- Discuss the nature and scope of Business Economics
The process by which businesses make decisions is as complex as the processes which characterize consumer decision-making.
Business draws upon microeconomic data to make a variety of critical choices, any one of which could mean the success or failure of their enterprise. The reliability and currency of the information a business uses, therefore, is of the utmost importance
Meaning of business economics
Managerial economics is a science that deals with the application of various economic theories, principles, concepts and techniques to business management in order to solve business and management problems. It deals with the practical application of economic theory and methodology to decision making problems faced by private, public and non-profit making organizations
According to Lord Robins, “Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses”.
According to SPENCER AND SIEGELMAN
“Business Economics is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management”.
What a business does with that data is decided by senior and top management. The major influences on their decisions may entail some or all of the following factors:
- what the competition is doing
- the state of the economy
- a variety of other variable and unknown factors
Scope of Business Economics:
Business economic meets these needs of the business firm. This is illustrated in the following presentation.
Characteristics of Business Economics
- Micro Economic Nature: Business Economics is micro economic in its nature because it deals with matters of a particular business firm only.
- Use of Economic Theories: Business Economics uses all economic theories relating to the profits, distribution of income etc.
- Realistic One: Business Economics is a realistic science. It studies all matters concerning business organization by considering the real conditions existing in the business field.
- Normative Science: Business Economics is a normative science. It studies the matters concerning the aims and objectives of a business firm. It determines the methods to be adopted for achieving such objectives. It also makes enquiry into the good and bad in decision making. Hence it is a normative science.
- Macro-Economic Uses: Even though Business Economics has the nature of Micro-Economics, it also uses Macro-Economic approaches frequently. Certain matters in Macro-Economics like Business Cycles, National Income, Public Finance, Foreign trade etc. are essential for Business Economics. So, Business Economics uses the macro-economic phenomenon for taking business decisions.
IMPORTANCE OF BUSINESS ECONOMICS
Business Economics is a useful subject. In fact it is the most significant of all social sciences, its study is highly useful for analysing and understanding the various economic problems. Its study brings utility to all sections of the people. Business Economics became the intellectual religion of the day. Business Economics is described as both light giving and fruit bearing science. It enriches our knowledge (light) and brings results (fruits).
The theoretical and practical utility or significance of Business Economics is explained from the following points:
- Understanding Economic Behavior
The study of Business Economics helps us to understand the economic behavior of human beings.
- Working of the Economic System
Business Economics explains the conditions which influence the progress of the economy. It makes suggestions for overcoming the complicated problems faced by the people and the government in various economic systems. Hence it has great significance for understanding the working of the economic system.
- Intellectual Value
The study of Business Economics sharpens the intellectual calibres of individuals. It imparts certain qualities like rational behavior, proper allocation of resources etc.
- Economic Tools
Mrs. Joan Robinson described Economics as a box of economic tools. It provides a good knowledge regarding the nature, causes and effects of various economic phenomena.
- Economic Growth
Business Economics suggests various ways and means for maintaining the growth rates in the developed economies. It also analyses the factors obstructing the economic growth of these countries.
- Economic Development
Developing countries aim at achieving economic development within a short span of time. Business Economics enables us to understand the nature and conditions necessary for the successful organisation of business firm.
- Performance of the Economy
Business Economics helps us to assess the performance of the economy. We can judge the position, progress and future of an economy through several theories and models of Business Economics.
- Economic Planning
Economic planning is an important branch of economics. Economics provides a good knowledge and information regarding the techniques of Economic Planning. It sharpens our mental abilities by clearly explaining the types, aims and objective of economic plans.
Business Economics serves as the best means for predicting the economic events. It helps us to predict the consequence of various economic phenomena.
- Ethical Value
Business Economics inculcate certain ethical norms like honesty, responsibility and adjustability etc. It upholds the moral and cultural values of individuals. It makes them honest and dignified citizens.
- Useful to the Finance Minister
The study of Business Economics is highly useful to the Finance Minister and the personnel working in the finance department. It provides a good knowledge about public revenue, public debt and public expenditure. It helps them in forming a sound financial policy and result oriented budget.
- Useful to the Minister for Planning
The study of Business Economics is also useful to the Minister for planning and his personnel. It furnishes a good knowledge about the various types of plans, mobilisation, plan implementation, capital output ratio, investment strategy etc.
- Useful to the Bankers
Business Economics is also useful to the bankers. It enables them to understand the nature, purpose and implications of different economic policies implemented by the business firms.
- Trade Union Leaders
Knowledge of Business Economics is also significant for the trade union leaders. The study of Business Economics helps the trade union leaders to understand the nature and causes of industrial disputes, wage problem etc.
