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K
Y = Quantity of output
L = Quantity of labour
K = Quantity of capital
= output elasticity of labour = % change in Y = Y L
% change in L L Y
= output elasticity of capital = % change in Y = Y K
% change in K K Y
Hint: Given your knowledge of MP
L
, MP
K
, AP
L
and AP
K
(Recall from
orientation course), prove that:
Output elasticity of Labour =
Output elasticity of Capital =
TP, MP, AP:
TP = Y
Y , Y = Marginal Products of L and K
L K
Y , Y = Average Products of L and K
L K
4. Laws of Production:
L O P: Relationship between output and input
Output can be produced by:
Keeping one/some inputs constant, by changing other inputs
Changing only one input and keeping other inputs constant Law of
Diminishing Marginal Returns (LDMR) or Law of Variable Proportions
Changing quantities of all inputs Law of Returns to Scale.
5. The Law of Variable Proportions (LDMR):
Vary only one input (say labour), and keep other inputs
(Ex: Capital) constant
Keep technology constant
All units of input varied are homogeneous All units have identical
characteristics.
LVP (LDMR): Stages of Production
Labour
Input
TP MP AP Stages of Production
1 20 20 20 S I: TP at an increasing rate
2 50 30 25
MP
L
AP
L
Max MP
L
3 90 40 30 AP
L
, but lower than MP
L
4 120 30 30
S II: TP at a decreasing rate. Then
Max.
5 135 15 27 MP
L
, but +ve,
6 144 9 24 AP
L
, but +ve
7 147 3 21 MP
L
= AP
L
, then AP
L
> MP
L
8 148 1 18.5
9 148 0 16.4
TP constant, MP
L
=0
AP
L
, +ve
10 145 -3 14.5
S III: TP
MP
L
, -ve
AP
L
, +ve
Note: S I: Fixed input (K), under utilized
: S II: Fixed input (K), properly utilized
: S III: Fixed input (K), inadequate
: S I: Increasing Marginal Returns
: S II: Diminishing Marginal Returns
: S III: Negative Marginal Returns
Draw diagram to illustrate the behaviour of TP, MP and AP.
The LDMR (LVP):
As more and more of the input (L) is employed, OR C, a point will
eventually be reached, where additional quantities of variable input (L)
will yield diminishing marginal returns.
LVP (LDMR) and Business Decisions
How much to produce?
How many units of V-inputs to employ?
Would a business firm like to operate either in S I or S III? Why
or why not?
Do you consider S I or S III as rational zones? Why or why not?
Do you consider S II as the rational zone? Why or why not?
Once you decide rational zone (stage), how many workers to be
employed and how much of output to be produced?
6. Optional ( - maximizing) use of Variable Input:
How many units of V I (Self Labour) should the business firm employ
for profit maximization?
Recall the Decision Rule:
MRP
L
= MC
L
(Necessary Condition)
Extra revenue generated from the sale of the output produced by extra
labour equals the extra cost.
MRP
L
= The extra revenue generated by the use of an extra unit of
labour
= MP
L
(MR)
= MP
L
X price of output per unit
MR = Price = AR, if all the units of output are sold at the same price
(as under P/C market)
MC
L
= W (Price of Labour) if all the units of labour are employed at
the same wage rate.
h
MRP
&
MC
L
O
MRP = MC
L
MC
L
= W
L
(units of L) MRP
L*
7. P. F with Two V Inputs: Isoquant Approach:
L & K: Two inputs vary quantity of both LRPF
Two-Input and one output (Y) Model
Isoquant Approach: Assumptions
Two-input and one-output production system
Isoquant (Iso-product curves)
Iso equal, Quant Quantity (of output)
Different input combinations to produce a specified quantity of
output
Two inputs (L&K) can substitute each other, but at a diminishing
rate
Constant technology.
Isoquant and Isoquant Map
Combinations of L and K to produce equal amount of Y (say 5 units of
output)
Combination Unit of L Units of K
MRTS
LK
= K
L
1 1 16 -
2 2 11 5
3 3 7 4
4 4 4 3
5 5 2 2
6 6 1 1
Isoquant and Isoquant Map
Different combinations of L & K producing the same levels of Y.
Isoquant Curve: Locus of all input combinations to produce a given level
of Y.
Y = 15
Y = 10
Y = 5
L
O
K
8. Properties (characteristics) of Isoquants:
Isoquants have ve slope
Substitutability between L & K
Employ more of L and less of K and Vice-Versa to produce the
same level of Y.
Isoquants are convex to the origin
Convexity Not only the substitution between L & K, but also
diminishing marginal rate of technical substitution (MRTS, Column 4 of
the above Table).
DMRTS As quantities of one input (say labour) is increased, the
less of another factor (say K) will be given up.
Thus MRTS The amount of one input (K) substituted for one unit
of another input (L) for producing a constant level of output.
MRTS
LK
= - K = Slope of an I.Q.
