discussion unit a & b

8/8/2019 Discussion Unit a & B

1/30

Discussion Unit A: Theoretical Foundation of ConsumerBehaviour:

1. Cardinal and Ordinal numbers and C and O Utility Concepts

Cardinal numbers:1, 2, 3, 4, - - - - -

o The number 2 is twice the site of number 1o Measure utility of commodities A & B by utilis:

A: 20 utilsB: 40 utils B Yields twice the utility of it.

Ordinal numbers:

I, II, III, . . . . . . . .o II > I, but II less than IIIo Dont know, by how much size relation of number not knowno Rank utility, and explain consumer behaviour without the

assumption of measurable utility.

2. The Marshallian Cardinal Utility Theory:

Assumptions:o Maximization of satisfaction.

o Rationality: Buys the commodity yielding highest amount ofutility per rupee.

o Utility is cardinally measurable. Measurable by the price thatthe consumer is prepared to pay.

o Utility function exists:

TU = (G, S)TU = M U of G, S

GTU = M U of S, G S

o Constant marginal, utility of money: Sine, money is used as ameasure of utility.

o Diminishing M U.

Law of Diminishing M U:

Page 1 of 30


2/30

No. oforanges

consumedT U M U

0 0 -

1 20 20

2 35 15

3 45 10

4 50 5

5 53 3

6 55 2

7 56 1

8 56 0

9 55 -1

10 53 -2

o Develop both TU and MU curves from this data.

o Observe how behaviour of TU and MU related.

o The LDMU:

As an individual increases consumption of a given product(say orange) holding consumption of other products constant,MU derived from consumption eventually diminishes.

o What are the implications of this law to a business manager?

Consumer Equilibrium and the Marshallian Proportionality Rule:MUA = MUB = MUZ = K

PA PB PZ

o Can we say that K is the MU of money i.e MUM?

o How does a consumer behaviour when:

MUA MUB ?PA < PB

LDMU and Demand Curve:

Page 2 of 30


3/30

o Co MU P D Co MU P D

o Hence inverse relationship between P and Quantitydemanded.

o Consumer Equilibrium:MUX = PX

o If MU of X is measured in terms of money, then the MU curvebecomes the demand curve of the good.

PMU/Price

P1P2 MU/Demand

O QQ1 Q2 At P1 Q1

At P2 Q2

o MU curve could enter IV Quadrant whether D. C could enter IVQuadrant?

3. Ordinal Utility Theory: The Hicksian Theory of IndifferenceCurve

Assumptions of O. U Theory:

U is Ordinal:

o Measurement of U Unrealistic and not needed to explainconsumer behaviour.

o Ordinal ranking to rank preferences according to thesatisfaction of each basket.

Rationality:

o Maximize satisfaction, given income and product prices.

The Axiom of consistency and transitivity:

o Consistency: of A > B, then B > Ao Transitivity: of A > B, B > C, then A > C.

Axiom of non satiability:

Page 3 of 30


4/30

The Consumer: Not oversupplied with either commodity.Consumers do not have enough of all things.

Indifference Schedule and Indifference Curve:

o Five different combinations of X & Y yielding the same

level of satisfactory (U1) Indifferent towards differentcombinations.

Indifference Curve: Diagramatic representation of indifferenceschedule.

Y

30 E

25

20 D

15 C

10 B

5 A IC1 (U1)O X

5 10 15 20 25

Units of X

Indifference Map:Y

Page 4 of 30

Combination

UnitsofX

UnitsofY

TotalUtility

A 25 3 U1

B 15 6 U1

C 8 9 U1

D 4 17 U1

E 2 30 U1

UnitsofY


5/30

IC3IC2IC1IC0

O X

o IC0 U0IC1 U1IC2 U2 Different satisfaction levelsIC3 U3o

U3 > U2 > U1 > U0

Properties of I. Curves:

Negative Slope:Along an IC: -(MUX) (X) = (MUY) (Y)- MUX = X = MRS = Slope of an IC

MUY Y

o Why not positive slope? Why not horizontal? Why not vertical?

