mefa notes from durga prasad navulla

MEFA NOTES UNIT-I

INTRODUCTION

Knowledge of economics is helpful to managers, engineers etc. it is helpful to engineer in determining several issues such as how much quantity is to be supplied issues such as how much quantity is to be supplied, produced and what should be the price of the product, should the produce be made internally or bought from the outside market, how much quantity is to be produced in order to earn certain profit etc.

Managerial economics provides us a basic insight into seeking solution for several managerial problems.

Introduction to Economics

Economics is the science related to the production, distribution and consumption of wealth or the material welfare of mankind, political economy, economic questions, affairs or aspects. Various economists defined economics in different ways. In general, economics can be defined as a social science which deals with human behavior, how he uses limited income to satisfy the unlimited wants.

The definitions of economics can be broadly classified into three different categories.1. Economics is Defined as Science of Wealth

Adam smith (the father of economics) defined economics as a science of wealth. According to him “economics is concerned with an inquiry into the nature and causes of wealth of nations”.He has given primary importance to wealth and secondary importance to mankind.

2. Economics as Science of Human Welfare

According to Alfred Marshall “economics is on one side a study of wealth and on the other and more important side a part of study of man”.He has given primary importance to making and secondary importance to wealth

3. Economics as Science of Scarcity

Here there are two important definitions to be considered.

1. According to Lionel Robbins, “Economics is a science which studies human behavior as a relationship between unlimited wants, and scarce resources which have alternative uses”.

2. According to J.M.Keynes, “Economics is the study of administration of scare resources and how the level of income and employment will be determined in the country”.

Economics influences the technical decisions of any industry by using the techniques such as demand analysis, elasticity of demand, demand forecasting, break-even analysis, production function, capital budgeting etc.Kinds of Economics:

1. Micro Economics

Micro Economics is also called “Theory of Firm”. Micro economics is that branch of economics which is concerned with the analysis of the behavior of the individual units or variables such as individual demand or the price of the product.

Micro economics basically deals with individual decision making ad the problem of resource allocation. It is concerned with applications such as Law of Demand, Price Theory etc.

2. Macro Economics

Macro economics is that branch of economics which deals with the aggregate behavior of the economy, as a whole it makes a study of the economic systems in general. E.g. National income, Total saving, Total Consumption, Unemployment, Economic Growth rate.

N. DURGA CHAITANYA PRASAD M.Com, M.B.A. (SITE) 1

MEFA NOTES *Difference between Micro and Macro EconomicsS.N Micro Macro1.

2.

3.

4.

5.

It is study of the behavior of the individual firms or units

It is individualistic.

It is concerned with the behavior of the micro variable such as individual demand, supply.

Its scope is limited.

It deals with the data of individual firm.

It is study of the behavior of the economy as a whole.It is aggregate.

It is concerned with the behavior of macro variables such as National Income, National Output, Total Savings.

Its scope is vast.

It deals with the data of total industry.

Managerial Economics-Meaning

Economics is concerned with the problem of allocation of scare resources among competing wants. Those economics principles, concepts methods, tools and techniques that can be applied practically to solve the problems of Business Management is known as managerial economics.

Therefore, Managerial Economics is a part of Economics and it is concerned with business practice for the purpose of facilitating decision making.

Definitions:

“Managerial Economics is the use of economic modes of thought to analyse business situations”. Mc Nair and Meriam.

“Managerial Economics is the economics applied in decision-making”.

Haynes, Mote and Paul

“Managerial Economics is the application of economic theory and methodology to business administration practice”

Brigham and Pappas

“Managerial Economics is a price theory in the service of business executives”

Watson.

Based on the above definitions the common view regarding managerial economics is as follows

1. Managerial Economics is concerned with decision making of economics nature.

2. Managerial economics is goal oriented.3. Managerial Economics facilitates

forward planning.4. Managerial economics provides link

between traditional economics and decision science.

5. Managerial Economics directs the utilization of scarce resources in a goal oriented manner.

Nature of Managerial Economics:Micro Economics in NatureNormative EconomicsApplication OrientedMacro EconomicsEvaluation of each alternativeAssumptions

Micro Economics in Nature:

Micro Economics studies about the individual firm. It studies how an individual firm can use scarce resource to produce more output with minimum cost and maximum profit.


Economics Principles, Concepts, Tools and Techniques

Managerial Economics, Application of Economics to solve the problems of business management

Solutions to business problems/ managers

Decision making problems of Business Management

MEFA NOTES Normative Economics:

Managerial Economics tells a business firm to do certain things which will benefit them and not to do certain things which leads to losses. Therefore managerial economics is normative economics because it prescribes

Application Oriented:

Managerial Economics tries to solve some complicated business problems. Decision making skills can be improved by applying some principles and concepts.

Macro Economics in Nature:

Managerial Economics gives an opportunity to evaluate each alternative depending on its cost and profit. There is a scope that the managerial economist can decide on the best alternative to maximize the profits for the firm.

Evaluation of each alternative:

Managerial economics gives an opportunity to evaluate each alternative depending on its cost and profit. There is a scope that the managerial economist can decide on the best alternative to maximize the profits for the firm.

Assumptions:

Managerial Economics is based on certain assumptions and the assumptions are not valid universally. Therefore, if there is a change in assumption, the theory may not hold good.

Chief Characteristics of Managerial Economics

Managerial Economics is the study of the allocation of the scarce resources available to a firm among the activities of that unit to maximize profit.The theory of managerial economics is based mainly on the theory of firm

Managerial economics is both conceptual and materialisticManagerial economics is concerned with managerial decision makingManagerial economics takes the help of other sources to make optimum use of scarce resourcesManagerial economics is goal oriented in its approachManagerial economics is micro-economics in character as it concentrated only on the study of the firm and not on the working of the economy.

Scope of Managerial Economics:

The following topics comes under the scope of managerial economics.

Demand analyse and ForecastingCost AnalysisProduction AnalysisPricing PoliciesProfit ManagementCapital management

Demand analyse and Forecasting:

A business firm convert raw material into finished products and these products are sold in the market, Hence the firm has to estimate and forecast the demand before starting production. A forecast of future demand is essential. The firm will prepare production schedule on the basis of demand forecast.

Cost Analysis:

Every business firm wants to reduce cost. A study of economic costs, and their estimates are useful for management decisions. Estimation of cost is essential for decision making. An element of cost uncertainty exists, as all the factors determining cost are not always known or controllable. Cost control is essential for pricing policies.


MEFA NOTES Production Analysis:

Production analysis refers to the physical terms while cost analysis refers to monetary terms. Production analysis deals with different production functions and their managerial uses.

Pricing Policies:

Pricing is an important area of managerial economics. Price is the basic thing for the revenue of a firm, and the success of the price decisions taken by it

Profit Management:

The primary aim of any firm is to maximize profits. Their exists an uncertainty in the estimation of profits, because of differences in the costs and revenues, and the effects of its internal and external factors. Therefore, profit management is the difficult area in managerial economics.

Capital management:

Capital Management implies planning acquisition, disposition and control of capital.

Decision Making in Managerial Economics

The managers face a number of problems in day to day management of the firm. He has to find the solutions to these problems.

