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MICROECONOMICS
NAME: Roll no: SESSION:
DIRECTORATE OF DISTANCE EDUCATION Gomal University Dera Ismail Khan
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Microeconomics DEFINITION o !Microeconomics! The branch of economics that ana!"es the mar#et beha$ior of in%i$i%&a cons&mers an% firms in an attem't to &n%erstan% the %ecision(ma#in) 'rocess of firms an% ho&seho%s* It is concerne% +ith the interaction bet+een in%i$i%&a b&!ers an% seers an% seers an% the factors that inf&ence the choices ma%e b! b&!ers an% seers* In 'artic&ar, microeconomics foc&ses on 'atterns of s&''! an% %eman% an% the %etermination of 'rice an% o&t'&t in in%i$i%&a mar#ets -e*)* coffee in%&str!.* Deinition St&%! of the economic beha$ior of of in%i$i%&a in%i$i%&a &nits of aneconom! -s&ch as a 'erson, ho&seho%, ho&seho%, firm firm,, or in%&str!. in%&str!. an% an% not not of the a))re)ate econom! econom! -+hich -+hich is the %omain the %omain of of macroeconomics. macroeconomics.* Micr Microe oeco cono nomi mics cs is 'rim 'rimar ari i! ! conc concer erne ne% % +ith +ith the factors the factors that that affect in%i$i%&a economic choices, the choices, the effect of chan)es in chan)es in these factors on the in%i$i%&a %e %ecis cisio ion nma#ers ma#ers,, ho+ their choices are coor%inate% b! mar#ets, mar#ets, an% ho+ 'rices ho+ 'rices an% an% %eman% %eman% are are %etermine% in in%i$i%&a mar#ets* The main s&b/ects co$ere% &n%er microeconom microeconomics ics inc&%e inc&%e theor! of theor! of %eman%, %eman%, theor! of the firm, firm, an% %eman% for abor an% an% other factors factors of 'ro%&ction I" INTRODUCTION
ee# 'refi mi#ro #ro( meanin) sm sma. is a branch nch Microeconomics -from ree# of economics that that st&%ie st&%iess the beha$i beha$ior or of in%i$i in%i$i%&a %&ass an% firms in ma#in) ma#in) %ecisi %ecisions ons re)ar%in) the aocation of imit imite% e% reso& eso&rc rces es** T!'ica!, it a''ies to mar#ets+here mar#ets+here )oo%s )oo%s or or ser$ices are bo&)ht an% so%* Microeconomics eamines ho+ these %ecisions an% beha$iors affect thes&''! thes&''! an% %eman% for %eman% for )oo%s an% ser$ices, +hich %etermines 'rices, an% ho+ 'rices, in t&rn, %etermine the &antit! s&''ie% an% &antit! %eman%e% of )oo%s an% ser$ices* ne )oa of microeconomics is to ana!"e the mar#et mechanisms that estabish reati$e 'rices amon) 'rices amon) )oo%s an% ser$ices ser$ices an% aocate aocate imite% reso&rces amon) aternati$ aternati$ee &ses* Micr Microe oeco cono nomi mics cs aso aso ana ana!" !"es es mar# mar#et et fai fai&r &ree, +here mar#ets fai to 'ro%&ce efficient 'ro%&ce efficient res&t res&ts, s, an% %escri %escribes bes the theore theoretic tica a con%it con%ition ionss nee%e% nee%e% for 'erfect for 'erfect com'etition* Si)nificant com'etition* Si)nificant fie%s of st&%! in microeconomics inc&%e )enera inc&%e )enera e&iibri&m, mar# mar#et etss &n% &n%er er as!mme as!mmetr tric ic inform informati ation on,, choice &n%er %er &ncertaint! an% an% econ econom omic ic a''icatio a''ications ns of )ame of )ame theor! theor!* Aso Aso cons consi% i%er ere% e% is the the easticit! of 'ro%&c 'ro%&cts ts +ithin +ithin the mar#et s!stem* Ass#m$tions an% %einitions
Microeconomic theor! t!'ica! be)ins +ith the st&%! of a sin)e rationa an% &tiit! an% &tiit! maimi"in) in%i$i in%i$i%&a %&a* * To economi economists sts,, rationait! mean meanss an in%i in%i$i $i%& %&a a 'oss 'osses esse sess stabe 'references stabe 'references that are both com'ete both com'ete an% an% transiti$e* transiti$e* The techni technica ca ass&m' ass&m'tio tion n that that 'reference reations are contin&o&s is contin&o&s is nee%e% to ens&re the eistence of a&tiit! a&tiit! f&nction* f&nction* Ath Atho& o&)h )h micr microe oeco conom nomic ic theo theor! r! can can cont contin in&e &e +ith +itho&t o&t this this ass& ass&m' m'ti tion on,, it +o& +o&% %
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ma#e com'arati$e statics im'ossibe since there is no )&arantee that the res&tin) &tiit! f&nction +o&% be %ifferentiabe* %ifferentiabe* Microeconomic theor! 'ro)resses b! %efinin) a com'etiti$e b&%)et set +hich set +hich is a s&bset of the cons&m'tion set* set* It is at this 'oint that economists ma#e the technica ass&m'tion that 'references are oca! non(satiate%* 5itho&t the ass&m'tion of LS -oca non( satiation. there is no )&arantee that a rationa in%i$i%&a +o&% maimi"e &tiit!* &tiit!* 5ith the necessar! toos an% ass&m'tions in 'ace the &tiit! &tiit! maimi"ati maimi"ation on 'robem 'robem -UM. is -UM. is %e$eo'e%* The &ti The &tiit it! ! mai maimi mi"a "ati tion on 'rob 'robe em m is the the hear heartt of cons&me cons&merr theor! theor!** Th Thee &ti &tiit it! ! maim maimi"at i"ation ion 'robe 'robem m attem't attem'tss to e'ai e'ain n the action action aiom b! im'osin) im'osin) rationait rationait! ! aioms on cons&mer 'references an% then mathematica! mo%ein) an% ana!"in) the conse&ences* The &tiit! maimi"ation 'robem ser$es not on! as the mathematica fo&n%ation of cons&mer theor! b&t as a meta'h!sica e'anation of it as +e* That is, the &tiit! maimi"ation 'robem is &se% b! economists to no t on! e'ain +hat or ho+ in%i$i%&as ma#e choices b! +h! in%i$i%&as ma#e choices ch oices as +e* The &tiit! maimi"ation 'robem is a constraine% o'timi"ation 'robem o'timi"ation 'robem in +hich an in%i$i in%i$i%&a %&a see#s see#s to maimi maimi"e "e &tiit &tiit! ! s&b s&b/ec /ectt to a b&%)et b&%)et constraint constraint** 8conom 8conomist istss &se the etrem etremee $a&e $a&e theore theorem m to )&arant )&arantee ee that that a so&ti so&tion on to the &tiit &tiit! ! maimi maimi"at "ation ion 'robem eists* That is, since the b&%)et the b&%)et constraint is constraint is both bo&n%e% an% cose%, a so&tion to the &tiit! maimi"ation 'robem eists* 8conomists ca the so&tion to the &tiit! maimi"ation 'robem a 5arasian %eman% f&nction or f&nction or corres'on%ence* The theor! of s&''! s&''! an% %eman% &s&a! %eman% &s&a! ass&mes that mar#ets are 'erfect! are 'erfect! com'etiti$e* com'etiti$e* This im'ies that there are man! b&!ers an% seers in the mar#et an% none of them ha$e the ca'acit! to si)nificant! inf&ence 'rices of )oo%s an% ser$ices* This is st&% This st&%ie ie% % in the the fie fie% % of coe of coecti$e cti$e action action an% '&bic an% '&bic choice theor!* theor!* 'tim 'tima a +ef +efar are e &s&a &s&a! ! ta#e ta#ess on a aretian norm, norm, +hich +hich is a mathem mathemati atica ca a''ic a''icati ation on of the a%o a%or: r:Hi Hic#s c#s meth metho% o%** This can %i$er)e from the Utiitarian )oa of maimi"in)&tiit! maimi"in)&tiit! beca&se beca&se it %oes not consi%er the %istrib&tion of )oo%s bet+een 'eo'e* Mar#et fai&re in 'ositi$e economics -microeconomics. is imite% in im'ications +itho&t miin) the beief of the economist an% their theor!* theor!* Im$ortance an% Si&niicance o Microeconomics
The st&%! of Microeconomic theor! he's in foo+in);
Un%e Un%erst rstan% an%in in& & o$er o$erati ation on o econ econom omy y at a micr micro o level level ( The st&%! of Microe Microecono conomic micss he's he's &s in &n%erst &n%erstan%i an%in) n) $ario& $ario&ss mar#et mar#et sit&at sit&ation ionss +hich +hich are 'ossibe in an! econom!* It he's in &n%erstan%in) the economic reasons behin% the %ecisions i#e : 5hat to ro%&ce< =or +hom to 'ro%&ce< Ho+ m&ch to ro%&ce< etc* O$timi'ation o reso#rce allocation ( The st&%! of Microeconomics he's in &n%e &n%ers rsta tan% n%in in) ) that that ho+ ho+ a firm firm or an in%& in%&st str! r! etc etc can can mai maimi mi"e "e its its 'ro% 'ro%&ct &ctio ion n efficienc! an% the 'rofit b! a''ro'riate aocation an% &tii"ation of reso&rces at its %is'osa*
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Minimi'ation o Cost ( The st&%! of Microeconomics he's in the %etermination of o'tim&m 'ro%&ction 'oint for a firm>in%&str!*The theor! aso he's in %eterminin) the 'oint of cost minimi"ation for a firm Un%erstan%in& Cons#mer (ehavio#r ( The st&%! of Mar)ina Utiit! theor!, ?e$eae% reference H!'othesis, @ons&mer In%ifferance c&r$es etc )i$e &sef& insi)ht into cons&mer beha$io&r an% th&s he' in &n%erstan%in) an% 're%ictin) the cons&mer beha$io&r in $arie% mar#et sit&ations* Deman% Forecastin& ( The theor! of Deman% an% Deman% ana!sis, easticit! of %eman% etc he' in &n%erstan%in) an% 're%ictin) %eman% of a 'ro%&ct* Im$act o chan&e in )rice*Income*)rices o relate% &oo%s etc on the %eman% o a )ro%#ct ( The st&%! of Microeconomic theor! can he' an in%i$i%&a firm to &n%erstan% the im'act of chan)e in 'rice, income, 'rices of reate% )oo%s etc on the %eman% the )oo% or ser$ice +hich the firm is offerin) to the mar#et* Government )olicy Ma+in& ( The st&%! of %eman% theor!, s&''! theor!, mar#et theor! etc can he' the )o$ernment in 'oic! ma#in) at macro e$e* =or eam'e the st&%! of microeconomic theor! can he' in %eci%in) a''ro'riate ta 'oic!, 'ricin) 'oic! of the '&bic )oo%s an% ser$ices, im'act of ta 'oic! in re%&cin) ine&ait! of income an% +eath etc Forei&n tra%e an% e,chan&e rate %etermination ( Microeconomic theor! of %eman%, s&''!, easticit! of %eman% etc he' in &n%erstan%in) the im'act of chan)e in tariff on the terms of tra%e* Simiar!, microeconomic theor! of %eman%,s&''! etc he's in &n%erstan%in) the echan)e rate %etermination 'rocess in the forei)n echan)e mar#et* Ma,imisation o Social -elare ( The st&%! of Microeconomic theor! can he' in %eci%in) the a''ro'riate aocation of reso&rces, commo%ities an% o&t'&t mi for the maimi"ation of the socia +efare*
A$$lie% microeconomics
A''ie% microeconomics inc&%es a ran)e of s'eciai"e% areas of st&%!, man! of +hich %ra+ on metho%s from other fie%s*In%&stria or)ani"ation eamines to'ics s&ch as the entr! an% eit of firms, inno$ation, an% the roe of tra%emar#s* Labor economics eamines +a)es, em'o!ment, an% abor mar#et %!namics* =inancia economics eamines to'ics s&ch as the str&ct&re of o'tima 'ortfoios, the rate of ret&rn to ca'ita, econometric ana!sis of sec&rit! ret&rns, an% cor'orate financia beha$ior* &bic economics eamines the %esi)n of )o$ernment ta an% e'en%it&re 'oicies an% economic effects of these 'oicies -e*)*, socia ins&rance 'ro)rams.* oitica econom! eamines the roe of 'oitica instit&tions in %eterminin) 'oic! o&tcomes* Heath economics eamines the or)ani"ation of heath care s!stems, inc&%in) the roe of the heath care +or#force an% heath ins&rance 'ro)rams* Urban economics,
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+hich eamines the chaen)es face% b! cities, s&ch as s'ra+, air an% +ater 'o&tion, traffic con)estion, an% 'o$ert!, %ra+s on the fie%s of &rban )eo)ra'h! an% socioo)!* i. -ants an% Scarcity
A basic con%ition of h&man eistence +hich means that 'eo'e are ne$er tota! satisfie% +ith the &antit! an% $ariet! of )oo%s an% ser$ices the cons&me* It means that 'eo'e ne$er )et eno&)h, that thereBs a+a!s somethin) ese that the! +o&% +ant or nee%* Unimite% +ants an% nee%s are one haf of the f&n%amenta 'robem of scarcit! that has 'a)&e% h&manit! since the be)innin) of time* The other haf of the scarcit! 'robem is imite% reso&rces* Unimite% +ants an% nee%s essentia! means that 'eo'e ne$er )et eno&)h, that there is a+a!s somethin) ese that the! +o&% i#e to ha$e* =or eam'e, once D&ncan Th&r! eats a heart! brea#fast of 'anca#es an% sa&sa)e, is he satisfie%< erha's* C&t then in a co&'e of ho&rs he +ants a t&na saa% san%+ich for &nch* Then he +ants in)&ini +ith afre%o sa&ce an% botte of @hianti for %inner* An% then +ants a be%time snac# of chocoate chi' coo#ies an% mi#* Cefore on), the mornin) s&n 'o's &' an% D&ncan is h&n)r!* It is brea#fast time a o$er a)ain* &ite ob$io&s!, no one 8E8? 'ermanent! satisfies that o% h&n)er nee%* 5hat abo&t other nee%s, i#e cothin), cars, or #itchen a''iances* nce D&ncan has a car, then he HAS a car an% his car nee% is satisfie%, ri)ht< The same can be sai% for other )oo%s, ri)ht< nce D&ncan has a can o'ener, then his can(o'ener nee% is satisfie%, ri)ht< This seems to im'! that, in 'rinci'e, D&ncan co&% obtain e$er! )oo% that satisfies his assorte% +ants an% nee%s* erha's* C&t once he has a car, then he nee%s )asoine, an% motor oi, an% ins&rance, an% f&""! %ice to han) from the rear $ie+ mirror, an% more )asoine, an% ne+ tires, an% an oi chan)e, an% more )asoine, an%*** the ist of nee%s )oes on* -ants or Nee%s
To &n%erstan% +h! +ants an% nee%s are &nimite%, consi%er the 'hrase +ants an% nee%s* 5ants an% nee%s is the term for*** +e*** +antin) an% nee%in) thin)s* H&man 'eo'e +ant some thin)s i#e hot f&%)e s&n%aes an% re% s'orts cars* H&man 'eo'e nee% other thin)s i#e foo%, +ater, an% o!)en* ee%s; ee%s are best tho&)ht of as 'h!sioo)ica or bioo)ica re&irements for maintainin) ife, s&ch as the nee% for air, +ater, foo%, sheter, an% see'* 5ants; 5ants are then the 's!choo)ica %esires that are not essentia for ife b&t that ma#e ife /&st a itte more en/o!abe*
Satisaction
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o+, consi%er the 'rocess of f&fiin) +ants an% nee%s* Satisfaction is the 'rocess of s&ccessf&! f&fiin) +ants an% nee%s* 5hether a )oo% is +ante% or nee%e%, it 'ro$i%es satisfaction* @onsi%er the sim'e 'rocess of cons&min) a hot f&%)e s&n%ae;
D&ncan Th&r! has a cra$in) for a hot f&%)e s&n%ae* D&ncan eats a hot f&%)e s&n%ae* D&ncan no on)er cra$es a hot f&%)e s&n%ae* D&ncan has been satisfie%, at east as far as his hot f&%)e s&n%ae %esire is concerne%*
Motivation
The $ast n&mber of &nsatisfie% +ants an% nee%s is im'ortant beca&se it 'ro$i%es 'eo'e +ith the moti$ation to ta#e action* Cein) h&n)r! in the mornin) moti$ates D&ncan to +hi' &' some 'anca#es an% sa&sa)e* Cein) h&n)r! before be%time moti$ates D&ncan to see# o&t chocoate chi' coo#ies* Simiar moti$ations eist for &nch an% %inner* D&ncan b&!s a car beca&se he nee%s to tra$e, D&ncan b&!s a can(o'ener beca&se he nee%s to o'en cans, D&ncan b&!s cothin) beca&se he nee%s 'rotection from the +eather an% %oes not +ant to hear 'eo'e snic#er +hen he 'asses b! +earin) nothin) b&t san%as an% a baseba ca'* =or economics, the '&rs&it of satisfaction, the act of satisf!in) +ants an% nee%s, is etreme! im'ortant* It moti$ates 'eo'e to ta#e action, to b&! )oo%s, to +or#, to 'ro%&ce, to cons&me* D&ncan is moti$ate% to b&! a hot f&%)e s&n%ae beca&se he +ants a hot f&%)e s&n%ae* Ho+e$er, beca&se +ants an% nee%s are &nimite%, so too is his moti$ation to ta#e action* Alternatives
ne of the most im'ortant as'ects of &nimite% +ants an% nee%s is not so m&ch the 'hioso'hica &estion +hether or not +ants an% nee%s are &timate! imite% or &nimite%, b&t the 'ra)matic obser$ation that the n&mber of &nsatisfie% +ants an% nee%s is so $ast that aternati$es r&n ram'ant* Usin) reso&rces to satisf! D&ncanBs car nee%, for eam'e, means that his can(o'ener nee%, his co&sinBs cothin) nee%, an% a $ast n&mber of aternati$e nee%s remain &nsatisfie%* DEFINITION o !Scarcity! Scarcit! refers to the basic economic 'robem, the )a' bet+een imite% : that is, scarce : reso&rces an% theoretica! imitess +ants* This sit&ation re&ires 'eo'e to ma#e %ecisions abo&t ho+ to aocate reso&rces efficient!, in or%er to satisf! basic nee%s an% as man! a%%itiona +ants at 'ossibe* An! reso&rce that has a non("ero cost to cons&me is scarce to some %e)ree, b&t +hat matters in 'ractice is reati$e scarcit!* ii. F#nctions o Economic System
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There are fo&r 'rimar! t!'es of economic s!stems in the +or%; tra%itiona, comman%, mar#et an% mie%* 8ach econom! has its stren)ths an% +ea#nesses, its s&b(economies an% ten%encies, an%, of co&rse, a tro&be% histor!* Ceo+ +e eamine each s!stem in t&rn an% )i$e am'e attention to the attrib&tes iste% abo$e* ItFs im'ortant to &n%erstan% ho+ %ifferent 'arts of the +or% f&nction economica!, as the econom! is one of the stron)est forces +hen it comes to baancin) 'oitica 'o+er, insti)atin) +ar an% %ei$erin) a hi)h -or o+. &ait! of ife to the 'eo'e it ser$es* An!one intereste% in economics on a )oba e$e sho&% chec# o&t this fantastic co#rse on the crisis o ca$italism an% /hy the &lo0al economy is teeterin& on the ver&e o colla$se" 1" Tra%itional Economic System
A tra%itiona economic s!stem is the best 'ace to start beca&se it is, &ite itera!, the most tra%itiona an% ancient t!'e of econom! in the +or%* There are certain eements of a tra%itiona econom! that those in more a%$ance% economies, s&ch as Mie%, +o&% i#e to see ret&rn to 'rominence* -here Tra%ition Is Cherishe%: Tra%itiona economies sti 'ro%&ce 'ro%&cts an% ser$ices that are a %irect res&t of their beiefs, c&stoms, tra%itions, rei)ions, etc* East 'ortions of the +or% sti f&nction &n%er a tra%itiona economic s!stem* These areas ten% to be r&ra, secon%( or thir%(+or%, an% cose! tie% to the an%, &s&a! thro&)h farmin)* Ho+e$er, there is an increasin)! sma 'o'&ation of noma%ic 'eo'es, an% +hie their economies are certain! tra%itiona, the! often interact +ith other economies in or%er to se, tra%e, barter, etc* Learn abo&t the com'eities of )obai"ation an% ho+ it sha'es economic reationshi's an% affects c&t&res +ith this &reat class on the &eo&ra$hy o &lo0ali'ation" Minimal -aste: Tra%itiona economies +o&% ne$er, e$er, in a miion !ears see the t!'e of 'rofit or s&r'&s that res&ts from a mar#et or mie% econom!* In )enera, s&r'&s is a rare thin)* A thir%(+or% an%>or in%i)eno&s co&ntr! %oes not ha$e the reso&rces necessar! -or if the! %o, the! are controe% b! +eathier economies, often b! force., an% in man! cases an! s&r'&s is either %istrib&te%, +aste%, or 'ai% to some a&thorit! that has been )i$en 'o+er* A%vanta&es An% Disa%vanta&es: @ertain! one of the most ob$io&s a%$anta)es is that tra%ition an% c&stom is 'reser$e% +hie it is $irt&a! non(eistant in mar#et>mie% economies* There is aso the fact that each member of a tra%itiona econom! has a more s'ecific an% 'rono&nce% roe, an% these societies are often $er! cose(#nit an% socia! satisfie%* The main %isa%$anta)e is that tra%itiona economies %o not en/o! the thin)s other economies ta#e for )rante%; 5estern me%icine, centrai"e% &tiities, technoo)!, etc* C&t as an!one in America can attest, these thin)s %o not )&arantee ha''iness, 'eace, socia or, most ironica! of a, economic stabiit!* 2" Comman% Economic System
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In terms of economic a%$ancement, the comman% economic s!stem is the net ste' &' from a tra%itiona econom!* This b! no means in%icates that it is fairer or an eact im'ro$ement there are man! thin)s f&n%amenta! +ron) +ith a comman% econom!* Centrali'e% Control: The most notabe feat&re of a comman% econom! is that a ar)e 'art of the economic s!stem is controe% b! a centrai"e% 'o+er often, a fe%era )o$ernment* This #in% of econom! ten%s to %e$eo' +hen a co&ntr! fin%s itsef in 'ossession of a $er! ar)e amo&nt of $a&abe reso&rce-s.* The )o$ernment then ste's in an% re)&ates the reso&rce-s.* ften the )o$ernment +i o+n e$er!thin) in$o$e% in the in%&stria 'rocess, from the e&i'ment to the faciities*
Intereste% in earnin) @=A certification< et a the trainin) !o& nee% from this CFA 3evel 1 Economics c#rric#l#m" S#$$ose% A%vanta&es: o& can see ho+ this #in% of econom! +o&%, o$er time, create &nrest amon) the )enera 'o'&ation* C&t there are act&a! se$era 'otentia a%$anta)es, as on) as the )o$ernment &ses intei)ent re)&ations* =irst of a, a comman% econom! is ca'abe of creatin) a heath! s&''! of its o+n reso&rces an% it )enera! re+ar%s its o+n 'eo'e +ith affor%abe 'rices -b&t beca&se it is &timate! re)&ate% b! the )o$ernment, it is &timate! 'rice% b! the )o$ernment.* Sti, there is often no shorta)e of /obs as the )o$ernment f&nctions simiar! to a mar#et econom! in that it +ants to )ro+ an% )ro+ &'on its 'o'&ace* 4an% In The Coo+ie 5ar: Interestin)! : or ma!be, 're%ictab! : the )o$ernment in a comman% econom! on! %esires to contro its most $a&abe reso&rces* ther thin)s, i#e a)ric&t&re, are eft to be re)&ate% an% r&n b! the 'eo'e* This is the nat&re of a comman% econom! an% man! comm&nist )o$ernments fa into this cate)or!*
o& sho&% aso consi%er this micro an% macro economics $ro&ram" ItFs been a''ro$e% b! the @=A instit&te an% foc&ses on the im'act of economic $ariabes on the financia mar#et an% in%&str!* 6" Mar+et Economic System
A mar#et econom! is $er! simiar to a free mar#et* The )o$ernment %oes not contro $ita reso&rces, $a&abe )oo%s or an! other ma/or se)ment of the econom!* In this +a!, or)ani"ations r&n b! the 'eo'e %etermine ho+ the econom! r&ns, ho+ s&''! is )enerate%, +hat %eman%s are necessar!, etc* Ca$italism An% Socialism: o tr&! free mar#et econom! eists in the +or%* =or eam'e, +hie America is a ca'itaist nation, o&r )o$ernment sti re)&ates -or attem'ts to re)&ate. fair tra%e, )o$ernment 'ro)rams, mora b&siness, mono'oies, etc* etc* The a%$anta)e to ca'itaism is !o& can ha$e an e'osi$e econom! that is $er! +e controe% an% reati$e! safe* This +o&% be contraste% to sociaism, in +hich the )o$ernment -i#e a comman% econom!. contros an% o+ns the most 'rofitabe an% $ita in%&stries b&t ao+s the rest of the mar#et to o'erate free! that is, 'rice is ao+e% to
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f&ct&ate free! base% on s&''! an% %eman%* If !o& +ant to #no+ ho+ the )oba econom! +or#s an% the roe !o& 'a! in it, chec# o&t this s/eet class on Economics -itho#t (o#n%aries" Mar+et Economy An% )olitics: Ar)&ab! the bi))est a%$anta)e to a mar#et econom! -at east, o&tsi%e of economic benefits. is the se'aration of the mar#et an% the )o$ernment* This 're$ents the )o$ernment from becomin) too 'o+erf&, too controin) an% too simiar to the )o$ernments of the +or% that o''ress their 'eo'e +hie i$in) a$ish! on controe% reso&rces* In the same +a! that se'aration of ch&rch an% state has been to $ita to AmericaFs socia s&ccess, so has a se'aration of mar#et an% state been $ita to o&r economic s&ccess* es, there is somethin) +ar! abo&t a s!stem +hich to be s&ccessf& m&st foster constant )ro+th, b&t as a res&t 'ro)ress an% inno$ation ha$e occ&rre% at s&ch incre%ibe rates as to affect the +a! the +or% econom! f&nctions* 7" Mi,e% Economic System
A mie% economic s!stem -aso #no+n as a D&a 8conom!. is /&st i#e it so&n%s -a combination of economic s!stems., b&t it 'rimari! refers to a mit&re of a mar#et an% comman% econom! -for ob$io&s reasons, a tra%itiona econom! %oes not t!'ica! mi +e.* As !o& can ima)ine, man! $ariations eist, +ith some mie% economies bein) 'rimari! free mar#ets an% others bein) stron)! controe% b! the )o$ernment* Learn more abo&t an essentia 'art of o&r econom! +ith this ree $ost on #n%erstan%in& the stoc+ mar+et" (eneits O A Mi,e% Economy: In the most common t!'es of mie% economies, the mar#et is more or ess free of )o$ernment o+nershi' ece't for a fe+ #e! areas* These areas are &s&a! not the reso&rces that a comman% econom! contros* Instea%, as in America, the! are the )o$ernment 'ro)rams s&ch as e%&cation, trans'ortation, USS, etc* 5hie a of these in%&stries aso eist in the 'ri$ate sector in America, this is not a+a!s the case for a mie% econom!* Disa%vanta&es O A Mi,e% Economy: 5hie a mie% econom! can ea% to incre%ibe res&ts -America bein) the ob$io&s eam'e., it can aso s&ffer from simiar %o+nfas fo&n% in other economies* =or eam'e, the ast h&n%re% !ears in America has seen a rise in )o$ernment 'o+er* ot /&st in im'osin) a+s an% re)&ations, b&t in act&a! )ainin) contro, becomin) more %iffic&t to access +hie sim&taneo&s! becomin) ess feibe* This is a common ten%enc! of mie% economies* )lease Res$ect The Thin 3ine: A c&rrent, 'i$ota %ebate bet+een Democrats an% ?e'&bicans is the amo&nt of )o$ernmenta contro* @an a tr&e baance eist< 5here sho&% there be more )o$ernment re)&ation< 5here sho&% there be ess< These &estions ha$e no rea ans+er it is s&b/ecti$e, an% therefore on! a reati$e! sma 'ortion of the 'o'&ation +i, at an! )i$en time, a)ree +ith the state of a mie% econom!* It m&st be a stron) form of )o$ernment in%ee% to a$oi% coa'sin) &n%er this constant 'ress&re*
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iii. Micro economic Theory an% the )rice System
The theor! that +e st&%! in this boo# ma#es &' the core of economic theor!, b&t b! no means eha&sts it* 5e in$esti)ate here the str&ct&re an% o'eration of a mar#et econom! in its broa%est theoretica o&tine an% it is +ithin this )enera bo%! of theor! that most other branches of economic theor! fin% their 'ace* 5e are 'ro$isiona! abe to refrain from 'a!in) attention to these other branches of theor! on! b! %rastica! sim'if!in) the h!'othetica mar#et econom! +e %ea +ith* nce the theor! of the sim'ifie% mar#et 'rocess has been mastere%, then more com'e an% 'artic&ar mar#et sit&ations can be %eat +ith b! o)ica etensions of the theor!* In o&r st&%!, for eam'e, +e i)nore the 'ossibiit! of tra%e bet+een t+o se'arate mar#et economies +e therefore %o not st&%! the theor! of internationa tra%e +ith its im'act on the mar#et 'rocess +ithin each co&ntr!* A)ain, in o&r st&%!, +e amost com'ete! i)nore the s'ecia roe 'a!e% b! the )o$ernment as an economic a)ent +e therefore %o not st&%! the theor! of '&bic finance an% the mo%ifications bro&)ht abo&t in the mar#et 'rocess b! )o$ernmenta taation, e'en%it&res, or %ebt* 5e %o not consi%er, in o&r st&%!, the n&mero&s com'eities that are intro%&ce% into the mar#et 'rocess b! the $ario&s 'ossibe instit&tions connecte% +ith mone! +e therefore %o not st&%! monetar! theor!*In the same +a! J12K -an% 'art! as a res&t of these sim'ifications. +e %o not consi%er the 'ossibiit! that mar#et forces mi)ht arise that can %isr&'t 'erio%ica! the smooth o'eration of the mar#et 'rocess in other +or%s +e i)nore the necessit! to constr&ct a theor! of the tra%e c!ce an% so on* In o&r st&%!, therefore, +e constr&ct the theoretica frame+or# +ithin +hich a as'ects of the economic theor! of a mar#et econom! m&st be set* 5e foo+ thro&)h the f&n%amenta mar#et forces &'on +hich an% thro&)h +hich the im'act of an! s'ecia, a%%itiona economic forces +i be fet* The theoretica attac# &'on an! 'artic&ar economic 'robem in the mar#et m&st then be carrie% o&t a)ainst the bac#)ro&n% of this )enera an% +i%e! acce'te% theor! of the mar#et* )rice system8 )rice system8 a means of or)ani"in) economic acti$it!* It %oes this 'rimari! b! coor%inatin) the %ecisions of cons&mers, 'ro%&cers, an% o+ners of 'ro%&cti$e reso&rces* Miions of economic a)ents +ho ha$e no %irect comm&nication +ith each other are e% b! the 'rice s!stem to s&''! each otherFs +ants* In a mo%ern econom! the 'rice s!stem enabes a cons&mer to b&! a 'ro%&ct he has ne$er 're$io&s! '&rchase%, 'ro%&ce% b! a firm of +hose eistence he is &na+are, +hich is o'eratin) +ith f&n%s 'artia! obtaine% from his o+n sa$in)s*
rices are an e'ression of the consens&s on the $a&es of %ifferent thin)s, an% e$er! societ! that 'ermits echan)es bet+een 'eo'e has 'rices* Ceca&se 'rices are e'resse% in terms of a +i%e! acce'tabe commo%it!, the! 'ermit a rea%! com'arison of the com'arati$e $a&es of $ario&s commo%itiesif shoes are 1 'er 'air an% brea% 30 cents 'er oaf, a 'air of shoes is +orth 0 oa$es of brea%* The 'rice of an!thin) is its $a&e in
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echan)e for a commo%it! of +i%e acce'tabiit!; the 'rice of an a&tomobie ma! be some 0 o&nces of )o% or 2 'ieces of 'a'er c&rrenc!* -See aso mone!*. A s!stem of 'rices eists beca&se in%i$i%&a 'rices are reate% to each other* If, for eam'e, co''er ro%s cost 40 cents a 'o&n% an% the 'rocess of %ra+in) a ro% into +ire costs 2 cents a 'o&n%, then it +i be 'rofitabe to 'ro%&ce +ire from a co''er ro% if its 'rice ecee%s 6 cents* @on$erse!, it +i be &n'rofitabe to 'ro%&ce +ire if its 'rice fas beo+ 6 cents* @om'etition +i ho% the 'rice of +ire abo&t 2 cents 'er 'o&n% abo$e that of ro%s* A $ariet! of s&ch economic forces tie the entire str&ct&re of 'rices to)ether* The 0asic #nctions o economic systems