L
As we move down an isoquant (towards right) MRTS of L for K
diminishes
Refer to Table:
Combination 1: K is too much in comparison to labour
Combination 6: K is less in comparison to L
MRTS
LK
: Diminishes from 5 to 1 from combination 1 to 6
Loss = Gain
Loss: Loss in output by using less amount of K: - K(MP
K
)
Gain: Gain in output by using a larger dosage of L input: L(MP
L
)
- K(MP
K
) = L(MP
L
)
MPL = - K = (Negative) slope of an I.Q
MP
K
L
or
- MPL = K = Slope of an I.Q = -ve slope
MP
K
L
Isoquants cannot intersect
Isoquants cannot be tangent to other
Upper isoquants represent higher level of output:
K
b
c
K* d
a Y = Y
1
Y = Y
0
O L
L*
Point a on Y
0
: OL* & OK*
Point b: More of K (a b) and same an out of L
Point c: More of both K & L
Point d: More of L (a d), but same about of K
Y
1
> Y
0
, Point a on Y
0
, but points b c d on Y
1
Hence a represents Y
0
, but b, c & d represent Y
1
with
different combinations of L & K.
h
h
h
h
9. Different Kinds of Isoquants:
Linear Isoquant: L & K are perfect substitutes
K
MRTS
LK
remain constant throughout
L
A given quantity of Y can be produced by using only K or L or by
using both
Linear I.Q not realistic
L shaped (Fixed proportion) Isoquants: L & K are perfect complements
K B
K
2
Y
2
K
1
Y
1
O L
L
1
L
2
Zero substitubility between L & K
A given quantity of Y can be produced by one and only combination of
L & K (L1+K1 for Y1, and L2+K2 for Y2)
If quantity of K is increased holding L constant, no change in Y
Y can be increased by increasing both inputs proportionately
Ex: Car and Driver.
Why not Isoquants be concave to the origin? Why not vertical or horizontal?
10. Isocost Lines: The Budgetary Constraint and Budget Line:
Isocost Line or curve represents a line of constant cost
C = L + K
Where: C = Total cost
= Wage rate of labour
L = Quantity of labour
= Rental price of K
K = Quantity of K
L = -----------------------
K = -----------------------
Solving for K:
K = C - L
C = Maximum quantity of K, which can be purchased, when L = 0
= Slope of I-C-Line = K
L
-ve slope, and the slope of BL is the ratio of input prices (viz & )
Let C = 1,000 = 250 = 500
Buy K = 4, L = 0
Buy L = 2, K = 0
Slope = - = - 500 = - 2
250
Multiple combinations in between C/ (intercept for K), and C/
(intercept for L)
What happens to location of I C Line (B.L) when:
C alone changes (, ), O R C
, ( proportionately and disproportionately), O R C
When the parallel shift in I C L, and change in slope of I C L?
When change in slope and when no change?
h
h
K = C - L
Slope: = Relative input prices.
K
C/
O L
C/
11. Optimal Input (Factor) Combinations: Equilibrium of The Firm:
Bring to-gether I.Q map and B.L or I.C.L to determine the optimal input
combinations for the firm to reach equilibrium
I.Q: Various combinations of L & K to produce a given level of Y
I.C.L: Various combinations of L & L that a firm can purchase at a given
cost
Superimpose the budget line (I.C.L) on I.Q map to determine optimal
input combination for minimizing cost or maximizing output:
h
h
h
h
h
K
K*
O L
A
B
E
C
D
Y3
Y2
Y1
L*
Fig: Least cost input combination.
Point E: Point of equilibrium of the firm
Point of tangency between ICL and I.Q Equal slope of both I.C.L
and I.Q (Y3)
- MPL = slope of I.Q
MPK
- = slope of I.C.L
Rule for optimal input combination: Ratio of marginal products of
inputs in equal to ratio of input prices:
- MPL = - or
MPK
MPL = or
MPK
MPL = MPK
Optimal input combination (for the firm to attain equilibrium)
when: an additional unit of money on any input by the business firm
yields the same increase in output.
Is this rule for optimal input combination comparable to that of
MU1 = MU2 under consumer equilibrium i.e equi-marginal
P1 P2
utility principle?
Are the following situations optimal or sub-optimal?
MPL > MPK
MPL < MPK
If suboptimal, what changes a business firm should effect to reach the
optimal point of input combination?
MPL = MPK Is this rule, a rule of maximization?
Optimal input combination: cost minimization or output maximization.
MPL = MPK : Considers only: input prices and marginal productivities
of inputs.
Rule for Profit Maximization:
MC = MR
MC = Supply related factor
MR = Demand related factor
Hence consider both supply related and demand related factors to
optimize .
Hence optimal input combination (cost minimization / output
maximization) is a necessary but not a sufficient condition for max.
sufficient conditions come from demand related MR of output (Y).
12. Expansion Path:
Case of a firm: Y
1
= 1000 = 2
K = 10 units = 2
L = 10 units
K
C
3
C
2
C
1
10
O
10
C
1
C
2
C
3
L
a
b
c
Y
3
= 1750
Y
2
= 1500
Y
1
= 1000
Point a: Y = 1000 L = 10 K = 10
C = (2) (10) + (2) 10 = 40
C
1
C
1
= 40 Iso cost line tangent to Y
1
= 1000
Optimal input combination to produce Y
1
.
Expand output to Y
2
and Y
3
:
New I.C Lines: C
2
C
2
and C
3
C
3
, assuming & remain constant
(parallel shift)
New points of optimal input combinations: b and c.
The firm expands by moving from one tangency or efficient production
point to another (a b C).
Connect all these efficient production points to represent expansion path.
13. Returns to Scale:
To explain the behaviour of output in response to proportionate and
simultaneous changes in input use Expansion/Contraction in the
scale of production.