Decision making is the process of choosing one best alternative from a list of alternative. A manager has to weigh merits and demerits of each action, He has to select the best alternative with the limited resources. The decisions made must take the business firm in the right direction. There are different types of decisions to be taken, among them the most important are

Product DecisionsPricing DecisionsQuantity Decision and Technological Decisions

Product Decisions:

These decision are related to the what products the firm will produce and offer for sale and decision may be related to additions of a product or deleting the existing product. It also includes the style, packing and size of the product.

Pricing Decisions:

These decisions are related to fixing a price for the products manufactured. If the price is very high the firm may not be able to sell its products. Even if the price is low, the consumers think it is an inferior product.

Quantity Decisions:

These decisions are related to how much to be manufactured. The production depends normally in anticipation of demand.

Technological Decisions:

It is concerned with the method to be adopted in manufacturing a product. One should see whether a change in technology will benefit the business firm or not.

Hence, there may be more problems to be faced while planning for the future. It may relate to production, pricing, capital and raw material. The resources are scarce but they have alternative uses.

Decision making is very important because it is related to uncertain. Managerial economics understand these decision making problems and guides us in a purposeful direction.


MEFA NOTES Importance or Usefulness or Significance or Application of Managerial Economics

1. Managerial economics provides a number of tools and techniques to build models and with the help of these models the managers can handle the real life situations.

2. Managerial economics provides most of the concepts that are needed for the analysis of business problems.

3. it is helpful in making decisions such as(a). What should be the product mix?(b). Which is the best production technique?(c) What should be the level of output and price for the product?(d). How to make investment decisions?

4. The managerial economics helps us to understand the economic behavior of individuals

5. The managerial economics helps us to explain the working of economic system

6. Managerial economics helps to assess the performance of the economy

7. Managerial economics provides a good knowledge about cause and effect of various economic phenomena

8. Managerial economics suggest how to improve the growth rates in developed economies

Relation with other subjects:

Managerial Economics and Traditional Economics

The relationship between managerial economics and traditional economics is very much like the relation of engineering to physics and medicine to biology. Traditional economics provide certain concepts, methods and principles which can be applied to solve the problems of business management. The both deal with the allocation of scarce resource in an optimum way. A managerial economist must know about traditional economics in order to understand the principles of managerial economics.

Managerial Economics and Operation Research

Operation research is an activity carried out by functional specialist within the firm to help the manager to do his job of solving decision making problems, while managerial economist is purely an academic subject which seeks to understand and anal7yse decision making problems of business.

Managerial Economics and Mathematics

Mathematics provides us a set of tools which helps in the derivation and exposition of economics analysis. Mathematics is closely linked to managerial economics. It tries to estimate and produce the relevant economics factors for decision making and forward planning. The branches of mathematics which are generally used by a managerial economist are geometry, Algebra and calculus.

Managerial economics and Stastics Statistics is widely used by managerial

economics. Managerial economics aims at quantifying the past economic activity to predict its future. Probability, correlation, interpolation are the concepts used by managerial economics to solve certain problems. The concept of statistics helps in decision making.

Managerial economics and Accounting

Managerial economics is closely related with accounting which is concerned with financial operations of a business firm. Accounting information is one of the principle sources of data used by managerial economist for his decision purpose.

Managerial economics and psychology Consumer psychology is the basis on which

managerial economist acts upon. We always assume that the behavior of the consumer is always rational, which is reality is not so. Psychology contributes towards understanding the behavioral implications, attitudes and motivations of each of the microeconomics variables such as


MEFA NOTES consumer, supplier, investors, workers or an employee.


MEFA NOTES Functions of Managerial Economist

The managerial economist has to gather economics data, analyse all crucial information about the business environment. He may have to make a continuous assessment of the impact of changing technology. In the Indian context a managerial economist is expected to perform the following functions.

1. Macro-forecasting for demand and supply

2. Production planning at micro, macro levels.

3. Capacity planning and product-mix-determination.

4. Economic feasibility of new production process

5. Assistance in preparation of overall development plan

6. preparation of periodical economic reports

7. Keeping management information at various national and international developments on economic matters

8. Preparing briefs, speeches, articles and papers for top management

Role of Managerial Economist:

The managerial economist plays a very important role in an organization

The objective of a managerial economist plays a very important role in an organizationThe managerial economist must try to maximize profits on their invested capitalManagerial economist must make an accurate forecast as possible, because forecast depends on future which is uncertain.he should advise the management on domestic and global economic issuesThe managerial economist has to maintain contact with data sources. He

has to obtain statistical data on national income, price level and tax policiesHe should identify new business opportunitiesHe should build micro and macro economic models to solve specific problems

Responsibilities:

Sales forecastingIndustrial market researchEconomic analysis of competing companiesPricing problems of industryCapital projectsProduction programmersSecurity analysis and forecastadvice on trade and public relationsadvice on primary commoditiesadvice on foreign exchangeEconomic analysis on agriculture.Analysis of underdeveloped economiesenvironmental forecasting

The important characteristics he needs to have are

i) Economic intelligenceii) Participating in public debates


MEFA NOTES DEMAND ANALYSIS

Introduction:Demand is the basis for the starting of

any business, as the product decision and amount of product to be produced would be decided only on the basis of the demand prevailing in the market i.e. depending on the market survey and demand forecast. Demand only decides indirectly the amount of factors of production to be employed in the organization i.e. money, men, material, machinery and management required. Without proper demand analysis, if production activity is undertaken the business firm may suffer huge losses.

Demand: MeaningDemand for a product refers to

1. Desire of an individual for a product2. Ability to pay for the product3. Willingness to pay for the product.

If there is ability and willingness but no desire then it is nor a demand. Similarly, without willingness if there is desire and ability, then also it is not a demand.

Law of demand:According to law of demand there is an

inverse relationship or a negative relationship between the price of a product and its demand. The law may be stated as follows “when the price falls, demand extends, price rises demand falls, other things, remaining constant.

Explanation of law of DemandDemand schedule

Price in Rs. Quantity Demanded(units)

54321

10002000300040005000

Demand schedule is the table showing the prices per unit of the commodity and the amount demanded per period of time.

In the above table or schedule when the price of the product is Rs.5, its demand is only 1000 units. But when the price has fallen to Rs.1, demand for the product has gone up to 5000 units. This shows that a fall in the price deals to extension of demand. Similarly when we take Rs. 1 price, the demand for the product is 5000 units, when the price started rising up to Rs.5 the demand for the product has fallen to 1000 units. This shows that a rise in price leads to contraction of demand.

This can be shown with the help of diagram, DD=Demand CurveOn X-axis the quantity of a product demanded is represented. On Y-axis the price of the product is represented. DD represents the demand curve. It slopes downwards from left to right as price increases, demand is decreasing. As price decreases demand curve moves away from the point of origin.

Demand curveIf we show the demand schedule

graphically, we get a demand curve. The demand curve shows the maximum quantities per unit of time that consumers will take at various prices.

Assumptions of Law of Demand:

The assumptions underlying the Law of Demand are:

No change in Consumer IncomeNo change in Consumer PreferenceNo change in the Tastes and FashionsNo change in the Price Related ProductNo change in the populationNo change in the Govt. PolicyNo change in Weather Conditions


MEFA NOTES

No change in Consumer Income If the income of the consumer increases,

inspite of increase in the price of the goods the demand will increase. Similarly if the income decreases, inspite of decrease in the price the demand will decrease.

No change in Consumer Preference If the consumer have a specific

preference of the product or he likes the product or he likes the product very much He purchases the product if it is costlier also.