Convex X to the origin:

o Marginal rate of substitution (MRS) between two goods

decreases as a consumer moves along a given I. C. Theslope of an I. C curve decreases as we move from point E to A

DMRS.

o Consider the following indifference schedule:

Combination Apples(X)

Bananas(Y)

MRSYX

a 1 12 -

b 2 8 - 4/1 = - 4

c 3 5 - 3/1 = - 3

d 4 3 - 2/1 = - 2

e 5 2 - 1/1 = - 1

DMRS: The consumer assigns a lesser and lesser

significance of the extra unit of a commodity in a larger stock,and relatively a higher significance for the one which is a

Page 5 of 30


6/30

smaller stock. Movement from a to e quantity of X becomeslarger and that of Y smaller. Each time, the consumer willsacrifice a lesser and lesser amount of Y in exchange for X.

o Why not an Indifference curve be concave to the origin?

o Why not an I. C a straight line?

I. Cs do not intersect:

Y

A

IC2 (U2)

IC1 (U1)X

U2 > U1, but at A, U2 = U1o Can one I. C tangent to another?

Upper I. Cs represent a higher level of satisfaction than the lowerones.

Y

bcd

Y* a IC2

IC1

XX*

o Vertical movement from a to b More of Y, same

amount of Xo Horizontal movement from a to d: Same amount of Y,more of Xo Diagonal: Larger quantity of X & Y.

Budgetary constraint and Budget Line:

B = PY Y + PX X = Exp. on Y + Exp. on X

Solving for Y:

Y = B - PX X Eqn. for B. LinePY PY

Page 6 of 30


7/30

o B = Qy that can be purchasedPY When QX = ?

o B = QX ?PX

o Slope of B. Line: dY = - PXdX PY

Price ratios of two commodities.

o Diagram:

YB/PY

BQY A B. L or Price Line

O X

QX B/PX B.L: The market opportunities available to consumer, given

his income and the prices of X and Y.

Feasibility Area: Budget line and area under B. L (A)

Non-feasibility Area: Area beyond the B. L (Ex. B).

Shifts in B. L: B = PYY + PXX __ __

o PY, PX, B B Parallel shift in B. L nochange in slope __ __

o PY, B, PX PX Change in slope of B.L. Butshift in B.L? __ __

o PX, B, PY PY Change in slope of B.L. But

shift in B.L?

o PX and PY change proportionately

No. Change in slope

P PY An increase in B

P PY A decrease in B.

o PX and PY change disportionately

o Draw diagrams to illustrate all these cases.

Total Effect of a Price Change = I.E + S.E__ __

Page 7 of 30


8/30

o Let PY, B and PXo Buy more of Y

o Reasons: S.E: Substitute cheaper Y for X__

I.E: With B, PY Real I Inducement to buy more of

Y(of Y is a . Good).

The consumers Equilibriumo I. Map: Preference of taste factorso B.L or P.L: Power to satisfy themo The point of consumer equilibrium or utility maximizingrule:

Y

B/PY Q

PIC4(U4)

R IC3(U3) IC2 (U2) IC1(U1)

O XB/PX

Q, P, R: 3 of the infinite number of attainable

combinations on B.L Q: Move towards right point P on U3

Move towards left: Lower IC

R: Move upward to hit point PShift from U2 to U3

Point of C Equilibrium at P

IC3 (U3) tangent to B.L

Slope of IC (U3) = slope of BL

MRSXY = Price Ratio

MRSXY: Rate at which consumer is willing to substitute X

for Y Price Ratio: Rate at which he can substitute X for Y

Point P: Two sets of forces those of the market operatingthrough BL and those of tastes operating through IC arebrought into balance.

o MRSXY = Price Ratio

X = - MUX = - PX Slope of IC = Slope of BLY MUY PY

MUX = MUY Does this imply the Marshallian

Page 8 of 30


9/30

PX PY Proportionality Rule?

Deriving Demand Curve from Price Consumption Curve(PCC):

P C C:

o Keep money income (M) constanto Keep price of Y constant

o Allow decrease in PX.

