP1TPP2TPP3TPP4TPP5Finding the maximum output for a given total cost212OsuUnits of capital (K)Units of labour (L)TPP1TPP2TPP3TPP4TPP5rvFinding the maximum output for a given total cost213OtUnits of capital (K)Units of labour (L)TPP1TPP2TPP3TPP4TPP5rvsuFinding the maximum output for a given total cost214OK1L1Units of capital (K)Units of labour (L)TPP1TPP2TPP3TPP4TPP5rvsutFinding the maximum output for a given total cost215Properties of Iso-QuantAn isoquant has a negative slope in the economic region and in the economic range of isoquant.Economic region is also known as the product maximizing region.The negative slope of the isoquant implies substitutability between the inputs.It means that if one of the inputs is reduced, the other input has to be so increased that the total output remains unaffected.

Isoquants are convex to the originConvexity of isoquants implies two things. substitution between the two inputs, and diminishing marginal rate of technical substitution (MRTS) between the inputs in the economic region.The MRTS is defined as, = slope of the isoquant.MRTS is the rate at which a marginal unit of labour can substitute a marginal unit of capital (moving downward on the isoquant) without affecting the total output.

This rate is indicated by the slope of the isoquant. The MRTS decreases for two reason:i) no factor is a perfect substitute for another, and ii) inputs are subject to diminishing marginal returns.Therefore, more and more units of an input are needed to replace each successive unit of the other input. the corresponding units of L substituting K go (in fig.) on increasing i.e.

As a result, MRTS = goes on decreasing i.e.,

Isoquants are non-intersecting and non-tangential. This implies that in terms of output.

L1Q2 = 200Q1 = 200L2OKMCapital (K)Labour (L)Fig. Intersecting IsoquantsJ

Since OL2 is common to both the sides, it means,J L2 (K) = K L2 (K)But it can be seen in fig that J L2 < K L2(K)but the intersection of the two isoquants means that JL2 and KL2 are equal in terms of isoquants will not intersect or be tangent to each other.

Upper isoquants represent higher level of output.baIQ2 = 200IQ1 = 200XOQuality of KQuality of LFig. Comparison of Output at Two IsoquaqntscEconomic regionQ1Upper ridge lineLower ridge linefghabcdQ3Q2Q4Capital (K)Labour (L)oEconomic region is that area of production plane in which substitution between two inputs is technically feasible without affecting the output.

This area is marked by locating the points on the isoquants at which MRTS = 0.

A zero MRTS implies that further substitution between inputs is technically not feasible.

It also determines the minimum quantity of an input that must be used to production a given output. Beyond this point, an additional employment of one input will necessitates employing additional units of the other input.

By joining the resulting points a, b, c and d we get a line called the upper ridge line, Od, similarly by joining the points e, f, f and h we get the lower ridge line, Oh. The ridge lines are locus of points on the isoquants where the marginal products (MP) of the inputs are equal to zero.

The upper ridge line implies that MP of capital is zero along the line, Od. The lower ridge line implies that MP of labour is zero along the line, Oh.

The area between the two ridge lines, Od, and Oh, is called Economic Region or technically efficient region of production. The laws of returns to scaleThe laws of returns to scale explain the behavior of output in response to a proportional and simultaneous change in inputs, increasing inputs proportionately and simultaneously is, in fact, an expansion of the scale of production.

Three technical possibilitiesTotal output may increase more than proportionately.

Total output may increase proportionately and

Total output may increase less than proportionately

kinds of returns to scaleIncreasing returns to scale;

Constant returns to scale, and

Diminishing returns to scale.

Increasing returns to scaleWhen inputs, K and L are increased at a certain proportion and output increase more than proportionately, it exhibits increasing returns to scale.The increasing returns to scale is illustrated in fig.

Increasing returns to scaleProduct linesQ = 50Q = 25Q = 10BCcba4K

3K

2K

1K

1L 2L 3L 4L Labour (L)Fig. Increasing Returns to ScaleThe movement from point a to b on the line OB means doubling the inputs.

It can be seen in fig that input combination increases from 1K + 1L to 2K + 2L.

As a result of doubling the inputs, output is more than doubled; it increases from 10 to 25 units e.g. an increase of 150%.

Similarly, the movement from point b to point c indicates 50% increase in inputs as a result of which the output increases from 25 units to 50 units i.e. by 100%.OCapital (K)Three reasons for increasing returns to scaleTechnical and managerial indivisibilities: Certain inputs, particularly mechanical equipments and managers, used in the process of production are available in a given size.

Such inputs cannot be divided into parts to suit small scale of production.

Because of indivisibility of machinery and manages, given the state of technology, they have to be employed in a minimum quantity even if scale of production is much less than the capacity output.

Therefore, when scale of production is expanded by increasing all the inputs, the productivity of indivisible factors increases exponentially because of technological advantage. This results in increasing returns to scale.Higher degree of specializationThe use of specialized labour suitable to a particular job and of a composite machinery increases productivity of both labour and capital per unit of inputs.iii)Dimensional relationsFor example, when the length and breadth of a room (15 x 10 =- 150 Sq. ft.) are doubled then the size of the room is more than doubled; it increases to 30 x 20 = 600 sq. ft.