No change in the Tastes and Fashions If fashion of the product is outdated, the

demand will decrease even if it is offered at a lower price

No change in the Price Related Product If the price of the related product

decreases, demand tends to decrease for the other similar products also.

No change in the population If the population goes on increasing the

demand tends to decrease even though the price increases. On the other hand if the population decreases demand tends to decline even though the price is low

No change in the Govt. Policy The change in the government policies

and political situation will influence the demand for the product.

No change in Weather Conditions In summer season the demand for fans, air coolers, air-condition is increasing considerably irrespective of changes in the price.

No expectation of future price changes.No change in the range of foods available to customers.

Hence all these assumptions are kept as constant.

Demand FunctionThe demand function for a commodity

describes the relationship between quantities of the commodity which consumers demand during a specific period and the factors which influence its demand. Mathematically, demand function can be expressed as follows

Dx =Where

D = Quantity demanded for the product xY = Consumer’s incomePx = Price of good xPs = Price of substitute of xPc = Price of complements of xT = Measure of consumer tastes and preferencesEp = Consumer’s expectations above future prices.N = No of customersD = Distribution of consumersu = Other determinants of the demand for xa = advertisement

= Unspecified Function

Why demand curve slopes downwards:The law of demand states that, other

things remaining the same, an individual consumer will but more units of a commodity at a lower price and less of that commodity at a higher price. Generally, the demand curve slopes downwards from left to right. Some of the reasons for this are

Income effectA commodity is utilized more when it become cheaperSubstitution effectMultiple use of product

Income effect:

The income of a consumer affects the demand of the product. If the income is fixed i.e. there is no change in income, but there is a change in the prices of the products, then it will affect the demand and the curve slope downwards.


MEFA NOTES

A commodity is utilized more when it become cheaper:If the price of the product falls, the

existing buyers purchase more and some new consumers enter the market

Substitution effect: A fall in the price of a product, while the

prices of its substitutes remain unchanged will make it attractive to the buyers who will now purchase more and vice versa.

Multiple use of product: Some products can be used for multiple

purpose. A fall in the price of steel, iron etc., will increase demand considerably.

FACTORS INFLUENCING THE DEMAND FOR A PRODUCT

1. Price of the Product2. Income of the Consumers3. Tastes, Habits and Preference of the

Consumer4. Relative price of Substitute Goods and

Complement Goods5. Consumer Expectation6. Population7. Climate and Weather8. Advertisement effect

1. Price of the Product:The most important factor affecting

amount demanded is the price of the product. The amount of product demanded at a particular price is called as price demand. Normally a large quantity is demanded at a lower price but not at a higher price. Not only the existing price but also the expected changes in price will affect demand.

2. Income of the Consumer:When consumer’s income increases the

demand will increase significantly. On the other hand if the income decreases the demand will decrease

3. Tastes, Habits and Preferences of the Consumer:Demand for many goods depends upon the tastes, habits and preference of the consumer.E.g.: Demand for several goods like ice-cream, chocolates, beverages depends on the taste of the individual

4. Relative Price of Substitute Goods and Complement Goods:

The demand for a product is also affected by the changes in price of the related by the changes in prices of the related goods. Related goods can be of two types1. Substitutes which can replace each other in useE.g.: Tea, Coffee and bournvita are substitutes.2. Complementary goods are those which are jointly demandedE.g.: Tea, Sugar and milk are complementary goods.

5. Consumer Expectation:A consumer expectation about the future

changes in the price of a given product may also affect its demand. When the consumer expects the prices to fall in the future he tends to but less and vice versa.

6. Population:Increase in population increases demand

for necessaries of life. Decrease in population will also affect the demand for different products.

7. Climate and Weather:The climates of areas woolen clothes are

demanded. On a rainy day, ice-cream is not much demanded.

8. Advertisement Effect:In modern times the consumer

preference can be changed by advertisement and sales propaganda. Demand for may products like toothpaste, soaps, washing powder etc., is partially caused by the advertisement affect.


MEFA NOTES Exceptions Or Limitation To the Law

of Demand1. Giffen Goods/ Inferior Goods2. Veblen Goods3. Consumer Expectation4. Consumer Psychological Bias5. Necessaries6. Impulse Buying7.

Giffen Goods/ Inferior Goods: Robert Giffen, British economist observed that when the price of the product is decreasing the demand for the product is decreasing. These Products are called as inferior goods or Giffen goods.

Similarly, when the price of the product is increasing the demand is also increasing. Such types of products are called superior goods.

Veblen Goods or Prestige Goods American economist, Veblen explained

that, there are certain goods which are purchased by the consumer not because they really need those goods but they purchase goods because of status symbol i.e., to maintains status in the society. Prestige goods are those which consumers will purchase even though they are costlier.

Consumer Expectations: Whenever the consumer expects a

further fall in the price in future he will not purchase the products or goods immediately, when price decreases, demand tends to decline. Similarly when the consumer expects a further increase in the price for the future he will but the products immediately

Necessaries: The demand almost remains constant

irrespective of the price changes concerned to these goods as people tend to adjust their consumption on other goods as they feel these are most necessary products.

Impulse buying: In Exhibitions and functions, the social habit, place or situation, force people to purchase goods at higher prices

Individual Demand Schedule and Market Demand Schedule

Consider the following tablePrice Rs.

Goods Demanded by individual

Total Demand in unitsX in

unitsY in units

Z in units

10095908580

1020304050

510121520

25101420

1735526990

In the above table Mr. X is demanding 10 units at Rs. 100 and 50 units at Rs 80, this demand is called individual demand. Individual demand refers to goods demanded by a single individual. The table showing at different prices different units were demanded by Mr. X that is called individual demand schedule.

Market demand refers to total demand made by all the individuals in the market. In the above table total demand is 17 units at Rs. 100 and 90 units at Rs. 80. The table representing different prices, different units were demanded by all the individuals that is called market demand schedule

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MEFA NOTES Types of Demand

1. Demand for Consumer Goods and Producer Goods

2. Durable Goods and Perishable Goods Demand

3. Derived Demand and Autonomous Demand

4. Industry Demand and Company Demand5. Short run Demand and Long run

Demand6. New demand and Replacement Demand7. Total Market Demand and Segment

Market Demand

Demand for consumer goods and producer goods:When Goods are demanded by consumer for

the direct satisfaction of their wants, they are called demand for consumer goods.E.g. Food items, Readymade clothes etc.

When goods are demanded by producer for production of other goods including consumer goods, they are called demand for producers’ goods.

E.g. Machines, tools, Equipment etc.

Durable goods and Perishable goods demandPerishable goods are those which can’t

consumed only once, while durable goods are those goods which can be used more than once over a period of time.

Derived Demand and Autonomous Demand

When the demand for a product is tied to the purchase of some parent product. Its demand is Called derived demand.

E.g. Demand for cement depends upon demand for construction industry.

When goods are demanded independently for the direct satisfaction of the consumer wants, it is called autonomous demand.

E.g. The demand for sugar is loosely tied up with the demand for drinks

Industry Demand and Company Demand :

Industry is a group of firms producing or manufacturing the same or similar product.

Company is an individual business unit or business firmWhen goods are demanded which are produced or manufactured by a particular company, that demand is called company’s demand.

E.g. Demand made for Maruti cars produced by Maruti Udyog Ltd.