Business Economics is also useful to the businessmen. Businessmen, with the help of Business Economics, can study the fluctuations in business, prices, production and employment. They can adopt a proper strategy for producing goods and services according to the changes in demand.
Statesmen will also get benefit by studying Business Economics. It enables them to understand the nature and causes of economic problems. It helps them to solve the economic problems like unemployment, inflation, scarcity of goods etc.
- International Economic Problems
International Economics is an important branch of Economics. It deals with matters like terms of trade, balance of payments, export and import regulations etc. Its knowledge enables the international agencies to determine the foreign exchange value of various national currencies. Thus, Business Economics has both theoretical and practical significance. Its study is useful to all sections of the people.
2 .How does the study of Business Economics help a business manager indecision-making? Illustrate your answer with the real world examples.
Keys to Success
Data shows that four out of five new business ventures fail within the first five years of opening. There are many causes for these failures, including inadequate financing, a poor business plan, an inability to compete in a difficult market, too much total debt, and occasionally, as the Small Business Administration (SBA) has reported, "Sometimes businesses close because the owners lose interest, or because they realize they would prefer to work for someone else." (For more on this, read 4 Steps to Creating A Stellar Business Plan.)
"The key predictors of success haven´t changed, though," says the SBA. "Businesses that have employees and that have good financing tend to survive longer."
Another key predictor of success for a start-up enterprise is the advanced microeconomic research and planning conducted by the entrepreneur starting the business. (To see is you have what it takes, read Are You an Entrepreneur?)
Planning, Strategy and Supply and Demand
Before studying the microeconomics of starting a business, however, the entrepreneur should also be aware of the larger aspects of a start-up business. These include writing a business plan, a strategy, a marketing and advertising plan, and a sales program. The entrepreneur should also consider whether employees will be required, and the legal and insurance aspects of the business.
Another major concern of start-up businesses are the vendors and suppliers required, the physical premises in which the business will be conducted, and the all-important financing. Most importantly in starting a business, at least from a microeconomics perspective, is the supply-demand factor. Will there be enough demand for what the new business intends to supply? That´s a critical question, and if the answer is negative, the chances that the business will succeed are minimal.
Whatever product or products, or whatever services the start-up business plans to sell, a thorough study of the potential market for those items should be undertaken before a business plan is written. (For a list of what needs to be done before opening, see Start Your Own Small Business.)
If your start-up business is positioned in a fast-growing market in which new consumers are being created regularly – clothing for teens, for example, or products for college students including the annual batch of freshmen – then demand for the product may also regularly increase. But in any age-dependent category of product, for every new customer coming into the market, an older customer will leave the market, resulting in a market that remains approximately the same size overall, but with new buyers continually coming into it.
If the new business is a restaurant, for example, or some other form of retailing, a study of the location – the neighbourhood in which the business is to be located – should be conducted to determine if there´s enough demand to sustain the business.
Know Your Competitors
Although accurate, detailed information about your potential consumers and competitors may be difficult to obtain, first-hand observation of activity in your competitor´s establishment, talking to potential customers and watching customer traffic and volume through the week and at various times of the day will give you a rough idea of what the new business may be up against.
This "competitive intelligence" may also provide information about consumer desires and preferences – what they want that your potential competition is not providing. Knowledge of your competition´s pricing is also essential. As we discussed in previous chapters, pricing, demand, marginal revenue and its relation to marginal costs, how much of a product to produce, and elasticity of demand, are all factors in which pricing is an essential element.
A microeconomic theory called "perfect competition," refers to small businesses and start-ups in which many small companies supply a single product or service. These businesses and their consumers are too small to influence the market price of what´s being bought and sold, and so their prices are locked in. But perfect competition seldom occurs, and even if it does, there are numerous ways to compete other than with price.
If, however, a start-up is forced to compete on price, it can still be profitable if the start-up´s profit margins and marginal revenues are adequate. This necessity requires a comprehensive knowledge of the business, effective negotiating skills and judicious decision-making. A thorough knowledge of the business you´re starting will reveal where costs may be cut or contained to yield bigger profit margins.
Judgment and Decision Making
Effective negotiating skills will enable you to get the best prices from vendors and suppliers when hiring employees, and from lending institutions when negotiating the terms of your start-up financing.
Judicious decision-making will enable the start-up entrepreneur to maximize profits using the microeconomic formulas described in the previous chapter. For a small start-up that intends to enter a business category already dominated by large, established players, the challenges can be overwhelming.