Technical possibilities of proportionate and simultaneous increase in
the use of both L & K:
Y (output) increases more than proportionately IRS
Y increases proportionately CRS
Y increases less than proportionately DRS
Y = ] (L, K)
Firm uses L units of Labour in combination with K units of capital to
obtain an output of Y: L + K Y
Let us change both L and K by a proportion, call it .
By how much Y increases?
Let output increase by b:
L + K bY bY
b = CRS
b > IRS
b < DRS
Diagram:
Why IRS?: Due to specialization use of specialized labour and
machinery (Details later under Economics of Scale).
Why DRS?: With increased scale of operation, increased problems of
co-ordination (Details later under Economies of Scale).
T
o
t
a
l
o
u
t
p
u
t
IRS (Increasing Slope Curve)
CRS (Constant Slope Curve)
DRS (Decreasing Slope Curve)
Units of L & K
Output elasticity and R to S:
o = % change in output (Y)
% change in all inputs (L & K)
o = Y . IO
I YO
Case1: o > 1 % change in Y >% change in inputs IRS
Case2: o = 1 % change in Y = % change in inputs CRS
Case3: o < 1 % change in Y < % change in inputs DRS
R to S In Iso Quant Framework:
3L + 3K Y
1
= 100
6L + 6K Y
2
= 200
C R S
K
6
3
O
L
3 6
A
B
Y
2
= 200
Y
1
= 100
?
K
6
3
O
L
3 6
A
C
Y
2
= 300
Y
1
= 100
?
K
6
3
O L
3 6
A
D
Y
2
= 1500
Y
1
= 100
14. Technology and P.F:
Technical Change: Economic Interpretation
Y, I
Y, I
Technical change for facing global competiveness.
Labour intensive technology: L ratio
K
Capital intensive technology: L ratio
K
Neutral technology: L ratio remains constant.
K
Impact of technology change on TP, MP and AP: TP with same amount
of input. MP and AP with same amount of input.
Upward shifts in product curves & shifts in iso-quant.
Embodied technology change & P.F shift: Embodied in inputs (say a new
and more efficient machine).
Disembodied technology change: P.F shifts due to improved efficiency in
input-combination, and improved managerial efficiency etc. Do you
contest this difference?
15. Derivation of cost functions from production function: Duality Theorem.
16. Production Theory and Managerial Decision Making:
Careful planning by a company to use its resources in a rational manner.
(Recall three stages of production where do you want the company to
operate)
Managers must understand the marginal benefits and cost of each
decision on resource allocation.
Use the concept of trade offs in decision making:
Ex: K L trade off: Install a new voice messaging system
Reduce the need for receptionists, operators or secretaries
Question: Cost of installing such a system outweighed by cost
of saving resulting from the elimination of certain support
personnel.
Ex: Similarly, L L trade off, K K trade off, etc.
17. Theory of Costs:
Role of Cost Management in Profit Maximization:
= P C.
C o P provides the floor to pricing.
A basis for managerial decision on product pricing
Whether to abandon an old product line or establish a new one
Whether to increase the volume of output or not
Whether to use idle capacity or rent facilities to outsiders.
Proper calculation of costs: Basis for decision making.
18. Kinds and concepts of costs:
Historical and Current Costs:
H.C: Market value of an asset at the time of purchase
C.C: Market value of an asset at the present time
Current Costs: Determined by replacement cost outlay
required for replacing an old asset.
Usually C.Cs exceed historical costs but in case of computers and
electronic equipments, C.C<H.C due to technological progress.
Explicit and Implicit Costs (Imputed Costs):
E.C: Actual expenditure of the firm to hire, rent or purchase the inputs
required in production.
Ex: Wages to hired labour, rental price (interest) of capital, equipment,
purchase of raw materials.
I.C: Costs of input owned and used by the business firmImputed Costs
Ex: Cost of equity capital, rent on company owned facilities.
To estimate : Which one (ones) should we use.
Usually, I.Cs, not considered while calculating the loss or gains of the
company.
E Costs: Also called paid-out costs. I.Cs: Book Costs
Economic Costs = E.Cs + I.Cs
Accountants consider Explicit Costs (E.Cs also called Accounting
Costs), but economists consider both for profitability analysis.
Opportunity Cost (Alternative Cost):
O.C: Value of a resource/input in its next best alternative use
Ex 1: Maximum salary an entrepreneur could earn working for some
one else.
Ex 2: O.C of attending college includes not only the explicit costs of
fees, books and so on, but also foregone earnings of not working.
O.C and efficient resource allocations
A producer with some amount of resources he can produce either
scooters or cars.
Let O.C of one Car is 6 Scooters
P
S
= 30,000 P
C
= 2,00,000
Which one should be produced?
Basis for efficient use of resources.
O.C: Relevant for managerial decision making. Consider the O.Cs of all
the inputs-purchased and used and owned and used.
Production and Selling Costs:
P.Cs: Costs of all inputs used in production
S.Cs: Expenditure on advertisement, display, cost of transport etc.
Incremental and Sunk Costs:
I Costs: Change in cost due to a given managerial decision.
Ex 1: An additional departure of an air career.
Ex 2: I.Cs due to introduction of a new product, replacement of old
technique of production.
S.Cs: Cannot be altered, these S.Cs due to prior commitment.
I.Cs vary with the decision.
S.Cs are not variable with the present decision.
I.Cs: Relevant for decision-making.
S.Cs: Do not depend on the decision at present.
Private and Social Costs:
P.Cs: Incurred by firms in the process of producing goods and services.