When goods are demanded which are produced or manufactured by a particular industry that demand is called industry demand.

E.g. Total demand for cars produced by automobile industry.

Short run Demand and Long Run Demand

Short run demand refers to that demand which changes immediately due to reaction in price changes and income fluctuation etc.

Long run demand refers to that demand which does not react immediately due to price change. It will take some time for change in demand

New Demand and Replacement Demand :New demand refers to the demand for the

new products and it is the addition to the existing stock. In replacement demand, the item is purchased to maintain the asset in good condition. The demand for cars is new demand and the demand for spare parts is replacement demand

Total market Demand and Segment Market demand


MEFA NOTES Take the E.g of the consumption of sugar in

a given region. The total demand for sugar in the region is the total market demand. The demand for sugar from the sweet-making industry from this region is the segment market demand.

UNIT-IIELASTICITY OF DEMAND

Elasticity of Demand is the measure of the degree of change in the amount demanded of the commodity in response to a given change in price of the commodity, price of some related goods or change in consumer income.

There are four important kinds of elasticity of demand.

1. Price elasticity of demand2. Income elasticity of demand3. Cross elasticity of demand4. advertising and promotional elasticity of

demandPrice Elasticity of Demand:

Meaning:Price elasticity of demand measures the

responsiveness of demand to changes in price. The price elasticity of demand for a commodity is the rate at which quantity bought changes as the price changes. It is denoted by (Ep)

or

WhereQ1= Quantity demanded before price changeQ2= Quantity demanded after price changeP1= Price charged before price changeP2= Price changed after price change

Higher the elasticity of demand, greater will be the percentage change in quantity demanded every percentage change in price.

Elastic Demand and Inelastic DemandWhen a small change in price may bring about a big change in demand then it represents elastic demand

What ever may be the changes in price if the demand remains more or less constant then it represents inelastic demand.

Types of Price Elastic of demand Types of Price Elastic of demand are

generally classified into five categories.Perfect Elastic

demandPerfect inelastic

demandUnit elasticity

demandRelative/

Comparative Elasticity of demandRelative/

Comparative Inelasticity of demand

Perfect Elasticity of Demand (Ep=∞):


MEFA NOTES It is one in which a small change in price

will cause a large change in amount demanded. A small rise in price reduces the demand to zero. A small decrease in price leads to a big expansion in demand.

In the above figure the quantity demanded increases from OX to OX1 from OX1 to OX2 even though there is no change in price. The price is fixed at OP.

Perfect Inelastic Demand(Ep=0):This is one which shows that whatever

the change in price may be the amount demanded remains same.

In the above figure it is shown that there is no change in the quantity demanded even though the price is changing (increase or decrease).

Even though there is an increase in price from OP0 to OP1 to OP2 there is no change in demand.

Unit Elasticity of Demand(Ep=1):In this type of demand a given

percentage change in price leads to exactly the same percentage change in amount demanded.

As there is no change in the demand and price it is called as unitary demand.

The figure shows that the quantity demanded increases OX0 to OX1, as there is a decrease in price from OP0 to OP1. The amount of increase in the quantity demanded is equal to the amount of fall in the price.

Relative Elastic Demand(E>1):

The demand is said to be relatively elastic when the change in demand is more than the change in price. The figure shows that the quantity demanded increases from OX0 to OX1

as there is a decrease in price from OP0 to OP1. The amount of the increase in the quantity demanded is greater than the amount of decrease in the price.

Relative Inelastic Demand(E<1):

When the change in demand is less than the change in price, then the demand is said to be inelastic.


MEFA NOTES

In the figure the demand increases from OX0 to OX1 as there is a decrease in the price from OP0 to OP1. The amount of increase in the quantity demanded is lesser than the amount of decreases in the price.

Factors Determine Price elasticity of DemandThe price of elasticity of demand depends on the following factors:

1. Nature of goods2. Availability of substitutes3. Income level4. Variety of uses5. Proportion of income spent on the

commodity6. Durability of a commodity7. Possibility of postponement8. Time period

1. Nature of goods:Goods may be classified into three

groups. They are necessaries, comforts and luxuries. The demand for necessaries like salt, food grains, clothes etc is inelastic like salt, food grains, clothes etc is inelastic where as demand for comforts and luxuries like television vehicles etc is elastic

2. Availability of Substitutes:A commodity having a number of

substitutes has relatively elastic demand whereas a commodity have less or without substitutes is relatively inelastic demand.

3. Income level:

High income group people are less affected by [rice changes than low income groups people. Demand for high priced and quality goods in inelastic for high income groups whereas the same is elastic for low income people

4. Variety of Use:

A commodity having a variety of uses has a comparatively inelastic demand. On the other hand, demand is elastic for a commodity having a limited use

5. Proportion of income spent on the commodityIf the consumer spends less percentage

on a commodity, then demand will be inelastic e.g. salt, match box. On the other hand if consumer spends large proportion of his income on a commodity, then the demand will be elastic

6. Durability When a commodity is durable e.g.

furniture, toothbrush etc, one is likely to use the commodity for a longer period having high price, then higher is its elasticity of demand.

7. Time Period:

Demand of a commodity always has a reference to a specific period. Generally demand is inelastic during short period and elastic during the long period.

Importance of Price Elasticity of DemandThe concept of elasticity of demand is of much practical importance. Given the fact that the actions of any enterprise are oriented towards improving its overall profitability. Here the concept of elasticity plays crucial role. It measures the proportionate change in sales and hence in profit. Price elasticity of demand is highly useful in the following cases.

1. Price Fixation of a Product2. Decision Regarding to Price Changes3. Price discrimination4. Taxation Policy


MEFA NOTES Income Elasticity of Demand

The income of consumer too greatly affects the demand for a commodity. Given the price, if the consumers have a higher income, they can buy more products. Thus at higher incomes or increase income levels the demand will be high and at lower income demand for the commodity will be lower.

When the income of the consumer increases, the demand for quality products increases, while that of poor quality goods decreases. Income demand curve called Engel curve is left to right upward for superiors goods and downward for inferior goods.


MEFA NOTES INCOME DEMAND (ENGEL) SCHEDULEIncome (Rs.) Demand for

Superior goodsDemand for Inferior goods

100020003000400050006000

123456

654321

As income of the consumer increases from Rs. 3,000 to 4,000 quantity demanded increases to 3 to 4 units for superior goods. Where as for inferior goods demand reduced from 4 to 3 units presented in the figure.

2. INCOME ELASTICITY OF DEMANDThe income elasticity is defined as a ratio of percentage or proportional change in the quantity demanded to the percentage change in income. It measures the degree of responsiveness in quantity demanded due to change in income.

Where Ei = Income elasticity of demandΔQ= Change in quantity demandQ = Quantity demandedΔI = Change in income I = Income INCOME ELASTICITY OF DEMAND TYPES:Income elasticity of demand is classified under three heads

1. Zero Income Elasticity of Demand2. Negative Income Elasticity of Demand3. Positive Income Elasticity of Demand

1. Zero Income Elasticity of DemandThis refers to the situation where a given increase in consumers’ income does not result in any change of the quantity demanded.E.g. Essential goods like salt, milk etc.

2. Negative Income Elasticity of DemandThis refers to that situation where given increase in the consumers’ income is followed by an actual fall in the quantity demanded for the commodity. E.g inferior goods


MEFA NOTES 3. Positive Income Elasticity of DemandThis refers to situation where a given increase in consumer’s income is lead to an increase in quantities demanded.