In accordance with this dimensional relationship, when the labour and capital are doubled, the output is more than doubled and so on.

Constant returns to scaleWhen the increase in output is proportionate to the increase in inputs it exhibits constant returns to scale. Fig. Constant Return to Scale Capital (K)

Product linesQ = 30Q = 20Q = 10Bcba4K

3K

2K

1K

1L 2L 3L 4LLabour (L)Decreasing Return to Scale When economies of scale reach their limits and diseconomies are yet to begin, returns to scale become constant.

For example, doubling of coal mining plant may not double the coal deposits.

Similarly doubling the fishing fleet may not double the fish output because availability of fish may decrease in the ocean when fishing is carried out on an increased scale.Product linesLabour (L)Fig. Decreasing Return to Scale ScaleQ = 24Q = 18Q = 10BC4K

3K

2K

1K

1L 2L 3L 4LCapital (K)Decreasing Return to Scalecba

Laws of Returns to Scale through Production Function

Qx = f (K, L)Let us also assume that the production function is homogeneous. A production function is said to be homogeneous when all the inputs are increased in the same proportion and the proportion can be factored out.The inputs are increased by a certain proportion (say k) and output increases in the same proportion (k) then production is said to be homogeneous of degree 1.

Constant returns to scale.Equation show that increase in inputs, K and L by a multiple of k, increases output, Qx by the same multiple (k).

If all the inputs are doubled, the output may not be doubled it may increase by less than or more than double. Then the production function may be expressed as,

When h denotes h-times increase in Qx as a result of k-times increase in inputs, K and L. The proportional h may be greater than k, equal to k, or less than k.

Accordingly, it reveals the three laws of returns to scale:If h = k production function reveals constant returns to scale.If h > k it reveals increasing returns to scale.If h < k it reveals decreasing returns to scale.

In case of a homogeneous production function of degree 1, k has an exponent equal to 1, i.e. k = k1.

But, all the production functions need not be homogeneous of degree 1.

They may be homogeneous of a degree less or greater than 1.

Let us assume that exponent of k is r, where r 1.

A production function is said to be of degree r when all the inputs are multiplied by k and output increases by a multiple of kr. that is,

From the production function we can again derive the laws of returns to scale.If k > 1 and r < 1 , it reveals decreasing returns to scaleIf k > 1 and r> 1, it reveals increasing returns to scale andIf k > 1 and r = 1 it means constant returns to scale.

For example, consider a multiplicative form of production function i.e. If K and L are multiplied by k, and output increases by a multiple of h then

By factoring out k, we get

Definition of CostThere are two types of cost associated with economic analysisOpportunity cost is the value that is forgone in choosing one activity over the next best alternative Out-of-pocket cost is actual transfer of value that occurWhich cost is relevant?Definition of CostThere are two types of cost associated with timeIncremental cost varies with the range of options available in the decision making process.Sunk cost does not vary with decision options.Is sunk cost relevant?SR Relationship Between Production and CostA firms cost structure is related to its production process.Costs are determined by the production technology and input prices.Assuming that the firm is a price taker in the input market.

Costs

247CostsIn buying factor inputs, the firm will incur costsCosts are classified as:Fixed costs costs that are not related directly to production rent, rates, insurance costs, admin costs. They can change but not in relation to outputVariable Costs costs directly related to variations in output. Raw materials primarily

248CostsTotal Cost - the sum of all costs incurred in productionTC = FC + VCAverage Cost the cost per unit of outputAC = TC/OutputMarginal Cost the cost of one more or one fewer units of productionMC = TCn TCn-1 units249CostsShort run Diminishing marginal returns results from adding successive quantities of variable factors to a fixed factorLong run Increases in capacity can lead to increasing, decreasing or constant returns to scale

250Cost Theory: fixed, variable, total, average and marginal costsEconomists try to use language precisely. The words cost and price are often confused. When we discuss costs we mean, how much did something cost to produce. This might be expressed as an opportunity cost, or in a currency such as Rupees. When price is mentioned, economists mean the amount the consumer pays.

Economists also try to explain the nature of costs. Why does one thing cost more to produce than another? Why does making an airplane cost so much less in a big factory than in a small factory. To help explain, total costs are broken down into several parts and looked at in different ways. Before we start we make one basic assumption, that the firm is operating in the short-run time period.251Fixed costsIf aircraft are to be made then a factory is required. The land, the factory building, the machinery and office equipment must be bought or rented. These costs are called fixed costs and must be paid even when the factory has not produced anything. Fixed costs are costs that do not change, whatever the level of output is. Assuming an airplane factorys fixed costs is a $60 million. See Table 1. below. A graph of the fixed costs (FC) would look like this;252

Graph 1. Fixed Costs253Variable costsVariable costs do change as the level of output changes. These costs are costs such as raw materials in production. In our example this would be the steel, components and labour needed to make each airplane. If nothing were made the variable costs would of course be nothing. But as production rises the total variable costs (TVC) would rise.