8$er! economic s!stem 'ro$i%es so&tions to fo&r &estions; +hat )oo%s an% ser$ices +i be 'ro%&ce% ho+ the! +i be 'ro%&ce% for +hom the! +i be 'ro%&ce% an% ho+ the! +i be aocate% bet+een cons&m'tion -for 'resent &se. an% in$estment -for f&t&re &se.* In a %ecentrai"e% -&s&a! 'ri$ate enter'rise. economic s!stem, these &estions are reso$e%, an% economic coor%ination is achie$e%, thro&)h the 'rice mechanism* )ro%#ct an% 9#antity
8$en the sim'er econom! of a tra%itiona societ! m&st choose bet+een foo% an% sheter, +ea'ons an% toos, or 'riests an% h&nters* In a mo%ern econom! the 'otentia $ariet! of )oo%s an% ser$ices that ma! be 'ro%&ce% is immense* @onsi%er, for eam'e, the tho&san%s of ne+ boo# tites that are '&bishe% each !earor the h&n%re%s of coo&rs of 'aint or the tho&san%s of st!es of cothin) that are bro&)ht to the mar#et ann&a!* 8ach of these act&a coections is m&ch smaer than the amo&nt that co&% be 'ro%&ce%* A 'rice s!stem +ei)hs the %esires of cons&mers in terms of the 'rices the! are +iin) to 'a! for $ario&s &antities of each commo%it! or ser$ice* The 'a!ment for the ser$ices of a s#ie% s&r)eon -a 'rice m&ch inf&ence% b! the n&mber of s&r)eons. refects the &ni&e nat&re of those s#is for the b&!er('atient, +hereas the 'rice of an eectric 'o'corn 'o''er refects the minor con$enience it 'ro$i%es* f co&rse, the amo&nt cons&mers a)ree to 'a! +i be inf&ence% b! their +eath as +e as their %esires, b&t for an! sin)e cons&mer, reati$e %esire is 'ro'ortiona to the 'rice offere%* )ro%#ction
The secon% &estion an econom! m&st ans+er in$o$es %eci%in) ho+ the %esire% )oo%s are to be 'ro%&ce%* There is more than one +a! to )ro+ +heat, train a+!ers, refine 'etroe&m, an% trans'ort ba))a)e* The efficient 'ro%&ction of )oo%s an% ser$ices re&ires that certain f&n%amenta r&es be foo+e%; no reso&rce sho&% be &se% in 'ro%&cin) one thin) +hen it co&% be 'ro%&cin) somethin) more $a&abe ese+here, an% each 'ro%&ct sho&% be ma%e +ith the smaest('ossibe amo&nt of reso&rces* A f&nctionin) 'rice s!stem in%&ces a 'artici'ants in the econom! to steer their reso&rces to+ar% acti$ities that !ie% a re+ar%* Nobs that 'a! a hi)h 'rice for abo&r +i attract +or#ers see#in) the re+ar% of a hi)h saar!* @ro's that !ie% a )reater 'rofit +i attract
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more farmers to c&ti$ate them* Simiar!, ca'ita +i be %ra+n from a faterin) tra%e an% re%irecte% to an in%&str! +here it can earn hi)her ret&rns* This same 'rice s!stem see#s to achie$e 'ro%&ction efficienc! thro&)h com'etition* If one firm, for instance, can %esi)n, 'ro%&ce, an% %istrib&te shoes +hie &sin) fe+er reso&rces than its ri$as, it +i ma#e ar)er 'rofits it is therefore moti$ate% to %isco$er more efficient combinations of in'&ts an% 'ant ocations, to %e$ise +a)e s!stems to stim&ate its +or#ers, to &se com'&ters to mana)e in$entories an% streamine shi''in), an% so forth* Distri0#tion
The thir% &estion an econom! ans+ers in$o$es %eterminin) +ho )ets the 'ro%&ct* =or eam'e, if fami! A ac&ires ,000 +orth of )oo%s this !ear an% fami! C recei$es fi$e times as m&ch, ho+ is this %i$ision to be %eci%e%< The incomes of in%i$i%&as are %etermine% b! the &antities of reso&rces -abo&r s#is, ca'ita in a its forms. the! o+n an% the 'rices the! recei$e for the &se of these reso&rces* 5or#ers are enco&ra)e% b! the 'rice s!stem to ac&ire ne+ s#is an% to eercise them %ii)ent!, an% famiies are enco&ra)e% to sa$e -ca'ita acc&m&ation. beca&se of the re+ar%s 'ai% as interest or %i$i%en%s* Inherite% abiit! an% +eath aso contrib&te to the %istrib&tion of income* If the 'rice s!stem is +or#in) reasonab! +e -some of the common fai&res +i be note% ater., it 'erforms a of these economic f&nctions +ith remar#abe s&btet! an% 'recision* Societ! %esires not on! the correct amo&nt of +heat b&t aso that it be cons&me% more or ess e$en! o$er the cro' !ear, +ith a s&r'&s to carr! o$er in case of a 'artia fai&re of the net !earFs cro'* The 'rice s!stem 'ro$i%es a seasona 'rice 'attern that enco&ra)es the ho%in) of in$entories rather than ear! s'&r)in) an% rich! re+ar%s s'ec&ators +ho correct! antici'ate a cro' fai&re an% ho% )rain that +i ae$iate it* In the same +a!, the %esires of e$er! si"abe )ro&' of cons&mers -or reso&rce o+ners. are re)istere% thro&)h the 'rice s!stem entre'rene&rs are incite% b! 'rice offers to 'ro$i%e o'era an% m&sica come%!, #osher foo%, an% ersian %eicacies* The /or+in&s o the $rice system
The com'eit! an% $ariet! of tas#s 'erforme% b! the 'rice s!stem +i be i&minate% b! an eamination of three s'ecific economic 'robems* The choice o occ#$ation
In%i$i%&as m&st be %istrib&te% amon) occ&'ations in s&ch a +a! as to ser$e t+o basic '&r'oses* =irst, the abo&rer m&st be 'ace% +here he is most 'ro%&cti$ema#in) certain that 8nrico =ermi becomes a 'h!sicist rather than a chef an% that there are not too man! '&mbers an% too fe+ eectricians* Secon%, the in%i$i%&a +or#er sho&% be )i$en an occ&'ation that is con)enia to him since he +i s'en% a ar)e 'art of his ife at +or#, it +i be a better ife if he can choose the t!'e he 'refers* The 'rice of abo&r is the instr&ment b! +hich +or#ers are %istrib&te% amon) occ&'ations; +a)es in ra'i%! )ro+in) occ&'ations an% ra'i%! )ro+in) 'arts of the
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nation are hi)her than in corres'on%in) em'o!ment in %ecinin) occ&'ations an% areas* The choice of occ&'ation in$o$es, ho+e$er, m&ch more than sim'! a com'arison of +a)e rates* The foo+in) are a fe+ of the com'ications; -1. The +a)es of an occ&'ation m&st as a r&e be s&fficient to com'ensate the costs of trainin)* -2. The +a)es of an occ&'ation m&st be s&fficient to com'ensate s'ecia %isa%$anta)es -s&ch as a ar)e chance of &nem'o!ment.* -3. 5a)es m&st be hi)her in ar)e cities than in sma beca&se i$in) costs are hi)her in ar)e cities* -4. 5a)es m&st com'ensate +or#ers for their a%%itiona s#i as the! ac&ire e'erience -the! &s&a! reach a 'ea# of earnin)s bet+een a)es 40 an% . an% thereafter %ecine as the +or#erFs efficienc! %ecines* -. 5a)es +i refect %ifferences in taation, frin)e benefits -'ensions, $acations., etc* Accor%in)!, the +a)e str&ct&re e$en for a sin)e occ&'ation in a sin)e cit! is eaborate* 5hen a sin)e +a)e -'rice. is im'ose% &'on an occ&'ation, abo&rers are no on)er 'ro'er! %istrib&te% b! +a)es for eam'e, a cit! schoo s!stem that 'a!s a teachers of )i$en e'erience the same +a)e fin%s it %iffic&t to staff its ess(attracti$e schoos* The 'references of the in%i$i%&a +or#er cannot be )i$en f& 'a!, or each 'erson +o&% become 'resi%ent of the cor'oration at a s&m't&o&s saar!* et the abo&rer ma! choose to i$e in @aifornia rather than Maine then the 'rice s!stem +i incite em'o!ers to mo$e their o'erations to @aifornia, +here the! can hire this abo&rer more chea'!* The abo&rer ma! 'refer to +or# on) ho&rs or short ho&rs, an% em'o!ers are in%&ce% b! +a)e offers to cater to the abo&rerFs %i$erse 'references* In fact, it is e&a! a''ro'riate to s'ea# of the +or#erFs b&!in) con%itions of +or# an% of the em'o!erFs b&!in) the ser$ices of the +or#er* The conservation o reso#rces
A societ! has some reso&rces that can be re'ace% b! in$estment timber, for eam'e, is no+ ar)e! )ro+n as a commercia cro'* =arman% is a more ancient eam'e; the fertiit! of soi can be increase% b! 'r&%ent c&ti$ation* ther reso&rces are not re'aceabe, s&ch as coa an% 'etroe&m* Ho+ %oes the 'rice s!stem conser$e these eha&stibe reso&rces< The metho% of &sin) a reso&rce is in%e'en%ent of the 'attern o$er time of income an% e'en%it&res that the o+ner of the reso&rce %esires* S&''ose that a farm +i ha$e a $a&e of 100,000 if it is maintaine% at a constant e$e of fertiit! an% !ie%s a !ear! income of 10,000 fore$er b&t that it can be c&ti$ate% -Omine%P. intensi$e! to !ie% 12,000 a !ear for fi$e !ears at the cost of a m&ch re%&ce% !ie% thereafter, +ith a $a&e of 90,000* 8$en if the farmer is in &r)ent nee% of imme%iate f&n%s an% %oes not e'ect to i$e more than fi$e !ears, he +i sti c&ti$ate the farm at the &niform rate* n! then is it +orth its maim&m $a&e to him, an% on! then -b! sae or mort)a)e. can he obtain the ar)est( 'ossibe f&n%s e$en in the near f&t&re* In short, one nee% not a%a't his e'en%it&re 'attern to his income 'attern so on) as he can borro+ or en%* If the )ro+th of cons&m'tion or the %ecine of reser$es threatens the eha&stion of s&''ies of a reso&rce, then the 'rice of that reso&rce +i rise an% 'romise to rise more in the f&t&re, an% this rise +i ser$e to re%&ce c&rrent cons&m'tion an% to re+ar% the o+ner of the reso&rce for ho%in) bac# m&ch of the s&''! for the f&t&re* This rise in 'rice +i
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therefore aso stim&ate b&!ers to fin% more economica +a!s of &sin) the commo%it! -for eam'e, b&rnin) the f&e more efficient!. an% stim&ate 'ro%&cers to fin% ne+ s&''ies or s&bstit&te 'ro%&cts* The 'rice s!stem +i therefore ens&re that the s&''! of the reso&rce +i be stretche% o&t so that the reso&rce +i be a$aiabe in both the 'resent an% the f&t&re* 3imitations an% ail#res o the $rice system
The 'rice s!stem is an etraor%inari! 'o+erf& instr&ment in or)ani"in) an economic s!stem, b&t it is s&b/ect to three broa% casses of imitations* )rivate an% $#0lic $rice control
Sometimes 'rices are not 'ermitte% to %o their +or#* Mono'oies are abe to eert contro o$er 'rices, an% the! &se it, sensib! eno&)h, to raise their 'rofits abo$e the e$e ao+e% b! com'etition* The mono'oist -or )ro&' of co&%in) enter'rises. sets 'rices at a e$e s&ch that 'rices are abo$e costs or, to &se +or%s of i%entica si)nificance, s&ch that reso&rces earn more in the mono'oi"e% in%&str! than the! can earn ese+here* The basis of the mono'o! is its abiit! to 're$ent o&tsi%ers from enterin) the in%&str! to share in the &n&s&a 'rofits an%, b! the act of 'ro%&cin), act&a! ser$e to eiminate them* The fiin) of 'rices b! mono'oists re%&ces the income of societ!* This is, in fact, the on! +e(estabishe% criticism -on )ro&n%s of efficienc!. to be e$ie% a)ainst mono'oies there is no reason to ass&me that the! +i ma#e 'ro%&cts ess(s&ite% to cons&mer tastes or inno$ate more so+! or 'a! o+er +a)es or other+ise misaocate reso&rces* C&t the basic inefficienc! e%, first in the Unite% States in 1G90 an% then increasin)! in 8&ro'ean nations, to )o$ernmenta 'oicies to maintain or restore com'etition* &bic 'rice contro has t+o as'ects* A ar)e 'art of '&bic re)&ation is inten%e% to correct mono'oistic 'ricin) -or other fai&res of the 'rice s!stem. this inc&%es most '&bic(&tiit! re)&ation in the Unite% States -trans'ortation, eectricit!, )as, etc*.* 5hate$er the s&ccess of these en%ea$o&rsan% on the +hoe there has been a s&bstantia %ecine in confi%ence in the re)&ator! bo%iesthe! are &s&a! instr&cte% to achie$e the )oas of an efficient 'rice s!stem* ther '&bic 'rice contros are %esi)ne% to ser$e en%s o&tsi%e the reach of the 'rice s!stem* rices of farm 'ro%&cts are re)&ate% -raise%. in most nations +ith the intention of im'ro$in) farmersF incomes, an% the fiin) of interest rates 'ai% b! ban#s is &n%erta#en to im'ro$e ban# earnin)s* S&ch 'oicies are in$ariab! %efen%e% on $ario&s economic an% ethica )ro&n%s b&t refect 'rimari! the 'oitica stren)th of ar)e an% +e(or)ani"e% 'ro%&cer )ro&'s* Im$erect +no/le%&e an% tastes
Another imitation to +hich the 'rice s!stem is s&b/ect has to %o +ith the contro of #no+e%)e an% tastes* To the etent that an economic actor, +hether a cons&mer, a abo&rer, or an in$estor, is 'oor! informe%, he is i#e! to ma#e %ecisions +hose
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conse&ences are m&ch %ifferent from those he %esire% an% e'ecte%* 5hat foo+s reates on! to cons&mer %ecisions, b&t 'arae iss&es arise in abo&r mar#ets, sec&rities mar#ets, etc* A cons&mer can satisf! his %esires on! if he ma#es intei)ent '&rchasesthat is, on! if the )oo%s he b&!s are +hat he beie$es them to be* Ho+ can the cons&mer #no+ +hether the meat is free of %isease or +hether the +ashin) machine +i f&nction +e an% on) or +hether the fabric of the )arment is one s!nthetic fibre or another< To ascertain these facts 'ersona!, the cons&mer +o&% ha$e to be a $ersatie scientist e&i''e% +ith a s&'erb aborator!, an% then he +o&% nee% to s'en% so m&ch time testin) )oo%s that he +o&% ha$e itte time to en/o! them* iv. )ositive an% Normative Economics
ositi$e an% normati$e economic tho&)ht are t+o s'ecific branches of economic reasonin)* Atho&)h the! are associate% +ith one another, 'ositi$e an% normati$e economic tho&)ht ha$e %ifferent foc&ses +hen ana!"in) economic scenarios* )ositive Economics
ositi$e economics is a branch of economics that foc&ses on the %escri'tion an% e'anation of 'henomena, as +e as their cas&a reationshi's* It foc&ses 'rimari! on facts an% ca&se(an%(effect beha$iora reationshi's, inc&%in) %e$eo'in) an% testin) economic theories* As a science, 'ositi$e economics foc&ses on ana!"in) economic beha$ior* It a$oi%s economic $a&e /&%)ments* =or eam'e, 'ositi$e economic theor! +o&% %escribe ho+ mone!Qs&''! )ro+th im'acts infation, b&t it %oes not 'ro$i%e an! )&i%ance on +hat 'oic! sho&% be foo+e%* The &nem'o!ment rate in =rance is hi)her than that in the Unite% States is a 'ositi$e economic statement* It )i$es an o$er$ie+ of an economic sit&ation +itho&t 'ro$i%in) an! )&i%ance for necessar! actions to a%%ress the iss&e* Normative Economics
ormati$e economics is a branch of economics that e'resses $a&e or normati$e /&%)ments abo&t economic fairness* It foc&ses on +hat the o&tcome of the econom! or )oas of '&bic 'oic! sho&% be* Man! normati$e /&%)ments are con%itiona* The! are )i$en &' if facts or #no+e%)e of facts chan)e* In this instance, a chan)e in $a&es is seen as bein) '&re! scientific* 5efare economist Amart!a Sen e'aine% that basic -normati$e. /&%)ments re! on #no+e%)e of facts* An eam'e of a normati$e economic statement is The 'rice of mi# sho&% be 6 a )aon to )i$e %air! farmers a hi)her i$in) stan%ar% an% to sa$e the fami! farm* It is a normati$e statement beca&se it refects $a&e /&%)ments* It states facts, b&t aso e'ains +hat sho&% be %one* ormati$e economics has s&bfie%s that 'ro$i%e f&rther scientific st&%! inc&%in) socia choice theor!, coo'erati$e )ame theor!, an% mechanism %esi)n* Relationshi$ (et/een )ositive an% Normative Economics
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ositi$e economics %oes im'act normati$e economics beca&se it ran#s economic 'oicies or o&tcomes base% on acce'tabiit! -normati$e economics.* ositi$e economics is %efine% as the +hat is of economics, +hie normati$e economics foc&ses on the +hat o&)ht to be* ositi$e economics is &tii"e% as a 'ractica too for achie$in) normati$e ob/ecti$es* In other +or%s, 'ositi$e economics cear! states an economic iss&e an% normati$e economics 'ro$i%es the $a&e(base% so&tion for the iss&e *
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II" DEMAND8 SU))3 AND MARKET i. Deman% C#rve8 In%ivi%#al an% Mar+et Deman% C#rve
At hi)her 'rices, the &antit! %eman%e% is ess than at o+er 'rices* A %eman% sche%#le in%icates that, t!'ica!, there is an in$erse reationshi' bet+een the 'rice of a 'ro%&ct an% the &antit! %eman%e%* This reationshi' is easiest to see +hen a )ra'h is 'otte%, as sho+n* Deman% c#rves )enera! ha$e a ne)ati$e )ra%ient in%icatin) the in$erse reationshi' bet+een &antit! %eman%e% an% 'rice* There are at east three acce'te% e'anations of +h! %eman% c&r$es so'e %o+n+ar%s; The a+ of %iminishin& mar&inal #tility
The income eect The s#0stit#tion eect Diminishin& mar&inal #tility
ne of the eariest e'anations of the in$erse reationshi' bet+een 'rice an% &antit! %eman%e% is the la/ o %iminishin& mar&inal #tility * This a+ s&))ests that as more of a 'ro%&ct is cons&me% the mar)ina -a%%itiona. benefit to the cons&mer fas, hence cons&mers are 're'are% to 'a! ess* This can be e'aine% as foo+s; Most benefit is )enerate% b! the first &nit of a )oo% cons&me% beca&se it satisfies a or a ar)e 'art of the imme%iate nee% or %esire* A secon% &nit cons&me% +o&% )enerate ess &tiit! ( 'erha's e$en "ero, )i$en that the cons&mer no+ has ess nee% or ess %esire* Utility
5hie tota &tiit! contin&es to rise from etra cons&m'tion, the a%%itiona -mar)ina. &tiit! from each bar fas* If mar)ina &tiit! is e'resse% in a monetar! form, the )reater the &antit! cons&me% the o+er the mar)ina &tiit! an% the ess the rationa cons&mer +o&% be 're'are% to 'a!* CA?S
TTAL UTILIT MA?IAL
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2
190
90
3
270
G0
4
340
70
400
60
6
40
0
7
490
40
G
20
30
G
40
20
The income eect
The income an% s&bstit&tion effect can aso be &se% to e'ain +h! the %eman% c&r$e so'es %o+n+ar%s* If +e ass&me that mone! income is fie%, the income effect s&))ests that, as the 'rice of a )oo% fas, rea income ( that is, +hat cons&mers can b&! +ith their mone! income ( rises an% cons&mers increase their %eman%* Therefore, at a o+er 'rice, cons&mers can b&! more from the same mone! income, an%, ceteris 'arib&s, %eman% +i rise* @on$erse!, a rise in 'rice +i re%&ce rea income an% force cons&mers to c&t bac# on their %eman%* The s#0stit#tion eect
In a%%ition, as the 'rice of one )oo% fas, it becomes reati$e! ess e'ensi$e* Therefore, ass&min) other aternati$e 'ro%&cts sta! at the same 'rice, at o+er 'rices the )oo% a''ears chea'er, an% cons&mers +i s+itch from the e'ensi$e aternati$e to the reati$e! chea'er one* It is im'ortant to remember that +hene$er the 'rice of an! reso&rce chan)es it +i tri))er both an income an% a s&bstit&tion effect* E,ce$tions
It is 'ossibe to i%entif! some ece'tions to the norma r&es re)ar%in) the reationshi' bet+een 'rice an% c&rrent %eman%* Gien Goo%s
iffen )oo%s are those +hich are cons&me% in )reater &antities +hen their 'rice rises* These )oo%s are name% after the Scottish economist Sir Ro0ert Gien , +ho is cre%ite%
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+ith i%entif!in) them b! Alre% Marshall in his hi)h! inf&entiarinci'es of 8conomics -1G9.* In essence, a iffen )oo% is a sta'e foo%, s&ch as brea% or rice, +hich forms are ar)e 'ercenta)e of the %iet of the 'oorest sections of a societ!, an% for +hich there are no cose s&bstit&tes* =rom time to time the 'oor ma! s&''ement their %iet +ith hi)her &ait! foo%s, an% the! ma! e$en cons&me the o%% &&r!, atho&)h their income +i be s&ch that the! +i not be abe to sa$e* A rise in the 'rice of s&ch a sta'e foo% +i not res&t in a t!'ica s&bstit&tion effect, )i$en there are no cose s&bstit&tes* If the rea incomes of the 'oor increase the! +o&% ten% to reaocate some of this income to &&ries, an% if rea incomes %ecrease the! +o&% b&! more of the sta'e )oo%, meanin) it is an inerior &oo%* Ass&min) that the mone! incomes of the 'oor are constant in the short r&n, a rise in 'rice of the sta'e foo% +i re%&ce rea income an% ea% to an in$erse income effect* Ho+e$er, most inferior )oo%s +i ha$e s&bstit&tes, hence %es'ite the in$erse income effect, a rise in 'rice +i tri))er a s&bstit&tion effect, an% %eman% +i fa* In the case of a iffen )oo%, this t!'ica res'onse %oes not ha''en as there are no s&bstit&tes, an% the 'rice rise ca&ses %eman% to increase* E,am$le
=or eam'e, a fami! i$in) on the e&i$aent of /&st 10 a month, ma! '&rchase some brea% -sa! 0 oa$es at 2 each, +hich is the minim&m the! nee% to s&r$i$e., an% a &&r! item at 0* If the 'rice of brea% rises b! 2R to 2*0 'er oaf, contin&in) to '&rchase 0 oa$es +o&% cost the in%i$i%&a 12, ma#in) the &&r! &naffor%abe* The! cannot re%&ce their cons&m'tion of brea%, )i$en that their c&rrent cons&m'tion is the minim&m the! re&ire, an% the! cannot fin% a s&itabe s&bstit&te for their stabe foo%* ot bein) abe to affor% the &&r! +o&% ea$e the fami! +ith an etra 2 to s'en%, an%, )i$en no aternati$es to brea%, the! +o&% '&rchase 10 more oa$es each month* Hence the 2R 'rice increase has res&te% in a 20R increase in the %eman% for brea% ( from 0 to 60 oa$es* In%ivi%#al Deman%
The in%ivi%#al %eman% c#rve for a )oo%, ser$ice, or commo%it!, is %efine% +ith the foo+in) in the bac#)ro&n%;
The s'ecific )oo%, ser$ice, or commo%it!* A &nit for meas&rin) the &antit! of that commo%it!* A &nit for meas&rin) 'rice* A con$ention on +hether saes taes are inc&%e% in the state% 'rice* A certain economic actor -in%i$i%&a, ho&seho%, or firm (( 'rofit(ma#in), non'rofit, or )o$ernmenta. A time frame +ithin +hich the %eman% is meas&re%* An economic bac#%ro' that inc&%es a the %eterminants of %eman% other than the &nit 'rice of that commo%it!*
The %eman% c&r$e is a c&r$e %ra+n +ith;
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The $ertica ais is the 'rice ais, meas&rin) the 'rice 'er &nit of the commo%it!* The hori"onta ais is the &antit! ais, meas&rin) the &antit! of the commo%it! %eman%e% b! the s'ecific economic actor*
Here &antit! %eman%e% is &n%erstoo% to be the maim&m &antit! that the economic actor +o&% be rea%!, +iin), an% abe to '&rchase at the )i$en 'rice* ote that the in%i$i%&a %eman% c&r$e ma#es sense on! ceteris 'arib&s (( a other %eterminants of %eman% bein) #e't constant* The term in%ivi%#al %eman% is &se% for the entire 'rice(&antit! reationshi' %e'icte% 'ictoria! b! the %eman% c&r$e* 8'icit!, the in%ivi%#al %eman% #ction refers to the f&nction that o&t'&ts, at an! )i$en 'rice, the &antit! %eman%e% at that 'rice* A %eman% sche%&e is a %iscrete $ersion of the %eman% c&r$e, s'ecif!in) %eman% $a&es for a n&mber of %ifferent 'rices* Relation /ith mar+et %eman% c#rve
The mar#et %eman% c&r$e for a )oo% +ithin a )i$en mar#et is obtaine% b! a%%in) &' the in%i$i%&a %eman% c&r$es of a economic actors in that mar#et* A ot of interestin) an% &ir#! 'henomena ma! be obtaine% at the e$e of in%i$i%&a %eman% c&r$es b&t ma! become ess $isibe -%&e to smoothin) an% a$era)in) o&t. at the a))re)ate e$e beca&se of the cancein) o&t or smoothin) o&t effects* Some eam'es are %isc&sse% beo+;
=or items +here '&rchase &antities are %iscrete, in%i$i%&a %eman% c&r$es are b! nat&re %iscontin&o&s, +hie a))re)ate %eman% c&r$es are i#e! to be contin&o&s )i$en s&fficient hetero)eneit! amon) in%i$i%&as* ote that in%i$i%&a %eman% &antities co&% be fractiona e$en +ith %iscrete '&rchase &antities (( for instance, m! +ee#! n&mber of oa$es of brea% '&rchase% co&% be if I '&rchase a oaf of brea% e$er! secon% %a!* In%i$i%&a %eman% c&r$es are more i#e! to ehibit shar' %iscontin&ities for other reasons; In%i$i%&as ma! &se thresho% 'rices an% reference 'rices to %etermine +hich item to '&rchase an% ho+ m&ch* =or instance, if, for me, an% are e&i$aent )oo%s -i*e*, the! are 'erfect s&bstit&te )oo%s for each other, then I b&! none of +hen its 'rice ecee%s that of , b&t I shift m! entire cons&m'tion to +hen its 'rice %ro's beo+ that of * The 'rice of is th&s a 'oint of %iscontin&it! in the %eman% c&r$e* In the a))re)ate, the hetero)eneit! of in%i$i%&as ens&res that the! %o not a 'ercei$e the same 'airs of )oo%s as 'erfect s&bstit&tes, an% hence these /&m's are ess i#e! to occ&r* Eario&s $ioations of the a+ of %eman%, both rationa an% irrationa, are more i#e! to be seen at the in%i$i%&a e$e than at the a))re)ate e$e; =or instance, the iffen )oo% 'henomenon an% the Eeben )oo% 'henomenon ma! 'a! an im'ortant roe in the cons&m'tion beha$ior of one in%i$i%&a or ho&seho%, b&t beca&se of %ifferin) incomes an% %ifferin) tastes an% 'references that ea% in%i$i%&as to $a&e s&bstit&tes %ifferent!, the 'henomena +o&% not a''! to a economic actors* Since an a))re)ate iffen )oo% 'henomenon %e'en%s on the 'henomenon
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affectin) a ar)e n&mber of in%i$i%&as, a))re)ate iffen )oo% 'henomena ma! be m&ch rarer than in%i$i%&a iffen )oo% 'henomena* The same ho%s for $ario&s forms of mi% irrationait! an% i%ios!ncratic beha$ior* Mar+et Deman% Mar#et %eman% 'ro$i%es the tota &antit! %eman%e% b! a cons&mers* In other +or%s, it re'resents the a))re)ate of a in%i$i%&a %eman%s* There are t+o basic t!'es of mar#et %eman%; 'rimar! an% seecti$e* rimar! %eman% is the tota %eman% for a of the bran%s that re'resent a )i$en 'ro%&ct or ser$ice, s&ch as a 'hones or a hi)h(en% +atches* Seecti$e %eman% is the %eman% for one 'artic&ar bran% of 'ro%&ct or ser$ice, s&ch as the ihone or a Michee +atch* Mar#et %eman% is an im'ortant economic mar#er beca&se it refects the com'etiti$eness of a mar#et'ace, a cons&merFs +iin)ness to b&! certain 'ro%&cts an% the abiit! of a com'an! to e$era)e itsef in a com'etiti$e an%sca'e* If mar#et %eman% is o+, it si)nas to a com'an! that the! sho&% terminate a 'ro%&ct or ser$ice, or restr&ct&re it so that it is more a''eain) to cons&mers* Mar+et Deman% C#rve Deinition
The mar+et %eman% c#rve is the s&mmation of a the in%i$i%&a %eman% c&r$es in a )i$en mar#et* It sho+s the &antit! %eman%e% of the )oo% b! a in%i$i%&as at $ar!in) 'rice 'oints* =or eam'e, at 10>atte, the &antit! %eman%e% b! e$er!one in the mar#et is 10 attes 'er %a!* At 4>atte, the &antit! %eman%e% b! e$er!one in the mar#et is 1,000 attes 'er %a!* The mar#et %eman% c&r$e )i$es the &antit! %eman%e% b! e$er!one in the mar#et for e$er! 'rice 'oint* The mar#et %eman% c&r$e is t!'ica! )ra'he% an% %o+n+ar% so'in) beca&se as 'rice increases, the &antit! %eman%e% %ecreases* It can aso be 'ro$i%e% as a sche%&e, +hich is in tabe format* E9#ation
To %etermine the mar#et %eman% c&r$e of a )i$en )oo%, !o& ha$e to s&m a the in%i$i%&a %eman% c&r$es for the )oo% in the mar#et* Here is the a)ebraic e&ation for mar#et %eman%* The &antit! %eman%e% -. is a f&nction of 'rice -. an% it is s&mmin) a the in%i$i%&a %eman% c&r$es -., +hich are aso a f&nction of 'rice* The s&bscri'ts one thro&)h n re'resent a the in%i$i%&as in the mar#et*
E,am$les o Mar+et Deman% C#rves
To ma#e thin)s eas!, etBs ass&me +e ha$e t+o 'eo'e in the mar#et for attes -+e a #no+ this is etreme! sim'ifie%., Nac# an% Ni* This tabe sho+s the in%i$i%&a %eman% sche%&es for attes* The co&mn on the far ri)ht is the s&mmation of the in%i$i%&a %eman% c&r$es, +hich becomes the mar#et %eman% c&r$e* At 3 'er atte, Ni +o&% b&! 24 attes a month an% Nac# +o&% b&! 1* Therefore, the mar#et %eman% at 3 'er atte is 39 'er month* o& can aso )ra'h the mar#et %eman%
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c&r$e, +hich is the most common metho% of 'resentin) a %eman% c&r$e* This )ra'h sho+s the same mar#et %eman% c&r$e as the tabe* ii. Movement vers#s Shit in Deman% C#rve
The 'osition of the %eman% c&r$e +i shift to the eft or ri)htfoo+in) a chan)e in an &n%er!in) %eterminant of %eman%* Increases in %eman% are sho+n b! a shift to the ri)ht in the %eman% c&r$e* This co&% be ca&se% b! a n&mber of factors, inc&%in) a rise in income, a rise in the 'rice of a s&bstit&te or a fa in the 'rice of a com'ement* Deman% sche%#le
A shift in %eman% to the ri)ht means an increase in the &antit! %eman%e% at e$er! 'rice* =or eam'e, if %rin#in) coa becomes more fashionabe %eman% +i increase at e$er! 'rice* ?I@8 -. ?IIAL %
85 %
1*10
0
100
1*00
100
200
90
200
300
G0
300
400
70
400
00
60
00
600
0
600
700
40
700
G00
30
G00
900
Increases in %eman%
An increase in %eman% can be i&strate% b! a shift in the %eman% c&r$e to the ri)ht* Decreases in %eman%
@on$erse!, %eman% can %ecrease an% ca&se a shift to the eft of the %eman% c&r$e for a n&mber of reasons, inc&%in) a fa in income, ass&min) a )oo% is a norma )oo%, a fa in the 'rice of a s&bstit&te an% a rise in the 'rice of a com'ement* Deman% sche%#le
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=or eam'e, if the 'rice of a s&bstit&te, s&ch as fi""! oran)e,fas, then ess coa is %eman%e% at each 'rice, as cons&mers s+itch to the s&bstit&te* ?I@8 -.