This may be further classified into Unitary income elasticity of demand (Ei=1), income elasticity of demand greater than unity (Ei>1) and income elasticity of demand less than unity (Ei<1). The following diagram is explaining it.

Use of Income elasticity of Demand1. For Demand forecasting2. For Product line Planning3. Advertisement Planning

3. Cross Elasticity of Demand:Cross Elasticity of Demand may be defined as “The proportionate change in the quantity demanded of a particular commodity in response to a change in the price of another related commodity”.

Where,EC= Cross elasticity of demandΔQA= Change in demand of given goodQA= Demand of a given goodΔPB=Change in price of related goodPB= Price of a related good

Note: Cross elasticity of demand in case of Substitutes is positive and in case of complements is negative.Cross Elasticity of demand is useful in the following cases.

1. To fix product pricing and changes in pricing of the product

2. To estimate the Effect of Competitors’ Pricing Decisions

4. Advertising or Promotional Elasticity of Demand:

Advertising elasticity of demand refers to percentage or proportionate change in sales in response to percentage change in advertisement expenditure. It is denoted by EA

In the present competitive world advertising occupied an important place, it consists of audio visual activities to increase the demand for a product. Advertising elasticity of demand is a measure to understand how far the demand for a product will be influenced by advertisement and other promotional activities.

Advertising Elasticity of demand is useful in the following cases.

1. To know the stage of product in the market

2. To know the effect of advertising in terms of time

3. To know the advertising by rivals or competitors

IMPORTANCE OF ELASTICITY OF DEMAND:

Useful to the Businessmen

Useful to the Government and Finance Minister

Useful to International Trade

Useful for Planning of the business activities


MEFA NOTES Useful to the consumersUseful to Trade unions

DEMAND FORECASTINGA forecasting is a prediction or

estimation of future situation under given conditions.

Demand Forecasting:Demand forecasting means expectation

about the future course of the market demand for product. Demand forecasting is essentially reasonable judgment of future probabilities of the future demand. It cannot be 100% precise.

Demand Estimation:Demand estimation tries to find our

expectation present sales level, given the present state of demand determinants.

Types of Demand Forecasting:Various types of demand forecasting are as follows

1. Passive forecasts2. Active forecasts3. micro forecasting4. Long term Forecasting5. Short term Forecasting

1. Passive Forecasting:Here prediction about future is based on

the assumption that the firm does not change the course of its action.

2. Active Forecasting:Forecasting is done assuming that, it will

be changes in the actions by the firm. 3. Micro Forecasting:

When individual business firm forecast the demand for their products, it is known as micro level forecasting.

4. Long term forecasting: Long term forecasting refers to the

forecasts prepared for long period during which

the firm’s scale of operations or the production capacity may be expanded or reduced.

5. Short term forecasting: Short-term forecasting normally related

to a period not more than a year. Short term forecasting relate to the day-to-day information. In the short term forecasting a firm is primarily concerned with the optimum utilization of its existing production capacity

Importance of Demand Forecasting:

For planning and Production analysisSales ForecastingControl of BusinessInventory ControlLong term Investment ProgrammesMaintain StabilityHelpful for Planners and Policy Makers

For planning and Production analysis: Demand forecasting is essential before

starting any production activity. It is dependent on accurate demand forecasting.

Sales Forecasting: Sales forecasting is dependent on the

demand forecasting. Advertisement pattern of the firm should be based on sales forecasting.

Control of Business: The business firm may have to prepare the

budget of cost and revenue occurring in future. The future accurate estimation of cost and revenues is based on the demand forecasting.

Inventory Control: The business form can have a better control

on raw materials, semi- finished goods, finished goods, spare parts etc., for future requirements of the firm with the help of demand forecasting.

Long term Investment Programmes: The growth rate and long term investment

planning of the firm can be estimated with the


MEFA NOTES help of demand forecasting. For planning and Production analysis

Maintain Stability:

Production and employment growth rates

can be stable through demand forecasting.

Helpful for Planners and Policy Makers:

Demand forecasting can be greatly used by

planners and policy makers in making optimum

allocation of scare resources.

Requisites of a Good Forecasting Methods:

Accuracy

Simple and Easy to Compute

Economy

Availability

Maintenance Should be Up to Date

Accuracy:

It is necessary to check the accuracy of past

forecast against future performance and of

present forecast against past performance.

Simple and Easy to Compute:

Management must be able to understand and

have confidence in the methods used for

forecasting.

Economy:

Costs must be weighted against the benefits of the forecast to the operation of the business.

Availability: The methods employed should be able to

produce meaning results quickly.

Maintenance Should be Up to Date :

The forecast should be capable of being maintained on an up-to-date basis

Approaches to Forecasting:

Identify and clearly state the objectives of

forecasting. The objective may be short-

term or long-term

Select Appropriate method of forecasting

Identify the variables affecting the demand

for the product and express them in

appropriate forms

Gather all relevant date o represent the

variable.

It may be made either in terms of physical

units or in terms of rupees of sales volume

It may be in terms of product group or

individual products

It may be annual basis or moth wise or

week wise on the basis of past records


MEFA NOTES Demand Forecasting Methods

I. Intentions of Customer

1. Survey Method:

Under this method the consumers are contacted personally to disclose their future purchase plans. This can be done by two ways1. Census method2. Sample Method

Census method: Under this method all consumers are contacted to know their preferences for the products in future. The interviews are conducted either orally or through questionnaire. With the help of census method the probable demand of all consumers is summed up.

Sample method: In this method a sample of consumers

is selected for interview. The sample may be random or stratified sampling. This method is easy, less costly and highly useful.

II. Collective Opinion Method:Under this method opinion of the

sales men taken for demand forecasting. The sales men can know the pulse of the consumer and they can give correct information about the likely demand for the products.

III. Delphi Technique:Opinions and views are taken from

experts coming from different backgrounds. Under this method experts are asked the likely demand for a particular product. The experts may give

different opinions on them. This process is repeated again and again unless a common view point is emerged.

IV. Test Market:This method is used for estimating

demand of new products of estimating sales potential of existing products in new geographical areas. In this method a test area is selected which truly represent the market. The product is launched in this area exactly in the manner in which it is intended to be launched in the market. If the product is found successful in the test area then the sales are taken as a basis for estimating sales in the market as a whole.

2. Market Experimentation Method:

This method involves giving a sum of money to each consumer with which he is asked to shop around in a simulated market. Consumer behavior is studied by varying prices, quantity, packing, advertisement, colour etc.

3. Based on Fast Trends:

Fitting a Trend Linear of Trend Forecasting Method:Under this method actual dales data is

drawn on a chart and estimating by observation where the trend line lies. That line can be extended further towards a future period and the corresponding sales graph can be read from the graph.

Least Square Method This method uses statistical data to

find the trend line which best fits the


MEFA NOTES available data. The following regression equation is used

S= a. T+bWhere S= Sales a, b = Past Data Calculation T = The year for which forecast is

required

Time Series Analysis: This method attempts to build

seasonal and cyclical variation into the estimating equation

S = a + b + c + dWhere

a= Trendb= Seasonc= Cyclea, b, c, d= Constant calculated from past data.