254Variable costs

255Total costs

Total costs are simply the sum of the total variable costs and the fixed costs. Note that the TC and TVC lines are parallel.The distance between the two lines is the amount of the fixed costs.

256Cost Chart

257Marginal costMarginal cost is the cost of producing one extra unit. marginal cost =the change in total costs the change in outputTCQNotice that this equation is the same as the formula for the gradients of the variable cost and the total cost linesExample:When output rises from 95 to 120 the change in output is 25. The corresponding change in total cost is 1150 - 1000 = 150. The cost of producing 25 extra units has been 150 Rs. Therefore the cost of producing one extra unit is 6 Rs..258Calculating Marginal Cost

259

Graph 3. Marginal Cost 260Features of Marginal CostThe key feature of this marginal cost curve is the shape. It is U-shaped, meaning it has a negative slope for small quantities of output, reaches a minimum value, then has a positive slope for larger quantities.

The U-shape of the marginal cost curve is directly attributable to increasing, then decreasing marginal returns (and the law of diminishing marginal returns).

As marginal product (and marginal returns) increases for relatively small output quantities, marginal cost declines. Then as marginal product (and marginal returns) decreases with the law of diminishing marginal returns for relatively larger output quantities, marginal cost increases. 261Features of Marginal CostMarginal cost is the slope of the total cost curve. Because the total cost curve is parallel to the total variable cost curve, marginal cost is also the slope of the total variable cost curve. This captures the basic mathematical relation that exists between any marginal and the corresponding total.

A marginal is always the slope of the total curve. If the total cost curve has a positive slope (that is, is upward sloping), then marginal cost is positive. If the total cost curve has a positive and increasingly steeper slope, then the marginal cost is positive and rising. If the total cost curve has a positive and decreasingly steeper slope, then the marginal cost is positive but falling. This applies in a like manner to total variable cost.262The Short Run Cost FunctionAverage total cost (ATC) is the average per-unit cost of using all of the firms inputs (TC/Q)Average variable cost (AVC) is the average per-unit cost of using the firms variable inputs (TVC/Q)Average fixed cost (AFC) is the average per-unit cost of using the firms fixed inputs (TFC/Q)The Short Run Cost FunctionAdd ATC = AFC + AVC to the table

The Short Run Cost FunctionATC = AFC + AVC

Marginal and average cost curvesOutputCostAFCAVCATCMC268The Short Run Cost FunctionProduction cost graph or map is

The Short Run Cost FunctionImportant Map ObservationsAFC declines steadily over the range of production. Why?

In general, ATC is u-shaped. Why?

MC intersects the minimum point (q*) on ATC. Why?

The Short Run Cost FunctionAverage total cost (ATC) is the average per-unit cost of using all of the firms inputs (TC/Q)At Q* - ATC is minimized or inputs are used most efficiently given the production function Going at 55 MPHThe Short Run Cost FunctionA change in input prices will shift the cost curves.If fixed input costs are reduced then ATC will shift downward. AVC and MC will remain unaffected.

Computer Chip CaseThe Short Run Cost FunctionA change in input prices will shift the cost curves.If variable input costs are reduced then MC, AVC, and AC will all shift downward.

Airline Industry CaseChart145199619965219971997481998199855199919996020002000

Sales TrendColumn1Column2

Sheet1Sales TrendColumn1Column2199645199752199848199955200060To resize chart data range, drag lower right corner of range.

Chart113.7199313.71993199315199415199419941619951619951995171996171519961819971816199718.7199818.716.9199820.2199920.218199922.3200022.319200023.7200123.720.5200120022002200222.1200220032003200320032003

Trend Line for 3 yearly moving avg.Column2Trend Line for 3 yearly moving avg.Trend line for 4 yearly moving avg.Column2

Sheet1Trend Line for 3 yearly moving avg.Trend line for 4 yearly moving avg.Column21993199413.7199515199616151997171619981816.9199918.718200020.219200122.320.5200223.722.12003To resize chart data range, drag lower right corner of range.

Number of

Workers (Lb)TPPAPP

(=TPP/Lb)MPP

(=TPP/Lb)

(a)00-

3

133

7

2105

(b)14

3248

12

(c)4369

4

5408

2

6427

(d)0

7426

-2

8405

Sheet: Sheet: Sheet: Sheet: Sheet: Sheet: Sheet: Sheet: Sheet: Sheet: Sheet: Sheet1Cost of Producing WheatOutputLabour (No.)Total Varaible CostTotal CostMCACAVC955750100010.537.891206900115069.587.501407105013007.59.297.50155812001450109.357.74165913501600159.708.1817010150017503010.298.82Wages: Rs 150 per worker ; Fixed Cost of Rs. 250

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Sheet1Cost of Producing WheatOutputLabour (No.)Total Varaible CostTotal CostMCACAVC955750100010.537.891206900115069.587.501407105013007.59.297.50155812001450109.357.74165913501600159.708.1817010150017503010.298.82Wages: Rs 150 per worker ; Fixed Cost of Rs. 250OutputTotal CostChange in OutputChange in TCMC95100012011502515061401300201507.515514501515010165160010150151701750515030

Sheet2

Sheet3