?IIAL %
85 %
1*10
0
1*00
100
90
200
100
G0
300
200
70
400
300
60
00
400
0
600
00
40
700
600
30
G00
700
Decreases in %eman% are sho+n b! a shift of the %eman% c&r$e to the eft*
The basic %ifference bet+een a mo$e aon) a %eman% c&r$e an% a chan)e in the c&r$e is that the former is ca&se% b! a chan)e in 'rice +hie the atter is not* A mo$e aon) the c&r$e res&ts in a %ifferent &antit! %eman%e% at a %ifferent 'rice* A chan)e in %eman% means that a %ifferent &antit! +i be %eman%e% at a )i$en 'rice than +as %eman%e% before the chan)e in %eman% occ&rre%* Let &s oo# at this +ith re)ar% to the DED of a 'artic&ar mo$ie* Let &s sa! the 'rice is no+ 1* C&t then the 'rice %ro's to 10* A other thin)s bein) e&a, more 'eo'e +i b&! the DED at the o+er 'rice* This is a mo$ement aon) a )i$en %eman% c&r$e* There has been no chan)e in ho+ man! 'eo'e +o&% b&! the DED at 1* Instea%, the 'rice has chan)e%, ca&sin) a chan)e in ho+ man! 'eo'e +i b&!* o+ et &s oo# at ho+ the c&r$e co&% mo$e* Let &s sa! the DED is sein) for 1 b&t then the star of the mo$ie commits a )hast! crime in rea ife* His 'o'&arit! '&mmets an% man! fe+er 'eo'e +ant to b&! the mo$ie* In this case the 'rice can remain at 1
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b&t man! fe+er 'eo'e +i b&! the DED* This is an instance in +hich the %eman% has act&a! chan)e%* iii. In%ivi%#al an% Mar+et S#$$ly C#rve an% Mar+et E9#ili0ri#m
The tabe in =i)&re sho+s the &antit! s&''ie% b! Cen, an ice(cream seer, at $ario&s 'rices of ice cream* At a 'rice beo+ 1*00, Cen %oes not s&''! an! ice cream at a* As the 'rice rises, he s&''ies a )reater an% )reater &antit!* This is the s#$$ly sche%#le8 a tabe that sho+s the reationshi' bet+een the 'rice of a )oo% an% the &antit! s&''ie%, ho%in) constant e$er!thin) ese that inf&ences ho+ m&ch 'ro%&cers of the )oo% +ant to se* The )ra'h in =i)&re &ses the n&mbers from the tabe to i&strate the a+ of s&''!* The c&r$e reatin) 'rice an% &antit! s&''ie% is cae% the s#$$ly c#rve" The s&''! c&r$e so'es &'+ar% beca&se, other thin)s e&a, a hi)her 'rice means a )reater &antit! s&''ie%* Mar#et e&iibri&m is one of the most im'ortant conce'ts in the st&%! of economics* In this esson, !o&B earn +hat mar#et e&iibri&m is an% ho+ it is estabishe%, an% !o&B aso be 'ro$i%e% some eam'es* A short &i" foo+s the esson* Deinition o Mar+et E9#ili0ri#m Mar+et e9#ili0ri#m is a mar#et state +here the s&''! in the mar#et is e&a to the %eman% in the mar#et* The e9#ili0ri#m $rice is the 'rice of a )oo% or ser$ice +hen the s&''! of it is e&a to the %eman% for it in the mar#et* If a mar#et is at e&iibri&m, the 'rice +i not chan)e &ness an eterna factor chan)es the s&''! or %eman%, +hich res&ts in a %isr&'tion of the e&iibri&m*
S#$$ly8 Deman% ; E9#ili0ri#m
If a mar#et is not at e&iibri&m, mar#et forces ten% to mo$e it to e&iibri&m* LetBs brea# this conce't %o+n* If the mar#et 'rice is abo$e the e&iibri&m $a&e, there is an ecess s&''! in the mar#et -a s&r'&s., +hich means there is more s&''! than %eman%* In this sit&ation, seers +i ten% to re%&ce the 'rice of their )oo% or ser$ice to cear their in$entories* The! 'robab! +i aso so+ %o+n their 'ro%&ction or sto' or%erin) ne+ in$entor!* The o+er 'rice entices more 'eo'e to b&!, +hich +i re%&ce the s&''! f&rther* This 'rocess +i res&t in %eman% increasin) an% s&''! %ecreasin) &nti the mar#et 'rice e&as the e&iibri&m 'rice*
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If the mar#et 'rice is beo+ the e&iibri&m $a&e, then there is ecess in %eman% -s&''! shorta)e.* In this case, b&!ers +i bi% &' the 'rice of the )oo% or ser$ice in or%er to obtain the )oo% or ser$ice in short s&''!* As the 'rice )oes &', some b&!ers +i &it tr!in) beca&se the! %onBt +ant to, or canBt, 'a! the hi)her 'rice* A%%itiona!, seers, more than ha''! to see the %eman%, +i start to s&''! more of it* 8$ent&a!, the &'+ar% 'ress&re on 'rice an% s&''! +i stabii"e at mar#et e&iibri&m* E,am$les o Mar+et E9#ili0ri#m Flat Screen T
Ima)ine that !o& ma#e fat screen tee$isions* o&r fa)shi' mo%e is a 72(inch 'asma that c&rrent! +hoesaes to !o&r retaiers at 2,00* Unfort&nate!, !o&r +areho&se has recent! been fiin) a bit too &ic#! +ith 72(inch 'asmas* This is 'robab! beca&se each of !o&r three ar)est com'etitors has fina! )otten aro&n% to intro%&cin) their o+n 72(inch tee$isions, +hich means that there are a b&nch more 72(inch tee$isions on the mar#et* Mar+et S#$$ly vers#s In%ivi%#al S#$$ly N&st as mar#et %eman% is the s&m of the %eman%s of a b&!ers, mar#et s&''! is the s&m of the s&''ies of a seers* The tabe in =i)&re 6 sho+s the s&''! sche%&es for t+o ice(cream 'ro%&cersCen an% Nerr!* At an! 'rice, CenFs s&''! sche%&e tes &s the &antit! of ice cream Cen s&''ies, an% Nerr!Fs s&''! sche%&e tes &s the &antit! of ice cream Nerr! s&''ies* The mar#et s&''! is the s&m of the t+o in%i$i%&a s&''ies* iv. )rice8 Income an% Cross Elasticities o Deman%
rice easticit! of %eman% -8D. sho+s the reationshi' bet+een 'rice an% &antit! %eman%e% an% 'ro$i%es a 'recise cac&ation of the effect of a chan)e in 'rice on &antit! %eman%e%* The foo+in) e&ation enabes 8D to be cac&ate%*
5e can &se this e&ation to cac&ate the effect of 'rice chan)es on &antit! %eman%e%, an% on the reven#e recei$e% b! firms before an% after an! 'rice chan)e* =or eam'e, if the 'rice of a %ai! ne+s'a'er increases from 1*00 to 1*20', an% the %ai! saes fas from 00,000 to 20,000, the 8D +i be; = >?@ * 2?@ B =. 2">
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The ne)ati$e si)n in%icates that an% are inversely relate% , +hich +e +o&% e'ect for most 'rice>%eman% reationshi's* This is si)nificant beca&se the ne+s'a'er s&''ier can cac&ate or estimate ho+ re$en&e +i be affecte% b! the chan)e in 'rice* In this case, re$en&e at 1*00 is 00,000 -1 00,000. b&t fas to 300,000 after the 'rice rise -1*20 20,000.* The ran&e o res$onses
The %e)ree of res'onse of &antit! %eman%e% to a chan)e in 'rice can $ar! consi%erab!* The #e! benchmar# for meas&rin) easticit! is +hether the co(efficient is )reater or ess than 'ro'ortionate* If &antit! %eman%e% chan)es 'ro'ortionate!, then the $a&e of 8D is 1, +hich is cae% &nit easticit!F* )ED can also 0e
Less than one, +hich means 8D is inelastic" reater than one, +hich is elastic * Vero -0., +hich is $erectly inelastic * Infinite -W., +hich is $erectly elastic 8D aon) a inear %eman% c&r$e 8D on a inear %eman% c&r$e +i fa contin&o&s! as the c&r$e so'es %o+n+ar%s, mo$in) from eft to ri)ht* 8D X 1 at the mi%'oint of a inear %eman% c&r$e*
)ED an% reven#e
There is a 'recise mathematica connection bet+een 8D an% a firmFs reven#e* There are three t!'esF of re$en&e; Tota re$en&e -T?., +hich is fo&n% b! m&ti'!in) 'rice b! &antit! so% - .
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A$era)e re$en&e -A?., +hich is fo&n% b! %i$i%in) tota re$en&e b! &antit! so% -T?>.* @onsi%er these fi)&res an% cac&ate Tota, Mar)ina an% A$era)e ?e$en&e* Mar)ina re$en&e -M?., +hich is %efine% as the re$en&e from sein) one etra &nit* This is cac&ate% b! fin%in) the chan)e in T? from sein) one more &nit* ?I@8 -.
%
10
1
9
2
G
3
7
4
6
6
4
7
3
G
2
9
1
10
TR
M?
AR
Ans/er
St&%! the 'atterns of n&mbers an% see if !o& can ana!se the reationshi's bet+een the three meas&res of re$en&e : then ans+er the foo+in); Ho+ are 'rice an% a$era)e re$en&e connecte%< 5hat ha''ens to tota re$en&e as o&t'&t increases< 5hat is the connection bet+een tota re$en&e an% mar)ina re$en&e< Ho+ are mar)ina re$en&e an% a$era)e re$en&e connecte%< O0servations
5hen T? is at a maim&m, M? X "ero, an% 8D X 1*
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1* rice an% A? are i%entica, beca&se A? X T?>, +hich is >, an% cance o&t the s to )et * 1*
A c&r$e 'ottin) A? -X. a)ainst is aso a firmFs %eman% c&r$e*
2*
T? increases, reaches a 'ea# an% %ecreases*
5h! %oes a firm +ant to #no+ 8D<
There are se$era reasons +h! firms )ather information abo&t the 8D of its 'ro%&cts* A firm +i #no+ m&ch more abo&t its interna o'erations an% 'ro%&ct costs than it +i abo&t its eterna en$ironment* Therefore, )atherin) %ata on ho+ cons&mers res'on% to chan)es in 'rice can he' re%&ce ris# an% &ncertain!* More s'ecifica!, #no+e%)e of 8D can he' the firm forecast its saes an% set its 'rice* Saes forecastin) The firm can forecast the im'act of a chan)e in 'rice on its saes $o&me, an% saes re$en&e -tota re$en&e, T?.* =or eam'e, if 8D for a 'ro%&ct is -(. 2, a 10R re%&ction in 'rice -sa!, from 10 to 9. +i ea% to a 20R increase in saes -sa! from 1000 to 1200.* In this case, re$en&e +i rise from 10,000 to 10,G00* )ricin& $olicy
no+in) 8D he's the firm %eci%e +hether to raise or o+er 'rice, or +hether to 'rice %iscriminate* rice %iscrimination is a 'oic! of char)in) cons&mers %ifferent 'rices for the same 'ro%&ct* If %eman% is eastic, re$en&e is )aine% b! re%&cin) 'rice, b&t if %eman% is ineastic, re$en&e is )aine% b! raisin) 'rice* Income easticit! of %eman% -8D. sho+s the effect of a chan)e in income on &antit! %eman%e%* Income is an im'ortant %eterminant of cons&mer %eman%, an% 8D sho+s 'recise! the etent to +hich chan)es in income ea% to chan)es in %eman%* 8D can be cac&ate% &sin) the foo+in) e&ation;
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Normal &oo%s
5hen the e&ation )i$es a 'ositi$e res&t, the )oo% is a norma )oo%* A norma )oo% is one +here %eman% is %irect! 'ro'ortiona to income* =or eam'e, if, foo+in) an increase in income from 40,000 to 0,000, an in%i$i%&a cons&mer b&!s 40 DED fims 'er !ear, instea% of 20, then the coefficient is; Y100>Y2 X -Y. 4*0 The 'ositi$e si)n means that the )oo% is a norma )oo%, an% beca&se the coefficient is )reater than one, %eman% for the )oo% res'on%s more than 'ro'ortionate! to a chan)e in income* This in%icates the )oo% is not a necessit! i#e foo%, an% +o&% be consi%ere% a reati$e &&r! for this in%i$i%&a* Inferior )oo%s 5hen 8D is ne)ati$e, the )oo% is cassifie% as inferior* =or eam'e, if, foo+in) an increase in income from 40,000 to 0,000, a cons&mer b&!s 1G0 oa$es of brea% 'er !ear instea% of 200, then the 8D is; (10>Y2 X -(. 0*4 The ne)ati$e si)n means that the )oo% is inferior, an%, beca&se the coefficient is ess than one, %eman% for the )oo% %oes not res'on% si)nificant! to a chan)e in income* This in%icates that the )oo% is not 'artic&ar! inferior com'are% +ith a )oo% +hich has a 8D of Z -(.1* The si)n an% the n&mber 'ro$i%e %ifferent information abo&t the reationshi' bet+een income an% %eman%* Income easticit! of %eman% can aso be i&strate% b! En&el c#rves* -hy %oes a irm /ant to +no/ ED
There se$era reasons +h! a firm +o&% +ant to #no+ 8D, inc&%in) the foo+in); Saes forecastin)
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A firm can forecast the im'act of a chan)e in income on saes $o&me -., an% saes re$en&e - .* =or eam'e, a h!'othetica car man&fact&rer has cac&ate% that 8D +ith res'ect to its &&r! car is -Y. 3*G, an% it has aso &n%erta#en research to %isco$er that cons&mer incomes +i rise b! 2R net !ear* It can no+ 're%ict the im'act of this chan)e* E,ercise
Usin) the 8D e&ation, cac&ate the effect on saes* The same 'ro%&cer ses a sma car +ith a 8D of -(. * Usin) the 8D e&ation, an% ass&min) income aso increases b! 2R, cac&ate the effect on saes* Ans/ers )ricin& $olicy
no+in) 8D he's the firm %eci%e +hether to raise or o+er 'rice foo+in) a chan)e in cons&mer incomes* If incomes are fain) an% 8D is 'ositi$e, a re%&ction in 'rice mi)ht he' com'ensate for the re%&ction in %eman%* Diversiication
=irms can %i$ersif! an% offer a ran)e of )oo%s +ith %ifferent 8Ds to s'rea% the ris#s associate% +ith chan)es in the e$e of nationa income* =or eam'e, a car man&fact&rer ma! 'ro%&ce cars +ith a ran)e of 8D $a&es, so that saes are stabiise% as the econom! )ro+s an% %ecines* ED an% the 0#siness cycle
@han)es in rea nationa income ten% to be c!cica* The %eman% for norma )oo%s increases +hen the econom! is e'an%in), b&t %ecreases +hen the econom! is contractin)* @on$erse!, the %eman% for inferior )oo%s is co&nter(c!cica*
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The hi)her the 'ositi$e $a&e for 8D, the )reater the effect of a chan)e in nationa income on cons&mer %eman%*
Cross Elasticity o Deman%: This meas&res ho+ sensiti$e cons&mer '&rchases of one 'ro%&ct -[. are to a chan)e in the 'rice of some other 'ro%&ct -.
S&bstit&te oo%s @ross easticit! of %eman% is $ositive if the saes of 'ro%&ct [ mo$es in the same %irection as a chan)e in the 'rice of 'ro%&ct ar)er 'ositi$e cross(easticit! coefficient X )reater s&bstit&tabiit! bet+een the t+o 'ro%&cts @om'ementar! oo%s @ross easticit! is ne&ative ; increase in 'rice of 'ro%&ct [ %ecreases the %eman% for 'ro%&ct Lar)er ne)ati$e cross(easticit! coefficient X )reater com'ementarit! bet+een the t+o )oo%s In%e'en%ent oo%s ero>near("ero cross easticit! X t+o 'ro%&cts are &nreate% A chan)e in one 'ro%&ctBs 'rice has no effect on the other 'ro%&ctBs %eman% A''ication A 'ro%&ctBs s&bstit&tabiit!, meas&re% b! the cross(easticit! coefficient, is im'ortant in b&sinesses an% )o$ernment beca&se the %eman% for their 'ro%&cts is %irect! affecte% b! the 'rice of other 'ro%&cts* v. Deman%8 Total Reven#e an% Mar&inal Reven#e MR. ?e$en&e is the income a firm retains from sein) its 'ro%&cts once it has 'ai% in%irect ta, s&ch as EAT* ?e$en&e 'ro$i%es the income +hich a firm nee%s to enabe it to co$er its costs o $ro%#ction , an% from +hich it can %eri$e a $roit* rofit can be %istrib&te% to the o+ners, or shareho%ers, or retaine% in the b&siness to '&rchase ne+ ca'ita assets or &')ra%e the firmFs technoo)!* ?e$en&e is meas&re% in three +a!s; Tota re$en&e Tota re$en&e -T?., is the tota fo+ of income to a firm from sein) a )i$en &antit! of o&t'&t at a )i$en 'rice, ess ta )oin) to the )o$ernment* The $a&e of T? is fo&n% b! m&ti'!in) 'rice of the 'ro%&ct b! the &antit! so%* A$era)e re$en&e
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A$era)e re$en&e -A?., is re$en&e 'er &nit, an% is fo&n% b! %i$i%in) T? b! the &antit! so%, * A? is e&i$aent to the 'rice of the 'ro%&ct, +here > X , hence A? is aso 'rice* Mar)ina re$en&e Mar)ina re$en&e -M?. is the re$en&e )enerate% from sein) one etra &nit of a )oo% or ser$ice* It can be fo&n% b! fin%in) the chan)e in T? foo+in) an increase in o&t'&t of one &nit* M? can be both 'ositi$e an% ne)ati$e* Reven#e sche%#le
A re$en&e sche%&e sho+s the amo&nt of re$en&e )enerate% b! a firm at %ifferent 'rices* ?I@8 -000.
TTAL -. UATIT ?8E8U8 D8MAD8D -000.
MA?IAL ?8E8U8 -000.
10
1
10
9
2
1G
G
G
3
24
6
7
4
2G
4
6
30
2
6
30
0
4
7
2G
(2
3
G
24
(4
2
9
1G
(6
1
10
10
(G
?e$en&e c&r$es Tota re$en&e Initia!, as o&t'&t increases tota re$en&e -T?. aso increases, b&t at a %ecreasin) rate* It e$ent&a! reaches a maim&m an% then %ecreases +ith f&rther o&t'&t* Less com'etition in a )i$en mar#et is i#e! to ea% to hi)her 'rices an% the 'ossibiit! of hi)her s&'er(norma 'rofits*
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A$era)e re$en&e Ho+e$er, as o&t'&t increases the a$era)e re$en&e -A?. c&r$e so'es %o+n+ar%s* The A? c&r$e is aso the firmFs %eman% c&r$e* Mar&inal reven#e
The mar)ina re$en&e -M?. c&r$e aso so'es %o+n+ar%s, b&t at t+ice the rate of A?* This means that +hen M? is 0, T? +i be at its maim&m* Increases in o&t'&t be!on% the 'oint +here M? X 0 +i ea% to a ne)ati$e M?* Tota re$en&e is the amo&nt of tota saes of )oo%s an% ser$ices* It is cac&ate% b! m&ti'!in) the amo&nt of )oo%s an% ser$ices so% b! the 'rice of the )oo%s an% ser$ices* Mar)ina re$en&e is %irect! reate% to tota re$en&e beca&se it meas&res the chan)e in the tota re$en&e +ith res'ect to the chan)e in another $ariabe* Mar)ina re$en&e meas&res the chan)e in re$en&e that res&ts from a chan)e in the amo&nt of )oo%s or ser$ices so%* It in%icates ho+ m&ch re$en&e increases for sein) an a%%itiona &nit of a )oo% or ser$ice* To cac&ate mar)ina re$en&e, %i$i%e the chan)e in tota re$en&e b! the chan)e in the &antit! so%* Therefore, the mar)ina re$en&e is the so'e of the tota re$en&e c&r$e* Use the tota re$en&e to cac&ate mar)ina re$en&e* =or eam'e, s&''ose a com'an! that 'ro%&ces to!s ses one &nit for 10 for each of its first 100 &nits* If it ses 100 to!s, its tota re$en&e +o&% be 1,000 -100 \ 10.* The com'an! ses the net 100 to!s for G a &nit* Its tota re$en&e +o&% be 1,G00 -1,000 Y 100\G.* S&''ose the com'an! +ante% to fin% its mar)ina re$en&e )aine% from sein) its 101st &nit* The tota re$en&e is %irect! reate% to this cac&ation* =irst, the com'an! m&st fin% the chan)e in tota re$en&e* The chan)e in tota re$en&e is G -1,00G ( 1,000.* et, it m&st fin% the chan)e in the to!s so%, +hich is 1 -101(100.* Th&s, the mar)ina re$en&e )aine% b! 'ro%&cin) the 101st to! is G* vi. Geometry o MR Determination: MR8 )rice an% Elasticity o Deman% )rice Elasticity E,$laine% rice easticit! %escribes +hat ha''ens to the %eman% for a 'ro%&ct as its 'rice chan)es* The reationshi' is in$erse, +ith %eman% risin) as the 'rice fas an% fain) as the 'rice
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rises* =or hi)h! eastic )oo%s an% ser$ices, %eman% chan)es %ramatica! as the 'rice chan)es* L&&r! items s&ch as bi)(screen TEs &s&a! ha$e a hi)h easticit!* In contrast, ineastic )oo%s an% ser$ices ten% to ha$e a fair! consistent e$e of %eman% e$en if the 'rice chan)es* asoine 'ro$i%es a )oo% eam'e* Most 'eo'e +ho b&! it ha$e no choice b&t to b&! it an% cannot si)nificant! c&t bac# on their cons&m'tion +itho&t '&rchasin) a ne+ $ehice or chan)in) their habits* Mar&inal Reven#e E,$laine% Mar)ina re$en&e is the a%%itiona re$en&e a com'an! )enerates b! sein) more &nits of a 'ro%&ct or ser$ice* =or eam'e, at a 'rice of 200, a com'an! mi)ht se 10 homema%e +oo%en tabes, for re$en&e of 2,000* C&t if it ses the tabes at a o+er 'rice of 190 (( thereb! ma#in) the 'ro%&ct more affor%abe an% increasin) %eman% (( it +i t!'ica! se more tabes* If it ses 11 tabes at 190 a'iece, that comes o&t to 2,090 in re$en&e (( 90 etra than at the 200 'rice 'oint* So in this case, the mar)ina re$en&e that comes from increasin) saes from 10 to 11 tabes b! %ecreasin) the 'rice from 200 to 190 e&as 90* In 'ractice, com'anies often maimi"e mar)ina re$en&e b! startin) o&t at a hi)her 'rice, +aitin) for saes to %ro' off an% on! then o+erin) the 'rice*
The &timate so&rce of 'o+er in a mar#et, e$en a mono'oistic mar#et, is the cons&mer, +ho sti res'on%s to 'rice b! chan)in) his %eman% e$e* As a cons&mer, !o& )et to %eci%e +hether !o&Fre +iin) an% abe to '&rchase a )oo% at a )i$en 'rice* In theor!, the mono'oist can char)e an! 'rice it +ants, b&t 'ractica!, the mono'oist canFt char)e too hi)h of a 'rice or !o& +onFt b&! the )oo%* The mono'oist is constraine% b! !o&r +iin)ness to 'a! the 'rice it char)es* =or eam'e, economists consi%er De Ceers a reso&rce mono'o! beca&se it effecti$e! contros the +or%Fs s&''! of %iamon%s* An% atho&)h %iamon%s are $er! 'o'&ar, if De Ceers #ee's raisin) its 'rice, cons&mers +i start s&bstit&tin) other 'recio&s )ems, s&ch as r&bies an% emera%s, for %iamon%s* Th&s, as %iamon% 'rices increase, the &antit! of %iamon%s cons&mers '&rchase +i %ecrease* The mono'oistFs 'ricin) %ecision is s&b/ect to the constraint im'ose% b! cons&mer %eman%* If the mono'oist char)es too hi)h of a 'rice, nobo%! +ants to b&! its 'ro%&ct* So, if the mono'oist +ants to se more 'ro%&ct, it m&st o+er 'rice as in%icate% b! the mar#et %eman% c&r$e* The in$erse reationshi' bet+een 'rice an% &antit! %eman%e% is the critica eement in mono'o! 'rice settin)* Ceca&se a sin)e firm 'ro$i%es the entire &antit! of the commo%it! in the mar#et, the %eman% for the mono'oistFs 'ro%&ct, re'resente% b! a o+er(case %, is the same as the mar#et %eman%, re'resente% b! a ca'ita D* The mar#et %eman% 'ossesses the &s&a characteristics an in$erse reationshi' bet+een 'rice an% &antit! %eman%e% an% chan)in) 'rice easticit! of %eman% aon) the %eman% c&r$e* In or%er to se more of its 'ro%&ct, the mono'oist m&st o+er its 'rice, not on! for the a%%itiona &nit b&t for e$er! other &nit as +e*
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The i&stration aso sho+s the reationshi' bet+een a mono'oistFs %eman% an% mar)ina re$en&e* ?emember that mar)ina re$en&e is the chan)e in tota re$en&e that occ&rs +hen one a%%itiona &nit of a )oo% is 'ro%&ce% an% so%* Ceca&se the mono'oistFs %eman% c&r$e is i%entica to the mar#et %eman% c&r$e, the mono'oist can se an a%%itiona &nit of o&t'&t on! b! o+erin) the 'ro%&ctFs 'rice* Ass&min) no 'rice %iscrimination -char)in) %ifferent c&stomers %ifferent 'rices for the same )oo%., this o+er 'rice is char)e% for a &nits of the commo%it! so%* As a conse&ence, the firmFs mar)ina re$en&e c&r$e ies beo+ its %eman% c&r$e* Mar)ina re$en&e is ess than 'rice* Mar)ina re$en&e the chan)e in tota re$en&e is beo+ the %eman% c&r$e* Mar)ina re$en&e is reate% to the 'rice easticit! of %eman% the res'onsi$eness of &antit! %eman%e% to a chan)e in 'rice* 5hen mar)ina re$en&e is 'ositi$e, %eman% is eastic an% +hen mar)ina re$en&e is ne)ati$e, %eman% is ineastic* The o&t'&t e$e at +hich mar)ina re$en&e e&as "ero corres'on%s to &nitar! easticit!* This occ&rs at the &antit! & in the i&stration* A inear %eman% c&r$e has the form
+here is the )oo%Fs 'rice in %oars an% is the &antit! %eman%e%* @onstants in the e&ation are re'resente% b! a an% b a is the interce't of the %eman% c&r$e -+here the %eman% c&r$e intersects the $ertica ais. an% bis the %eman% c&r$eFs so'e* Tota re$en&e, T?, e&as 'rice times &antit! or
Mar)ina re$en&e, M?, e&as the %eri$ati$e of tota re$en&e ta#en +ith res'ect to &antit!