Moving Average Method: This method is based on past sales

data and it is used for short term forecasting and it is based on assumption that the future is the average of past performance

4. Economic Barometer:

This method forecasts the future based on the occurrence of present events, first we have to see whether their exists a relationship between the demand for a commodity or product and certain economic indicator. The above relationship can be established through the method of least square. E.g. demand for tractors depends on the farmer’s income or agricultural income.

5. Statistical Method:

Naïve Method: It is based on the past data of information available for example Historical Observation of sales

Regression Analysis: This is a statistical technique by

which the demand is forecasted with the help of certain independent variables. There are two types of regression analysis

a. Simpleb. MultipleSimple regression analysis is used

when the quantity demanded is taken as a function of a single independent variable. Multiple regression analysis is used to estimate demand as a function of two or more independent variables that varies simultaneously.

6. Judgmental Approach:If the management is unable to use

any of the above method they have to make their own judgment in forecasting the demand

These are the demand forecasting techniques .


MEFA NOTES III unit

PRODUCTION ANALYSISProduction in Economics means

creation of goods and services which have exchange value. In other words, it implies creation of utilities. Production is an organized activity of transforming input into outputs to satisfy the demand for the commodities and services of the company.

Inputs refers to the all those things

which a firm buts and employs to produce a particular product. Output means the quantity of goods in the finished form produced by the firm for selling. Production analysis deal with physical production and supply side of the market.

Definition for Production:According to the Parkinson:

“Production is the organized activity of transformation resources into finished products in the form of goods and services”.

Production Function:

Production function expresses a functional or technical relationship between physical inputs and physical outputs of a firm at any particular time period. The output is thus a function of inputs. Production is the result of combination of factors of production land, labor, capital and organization. The factors used for production are called “inputs”. The production we get is called “output”. The production functions show the maximum rates of output that can be obtained from different combinations of inputs in a given

time with a given state of technology, managerial ability etc.

Production function enables production manager to understand how better he can make use of technology to its greatest potential

Definition for Production function:

“The production function is the name given to the relationship between the rates of productive services and the rates of output of the product.”

-------> Stigler

“Production function is that function which defines the maximum amount of output that can be produced with a given set of inputs”.

-------> Michael R Baye.

Production Function:

It can be expressed in an allegorical equation:

Where Q stands for the quantity of output a, b, c, d…..n are the various inputs.

Each form has its own production function depending on the technical


MEFA NOTES knowledge and managerial ability. An improvement in the technical knowledge or managerial ability will bring about a new production function.

Here output is the function of inputs, the output becomes the dependent variable and inputs are the independent variables. Production function has to be expressed in a precise mathematical equation i.e.

It is showing the there is constant relationship between application of input (x) and the amount of output(Y).

The production function may be fixed production function are variable production function. In fixed production function each level of output requires a unique combination of inputs. On the other hand a variable production proportion production function is one which the same level of output may be produced by two or more combinations of inputs.

Assumptions:The production function is related to a particular period of timeThere is no change in technologyThe producer is using the best technique availableThe factors of production are divisibleProduction can be fitted to a short run or to long run.Utilization of inputs at maximum level of efficiency.

Importance of production function:

When inputs are specified in physical units, production function helps to estimate the level of productionWith the help of iso-quants, production function explains the difference combinations of inputs which will yield the same level of output.Production function indicates the manner in which the firm can substitute one input for another without altering the total outputWhen prices are taken into consideration, the production function helps to select the least combination of inputs for desired outputIt considers two types of input- output relationship namely

1. Law of variable proportion and 2. Law of returns to scale.

It helps us to under stand the laws of returns in production

COBB- DOUGLAS PRODUCTION FUNCTION

Production function of the linear homogenous type is invented by Jnut Wicksell and first tested by C.W. Cobb and P.H. Douglas in 1928. This famous statistical production function is known as Codd- Dougles production function. Originally the function is applied on the empirical study of the American manufacturing industry. Cobb-Dougles production function takes the following mathematical form

Where,Y= Output


MEFA NOTES K= CapitalL= LabourA, α = Positive Constant

Assumptions:

It assumes that output is the function of two factors, i.e. capital and labour

It is a linear homogenous production function of the first degree

There are constant returns to scaleAll inputs are homogenousThere is perfect competitionThere is no change in technology

Criticism:

Cobb-Douglas production function is criticized because it shows constant returns to scale. But constant returns to scale are not actuality. Industry is either subject to increasing returns or dimishing returns.

No entrepreneur will like to increase the inputs in order to have constant returns only. His aim will be to get increasing returns and not constant returns

This function as applied to each firm may not give the same result as that of the industry.

It based on the assumption that factors of production are substitutable and excludes complementarity of factors. But in the short run non- complementarity of factors is possible. Therefore, it applies more to the long-run than to the short-run

ISO QUANTS

“Iso” means equal; “quants” means quantity. It means the quantities throughout a given isoquant are equal. Isoquants are also called isoproduct curves. It shows various combinations of two input factors such as capital and labour, which yield the same level of output.

The production functions like this when only two inputs are there for production.

This function has three variablesQ= output of commodity, L= Labour andK=Capital

For a given value of Q, there will be alternative combinations of L and K. these combinations of L and K will vary with variation in Q. Generally both labour and capital are necessary for the production of commodity; there are substitutes to each other. Thus, for any given level of output, no entrepreneur will need to hirer both labour and capital but he would have an option to employ any one combination of these factors, out of several possible combinations

Q=2 Q=5 Q=9 Q=12 Q=14K L K L K L K L K L

1 20 2 20 3 20 4 20 5 20

2 12 3 14 4 13 5 15 6 17

3 8 4 10 5 10 6 12 7 15

4 6 5 7 6 8 7 10 8 13

5 4 6 5 7 6 8 8 9 11

6 3 7 4 8 5 9 7 10 10

In the above table all those combinations of labour and capital which yield the same output. In our example the farmer could employ 1 tractor and 20 labour, 2 tractors and 12 labour… 6 tractors 3 labour to manufacture 2 Quintals of output.


MEFA NOTES If he aims at producing 5 quintals of output, the alternative input combinations open to him are 2 tractors and 20 labour, 3 tractors and 14 labour and so on.

If we plot these alternative input combinations for a given output and assume a continuous variation in the possible combination of labour and capital, we can draw a curve called isoquants for various output levels of table are shown in the figure

Features of Isoquants:

1. Downwards Slopping2. Convex to Origin3. Do not intersect4. Do not touch axes

1. Downward sloping:Isoquants are downwards sloping curves

because, if one input increases, the other one reduces. There is no question of increase in both the inputs to yield a given output. A degree of substitution is assumed between the factors of production

2.Convex to Origin:Isoquants are convex to the origin. It is

because the input factors are not perfect substitutes. One input factor can be substituted by other input factor in a diminishing marginal rate. If the input factors were perfect substitutes, the isoquants would be a falling straight line.

3. Don’t intersect:Two isoproducts do not intersect with

each other, it is because, and each of these denotes a particular level of output. If the manufacturer wants to operate at higher level of output, he has to switch over to another isoquants with higher level of output and vice verse

4. Do not touch axes:The isoquants touches neither X-axis

not Y-axis, as both inputs are required to produce a given product

Types of IsoquantsDepending upon the degrees of

substitutability of inputs, there are four types of Iso-quants.

Linear IsoquantsInput-Output IsoquantsKinked IsoquantsSmooth Isoquants

Explanation of those

Linear Isoquants: It represents perfect substitutability of factors of production.

