Principles of Economics - Updated
Principles of Economics - Updated
Principles of Economics - Updated
Households Firms
Factor Market
Draw curves for TFC, TVC, TC, MC, AC, AVC by using the above data; MC,
AC and AVC first decline, reach a minimum and then shift upwards;
short-run cost curves are U-shaped, long-run cost curves are flatter.
Costs and the Concept of Profit-1
Total cost (TC), fixed cost (FC), variable cost (VC), average cost (c/q), marginal cost (c/q;
m in y = mx + c) accounting cost, explicit cost, implicit cost, economic cost (explicit
+ implicit cost),opportunity cost; revenue and break-even analysis
Show the graphs for FC, VC, TC, TR and the BE value
Finding minimum average variable cost
TC = 1000 + 10Q 0.9Q2 + 0.04Q3, Find the rate of output that
results in minimum average variable cost.
Solution:
d
MC = --- (TC) = 10 1.8Q + 0.12Q2
dQ
TVC = 10Q 0.9Q2 + 0.04Q3 and AVC = 10 0.9Q + 0.04Q2
AVC will be minimum at the point of intersection of the MC and
AVC curves and therefore, for AVC to be minimum, AVC = MC
or, 10 0.9Q + 0.04Q2 = 10 1.8Q + 0.12Q2
solving which we get Q = 0, 0r 11.25
i.e, the average variable cost will be minimum when the out is
11.25 units.
Alternative Solution: Minimize the AVC function i.e., find the value
of Q for which AVC is minimum.
Optimization of a Firms Output
Following are the cost and revenue functions for a firm:
TC = 50 + 4q and TR = 20q q2; Calculate
the volume of output for which profit would be maximum.
Profit = (20q q2) (50 + 4q) = 16q q2 50
d/ = 16 2q d/ = 0 => 16 2q => q = 8 (i) and
dq dq
d/ (d/ )= 2 < 0 ...(ii)
dq dq
Conditions (i) and (ii) indicate that the firm will have
maximum profit if the output is 8 units and the profit at
output 8 is: 8 = 16q q2 50 = 16x8 82 50 = 30 units
Alternatively,
MC = dc/dq = 4 and MR = d/dq = 20 2q and For max
MC = MR => 4 = 20 2q i.e., q = 8
implying that profit is maximum when q = 8 units.
Consumer Behavior
Consumers equilibrium means the amount of a product Units of Toast Total Marginal
consumed that maximizes the satisfaction of a consumer.
Utility: Capacity of a product to satisfy needs; consumed Utility Utility
Marginal Utility: the utility of the last added one 1 20 20
unit consumed
Illustration: 2 18 18
Marginal Utility Theory can be explained by the 3 83 15
utility schedule as shown in the utility schedule in
Illustration. The theory suggests that 4 64 11
a. MU diminishes; b. TU is maximum when MU is zero; & 5 70 6
c. Consumer is in equilibrium when MU = 0
This means that a consumer is in equilibrium (in terms of 6 70 0
how much of a product he/she will Consume) when the 7 62 8
satisfaction from the consumption is maximum and that
level is reached by consuming up to an amount when the 8 46 16
marginal utility is zero. The theory assumes that
Utility can be measured and the measurement can be done by assigning definite numbers
(when actually, utility can not be cardinally measured, it can be measured only ordinally);
Utility of different commodities are independent (but utility of one commodity affects
that of another that means total utility is not a simple summation of utilities of individual
commodities);
From the experience of utility of a product for someone, an inference can be drawn for
utility of it for others (but utility can not be assumed through introspection); and
Utility of money is constant (not true, money has different utilities to different persons).
x
Indifference Curve Theory
Indifference meaning and also, the meaning of indifference curve (shows all
those combinations of two products the total satisfaction from which is the
same); Suppose that the following is a hypothetical indifference schedule
(different combinations of two products consumed for which the total
satisfaction will remain the same):
Mango(y)
Combination Apples Mangoes Marginal Rate of Substitution: MRS xy y
x
1 15 1 of x for y
y
2 11 2
x
3 8 3
4 6 4
Apple(x)
5 5 5
Marginal product
Average product
Budget
Line
Producers Equilibrium: Minimizing costs
Isoquant (also known as product indifference curves or
equal product curves) and isocost (also known as price
line or outlay line) curves are used to determine
efficient input rate combination for given production
rates. All points on the isoquant represent the
combination of inputs that produce the same amount of
output. Isoquants generally slope downward, are convex
to the origin and do not intersect each other.
Marginal Rate of Technical Substitution of X for Y is the
number of units of factor Y, which can be replaced by
one unit of factor X, quantity of output remaining the
same. Thus, MRTSxy = y/x
The MRTSxy generally diminishes as the quantity of X is
increased relative to quantity of Y (quantity of output
remaining unchanged). This is called the law of
diminishing marginal rate of substitution.