If !o& com'are the mar)ina re$en&e e&ation +ith the %eman% e&ation, !o& see that both e&ations ha$e an interce't re'resente% b! a* The so'e of the %eman% e&ation is re'resente% b! :b, +hie the so'e of the mar)ina re$en&e e&ation is :2b* Th&s, for a
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inear %eman% c&r$e, the mar)ina re$en&e c&r$e starts at the same interce't as the %eman% c&r$e, b&t its so'e is t+ice as stee'* Elasticity o Deman% This is a $a&e that is cac&ate% b! the 'ercenta)e chan)e of %eman% for a 'ro%&ct %i$i%e% b! the 'ercenta)e chan)e in the 'rice of a 'ro%&ct* 8asticit! of %eman% is a $a&abe cac&ation to 're%ict ho+ s&''iers or cons&mer +i res'on% to a chan)e is 'rice of a %eman%e% 'ro%&ct* If +e &se the che+in) )&m eam'e an% sa! that this s&''iers choses to o+er itBs cost b! *2 for a ne+ 'rice of *7 an% the %eman% is no+ 12 &nits* 5ith these $a&es +e can cac&ate this cons&mer o+n 'rice easticit! of %eman% b! %i$i%in) the 'ercenta)e chan)e in &antit! -12(10.>10X*2 b! the 'ercenta)e chan)e in 'rice -1(*7.>1X*2* =or this eam'e the o+n 'rice easticit! of %eman% is *G +hich sho+s that the %eman% for che+in) )&m, in this eam'e, is rather ineastic to 'rice chan)es* Form#la or O/n )rice Elasticity o Deman%
8 X +n rice 8asticit! of Deman% of oo% 聽 at an% beo+ R]^ X the ercenta)e @han)e in &antit! Deman%e% of oo% R]^ X the ercenta)e @han)e in rice of oo% 8 X - R]^ . > - R]^ . More abo&t 8acticit! of Deman% is ocate% 聽 in this MCAecon site as +e* Relationshi$ (et/een Mar&inal Reven#e an% Elasticity o Deman% The reationshi' bet+een M? an% 8D is that each meas&rement is im'ortant in mana)eria %ecisions on 'rice an% &antit!* =or eam'e if a mana)ers &n%erstan%s the easticit! of %eman% for its 'ro%&ct, he or she +i be abe to ma#e in informe% %ecision on ho+ cons&mers +i react to a 'rice increase or %ecrease* If the mana)er %eci%es to raise the 'rice of the 'ro%&ct an% %eman% for the 'ro%&ct is eastic, cons&mers +i i#e! '&rchase ess of the 'ro%&ct* Form#la
M? X Mar)ina ?e$en&e X rice of the oo% 8 X +n rice 8asticit! of Deman% M? X \ J - 1 Y 8 . > - 8 . K =orm&a @onse&ences
5hen 8 is bet+een ne)ati$e infinit! -ec&si$e. an% (1 -ec&si$e., then %eman% is eastic, an% the form&a im'ies that M? is 'ositi$e* 5hen 8 X (1, %eman% is &nitar! eastic, an% the form&a imies that M? is 'ositi$e*
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5hen 8 is bet+een (1 -ec&si$e. an% 0 -ec&si$e., %eman% is ineastic, an% mar)ina re$en&e is ne)ati$e* A%%itional )rinci$les
A*. Tota ?e$en&e Test ( if the %eman% is eastic, then an increase in 'rice +i ea% to a %ecrease in tota re$en&e* This is tr&e beca&se, accor%in) to the form&a, the %ecrease in &antit! so%, as a 'ercenta)e, +i more than co&nteract the increase in re$en&e from char)in) ar)er 'irces* So on the contrar!, if %eman% is eastic, then a %ecrease in 'rices +i ea% to a increase in tota re$en&e* n the other han%, if the %eman% is ineastic, then an increase in 'rice +i ea% to an increase in tota re$e&ne* This is tr&e beca&se, accor%in) to the form&a, the increase in re$en&e, as a 'ercenta)e, is ar)er than the %ecrease in %eman% that +i res&t from the 'irce increase* So on the contrar!, if %eman% is ineastic, then a %ecrease in 'rice +i ea% to an %ecrease in tota re$en&e*
C*. Tota re$ne&e is maimi"e% at the 'oint +here %eman% is &nitar! eastic -+here the o+n 'rice easticit! of %eman% is e&a to 聽 ne)ati$e one Real -orl% E,am$les 8am'e 1; Nesse +or#s at the S&'er'e G, +hich is a ma/or mo$ie theatre in his to+n* His mana)er, Sharon, has recent! hire% economic cons&tants that ha$e to% her that at the c&rrent of 'o'corn, the easticit! of %eman% is (0*7* Sharon tes Nesse to raise the 'rice of an or%er of 'o'corn from to 6* Nesse, a mathematics st&%ent, sa!s, That is a 20R rise in the 'rice of 'o'corn @&stomers +i re$ot an% b&! man! fe+er or%ers of 'o'corn, or none at a*
Ans+er 1; 聽 5hie Nesse is mathematica! correct, he co&% &se a itte he' in economics* Since the easticit! of %eman% for 'o'corn is (0*7, that means that the %eman% is ineastic at that 'oint* Ta#in) it f&rther, this means that the tota re$n&e +i rise +ith an increase in the 'rice*
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III" T4EOR OF CONSUMER (E4A
@ar%ina a''roach is the one, +hich rests on the ass&m'tion that &tiit! can be meas&re%* Here it im'ies that &tiit! can be &antifie%* In car%ina a''roach, &tiit! is state% or meas&re% in +hat is #no+n as &tisF* 5hat are these &tis< These are the meas&rements of &tiit!, atho&)h in rea terms the! are not i#e the stan%ar% &nits of meas&rements i#e mies, #iometres, metres an% so on* So if the &tis are not i#e the stan%ar% meas&rement &nits, then +hat %o the! e'ain< Ho+ %o +e then com'rehen% the conce't of &tis< =or instance, a san%+ich ma! 'ro$i%e a &tiit! of 30 &tis an% a b&r)er ma! 'ro$i%e a &tiit! of 40 &tis to a cons&mer* It sho+s that b&r)er has more &tiit! to the cons&mer than the san%+ich has an% b! ho+ man! &tis the b&r)er 'ro$i%es more &tiit!, is aso inferre%* @onsi%er another eam'e, +herein one )ass of ime +ater 'ro$i%es a &tiit! of 10 &tis, one )ass of a''e /&ice 'ro$i%es a &tiit! of 20 &tis an% a sin)e )ass of man)o mi#sha#e 'ro$i%es a &tiit! of 3 &tis to a cons&mer* In this case aso, the &tiit! 'ro$i%e% to the cons&mer is bro&)ht o&t thro&)h the &tis an% one can &n%erstan% ho+ a cons&mer 'refers man)o mi# sha#e o$er a''e /&ice an% a''e /&ice o$er ime +ater thro&)h the n&mber of &tis* C&t here care nee%s to be ta#en that this %oes not im'! an! conc&sion or reation bet+een the three choices b&t /&st the 'references of the cons&mer* The eam'e in%icates the %ifference of &tis bet+een the ime +ater an% a''e /&ice an% bet+een a''e /&ice an% man)o mi#sha#e* So, the abo$e eam'es in%icate that car%ina &tiit! ma#es &se of &tis to arri$e at the &tiit!* The &n%er!in) satisfaction that a cons&mer %eri$es from a 'ro%&ct is '&t into &tis an% hence &ni#e other meas&rement &nit &tis rest &'on the intan)ibe satisfaction or contentment, +hich in itsef is not 'h!sica in nat&re* Does car%ina &tiit! faciitate &tiit! com'arisons across in%i$i%&as< 5e nee% to reai"e that the abo$e eam'es, +hich +ere cite% b! &s, in%icate the 'references of the cons&mer* These 'references ma! $ar! across the cons&mers an% therefore it +o&% not be a''ro'riate to )enerai"e or ma#e inter'ersona com'arisons* Another im'ortant as'ect in this case, is the 'ro'ortion of amo&nt s'ent on the 'ro%&cts* Do more amo&nts 'ai%, in%icate more &tis< @onsi%er a cons&mer +ho shes o&t 100 ?&'ees on a chocoate ca#e an% 10 ?&'ees on a cheese ca#e* The &tiit! he>she %eri$es from one chocoate ca#e is 0 &tis, +hereas that from one cheese ca#e is 4 &tis* So here the settin) factor is the 'reference, i#es an% %isi#es of the cons&mer* 8$en tho&)h the cons&mer has 'ai% more for the cheese ca#e, the &tiit! for him is more thro&)h the chocoate ca#e sim'! beca&se his 'reference is s#e+e% to+ar%s chocoate ca#e rather than cheese ca#e* Car%inal A$$roach to Utility :
The @ar%inaist schoo asserts that &tiit! can be meas&re% an% &antifie%* It means, it is 'ossibe to e'ress &tiit! that an in%i$i%&a %eri$es from cons&min) a commo%it! in &antitati$e terms* Th&s, a 'erson ma! e'ress the &tiit! he %eri$es from cons&min) an a''e as 10 &tis or 20 &tis*Moreo$er, it ao+s cons&mers to com'are an% %efine the
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%ifference in &tiities 'ercei$e% in t+o commo%ites* Th&s, it ao+s an in%i$i%&a to state that commo%it! A -accr&in) an &tiit! of 20 &tis. )i$es %o&be the &tiit! of commo%it! C - +hich accr&es an &tiit! of 10 &tis.* Or%inal A$$roach to Utility :
The or%inaist schoo asserts that &tiit! cannot be meas&re% in &antitati$e terms* ?ather, the the cons& cons&me merr can can com'a com'are re the &ti &tiit it! ! accr accr&i &in) n) from from %iffe %iffere rent nt comm commo%i o%iti ties es -as -as a combination of them. an% ran# them in accor%ance +ith the satisfaction each commo%it! -or combination of commo%ities. )i$es him* Th&s, the car%ina a''roach to the meas&rement of &tiit! beie$es that &tiit! %eri$e% from the cons&m'tion of a commo%it! can be e'resse% in &antitati$e terms* The or%inaist or%inaist a''roach a''roach re/ects re/ects this an% states that the cons&mer at best can ran# the $ario&s $ario&s commo%ities -or combination of them. in accor%ance +ith the satisfaction that he e'ects from their cons&m'tion* Total Utility an% Mar&inal Utility :
Tota &tiit! -TU. is the a))re)ate &tiit! %eri$e% b! a cons&mer after cons&min) a the a$aiabe &nits of a commo%it!* Th&s, it is the s&m of a the &tiities accr&in) from each in%i$i%&a &nits of the commo%it!* commo%it!* Mar)ina &tiit! -MU., on the other han%, is the &tiit! fo+in) from an a%%itiona &nit of a commo%it!, o$er an% abo$e +hat ha% been cons&me%* ii. Cons#mer E9#ili0ri#m an% Income Cons#m$tion C#rve
A cons&mers stri$e to maimi"e their &tiit!* 5e tr! to )et as m&ch satisfaction as +e can* The cons&merFs scae of 'reference is %eri$e% b! means of in%ifference ma''in) that is a set of in%ifference c&r$es +hich ran#s the 'references of the cons&mer* ettin) to the in%if in%iffer ference ence c&r$e c&r$e +hich +hich is farthe farthest st from from the ori)in ori)in )i$es )i$es the hi)hes hi)hestt tota tota &tii &tiit! t!** Atho&) Atho&)h h the )oa )oa of the cons&m cons&mer er is maimi maimi"at "ation ion of satisf satisfact action ion,, the means means of achi achie$i e$in) n) the the )oa )oa is not cea cearr* Hi)h Hi)her er in%i in%ifffere ferenc ncee c&r$e c&r$e not on! on! )i$es )i$es hi)h hi)her er satisfact satisfaction ion b&t aso are more e'ensi$e* e'ensi$e* Here +e are confronte% confronte% +ith the basic confict confict bet+een 'references an% the 'rices of the commo%ities cons&mer +ants to cons&me* 5ith 5ith a )i$en amo&nt of mone! income to s'ent, +e cannot attain the hi)hest satisfaction b&t ha$e to sette for ess* Ass#m$tions Con%itions or cons#mer!s e9#ili0ri#m
1*A )i$en b&%)et ine m&st be tan)ent to an in%ifference c&r$e , or the mar)ina rate of s&bstit&tion bet+een commo%it! [ an% commo%it! -M?S ,!. m&st be e&a to the 'rice ratio bet+een the t+o )oo%s *
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2*At the 'oint of e&iibri&m, in%ifference c&r$e m&st be con$e to the ori)in*
The imi The imita tati tion on on &ti &tiit it! ! mai maimi mi"a "ati tion on is e$i% e$i%en ent* t* 5e +ant +ant to reac reach h the the hi)he hi)hest st in%ifference c&r$e +ith o&r imite% income* o& can )o on! as far as !o&r b&%)et constraint ao+s* S&''ose !o& ha$e on! 0 r&'ees to s'en% on )oo% [ an% )oo% * The 'rice of a &nit of [ is 10 r&'ees +here as the 'rice of )oo% is r&'ees* o& can ha$e as man! as &nits of )oo% [ if !o& +ant to forsa#e )oo% * * Simiar! !o& can ha$e 10 &nits of )oo% +ith the same 0 r&'ees*The b&%)et constraints i&strates a combination of )oo%s !o& can b&! +ith a imite% income* In this case the b&%)et ine i&strates the combination of [ an% , that can be '&rchase% +ith 0 r&'ees*
Abo$e Abo$e %ia) %ia)ra ram m e'a e'ain in the the 'roc 'roces esss of cons cons&m &merF erFss e&i e&ii ibr bri& i&m m * Th Thee cons cons&m &merF erFss 'reference scae is %escribe% b! means of in%ifference ma''in) *Then +e im'ose a b&%)et ine that refects o&r income* In this case +e ha$e r 0 an% the 'rice of )oo% [ an% )oo% is r 10 an% r res'ecti$e!* res'ecti$e!* Therefore, +e can affor% on! those combinations that are on or insi%e the 'rice ine H* In this %ia)ram e$er! combination on the 'rice ine H cost !o& the same amo&nt of mone!* In or%er to maimi"e the &tiit! , +e +i tr! to reach the hi)hest in%ifference c&r$e +hich !o& co&% )et +ith a )i$en e'en%it&re of mone! an% )i$en 'rices of t+o )oo%s*The b&%)et ine to&ches I@2 at 'oint 8 re'resents the most &tiit!* This is the hi)hest attainabe in%ifference c&r$e +ith +hich !o& can )et 1 &nits of )oo% [ an% 2 &nits of )oo% for r 0* An! other affor%abe combinations on the 'rice ine H )i$es !o& ess satisfaction, beca&se that +i be on a o+er in%ifference c&r$e I@1* 5ith this +e conc&%e that the 'oint of tan)enc! bet+een the b&%)et ine an% an in%ifference c&r$e re'resents o'tima cons&m'tion* It is the affor%abe combination that maimi"e o&r &tiit!* At the tan)enc! 'oint 8 the so'e of the 'rice ine H an% in%ifference c&r$e are e&a* So'e of the in%ifference c&r$e sho+s the mar)ina rate of s&bstit&tion of [ for * The 'rice ine in%icates the ratio bet+een the 'rices of t+o )oo%s -[>.* Th&s at the e&iibri&m 'oint 8,MRSHX)rice o &oo% ,*)rice o &oo% y X )H*) The tan)enc! bet+een the )i$en 'rice ine an% an in%ifference c&r$e is a necessar! b&t
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not a s&fficient con%ition cons&merFs e&iibri&m *The secon% con%ition for cons&merFs e&iibri&m is con$eit! of in%ifference c&r$e to the ori)in * -hich means MRS,y is allin& at the $oint o e9#ili0ri#m *
In fi) no (1 in%ifference c&r$e I@2 is con$e to the ori)in at 'oint 8, is the o'tim&m or best choice for the cons&mer *The cons&mer attains a stabe e&iibri&m 'osition +here he is abe to cons&me the most 'referre% combination +hich )i$es him hi)hest &tiit!* In fi)&re no (2 ,I@1 is conca$e to the ori)in at 'oint 8* rice ine AC is tan)ent to the in%ifference c&r$e I@1 at 'oint 8 an% the mar)ina rate of s&bstit&tion of [ for is e&a to the the 'ric 'ricee rati ratio o of t+o t+o )oo )oo%s %s -[> -[> .* .* C&t C&t 8 canno cannott be the the 'osi 'ositi tion on of stab stabe e e&iibri&m beca&se satisfaction +o&% not be maim&m *There are other combinations i#e an% H in the )i$en 'rice ine +i be on hi)her in%ifference in%ifference c&r$e *The con)&mer b! mo$in) aon) the )i$en 'rice ine AC can )o to other tan)enc! 'oints&ch as an% H an% obtain )reater satisfaction than at 'oint 8* Mar&inal Utility an% )rice
The so'e of the in%ifference c&r$e sho+s the mar)ina rate of s&bstit&tion of )oo% [ for )oo% , +hie the so'e of 'rice ine in%icates the ratio bet+een 'rices of t+o )oo%s i*e* - [ >.* @onsa&mer e&iibri&m +as re'resente% as the combination of )oo% [ an% )oo% can be +ritten as X Aternati$e!, X This e&ation e'ains that at the 'oint of e&iibri&m the reati$e mar)ina &tiities of )oo% [ an% )oo% sho&% sho&% e&a to their reati$e reati$e 'rices* 'rices* In other +or%s , if )oo% [ cost t+ice as m&ch as )oo% , then mar)ina &tiit! of )oo% [ m&st !ie% %o&be , then the cons&mer is in an o'tima state* The so'e of the b&%)et constraint e&a the reati$e 'rices of the t+o )oo%s* In =i)(1, the so'e of the 'rice ine e&a to the 'rice of )oo%s [ an% )oo% * It means the rate of s&bstit&tion bet+een the )oo% [ an% )oo% is 1;2* The reati$e mar)ina &tiities of the t+o )oo%s are refecte% in the so'e of the in%ifference c&r$e* It is the mar)ina r ate of s&bstit&tion +hich is e&a to the reati$e mar)ina &tiities of the t+o )oo%s*
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At the 'oint of o'tima cons&m'tion 8 in fi)(1 the b&%)et constraint is tan)ent to the in%ifference c&r$e I@2* 5hich means, r Mar)ina rate of s&bstit&tion of [ for X Cons#mer!s E9#ili0ri#m an% Non=normal cases
As +e %isc&sse% earier , in%ifference c&r$es are &s&a! con$e to the ori)in *@on$eit! of in%ifference c&r$e im'ies the mar)ina rate of s&bstit&tion of [ for %ecreases *The 'ossibiit! of conca$it! cannot be r&e% o&t in some ece'tiona cases* C&t at the same time conca$it! im'ies increasin& mar&inal rate o s#0stit#tion o H or *The cons&mer +i choose or b&! on! one &oo%*
=i) o(3 The 'rice ine AC is tan)ent to the in%ifference c&r$e I@2 * C&t the co ns&mer cannot be in e&iibri&m at 'oint 8 beca&se it can obtain )rater satisfaction b! mo$in) aon) the )i$en 'rice ine *@ons&mers satisfaction increases b! either mo$in) &'+ar% or %o+n+ar% ti he reaches the etremit! 'oints A on the !(ais or C on the :ais* In these cases cons&mer +i choose on! one of t+o )oo%s, %e'en%in) on his scae of 'reference an% e$e of satisfaction bet+een )oo% an% )oo% !* In the abo$e %ia)ram A ies on a hi)her in%ifference c&r$e than Therefore the cons&mer +i choose on! an% b&! A of commo%it! * It is aso note% that cons&mer is not tan)ent to the in%ifference c&r$e at 'oint A *Therefore cons&merFs e&iibri&m cannot be estabish at 'oint A * In case of 'erfect com'ementar! )oo%s ,the sha'e of the in%ifference c&r$e ha$e a ri)ht :an)e% *The e&iibri&m of the cons&mer cannot be estabishe% beca&se on! one 'oint of the in%ifference c&r$e is tan)ent to the 'rice ine AC* The Income @ons&m'tion @&r$e is the set of o'tima b&n%es +hen income chan&es , +hie 'references an% 'rices of )oo%s are #e't constant* ict&re% beo+ is the c&r$e for a norma )oo%* The I@@ for an inferior )oo% ben%s bac#+ar%s* iii. En&els C#rve an% Deman% C#rve
@ons&mer income -. is a #e! %eterminant of cons&mer %eman% -%.* The reationshi' bet+een income an% %eman% can be both %irect an% in$erse* orma )oo%s
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In the case of norma )oo%s, income an% %eman% are %irect! reate%, meanin) that an increase in income +i ca&se %eman% to rise an% a %ecrease in income ca&ses %eman% to fa* =or eam'e, &&ries i#e cars an% com'&ters are norma )oo%s for most 'eo'e* Inferior )oo%s In the case of inferior )oo%s income an% %eman% are in$erse! reate%, +hich means that an increase in income ea%s to a %ecrease in %eman% an% a %ecrease in income ea%s to an increase in %eman%* =or eam'e, necessities i#e brea% are often inferior )oo%s* It sho&% be note% that normaF an% inferiorF are '&re! reati$e conce'ts* An! )oo% or ser$ice co&% be an inferior one &n%er certain circ&mstances* 8$en &&r! )oo%s can become inferior o$er time* Ei%eo 'a!ers +ere once &&ries, b&t as incomes ha$e risen cons&mers ha$e s+itche% to DEDs* 8n)e c&r$es 8n)e @&r$es, name% after 19th @ent&r! erman statistician 8rnst 8n)e, i&strate the reationshi' bet+een cons&mer %eman% an% ho&seho% income* 8n)e c&r$es for norma )oo%s so'e &'+ar%s : the fatter the so'e the more &&rio&s the )oo%, an% the )reater the income easticit!* In contrast, 8n)e c&r$es for inferior )oo%s ha$e a ne)ati$e so'e*
Deman% for the three )oo%s, sho+n here, a res'on% $er! %ifferent! to the same chan)e in income, to 1* Deman% for the norma )oo% increases from to 1, %eman% for the &&r! )oo% rises m&ch more, to 2, an% %eman% for the inferior )oo% fas from to 3* iv. En&els C#rve an% Income Elasticity o Deman% Income Elasticity o Deman% . Definition; A meas&re of the res'onsi$eness of the %eman% c&r$e to chan)es in the income of the 'eo'e %eman%in) the )oo% 8&ation; JH*H. JI*I. often sim'ifie% to JH*JI. I*H. The e&ation in 'ain 8n)ish; the ratio of the 'ercenta)e chan)e in %eman% for a )oo% -[. to the 'ercenta)e chan)e in income of cons&mers
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Income easticit! is a too &se% to fi)&re o&t cons&mer '&rchasin) beha$ior re)ar%in) a certain 'ro%&ct +hen incomes are raise% or o+ere%* This is t!'ica! %one b! %ra+in) a )ra'h +ith cons&mer in%ifference c&r$es at %ifferent e$es of &tiit! an% b&%)et constraint ines* 5hen +e %o this an% connect a the %ifferent 'oints of tan)enc! bet+een in%ifference c&r$es an% b&%)et constraint ines, +e )et an Income 8'ansion ath -I*8**. that re'resents a the &tiit!(maimi"in) combinations of the )oo% +e are intereste% in -)oo% [. an% mone! s'ent on a other )oo%s -)oo% .* See the )ra'h beo+ for an eam'e*
It is im'ortant to note that this is a norma )oo%* Most )oo%s beha$e norma!, +hich means that as a cons&merBs income rises, the! '&rchase more of a )i$en )oo%* This )ra'h )i$es &s eno&)h information to create an 8n)e @&r$e for )oo% [*
The 8n)e @&r$e Definition; @&r$e 'ottin) 8'en%it&re on oo% [ -+hich is the same as the &antit! of [ times a constant 'rice. $ers&s Income
Ceo+ +e ha$e the 8n)e @&r$e for the )oo% [ sho+n in the )ra'h abo$e* ote the 'oints here corres'on% to the 'oints on the I*8** from the 're$io&s )ra'h an% the c&r$e has a 'ositi$e so'e, in%icati$e of a norma )oo%* The 'rice of )oo% [ has been set as 1* -Ce caref&* Tetboo#s &s&a! '&t income I on the hori"onta ais an% cons&m'tion of [ on the $ertica ais* The %ia)ram beo+ has them in the re$erse of the &s&a 'ositions*.
A &&r! )oo% is a s'ecific t!'e of norma )oo% an% is sometimes cassifie% %ifferent!* It is a )oo% that beha$es i#e a norma )oo%, b&t as income rises, a hi)her 'ercenta)e of tota income is s'ent on the )oo% -it has a hi)h income easticit!.* 8am'es inc&%e /e+er!, fashionabe cothin), an% fine acohos*
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Inferior oo%s Definition; As income rises, cons&mers '&rchase ess of an inferior )oo%
Ceo+ +e ha$e the I*8** for an inferior )oo%, aon) +ith the stan%ar% in%ifference c&r$es an% b&%)et ines*
8n)e @&r$e for an Inferior oo%; Ass&me a 'rice of 1 for )oo% [* ote the ne)ati$e the c&r$e, a characteristic of an inferior )oo%* inc&%e &se% cars, ?amen noo%es, an% b&s fare* v. )rice Cons#m$tion C#rve an% Deman% C#rve
so'e of 8am'es
5e ha$e area%! seen ho+ the 'rice cons&m'tion c&r$e traces the effect of a chan)e in 'rice of a )oo% on its &antit! %eman%e%* Ho+e$er, it %oes not %irect! sho+ the reationshi' bet+een the 'rice of a )oo% an% its corres'on%in) &antit! %eman%e%* It is the %eman% c&r$e that sho+s reationshi' bet+een 'rice of a )oo% an% its &antit! %eman%e%* In this section +e are )oin) to %eri$e the cons&merBs %eman% c&r$e from the 'rice cons&m'tion c&r$e * =i)&re*1 sho+s %eri$ation of the cons&merBs %eman% c&r$e from the 'rice cons&m'tion c&r$e +here )oo% [ is a norma )oo%* FIGURE"1 Derivation o the Deman% C#rve: Normal Goo%s
The &''er 'ane of =i)&re*1 sho+s 'rice effect +here )oo% [ is a norma )oo%* AC is the initia 'rice ine* S&''ose the initia 'rice of )oo% [ - . is * e is the initia o'tima cons&m'tion combination on in%ifference c&r$e U* The cons&mer b&!s [ &nits of )oo% [* 5hen 'rice of [ -.fas, to sa! 1, the b&%)et constraint shift to AC1* The o'tima cons&m'tion combination is e1 on in%ifference c&r$e U1* The cons&mer no+ increases cons&m'tion of )oo% [ from [ to [ 1 &nits* The rice @ons&m'tion @&r$e -@@. is risin) &'+ar%s* @hart*1 sho+s the %eman% reationshi' %eri$e% form the 'rice cons&m'tion c&r$e* Chart"1
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The o+er 'ane of =i)&re*1 sho+s this 'rice an% corres'on%in) &antit! %eman%e% of )oo% [ as sho+n in @hart*1* At initia 'rice , &antit! %eman%e% of )oo% [ is [* This is sho+n b! 'oint a* At a o+er 'rice 1, &antit! %eman%e% increases to [1* This is sho+n b! 'oint b* DD 1 is the %eman% c&r$e obtaine% b! /oinin) 'oints a an% b* The %eman% c&r$e is %o+n+ar% so'in) sho+in) in$erse reationshi' bet+een 'rice an% &antit! %eman%e% as )oo% [ is a norma )oo%* In this section +e are )oin) to %eri$e the cons&merBs %eman% c&r$e from the 'rice cons&m'tion c&r$e in the case of inferior )oo%s* =i)&re*2 sho+s %eri$ation of the cons&merBs %eman% c&r$e from the 'rice cons&m'tion c&r$e +here )oo% [ is an inferior )oo%* Derivation o the Deman% C#rve: Inerior Goo%s
The &''er 'ane of =i)&re*2 sho+s 'rice effect +here )oo% [ is an inferior )oo%* AC is the initia 'rice ine* S&''ose the initia 'rice of )oo% [ - .is * e is the initia o'tima cons&m'tion combination on in%ifference c&r$e U* The cons&mer b&!s [ &nits of )oo% [* 5hen 'rice of [ . fas, to sa! 1, the b&%)et constraint shift to AC1* The o'tima cons&m'tion combination is e1 on in%ifference c&r$e U1* The cons&mer no+ re%&ces cons&m'tion of )oo% [ from [ to [1 &nits as )oo% is inferior* The rice @ons&m'tion @&r$e -@@. is risin) &'+ar%s an% ben%in) bac#+ar%s to+ar%s the (ais* @hart*1 sho+s the %eman% reationshi' %eri$e% form the 'rice cons&m'tion c&r$e* Chart"2
The o+er 'ane of =i)&re*2 sho+s this 'rice an% corres'on%in) &antit! %eman%e% of )oo% [ as sho+n in @hart*2* At initia 'rice , &antit! %eman%e% of )oo% [ is [* This is sho+n b! 'oint a* At a o+er 'rice 1, &antit! %eman%e% %ecreases to [1* This is sho+n b! 'oint b* DD1 is the %eman% c&r$e obtaine% b! /oinin) 'oints a an% b* The %eman% c&r$e is &'+ar% so'in) sho+in) %irect reationshi' bet+een 'rice an% &antit! %eman%e% as )oo% [ is an inferior )oo%* In this section +e are )oin) to %eri$e the cons&merBs %eman% c&r$e from the 'rice cons&m'tion c&r$e in the case of ne&tra )oo%s* =i)&re*3 sho+s %eri$ation of the cons&merBs %eman% c&r$e from the 'rice cons&m'tion c&r$e +here )oo% [ is a ne&tra )oo%* FIGURE"6 Derivation o the Deman% C#rve: Ne#tral Goo%s
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The &''er 'ane of =i)&re*3 sho+s 'rice effect +here )oo% [ is a ne&tra )oo%* AC is the initia 'rice ine* S&''ose the initia 'rice of )oo% [ -. is * e is the initia o'tima cons&m'tion combination on in%ifference c&r$e U* The cons&mer b&!s [ &nits of )oo% [* 5hen 'rice of [ - .fas, to sa! 1, the b&%)et constraint shift to AC1* The o'tima cons&m'tion combination is e1 on in%ifference c&r$e U1 at +hich the cons&mer b&!s same [ &nits of )oo% [ as it is a ne&tra )oo%* The rice @ons&m'tion @&r$e -@@. is a $ertica strai)ht ine* @hart*3 sho+s the %eman% reationshi' %eri$e% form the 'rice cons&m'tion c&r$e* Chart"6