Input-output Isoquants: If the factors of production are strict complementaries and hence show zero substitutability, we derive this isoquants


MEFA NOTES

Kinked Isoquants: If the factors of production show limited substitutability we find this type of isoquant

Smooth Convex Isoquants: This form assumes continuous substitutability of factors of production

Iso CostsIsocosts refers to that cost curve that

represents the combination of inputs that will cost the producer the same amount of money. In other words, each isocost denotes a particular level of total cost for a given level of production. If the given level of production changes, the total cost changes and thus the isocost curve moves upwards. And vice versa.

In the following figure three

downwards sloping straight line cost curves each costing Rs.1.0 lakh, Rs. 1.5 lakh and Rs. 2.0lakh for the output levels of 20,000, 30,000 and 40,000 units. Isocosts farther from the origin, for given input costs, are associated with higher costs. Any change in input prices changes the slope of isocost lines

Marginal Rate of Technical Substitution

The marginal rate of technical substitution refers to the rate at which one input factor is substituted with other to attain a given level of output. In other words, the lesser units of one input must be compensated by increasing amopunt of another input to produce the same level of output. In the following table presents the ratio of MRTS between teh two input factors, say capital and labour. 5 units of decrease in labout are compensated by an increase in 1 unit of capital, resulting in a MRTS of 5:1.

Combinations

inputs UnitsMRTS

K LA 1 20 -B 2 15 5:1C 3 11 4:1D 4 8 3:1E 5 6 2:1F 6 5 1:1


MEFA NOTES Least Cost Combination Of Inputs

The isocosts curve indicates the alternative combinations of various factors of production which can produce a given output. Of these, an entrepreneur would like to choose the combination of input factors, which costs him the least.

To explain this how he can determine the least cost combination for a given output. We need the prices of the factors of production. Let the price of labour (L) be Rs.6 per unit and price of capital (K) Rs.9 per unit. Assume that any amount of labour and capital can be bought at these respective fixed prices.

Let our farmer wants to produce a certain amount of paddy. Assume that the farmer has certain cost combination. There are two ways to determine the least cost combination of input for given output.

In the following example there are six alternative combinations of labour and capital to produce the given production, say 9 quintals. The cost of each of these combinations will be as follows

Combinations

inputs UnitsCostRs.K L

1 3 20 3*9 + 20*6=1472 4 13 4*9 + 13*6=1053 5 10 5*9 + 10*6=1054 6 8 6*9 + 8*6=1025 7 6 7*9 + 6 * 6=996 8 5 8*9 + 5* 6=102

From the above table we can find the combination of 5 represents the least cost for producing the desired production. The least total cost producing various other quantities can be determined in a similar way.

Graphically we can determine the least cost input combination or the maximum output for given cost, first we have to draw iso-quant map and than iso-costs map. Later we have superimpose the iso-quants map and the iso-costs map as shown in figure.

As per the above figure the desired quantity of output can be produced at a least cost Rs.99 by having 6 units of capital and 7 units of labour. It is known by the point E where the isoquant curve is just tangent to the iso-cost curve. At any other point of iso-quant the total cost is more than Rs.99. similarly for a given cost, an entrepreneur can select the best combination of two inputs which will give the maximum output by way of selecting that iso-quant curve which is just tangent to a given iso-cost curve.


MEFA NOTES Laws of Returns

Production function shows the relationship between the quantity of inputs and the possible output. But the laws of production deal with the relationship in the form of

Law of variable proportion/ Law of diminishing returns/ law of returnsLaw of returns to scale

Law of Diminishing Return Or Law of Variable

ProportionThe law of variable proportion

explains the input- output relation, the change in output due to addition of one variable input. This is a short run phenomenon. The short run is a period in which at least one input is fixed. Thus in the short-run, the increase in production is possible only by increasing the variable inputs. Variation is made only in one factors keeping the other factors fixed, the proportion between the fixed factors and the variable factors is varied. Hence the study is called the law of variable proportion.

The law also brings diminishing tendency in production is also known as the law of diminishing returns. It states that when at least one factor of production is fixed or factor input is fixed and when all other factors are varied, the total output in the initial stages will increase at an increasing rate, and after reaching certain level of output the total output will increase at declining rate.

If variable factor inputs are added further to the fixed factor input, the total output may decline. This Law of Returns is also called The Law of Variable proportions or The Law of Diminishing Returns

Labour TP AP MP Stages

0 0 0 0 Stage I1 10 10 102 22 11 123 33 11 11 Stage

II4 40 10 75 45 9 56 48 8 37 48 6.85 0 Stage

III8 45 5.62 –3

TP = Total ProductionAP =Average Production

MP= Marginal Production

Here both Average production and marginal production first rise reaches maximum and then decline. The total production increase at increasing rate till the employment of the 4th worker.

After that total product increase at a decreasing rate till 8th worker. The employment of 9th worker will not add any production and thereafter any addition of worker will result in decrease in total product. This is what shown in marginal products. From the above first output is an increasing rate, then increases at decreasing rate and finally decreases.

The follwing diagram explains three stages of diminishing returns. In first state total production increases at a increasing rate. The marginal product in this stage increase at an increasing rate resulting a greater increase in total production. The average product also increases. This stage continuous up to the point where average product is equal to marginal product. The law of increasing returns is in operation till this state.


MEFA NOTES

Diminishing returns starts from the second state onwards. In this stage total product increases only at a diminishing rate. The average product also decline. The second stage comes to an end where total product becomes maximum and marginal product becomes zero. The marginal production becomes negative in the third stage. So the total product also decline. The average product continues to decline.

Assumptions:

The production technology remains unchanged

Homogeneous Variable FactorsAtleast One Input is Fixed The fixed Factor is indivisible

The production technology remains unchanged:It is assumed that there is no

improvement in technology. If an improved technology is adopted then the increase in returns may be more than proportionate mix.

Homogeneous Variable Factors:

The law assumes that all the units of the variables factor are identical and exactly similar to each other. Other wise output may be increase

Atleast One Input is Fixed: The law assumes that at least one factor

of production remains constant or fixed. So increase in production can be attempted only with the variable factor

The fixed Factor is indivisible: The fixed factor remains constant. Its

capacity cannot be divided and used for some other proportion

Cause For Operation of the Law of Diminishing Returns

Wrong Combinations of inputs will give Diminishing returns

Scarcity of Certain factors like land and capital in the short run will give diminishing marginal productivity of the variable factor

Imperfect substitutes also give diminishing returns


MEFA NOTES Laws of Returns

Production function shows the relationship between the quantity of inputs and the possible output. But the laws of production deal with the relationship in the form of

Law of returns to scaleLaw of variable proportion/ Law of diminishing returns/ law of returns

Law of Return to Scale

In the long run all the factors of production are variable and an increase in output is possible by increasing all the inputs. Returns to scale implies the change in output or returns when all factors are change simultaneously in same ratio. In this law all the factors of production are changed in the same ratio.