Large firms can buy from wholesalers at volume discount prices. They can negotiate with unions to reduce labour costs and benefits. Generally, they may be able to secure better terms with lenders, and better credit arrangements with vendors and suppliers. Smaller firms, and especially small start-ups in which there´s a higher level of risk to the lenders and to the firms that provide credit, may not be able to borrow money or obtain credit from vendors at favourable terms. (For more, see Plans the Small Business Owner Can Establish and What Are Economies of Scale.)
Large, well-established firms also possess institutional knowledge about their industry that the newcomer does not have. The larger firms may also have greater cash reserves to weather market downturns, or unforeseen problems that may compromise profitability.
A small start-up will have few if any of the advantages cited above, and will therefore find it very difficult, if not impossible, to compete against large, dominant firms. Unless an entrepreneur has a unique and effective means of battling these daunting odds against success, he´d be well-advised to start a different category of business. (To learn about how the little guy can beat out big competition, see the answer to your frequently asked question How did Dow Chemical defeat an international monopoly in the 1900s?)
Still, small, independent restaurants, as just one example, compete successfully against giant fast food chains such as McDonalds (NYSE:MCD), Wendy´s (NYSE:WEN) or Burger King (NYSE:BKC). The successful independent restaurant or diner offers unique elements to the consumer that are unobtainable at the majors. These could be convenience of location, menu specialties and a wider variety of choices, a friendlier ambience, a higher quality product, or even competitive pricing.
As a start-up business grows and matures it begins to face the same microeconomic decisions that an established business confronts. The same decision-making processes described in the previous chapter then become necessities and the same rules apply.
The longer a small start-up survives, the more data it will acquire on supply and demand, price elasticity, marginal revenues and marginal costs, and other important data. Adjustments in planning can then be made to produce a better bottom line for the firm.
Assuming a start-up is profitable, the problem of taxes then arises. This is an obvious point, but worth mentioning anyway - the government will want its share of your profits and a smart, experienced accountant with expertise in taxes should be employed to make sure you keep as much of your hard-earned money as possible, and legally, of course.
In gathering information as part of your start-up planning, the government and various trade associations may be able to provide valuable data. Government sources of consumer information include the U.S. Department of Commerce, the Small Business Administration, and the Small Business Answer Desk.
- What is the Opportunity Cost? How can it be calculated? What are the precautions to be kept in view while using the Opportunity Cost?
Answer: When economists refer to the “opportunity cost” of a resource, they mean the value of the next-highest-valued alternative use of that resource. If, for example, you spend time and money going to a movie, you cannot spend that time at home reading a book, and you cannot spend the money on something else. If your next-best alternative to seeing the movie is reading the book, then the opportunity cost of seeing the movie is the money spent plus the pleasure you forgo by not reading the book.
The word “opportunity” in “opportunity cost” is actually redundant. The cost of using something is already the value of the highest-valued alternative use. But as contract lawyers and airplane pilots know, redundancy can be a virtue. In this case, its virtue is to remind us that the cost of using a resource arises from the value of what it could be used for instead.
How to calculate Opportunity Cost:
Evaluating a financial decision often means predicting possible costs. If you have a decision to make, choosing 1 option means a missed opportunity. Looking at the opportunity cost of each choice can help you find the most valuable opportunity. Learn how to calculate opportunity cost with these basic methods.
Opportunity cost of an item is a relative term defined as what you give up to obtain that item. Say if you are a farmer and by working 1 hr you can produce 1 ozpotato. But if you intend to spend that same 1 hr to produce banana, you can produce 3 oz banana.
From these you can calculate opportunity cost of potato in terms of banana and vice-versa.
Opportunity cost of 1 oz potato is 3 oz banana. Because you need to give up 3 oz banana to produce 1 oz potato.
Similarly opportunity cost of 1 oz banana is 1/3 oz potato.
- Understand that opportunity cost is a relative term.
This means that there must be at least 2 choices that will be compared in light of the other choices.
A lost opportunity means that when you choose 1 path, you lost the ability to take the other opportunity. For instance, if you went on a trip around the world for a year, you lost the opportunity to earn money in a job that year.
2Compare based on a similar unit of measurement.
Opportunity cost can be calculated in currency, weight or in products. Sometimes, it can also be measured in intangible things, such as personal happiness or experience, in addition to the original unit of measurement.
3Choose a similar time period.
Each opportunity should be evaluated using the information from a single period of time, such as an hour, day, month or year.