The o+er 'ane of =i)&re*3 sho+s this 'rice an% corres'on%in) &antit! %eman%e% of )oo% [ as sho+n in @hart*3* At initia 'rice , &antit! %eman%e% of )oo% [ is [* This is sho+n b! 'oint a* At a o+er 'rice 1, &antit! %eman%e% remains fie% at [* This is sho+n b! 'oint b* DD1 is the %eman% c&r$e obtaine% b! /oinin) 'oints a an% b* The %eman% c&r$e is a $ertica strai)ht ine sho+in) that the cons&m'tion of )oo% [ is fie% as )oo% [ is a ne&tra )oo%* Deman% C#rve o& sho&% &se the %eman% c&r$e +hen consi%erin) ho+ to 'rice a sin)e 'ro%&ct* enera!, the o+er the 'rice, the hi)her the %eman% +i be* The %eman% c&r$e can ha$e a stee' so'e or a )ente so'e, %e'en%in) on the 'ro%&ct* This means that for some items, a si)ht chan)e in 'rice can )reat! affect the %eman% for it, +hie other 'ro%&cts e'erience a m&ch stea%ier %eman% %es'ite 'rice chan)es* o& ha$e to e'eriment +ith the 'ricin) on in%i$i%&a 'ro%&cts to %etermine ho+ 'rice +i affect %eman%* )rice Cons#m$tion C#rve The rice @ons&m'tion @&r$e %eas +ith t+o e&a! attracti$e 'ro%&cts a cons&mer ma! be consi%erin)* The c&r$e aso ta#es into acco&nt the c&stomerFs b&%)et* The t+o 'ro%&cts can be entire! %ifferent from each other, s&ch as )as an% foo%, an% !o& ass&me the cons&mer +ants or nee%s both of them* At the 'oint +here the 'rice for the t+o 'ro%&cts to)ether is in the c&stomerFs b&%)et an% she can ha$e both of them, !o& fin% e&iibri&m* If !o& raise !o&r 'rice, the cons&mer ma! c&t bac# on '&rchases of the other 'ro%&ct for a+hie, b&t a s&staine% 'rice increase on !o&r 'art can ca&se the b&!er to for)o !o&r 'ro%&ct beca&se of the 'ercei$e% nee% for the other one o$er !o&rs* )rice Cons#m$tion C#rve an% )rice Elasticity o Deman%
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It is aso 'ossibe to #no+ +ith in%ifference c&r$e ana!sis +hether 'rice easticit! is more than one, e&a to one or ess than one* It is from the so'e of 'rice cons&m'tion c&r$e that +e are abe to /&%)e the 'rice easticit! of %eman%* Let &s ta#e =i)* 13*19 +here on the (ais mone! income is meas&re% an% on [(ais the &antit! of a commo%it! [* It is ass&me% that the cons&mer has A amo&nt of mone! to s'en%* 8ach of the in%ifference c&r$es %ra+n bet+een the t+o aes +i sho+ the $ario&s combinations of mone! an% )oo% [ amon) +hich cons&mer is in%ifferent* To be)in +ith, AC is the 'rice ine* The so'e of the 'rice ine AC, i*e*, A>C +i )i$e the 'rice of )oo% [* At this 'rice -i*e*, +ith 'rice ine AC. the cons&mer is in e&iibri&m at 'oint 1 on in%ifference c&r$e I@1an% is b&!in) [1 of )oo% [* Th&s, in this e&iibri&m 'osition, he is ha$in) combination of [1 of )oo% [ an% 1 of mone!* It means that he has s'ent A1 of mone! on the )oo% [ an% has obtaine% [1 of its &antit!* Let 'rice of )oo% [ fas, mone! income of the cons&mer remainin) the same, so that +e )et a ne+ 'rice ine A@* The ne+ 'rice of )oo% [ +i be )i$en b! the so'e of the ne+ 'rice ine A@, i*e*, A>@* 5ith this o+er 'rice or +ith 'rice ine A@, the cons&mer is in e&iibri&m at 2 on in%ifference c&r$e I@2* At this ne+ e&iibri&m 'osition 2 the cons&mer is )ettin) [2of )oo% [ an% amo&nt 2 of mone! is et +ith him* It means that at the o+er 'rice of )oo% [ he has s'ent A2 amo&nt of mone! on it +hich is )reater than the amo&nt A1of mone! +hich he s'ent at the ori)ina 'rice* Th&s, +ith the fa in 'rice, his e'en%it&re on the )oo% [ has increase%* Simiar!, +hen the 'rice of )oo% [ fas f&rther so that AD is no+ the ree$ant 'rice ine, cons&mer is in e&iibri&m at 3 +here he is s'en%in) A3 amo&nt of mone! an% is ha$in) [3 &antit! of the )oo% [* Mone! e'en%it&re A3 is )reater than A2* It is th&s cear that in the 'resent case +hen the 'rice cons&m'tion c&r$e is so'in) %o+n+ar% -i*e*, @@ has a ne)ati$e so'e., +ith the re%&ction in 'rice of the )oo% [ the cons&merFs mone! o&ta! on the )oo% [ increases* In =i)* 13*19 in%ifference ma' %e'ictin) 'references of the cons&mer is s&ch that +e )et a %o+n+ar% so'in) cons&m'tion c&r$e +hich means, as e'aine% abo$e, that +ith the fa in the 'rice of )oo% [, cons&merFs e'en%it&re on it rises* In =i)* 13*21, in%ifference or 'reference ma' of the cons&mer is s&ch that it !ie%s an &'+ar%( so'in) 'rice cons&m'tion c&r$e @@ -that is, the so'e of the 'rice cons&m'tion c&r$e is 'ositi$e.* It +i be seen that in this case cons&merFs o&ta! on the )oo% %ecreases +ith the fa in the 'rice of the )oo%* 5hen the 'rice fas an% the 'rice ine shifts from AC to A@, the &antit! %eman%e% of the )oo% rises from [1 to [2 b&t cons&merFs e'en%it&re on the )oo% [ fas from A1 to A3*
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Li#e+ise, +hen 'rice fas f&rther an% as a res&t 'rice ine shifts from A@ to AD, tho&)h &antit! %eman%e% of the )oo% [ rises from [2, to [3, cons&merFs e'en%it&re on the )oo% [ fa s from A2 to A3* Th&s &'+ar% so'in) 'rice cons&m'tion c&r$e means a %ecine in cons&merFs e'en%it&re as the 'rice of the )oo% [ fas* Since a fa in cons&merFs e'en%it&re as a res&t of the fa in 'rice means that %eman% for the )oo% is ineastic, &'+ar%(so'in) 'rice cons&m'tion c&r$e +i therefore sho+ ineastic %eman%, i*e*, easticit! +i be ess than one* To s&m &', %o+n+ar%(so'in) 'rice cons&m'tion c&r$e for a )oo% means that %eman% for the )oo% is eastic, &'+ar%(so'in) 'rice cons&m'tion c&r$e means that %eman% for the )oo% is ineastic an% hori"onta strai)ht(ine 'rice cons&m'tion c&r$e means that %eman% for the )oo% is &nit eastic* In o&r abo$e ana!sis, +e ha$e %ra+n s&ch in%ifference('reference ma's +hich !ie% s&ch a 'rice cons&m'tion c&r$e that sho+s either on! 'rice cons&m'tion c&r$e that sho+s either on! eastic %eman%, or on! ineastic %eman%, or on! &nitar! eastic %eman% o$er its entire ran)e* Since easticit! of %eman% $aries at %ifferent 'rices, +e can aso %ra+ s&ch an in%ifferent ma' that !ie%s 'rice cons&m'tion c&r$e +hich sho+s %ifferent easticities at %ifferent 'rice e$es* This +e ha$e %e'icte% in fi)* 13*22 +here it +i be seen that from 1 to 2 'rice cons&m'tion c&r$e is so'in) %o+n+ar%, therefore o$er this ran)e %eman% for the )oo% is eastic -i*e*, e'Z 1.* =rom 2to 3 'rice cons&m'tion c&r$e is hori"onta, therefore, the easticit! is here e&a to &nit -i*e* e' X 1.* =rom 3 to 4 an% on+ar% 'rice cons&m'tion c&r$e so'es &'+ar%, so o$er this ran)e %eman% for the )oo% is ineastic -i*e* e']1.*
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I<" TO)ICS IN CONSUMER DEMAND The branch of economics %e$ote% to the st&%! of cons&mer beha$ior, es'ecia! as it a''ies to %ecisions reate% to '&rchasin) )oo%s an% ser$ices thro&)h mar#ets* @ons&mer %eman% theor! is ar)e! centere% on the st&%! an% ana!sis of the &tiit! )enerate% from the satisfaction of +ants an% nee%s* The #e! 'rinci'e of cons&mer %eman% theor! is the a+ of %iminishin) mar)ina &tiit!, +hich offers an e'anation for the a+ of %eman% an% the ne)ati$e so'e of the %eman% c&r$e* @ons&mer %eman% theor! 'ro$i%es insi)ht into an &n%erstan%in) mar#et %eman% an% forms a cornerstone of mo%ern microeconomics* In 'artic&ar, this theor! ana!"es cons&mer beha$ior, es'ecia! mar#et '&rchases, base% on the satisfaction of +ants an% nee%s -that is, &tiit!. )enerate% from the cons&m'tion of a )oo%* A basic $ersion of this theor!, 'rimari! ta&)ht in intro%&ctor! co&rses, in$o$es the ana!sis of tota an% mar)ina &tiit!, es'ecia! the roe 'a!e% b! the a+ of %iminishin) mar)ina ret&rns* A more so'histicate% $ersion of the theor!, more common! fo&n% at the interme%iate co&rse e$e an% abo$e, reies on the ana!sis of in%ifference c&r$es an% reati$e &tiit!, +ith a #e! roe 'a! b! %ecreasin) mar)ina rate of s&bstit&tion* Coth $ersions 'ro$i%e insi)ht into the a+ of %eman% an% the ne)ati$e so'e of the %eman% c&r$e* A 3ittle 4istory
The notion that mar#et %eman% %e'en%s on the satisfaction of +ants an% nee%s has been an essentia 'art of the economic ana!sis of mar#ets since at east the time of A%am Smith* Ho+e$er, three schoars +or#in) in 'ro)ression from the ate 1700s to the ate 1G00s )a$e the %e$eo'ment of cons&mer %eman% theor! a ar)e, forma boost* Nerem! Centham; The first ma/or a%$ance in the %e$eo'ment of cons&mer %eman% theor! +as 'ro$i%e% b! Nerem! Centham in the ate 1700s* Centham coine% the term &tiit! in reference to the satisfaction of +ants an% nee%s* He aso %e$eo'e% the notion that 'eo'e are moti$ate% b! the %esire to maimi"e &tiit!* Centham firm! beie$e% that &tiit! +as a meas&rabe, &antifiabe characteristic of a 'erson, m&ch i#e hei)ht or +ei)ht* Nohn St&art Mi; The theoretica +or# %e$eo'e% b! Centham +as eten%e% an% 'o'&ari"e% b! Nohn St&art Mi, +hose father Names Mi +as a contem'orar! an% cose frien% of Centham* The e%er Mi intro%&ce% the !o&n)er Mi to the tho&)hts an% teachin)s of Centham at an ear! a)e* Nohn St&art Mi e'an%e% an% 'romote% these cons&mer %eman% 'rinci'es in a n&mber of '&bications, inc&%in) his boo#, rinci'es of oitica 8conomic, +hich +as the %ominate economics tetboo# for se$era %eca%es* 5iiam Stane! Ne$ons; A ma/or im'ro$ement in cons&mer %eman% theor! +as 'ro$i%e% b! 5iiam Stane! Ne$ons +ith the notion of mar)ina &tiit!* Ne$ons aso %e$eo'e% the r&e of cons&mer e&iibri&m, statin) that cons&mers '&rchase )oo%s s&ch that the ratio of mar)ina &tiities is e&a to the ratio of 'rices* Aon)
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the +a!, Ne$ons he'e% to transform cons&mer %eman% theor! -as +e as microeconomics in )enera. into a ri)oro&s mathematica science* Utiit! A basic form&ation of cons&mer %eman% theor! in$o$es anUtility Analysis ana!sis of the tota &tiit! an% mar)ina &tiit! %eri$e% from the cons&m'tion of a )oo%* The foca 'oint of &tiit! ana!sis is &s&a! a tabe of the tota an% mar)ina &tiit! )enerate% b! cons&min) %ifferent &antities of a )oo%, s&ch as the one %is'a!e% in the ehibit to the ri)ht* This ana!sis is base% on the 'res&m'tion that the amo&nt of &tiit! )enerate% from the cons&m'tion of a )oo% can be e'icit! meas&re%* The stan%ar% meas&rement &nit is &tis* This 'artic&ar set of n&mbers i&strates the tota an% mar)ina &tiit! )enerate% b! ri%in) a roer coaster at the oca am&sement 'ar#* The #e! bits of information 'resente% in this tabe are;
=irst, the far eft co&mn 'resents the n&mber of ri%es on the roer coaster, +hich is the &antit! of the )oo% cons&me%* It increases from 0 ho&rs to G ri%es*
Secon%, the mi%%e co&mn in%icates the tota &tiit!, or the c&m&ati$e! amo&nt of &tiit!, obtaine% from the ri%es* =or eam'e, ta#in) 3 roer coaster ri%es )enerates 27 &tis of tota &tiit!* Most notab!, tota &tiit! )enera! increases +ith the n&mber of ri%es* Ho+e$er, it %oes reach a maim&m for the 6 ri%es, then %ecines* Thir%, the far ri)ht co&mn sho+s mar)ina &tiit!, or the amo&nt of a%%itiona &tiit! %eri$e% from each etra ri%e* =or eam'e, beca&se 2 ri%es )enerates a tota &tiit! of 20 &tis an% 3 ri%es )enerates a tota &tiit! of 27 &tis, the amo&nt of etra &tiit! )enerate% b! ta#in) the thir% ri%e on the roer coaster is 7 &tis* =o&rth, mar)ina &tiit! in the far ri)ht co&mn %ecines +ith a%%itiona ri%es on the roer coaster* This refects the a+ of %iminishin) mar)ina &tiit!, the #e! economic 'rinci'e &n%er!in) &tiit! ana!sis*
The La+ of Diminishin) Mar)ina Utiit! The a+ of %iminishin) mar)ina &tiit! states that mar)ina &tiit!, or the etra &tiit! obtaine% from cons&min) a )oo%, %ecreases as the &antit! cons&me% increases* In essence, each a%%itiona )oo% cons&me% is ess satisf!in) than the 're$io&s one* This a+ is 'artic&ar! im'ortant for insi)ht into mar#et %eman% an% the a+ o f %eman%* If each a%%itiona &nit of a )oo% is ess satisf!in), then a b&!er is +iin) to 'a! ess* As s&ch, the %eman% 'rice %ecines* This in$erse a+ of %eman% reation bet+een %eman%
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'rice an% &antit! %eman%e% is a %irect im'ication of the a+ of %iminishin) mar)ina &tiit!* In%ierence C#rves
A more a%$ance% form of cons&mer %eman% In%ierence C#rve Analysis theor! in$o$es the ana!sis of in%ifference c&r$es* An in%ifference c&r$e, s&ch as the one abee% U in the ehibit to the ri)ht, 'resents a combinations of t+o )oo%s that 'ro$i%e the same amo&nt of &tiit!* Hence a cons&mer is in%ifferent bet+een cons&min) an! combination of the t+o )oo%s an!+here on the c&r$e* In%ifference c&r$e ana!sis reies on a reati$e ran#in) of 'references bet+een t+o )oo%s rather than the abso&te meas&rement of &tiit! -&tis. %eri$e% from the cons&m'tion of a 'artic&ar )oo%* e! bits of insi)ht obtaine% from this %ia)ram are;
=irst, the in%ifferent c&r$e re'resentin) e&a &tiit! obtaine% from an! cons&m'tion combination of the t+o )oo%s -time at the beach an% time at an am&sement 'ar#. is re'resente% b! U* Secon%, the cons&mer is face% +ith an income or b&%)et constraint,I, +hich sho+s the aternati$e combinations of the t+o )oo%s that the b&!er can '&rchase )i$en a s'ecific amo&nt of income an% eistin) 'rices* Thir%, the ne)ati$e so'e of the b&%)et constraint refects the tra%eoff bet+een the cons&mers abiit! to '&rchase the t+o )oo%s* &rchasin) more of one )oo% necessari! means the cons&mer m&st '&rchase ess of the other* =o&rth, the ne)ati$e so'e an% con$e sha'e of the in%ifference c&r$e refects the tra%eoff bet+een the cons&mers +iin)ness to '&rchase the t+o )oo%s* In 'artic&ar, the con$e sha'e refects the %ecreasin) mar)ina rate of s&bstit&tion bet+een the t+o )oo%s*
Decreasin& Mar&inal Rate o S#0stit#tion
The %ecreasin) mar)ina rate of s&bstit&tion means that a cons&mer is +iin) to )i$e &' increasin)! smaer &antities of one )oo% in or%er to obtain more of another )oo%* The reason is that as more of a )oo% is cons&me% it becomes reati$e! ess satisf!in)* A %ecreasin) mar)ina rate of s&bstit&tion )enerai"es the a+ of %iminishin) mar)ina &tiit!* Ho+e$er, rather than statin) that the incrementa satisfaction %ecines abso&te!, it states that incrementa satisfaction %ecines reati$e to that obtaine% from other )oo%s*
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Moreo$er, i#e the a+ of %iminishin) mar)ina &tiit!, the %ecreasin) mar)ina rate of s&bstit&tion &se% in in%ifference c&r$e ana!sis 'ro$i%es insi)ht into mar#et %eman% an% the a+ of %eman%* If a )oo% )enerates ess reati$e satisfaction, then a b&!er is +iin) to 'a! a reati$e! o+er 'rice, +hich aso e'ains the in$erse a+ of %eman% reation bet+een %eman% 'rice an% &antit! %eman%e%* A$$lyin& the Theory
@ons&mer %eman% theor! is 'rimari! %irecte% to+ar% an &n%erstan%in) of mar#et %eman% an% the a+ of %eman%* Ho+e$er, it 'ro$i%es a )reat %ea of insi)ht into a sorts of h&man beha$ior an% acti$ities* A short ist inc&%es; Labor S&''!; Insi)ht into the &antit! of abor that +or#ers are +iin) to s&''! at %ifferent +a)es can be obtaine% +ith cons&mer %eman% theor! b! ana!"in) the tra%eoff bet+een abor an% eis&re acti$ities* Ho&seho% ro%&ction; In a simiar manner, insi)ht into the amo&nt of +or# 'erforme% aro&n% the ho&se, +itho&t e'icit com'ensation, be ana!"e% &sin) cons&mer %eman% theor!* @rime; The choice bet+een committin) a crime an% not committin) a crime can aso be in$esti)ate% &sin) cons&mer %eman% theor!, +ith the 'rice 'ai% for crimina acti$ities base% on the 'robabiit! of bein) ca&) ht an% '&nishe%* Eotin); The amo&nt of time an% effort %e$ote% to $otin) in eections has aso been s&b/ecte% to ana!sis &sin) cons&mer %eman% theor!*
A com'ete ist of areas that ha$e been or can be ana!"e% an% better &n%erstoo% &sin) cons&mer %eman% theor! is imite% on! b! the choices 'eo'e ma#e an% the t!'es of acti$ities the! '&rs&e* In essence, cons&mer %eman% theor! can be a''ie% to $irt&a! an! form of h&man beha$ior that in$o$es a tra%eoff an% a choice*
i. S#0stit#tion an% Income Eects
@han)es in 'rice can affect b&!ersB '&rchasin) %ecisions this effect is cae% the income effect* Increases in 'rice, +hie the! %onBt affect the amo&nt of !o&r 'a!chec#, ma#e !o& fee 'oorer than !o& +ere before, an% so !o& b&! ess* Decreases in 'rice ma#e !o& fee richer, an% so !o& ma! fee i#e b&!in) more* 5hat if +eBre oo#in) at t+o )oo%s at once< =or instance, a fast foo% chain ses hamb&r)ers an% hot %o)s* If the 'rice of hamb&r)ers )oes &', b&t the 'rice of hot %o)s sta!s the same, !o& mi)ht be more incine% to b&! a hot %o)* This ten%enc! to chan)e !o&r '&rchase base% on chan)es in reati$e 'rice is cae% the s&bstit&tion effect* 5hen the 'rice of hamb&r)ers )oes &', it ma#es hamb&r)ers reati$e! e'ensi$e an% hot %o)s reati$e! chea', +hich inf&ences !o& to b&! fe+er hamb&r)ers an% more hot %o)s than !o& &s&a! +o&%* Li#e+ise, a %ecrease in hamb&r)er 'rice +o&% ca&se !o& to eat more hamb&r)ers an% fe+er hot %o)s, accor%in) to the s&bstit&tion effect*
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The income effect aso affects b&!in) %ecisions +hen there are t+o -or more. )oo%s* 5hen the 'rice of hamb&r)ers )oes &', it ma#es !o& fee reati$e! 'oorer, so !o&r ten%enc! mi)ht be to b&! fe+er of both hamb&r)ers an% hot %o)s* If !o& oo# at the combine% res&ts of the income effect an% the s&bstit&tion effect, the tota effect is a itte &ncear* Accor%in) to the income effect, an increase in the 'rice of hamb&r)ers %ecreases cons&m'tion of both hamb&r)ers an% hot %o)s* Accor%in) to the s&bstit&tion effect, ho+e$er, hamb&r)er cons&m'tion %ro's, b&t hot %o) cons&m'tion rises* Th&s, +hie it is cear +hat ha''ens to hamb&r)er cons&m'tion, since both effects ten% to ca&se a %ecrease, +e cannot be s&re +hat ha''ens to hot %o) cons&m'tion, since there is both an increase -s&bstit&tion effect. an% a %ecrease -income effect.*
Ta0le o Income an% S#0stit#tion Eects
5hie +e cannot be abso&te! certain abo&t the net res&t, in )enera, the s&bstit&tion effect is stron)er than the income effect* That is, +hen the 'rice of hamb&r)ers )oes &', !o& +i most i#e! eat fe+er hamb&r)ers an% more hot %o)s, since the chan)e in reati$e 'rices -s&bstit&tion effect. affects !o& more than the 'ercei$e% chan)e in !o&r income -income effect.* Another factor inf&encin) %eman% is one +hich mar#eters an% a%$ertisers are a+a!s tr!in) to &n%erstan% an% tar)et; b&!ersB 'references* 5hat %o 'eo'e i#e< 5hen an% ho+ %o the! i#e it< Sti oo#in) at so%a, it ma#es sense that 'eo'e %rin# more so%a +hen itBs hot, or +hen the!Bre eatin) a mea, or +hen the!B$e been eercisin)* In these cases, b&!ersB 'references ha$e chan)e%; the! +ant the so%a more, an% are therefore +iin) to 'a! more for the same )oo%* Li#e+ise, if itBs sno+in), fe+er 'eo'e +i cra$e a co% so%a, an% the 'rice the! are +iin) to 'a! for a co% so%a is o+er, atho&)h the! ma! be +iin) to 'a! a itte etra mone! for a hot coffee* ii. S#0stit#tion an% Income Eects in Normal an% S#$erior &oo%s"
Are a )oo%s the same< Is more a+a!s better< U' to this 'oint, +e ha$e been ass&min) that +hen +e ha$e more mone!, or fee i#e +e ha$e more mone!, +e +i ten% to b&! more )oo%s* It ma#es sense; the more mone! +e ha$e, the more +e b&!* If +e ha$e ess mone!, or if the 'rice )oes &', ho+e$er, +e ten% to b&! ess* Ceca&se this is &s&a! the case, +e ca s&ch )oo%s norma )oo%s* If !o& b&! more of a )oo% +hen !o& ha$e more mone!, that )oo% is a norma )oo%* If the 'rice of a norma )oo% increases, !o& b&! ess*
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There are some ece'tions, ho+e$er; not a )oo%s are norma )oo%s* =or instance, if an increase in !o&r income ca&ses !o& to b&! ess of a )oo%, that )oo% is cae% an inferior )oo%* =or instance, 'oor coe)e st&%ents often satisf! themse$es +ith )eneric so%a an% chea' ramen* 5hen the! )et /obs an% a stea%! income, ho+e$er, the! mi)ht fore)o the chea' so%a an% ramen in fa$or of @o#e an% 'asta* In this eam'e, the )eneric so%a an% chea' ramen are inferior )oo%s* 5h! is this tr&e< @onsi%er the case +here the 'rice of )oo% A )oes &'*
Income an% S#0stit#tion Eects /ith Normal an% Inerior Goo%s
The s&bstit&tion effect ma#es C reati$e! chea'er, so cons&m'tion of C +i increase, an% cons&m'tion of A +i %ecrease* The income effect ma#es the b&!er fee 'oorer, an% so cons&m'tion of A +i %ecrease, b&t cons&m'tion of C +i increase* ?emember that cons&m'tion of an inferior )oo% $aries in$erse! +ith income; +hen !o& are rich, !o& b&! ess, +hen !o& are 'oor, !o& b&! more* If the A is sti norma an% C is sti inferior, an% the 'rice of A fas, then the s&bstit&tion effect +i ca&se hi)her cons&m'tion of A an% o+er cons&m'tion of C, an% the income effect +i ca&se hi)her cons&m'tion of A an% o+er cons&m'tion of C* Ceca&se the b&!er no+ fees richer, the! are ess incine% to b&! the inferior )oo%*
Income an% S#0stit#tion Eects /ith Normal an% Inerior Goo%s
Another ece'tion is the case +here an increase in 'rice ca&ses an increase in %eman%* This res&ts in an &'+ar%(so'in) %eman% c&r$e, an% the )oo% is cae% a iffen )oo%* iffen )oo%s are theoretica! 'ossibe, b&t $er! im'robabe, since it is &ni#e! that an increase in 'rice ca&ses increase in %eman%* ne 'ossibe /&stification for a iffen )oo% is that 'eo'e associate hi)her 'rices +ith stat&s, &&r!, an% &ait!, so that a hi)her 'rice mi)ht increase the 'ercei$e% $a&e of a )oo%* In reait!, ho+e$er, this effect is o&t+ei)he% b! the o$er+hemin) ten%enc! to 'refer o+er 'rices; e$en if a fe+ 'eo'e 'refer the a%%e% cachet of a hi)h('rice% &&r! )oo%, the )enera '&bic +i 'refer o+er 'rices* Another 'ossibe case that co&% ca&se a iffen )oo% is the case in +hich a )oo% is inferior an% the income effect o&t+ei)hs the s&bstit&tion effect* To i&strate, ass&me that A@M8 @oa is an inferior )oo%*
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v. S#0stit#tion an% Com$lementary 0y Cross Elasticity o Deman%"
The meas&re of res'onsi$eness of the %eman% for a )oo% to+ar%s the chan)e in the 'rice of a reate% )oo% is cae% cross 'rice easticit! of %eman%* Deinition: The meas&re of res'onsi$eness of the %eman% for a )oo% to+ar%s the chan)e in the 'rice of a reate% )oo% is cae% cross 'rice easticit! of %eman%* It is a+a!s meas&re% in 'ercenta)e terms* Descri$tion: 5ith the cons&m'tion beha$ior bein) reate%, the chan)e in the 'rice of a reate% )oo% ea%s to a chan)e in the %eman% of another )oo%* ?eate% )oo%s are of t+o #in%s, i*e* s&bstit&tes an% com'ementar! )oo%s* In case the t+o )oo%s are not reate%, the @oefficient of @ross 8asticit! is "ero* @ross easticit! of %eman% -[8D. is the res'onsi$eness of %eman% for one 'ro%&ct to a chan)e in the 'rice of another 'ro%&ct* Man! 'ro%&cts are reate%, an% [8D in%icates /&st ho+ the! are reate%*
The foo+in) e&ation enabes [8D to be cac&ate%*
R chan)e in -_. &antit! %eman%e% of )oo% A R chan)e in -_. 'rice of )oo% C S&bstit&tes 5hen [8D is 'ositi$e, the reate% )oo%s are s&bstit&tes* =or eam'e, if the 'rice of @oca @oa increases from 0' to 60' 'er can, an% the %eman% for e'si @oa increases from 1m to 2m 'er !ear, the [8D bet+een the t+o 'ro%&cts is; 1??*2? B . >
The 'ositi$e si)n means that the t+o )oo%s are s&bstit&tes, an% beca&se the coefficient is )reater than one, the! are re)ar%e% as cose s&bstit&tes* @om'ements 5hen [8D is ne)ati$e, the )oo%s are com'ementar! 'ro%&cts* The e&ation is the same as for s&bstit&tes* =or eam'e, if the 'rice of @inema Tic#ets increases from *00 to 7*0, an% the %eman% for o'corn %ecreases from 1000 t&bs to 700, the [8D bet+een the t+o 'ro%&cts +i be; =6?*>? B =. ?"L
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The ne)ati$e si)n means that the t+o )oo%s are com'ements, an% the coefficient is ess than one, in%icatin) that the! are not 'artic&ar! com'ementar!* -hy %oes a irm /ant to +no/ HED
no+in) the [8D of its o+n an% other reate% 'ro%&cts enabes the firm to ma' o&t its mar#et* Ma''in) ao+s a firm to cac&ate ho+ man! ri$as it has, an% ho+ cose the! are* It aso ao+s the firm to meas&re ho+ im'ortant its com'ementar! 'ro%&cts are to its o+n 'ro%&cts* This #no+e%)e ao+s the firm to %e$eo' strate)ies to re%&ce its e'os&re to the ris#s associate% +ith 'rice chan)es b! other firms, s&ch as a rise in the 'rice of a com'ement or a fa in the 'rice of a s&bstit&te* ?is#s can be re%&ce% in a n&mber of +a!s, inc&%in) a%o'tin) the foo+in) strate)ies; 4ori'ontal inte&ration
Hori"onta inte)ration &s&a! means mer&in& +ith a ri$a, s&ch as the mer)er of 'harmace&tica )iants ao 5ecome an% Smithine Ceecham to createGla,oSmithKline -S. in 2000* Hori"onta inte)ration occ&rs +hen t+o or more firms 'ro%&cin) simiar 'ro%&cts mer)e +ith each other, or +here one ta#es o$er the other*
Noint aiances +ith com'etitors can aso ta#e Ericsson combinin) reso&rces to create mobie 'hones*
'ace, s&ch
as Sony=
Coll#sion is aso a 'ossibiit!* =or eam'e, firms ma! enter into 'rice fiin) a)reements so that the! a$oi% ha$in) to fi)ht a 'rice +ar* This is more i#e! to occ&r inoli&o$olostic mar#ets, +here there are on! a fe+ com'etitors*
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<" T4EOR OF )RODUCTION
In economics, 'ro%&ction theor! e'ains the 'rinci'es in +hich the b&siness has to ta#e %ecisions on ho+ m&ch of each commo%it! it ses an% ho+ m&ch it 'ro%&ces an% aso ho+ m&ch of ra+ materia ie*, fie% ca'ita an% abor it em'o!s an% ho+ m&ch it +i &se* It %efines the reationshi's bet+een the 'rices of the commo%ities an% 'ro%&cti$e factors on one han% an% the &antities of these commo%ities an% 'ro%&cti$e factors that are 'ro%&ce% on the other han%* @once't ro%&ction is a 'rocess of combinin) $ario&s in'&ts to 'ro%&ce an o&t'&t for cons&m'tion* It is the act of creatin) o&t'&t in the form of a commo%it! or a ser$ice +hich contrib&tes to the &tiit! of in%i$i%&as* In other +or%s, it is a 'rocess in +hich the in'&ts are con$erte% into o&t'&ts* =&nction The ro%&ction f&nction si)nifies a technica reationshi' bet+een the 'h!sica in'&ts an% 'h!sica o&t'&ts of the firm, for a )i$en state of the technoo)!* B a8 08 c8 " " " " " " '.
5here a,b,c ****" are $ario&s in'&ts s&ch as an%, abor ,ca'ita etc* is the e$e of the o&t'&t for a firm* If abor -L. an% ca'ita -. are on! the in'&t factors, the 'ro%&ction f&nction re%&ces to ` B 38 K.