P.Cs internalized costs incorporated in the firms total cost of
production.
S.Cs: Incurred by society as a whole.
Ex 1: Mathura Oil Refinery discharging its wastage in Yamuna River
water pollution.
Ex 2: Factories located in a city causing air pollution.
An alternative interpretation of S.C: Social Costs to include both private
and external costs (Costs of Water, Air Pollution etc).
S.C: Total cost borne by the society due to production of a commodity.
Fixed and Variable Costs:
F.C: (overhead, prime or supplementary cost): Do not vary with output.
Ex: Property taxes, insurance etc.
V.C: Vary with output.
Ex: Payments for raw materials, fuel, excise tax etc.
S.R: Differentiate between F.C and V.C.
L.R: All costs are variable.
Engineering Costs:
Important from the view point of project management.
Pre-investment Phase: Planning costs.
Investment Phase: Project execute on costs including
drawing/designing, procurement and construction, commission etc.
Post-investment (operation phase): Running/operation costs,
maintenance costs, replacement costs etc.
Total and Unit Costs:
TFC and TVC
TC = TFC + TVC
AFC = TFC
Q
AVC = TVC
Q
AC = AFC + AVC
MC = TC
Q
19. Short Run Cost Output Relations:
S.R: Some costs are fixed (TFC) and some costs variable (TVC).
AFC, AVC, AC and MC: Relevant Unit Costs.
Cost Function: Symbolic statement of the technological relationship
between the cost and output.
TC = f (Q)
T. Costs, Unit Costs and Output Relations.
Output (Y) TFC TVC TC MC AFC AVC AC
0 55 0 55 - - - -
1 55 30 85 30 55 30 85
2 55 55 110 25 27.5 27.5 55
3 55 75 130 20 18.33 25 43.33
4 55 105 160 30 13.75 26.25 40.0
5 55 155 210 50 11 31 42
6 55 225 280 70 9.17 37.5 46.67
7 55 315 370 90 7.86 45 52.86
8 55 425 480 110 6.88 53.13 60.01
TFC, TVC and TC:
TFC: Constant (55) althrough in the short run, even thought output
(Y) .
TVC: Increases althrough with an increase in output (Y).
TC: Increases althrough with an increase in output (Y).
TVC and TC do not increase at the same rate with Y althrough.
Can you observe the rate of change in TVC and TC with an increase
in Y.
Diagrammatic Representation of TFC, TVC and TC.
TFC, TVC
& TC TC TVC
TFC
O Output
TC = TFC + TVC
Behaviour of unit costs with change in Y:
AFC: Decreases althrough with an increase in Y, because.... constant
AFC
AFC
Y (output)
AVC: First decreases, reaches the point of minimum and then
increases.
AVC
AVC
O Y (output)
Y*
Relate AVC to APL: AP
L
= Y
L
AVC = TVC = PL.L = P
L
(L) = P
L
( 1 )
Y Y Y AP
L
AP
L
AVC
Max. AP
L
Min. AVC
AP
L
AVC
AVC curve is the mirror image of the shape of AP
L
curve.
AC: First decreases, becomes minimum and then increases.
AC
AC
Y (output)
The behaviour AC depends on the behaviour of AFC and AVC:
When AFC and AVC fall, AC
When AFC falls, but AVC increases, change in AC depends on the
rate of change in AFC & AVC
If Decrease in AFC > Increase in AVC, then AC - - - - - - -
If Decrease in AFC = Increase in AVC, AC - - - - - - -
If Decrease in AFC < Increase in AVC, AC - - - - - - -
MC: First decreases, becomes minimum and then increases
MC MC
O Y (output)
MC Y* MC
Behaviour of MC related to behaviour of MP
L
: MP
L
= Y
L
MC = TC = TFC + TVC , but TFC = O
Q Q Q Q
MC = TVC = PLL = P
L
(L)
Q Q Q
MP
L
MC
Max MP
L
Min MC
MP
L
MC
MC curve is the mirror image of the shape of MP
L
curve.
Assignment: Use Data on Total and Unit Costs of page 16
Plot TFC, TVC and TC in one graph sheet
Plot all Unit Costs in an other graph sheet
Record the behaviour of each one of Total and Unit Costs
Record how AFC, AVC, AC and MC related.
20. Long Run Cost Output Relations:
L R: All inputs are variable scale of the firm changes.
The length of the time of the LR depends on the industry
Ex1: Service industry like dry cleaning
LR may be a few months or weeks
Ex2: Construction of a new electricity generating plant
LR may be many years.
The firms LR total cost (LTC) is derived from the firms expansion path
LR is composed of a series curve of short run production functions.
LTC shows the min LR costs of producing various levels of output.
The firms LAC and LMC curves derived from the LTC.
Expansion Path, LTC, MC and LAC.
Capital
(K)
Expansion Path
IQ
5
IQ
3
IQ
4
IQ
1
IQ
2
Labour (L)
LTC
LTC
Derived from
Expansion Path
Y (output)
LMC
&
LAC LMC
LAC
LAC = LTC
Y
LMC = LTC
Y
Y (output)
LTC: To produce different levels of output indicated by Iso-Quants.
LAC: First decreases, becomes min and then increases. Does this
have relationship with returns to scale.
LMC: Slope of the LTC curve intersects the LAC curve from below
at the lowest point on LAC curve.