Y

M

E1 E3 PCCE2 IC3

IC1 IC2

OX

X1 N1 X2 N2 X3N3

Quantity of X consumed.

o Original BL: MN1 Quantity of X bought X1 Point ofequilibrium: E1

o Allow PX New BL: MN2 Q of X bought: X2 New point ofequilibrium: E2

o Allow further fall in PX New BL: MN3 Q of X bought: X3 New point of equilibrium: E3

o Connect successive equilibrium points E1, E2 and E3: calledPCC

o Thus, PCC is a locus of points of equilibrium on indifference

curves, resulting from the change in the price of a commodity.In this case, PCC shows the change in consumption basketdue to fall in PX.

Derive individual consumer demand curve for commodity X fromPCC.

PX

Page 9 of 30

MoneyIncom

e


10/30

P

O XX1 X2 X3

D for Xo Slope of B. Line: MN1 Quantity of X bought: X1

o Fall in PX New BL: MN2 Q of X bought: X2

o Further fall in PX New BL: MN3 Q of X bought: X3 When price consumption relations are taken out and

plotted separately, that gives the demand curve depictinginverse relationship between price and quantitydemanded, ORC.

Page 10 of 30


11/30

Discussion Unit B

1. The Revealed Preference Theory

1. The Marshallian Cardinal approach to Demand Theory: Based on Cardinal

Measurement of utility.

The Hicksian ordinal approach: Based on relative or ordinal or

introspective measurement of U. But non-observable.

The RPT of Samuelson: Based on actual, behaviour of the consumer

2. The RPT based on the following assumptions

Rationality: Consumer prefers a large basket of goods to the smaller

ones

Transitivity: A,B,C, alternative basket of goods

APB

BPC

APC

Consistency: APB, then B is not preferred to A

Strong ordering

Makes definitely one and only choice Reveals his specific preference

Effective price inducement: Consumer can be induced to buy a

particular collection by providing him sufficient price incentive.

Positive income Elasticity of Demand: Recall: Income demand

function cases of normal, inferior and neutral good.

Negative Income Elasticity or Zero Income Elasticity is ruled out

3. Diagrammatic Exposition of RPT:

Two commodities: X & Y

Prices of X and Y: Given

Page 11 of 30


12/30

Has a given money income

MN: BL

Choice of commodity combination A: oY1 & oX1

Prefers A to any other feasible combination on MN

B or any other combination on MN: Not preferred.

His preference is revealed for A.

Any other point:

Point C: Smaller and cheaper basket of X & Y

Point D: Larger and more expensive basket

Hence A is a preferred combination.

4. Derivation of Inverse Relationship between P & Q (Law of Demand) from

RPT:

Page 12 of 30

A

DB

NX0

M

Y

Y1

C

X1

Units of Com X

UnitsofCom

Y

OMN: Comsumers choice triangle

AB

C

N3N2N1

X3X2X1

0

M1

Comm Y

Comm X

M2


13/30

M1N1 = initial budget

A = Choice at point A: with Ax1 of Y and 0X1 of X

Know: All the points on M1N1, feasible combinations of X and Y

But: Prefers A to all the other feasible bundles.

Let: Px, Py M New B.L , M1 N3.

But: Shift from A and C due to effects of price change viz income and

substitution effects

Decompose total effect of price change into substitution and incomeeffects.

M2 N2 : BL passing through point A.

Adjustment budget point A with AX1 of Y and 0X1 of X still available

Consumer: Not to choose any point between A and M2; because inferior

to bundle represent by Point A.

: Not to choose any other point say B on AN2 segment of the BL

: If continues to buy basket at point A S.E is zero

: If chooses point B, SE = X1 X2

D for X with a PxSamuel Sons Fundamental Demand Theorem.

Law of D is established

The income effect: X2 to X3

The S.E : X1 to X2

Total effect of price change: X1 X3 = X1 X2 + X2 X3Move from point

A to point C

RPT considers only the case of normal goods.

2. Demand Estimation and Forecasting:

2.1 Methods of Estimating Demand Function:

Why demand estimation in BM?

Page 13 of 30

Fig: SE & IE Effects: Revealed Preference Approach


14/30

Impact of changes in exercise duty, lower prices, rising GDPetc on demand for products.

Consumer interviews (Surveys)o Interview consumers on their consumption habitso Census and sample methodso Information on quantities of the concerned good bought at

different periods at various prices of the product, prices ofrelated goods, income of the consumer and so on.