- Precautions to be kept in view while using the Opportunity Cost:
Using Opportunity Costs in Our Daily Lives
For big choices like buying a home or starting a business, you may weigh the pros and cons, but generally, most of our day-to-day choices aren´t made without a full understanding of the potential opportunity costs. If they´re cautious about a purchase, most people just look at their savings account and check their balance before spending money. For the most part, we don´t think about the things that we must give up when we make those decisions.
However, that kind of thinking could be dangerous. The problem lies when you never look at what else you could do with your money, or buy things blindly without considering the lost opportunities. Certainly, buying a cheeseburger for lunch occasionally can be a wise decision, especially if it gets you out of the office when your boss is throwing a fit. However, buying one cheeseburger every day for the next 25 years could lead to several missed opportunities. Aside from the potential harmful health effects of high cholesterol, investing that $4.50 could add up to just over $52,000 in that time frame, assuming a very doable rate of return of 5%.
This is just one simplistic example, but the basic message holds true for a variety of situations. From choosing whether to invest in "safe" treasury bonds or deciding to attend a public college over a private one in order to get a degree, there are plenty of things to consider when making a decision in your personal finance life.
While it may sound like a bummer to have to think about opportunity costs every time you want to buy a candy bar or go on vacation, it´s an important tool in order to make the best use of your money. When it comes to personal finance, you cannot go through your life on autopilot. There are unseen positives and negatives with each financial decision. However, the good news is that once you recognize that these costs exist, it becomes easier to make good personal finance choices.
The Bottom Line
Most people are aware of the seen costs when it comes to personal finance. We understand the direct costs for our actions. However, the unseen costs could be more important to realize. Understanding these opportunity costs is critical to making the best possible decisions with our money.
- Draw individual and market demand schedules. Discuss the difficulties in preparing a market demand schedule.
Answer: Demand curve is a graphical representation of demand schedule. It is the locus of all the points showing various quantities of a commodity that a consumer is willing to buy at various levels of price, during a given period of time, assuming no change in other factors.
- It shows the inverse relationship between the quantities demanded of a commodity with its price, keeping other factor constant.
- It can be drawn for any commodity by plotting each combination of demand schedule on a graph.
iii. Like demand schedules, demand curves can also be drawn both for individual buyers and for the entire market. So, demand curve is of two types:
(a) Individual Demand Curve
(b) Market Demand Curve
Individual Demand Curve:
Individual demand curve refers to a graphical representation of individual demand schedule.
With the help of Table 3.1 (Individual demand schedule), the individual demand curve can be drawn as shown in Fig. 3.1.
As seen in the diagram, price (independent variable) is taken on the vertical axis (Y-axis) and quantity demanded (dependent variable) on the horizontal axis (X-axis). At each possible price, there is a quantity, which the consumer is willing to buy. By joining all the points (P to T), we get a demand curve ‘DD’.
The demand curve ‘DD’ slopes downwards due to inverse relationship between price and quantity demanded.
Market Demand Curve:
Market demand curve refers to a graphical representation of market demand schedule. It is obtained by horizontal summation of individual demand curves.
The points shown in Table 3.2 are graphically represented in Fig. 3.2. DA and DB are the individual demand curves. Market demand curve (DM) is obtained by horizontal summation of the individual demand curves (DA and DB).
Market demand curve ‘DM‘also slope downwards due to inverse relationship between price and quantity demanded.
Market Demand Curve is Flatter:
Market demand curve is flatter than the individual demand curves. It happens because as price changes, proportionate change in market demand is more than proportionate change in individual demand.
- Difficulties in preparing a market demand schedule:
Companies and other organizations use marketing research to manage the risks associated with offering new products and services. These organizations don´t want to spend too much money developing a product line that research indicates will be unsuccessful. Some problems make marketing research costly and produce results of questionable value for the organization.
Organizations use marketing research to find out what customers think and what they want. The survey is a direct way of collecting quantitative, or numerical, information and qualitative, or descriptive, information. When there are errors in the survey design, marketing research problems can surface. For example, a company might use a method that is designed to collect a random sample from the target consumer population, but the method is not really random. Therefore, the organization cannot generalize its survey results to represent the target population.
One marketing research problem relates to how the survey is offered to the target population. Marketers design a survey that many customers choose not to respond to. They look at reasons why people don´t want to participate, and they might reach conclusions such as the survey takes too much effort or that the incentive for participation is not appealing to respondents.
Related Reading: The Basic Steps of the Marketing Research Process
A survey might include one or more sources of bias. Marketers might believe, for example, that they have created an online survey to appeal to respondents of all ethnic backgrounds, but the survey questions, and even images, might be biased to favor one ethnic group or could offend one or more ethnic groups. A survey´s format and content must be acceptable to all audiences from which marketers seek to gather information.