There are three laws of returns governing production function. They are

Law of Increasing Returns to Scale

Law of Constant Returns to Scale

Law of Decreasing Returns to Scale

1. Law of Increasing Returns to ScaleThis law states that the volume of output

keeps on increasing with every increase in the input. Where given increase in factors of production results in a more than proportionate increase in output. In this first stage of production, the marginal output increases. It will explain through the following

Causes for Increasing Returns

Indivisible factorsScope for greater specializationAdvantage of increasing dimensionsExternal economies

1. Indivisible factors: Some factors of production are available

only in a certain minimum size. E. g. Suppose we have installed an electricity generating plant capable of producing one million K.W. power, even though the needs of the town is only 5000 K.W. because it id the smallest size available.

The capacity may not be utilized fully. Demand for electricity may be increased. With same plant we can produce more. No additional expenditure on plant and machinery is required. Thus, we get increasing returns where there are indivisible factors.

2. Scope for greater specialization:When the scale of production is

increased, there is scope for introduction greater specialization of labour and equipment. Work can be divided into small tasks. It increases efficiency of the factors resulting in increasing returns.

3. Advantages of increasing dimensions

Increased dimensions give rise to certain economies. E.g. the cost of constructing a double ducker bus is less than that of two single buses. So the cost of operating large and bigger machinery will be less. Thus, the economies of increased dimensions reduce costs and give rise to the law of increasing returns.

4. External Economies:External economies are those that

arise when the industry expands. Transport,


MEFA NOTES banking, insurance, Research Facilities etc. develop when the industry expands. Cost of production is reduced.

Law of Constant Returns to Scale

Increasing returns to scale do not continue indefinitely. As the firm expands production more and more, the advantages of large scale production gradually give place to disadvantages. There is a limit to the advantages of size. At certain size of production the advantages and disadvantages of large scale production balance each other and we get constant result. i.e.

Law of Decreasing Returns to ScaleConstant returns to scale are only a

passing phase. If the scale of production is increased further, diminishing returns will se in and the costs of production will rise.

They are Business may becomes unmanageableIndivisible factors may become unmanageableProblems due to supervision control and coordination will arise.

To these internal diseconomies are added external diseconomies will give diminishing returns.

Assumptions:

All the factors are variableThere are no technological changesThere is perfect competition

The output is measured in physical units

The following table and diagram will explain about law of returns to scaleFactorsC : L

TotalProduction

MarginalProduction

Stages

1:2 4 4Stage

I2:4 10 63:6 18 84:8 28 105:10 38 10 Stage

II6:12 48 107:14 56 8 Stage

III8:16 62 6

In the above table 1 acre of land and 2 labour are employed, the total product sis 4 units of paddy. When the inputs are doubled i.e. 2 acre of land and 4 labour are employed, the output of paddy is more than double i.e. 10 and marginal output goes up from 4 units to 6 units and so on. So in the first stage increasing returns will come.

Increasing returns to scale cannot be experienced by the firm indefinitely. Firms slowly enter the phase of constant returns to scale. When the input factors are increased to 5 acres of land and 10 labour then the marginal out put remain constant. Doubling in all inputs simple results in doubling the output. This is the stage of constant returns.

A firm cannot enjoy increasing returns indefinitely. Sooner or later they reach the stage of decreasing to scale which implies that proportionate increase in all inputs resulting less than proportionate increase in output. This is the third stage or the decreasing returns stage.


MEFA NOTES

Every firm experience three phase-increasing returns in the beginning then constant returns for a short period and ultimately decreasing returns to scale.

OX axis shows scale of production. OY axis Output. As the scale of production increases, up to the point C we get Increasing returns. From C to D we get Constant returns. From D onwards we get Diminishing Returns.

Law of Returns to scale are shown separately in the following diagrams in terms of Isoquants

Diagram A shows increasing Returns to scale. The output increases by 100 units from 100 to 200 and 200 to 300. But the distance between the Isoquants shortens. MN is shorter than OM and NP is shorter than MN. It means that for the given increase in output the firm has to devote less factors than before. It implies Increasing Returns

Diagram B shows Constant Returns to scale. The output increases by 100 units.

But the distance between the different Isoquants is same

Diagram C shows Diminishing Returns to scale. The output increases by 100 units. But the distance between the different Isoquants is increasing showing that more factors have to be used than before NP is greater than MN

Economies of Scale

Production may be carried on a small scale or on a large by a firm. When a firm expands its size of production by increasing all the factors, it secures certain advantages known as economies of production. These economies of large scale production have been classified by Marshall in to two kinds they are

Internal Economies:

Internal Economies are those which are opened to a single factory or a single firm independently of the action of other firms. It is based on the size of the firm and it is different for different firms.Causes for internal economies

1. Indivisibilities2. Specialisation of workers

It may be of following types

Technical EconomiesManagerial EconomiesMarketing Economies

N. DURGA CHAITANYA PRASAD M.Com, M.B.A. (SITE)

Economies

Internal Economies

External Economies

33

MEFA NOTES Financial EconomiesRisk Bearing EconomiesEconomies of ResearchEconomies of WelfareEconomies of By-productsEconomies of Labour

Technical Economies: It may be arise to a firm from the

use of better machines and superior techniques of production. As a result, production increases and the per unit cost of production falls. Another technical economy lies in the mechanical advantage is using large machines. Because the cost of operating large machines is less than that of operating large machine. Technical economies also be associated when large firm is able to utilize all its waste materials for the development of by-products.

Managerial Economies: A large firm can appoint specialists to

supervise and manage the various departments. It increases its productive efficiency.

Marketing Economies: A large fir buys material in bulk.

There it can get them at relatively lower prices. It can increase its sales by salesmanship, advertisement attractive packing etc. it can produce quality products. These are also called “Commercial Economies”

Financial Economies: A large firm can get finance easily

and even at lower rates of interest because it has large assets, properties and reputation in the society.

Risk Bearing Economies:

A large firm can produce a variety of products. It can sell the products in different markets both within the country and in foreign countries also if the products can be exported. It can purchase the materials from different sources. This is called diversification.

Diversification reduces risks. If more than one commodity is produced,, the loss on one product can be compensated by the profit on the other products. Diversification of production and marketing increases the ability of the firm to withstand losses. It will have greater stability.

Economies of Research: Large firm can establish its own research laboratory and employ trained research workers. It can thus invent new methods of production, new products etc., which will reduce costs and increase scales.

Economies of Welfare: A large firm can provide better

working conditions in and out side the factory. Facilities like subsidized canteens, crèches for the infants, recreation rooms, cheap houses, educational and medical facilities ten to increase the productive efficiency of the workers which helps in raising production and reducing costs

External Economies:Business firms enjoys a number of

external economies, which are discussed below

Economies of ConcentrationEconomies of informationEconomies of WelfareEconomies of Specilisation


MEFA NOTES Economies of Concentration:

When an industry is concentrated in a particular area, all the member firms reap some common economies like skilled labour, improved means of transport and communications, banking and financial services etc. all these factors felicities tend to lower the unit cost of production.

Economies of Information: Information centre can be set up be

large organizations which can publish a journal and passes on the information to the firms regarding the availability of raw materials, modern machines, export possibilities etc. this would help the firms in raising the productive efficiency

Economies of Welfare: Housing colonies, educational

institutions, hospitals, recreation facilities etc, can be provided to the workers by the industry, it would improve efficiency of the workers and every firm benefits from it

Economies of Specialisation: The firms in the industry can specialize in one variety of the product or in one stage of production. Such vertical and lateral specialisation reduces the costs of production of the firms and improvement of quality.

Thus internal economies depend upon the size of the firm and external economies depend upon the size of the industry


mefa notes from durga prasad navulla

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