ro%&ction =&nction %escribes the technoo)ica reationshi' bet+een in'&ts an% o&t'&ts* It is a too that ana!sis the &aitati$e in'&t : o&t'&t reationshi' an% aso re'resents the technoo)! of a firm or the econom! as a +hoe* ro%&ction Ana!sis ro%&ction ana!sis basica! is concerne% +ith the ana!sis in +hich the reso&rces s&ch as an%, abor, an% ca'ita are em'o!e% to 'ro%&ce a firmFs fina 'ro%&ct* To 'ro%&ce these )oo%s the basic in'&ts are cassifie% into t+o %i$isions ` Eariabe In'&ts In'&ts those chan)e or are $ariabe in the short r&n or on) r&n are $ariabe in'&ts* =ie% In'&ts In'&ts that remain constant in the short term are fie% in'&ts* @ost =&nction
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@ost f&nction is %efine% as the reationshi' bet+een the cost of the 'ro%&ct an% the o&t'&t* =oo+in) is the form&a for the same ` C B F
@ost f&nction is %i$i%e% into name! t+o t!'es ` Short ?&n @ost Short r&n cost is an ana!sis in +hich fe+ factors are constant +hich +onFt chan)e %&rin) the 'erio% of ana!sis* The o&t'&t can be chan)e% ie*, increase% or %ecrease% in the short r&n b! chan)in) the $ariabe factors* =oo+in) are the basic three t!'es of short r&n cost `
Lon) ?&n @ost Lon)(r&n cost is $ariabe an% a firm a%/&sts a its in'&ts to ma#e s&re that its cost of 'ro%&ction is as o+ as 'ossibe* 3on& r#n cost B 3on& r#n varia0le cost
In the on) r&n, firms %onFt ha$e the ibert! to reach e&iibri&m bet+een s&''! an% %eman% b! aterin) the e$es of 'ro%&ction* The! can on! e'an% or re%&ce the 'ro%&ction ca'acit! as 'er the 'rofits* In the on) r&n, a firm can choose an! amo&nt of fie% costs it +ants to ma#e short r&n %ecisions* La+ of Eariabe ro'ortions The a+ of $ariabe 'ro'ortions has foo+in) three %ifferent 'hases `
?et&rns to a =actor ?et&rns to a Scae Iso&ants
In this section, +e +i earn more on each of them* ?et&rns to a =actor Increasin& Ret#rns to a Factor Increasin) ret&rns to a factor refers to the sit&ation in +hich tota o&t'&t ten%s to increase at an increasin) rate +hen more of $ariabe factor is mie% +ith the fie% factor
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of 'ro%&ction* In s&ch a case, mar)ina 'ro%&ct of the $ariabe factor m&st be increasin)* In$erse!, mar)ina 'rice of 'ro%&ction m&st be %iminishin)* Constant Ret#rns to a Factor
@onstant ret&rns to a factor refers to the sta)e +hen increasin) the a''ication of the $ariabe factor %oes not res&t in increasin) the mar)ina 'ro%&ct of the factor : rather, mar)ina 'ro%&ct of the factor ten%s to stabii"e* Accor%in)!, tota o&t'&t increases on! at a constant rate* Diminishin& Ret#rns to a Factor
Diminishin) ret&rns to a factor refers to a sit&ation in +hich the tota o&t'&t ten%s to increase at a %iminishin) rate +hen more of the $ariabe factor is combine% +ith the fie% factor of 'ro%&ction* In s&ch a sit&ation, mar)ina 'ro%&ct of the $ariabe m&st be %iminishin)* In$erse! the mar)ina cost of 'ro%&ction m&st be increasin)* ?et&rns to a Scae If a in'&ts are chan)e% sim&taneo&s! or 'ro'ortionate!, then the conce't of ret&rns to scae has to be &se% to &n%erstan% the beha$ior of o&t'&t* The beha$ior of o&t'&t is st&%ie% +hen a the factors of 'ro%&ction are chan)e% in the same %irection an% 'ro'ortion* ?et&rns to scae are cassifie% as foo+s ` Increasin& ret#rns to scale ` If o&t'&t increases more than 'ro'ortionate to the increase in a in'&ts* Constant ret#rns to scale ` If a in'&ts are increase% b! some 'ro'ortion, o&t'&t +i aso increase b! the same 'ro'ortion* Decreasin& ret#rns to scale ` If increase in o&t'&t is ess than 'ro'ortionate to the increase in a in'&ts* For e,am$le ` If a factors of 'ro%&ction are %o&be% an% o&t'&t increases b! more than t+o times, then the sit&ation is of increasin) ret&rns to scae* n the other han%, if o&t'&t %oes not %o&be e$en after a 100 'er cent increase in in'&t factors, +e ha$e %iminishin) ret&rns to scae*
The )enera 'ro%&ction f&nction is X = -L, . Iso&ants Iso&ants are a )eometric re'resentation of the 'ro%&ction f&nction* The same e$e of o&t'&t can be 'ro%&ce% b! $ario&s combinations of factor in'&ts* The oc&s of a 'ossibe combinations is cae% the Iso&antF* Characteristics o Iso9#ant
An iso&ant so'es %o+n+ar% to the ri)ht* An iso&ant is con$e to ori)in* An iso&ant is smooth an% contin&o&s*
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T+o iso&ants %o not intersect*
Ty$es o Iso9#ants
The 'ro%&ction iso&ant ma! ass&me $ario&s sha'es %e'en%in) on the %e)ree of s&bstit&tabiit! of factors* 3inear Iso9#ant
This t!'e ass&mes 'erfect s&bstit&tabiit! of factors of 'ro%&ction* A )i$en commo%it! ma! be 'ro%&ce% b! &sin) on! ca'ita or on! abor or b! an infinite combination of an% L* In$#t=O#t$#t Iso9#ant
This ass&mes strict com'ementari!, that is "ero s&bstit&tabiit! of the factors of 'ro%&ction* There is on! one metho% of 'ro%&ction for an! one commo%it!* The iso&ant ta#es the sha'e of a ri)ht an)e* This t!'e of iso&ant is cae% OLeontief Iso&antP* Kin+e% Iso9#ant
This ass&mes imite% s&bstit&tabiit! of an% L* enera!, there are fe+ 'rocesses for 'ro%&cin) an! one commo%it!* S&bstit&tabiit! of factors is 'ossibe on! at the #in#s* It is aso cae% Oacti$it! ana!sis(iso&antP or Oinear('ro)rammin) iso&antP beca&se it is basica! &se% in inear 'ro)rammin)* 3east Cost Com0ination o In$#ts
A )i$en e$e of o&t'&t can be 'ro%&ce% &sin) man! %ifferent combinations of t+o $ariabe in'&ts* In choosin) bet+een the t+o reso&rces, the sa$in) in the reso&rce re'ace% m&st be )reater than the cost of reso&rce a%%e%* The 'rinci'e of east cost combination states that if t+o in'&t factors are consi%ere% for a )i$en o&t'&t then the east cost combination +i ha$e in$erse 'rice ratio +hich is e&a to their mar)ina rate of s&bstit&tion* Mar&inal Rate o S#0stit#tion
M?S is %efine% as the &nits of one in'&t factor that can be s&bstit&te% for a sin)e &nit of the other in'&t factor* So M?S of 2 for one &nit of 1 is ` X &mber of &nit of re'ace% reso&rce -2.&mber of &nit of a%%e% reso&rce -1. rice ?atio -?. X @ost 'er &nit of a%%e% reso&rce@ost 'er &nit of re'ace% reso&rce X
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rice of 1rice of 2 Therefore the east cost combination of t+o in'&ts can be obtaine% b! e&atin) M?S +ith in$erse 'rice ratio* ,2 P )2 B ,1 P )1 i. )ro%#ction F#nction
Ho+e$er m&ch of a commo%it! a b&siness firm 'ro%&ces, it en%ea$o&rs to 'ro%&ce it as chea'! as 'ossibe* Ta#in) the &ait! of the 'ro%&ct an% the 'rices of the 'ro%&cti$e factors as )i$en, +hich is the &s&a sit&ation, the firmFs tas# is to %etermine the chea'est combination of factors of 'ro%&ction that can 'ro%&ce the %esire% o&t'&t* This tas# is best &n%erstoo% in terms of +hat is cae% the 'ro%&ction f&nction, i*e*, an e&ation that e'resses the reationshi' bet+een the &antities of factors em'o!e% an% the amo&nt of 'ro%&ct obtaine%* It states the amo&nt of 'ro%&ct that can be obtaine% from each an% e$er! combination of factors* This reationshi' can be +ritten mathematica! as ! X f -1, 2, * * * , n #1, #2, * * * , #m.* Here, ! %enotes the &antit! of o&t'&t* The firm is 'res&me% to &se n $ariabe factors of 'ro%&ction that is, factors i#e ho&r! 'ai% 'ro%&ction +or#ers an% ra+ materias, the &antities of +hich can be increase% or %ecrease%* In the form&a the &antit! of the first $ariabe factor is %enote% b! 1 an% so on* The firm is aso 'res&me% to &se m fie% factors, or factors i#e fie% machiner!, saarie% staff, etc*, the &antities of +hich cannot be $arie% rea%i! or habit&a!* The a$aiabe &antit! of the first fie% factor is in%icate% in the forma b! #1 an% so on* The entire form&a e'resses the amo&nt of o&t'&t that res&ts +hen s'ecifie% &antities of factors are em'o!e%* It m&st be note% that tho&)h the &antities of the factors %etermine the &antit! of o&t'&t, the re$erse is not tr&e, an% as a )enera r&e there +i be man! combinations of 'ro%&cti$e factors that co&% be &se% to 'ro%&ce the same o&t'&t* =in%in) the chea'est of these is the 'robem of cost minimi"ation* The cost of 'ro%&ction is sim'! the s&m of the costs of a of the $ario&s factors* It can be +ritten;
in +hich '1 %enotes the 'rice of a &nit of the first $ariabe factor, r1 %enotes the ann&a cost of o+nin) an% maintainin) the first fie% factor, an% so on* Here a)ain one )ro&' of terms, the first, co$ers$ariabe cost -ro&)h!O%irect costsP in acco&ntin) terminoo)!., +hich can be chan)e% rea%i! another )ro&', the secon%, co$ers fie% cost -acco&ntantsF Oo$erhea% costsP., +hich inc&%es items not easi! $arie%* The %isc&ssion +i %ea first +ith $ariabe cost* ii. Fi,e% an%
=I[8D IUT;
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An in'&t +hose &antit! cannot be chan)e% in the time 'erio% &n%er consi%eration* The ree$ant time 'erio% is &s&a! terme% the short r&n* The most common eam'e of a fie% in'&t is ca'ita* The aternati$e to fie% in'&t is $ariabe in'&t* A fie% in'&t, s&ch as ca'ita, 'ro$i%es the ca'acit! constraint for the short(r&n 'ro%&ction of a firm* A $ariabe in'&t, s&ch as abor, 'ro$i%es the means of chan)in) short(r&n 'ro%&ction* As ar)er &antities of a $ariabe in'&t are a%%e% to a fie% in'&t, the $ariabe in'&t becomes ess 'ro%&cti$e, +hich is the a+ of %iminishin) mar)ina ret&rns* A fie% in'&t is a reso&rce or factor of 'ro%&ction +hich cannot be chan)e% in the short r&n b! a firm as it see#s to chan)e the &antit! of o&t'&t 'ro%&ce%* Most firms ha$e se$era fie% in'&ts in short(r&n 'ro%&ction, es'ecia! b&i%in)s, e&i'ment, an% an%* Ho+e$er, in the ana!sis of short(r&n 'ro%&ction, a )reat %ea of insi)ht is achie$e% b! foc&sin) on the fie% roe of ca'ita* Short(?&n Taco ro%&ction As an i&stration of fie% in'&ts, consi%er the short(r&n 'ro%&ction of Sha%! Eae!Bs fa$orite &nch time mea, S&'er De&e TeMe ar)ant&an Tacos -+ith so&r cream an% /aa'eno 'e''ers.* The #e! fie% in'&t for 5a%o Mibottom, the o+ner an% 'ro'rietor of 5a%oBs TeMe Taco 5or%, is the resta&rant an% accom'an!in) ca'ita e&i'ment* In the %a!(to(%a! 'ro%&ction of TeMe ar)ant&an Tacos, 5a%o %oes not concern himsef +ith the si"e of the resta&rant, n&mber of tabes an% chairs, amo&nt of #itchen e&i'ment, an% a$aiabe 'ar#in) s'aces* The &antities of these items are fie% in the short r&n* In the short(r&n, 5a%o is 'rimari! intereste% in ha$in) a s&fficient &antit! of abor (( +ait'ersons, #itchen he', etc* 5a%o aters the &antit! of abor to chan)e the &antit! of 'ro%&ction* Us&a! @a'ita, C&t ot A+a!s The %esi)nation of ca'ita as a fie% in'&t is not /&st an arbitrar! choice ma%e to ease the economic e'osition of short(r&n 'ro%&ction* @a'ita is &s&a! an in'&t that cannot be chan)e% &ic#!* If a firm +ants to a%% a haf %o"en a%%itiona machinists to its +or#force, it can 'robab! %o so in a fe+ +ee#s* Ho+e$er, if a firm +ants to a%% 0,000 s&are feet of factor! s'ace, then the constr&ction com'an! 'robab! nee%s a !ear or t+o to com'ete this /ob* In terms of short(r&n 'ro%&ction, abor is t!'ica! $ariabe an% ca'ita is t!'ica! fie%* Ho+e$er, not a firms are t!'ica* In some eam'es of short(r&n 'ro%&ction, ca'ita is the $ariabe in'&t an% abor is the fie% in'&t* ne i&stration is offere% b! the aca%emic +or% of hi)her e%&cation* The abor of ten&re% fac&t! -+ith em'hasis on ten&re%. ten%s to be a fie% in'&t in the 'ro%&ction of e%&cation* C! contrast, some forms of
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ca'ita, es'ecia! com'&ter e&i'ment, are more easi! chan)e% an% can be tho&)ht of as $ariabe in'&ts in the 'ro%&ction of e%&cation*
An in'&t +hose &antit! can be chan)e% in the time 'erio% &n%er consi%eration* The most common eam'e of a $ariabe in'&t is abor* Eariabe in'&ts 'ro$i%e the means &se% b! a firm to contro short(r&n 'ro%&ction* The aternati$e to $ariabe in'&t is fie% in'&t* A fie% in'&t, i#e ca'ita, 'ro$i%es the ca'acit! constraint in 'ro%&ction* As ar)er &antities of a $ariabe in'&t, i#e abor, are a%%e% to a fie% in'&t i#e ca'ita, the $ariabe in'&t becomes ess 'ro%&cti$e, +hich is the a+ of %iminishin) mar)ina ret&rns* A $ariabe in'&t is a reso&rce or factor of 'ro%&ction +hich can be chan)e% in the short r&n b! a firm as it see#s to chan)e the &antit! of o&t'&t 'ro%&ce%* Most firms &se se$era $ariabe in'&ts in short(r&n 'ro%&ction, es'ecia! abor , materia in'&ts, an% ener)!* Ho+e$er, in the ana!sis of short(r&n 'ro%&ction, a )reat %ea of insi)ht is achie$e% b! foc&sin) on the $ariabe &se of abor* iii. Conce$t o Short R#n an% 3on& R#n DEFINITION o !3on& R#n! A 'erio% of time in +hich a factors of 'ro%&ction an% costs are $ariabe* In the on) r&n,firms are abe to a%/&st a costs, +hereas in the short r&n firms are on! abe to inf&ence 'rices thro&)h a%/&stments ma%e to 'ro%&ction e$es* A%%itiona!, +hereas firms ma! be a mono'o! in the short(term the! ma! e'ect com'etition in the on)( term* In economics, on)(r&n mo%es ma! shift a+a! from short(t&rn e&iibri&ms, in +hich s&''! an% %eman% react to 'rice e$es +ith more feibiit!* DEFINITION o !Short R#n! In economics, it is the conce't that +ithin a certain 'erio% of time, in the f&t&re, at east one in'&t is fie% +hie others are $ariabe* The short r&n is not a %efinite 'erio% of time, b&t rather $aries base% on the en)th of the firmBs contracts* =or eam'e, a firm ma! ha$e entere% into ease contracts +hich fi the amo&nt of rent o$er the net month, !ear or se$era !ears* r the firm ma! ha$e +a)e contracts +ith certain +or#ers +hich cannot be chan)e% &nti the contract rene+a* iv. Total8 Avera&e an% Mar&inal )ro%#cts
TTAL ?DU@T; The tota &antit! of o&t'&t 'ro%&ce% b! a firm for a )i$en &antit! of in'&ts* Tota 'ro%&ct is the fo&n%ation &'on +hich the ana!sis of short( r&n 'ro%&ction for a firm is base%* The &s&a frame+or# is to ana!"e tota 'ro%&ct +hen a $ariabe in'&t -abor. chan)es, +hie a fie% in'&t -ca'ita.
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%oes not chan)e* T+o reate% conce'ts %eri$e% from tota 'ro%&ct are a$era)e 'ro%&ct an% mar)ina 'ro%&ct* Tota 'ro%&ct is the o$era &antit! of o&t'&t that a firm 'ro%&ces, &s&a! s'ecifie% in reation to a $ariabe in'&t* Tota 'ro%&ct is the startin) 'oint for the ana!sis of short(r&n 'ro%&ction* It in%icates ho+ m&ch o&t'&t a firm can 'ro%&ce accor%in) to the a+ of %iminishin) mar)ina ret&rns* The 3a/ o Diminishin& Mar&inal Ret#rns
Tota 'ro%&ct %oes not increase in a inear fashion %&e to the a+ of %iminishin) mar)ina ret&rns* This a+ states that as more of a $ariabe in'&t is a%%e% to a fie% in'&t in short( r&n 'ro%&ction, then the mar)ina 'ro%&ct -that is, the mar)ina ret&rns. of the $ariabe in'&t e$ent&a! %ecines* =or eam'e, the secon% em'o!ee of 5a%oBs TeMe Taco 5or% mi)ht increase taco 'ro%&ction from 20 to 0 -a chan)e of 30 tacos., the sith +or#er increases 'ro%&ction on! from 110 to 120 -a chan)e of 10 tacos.* The Total )ro%#ct C#rve
The tota 'ro%&ct c&r$e is a )ra'hica Total )ro%#ct C#rve re'resentation of the reation bet+een the tota 'ro%&ct an% the $ariabe in'&t* The tota 'ro%&ct c&r$e for ar)ant&an Taco 'ro%&ction is %is'a!e% to the ri)ht* The o$era so'e of this c&r$e is 'ositi$e, +ith etra +or#ers )enera! ea%in) to )reater 'ro%&ction* Ho+e$er, the c&r$e has a %istincti$e sha'e, emer)in) stee'! from the ori)in, then fattenin), an% e$ent&a! %ecinin)* The sha'e of this c&r$e is attrib&tabe to the a+ of %iminishin) mar)ina ret&rns* @onsistent +ith the n&mbers in the tabe, the c&r$e reaches a 'ea# of 12 ar)ant&an Tacos at both 7 an% G +or#ers* To the eft of this 'ea# of 12 ar)ant&an Tacos, etra +or#ers increase the 'ro%&ction an% to the ri)ht of the 'ea# etra +or#ers act&a! re%&ce tota taco 'ro%&ction* A$era)e an% Mar)ina T+o reate% 'ro%&ct meas&res are %eri$e% %irect! from tota 'ro%&ct((a$era)e 'ro%&ct an% mar)ina 'ro%&ct* Avera&e )ro%#ct: This is the amo&nt of o&t'&t 'ro%&ce% 'er +or#er, fo&n% b! %i$i%in) the tota 'ro%&ct b! the n&mber of +or#ers* If, for eam'e, 5a%oBs TeMe Taco 5or% has a staff of that )enerates a tota 'ro%&ct of 110 tacos, then a$era)e 'ro%&ct is 22 tacos*
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Mar&inal )ro%#ct: This is the chan)e in tota 'ro%&ct res&tin) from a chan)e in the n&mber of +or#ers* Mar)ina 'ro%&ct in%icates ho+ the tota 'ro%&ction of TeMe ar)ant&an Tacos chan)es +hen an etra +or#er is hire% or fire%* =or eam'e, hirin) a th +or#er means that 5a%oBs TeMe Taco 5or% tota 'ro%&ct increases from 9 to 110 tacos* The a%%ition of th +or#er res&ts in the 'ro%&ction of an a%%itiona 1 TeMe ar)ant&an Tacos*
MARGINA3 )RODUCT:
The chan)e in the &antit! of tota 'ro%&ct res&tin) from a &nit chan)e in a $ariabe in'&t, #ee'in) a other in'&ts &nchan)e%* Mar)ina 'ro%&ct, &s&a! abbre$iate% M, is fo&n% b! %i$i%in) the chan)e in tota 'ro%&ct b! the chan)e in the $ariabe in'&t* Mar)ina 'ro%&ct, +hich occasiona! )oes b! the aias mar)ina 'h!sica 'ro%&ct -M., is one of t+o meas&res %eri$e% from tota 'ro%&ct* The other is a$era)e 'ro%&ct* Mar)ina 'ro%&ct is the etra o&t'&t )enerate% b! an etra in'&t* Mar)ina 'ro%&ct ies at the $er! fo&n%ation of the ana!sis of short(r&n 'ro%&ction, 'a!in) TH8 critica roe in the e'anation of the a+ of s&''! an% the &'+ar%(so'in) s&''! c&r$e &sin) the a+ of %iminishin) mar)ina ret&rns* f the m!ria% of short(r&n 'ro%&ction(reate% terms -inc&%in)tota 'ro%&ct, a$era)e 'ro%&ct, fie% in'&t, $ariabe in'&t, short r&n, on) r&n. mar)ina 'ro%&ct is b! far the most im'ortant* The form&a for s'ecif!in) an% cac&atin) mar)ina 'ro%&ct from tota 'ro%&ct is )i$en as; chan)e in tota 'ro%&ct mar)ina 'ro%&ct X chan)e in $ariabe in'&t The 'ro'er economic inter'retation of mar)ina 'ro%&ct is as the contrib&tion of the ast &nit of $ariabe in'&t to tota 'ro%&ction* That is, ho+ m&ch %oes tota 'ro%&ct chan)e b! a%%in) the ast &nit< If, for eam'e, the mar)ina 'ro%&ct of abor is 2 tacos, then this means that em'o!in) the ast +or#er ca&ses tota 'ro%&ct to increase b! 2 tacos* Does this mean the ast +or#er 'ersona! 'ro%&ces 2 tacos< o, not at a* r at east, not necessari!* It means that ha$in) this 'erson em'o!e% b! the firm ca&ses tota 'ro%&ct to increase b! 2 tacos* More often that not, this a%%e% +or#er ma#es eistin) +or#ers more 'ro%&cti$e* Mar&inal Taco )ro%#ction
The tabe at the ri)ht s&mmari"es the ho&r! 'ro%&ction b! 5a%oBs TeMe Taco 5or% of S&'er De&e TeMe ar)ant&an Tacos -+ith so&r cream an% /aa'eno 'e''ers.* The tota 'ro%&ct n&mbers 'resente% can be &se% to %eri$e the mar)ina 'ro%&ct*
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The co&mn on the eft is the $ariabe in'&t, s'ecifica! the Mar&inal Taco )ro%#ct n&mber of +or#ers em'o!e% b! 5a%oBs TeMe Taco 5or%, +hich ran)es from 0 to 10* The center co&mn is the tota 'ro%&ct, the tota n&mber of TeMe ar)ant&an Tacos 'ro%&ce% each ho&r, +hich ran)es from a o+ of 0 to a hi)h of 12 before %ecinin) to 110* ee' in min% that the taco 'ro%&ction from these +or#ers %e'en%s on a )i$en amo&nt of fie% in'&ts, 5a%oBs TeMe Taco 5or% resta&rant an% a of the ca'ita that )oes +ith it* Missin) from this tabe is an! mention of mar)ina 'ro%&ct* This a''arent o$ersi)ht can be rectifie% +ith a fe+ b&tton cic#s* =irst, consi%er this &estion; 5hat is the contrib&tion of the first +or#er to tota ar)ant&an Taco 'ro%&ction< r '&t another +a!; 5hat is the chan)e in tota 'ro%&ct res&tin) from a chan)e in the $ariabe in'&t< To ans+er these &estions, note that tota ho&r! ar)ant&an Taco 'ro%&ction +ith "ero +or#ers is aso "ero* o in'&t, no o&t'&t* C&t +ith one +or#er b&si! ma#in) ar)ant&an Tacos, the ho&r! taco 'ro%&ction increases to 20* The chan)e in tota 'ro%&ct res&tin) from the em'o!ment of the first +or#er is 20* @ic# the J=irstK b&tton to $erif! that the mar)ina 'ro%&ct of the first +or#er is 20 tacos* Ho+ abo&t the mar)ina 'ro%&ct of the secon% +or#er< A cic# of the JSecon%K b&tton re$eas that em'o!in) the secon% +or#er a%%s 30 ar)ant&an Tacos to the ho&r! taco 'ro%&ction of 5a%oBs TeMe Taco 5or%* This n&mber is fo&n% b! ta#in) the %ifference bet+een tota ho&r! taco 'ro%&ction +ith one +or#er -20 ar)ant&an Tacos. an% the tota ho&r! taco 'ro%&ction +ith t+o +or#ers -0 ar)ant&an Tacos.* o+ consi%er the mar)ina 'ro%&ct of the thir% +or#er* A%%in) a thir% +or#er boosts tota ho&r! taco 'ro%&ction from the 0 ar)ant&an Tacos 'ro%&ce% b! t+o +or#ers to 7 ar)ant&an Tacos 'ro%&ce% b! three +or#ers* This means that the mar)ina 'ro%&ct of the thir% +or#er is 2 ar)ant&an Tacos* To %is'a! mar)ina 'ro%&cts associate% +ith the a%%ition of the remainin) +or#ers, cic# the JthersK b&tton* 5hat interestin) an% &sef& information can be %eri$e% from this e'an% e% tabe< =irst, the mar)ina 'ro%&ct of +or#ers increases for the first t+o +or#ers, reachin) a 'ea# of 30 ar)ant&an Tacos, then %ecines thereafter* The increasin) mar)ina 'ro%&ct obser$e% for the first fe+ +or#ers i&strates increasin) mar)ina ret&rns an% the %ecreasin) mar)ina 'ro%&ct obser$e% for a s&bse&ent +or#ers i&strates %ecreasin) mar)ina ret&rns* Moreo$er, the %ecreasin) mar)ina 'ro%&cts is
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attrib&tabe to the a+ of %iminishin) mar)ina ret&rns, TH8 #e! 'rinci'e &n%er!in) the st&%! of short(r&n 'ro%&ction* Secon%, notice that mar)ina 'ro%&ct %ecreases so m&ch that it becomes "ero for the ei)hth +or#er an% e$en becomes ne)ati$e for the ninth an% tenth +or#ers* The "ero $a&e of mar)ina 'ro%&ct for the ei)hth +or#er aso occ&rs +here the tota 'ro%&ct has reache% its maim&m $a&e* @oinci%ence< ot at a* The 'ea# of the tota 'ro%&ct c&r$e has a "ero so'e* Mar)ina 'ro%&ct is another term for the so'e of the tota 'ro%&ct c&r$e* The Mar)ina ro%&ct @&r$e The mar)ina 'ro%&ct c&r$e is a )ra'hica re'resentation of Mar&inal )ro%#ct C#rve the reation bet+een mar)ina 'ro%&ct an% the $ariabe in'&t* The mar)ina 'ro%&ct c&r$e for ar)ant&an Taco 'ro%&ction is %is'a!e% to the ri)ht* The )enera so'e of this c&r$e is ne)ati$e, +ith incrementa o&t'&t %ecinin) for ar)er +or#forces* Ho+e$er, the mar)ina 'ro%&ct c&r$e is act&a! h&m' sha'e%, +ith a 'ositi$e so'e )i$in) +a! to a ne)ati$e so'e* @onsistent +ith the n&mbers in the tabe, the c&r$e reaches a 'ea# of 30 ar)ant&an Tacos for the secon% +or#er* Tota an% A$era)e T+o reate% 'ro%&ct meas&res are tota 'ro%&ct an% a$era)e 'ro%&ct* Tota ro%&ct; This is the tota &antit! of o&t'&t 'ro%&ce% b! a firm for a )i$en &antit! of in'&ts* Tota 'ro%&ct is the fo&n%ation &'on +hich the ana!sis of short(r&n 'ro%&ction for a firm is base%* It aso 'ro$i%es the basis for cac&atin) mar)ina 'ro%&ct* A$era)e ro%&ct; This is the amo&nt of o&t'&t 'ro%&ce% 'er +or#er, fo&n% b! %i$i%in) the tota 'ro%&ct b! the n&mber of +or#ers* If, for eam'e, 5a%oBs TeMe Taco 5or% has a staff of that )enerates a tota 'ro%&ct of 110 tacos, then a$era)e 'ro%&ct is 22 tacos*
AE8?A8 ?DU@T @U?E8; A c&r$e that )ra'hica! i&strates the reation bet+een a$era)e 'ro%&ct an% the &antit! of the $ariabe in'&t, ho%in) a other in'&ts fie%* This c&r$e in%icates the 'er &nit o&t'&t at each e$e of the $ariabe in'&t* The a$era)e 'ro%&ct c&r$e is one of three reate% c&r$es &se% in the ana!sis of the short(r&n 'ro%&ction of a firm* The other t+o are tota 'ro%&ct c&r$e an% mar)ina 'ro%&ct c&r$e* The a$era)e 'ro%&ct c&r$e i&strates ho+ a$era)e 'ro%&ct is reate% to a$ariabe in'&t* 5hie the stan%ar% ana!sis of short(r&n 'ro%&ction reates a$era)e 'ro%&ct to abor, an a$era)e 'ro%&ct c&r$e can be constr&cte% for an! $ariabe in'&t*
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The %ia)ram to the ri)ht )ra'hica! re'resentsAvera&e )ro%#ct C#rve the reation bet+een a$era)e 'ro%&ct an% the $ariabe in'&t* This 'artic&ar c&r$e is %eri$e% from the ho&r! 'ro%&ction of S&'er De&e TeMe ar)ant&an Tacos -+ith so&r cream an% /aa'eno 'e''ers. as 5a%oBs TeMe Taco 5or% resta&rant em'o!s a%%itiona +or#ers* The n&mber of +or#ers, meas&re% on the hori"onta ais, ran)es from 0 to 10 an% the a$era)e ar)ant&an Taco 'ro%&ction 'er +or#er, meas&re% on the$ertica ais, ran)es from 0 to 2* The sha'e of this a$era)e 'ro%&ct c&r$e is +orth notin)* =or the first t+o +or#ers of $ariabe in'&t, a$era)e 'ro%&ct increases* This is refecte% in a 'ositi$e so'e of the a$era)e 'ro%&ct c&r$e* After the thir% +or#er, the a$era)e 'ro%&ct %ecines* This is seen as a ne)ati$e so'e* 5hie a$era)e 'ro%&ct contin&es to %ecine, it ne$er reaches "ero nor becomes ne)ati$e* To %o so +o&% re&ire tota 'ro%&ct to become "ero an% ne)ati$e, +hich /&st %oes not ha''en* The h&m'(sha'e of the a$era)e 'ro%&ct c&r$e in%irect! res&ts from increasin) an% %ecreasin) mar)ina ret&rns* The &'+ar%(so'in) 'ortion of the a$era)e 'ro%&ct c&r$e, &' to the secon% +or#er, is in%irect! %&e to increasin) mar)ina ret&rns* The %o+n+ar%( so'in) 'ortion of the a$era)e 'ro%&ct c&r$e, after the thir% +or#er, is in%irect! %&e to %ecreasin) mar)ina ret&rns* an% the a+ of %iminishin) mar)ina ret&rns* vi. Sta&es o )ro%#ction
The three sta)es of 'ro%&ction are characteri"e% b! the so'es, sha'es, an% interreationshi's of the tota, mar)ina, an% a$era)e 'ro%&ct c&r$es* The first sta)e is characteri"e% b! a 'ositi$e so'e of the a$era)e 'ro%&ct c&r$e, en%in) at the intersection bet+een the a$era)e 'ro%&ct an% mar)ina 'ro%&ct c&r$es the secon% sta)e b! contin&es &' to the 'oint in +hich the mar)ina 'ro%&ct becomes ne)ati$e, at the 'ea# of the tota 'ro%&ct c&r$e an% the thir% sta)e eists o$er the ran)e of in +hich the tota 'ro%&ct c&r$e is ne)ati$e! so'e%* In Sta)e I, a$era)e 'ro%&ct is 'ositi$e an% increasin)* In Sta)e II, mar)ina 'ro%&ct is 'ositi$e, b&t %ecreasin)* An% in Sta)e III, tota 'ro%&ct is %ecreasin)* Short(r&n 'ro%&ction b! a firm t!'ica! enco&nters three %istinct sta)es as a ar)er amo&nts of a $ariabe in'&t -es'ecia! abor . are a%%e% to afie% in'&t -s&ch as ca'ita.* The first sta)e res&ts from increasin)a$era)e 'ro%&ct* The secon% sta)e sets it at the 'ea# of a$era)e 'ro%&ct, e'eriencin) a +i%e ran)e of %ecreasin) mar)ina ret&rns, an% the a+ of %iminishin) mar)ina ret&rns* The thir% sta)e is then characteri"e% b! ne)ati$e mar)ina ret&rns an%* Three ro%&ct @&r$es
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The three sta)es of short(r&n 'ro%&ction areThree Sta&es rea%i! seen +ith the three 'ro%&ct c&r$es((tota 'ro%&ct, a$era)e 'ro%&ct, an%mar)ina 'ro%&ct* A set of 'ro%&ct c&r$es is 'resente% in the ehibit to the ri)ht* The $ariabe in'&t in this eam'e is abor* The to' 'ane contains the tota 'ro%&ct c&r$e -T.* It )enera! rises, reaches a 'ea#, then fas* The bottom 'ane contains themar)ina 'ro%&ct c&r$e -M. an% the a$era)e 'ro%&ct c&r$e -A.* Coth c&r$es rise a bit for sma &antities of the $ariabe in'&t abor, then %ecine* Mar)ina 'ro%&ct e$ent&a! t&rns ne)ati$e, b&t a$era)e 'ro%&ct remains 'ositi$e* The three short(r&n 'ro%&ction sta)es are con$enient! abee% I, II, an% III, an% are se'arate% b! $ertica ines eten%in) thro&)h both 'anes* Sta)e I Short(r&n 'ro%&ction Sta)e I arises %&e to increasin) a$era)e 'ro%&ct* As more of the $ariabe in'&t is a%%e% to the fie% in'&t, the mar)ina 'ro%&ct of the $ariabe in'&t increases* Most im'ortant!, mar)ina 'ro%&ct is )reater than a$era)e 'ro%&ct, +hich ca&ses a$era)e 'ro%&ct to increase* This is %irect! i&strate% b! the so'e of the a$era)e 'ro%&ct c&r$e* @onsi%er these obser$ations abo&t the sha'es an% so'es of the three 'ro%&ct c&r$es in Sta)e I*
The tota 'ro%&ct c&r$e has a 'ositi$e so'e* Mar)ina 'ro%&ct is )reater than a$era)e 'ro%&ct* Mar)ina 'ro%&ct initia! increases, the %ecreases &nti it is e&a to a$era)e 'ro%&ct at the en% of Sta)e I* A$era)e 'ro%&ct is 'ositi$e an% the a$era)e 'ro%&ct c&r$e has a 'ositi$e so'e*
Sta)e II In Sta)e II, short(r&n 'ro%&ction is characteri"e% b! %ecreasin), b&t 'ositi$e mar)ina ret&rns* As more of the $ariabe in'&t is a%%e% to the fie% in'&t, the mar)ina 'ro%&ct of the $ariabe in'&t %ecreases* Most im'ortant of a, Sta)e II is %ri$en b! the a+ of %iminishin) mar)ina ret&rns* The three 'ro%&ct c&r$es re$ea the foo+in) 'atterns in Sta)e II*
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The tota 'ro%&ct c&r$e has a %ecreasin) 'ositi$e so'e* In other +or%s, the so'e becomes fatter +ith each a%%itiona &nit of $ariabe in'&t* Mar)ina 'ro%&ct is 'ositi$e an% the mar)ina 'ro%&ct c&r$e has a ne)ati$e so'e* The mar)ina 'ro%&ct c&r$e intersects the hori"onta &antit! ais at the en% of Sta)e II* A$era)e 'ro%&ct is 'ositi$e an% the a$era)e 'ro%&ct c&r$e has a ne)ati$e so'e* The a$era)e 'ro%&ct c&r$e is at its a 'ea# at the onset of Sta)e II* At this 'ea#, a$era)e 'ro%&ct is e&a to mar)ina 'ro%&ct*
A$era)e 'ro%&ct remains 'ositi$e b&t the a$era)e 'ro%&ct c&r$e has a ne)ati$e so'e* Economic )ro%#ction
These three %istinct sta)es of short(r&n 'ro%&ction are not e&a! im'ortant* Sta)e I, an% +ith ar)e! increasin) mar)ina ret&rns, is a )reat 'ace to $isit, b&t most firms mo$e thro&)h it &ic#!* Ceca&se each $ariabe in'&t is increasin)! more 'ro%&cti$e, firms em'o! as man! as the! can, as &ic#! as the! can* Sta)e III, +ith ne)ati$e mar)ina ret&rns, is not 'artic&ar! attracti$e to firms* ro%&ction is ess than it +o&% be in Sta)e II, b&t the cost of 'ro%&ction is )reater %&e to the em'o!ment of the $ariabe in'&t* ot a ot of benefits are to be ha% +ith Sta)e III* Sta)e II, +ith %ecreasin) b&t 'ositi$e mar)ina ret&rns, 'ro$i%es a ran)e of 'ro%&ction that is s&itabe to most e$er! firm* Atho&)h mar)ina 'ro%&ct %ecines, a%%itiona em'o!ment of the $ariabe in'&t %oes a%% to tota 'ro%&ction* 8$en tho&)h 'ro%&ction cost rises +ith a%%itiona em'o!ment, there are benefits to be )aine% from etra 'ro%&ction* The tric# is to baance the etra cost +ith the etra 'ro%&ction* As a matter of fact, beca&se Sta)e II ten%s to be the choice of firms for short(r&n 'ro%&ction, it is often referre% to as the economic re)ion* =irms &ic#! mo$e from Sta)e I to Sta)e II, an% %o a the! can to a$oi% mo$in) into Sta)e III* =irms can comfortab!, an% 'rofitab!, 'ro%&ce fore$er an% e$er in Sta)e II* vii. 3inearly 4omo&eneo#s )ro%#ction F#nctionQ an% Co00=Do#&las )ro%#ction F#nction"
Man! st&%ies ha$e been &n%erta#en to em'irica! st&%! an% statistica! cac&ate the reationshi' bet+een 'h!sica in'&ts an% 'h!sica o&t'&t* ne of s&ch em'irica 'ro%&ction f&nctions is 聽 Co00 Do#&las )ro%#ction F#nction * It is interme%iate bet+een a inear an% a fie% 'ro'ortion 'ro%&ction f&nction* It is )i$en b! a form&a (((((( B A3
K
5here is tota o&t'&t, L stan%s for &antit! of abo&r, is &antit! of ca'ita,聽 A, 伪 an% 尾 are 'ositi$e constants*
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8m'irica! it +as fo&n% that, 7R increase in o&t'&t can be attrib&te% to increase in abo&r in'&t an% the remainin) 2R +as %&e to ca'ita in'&t* It +as aso fo&n% that the s&m of e'onents of @obb(Do&)as 'ro%&ction f&nction is e&a to one* That is 伪 Y 尾 is e&a to one* This im'ies that it is a inear! homo)eno&s 'ro%&ction f&nction* =oo+in) are im'ortant feat&res of @obb(Do&)as ro%&ction =&nction 1* A$era)e ro%&ct of factors of 'ro%&ction &se% &' in this f&nction %e'en%s &'on the ratio in +hich the factors are combine% for the 'ro%&ction of commo%it! &n%er consi%eration 2* Mar)ina ro%&ct of factors of 'ro%&ction &se% &' in this f&nction aso %e'en%s &'on the ratio in +hich the factors are combine% for the 'ro%&ction of commo%it! &n%er consi%eration 3* @obb(Do&)as 'ro%&ction f&nction is &se% in obtainin) mar)ina rate of technica s&bstit&tion - the rate at +hich one in'&t can be s&bstit&te% for the other to 'ro%&ce same e$e of o&t'&t. bet+een t+o in'&ts* 3inear 4omo&eneo#s )ro%#ction F#nction
The Linear Homo)eneo&s ro%&ction =&nction im'ies that fa the factors ofF'ro%&ction are increase% in sime 'ro'ortion* the o&t'&t aso increases in the same 'ro'ortion* That is* the %o&bin) of a in'&ts +i %o&be the o&t'&t an% trebin) them +i res&t in the trebin) of the o&t'&t, aim so on* This re'resents a case of constant ret&rns to scae* This t!'e of 'ro%&ction f&nction is cae% b! the economists as a +e beha$e% 'ro%&ction f&nction beca&se it can be easi! han%e% an% &se% in em'irica st&%ies* It can he &se% b! com'&ters in cac&ations* That is +h! it is +i%e! &se% in inear 'ro)rammin) an% in'&t( o&t'&t ana!sis * It is etensi$e! &se% in mo%e ana!sis of 'ro%&ction* %istrib&tion an% economic )ro+th* This is a 'ro%&ction f&nction +hich is homo)eneo&s of the first %e)ree* That is, it sho+s that the increase in o&t'&t in the same 'ro'ortion foo+s a )i$en chan)e in the factors of 'ro%&ction* This has been '&t mathematica! as* This f&n is homo)eneo&s of th %e)ree* If is e&a to one then this homo)eneo&s f&n is homo)eneo&s the first %e)ree an% if - is e&a to t+o it is homo)eneo&s of the secon% %e)ree, an% so on* If -- is )reater than one the 'ro%&ction f&nction )i$es increasin) ret&rns to scae an% if it is ess than one it )i$es %ecreasin) ret&rns to scae* In the case of homo( (i)neo&s 'ro%&ction f&nction, the e'ansion 'ath is a+a!s a strai)ht ine thro&)h the means that in the case of homo)eneo&s 'ro%&ction f&nction of the first %e)ree* )i$en constant reati$e factor 'rices* the 'ro'ortions bet+een the factors &se% +i a+a!s be the 5hate$er the e$e of o&t'&t* This ma#es the tas# of the entre'rene&r eas! * Ha$in) hit on an o'tim&m factor 'ro'ortions, he nee% not chan)e the %ecision so on) as the reati$e 'rices the factors remain &nchan)e%* i,. Iso9#ants an% Isocost lines
L. an% @a'ita -. that +i 'ro%&ce a certain o&t'&t * Mathematica!, the %ata that an iso&ant 'ro/ects is e'resse% b! the e&ation K83. B
K
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A
Q=25 B
Q=15
KB = 2 Q=5 2 = L A
8 = LB
L
Figure 9.1- An Isoquant Map Each curve shows the rate at which L can e sustitute! "or K# or vice versa# whi$e %eepin& output constant'
This e&ation basica! sa!s that the o&t'&t that this firm 'ro%&ces is a f&nction of Labor an% @a'ita, +here each iso&ant re'resents a fie% o&t'&t 'ro%&ce% +ith %ifferent combinations of in'&ts* A ne+ iso&ant emer)es for e$er! e$e of o&t'&t -See =i)&re 9*1.* Iso&ants ha$e certain 'ro'erties that resembe that of in%ifference c&r$es : con$e to the ori)in, %o+n+ar% so'in), an% nonintersectin) c&r$es* The Mar)ina ?ate of Technica S&bstit&tion -M?TS. e&as the abso&te $a&e of the so'e* The M?TS tes &s ho+ m&ch of one in'&t a firm can sacrifice +hie sti maintainin) a certain o&t'&t e$e* The M?TS is aso e&a to the ratio of Mar)ina ro%&cti$it! of Labor -ML.: Mar)ina ro%&cti$it! of @a'ita -M .* The mathematica form of ho+ Labor -L. can be s&bstit&te% for @a'ita -. in 'ro%&ction is )i$en b!; MRTS 3 or K.B =%K*%3 B M) 3*M)K
=or 8am'e; 5hen )oin) from 'oint C to A in =i)&re 9*1, the So'e X -G &nits of @a'ita.>-(6 &nits of Labor.* The M?TS -L for . X (-G>(6. X 4 >3 bet+een 'oints C an% A, +hich means that 4 &nits of @a'ita can s&bstit&te for 3 &nits of abor*
Isocosts: An isocost line -e&a(cost ine. is a Tota @ost of 'ro%&ction ine that reco)ni"es a combinations of t+o reso&rces that a firm can &se, )i$en the Tota @ost -T@.* Mo$in) &' or %o+n the ine sho+s the rate at +hich one in'&t co&% be s&bstit&te% for another in the in'&t mar#et* =or the case of Labor an% @a'ita, the tota cost of 'ro%&ction +o&% ta#e on the form; TC B -3. RK.