Some marketing research involves observing consumers in action and noting their preferences. Marketers can become intrusive, interfering with a consumer´s experience to the point that a consumer feels disgusted and leaves the business site. For example, a fast-food chain´s researchers need to determine if there is a need for a new location of its store so they survey people going through the drive-through line. Although researchers conduct a short survey, they aggravate customers by slowing down the line.
- Write short notes on:
a) Demand forecasting
Answer: Forecasting demand is an important task for just about any type of business. Accurately projecting the demand for specific goods and services helps companies to order raw materials and schedule production of those products in a timely manner, making it possible to fill consumer orders quickly and efficiently without the need to build up a large inventory that adds to the tax burden of the business. While the process may vary in detail from one setting to another, there are a few basic steps that can make demand forecasting a much simpler process.
- Identify the products that are to be considered as part of the forecast process. Doing so helps to create a sense of focus for the effort and make it easier to gauge the public´s recognition and attraction to those products, rather than simply relying on the overall reaction of consumers to the brand name or the overall product line.
- Set parameters for the demand forecast. Establish a specific time frame for the projection, such as the beginning of the second quarter to the end of that same quarter in the upcoming business year. This makes it easier to include events that are highly likely to occur in that time frame and have some effect on consumer demand for the product under consideration.
- Determine the target market or markets for the product. The market may be composed of demographics that have to do with age, gender, location or any other set of identifying characteristics desired. This can also add focus to the demand forecast since it helps the business understand the level of business volume that can be reasonably anticipated from that demographic.
4 .Gather data relevant to the effort to forecast demand. Information such as a breakdown in population within targeted areas, dividing by age groups or economic classes, can often help make it easier to determine the approximate number of sales to anticipate during the period under consideration.
- Calculate the actual forecast. While there are several different formulas used for this process, most will require assuming that a fixed percentage of the target market will consume the product a certain number of times during the forecast period. Typically, those percentages are based on either industry standards relevant to the product or the actual history of past periods associated with the actual good or service offered by the business.
b) Consumer Surplus
Consumer surplus, also called social surplus and consumer’s surplus, in economics, the difference between the price a consumer pays for an item and the price he would be willing to pay rather than do without it. As first developed by Jules Dupuit, French civil engineer and economist, in 1844 and popularized by British economist Alfred Marshall, the concept depended on the assumption that degrees of consumer satisfaction (utility) are measurable. Because the utility yielded by each additional unit of a commodity usually decreases as the quantity purchased increases, and because the commodity’s price reflects only the utility of the last unit purchased rather than the utility of all units, the total utility will exceed total market value. A telephone call that costs only 20 cents, for example, is often worth much more than that to the caller. According to Marshall, this excess utility, or consumer surplus, is a measure of the surplus benefits an individual derives from his environment.
When there is a difference between the price that you pay in the market and the value that you place on the product, then the concept of consumer surplus becomes a useful one to look at.
- Consumer surplus is a measure of the welfare that people gain from consuming goods and services
- Consumer surplus is the difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they actually do pay (i.e. the market price).
- Consumer surplus is shown by the area under the demand curve and above the equilibrium price as in the diagram below.
c) Marginal Utility
Utility is the economist´s way of measuring pleasure or happiness and how it relates to the decisions that people make. Utility measures the benefits (or drawbacks) from consuming a good or service or from working. Although utility is not directly measurable, it can be inferred from the decisions that people make.
Utility in economics is typically described by a utility function, such as:
U(x) = 2x + 7, where U is utility and X is wealth
Marginal Analysis in Economics:
The article Marginal Analysis describes the use of marginal analysis in economics:
From an economist´s perspective, making choices involves making decisions ´at the margin´ - that is, making decisions based on small changes in resources:
- How should I spend the next hour?
- How should I spend the next dollar?
Marginal utility, then, asks how much a one-unit change in a variable will impact our utility (that is, our level of happiness. Marginal utility analysis answers questions such as:
How much happier, in terms of ´utils´, will an additional dollar make me (that is, what is the marginal utility of money?)
How much less happy, in terms of ´utils´, will working an additional hour make me (that is, what is the marginal disutility of labour?)
Now we know what marginal utility is, we can calculate it. There are two different ways to do so.
Calculating Marginal Utility without Calculus:
Suppose you have the following utility function: U (b, h) = 3b * 7h
b = number of baseball cards
h = number of hockey cards
And you´re asked "Suppose you have 3 baseball cards and 2 hockey cards. What is the marginal utility of adding a 3rd hockey card?"