Market Experiments Method:

o Actual Experiment:Record consumers reactions in different shop locations withrespect to income, religion, sex, age group etc.

o Market simulation (Consumer clinic or laboratory experiment)method:

Provide token money to a set of consumers. Vary prices of various goods, their quality, packagingetc and record shopping behaviour of consumers.

Too costly and consumers may not take the experimentseriously.

o Functional forms for estimation: Simple and

Multiple Regression.

Regression Method:

Identify variables which influence demand for aparticular commodity

Collect data Select appropriate functional form Estimate the functionEx: Demand Function for Groundnut OilDg = f (Y, Po, Pv, Pg, U)Where: Dg = demand for groundnut oil

Y = national incomePo = price of groundnut oilPv = price of vanaspathiPg = price of pure gheeU = other determinants of g.n.o

Time series or cross section data.

2.2 Demand Forecasting

Page 14 of 30


15/30

D. Forecasting: An estimate of the futuredemand, based on laws of probability.

Levels of D. F:o Micro Level: Forecast by an individual

business firm.o Industry Level:o Macro Level: Ex: Country consumption

function.

Why D. F?o Production planningo Sales forecastingoTo control business and inventoryoTo plan long term growth and investment

programmes. Demand led business strategy.

Demand Forecasting Methods:

o Consumers survey

o Experts opinion

Simple expert opinion pollDelphi Method: An extension of the

simple expert opinion poll

Use Delphi Method (DM) toconsolidate the divergent expertopinion and to arrive at a compromiseestimate of future demand.

Under DM: Collect opinions fromexperts. Instead of taking averages, try

Page 15 of 30


16/30

to match the opinions by bringingexperts to-gether and to arrive at aconsensus.

Statistical Methods:

Trend method to extrapolateDg = f (T)Where: Dg = demand for groundnut oil

T = Time (Years)

Barometric Method of Forecastingo Meteorologists use the barometer to

forecast weather conditions on the basisof movements of mercury in thebarometer.

o So use relevant economic indicators such

as GDP, prices, lending rate for loans.

Econometric Method: Regression Method

o Simple or Bivariate RegressionTechnique:Y = f (X)

Y = Sugar consumedY = Population

o Multivariate RegressionDx = f (Px, Ps, M, A)Where: Dx = Quantity of x demanded

Px = Price of X

Ps = Price of substitutes

Page 16 of 30


17/30

M = Consumers incomeA = Advertisement expenditure

Page 17 of 30


18/30

3. Returns to Scale:

To explain the behaviour of output inresponse to proportionate and simultaneouschanges in input use Expansion/Contraction in the scale ofproduction.

Technical possibilities of proportionate and

simultaneous increase in the use of both L &K:

o Y (output) increases more than

proportionately IRS

o Y increases proportionately CRS

o Y increases less than proportionately

DRS

o Y = (L, K)

o Firm uses L units of Labour incombination with K units of capital to

obtain an output of Y: L + K Y

o Let us change both L and K by aproportion, call it .

By how much Y increases?

Let output increase by b:

Page 18 of 30


19/30


20/30


21/30

K ?

6 DA Y2 = 1500

3Y1 = 100

O L3 6

4. Technology and P.F:

Technical Change: Economic InterpretationY, I

Y, I

Technical change for facing global competiveness.

Labour intensive technology: L ratio K

Capital intensive technology: L ratio K

Neutral technology: L ratio remains constant.K

Impact of technology change on TP, MP and AP: TP with sameamount of input. MP and AP with same amount of input.

Upward shifts in product curves & shifts in iso-quant.

Embodied technology change & P.F shift: Embodied in inputs (say anew and more efficient machine).

Disembodied technology change: P.F shifts due to improvedefficiency in input-combination, and improved managerial efficiencyetc. Do you contest this difference?

5. Economics and Diseconomics of Scale: Real and PecuniaryEconomics.

o Economics of Scale: Decreasing segment of LRAC curve.o Diseconomics of Scale: Increasing segment of LRACcurve.

Page 21 of 30


22/30

Economics of Scale:

o Internal (internal to the firm) Economies:

Economies of Production: Technological advantages andadvantages of division of labour and specialization.