Producers Equilibrium: Maximizing Revenue
Use Production Possibility curve and Iso-Revenue Line: Production Possibility
Curve represents what assortment of goods and services an economy can
produce with the resources and techniques at its disposal. Increase in the
resources at the disposal of the firm would take it to a higher production
possibility curve.
Production possibilities Good X (thousands) Good Y (thousands)
A 0 15
B 1 14
C 2 12
D 3 9
E 4 5
F 5 0
The question is: which of the various combinations the firm will decide to
produce? The answer is: the combination that is shown at the point of
tangency with the iso-revenue line. Production possibility curves move
upwards or downwards in a way that they remain parallel to each other. Iso-
revenue lines also do the same. Their movements, along with the shifts of
the points of tangency, determine the output expansion path.
Producers Equilibrium
The manufacturer has a fixed amount of resources and he
can produce different combination of two goods that
may be produced by the same amount of resources.
The curve drawn by plotting the points showing such
combinations is called production possibility curve and
the manufacturer can choose any of these
combinations.
But the manufacturers choice will be determined by the
market prices of the goods and he will chose the
combination that gives him the maximum revenue.
The curve that shows the different combinations of two
goods that can give the same amount of revenue is
called the iso-revenue curve.
Production Iso-revenue
possibility curve
curve
Returns to Scale
Q = f(K,L), if both inputs are changed by some factor output may
change to some factor h, which may be equal to , more than
or less than . Now consider the case hQ = f(k, L), where = 2
i.e., both the inputs are doubled. In such case, the Cobb-
Douglas production function Q = AKL may look like
hQ = A(2K)(2L) = 2 + (AKL) = 2 + (Q) => h = 2 +
The equation h = 2 + is derived from a production function that
uses both factors K and L increased by 2 times and the equation
shows that if both factors of production are increased by 2
times, the output increases by this increases 2 + times.
If the proportion in which the output increases is the same as the
proportion of increase of the inputs i.e., if h = 2 then + = 1
This is a situation when we have constant returns to scale.
Similarly, if h > 2, + > 1, it is a situation, when we have
increasing returns to scale and if h < 2, + < 1, it is a
situation, when we have decreasing returns to scale. Thus in
case of constant returns to scale, the function Q = AKL may be
written as Q = AKL1
Returns to Scale: Matrix of Inputs and Output
CAPITAL
8 283 400 490 565 632 693 748 800
7 265 374 458 529 592 648 700 748
6 245 346 424 490 548 600 648 693
5 224 316 387 447 500 548 592 632
4 200 283 346 400 447 490 529 565
3 173 245 300 346 387 424 458 490
2 141 200 245 283 316 346 374 400
1 100 141 173 200 224 245 265 283
Labor 1 2 3 4 5 6 7 8
The table indicates that there is a substitutability between the factors of production.
The firm can use a capital-intensive production process or a labour intensive one.
Now, if inputs rates are doubled, the output also doubles e.g., K = 1, L = 4 q = 200
and K = 2, L = 8 q = 400, this is a case of constant returns to scale. Returns to scale
means change in output because of proportionate change in inputs.
In reality, output may increase more (or less) than in proportion to changes in inputs.
Also output may change because of change in one input while the other inputs
remains constant. In such case, the change in the output rate is referred to as returns
to factor.
The output table does not allow for determination of the profit maximizing output or
the best way to produce some specified rate of output.
Production with one variable input
Assumes that the rate of input of one factor of production is fixed
(the period of production is not long enough to change the
input rate of that factor). The question is: how to determine the
optimal (profit maximizing) rate of employment of the variable
factor?
Say, of the two input labour and capital, capital is fixed. In that
case, the principle to be followed to optimize the level of
employment of labour is that the additional units of labour be
hired until the marginal revenue product of labour (MRPL)
equals the wage rate (w). MRP is defined as marginal revenue
times marginal product, which is in fact, the value of the extra
unit of labour. Thus the optimizing condition is MRPL = w
Similarly, if labour input is fixed, the capital stock would be varied
and the capital would be employed until the marginal revenue
product of capital equals the price of capital (r) i.e., MRPK = r
External
Economies of concentration (arising out of availability of
skilled worker, provision of better transport and credit,
advantage of localized industries etc);
Economies of information (publication of trade journals,
dissemination of research etc);
Economies of disintegration (splitting of some processes for
taking up by specialist firms).
Theory of Production
Production: Transformation of inputs into outputs. inputs are
what a firm buys (i.e., productive resources) and outputs
are what it sells (i.e., goods and services). Production is
defined as creation of utility and more precisely,
creation/addition of value.
Production is creation of utility and utility created may be of
three types:
Form utility (physical change/transformation of one set of
goods into another
Place utility transportation of goods/services to place of
use
Time utility keeping in store till required.