First step is to calculate the marginal utility of each scenario:
U (b, h) = 3b * 7h
U (3, 2) = 3*3 * 7*2 = 126
U (3, 3) = 3*3 * 7*3 = 189
The marginal utility is simply the difference between the two: U (3, 3) - U (3, 2) = 189 - 126 = 63.
Calculating Marginal Utility with Calculus:
Using calculus is the fastest and easiest way to calculate marginal utility. Suppose you have the following utility function: U (d, h) = 3d / h where:
d = dollars paid
h = hours worked
Suppose you have 100 dollars and you worked 5 hours; what is the marginal utility of dollars? To find the answer, take the first (partial) derivative of the utility function with respect to the variable in question (dollars paid):
dU/dd = 3 / h
Substitute in d = 100, h = 5.
MU (d) = dU/dd = 3 / h = 3 /5 = 0.6
d) Gross price elasticity of demand
In economics, the cross elasticity of demand or cross-price elasticity of demand measures the responsiveness of the demand for a good to a change in the price of another good. It is measured as the percentage change in demand for the first good that occurs in response to a percentage change in price of the second good. For example, if, in response to a 10% increase in the price of fuel, the demand of new cars that are fuel inefficient decreased by 20%, the cross elasticity of demand would be: . A negative cross elasticity denotes two products that are complements, while a positive cross elasticity denotes two substitute products. These two key relationships may go against one´s intuition, but the reason behind them is fairly simple: assume products A and B are complements, meaning that an increase in the demand for A is caused by an increase in the quantity demanded for B. Therefore, if the price of product B decreases, then the demand curve for product A shifts to the right, increasing A´s demand, resulting in a negative value for the cross elasticity of demand. The exact opposite reasoning holds for substitutes
The formula used to calculate the coefficient cross elasticity of demand is
e) Complementary goods
In economics, a complementary good is a good with a negative cross elasticity of demand, in contrast to a substitute good. This means a good´s demand is increased when the price of another good is decreased. Conversely, the demand for a good is decreased when the price of another good is increased. If goods A and B are complements, an increase in the price of A will result in a leftward movement along the demand curve of A and cause the demand curve for B to shift in; less of each good will be demanded. A decrease in price of A will result in a rightward movement along the demand curve of A and cause the demand curve B to shift outward; more of each good will be demanded. Basically this means that since the demand of one good is linked to the demand of another good, if a higher quantity is demanded of one good, a higher quantity will also be demanded of the other, and if a lower quantity is demanded of one good, a lower quantity will be demanded of the other. The prices of complementary goods are related in the same way: if the price of one good rises, so will the price of the other, and vice versa. With substitute goods, however, the price and quantity demanded of one good is related inversely to the price and quantity demanded of a substitute good, meaning that if the price or quantity demanded of one good rises, the price or quantity demanded of its substitute will fall.
An example of this would be the demand for hot dogs and hot dog buns. The supply and demand of hot dogs is represented by the figure at the right with the initial demand D1. Suppose that the initial price of hot dogs is represented by P1 with a quantity demanded of Q1. If the price of hot dog buns were to decrease by some amount, this would result in a higher quantity of hot dogs demanded. This higher quantity demanded would cause the demand curve to shift outward to a new position D2. Assuming a constant supply S of hot dogs, the new quantity demanded will be at D2 with a new price P2.
Other examples include:
- Printers and ink cartridges
- DVD players and DVDs
- Computer hardware and computer software
- Boots and laces
- Torch and battery
- Explain the law of Variable proportions. Which is the bet stage of production?
The law of variable proportion is one of the fundamental laws of economics. It is the generalized form of Law of Diminishing marginal return. The law of variable proportion is the study of short run production function with some factors fixed and some factors variable.
The law of variable proportions states that as the quantity of one factor is increased, keeping the other factors fixed, the marginal product of that factor will eventually decline. This means that up to the use of a certain amount of variable factor, marginal product of the factor may increase and after a certain stage it starts diminishing. When the variable factor becomes relatively abundant, the marginal product may become negative.
In the short run the volume of production can be changed by altering variable factors only. In the study of production function (variable proportion) the effect on output is examined by varying factor proportions. When we increase the quantity of variable factors to the combination of fixed factor, the proportion between fixed and variable factors change. The change in factor proportion and its effect on output forms the subject- matter of the law of variable proportions.
The ratio of variable factor to the fixed factor changes as the variable factors are increased in the combination. Thus the main thing to be noted is the break of proportion between fixed and variable factors of production. With disproportionate combination of factors, the returns may initially increase then remain constant for some time and ultimately diminishes.