T@X Tota @ost, 5X 5a)e, LX Labor, ?X @ost of @a'ita, X @a'ita 8am'e; A com'an! 'ro%&cin) +i%)ets enco&nters the foo+in) costs( cost of ca'ita is 2000, abor cost is 1000, an% the tota cost the firm is +iin) to 'a! is 10,000* K
(
150#000 = 15#000L ) 25#000K
10 Figure 9.2 * Isocost Line +he s$ope o" this $ine is ,a&e ,./ ost o" apita$ . ,/= -15#000./25#000.= -0'( or ever3 one unit o" L the "ir4 wants to hire# the3 4ust &ive up 0'( units o" K
Sho+ the isocost ine )ra'hica!*
L
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The e&ation re'resente% b! the %ata is; 10,000X -1000.L Y -2000. Settin) LX0, +e fin% the !(interce't to be X6* Settin) X0, +e fin% the (interce't to be 10 -See =i)&re 9*2. ,i. O#t$#t Ma,imi'ation an% Cost minimi'ation 5e can conce't&a! %i$i%e the 'rofit maimi"ation 'robem into t+o s&b('robems;
5hat is the o+est cost combination of in'&ts that +i 'ro%&ce a e$e of o&t'&t e&a to !< 5hat is the o&t'&t e$e ! that +i maimi"e 'rofits<
@ost minimi"ation is a necessar! -b&t not s&fficient. con%ition for 'rofit maimi"ation* 8$en +hen a 'ro%&cer is not a 'rice ta#er in the o&t'&t mar#et, or +hen the so&tion to the 'rofit maimi"ation 'robem is not +e %efine% -sa!, %&e to increasin) ret&rns., the 'ro%&cer m&st sti minimi"e costs* Ass&m'tions;
ro%&ction f&nction is ! X f-1,2.* The 'ro%&ction f&nction is ass&me% to be &asi(conca$e* The 'ro%&cer is a 'rice ta#er in the in'&t mar#et*
The 'ro%&cer chooses 1 an% 2 -the choice $ariabes. to minimi"e @-1,2. -the ob/ecti$e f&nction. minimi"e @-1,2. X +1 1 Y +2 2 s&b/ect to the constraint f-1,2. X ! The 'arameters of this 'robem are +1, +2, an% !* =orm the La)ran)ian f&nction; L X +1 1 Y +2 2 Y - ! ( f- 1,2. . The $ariabe is cae% the La)ran)e m&ti'ier for the constraint* The =@ for this minimi"ation 'robem is; L>1 X +1 ( f 1 -1,2. X 0 L>2 X +2 ( f 2 -1,2. X 0 L> X ! ( f-1,2. X 0
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S&fficient SOC for minimi"ation is that a the bor%er('reser$in) 'rinci'e minor %eterminants of the matri J ( f 11 ( f 12 (f 1 K H X J ( f 21 ( f 22 (f 2 K J (f 1 (f 2 0 K are ne)ati$e* Inter'retation; The =@ im'! +1>+2 X f 1>f 2* That is, the ratio of factor 'rices is e&a to the mar)ina rate of technica s&bstit&tion* The ass&m'tion of &asi(conca$it! )&arantees that the S@ is satisfie%* Aternati$e!, if +e aban%on the ass&m'tion of &asi(conca$it!, the S@ im'ies that the 'ro%&ction f&nction is oca! &asi(conca$e at the o'tima in'&t combination* Here, the &asi( conca$it! con%ition is e&i$aent to the con%ition of %iminishin) M?TS* The S@ %oes not sa! an!thin) abo&t ret&rns to scae* 8$en if +e ha$e an increasin) ret&rns to scae 'ro%&ction f&nction -e*)*, ! X 1 2., the cost(minimi"ation 'robem sti has a +e %efine% so&tion* The =@ can be consi%ere% as three e&ations in three &n#no+ns -1, 2, .* i$en an! 'arameter $a&es for +1, +2, an% !, +e can so$e these e&ations for the &n#no+ns* f co&rse, the so&tion $a&es %e'en% on the $a&es of the 'arameters* If 1, 2, an% are the so&tions to the cost minimi"ation 'robem, +e em'hasi"e the %e'en%ence of these o'tima choice f&nctions on the 'arameters b! +ritin) 1 X 1 -+1,+2,!. an% 2 X 2 -+1,+2,!.* These f&nctions are %ifferent from the factor %eman% f&nctions %eri$e% from the 'rofit maimi"ation 'robem* 5e ca them cost(minimi"in) factor %eman% f&nctions orcon%itiona factor %eman% f&nctions* C! %efinition, if !o& s&bstit&te the o'tima choice f&nctions into the =@ e&ations, the e&ations are a+a!s satisfie%* 5e therefore +rite +1 ( -+1,+2,!. f 1- 1 -+1,+2,!., 2 -+1,+2,!. . d 0 +2 ( -+1,+2,!. f 2- 1 -+1,+2,!., 2 -+1,+2,!. . d 0 ! ( f- 1 -+1,+2,!., 2 -+1,+2,!. . d 0 @onsi%er ho+ +1 affects factor %eman%* Use the i%entities abo$e, %ifferentiate +ith res'ect to +1, an% em'o! the chain r&e of %ifferentiation, +e )et 1 ( f 11 -1> +1. ( f 12 -2 >+1. ( f 1 - >+1. X 0 0 ( f 21 -1> +1. ( f 22 -2 >+1. ( f 2 - >+1. X 0 0 ( f 1 -1 >+1. ( f 2 -2 >+1. ( 0 - >+1. X 0 In matri notation;
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J ( f 11 ( f 12 (f 1 K J 1>+1 K X J (1 K J ( f 21 ( f 22 (f 2 K J 2>+1 K X J 0 K J (f 1 (f 2 0 K J >+1 K X J 0 K Use @ramerBs r&e to )et 1>+1 X ^ (1 ( f 12 (f 1 ^ > ^ 0 ( f 22 (f 2 ^ > ^ H ^ ^ 0 (f 2 0 ^> X (1 ^ ( f 22 (f 2 ^ > ^ H ^ ^ (f 2 0 ^> The %eterminant in the n&merator is a bor%er('reser$in) 'rinci'a minor %eterminant, so b! the S@ it is ne)ati$e -$erif!.* Simiar!, the S@ aso re&ires the ^ H ^ ] 0* Therefore 1 >+1 ] 0 -%o+n+ar% so'in) con%itiona factor %eman% c&r$e.* 5e can aso so$e for 2> +1; 2>+1 X ^ ( f 11 (1 (f 1 ^ > ^ ( f 21 0 (f 2 ^ > ^ H ^ ^ (f 1 0 0 ^> X 1 ^ ( f 21 (f 2 ^ > ^ H ^ ^ (f 1 0 ^> The %eterminant in the n&merator is not a bor%er('reser$in) 'rinci'a minor %eterminant, so in )enera its si)n is &n%etermine%* C&t for the t+o(in'&t case, this %eterminant is ne)ati$e, so 2> +1 Z 0* -5h!< Theor! im'ies 1 >+1 ] 0* So +hen +1 increases, +e &se ess 1, b&t +e sti +ant to 'ro%&ce the same amo&nt of o&t'&t !* This is achie$e% b! increasin) the &se of 2*. If !o& are c&rio&s, !o& can %o a simiar com'arati$e statics ana!sis for + 2* o& +i then $erif! that 1> +2 X 2> +1 LetBs aso tr! the com'arati$e statics for !* Differentiate the =@ +ith res'ect to ! an% +rite in matri notation, +e ha$e J ( f 11 ( f 12 (f 1 K J 1>! K X J 0 K J ( f 21 ( f 22 (f 2 K J 2>! K X J 0 K J (f 1 (f 2 0 K J >! K X J (1 K Therefore,
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1>! X ^ 0 ( f 12 (f 1 ^ > ^ 0 ( f 22 (f 2 ^ > ^ H ^ ^ (1 (f 2 0 ^> X (1 ^ ( f 12 (f 1 ^ > ^ H ^ ^ ( f 22 (f 2 ^ > The %eterminant in the n&merator is not a bor%er('reser$in) 'rinci'a minor %eterminant, so this %eri$ati$e cannot be si)ne%* If 1>! Z 0, then 1 is a norma factor* If 1>! ] 0, then +e ca it an inferior factor* 5e ha$e not %eri$e% an! com'arati$e statics for the -+1,+2,!. f&nction* C&t if +e %o it, +e +i see that a the 'artia %eri$ati$es ha$e ambi)&o&s si)ns* =ina!, if +e oo# at the =@ e&ations a)ain, an% consi%er the effect of chan)in) a in'&t 'rices from -+1, +2. to -t+1, t+2. +hie #ee'in) the 'arameter ! &nchan)e%* The =@ become t+1 ( f 1 -1,2. X 0 t+2 ( f 2 -1,2. X 0 ! ( f-1,2. X 0 If - 1, 2, . so$e the ori)ina =@ e&ations, then - 1, 2, t . m&st so$e the ne+ set of e&ations* 5e therefore conc&%e that 1 -t+1, t+2, !. d 1 -+1, +2, !. 2 -t+1, t+2, !. d 2 -+1, +2, !. That is, the con%itiona in'&t %eman% f&nctions are homo&eneo#s o %e&ree ? in +1 +2 -b&t not in !.* -Since -t+1, t+2, !. d t -+1, +2,!., +e aso see that the -. f&nction is homo)eneo&s of %e)ree 1*. SUMMA?; ro'erties of con%itiona in'&t %eman% f&nctions
i -+1, ***, +n, !. is homo)eneo&s of %e)ree 0 in the in'&t 'rices* i> +i ] 0 -%o+n+ar% so'in) con%itiona factor %eman% c&r$e. i> + / X /> +i -s!mmetr!.
?eationshi' bet+een cost minimi"ation an% 'rofit maimi"ation If +e com'are the =@s for the 'rofit(maimi"ation 'robem +ith the =@s for the cost minimi"ation 'robem, +e can see that the! +i )i$e the same so&tion $a&es for 1 an% 2 if the $a&e of the La)ran)e m&ti'ier is X '* =rom intro%&ctor! microeconomics, +e #no+ that a con%ition for 'rofit maimi"ation is Mar)ina @ost X '* This is a hint that the La)ran)e m&ti'ier can be inter'rete% as Mar)ina @ost*
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The =@ im'ies X +1>f 1 X +2>f 2* 5hat is the mar)ina cost of 'ro%&cin) one &nit of o&t'&t< 5e, +e can 'ro%&ce more o&t'&ts b! &sin) more 1* If the mar)ina 'ro%&ct of 1 is f 1, +e nee% 1>f 1 &nits of 1 to 'ro%&ce one more &nit of o&t'&t* 8ach &nit of 1 costs +1, so the cost of 1>f 1 &nits of 1 is + 1>f 1* This is another hint that can be inter'rete% as Mar)ina @ost* More on this ater* If !o& +ant to 'ro%&ce ! X !\-',+1,+2. &nits of o&t'&t, the cost(minimi"in) in'&t b&n%e m&st be the same as the 'rofit(maimi"in) in'&t b&n%e* So +e m&st ha$e 1 -+1, +2, !\-',+1,+2. . d 1\ -',+1,+2. Differentiate the i%entit! +ith res'ect to, sa! +1, +e )et 1> +1 Y -1 >!. -!\>+1. X 1\>+1 To fin% o&t +hat 1>! is, +e %ifferentiate the i%entit! +ith res'ect to ' to )et -1 >!. -!\>'. X 1\>' So 1 >! X - 1\>'. > -!\>'.* S&bstit&te this e'ression bac# in; 1> +1 ( 1\> +1 X ( -1\>'. -!\>+1. > -!\>'. Since the s!mmetr! con%ition ens&res that the 1\>' X ( !\>+1, the n&merator is a s&are m&st be 'ositi$e* The %enominator is aso sho+n to be 'ositi$e, so the +hoe term is 'ositi$e* I*e*, 1> + 1 Z 1\>+1* C&t beca&se %eman% c&r$es are ne)ati$e! so'e%, this means that the %eri$ati$e of the 'rofit(maimi"in) %eman% f&nction is ar)er in abso&te $a&e than is the %eri$ati$e of the cost(minimi"in) %eman% f&nction* @onsi%er the effect of an increase in +1 on the 'rofit( maimi"in) choice of 1; 1\>+1 X 1>+1 Y -1>!. -!\>+1. s&bstit&tion scae effect effect The s&bstit&tion effect is a+a!s ne)ati$e* The scae effect is aso a+a!s ne)ati$e - for norma factors, 1>! Z 0 an% !\>+1 ] 0 for inferior factors, 1>! ] 0 an% !\>+1 Z 0.* The t+o effects reinforce each other* ,ii. 3a/s o Ret#rns an% Elasticity o S#0stit#tion"
S&''ose that Nosh +ants to e'an% his b&siness an% mo+ more a+ns* He co&% ease another a+nmo+er* This mi)ht enabe him to +or# more stea%i!, beca&se if one a+nmo+er r&ns o&t of )as or re&ires maintenance, he can &se the other a+nmo+er*
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C&t easin) another a+nmo+er +i not enabe Nosh to %o&be the n&mber of a+ns that he mo+s* The fact that %o&bin) the n&mber of a+nmo+ers +i not %o&be the n&mber of a+ns one 'erson can mo+ is an i&stration of the a+ of %iminishin) ret&rns* 5hen a 'ro%&ction 'rocess re&ires man! in'&ts -or factors., a%%in) more of one in'&t &s&a! res&ts in a ess(than('ro'ortionate increase in o&t'&t* S&''ose that Nosh #ee's /&st one a+nmo+er, b&t he tries to %o&be the n&mber of a+ns he mo+s b! +or#in) on)er* He +i )et tire%, an% he +i fin% that +or#in) ei)ht more ho&rs %oes not enabe him to mo+ ei)ht more a+ns in a %a!* That is another i&stration of the a+ of %iminishin) ret&rns* Constant Ret#rns to Scale
In theor!, if !o& %o&be a in'&ts in a 'ro%&ction 'rocess, !o& sho&% be abe to %o&be the o&t'&t* That is cae% constant ret&rns to scae* In 'ractice, b&sinessmen ten% to oo# at scae in terms of increases in some in'&ts b&t not in others* If the! can %o&be o&t'&t +itho&t ha$in) to %o&be a in'&ts, the! sa! that there are economies of scae* =or eam'e, if Nosh can %o&be the n&mber of a+ns mo+e% b! a%%in) another +or#er an% another a+nmo+er((b&t +itho&t ha$in) to a%% another 'ic#&' tr&c#((then his b&siness has economies of scae* In )enera, s&''ose that !o& can 'ro%&ce &nits of o&t'&t +ith a )i$en set of in'&ts* o+, s&''ose +e %o&be the e$e of in'&ts, an% as# +hether or not +e )et 2 &nits of o&t'&t* 5e %escribe the ret&rns to scae as foo+s; O#t$#t
Ret#rns to Scale
more than 2 economies of scae, or increasin) ret&rns eact! 2
constant ret&rns to scae
ess than 2
%iseconomies of scae, or %iminishin) ret&rns
There is an ar)&ment to be ma%e that an! b&siness o&)ht to ha$e constant ret&rns to scae if !o& can i%entif! a in'&ts an% increase them 'ro'ortionate!* Ho+e$er, in 'ractice, there are in'&ts, s&ch as mana)eria s&'er$ision, that are near! im'ossibe to increase 'ro'ortionate!* =or eam'e, s&''ose that NoshBs in'&ts consist of fo&r +or#ers -inc&%in) himsef., fo&r a+nmo+ers, an% one 'ic#&' tr&c#* If he %o&bes a of those in'&ts, then the secon% 'ic#&' tr&c# +i ha$e to )o to +or# at a %ifferent nei)hborhoo%, an% it +i be more %iffic&t for Nosh to s&'er$ise the +or#ers* Th&s, NoshBs b&siness is i#e! to ehibit %iminishin) ret&rns once he has to &se more than one 'ic#&' tr&c#* Diminishin) ret&rns arise +hen an im'ortant factor or in'&t is fie%, in that it cannot be increase% aon) +ith other factors* 8conomists beie$e that /&st abo&t an! b&siness is
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s&b/ect to %iminishin) ret&rns at some 'oint* Ho+e$er, man! b&sinesses ha$e increasin) ret&rns at norma e$es of o&t'&t* S#0stit#tion
S&''ose that there are t+o t!'es of a+nmo+ers((econom! an% %e&e* 5ith the econom! a+nmo+er, Nosh can mo+ G00 a+ns in a season* 5ith the %e&e a+nmo+er, he can mo+ G40 a+ns in a season* At 2 a a+n, the %e&e a+nmo+er is +orth 1000 more for a season* If the econom! a+nmo+er costs 300 to ease an% the %e&e a+nmo+er costs G00 to ease, he sho&% )o for the %e&e a+nmo+er* Ho+e$er, if the %e&e a+nmo+er costs 100 to ease, Nosh sho&% stic# +ith the econom! a+nmo+er* The %ecision of +hich a+nmo+er to &se is an eam'e of s&bstit&tion* If the 'rice is ri)ht, Nosh +i s&bstit&te the %e&e a+nmo+er for the econom! a+nmo+er* Another t!'e of s&bstit&tion in$o$es ca'ita an% abor* S&''ose that Nosh r&ns his b&siness +ith fo&r +or#ers -inc&%in) himsef. an% fo&r a+nmo+ers* 5hat +o&% ma#e him &se fi$e +or#ers an% three a+nmo+ers, or $ice($ersa< S&''ose that a +or#er nee%s a a+nmo+er to be 'ro%&cti$e, an% that a+nmo+ers sometimes brea# %o+n* It mi)ht be +orth+hie for Nosh to ha$e s'are a+nmo+ers an% fe+er +or#ers, so that +or#ers ne$er ha$e to sit i%e beca&se of mechanica fai&re* Aternati$e!, s&''ose that a+nmo+ers are $er! cost! to ease, b&t that abor is ine'ensi$e* Nosh mi)ht +ant to ha$e more +or#ers than a+nmo+ers, so that +hen one +or#er is ta#in) a brea# that +or#erBs a+nmo+er is &se% b! another +or#er* That +a!, a+nmo+ers ne$er sit i%e* NoshBs %ecisions abo&t s&bstit&tion bet+een ca'ita an% abor +i %e'en% on t+o )enera factors* 1"
Technolo&y"
Different combinations of +or#ers an% a+nmo+er +i 'ro%&ce %ifferent e$es of o&t'&t in terms of a+ns mo+e%* The res&ts of %ifferent combinations of abor an% ca'ita constit&te the technoo)! that is a$aiabe to Nosh* 2"
Relative $rices"
The +a)es of +or#ers an% the easin) cost of %ifferent a+nmo+ers he' %etermine +hether Nosh +ants to &se more or ess of either in'&t* A hi)her ho&r! +a)e rate +o&% ea% Nosh to &se ess abor an% more ca'ita* A hi)her easin) cost +o&% ea% him to &se ess ca'ita an% more abor* The ratio of the easin) cost to the +a)e rate is cae% a reati$e 'rice*
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The b&r%en s&staine% in or%er to 'erform a certain acti$it!, to carr! o&t a certain 'ro%&ction, to achie$e certain )oas* In a baance sheet, costs raise commercia iabiities to be sette%* The! sho&% not be conf&se% +ith mone! o&tfo+s* C! contrast, in economics, most forma mo%es i)nore this %istinction bet+een costs an% 'a!ments* Cost cate&ories Act#al costs refer to rea transactions, +herease o$$ort#nity costs refer to the aternati$e ta#en into consi%eration b! %ecision ma#ers +ho mi)ht +ant to choose the ine of acti$it! +hich minimise the costs* =rom an eterna 'oint of $ie+, it is %iffic&t to ascertain +hich are the aternati$e consi%ere%* Discretionary costs are not strict! necessar! for c&rrent 'ro%&ction b&t corres'on% to strate)ic )oas -e*)* im'ro$in) the firmBs ima)e thro&)h an a%$ertisin) instit&tiona cam'ain).* Attri0#te% costs are com'&te% $a&es from acco&ntanc! that are con$entiona! attrib&te% to 'ro%&cts as 'art of the 'rocess tr!in) to estabish 'rofitabe 'rices b! a''ro'riate ro&tines* )ro%#ction costs
i$en a s'ecific 'ro%&ct $ersion, 'ro%&ction costs are &s&a! cassifie% accor%in) to their res'onsi$eness to %ifferent e$es of 'ro%&ction attaine%* Fi,e% costs are sim'! not res'onsi$e to 'ro%&ction e$es*
If there are on! fie% costs, the tota costs foo+ this r&e;
=or instance, the cost of rentin) an office is a fie% cost, since &s&a! the contract fies it for a certain 'erio% of time -sa! one !ear., +itho&t an! reference to the income 'ro%&ce% b! the o'erations that ta#e 'ace in the same office*
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The firm %eci%in) to rent this office, ho+e$er, +i ha$e &s&a! e'ecte% to be abe to affor% it as +e as to be reasonab! s&re that it +i not be too sma for the #in% of o'eration it inten%s to carr! o&t* This brin)s &s to an im'ortant conc&sion; a $er! common sit&ation is that of 9#asi= i,e% costs* The! are fat in a certain ran)e of -e'ecte%. 'ro%&ction b&t the! are force% to /&m' to hi)her e$es if certain thresho%s are o$ercome* ear these thresho%s, in fact, &ait! %eterioration of o&t'&t an% other ne)ati$e 'henomena ta#e 'ace* S!mmetrica!, beo+ other minim&m thresho%s in e$e of acti$ities, the same costs become &naffor%abe an% +i 'robab! be re%&ce%* Here !o& ha$e the )ra'h of tota costs +hen there are on! &asi(fie% costs;
In 'artic&ar, economies o scale %escribe sit&ation +hen the tota costs rise ess than 'ro'ortiona! to 'ro%&ction increases, as !o& see in the foo+in) %ia)ram;
Dis=economies o scale re'resent the o''osite sit&ation;
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Constant ret#rn to scale are the interme%iate sit&ation in +hich the )ro+th in 'ro%&ction is eact! matche% b! the same 'ercenta)e increase in tota costs, i*e* eacticit! of costs to 'ro%&ction e$es is 1;
In this case, 'ro%&cti$it! is constant* To &n%erstan% the so&rces of economies of scae is he'f& to consi%er that total costs for 'ro%&ction in'&ts %e'en%s on t+o com'onents; the 9#antity an% the $rice o the in$#ts* Accor%in)!, it is often &sef& to %istin)&ish t+o broa% reasons for cost to rise; an increase of the in'&t &antit! or a soarin) 'rice for in'&t* This ao+ for %istin)&ishin) %ifferent reasons for costs beha$io&rs in reaction to chan)es in 'ro%&ction e$es* In 'artic&ar, economies of scae can be %&e; a. to sa$in)s in a$era)e 'h!sica &antit! of in'&t +hen the 'ro%&ction is hi)her -e*)* eectricit! %is'ersion is o+er in 'ercenta)e +hen the eectricit! thro&)h'&t is hi)h. b. to re%&ction in 'rices 'ai% +hen b&!in) ar)er &antities -e*)* beca&se of stron)er 'o+er in '&rchase ne)otiation.* If saes increase, $ariabe costs rise an% fie% costs remain the same* To ma#e e'eriments +ith %ifferent sit&ations, !o& can &se the free @osts soft+are, %istrib&te% b! the 8conomics 5eb Instit&te* Total an% avera&e costs Total costs are the s&m of a costs* C! %i$i%in) the tota costs b! the &antit! 'ro%&ces, one )ets the avera&e costs; ho+ m&ch a &nit of 'ro%&ction costs -&nit cost.*
A$era)e costs can be %irect! com'are% +ith 'rice to com'&te 'rofitabiit!; if the 'rice is hi)her than a$era)e cost, the 'ro%&ction is 'rofitabe*
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Total $roits +i be )i$en b! m&ti'!in) the a$era)e 'rofit +ith the &antit! 'ro%&ce% an% so%*
I%entica!, tota 'rofits can be obtain as tota re$en&es ess tota costs* The reationshi' bet+een tota re$en&e an% tota costs %e'en%in) on the 'ro%&ction e$e is ana!se% b! the so(cae% brea#(e$en ana!sis* LetBs see mathematica! +hat com'onent cr&cia! inf&ences a$era)e costs at t+o +i%e! %ifferent e$es of 'ro%&ction* In the sim'ifie% sit&ation of a 'ro%&ction 'rocess characterise% b! a i,e% cost F. '&s a $ro$ortionally=&ro/in& varia0le cost
T@ X = Y E@ +here is the &antit! of )oo%* Avera&e costs AC. are th&s the foo+in); A@X T@> X => Y E@
The first term of the ri)ht si%e -=>. %ecreases s!stematica! the hi)her the ' ro%&ction e$e -.* At o+ 'ro%&ction e$es, this re%&ction is &antitati$e! ree$ant +herease for a hi)h it is not* In fact, for hi)h , the a$era)e cost is 'ractica! e&a to $ariabe cost E@* i. @once't of @osts O$$ort#nity Cost
The reso&rces of an! firm o'eratin) in the mar#et are imite% an% in$estment o'tions are man!* The firm therefore has to %eci%e or seect on! those in$estment o''ort&nities>o'tions +hich 'ro$i%e the firm +ith the best ret&rn or best income on in$estment* This means that if a firm can in$est mone!> reso&rces on! in one in$estment o'tion then the firm +i seect that in$estment o'tion +hich 'romises best ret&rn on in$estment to the firm* In other +or%s +hie %oin) so the firm )i$es &'>re/ects the net best o'tion for in$estin) the f&n%s* The o''ort&nit! cost of a com'an! is th&s this income> ret&rn +hich the firm co&% ha$e earne% on the net best in$estment aternati$e* This can aso be &n%erstoo% b! a sim'e eam'e ( Let &s ass&me that an in%i$i%&a has t+o /ob offers in han%* ne /ob offer is 'romisin) him a saar! of ?s* 30, 000 'er month +hie the other /ob offer +i ens&re saar! of ?s* 2, 000 'er month* If the /ob 'rofie an% other factors reate% to the /ob offers are more or ess same then it can be easi! e'ecte% that the in%i$i%&a +i seect the /ob offer +hich +i 'ro$i%e him +ith hi)her saar! that
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is saar! of ?s* 30, 000 'er month* Th&s, in this case, the o''ort&nit! cost is the ret&rn in$o$e% in the net best aternati$e i*e Saar! of ?s* 2, 000 in the net best /ob offer* @once't of o''ort&nit! cost is cose! reate% to the conce't of Economic $roit or Economic Rent * A firm earns or ma#es 8conomic 'rofit on! +hen besi%es co$erin) $ario&s costs of o'eration, a firm is aso abe to earn more than its o''ort&nit! cost -or its 'ossibe earnin)s &n%er the net best in$estment aternati$e.* ''ort&nit! @ost is aso terme% as Im$licit Cost * Economic )roit is th#s earne% only /hen ollo/in& is tr#e or the Firm ; Income o a Firm
? Economic )roit B Earnin&s or Reven#e o Firm = Ecomomic Costs * Here 8conomic @ost is $ario&s e'enses of the b&siness '&s the o''ort&nit! cost Some sim'e eam'es of O$$ort#nity Cost an% Economic )roit are %isc&sse% in foo+in) three brief case st&%ies* Un%erstan%in& O$$ort#nity Cost an% Economic )roit
@AS8 1; Mr* S&bo%h has t+o /ob o''ort&nities in han%* =irst /ob o''ort&nit! can he' him to earn ?s* 20, 000 'er month an% the secon% o''ort&nit! can )et him ?s* 17, 000 'er month* Un%er norma circ&mstances Mr* S&bo%h +i o't for the /ob o''ort&nit! +hich can he' him to earn ?s* 20, 000 'er month* In the 'rocess S&bo%h re/ects the other /ob o''ort&nit! +hich can he' him to earn ?s* 17, 000 'er month* In this case ''ort&nit! cost of Mr* S&bo%h is ?s* 17, 000 'er month as this is the income +hich the can be earn from the net best aternati$e*
In a0ove case Economic )roit or Economic Rent is Rs" 68 ???" This has 0een o0taine% ater %e%#ctin& Rs" 18 ??? o$$ort#nity cost. rom Rs" 2?8 ???