- Possible Shapes of LAC Curve:
LAC LAC
LAC
LAC
O Y (output) O Y
Fig. A Fig. B
LAC
O Y
Fig. C
Fig A: IRS(LAC) and DRS(LAC)
Fig B: IRS(LAC) Constant CRS(LAC) DRS(LAC)
Fig C: Althrough decreasing with an increase in Y.
Plant size, SRAC Curve (SRAC) and Long RAC Curve (LRMC):
LRAC Curve derived from SRAC Curves.
LRAC Curve is also called Planning Curve or Envelope Curve.
Average
Cost in
SRAC
1
SRAC
2
SRAC
3
SRAC
4
SRAC
5
LRAC
O
Q
1
Q
2
Q
3
Q
4
Quantity of output
per period of time
The Long Run Average Cost Curve for Alternative Plant Sizes
Wants to produce OQ
1
level of output plant size represented by
SRAC
1
: The most efficient.
Forecast more demand for output OQ
2
plant represented by SRAC
2
:
the most efficient. OQ
2
could reproduced with SRAC
1
also, but AC
with SRAC
1
> AC with SRAC
2
.
Level of demand, further to OQ
3
go for plant size SRAC
3
. Why not
to stay with SRA
2
?
Level of demand, further to OQ
4
go for plant size SRAC
4
. Why not
to stay with SRA
3
?
SRAC
4
plant size is called the optimum or least cost (least AC) size.
The LRAC curve is an envelope of the SRAC curves and is tangent to
each of the SRAC curves.
LRAC curve is not tangent to the SRAC curves of their minimum points
except in the case of optimum plant size i.e SRAC
4
.
Note: LRAC curve is U-shaped due to economies and diseconomies of
scale.
21. Economics and Diseconomics of Scale: Real and Pecuniary Economics.
Economics of Scale: Decreasing segment of LRAC curve.
Diseconomics of Scale: Increasing segment of LRAC curve.
Economics of Scale:
Internal (internal to the firm) Economies:
Economies of Production: Technological advantages and
advantages of division of labour and specialization.
Economies in Marketing: Large scale purchase of inputs and sale of
output.
Managerial Economies: Specialised management in production,
HRD, Marketing, Finance etc.
Economies in Transport and Storage: Fuller utilization of transport
and storage facilities.
External or Pecuniary Economies of Scale:
Large scale purchase of inputs: Concessions and discounts.
Large scale acquisition of external finance.
Massive advertisement campaigns.
Declining portion of LRAC due to economies of scale due to output
expansion.
Diseconomics of Scale: Rising portion of LRAC curve:
Overcrowding of labour
Managerial inefficiencies
With full in demand for the product, underutilization of capacity.
Impact of Technological Change on LRAC Curve.
Economies of Scope:
Not the same as economics of scale.
Many times, companies/firms produce more than one product to
lower the cost of each operation alone.
Ex1: Automobile companies producing cars and trucks product
diversification.
Ex2: A smaller commuter airline providing cargo services.
Ex3: Use the byproducts arising from the production of the first
product sugar industry.
Economies of Scale: Total of point production of cars and trucks <
Total cost of producing cars and trucks independently by different
firms. TC(C,T) < TC(C) + TC(T) Less expensive to produce jointly.
Diseconomies of Scale: TC(CT) > TC(C) + TC(T) Less expensive to
produce independently.
22. Learning of Curves (Experience Curves).
Decline in AC of inputs with rising cumulative output over time.
Take 1,000 hours to assemble the 100
th
aircraft, but only 700 hours to
assemble 200
th
aircraft workers and managers become more efficient
with passage of time.
AC
F
G
Learning Curve
O Cumulative Total
Qt 2Qt Output
Ot
th
output (like 100
th
aircraft)
2Qt
th
output (like 200
th
aircraft)
h
h
Economies of Scale: Declining AC of input due to output expansion.
But Learning Curve: Cumulative experience and decling AC of input for
different units of output.
Learning Curve: Experienced in manufacturing airplanes, appliances, ship
building, refined petroleum products and operation of power plants.
Learning Curve: Used to forecast the requirement of personnel, machinery
and raw materials and scheduling product and determining the price at
which to sell output.
Ex: Texas instruments has followed an aggressive price policy for computer
chips, based on the learning curve.
Comparison of E of S and Learning Curve:
Know:
Technical Progress: Downward shift in LRAC Curve.
Managers and workers gaining experience: Downward shift in
LRAC Curve.
LRAC
C
B
A LRACt
LRACt+1
O Output
Qt Qt+1
Observations:
Two periods: t and t+1
Qt and Qt+1 levels of output during t and t+1
LRAC at t: OC for Qt level of output
LRAC at t+1: OB
Lower LRAC during t+1 period
BC = Unit cost saving.
Expand output from Qt to Qt+1
Economics of Scale:
LRAC at Qt+1: OA
OA < OB < OC
Learning Curve Effect: BC
E of Scale Effect: AB
Downward shift due to learning and movement along a given
LRAC curve due to E of scale
Remember: Downward shift in LRAC curve (AC reductions) may
be due to Learning Experience, Economies of Scale, technology and
input price decline.
Hold other things constant to sort out net effect of L.C (Previous
Diagram).
23. Cost Value Profit Analysis: Break Even Point and Operating
Leverage.
Examine the relationship among TR, TC and total profit at various
levels of output (Q).
C V P analysis or B E A: used by business executives to
determine volume of sale required for the firm to break even and the
total profits and losses at other sales levels. At what output level B E,
Losses and Profits?