Therefore, the law of variable proportion is called non-proportional returns. The law can be explained with an example. Supposing there are two factors-land and labour. Land is fixed and labour is variable factor. Further we have one acre of land and 2 labourers. The ratio of land to labour is 1:2. To increase the production 3 labours are employed with the same plot of land. The new ratio will be 1:3.
Illustration of the Law: The law of variable proportion is illustrated in the following table and figure. Suppose there is a given amount of land in which more and more labour (variable factor) is used to produce wheat.
It can be seen from the table that up to the use of 3 units of labour, total product increases at an increasing rate and beyond the third unit total product increases at a diminishing rate. This fact is shown by the marginal product which the addition is made to Total Product as a result of increasing the variable factor i.e. labour.
It can be seen from the table that the marginal product of labour initially rises and beyond the use of three units of labour, it starts diminishing. The use of six units of labour does not add anything to the total production of wheat. Hence, the marginal product of labour has fallen to zero. Beyond the use of six units of labour, total product diminishes and therefore marginal product of labour becomes negative. Regarding the average product of labour, it rises up to the use of third unit of labour and beyond that it is falling throughout.
Three Stages of the Law of Variable Proportions: These stages are illustrated in the following figure where labour is measured on the X-axis and output on the Y-axis.
Stage 1. Stage of Increasing Returns: In this stage, total product increases at an increasing rate up to a point. This is because the efficiency of the fixed factors increases as additional units of the variable factors are added to it. In the figure, from the origin to the point F, slope of the total product curve TP is increasing i.e. the curve TP is concave upwards upto the point F, which means that the marginal product MP of labour rises. The point F where the total product stops increasing at an increasing rate and starts increasing at a diminishing rate is called the point of inflection. Corresponding vertically to this point of inflection marginal product of labour is maximum, after which it diminishes. This stage is called the stage of increasing returns because the average product of the variable factor increases throughout this stage. This stage ends at the point where the average product curve reaches its highest point.
Stage 2. Stage of Diminishing Returns: In this stage, total product continues to increase but at a diminishing rate until it reaches its maximum point H where the second stage ends. In this stage both the marginal product and average product of labour are diminishing but are positive. This is because the fixed factor becomes inadequate relative to the quantity of the variable factor. At the end of the second stage, i.e., at point M marginal product of labour is zero which corresponds to the maximum point H of the total product curve TP. This stage is important because the firm will seek to produce in this range. There is always an optimum combination of factors of production at which cost per unit is minimum. Too less or too much of the variable factors leads to cost increases. The law speaks about three stages of production. The first stage goes from origin to the point where the average output is maximum. When a firm expands output by increasing the quantity of variable factors in proportion to fixed it moves towards optimum combination of factors of production. In this stage the law of increasing return maybe said to operate and marginal product begins to fall i.e. law of diminishing returns sets in.
The second stage goes from the point where the average output is maximum to the point where the marginal output is zero. After having attained the optimum. Combination of the fixed inputs and the variable input, if the firm increases still further the quantity of the variable input, the per unit output of the variable input falls. In this stage, total output rises but only at a diminishing rate.
Stage 3. Stage of Negative Returns: In stage 3, total product declines and therefore the TP curve slopes downward. As a result, marginal product of labour is negative and the MP curve falls below the X-axis. In this stage the variable factor (labour) is too much relative to the fixed factor.
The third stage covers the range over which the marginal output is negative and total output naturally falls. No producer will operate at this stage, even if he can procure the variable input at zero price. The first and the third stages are known as stages are known as stages of economic absurdity or economic non-sense. A producer will always seek to operate in the second stage. At which point the producer will operate in this stage will depend upon the prices of the factor inputs. In the following figures we have drawn TP and units of variable inputs in one figure and AP and MP and units of variable inputs in the other figure. In both the table and the graphic representation, we see that both average and marginal products first increase reach the minimum and eventually decline.
- Explain Least Cost Combination of the factors.
Producer always tries to achieve the largest possible volume of output from a given cost outlay on factors with given prices such that these are combined in an optimal manner. Alternatively, producer minimise his cost of production for producing a given level of output. In this way, the producer maximises his profits and produces a given level of output with least cost combination of factors. This least cost combination of factors will be optimum for him.
Given iso-cost line and the series of isoquants (isoquant-map), the producer will choose the level of output, where the given iso-cost line is tangent to the highest possible isoquant. In Fig. 7.10 (a), E1 is the point of equilibrium, where isoquant IQ2 is tangent to iso-cost line AB.