The theory of production studies
factors of production and their organization,
the laws of production that govern the relations between
inputs and outputs, and among others,
the theory of population (because population supplies
labour, the most important factor of production).
Theory of Production: Importance
The theory of production
plays an important role in the theory of relative prices,
helps in analyzing relations between costs and volumes
of outputs,
tells how manufacturers combine various inputs to
optimize the production of output,
provides a base for the theory of demand of firms for
productive resources and thus, the prices to be fixed
for the factors of production, which implies that
the theory of production has a great relevance to the
theory of distribution.
Factors of Production
Land, Labour, Capital and Organization
Land: All natural resources (useful and scarce, actually and
potentially), which yield an income or have exchange value.
Land has features that have bearing on rent:
Land is natures gift to man
Land is permanent (original and indestructible)
Land lacks mobility in geographical sense
Land is fixed in quantity (land has no supply price i.e.,
supply of land remains the same, no matter whether there
is any change in price)
Land provides infinite variation in degrees of fertility; No
two pieces of land are alike.
Labour
Labour: Any work whether manual or mental, which is
undertaken for a monetary consideration.
Peculiarities of labour that have bearing on its price
i.e., wage:
Labour is inseparable from the labourer himself
Labourer has to sell his labour in person
Labour does not last (it is perishable, it has no
reserve price whether one sells or holds it for some
time)
Labourer has very weak bargaining power
Changes in price of labour react rather curiously on
its supply (fall in price i.e., wage below a certain
point may increase the supply of labour; some
members of the family who did not work before,
may start seeking job).
Efficiency of Labour
Factors that determine efficiency of Labour
racial qualities
climatic conditions
education (general and technical)
personal qualities (physique, mental alertness,
intelligence, resourcefulness, initiative, and
above all, integrity)
industrial organization and equipment
factory environment
working hours
fair and prompt payment
social and political factors
Division of labour
Simple also called functional division of labour, is the division by
major occupations (carpenters, blacksmiths, weavers etc)
Complex No group of workers makes a complete article; the
making of an article is split into a number of processes and sub-
processes which are carried out by separate groups of people.
Territorial locations specializing in different trade or product
Advantages:
Increase in productivity; increase in dexterity and skill; facilitating
inventions; introduction of machinery; saving in time, tools and
implements; diversity in employment; promotion of large-scale
production.
Disadvantages:
Monotony; retardation of human development; loss of skill, risk of
unemployment; industry dehumanized (under division of
labour, many people combine to produce an article and
everybodys business becomes nobodys business, the workers
lose all sense of responsibility and pride in their work and thus
the industry is dehumanized)
Capital
Capital: That part of mans wealth which is used in producing
further wealth or which yields income. Capital is not a primary
or original factor of production; it is produced means of
production, often referred to as dead labour. The term capital is
generally used for capital goods such as plant, machinery, tools,
accessories, stocks of raw material, goods in process, and fuel.
Land is not regarded as capital because, it is a free gift of nature
and it is permanent i.e, it has no mobility, while capital is
perishable and mobile.
Capital formation
increase in stock of real capital in a country and it involves making
of more capital goods such as machinery, tools, factories,
transport equipment, materials, electricity etc, which are all
used for further production of goods. Capital formation
essentially requires savings, which must be invested in order to
have new capital goods.
Capital Formation: stages/components
The three stages of the process of capital formation are:
Creation of savings by individuals or households the level of savings in a
country depends upon the power to save and will to save. The power to
save is a function of the average level of income and the distribution of
national income. savings at the household level may be voluntary and
forced. Besides households, other important agents of savings are the
business and enterprises and the government.
Mobilization of savings transfer of savings from households to
businessmen for investment; development of capital market.
Investment of savings in real capital The primary factor that determines
the level of investment is the size of the market; other important factors are
inducement to invest, marginal efficiency of capital, and the rate of interest
(prospective yield).
An important component of capital is foreign capital (foreign savings) that
comprises
direct private investments,
loans or grants by foreign governments, and
loans or grants by international agencies.
Capital formation may take place also through deficit financing, which is newly
created money and this usually takes place by deliberate allocation of
expenditure in excess of incomes.
Organization/Enterprise
Organization/Enterprise: two main functions of this factor of
production are
(a) organizing; and
(b) risk taking/uncertainty bearing. Entrepreneurs initiate
business, mobilize productive resources, take financial
responsibility of enterprises and play the role of investors
Another important function of entrepreneur: innovation and
initiatives of invention
Market and Market Structure
Why do we study markets?
Firms in monopolistic competition have some control over price because their
products are to some extent differentiated.
In the long run, monopolistic competition generates results similar to those of
perfect competition, and with perfect competition, although there may be
economic profits in the short run there are no economic profits in the long run.
In the short run, the representative firm in monopolistic competition maximizes
profit by equating marginal revenue with marginal cost.
Market and Market Structure
Oligopoly:
The term means few sellers