Use C V P or B E Analyse.
B E Analysis: Linear Cost and Revenue Function
CF: TC = 100 + 10 Q
RF: TR = 15 Q.
100 = TFC
V.C varies with output (Q) and varies at a constant rate of 10 per unit.
Sale Price = 15
Algebraic Calculation of B E P:
TR = TC
15Q = 100 + 10Q
Q = 20 20 is the B E output
Beyond 20: operating profit
Below 20: operating loss.
Diagrammatic Representation:
TR
TVC
Operating
loss
Q (output)
TFC = 100
TVC: Variable Cost
TC = TC function i.e TFC + TVC
TR = Total Revenue: P.Q
Point B:Point of intersection between TR&TC lines Q=20, B.E level of output
Thus Point B: B E Point
Below Q=20, TC > TR operating loss
Above Q=20, TR > TC operating profit
B.E.P:TR=TC =0 losses cease to ever and profits yet to begin.
h
Costs
Revenue
700
600
500
400
300
200
100
O
Operating
TC
>0
<0
B
TFC
10
20
30 40
Limitation of L C and L R functions
C and Revenue functions may be non linear: Because AVC and
price of output vary at different rates with variations is output.
Under non linear conditions, there might be two B E points,
instead of one.
B E Analysis: Non Linear Cost and Revenue Functions.
Costs
and
Revenue TC
B
2
TR
B
1
A TFC
O Q (output)
Q
1
Q
2
h
h
TFC = Total Fixed Cost (OA)
TVC = TC TFC = The vertical distance between TC and TFC
TC = Total Cost = TFC + TVC
B
1
& B
2
: Points of intersection between TR & TC TR = TC
B
1
: Lower B E point at Q
1
output level
B
2
: Upper B E point of Q
2
output level
Firm, producing more than OQ
1
and less than OQ
2
will make profit
Profitable range of output:
More than OQ
1
Less than OQ
2
.
Producing less than OQ
1
more than OQ
2
losses.
Contribution Analysis:
Recall: IC = Incremental Cost of a business decision
IR = Incremental Revenue from a business decision.
Contribution: TR TVC, TFC not considered
At B E Point
Contribution = Fixed Costs.
Uses of B E Analysis:
To Know: Level of sales required to cover all costs
To Know: What happens to overall profitability, when the company
incurs higher or lower fixed or variable costs
To Know: Between two alternative investments, which one offers the
greater margin of profit
To Know: What happens to overall profitability when a new product is
introduced
To forecast , when revenue and cost estimates are available.
To Know: Margin of safety
Useful for production planning
Useful for deciding when to start paying dividend to its share holders.
Degree of operating leverage:
Percentage change in profits that results from percentage change in
number of units sold i.e elasticity of profit with respect to output sold.
DOL = % = o = . Qo
%Q Q Q o
Qo
24. Estimation of Cost Function:
Forward Planning: Basis for decision making.
SR Cost Function: Necessary for the firm determing the optimum level
of output and the price to charge.
LRC Function: Essential in planning for the optimal scale of plant for
the firm.
Methods for obtaining appropriate information of its future cost
output relationship.
Engineering Method:
Based directly on the production function, input prices and the
optimum input combination for producing a given quantity of
output.
Using this information, engineers provide least cost
estimates.
Based on given technology and input prices.
When technology and input prices are changing, difficult to
obtain accurate estimates.
Survivorship Method (Survival Technique)
Classify various firms of an industry into size groups: small,
medium and large
Most efficient size group: share in the industry in creases
Least efficient size group: share in the industry decreases
Industry Share (%)
Site group Base Year Current Year
S 10 12
M 30 50
L 60 38
M Size group: Most efficient
L Size group: Most inefficient
Competition will eliminates inefficient firms
Firms with lower average cost will survive.
Limitation: The method does not yield the cost function. Does not
allow the measurement of degree of economies and diseconomies of
scale.
Statistical Method: Regression Method
Short Run Cost Function:
C = TC = f (Q)
C = total cost = TFC + TVC
Q = output
Linear Cost Function:
TC = a + b Q
TC = 100 + 0.5 Q
TFC = 100
TVC = 0.5 Q
Let Q = 10
TVC = (0.5) (10) = 5
TC = 100 + 5 = 105
AC = -----------------
MC = ----------------
Quadratic Cost Function:
TC = a + b Q + CQ
2
TC = 100 + 60Q + 3Q
2
, TFC = 100
Cubic Cost Function:
TC = a + b Q CQ
2
+ dQ
3
TC = 100 + 60Q 5Q2 + 0.7 Q
3
, TFC = 100
Long Run Cost Functions:
To determine the best scale of plant for the firm to build in order
to minimize the cost of producing the anticipated level of output in
the long run.
Can use either time series data or cross section data.
Can estimate L R Cost Functions with engineering and survival
techniques.
Managerial Uses of Estimated Cost Functions:
To determine the optimum scale or size of the fixed plant and
equipment.
To determine the optimum output for a given plant size.
To determine the supply schedule/curve.
MODULE 3: Market Structure and Theory of Firm.
1. Markets and Market Structure:
Markets:
o Four components of a market: Buyers, sellers, a commodity and a
price.
o Personal contact between buyers and sellers: Not necessary.
o Contact between buyers and sellers: May be through telephonic
conversion or teleprinter or any such modern device.
o Does not necessarily mean a place.