Given budgeted expenditure, all other points are either not in the reach of producer (like points ‘P’, ‘Q’ etc. on the same isoquant IQ2 or any point on higher isoquant IQ3) or give lesser output (like points ‘R’, ‘S’ on isoquant IQ1) than the point of equilibrium E1 with the same cost and hence are inefficient.
Similarly, when the series of iso-cost lines and one isoquant is given, then the producer equilibrium will be at the point, where the given isoquant touches the lowest possible iso-cost line (E2 in Fig. 7.10 (b)).
All other points are either not desirable (implying higher total cost indicated by points lying on higher iso-cost line than EF) or not feasible though preferable (points lying on lower iso-cost line than EF), as the given output cannot be produced with factor combinations indicated by these points.
How the entrepreneur ultimately arrives at the point of equilibrium, can best be explained with the help of the concept of marginal rate of technical substitution (MRTS) and the price ratio of the two factors. The producer will not choose to produce the given output at point ‘P’ (on isoquant IQ2 in Fig. 7.10 (a)) or point ‘T’ (on isoquants IQ in Fig. 7.10 (b)), as at these points MRTS (slope of the isoquant) is greater than the price ratios (slopes of the price lines) of the factors.
Hence, producer will use more of factor ‘X’ (labour) for factor ‘Y’ (capital) and go down on the corresponding isoquants to become better off. Similarly, at point ‘Q’ (on isoquant IQ2 in Fig. 7.10 (a)) or point ‘U’ (on isoquant IQ in Fig. 7.10 (b), we face the reverse situation and the producer will substitute factor ‘Y’ (capital) for factor ‘X’ (labour) and will go up on the respective isoquants to ultimately reach the equilibrium points E1 and E2 to achieve greater output or lower cost in the two cases respectively. At these points, marginal rate of technical substitution is equal to the price ratio of the factors and the producer would be maximising the output or minimising the cost using the factor combination in this manner.
Slop of isoquant = Slop of iso-cost line
That is, at the point of equilibrium, the marginal physical products of the two factors are proportional to the factor prices. In other words, the last rupee spent on one factor (say, labour) is as productive as the last rupee spent on other factor (say, capital) and producer has no incentive to change the combination of two factors.
If, for instance, the price of factor ‘X’ is twice as much as that of factor ‘Y’ then the producer will purchase and use such quantities of the two factors that the marginal physical product of factor ‘X’ is twice the marginal physical product of factor ‘Y’ The result can be extended for more number of factors as MPX/PX = MPy/ PY = MPZ/PZ = …
It is to be noticed that at the point of equilibrium, the isoquant must be convex to the origin; i. e. at the point of equilibrium, MRTSX must be diminishing for equilibrium to be stable. In Fig. 7.11, ‘e’ cannot be the point of equilibrium, as isoquant IQ1 is concave at this point and MRTS increases here. With a concave isoquant, we have corner solution (point e3 in Fig. 7.11). Thus, e2 is the point of stable equilibrium, where isoquant is at a higher level and it is convex.
The behaviour of the producer in choosing the quantities of factors is exactly symmetrical with the behaviour of the consumer. Both the producer and the consumer purchase things in such quantities as to equate marginal rate of substitution with the price ratio.
The consumer, to be in equilibrium, equates his marginal rate of substitution (or the ratio of the marginal utilities of two commodities) with the price ratio of the commodities. The producer equates the marginal rate of technical substitution (or, the ratio of the marginal physical products of the two factors) with the price ratio of the two factors.
- Distinguish between Average and Marginal Cost and show by examples and diagrams that marginal cost is less than average cost if average cost is falling and marginal cost is more than average cost is rising.
There are a number of different ways to measure the costs of production, and some costs are related in interesting ways. Let´s look at the way in which average cost (or average total cost, i.e. total cost divided by quantity produced) and marginal cost (i.e. the incremental cost of the last unit produced) are related.
A Review of Average and Marginal Cost
Marginal cost is the change in total cost when another unit is produced; average cost is the total cost divided by the number of goods produced
The increase in cost that accompanies a unit increase in output; the partial derivative of the cost function with respect to output. Additional cost associated with producing one more unit of output.
- The marginal cost is the cost of producing one more unit of a good.
- Marginal cost includes all of the costs that vary with the level of production. For example, if a company needs to build a new factory in order to produce more goods, the cost of building the factory is a marginal cost.
- Economists analyze both short run and long run average cost. Short run average costs vary in relation to the quantity of goods being produced. Long run average cost includes the variation of quantities used for all inputs necessary for production.
- When the average cost declines, the marginal cost is less than the average cost. When the average cost increases, the marginal cost is greater than the avera