@AS8 2; Miss* anta can in$est her mone! &n%er the foo+in) t+o in$estment o'tions -a. In$estment in Shares* S&ch In$estment -in$estment ma%e in the shares. is i#e! to 'ro$i%e Miss anta +ith ret&rn of 20R 'er ann&m* -b. In$estment in o$ernment Con%s +hich can 'ro$i%e Miss* anta +ith ret&rn of 10R 'er ann&m on the amo&nt in$este% in the bon%s* If it is ass&me% that ris# in$o$e% in in$estin) in the stoc#s>shares is $er! mo%erate then Miss* anta +i most i#e! in$est in shares -on acco&nt of hi)her ret&rn on in$estment in shares in com'arison to the bon%s* In this case the o''ort&nit! cost is the ret&rn of 10R 'er ann&m, +hich can be earne% b! Miss anta in the net best in$estment aternati$e @AS8 3; A @om'an! BEen&s A&tomobies imite%B, in$o$e% in the 'ro%&ction of t+o an% three +heeer a&tomobies, is thin#in) of %i$ersif!in) its b&siness o'erations* There are t+o %i$ersification o'tions the com'an! can choose bet+een* ne o'tion is that the com'an! can o'en com'an! o+ne% an% o'earte% a&tomobie ser$ice stations an% the other o'tion is that com'an! can enter into the b&siness of 'ro%&cin) a&tomobie s'are 'arts* If it is e'ecte% that o'tion of o'enin) the com'an! o+ne% an% o'erate% ser$ice stations +i )enerate an a%%itiona 'rofit -'ost char)in) $ario&s e'enses. of ?s* 9 miion for the com'an! +hie the o'tion of 'ro%&ction of s'are
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'arts +i )enerate 'rofit of ?s* 10 miion for the com'an!* As e'ecte% 'rofit after char)in) $ario&s e'enses is hi)her in the a&tomobie s'are 'art b&siness, the com'an! +i choose to %i$ersif! in the s'are 'art b&siness* Th&s, in this case, the o''ort&nit! cost +i be the 'rofit of ?s* 9 miion, +hich the com'an! is e'ecte% to earn in the nest best aternati$e that is startin) com'an! o+ne% an% o'erate% ser$ice station b&siness For the a0ove case8 let #s ass#me8 that the com$any act#ally earns acco#ntin& $roit o Rs" " million on its 0#siness o $ro%#cin& an% mar+etin& a#tomo0ile s$are $arts" The Economic )roit or Economic Rent then /ill 0e the amo#nt o Rs" ?" million o0taine% ater %e%#ctin& Rs" million o$$ort#nity cost. rom Rs" " million $roit earne%. Money Cost an% Real Cost
Money Cost of 'ro%&ction is the act&a monetar! e'en%it&re ma%e b! com'an! in the 'ro%&ction 'rocess* Mone! cost th&s inc&%es a the b&siness e'enses +hich in$o$e o&ta! of mone! to s&''ort b&siness o'erations* =or eam'e the monetar! e'en%it&re on '&rchase of ra+ materia, 'a!ment of +a)es an% saaries, 'a!ment of rent an% other char)es of b&siness etc can be terme% as Mone! @ost* Real Cost of 'ro%&ction or b&siness o'eration on the other han% inc&%es a s&ch e'enses>costs of b&siness +hich ma! or ma! not in$o$e act&a monetar! e'en%it&re* =or eam'e if o+ner of a b&siness $ent&re &ses his 'ersona an% an% b&i%in) for r&nnin) the b&siness $ent&re an% he>she %oes not char)e an! rent for the same then s&ch hea% +i not be consi%ere%>inc&%e% +hie com'&tin) the Mone! @ost b&t this hea% +i be 'art of ?ea @ost com'&tation* Here the cost in$o$e% is the ''ort&nit! @ost of the an% an% b&i%in)* If the 'romoter of the com'an! ha% not &se% the an% an% b&i%in) for the b&siness $ent&re then the an% an% b&i%in) co&% ha$e been &se% ese+here for some other ent&re an% co&% ha$e )enerate% some income for the 'romoter* This income>rent +hich co&% ha$e been earne% &n%er the net best in$estment o'tion is the o''ort&nit! cost +hich nee%s to be consi%ere% +hie cac&atin) the ?ea @ost for the firm* )rivate Cost an% Social Cost
The act&a e'enses of in%i$i%&as> firms +hich are borne or 'ai% o&t b! the in%i$i%&a or a firm can be terme% as )rivate Cost * Th&s for a b&siness firm this ma! inc&%e e'enses i#e @ost of ?a+ Materia, Saaries an% 5a)es, ?ent, Eario&s $erhea% 8'enses etc* n the other han% ri$ate @ost for an in%i$i%&a +i be his or her 'ri$ate e'enses s&ch as e'ense on foo%, rent of ho&se, e'enses on cothin), e'enses on tra$e, e'enses on entertainment etc* Social Cost on the other han% inc&%es ri$ate @ost an% aso s&ch costs +hich are not borne b! the firm b&t b! the societ! at ar)e* =or eam'e the cost of %ama)e or %is&tiit! ca&se% b! the o'erations of a firm in an econom! ma! not be borne b! the firm in &estion b&t it im'acts the societ! at ar)e an% th&s s&ch cost is a%%e% to the ri$ate @ost to fin% the Socia @ost of 'ro%&cin) the 'ro%&ct* S&ch @ost -that is cost not borne or 'ai%
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o&t b! the firm. is aso #no+n as E,ternal Cost * Another eam'e of eterna cost can be the cost of 'ro$i%in) the basic infrastr&ct&re faciities i#e )oo% roa%s, se+a)e s!stem or net+or#, street i)hts etc* @ost of s&ch faciities is not borne b! a b&siness firm e$en tho&)h the firm is benefits from s&ch faciities* S&ch costs -8terna @osts. are th&s a%%e% to the ri$ate @ost to fin% the Socia @ost of 'ro%&cin) a 'ro%&ct or )oo%* Abo$e can be &n%erstoo% b! foo+in) eam'e; If a Tanner! firm -A firm 'rocessin) anima s#ins. reeases its toic +astes in the ri$er fo+in) nearb! its factor! 'remises then this act of the Tanner! firm res&ts in +ater 'o&tion an% en$ironmenta %ama)e* The @ost of s&ch %ama)e>oss -aso #no+n as 8terna @ost. is a%%e% to the 'ri$ate costs of the tanner! firm to )et fair i%ea of Socia cost in$o$e% in the 'ro%&ction of the 'ro%&ct in &estion* Socia @ost of an in%i$i%&a +i inc&%e his 'ri$ate cost an% the cost of %ama)e on acco&nt of his actions -that has res&te% in %oin) harm>%ama)e to the en$ironment>societ! at ar)e.* Fi,e% Cost8
=ie% @ost is that cost +hich %oes not chan)e -that is either )oes &' or )oes %o+n. irres'ecti$e of +hether the firm is o'eratin) or not* =or eam'e on acco&nt of Stri#e on acco&nt of Loc#o&t in Mar&ti(S&"&#iFs Manesar 'ant the 'ro%&ction 'rocess stan%s sti* 8$en +hen the 'ant is not o'eratin) the =irm sti has to bear s&ch e'enses +hich are in%irect in nat&re* =or 8am'e ?ent of the factor! 'remises, 5a)es of a%ministrati$e em'o!ees etc* In other =ie% cost is not reate% %irect 'ro%&ction>man&fact&rin) e'enses* Eariabe @ost on the ther han% is %irect! 'ro'ortiona to the 'ro%&ction o'erations* As the si"e of 'ro%&ction at an! b&siness )ro+s, aon) +ith that )ro+ the $ariabe e'enses* As the name s&))ests, the $ariabe e'enses $ar! +ith the b&siness o'erations* 5hen the firm is not o'eratin) on acco&nt of Stri#e>Loc#o&t etc, then the $ariabe cost of the firm is Vero A$era)e @ost is the cost that is obtaine% after %i$i%in) Tota @ost +ith the n&mber of &nits 'ro%&ce%*
Total Cost B Fi,e% Cost
Mar)ina @ost is the chan)e in the Tota cost +hen an a%%itiona &nit of )oo% is 'ro%&ce%* In other +or%s Mar)ina @ost is %ifference bet+een tota @ost of 'ro%&cin) Y 1F &nits of )oo% an% F &nits of )oo%*
Mar&inal Cost B TC n1. = TCn.
Follo/in& ta0le can hel$ in #n%erstan%in& the cost conce$ts li+e Total Cost TC.8 Avera&e Cost AC.8 Mar&inal Cost MC. etc
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Un%erstan%in& Fi,e%8
N#m0er o Units )ro%#ce%
Fi,e% Cost
Total Cost
Avera&e Cost
Mar&inal Cost
1
10
1
1
1
2
10
10
20
10
3
10
17
27
9
7
4
10
30
40
10
13
10
4
11
1
In the abo$e tabe, it is cear! $isibe that =ie% cost -+hich is 10. remains same irres'ecti$e of the n&mber of &nits of the )oo% bein) 'ro%&ce%* n the other han% the Eariabe @ost is increasin) as the n&mber of &nits of )oo% bein) 'ro%&ce% is increasin)* Th&s, Eariabe @ost is )oin) &' from to 10 an% from 10 to 17 etc as the n&mber of &nits of )oo% bein) 'ro%&ce% is increasin)* A)ain it can be seen from the abo$e tabe that Tota @ost is the s&m tota of =ie% @ost an% Eariabe @ost* Th&s Tota @ost is 1 for the first &nit -+here 10 is =ie% @ost an% is Eariabe @ost.* A)ain for 'ro%&cin) 2 &nits, the Tota @ost is 20 -+here 10 is =ie% @ost an% remainin) 10 is the Eariabe @ost.* Abo$e Tabe aso cear! in%icates that the A$era)e @ost is bein) obtaine% b! %i$i%in) Tota @ost +ith the n&mber of &nits of )oo% bein) 'ro%&ce%* Th&s for the first &nit of )oo% bein) 'ro%&ce% it is 1* This $a&e has been obtaine% b! %i$i%in) Tota @ost -1. +ith the n&mber of &nits of )oo% 'ro%&ce% -1.* Simiar!, the A$era)e @ost of 'ro%&cin) t+o &nits is 10, +hich is obtaine% b! %i$i%in) Tota @ost -20. +ith n&mber of &nits 'ro%&ce% -2.* n the other han% Mar)ina @ost is the chan)e in the tota cost +hen an a%%itiona &nit of )oo% is bein) 'ro%&ce%* Th&s for the first &nit of )oo% bein) 'ro%&ce%, it is 1* This $a&e is obtaine% b! %e%&ctin) from the Tota @ost of 'ro%&cin) BneB &nit of )oo% -1. the Tota @ost of 'ro%&cin) BVeroB &nits of )oo%* =or 'ro%&cin) the secon% &nit, the
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mar)ina cost is * This is obtaine% b! %e%&ctin) from the Tota @ost of 'ro%&cin) Bt+oB &nits of )oo% -20. the Tota @ost of 'ro%&cin) BoneB &nit of )oo% -1. S#mmary o Cost Conce$ts
Eario&s cost conce'ts he' in &n%erstan%in) the b&siness o'erations an% cost in$o$e% in b&siness o'eration of the firms better* =or eam'e o''ort&nit! cost is the ret&rn in$o$e% in the net best aternati$e* Socia cost is the cost of %ama)e ca&se% b! a b&siness firm>in%i$i%&a to societ! at ar)e* ri$ate cost are the $arie% b&siness e'enses +hich a firm>in%i$i%&a has to bear on acco&nt of its b&siness>'ersona o'erations 'ertainin) to the b&siness of the firm* oints to ?emember are as foo+s;
The o''ort&nit! cost of a com'an! is th&s this income> ret&rn +hich the firm can earn on the net best in$estment aternati$e* Mone! @ost of 'ro%&ction is the act&a monetar! e'en%it&re ma%e b! com'an! in the 'ro%&ction 'rocess* Mone! cost th&s inc&%es a the b&siness e'enses +hich in$o$e o&ta! of mone! to s&''ort b&siness o'erations* ?ea @ost of 'ro%&ction or b&siness o'eration inc&%es a s&ch e'enses>costs of b&siness +hich ma! or ma! not in$o$e act&a monetar! e'en%it&re* 8conomic cost inc&%es a the acco&ntin) e'enses an% the ''ort&nit! cost or im'icit cost of the b&siness* The act&a e'enses of in%i$i%&as> firms in the mar#et can be terme% as 'ri$ate cost* Th&s for a b&siness firm this ma! inc&%e e'enses i#e @ost of ra+ materia, saaries an% 5a)es, ?ent, Eario&s o$erhea% e'enses etc* =or an in%i$i%&a his>her 'ri$ate e'enses can be e'enses on foo%, rent of ho&se, e'enses on cothin), e'enses on tra$e, e'enses on entertainment etc can be consi%ere% as ri$ate @osts* Socia @ost on the other han% inc&%es the 'ri$ate costs of in%i$i%&as an% firms an% aso the cost of %ama)e>%is&tiit! ca&se% b! the o'erations of in%i$i%&as an% the b&siness firms* =or eam'e is a Tanner! reeases its toic +astes in the ri$er fo+in) nearb! then s&ch act res&ts in +ater 'o&tion an% en$ironmenta %ama)e* S&ch %ama)e>oss>cost is a%%e% to the 'ri$ate costs to )et fair i%ea of Socia cost* =ie% @ost; =ie% @ost is that cost +hich %oes not chan)e -that is either )oes &' or )oes %o+n. irres'ecti$e of +hether the firm is o'eratin) or n ot* Eariabe @ost on the ther han% is %irect! 'ro'ortiona to the 'ro%&ction o'erations* As the si"e of 'ro%&ction at an! b&siness )ro+s, aon) +ith that )ro+ the $ariabe e'enses* As the name s&))ests, the $ariabe e'enses $ar! +ith the b&siness o'erations* 5hen the firm is not o'eratin) on acco&nt of Stri#e>Loc#o&t etc, then the $ariabe cost of the firm is Vero A$era)e @ost on the other han% is the cost that is obtaine% after %i$i%in) Tota @ost +ith the n&mber of &nits 'ro%&ce%* Mar)ina @ost is the chan)e in the Tota cost +hen an a%%itiona &nit of )oo% is 'ro%&ce%* In other +or%s Mar)ina @ost is %ifference bet+een tota @ost of 'ro%&cin) Y 1F &nits of )oo% an% F &nits of )oo%*
ii. Short r#n Cost Theory
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A famo&s statement ma%e b! ceebrate% economist N*M* e!nes states that In the Lon) ?&n +e are a %ea%* Th&s, +hie &n%er)oin) an! earnin) on microeconomic theor! it becomes im'ortant for &s to #no+ that +hat is meant b! the terms Short R#n an% the 3on& R#n in economic theor!* BShort ?&nB is the time 'erio% in +hich if a firm +ishes to increase its o&t'&t it can %o so b! chan)in) on! certain $ariabe in'&ts or factors of 'ro%&ction i#e Labo&r, ?a+ materia etc +hie certain other n'&ts or factors of 'ro%&ction i#e @a'ita* Short r&n is the time 'erio% %&rin) +hich if a firm +ishes to increase its o&t'&t then it can %o so on! b! chan)in) the $ariabe factors - i#e Labor.* ther factors -i#e ca'ita. remain fie% in the short r&n or in other +or%s cannot be $arie% on acco&nt of time imitation a''icabe on the com'an!* Ty$es o Short R#n Cost F#nctions
Linear @ost =&nction In case, for a firm or a com'an!, its $ariabe cost chan)es in the same 'ro'ortion as the o&t'&t of the firm, then a strai)ht ine or inear reationshi' is obser$e% bet+een the o&t'&t )enerate% b! the firm an% the cost in$o$e% in the 'ro%&cin) the same* It is 'ossibe for &s to e'ress this reationshi' b! &sin) the mathematica e&ation of a strai)ht ine* This can be as foo+s; For the a0ove e9#ation ollo/in& terms mean as ollo/s: TC B Total Cost8 a an% b are constant" is the #antity )ro%#ce%" 4ere8 the constant Va in%icates the val#e o total cost /hen the o#t$#t o the irm is 'ero" This val#e o total cost /ill 0e e9#al to the i,e% cost o the irm as at this $oint the varia0le cost o the irm /ill 0e 'ero as the o#t$#t o the irm is 'ero" On the other han% constant V0 in%icates the slo$e o strai&ht line c#rve %e$ictin& the relationshi$ 0et/een the cost an% the o#t$#t"
The inear reationshi' eistin) bet+een @ost an% &t'&t is e'rsse% in the foo+in) tabe; #antity!! FC
0
10 0
0
0
0
0
0
1
10 2
12
10*0
2
12*0
2
2
10 4
14
*0
2
7*0
2
3
10 6
16
3*33
2
*33
2
4
10 G
1G
2*
2
4*
2
10 10 20
2*0
2
4*0
2
6
10 12 22
1*67
2
3*66
2
7
10 14 24
1*43
2
3*42
2
G
10 16 26
1*2
2
3*2
2
9
10 1G 2G
1*11
2
3*11
2
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10 20 30
91
1
2
3*0
2
In the abo$e tabe BB is the &antit! 'ro%&ce% =@ is =ie% @ost E@ is Eariabe @ost T@ is Tota @ost -5hich is =@ Y E@. A=@ is A$era)e =ie% @ost obtaine% b! %i$i%in) =@ +ith AE@ is A$era)e Eariabe @ost obtaine% b! %i$i%in) E@ +ith AT@ is A$era)e Tota @ost obtaine% b! %i$i%in) T@ +ith an% M@ is Mar)ina @ost obtaine% b! s&btractin) the Tota @ost of 'ro%&cin) BnB n&mber of )oo%s from the Tota @ost of 'ro%&cin) Bn X 1B n&mber of )oo%s The %ia&rammatic re$resentation o s#ch a strai&ht line cost c#rve /ill 0e as ollo/s:
The %ia&rammatic re$resentation o the Avera&e Cost an% the Mar&inal Cost or the 3inear Cost #nction /ill 0e as ollo/s:
#a%ratic Cost F#nction
A &a%ratic @ost f&nction can be mathematica! %e'icte% as foo+s; In the abo$e state% &a%ratic e&ation aB is constant in%icatin) the $a&e of tota cost +hen the o&t'&t of the firm is "ero* The $a&e of tota cost in s&ch a case +i be e&a to the fie% cost of the firm as at this 'oint the $ariabe cost of the firm +i be "ero* 5hie, the constants bF an% cF, in%icate the so'e of the &a%ratic cost f&nction* A &a%ratic @ost f&nction can be e'resse% as foo+s;
#antity!! FC
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0
10 0
0
0
0
0
0
1
10 4
14
10*0
4
14*0
4
2
10 10
20
*0
*0
10*0
6
3
10 17
27
3*33
*66
9
7
4
10 26*4 36*4
2*
6*6
9*1
9*4
10 37
47
2*0
7*4
9*4
10*6
6
10 0
60
1*67
G*33
10*0
13
7
10 67
77
1*43
9*7
11
17
G
10 92
102
1*2
11*
12*7
2
9
10 132 142
1*11
14*66
1*77
40
In the abo$e tabe BB is the &antit! 'ro%&ce% =@ is =ie% @ost E@ is Eariabe @ost T@ is Tota @ost -5hich is =@ Y E@. A=@ is A$era)e =ie% @ost obtaine% b! %i$i%in) =@ +ith AE@ is A$era)e Eariabe @ost obtaine% b! %i$i%in) E@ +ith AT@ is A$era)e Tota @ost obtaine% b! %i$i%in) T@ +ith an% M@ is Mar)ina @ost obtaine% b! s&btractin) the Tota @ost of 'ro%&cin) BnB n&mber of )oo%s from the Tota @ost of 'ro%&cin) Bn X 1B n&mber of )oo%s The %i&ramtic re$resentation o #a%ratic Cost #nction can 0e as ollo/s:
The sha'e of A$era)e cost c&r$e an% the Mar)ina cost c&r$e &n%er the &a%ratic @ost f&nction can be as foo+s;
C#0ic Cost F#nction
The @&bic as foo+s;
@ost
f&nction
can
be
mathematica! %e'icte%
I the cost #nction is C#0ic then ollo/in& can 0e the sha$e o the TC Total Cost.8 FC Fi,e% Cost. an% the T
In the abo$e %ia)ram, the sha'e of the tota $ariabe cost c&r$e is i#e in$erse SF* This sha'e in%icates that if more an% more of the $ariabe factor is a''ie% to the fie% factor then the o&t'&t of the firm initia! increases at an increasin) rate then at a constant rate an% fina! it starts to %iminish* ease refer to the n acco&nt of the abo$e the A$era)e Eariabe cost initia! %ecreases, reaches its minim&m an% fina! it starts to increase a)ain* This aso res&ts in
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the increase in the Tota Eariabe @ost an% the Tota @ost at a %iminishin) rate initia!, then at a constant rate at fina! at an increasin) rate The sha$e o the ATC Avera&e Total Cost.8 MC Mar&inal Cost. an% A
The abo$e %e'icte% @&bic @ost =&nction can aso be e'aine% b! &sin) the foo+in) @ost $a&es as state% in the foo+in) tabe; A)ain, in the abo$e tabe BB is the &antit! 'ro%&ce% =@ is =ie% @ost E@ is Eariabe @ost T@ is Tota @ost -5hich is =@ Y E@. A=@ is A$era)e =ie% @ost obtaine% b! %i$i%in) =@ +ith AE@ is A$era)e Eariabe @ost obtaine% b! %i$i%in) E@ +ith AT@ is A$era)e Tota @ost obtaine% b! %i$i%in) T@ +ith an% M@ is Mar)ina @ost obtaine% b! s&btractin) the Tota @ost of 'ro%&cin) BnB n&mber of )oo%s from the Tota @ost of 'ro%&cin) Bn X 1B n&mber of )oo%s Sha$e o the 3on& r#n Avera&e Cost" 3on& R#n Costs
Lon) r&n costs are acc&m&ate% +hen firms chan)e 'ro%&ction e$es o$er time in res'onse to e'ecte% economicQ 'rofits or osses* In the on) r&n there are no fie%factors of 'ro%&ction* The an%, abor , ca'ita )oo%s, an% entre'rene&rshi' a $ar! to reach the the on) r&n cost of 'ro%&cin) a )oo% or ser$ice* The on) r&n is a 'annin) an% im'ementation sta)e for 'ro%&cers* The! ana!"e the c&rrent an% 'ro/ecte% state of the mar#et in or%er to ma#e 'ro%&ction %ecisions* 8fficient on) r&n costs are s&staine% +hen the combination of o&t'&ts that a firm 'ro%&ces res&ts in the %esire% &antit! of the )oo%s at the o+est 'ossibe cost* 8am'es of on) r&n %ecisions that im'act a firmBs costs inc&%e chan)in) the &antit! of 'ro%&ction, %ecreasin) or e'an%in) a com'an!, an% enterin) or ea$in) a mar#et* Short R#n Costs
Short r&n costs are acc&m&ate% in rea time thro&)ho&t the 'ro%&ction 'rocess* =ie% costs ha$e no im'act of short r&n costs, on! $ariabe costs an% re$en&es affect the short r&n 'ro%&ction* Eariabe costs chan)e +ith the o&t'&t* 8am'es of $ariabe costs inc&%e em'o!ee +a)es an% costs of ra+ materias* The short r&n costs increase or %ecrease base% on $ariabe cost as +e as the rate of 'ro%&ction* If a firm mana)es its short r&n costs +e o$er time, it +i be more i#e! to s&ccee% in reachin) the %esire% on) r&n costs an% )oas* Dierences
The main %ifference bet+een on) r&n an% short r&n costs is that there are no fie% factors in the on) r&n there are both fie% an% $ariabe factors in the short r&n * In the on) r&n the )enera 'rice e$e, contract&a +a)es, an% e'ectations a%/&st f&! to the state of the
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econom!* In the short r&n these $ariabes %o not a+a!s a%/&st %&e to the con%ense% time 'erio%* In or%er to be s&ccessf& a firm m&st set reaistic on) r&n cost e'ectations* Ho+ the the shor shortt r&n r&n cost costss are are han% han%e% e% %eter %etermi mines nes +het +hethe herr the the firm firm +i +i meet meet its its f&t& f&t&re re 'ro%&ction an% financia )oas* Economics an% Diseconomics o Scale
the 'ro% 'ro%&ct &ctio ion n incr increas eases es,, effi effici cienc enc! ! of 'ro%& 'ro%&ct ctio ion n aso aso Econom Econ omie iess o scale scale : As the increases* * The a%$anta)es of ar)e scae 'ro%&ction that res&t in o+er &nit -a$era)e. costs -cost 'er &nit. is the reason for the economies of scae is that the tota costs are share% o$er the increase% o&t'&t* There are t+o t!'es of economies of scae; 1"Internal economies o scale 2*E,ternal economies o scale Internal economies o scale refers to the a%$anta)es that arise as a res&t of the )ro+th of the firm* hen a com'an! re%&ces costs an% increases 'ro%&ction, interna economies of scae ha$e been achie$e%* Interna economies of scae reate to the o+er &nit costs a sin)e firm can obtain b! )ro+in) in si"e itsef* There are fi$e main t!'es of interna economies of scae* (#l+=0#yin& economies
As b&s b&sine inesse ssess )ro+ )ro+ the! the! nee% to or%er or%er ar)er ar)er &anti &antitie tiess of 'ro%&ct 'ro%&ction ion in'&ts in'&ts** =or eam'e, the! +i or%er more ra+ materias* As the or%er $a&e increases, a b&siness obtains more bar)ainin) 'o+er +ith s&''iers* It ma! be abe to obtain %isco&nts an% o+er 'rices for the ra+ materias* Technical economies
C&sinesses +ith ar)e(scae 'ro%&ction can &se more a%$ance% machiner! -or &se eistin) machiner! more efficient!.* This ma! inc&%e &sin) mass 'ro%&ction techni&es, +hich are a more efficient form of 'ro%&ction* A ar)er firm can aso affor% to in$est more in research an% %e$eo'ment* Financial economies
Man! sma b&sinesses fin% it har% to obtain finance an% +hen the! %o obtain it, the cost of the finance is often &ite hi)h* This is beca&se sma b&sinesses are 'ercei$e% as bein) ris#ier than ar)er b&sinesses that ha$e %e$eo'e% a )oo% trac# recor%* Lar)er firms therefore fin% it easier to fin% 'otentia en%ers an% to raise mone! at o+er interest rates* Mar+etin& economies
8$er! 'art of mar#etin) has a cost : 'artic&ar! 'romotiona metho%s s&ch as a%$ertisin) a %$ertisin)
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an% r&nnin) a saes force* Man! of these mar#etin) costs are fie% costs an% so as a b&siness )ets ar)er, ar)er, it is abe to s'rea% the cost of mar#etin) o$er a +i%er ran)e of 'ro%&cts an% saes : c&ttin) the a$era)e mar#etin) cost 'er &nit* Mana&erial economies
As a firm )ro+s, there is )reater 'otentia for mana)ers to s'eciaise in 'artic&ar tas#s -e*)* mar#etin), h&man reso&rce mana)ement, finance.* S'eciaist mana)ers are i#e! to be more efficient as the! 'ossess a hi)h e$e e$e of e'ertise, e'erience e 'erience an% &aifications com'are% to one 'erson in a smaer firm tr!in) to 'erform a of these roes* E,ternal economies o scale
8terna economies of scae refers to the a%$anta)es firms can )ain as a res&t of the )ro+th of the in%&str!* It is norma! associate% +ith a 'artic&ar area* 8terna economies of scae occ&r o&tsi%e of a firm, +ithin an in%&str!* Th&s, +hen an in%&str!Bs sco'e of o'erations e'an%s %&e to, for eam'e, the creation of a better trans'ortation net+or#, res&tin) in a s&bse&ent %ecrease in cost for a com'an! +or#in) +ithin that in%&str!, eterna economies of scae are sai% to ha$e been achie$e%* 8terna economies of scae occ&r +hen a firm benefits from o+er &nit costs as a res&t of the +ho +hoee in%& in%&st str! r! )ro+ )ro+in in) ) in si"e si"e** Th Thee main main t!'es are; Trans'ort an% comm&nication in#s im'ro$e As an in%&str! estabishes itsef an% )ro+s in a 'artic&ar re)ion, it is i#e! that the )o$ernment +i 'ro$i%e better trans'ort an% comm&nication in#s to im'ro$e accessibiit! to the re)ion* This +i o+er trans'ort costs for firms in the area as /o&rne! times are re%&ce% an% aso attract more 'otentia c&stomers* Trainin) an% e%&cation becomes more foc&se% on the in%&str! Uni$ersities an% coe)es +i offer more co&rses s&itabe for a career in the in%&str! +hich has become %ominant in a re)ion or nationa!* ther in%&stries )ro+ to s&''ort this in%&str! A net+or# of s&''iers or s&''ort in%&stries ma! )ro+ in si"e an%>or ocate cose to the main in%&str!* This means a firm has a )reater chance of fin%in) a hi)h &ait! !et affor%abe s&''ier cose to their site* Diseconomies o scale
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8conomic theor! 're%icts that a firm ma! become ess efficient if it becomes too ar)e* The a%%itiona costs of becomin) too ar)e are cae% ca e% %iseconomies of scae* Diseconomies of scae res&t in risin) on) r&n a$era)e costs +hich are e'erience% +hen a firm e'an%s be!on% its o'tim&m scae, at *
8am'es of %iseconomies inc&%e; 1*
Lar Lar)er )er firm firmss ofte often n s&f s&ffer fer 'oor 'oor comm& comm&ni nicat catio ion n beca& beca&se se the! the! fin% fin% it %if %iffic& fic&tt to maintain an effecti$e fo+ of information bet+een %e'artments, %i$isions or bet+een hea% office an% s&bsi%iaries* Time a)s in the fo+ of information can aso create 'robems in terms of the s'ee% of res'onse to chan)in) mar#et con%itions* =or eam'e, a ar)e s&'ermar#et chain ma! be ess res'onsi$e to chan)in) tastes an% fashions than a m&ch smaer, smaer, ocaF retaier* retaier* 2* @o(or%inat @o(or%ination ion 'robems 'robems aso aso affect affect ar)e ar)e firms firms +ith +ith man! %e'artm %e'artments ents an% %i$is %i$isions, ions, an% ma! fin% it m&ch har%er to co(or%inate its o'erations than a smaer firm* =or eam'e, a sma man&fact&rer can more easi! co(or%inate the acti$ities of its sma n&mber of staff than a ar)e man&fact&rer em'o!in) tens of tho&san%s* 3*
[F inefficie inefficienc! nc! is the oss oss of mana)emen mana)ementt efficienc efficienc! ! that occ&rs occ&rs +hen firms firms become become ar)e an% o'erate in &ncom'etiti$e mar#ets* S&ch oses of efficienc! inc&%e o$er 'a!in) for reso&rces, s&ch as 'a!in) mana)ers saaries hi)her than nee%e% to sec&re their ser$ices, an% ecessi$e +aste of reso&rces* [F inefficienc! means that a$era)e costs are hi)her than +o&% be e'erience% b! firms in more com'etiti$e mar#ets*
4*
Lo+ mo Lo+ moti ti$a $ati tion on of +or#er +or#erss in ar)e ar)e firm firmss is a 'ote 'otent ntia ia %ise %iseco conom nom! ! of scae scae that that res&ts in o+er 'ro%&cti$it!, as meas&re% b! o&t'&t o& t'&t 'er +or#er*
*
Lar)e Lar)e firms firms ma! e'erience e'erience ineffi inefficienci ciencies es reate% reate% to to the'rinci'a the'rinci'a(a)ent (a)ent 'robem* 'robem* This This 'robem is ca&se% beca&se the si"e an% com'eit! of most ar)e firms means that their o+ners often ha$e to %ee)ate %ecision ma#in) to a''ointe% mana)ers, +hich can ea% to ineff ineffici icienci encies* es* =or eam'e, eam'e, the o+ners o+ners of a ar)e ar)e chain chain of cothes cothes retaiers +i ha$e to em'o! mana)ers for each store, an% %ee)ate some of the /obs to mana)ers b&t the! ma! not necessari! ma#e %ecisions in the best interest of the o+ners* =or eam'e, a store mana)er ma! em'o! the most attracti$e saes assistant rather than the most 'ro%&cti$e one*
Economies o Scale In their most basic form, economies of scae refer to the i%ea that as more 'ro%&cts are 'ro%&ce% the mar)ina cost, or cost 'er &nit, %ecreases beca&se of increase% efficiencies* $erhea% costs can be share% o$er o $er more 'ro%&cts* ften the %esire for economies of o f scae %ri$es an or)ani"ation to become ar)er or to mer)e +ith a i#e(min%e% com'an!, +hich can brin) a%%itiona efficiencies or o''ort&nities* C&t economies of scae ha$e their imits*