Economies in Marketing: Large scale purchase of inputsand sale of output.

Managerial Economies: Specialised management inproduction, HRD, Marketing, Finance etc.

Economies in Transport and Storage: Fuller utilization oftransport and storage facilities.

o External or Pecuniary Economies of Scale:

Large scale purchase of inputs: Concessions and discounts.

Large scale acquisition of external finance.

Massive advertisement campaigns.

Declining portion of LRAC due to economies of scale due tooutput expansion.

Diseconomics of Scale: Rising portion of LRAC curve:o Overcrowding of labouro Managerial inefficiencies

o With full in demand for the product, underutilization ofcapacity.

Impact of Technological Change on LRAC Curve.

5.1 Economies of Scope: Multi-Product Firm

o Not the same as economies of scale.

o Many times, companies/firms produce more than oneproduct to lower the cost of each operation alone.

Ex1: Automobile companies producing cars and trucks product diversification.

Ex2: A smaller commuter airline providing cargo services.Ex3: Use the byproducts arising from the production of thefirst product sugar industry.

o Economies of Scope: Total of point production of carsand trucks < Total cost of producing cars and trucksindependently by different firms.

TC(C,T) < TC(C) + TC(T) Less expensive to produce jointly.

o Diseconomies of Scope: TC(CT) > TC(C) + TC(T) Lessexpensive to produce independentlyo Degree of Economies of Scope:DES= TC(An)+TC(Bn)-TC(An+Bn)

Page 22 of 30


23/30


24/30

Comparison of E of S and Learning Curve:Know:o Technical Progress: Downward shift in LRAC Curve.o Managers and workers gaining experience: Downward shift in

LRAC Curve.

Page 24 of 30


25/30

LRAC

C

B

A LRACtLRACt+1

O OutputQt Qt+1

Observations:o Two periods: t and t+1o Qt and Qt+1 levels of output during t and t+1

o LRAC at t: OC for Qt level of outputo LRAC at t+1: OB

Lower LRAC during t+1 periodBC = Unit cost saving.

o Expand output from Qt to Qt+1

Economics of Scale:LRAC at Qt+1: OAOA < OB < OC

o Learning Curve Effect: BCo E of Scale Effect: ABo Downward shift due to learning and movement along a given

LRAC curve due to E of scaleo Remember: Downward shift in LRAC curve (AC reductions)

may be due to Learning Experience, Economies of Scale,technology and input price decline.

Hold other things constant to sort out net effect of L.C (PreviousDiagram)

7. X Efficiency:

Efficiency in production Cost Economy Any improvement in efficiency downward shift in cost

functions

Cost reduction: Possible through minimizing wastage ofresources

X-efficiency: Firms ability to monitor and control production unitto minimize the wastage of resources

X-efficiency: A function of management to minimize the wastageof resources

Page 25 of 30


26/30

New Managerial Approaches: Six-Sigma Methodology (Adoptedby Motorola, GE and others) to achieve X-efficiency so as tominimize waste and to attain zero defect level of the businessfirm.

8. Cost Volume Profit Analysis: Break Even Point andOperating Leverage.

Examine the relationship among TR, TC and total profit at variouslevels of output (Q).

C V P analysis or B E A: used by business executives todetermine volume of sale required for the firm to break even andthe total profits and losses at other sales levels. At what output levelB E, Losses and Profits?

Use C V P or B E Analyse.

B E Analysis: Linear Cost and Revenue FunctionCF: TC = 100 + 10 QRF: TR = 15 Q. 100 = TFC

V.C varies with output (Q) and varies at a constant rate of 10 perunit. Sale Price = 15

Algebraic Calculation of B E P: TR = TC 15Q = 100 + 10Q

Q = 20 20 is the B E output Beyond 20: operating profit Below 20: operating loss.

Diagrammatic Representation:Costs

Revenue TR

Operating 700 >0 TC600 TVC500400 Operating300 loss B200100


27/30

o TVC: Variable Costo TC = TC function i.e TFC + TVC

o TR = Total Revenue: P.Qo Point B: Point of intersection between TR & TC lines Q=20, B.E

level of outputo Thus Point B: B E Pointo Below Q=20, TC > TR operating losso Above Q=20, TR > TC operating profito B.E.P: TR=TC =0 losses cease to ever and profits yet to

begin.