Structure Conduct Performance Paradigm:
Market
Structure
Business Conduct
or Industry
Behaviour
Corporate
Performance
(Price Profit
Output etc)
Definition of Market Structure: Use market characteristics
o In terms of number and size of the buyers and sellers of the product.
o In terms of type of product sold (standardized/homogeneous or
differentiated products).
o The degree of mobility of resources: Entry and exit of firms.
o The degree of knowledge of economic agents (firms, suppliers of
inputs and consumers): About prices and costs and demand and
supply conditions.
Two Broad Market Models:
o Perfect Competition
o Imperfect Competition
Monopoly
Monopolistic Competition
Oligopoly.
Nature of industry where prevalent:
P/C: Financial markets (to some extent) and some farm products
Monopoly: Public utilities
M/C: Manufacturing: Toothpaste, TV sets, Refrigerators etc
Oligopoly: Aluminium, Cigarettes etc.
Different Market Models: Some Broad Characteristics
Market Model
No. of
Sellers
Nature of
Product
Entry
Barriers
to Sellers
Degree of
Control Over
Price
PED CED
1. Perfect
Competition
Large, small,
independent
Homogeneous None None Infinite
Infini
te
2. Monopoly One
Homogeneous
, but no close
substitutes
Insurmou
ntable
Considerable
Very
Small
Zero
or
Very
Low
3. Monopolistic
Compn.
Many, small
virtually
independent
Differentiated,
but very close
substitutes
None Some Large
Very
High
4. Oligopoly
Few,
interdepend
ent
Homogeneous
or
differentiated
Substanti
al
Some Small Low
Kinds of Revenue and Their Behaviour under P/C and I/C
T R = P. Q
A R = TR = P.Q = P
Q Q
M R = TR
Q
Behaviour of AR (Price), TR and MR under P/C & I/C: A Test of Market
Structure
Assignment: Draw diagrams and interpret the Behaviour of Revenues.
Quantity
Price TR MR
P/C I/C P/C I/C P/C I/C
1 16 16 16 16 16 16
2 16 15 32 30 16 14
3 16 14 48 42 16 12
4 16 13 64 52 16 10
5 16 12 80 60 16 8
6 16 11 96 66 16 6
7 16 10 112 70 16 4
8 16 9 128 72 16 2
9 16 8 144 72 16 0
10 16 7 160 70 16 -2
Algebraic Presentation of Behaviour of TR, AR and MR under P/C and I/C:
TR = P.Q
Let TR = 55Q
MR = d(TR) = 55
dQ
AR = TR = 55Q = 55
Q Q
MR = AR under P/C
Let TR = 55Q 2Q
2
MR = d(TR) = 55 4Q
dQ
AR = TR = 55Q 2Q
2
= 55 2Q
Q Q
AR = 55 2Q Falling AR (P) with an increase in Q
MR = 55 4Q
2
Falling MR at twice the rate of AR under I/C.
Assignment: Consider the following TR and TC functions:
1) TR = 55Q. TC = 100 5Q + Q
2
under P/C
2) TR = 55Q 2Q
2
. TC = 100 5Q + Q
2
under I/C
3) Definition: = TR TC
Max : MR = MC: Necessary Conditions
4) Calculate maximizing output (Q) and volume of under P/C
and under I/C.
2. Pricing Under Perfect Competition:
Characteristics of P/C:
A large number of sellers and buyers of the product. Small share
of each buyer and seller in total demand and total supply. No
individual buyer and seller can influence the price. A firm: price
taker and not a price maker.
Homogeneous Products:
Product of each firm is a perfect substitute for the product of other
firms.
Perfect mobility of factors of production: No control of any firm on
factors of production. Inputs can respond to incentives.
Free entry and free exit of firms. No restriction on entry or exit.
No patents or copy rights.
Perfect knowledge among buyers and sellers about costs, prices,
quality of products etc.
Price differences, quickly eliminated
Prevalence of a single price
Resources sold to the highest bidder.
Absence of collusion: No sellers union or buyers associations. Each
buyer or seller acts independently.
No government intervention: No licensing system, no control over
inputs, no fixation of lower or higher prices etc.
P/C: uncommon
May be in stock market and agricultural commodities
Even though uncommon, useful as a reference point for an ideal
market situation. Can evaluate the efficiency of other market models
with the characteristics of P/C as denominators.
Price Determination under P/C:
Price Determined by Market Demand and Market Supply: A Firm
Price Taker
Industry
Price S P
Firm
E
P*
MR=P=AR
P
O Q O Q
h
Market Supply Demand Curve facing
and Demand an individual firm
Q*
Price Determined by MS and MD: P = P* Q = Q*.
A perfectly Competitive Firm: A price taker.
Hence, a P/C firm has to determine quantity to sell at P*
MR = P* = AR
When P is constant, TR changes proportionately to change in Q MR is
constant and equal to price.
AR curve is the demand curve facing of a firm. A firm faces horizontal
or infinitely elastic demand curve.
Pricing in Market Period:
Each firm has fixed stock of commodity to be sold. The stock with all the
firms. Fixed Supply in the market vertical supply curve.
Given fixed supply, price determined by demand.
P
P
2
P
1
O Q
Q*
D
1
D
2
S
Examples:
Pricing in Short Run and Equilibrium of a Firm:
Case 1: Supernormal Profit
Case 2: Belownormal Profit
Case 3: Normal Profit.