Limitation of L C and L R functionso C and Revenue functions may be non linear: Because AVC

and price of output vary at different rates with variations isoutput.

o Under non linear conditions, there might be two B E points,instead of one.

B E Analysis: Non Linear Cost and RevenueFunctions.

Costsand

RevenueTC

B2 B1 TR

A TFC

O Q (output)Q1 Q2

o TFC = Total Fixed Cost (OA)o TVC = TC TFC = The vertical distance between TC and TFCo TC = Total Cost = TFC + TVC

o B1 & B2: Points of intersection between TR & TC TR = TCo B1: Lower B E point at Q1 output level

B2: Upper B E point of Q2 output level

Firm, producing more than OQ1 and less than OQ2 will makeprofit

Profitable range of output:More than OQ1Less than OQ2.

Producing less than OQ1more than OQ2

losses.o Contribution Analysis:

Page 27 of 30


28/30

Recall: IC = Incremental Cost of a business decisionIR = Incremental Revenue from a business decision.

Contribution: TR TVC, TFC not considered

At B E PointContribution = Fixed Costs.

Uses of B E Analysis:

o To Know: Level of sales required to cover all costso To Know: What happens to overall profitability, when the

company incurs higher or lower fixed or variable costso To Know: Between two alternative investments, which one

offers the greater margin of profito To Know: What happens to overall profitability when a new

product is introduced

o To forecast , when revenue and cost estimates are available.o To Know: Margin of safety

o Useful for production planningo Useful for deciding when to start paying dividend to its share

holders.

9. Degree of operating leverage:

Percentage change in profits that results from percentagechange in number of units sold i.e elasticity of profit with respect

to output sold.

DOL = % = o = . Qo

%Q Q Q oQo

10. Estimation of Cost Function:

Forward Planning: Basis for decision making.

SR Cost Function: Necessary for the firm determing the optimumlevel of output and the price to charge.

LRC Function: Essential in planning for the optimal scale of plantfor the firm.

Methods for obtaining appropriate information of its future cost output relationship.

o Engineering Method:

Page 28 of 30


29/30

Based directly on the production function, input pricesand the optimum input combination for producing a givenquantity of output.

Using this information, engineers provide least costestimates.

Based on given technology and input prices. When technology and input prices are changing, difficultto obtain accurate estimates.

Survivorship Method (Survival Technique)

Classify various firms of an industry into size groups: small,medium and large

Most efficient size group: share in the industry in creases

Least efficient size group: share in the industry decreases

Industry Share (%)

Site group Base Year Current YearS 10 12M 30 50L 60 38

M Size group: Most efficient

L Size group: Most inefficientCompetition will eliminates inefficient firmsFirms with lower average cost will survive.

Limitation: The method does not yield the cost function. Doesnot allow the measurement of degree of economies anddiseconomies of scale.

Statistical Method: Regression Method

Short Run Cost Function:C = TC = f (Q)C = total cost = TFC + TVCQ = output

Linear Cost Function:TC = a + b QTC = 100 + 0.5 Q

TFC = 100TVC = 0.5 Q

Let Q = 10TVC = (0.5) (10) = 5

Page 29 of 30


30/30

TC = 100 + 5 = 105AC = -----------------MC = ----------------

Quadratic Cost Function:

TC = a + b Q + CQ2TC = 100 + 60Q + 3Q2, TFC = 100

Cubic Cost Function:TC = a + b Q CQ2 + dQ3

TC = 100 + 60Q 5Q2 + 0.7 Q3, TFC = 100

Long Run Cost Functions:o To determine the best scale of plant for the firm to build in

order to minimize the cost of producing the anticipated level

of output in the long run.o Can use either time series data or cross section data.o Can estimate L R Cost Functions with engineering and

survival techniques.

Managerial Uses of Estimated Cost Functions:o To determine the optimum scale or size of the fixed plant and

equipment.o To determine the optimum output for a given plant size.o To determine the supply schedule/curve.

discussion unit a & b

Documents