Case 1 SMC SAC
E
P AR=MR
T C
O
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P
r
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c
e
,
C
o
s
t
s
Q
Output
h
h
h
Case 2 SMC SAC
AVC
AR=MR
C
E
T
P
O
Q
Output
P
r
i
c
e
,
C
o
s
t
s
Case 3 SMC SAC
AR=MR
E
C
P
O
Q
Output
P
r
i
c
e
,
C
o
s
t
s
Observations:
Case 1: ECTP = Supernormal , because P > SAC.
Excess supply of output in the market P.
Excess demand for inputs . An increase in input prices.
The process of adjustment till normal profit is restored.
Case 2: ECTP = Belownormal
Exit of firms
Excess supply of inputs, decreasing input prices
Excess demand for products, increasing product price
The process of adjustment, till normal profit is reached.
Case 3: Normal profit situation
P = SAC = SMC
Normal profit is included in cost of production.
Reproduce Case 3 by relabelling cost/revenue curves to create
long run equilibrium conditions.
Pricing in Long Run: Equilibrium Conditions
LR : All inputs and costs of production variable.
: Optimum plant size to produce least cost output i.e the best
level of output. Condition for BLO: AR = P = MR = LMC =
lowest LAC.
: All supernormal profits and losses eliminated, only normal profit
accrued.
: Firm produces at the lowest point on its LAC.
: The firm operates the scale of plant given by SATC at its lowest
point SMC = LMC.
Conditions of equilibrium of a firm in the LR:
P = AR = MR = LMC = LAC
h
Output
Price
& Costs
LMC
LAC
E
P
O Q
AR=MR
E = Point of equilibrium
P = AR: By definition
AR = MR: By the nature of market (P/C)
MR = MC: By equilibrium condition
MC = AC: By optimum output scale.
Normal Profit: Free entry and exit of firms critical to the operation of a
highly competitive market.
Supernormal profit and losses in the short run
Normal profit in the LR, due to process of market adjustment.
LR Equilibrium at the point E:
P = AR = MR = LMC = LAC: Both the individual firms and industry
are in Long run equilibrium.
3. Pricing and Output Determination Under Monopoly:
Meaning of M:
A single firm to produce and sell a product.
No close substitutes for the firms product.
Cross elasticity of demand: Zero for a monopoly product.
Firm and industry: Identical.
A monopolist: Price maker.
Downward sloping demand curve for the monopoly product
Downward sloping AR Curve MR Curve, below AR Curve.
Bilateral Monopoly: One seller and one buyer.
Reasons for Monopoly Market Power:
Control over key raw materials: Called raw material monopolies.
Before II World War: Aluminium company of America: Monopoly in
Aluminium production, because of control over bauxite supply.
Patent or copy right ownership: Ex: Polaroid on instant camera.
Economies of scale and efficiency: Ex: Public utilities (water, gas etc.)
called natural monopoly.
Monopoly established by government franchise i.e by Government
Law called franchise monopolies. Ex: Indian Railways.
Barriers to entry of new firms. But even though a sole producer and
distributor of service, regulated by government.
Pure monopoly power rare monopolist faces indirect competition.
Substitutes still exist. (Steel, plastics as substitutes for aluminium).
Short Run Price and Output Determination under Monopoly:
Recall price and output are determined based on revenue and cost
conditions under P/C.
Under monopoly, AC and MC Curves are generally identical with that of
P/C, but AR and MR Curves differ.
AR Curve (same as demand curve) slopes downward To sell more reduce
price MR Curve lies below the AR Curve.
Slope of the MR: Twice the slope of AR Curve.
AR function: P = a b
TR function: TR = Q.P = Q (a b Q)
= a Q b Q
2
MR = dTR = Q 2bQ
dQ
Slope of AR: - b
Slope of MR: - 2b.
Short Run Price Output Determination:
o AR = Average revenue curve or D C.
o MR = Marginal revenue curve.
o Observe = MR < AR. Reason?
o SAC = Short run AC curve.
o SMC = S R MC curve.
o Profit maximization decision rule for a monopoly firm:
MR = SMC Same as that of P/C firm.
o O Q* = maximizing output.
o P Q* = Price per unit of output.
o M Q* = Average cost.
o Profit per unit of output: PQ* - MQ* = PM
o Total : O Q* X PM O Q* = P2M
: P
1
P M P
2
Shaded area.
U
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t
C
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t
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&
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u
e
s
SMC
SAC
O Output
M
N
P
MR AR=D
P
1
Q*
P
2
Does a monopoly firm always earn economic or supernormal ?
Not necessary, depends on AR and AC levels:
AR = AC Normal
AR > AC Economic or supernormal
AR < AC Losses.
Scope for earning economic or super normal profit: High in case of
monopoly.
Assignment: Draw diagrams to illustrate all the three conditions.
Long Run Monopoly Pricing and Output Determination:
Monopolist: An opportunity to expand the size of its firm to increase its
long run profits.
Utilization and size of the plant: Determined by market demand.
Market demand: Determines whether to operate at minimum LAC,
falling part of LAC, or increasing part of LAC.
Equilibrium condition: MR = LAC.
Three possible cases:
Case 1: Monopolist operating at falling segment of LAC
Case 2: Operating at increasing segment of LAC
Case 3: Operating at minimum point of LAC.
But in all these cases: Makes supernormal profit.
Which of these cases: Determined by market demand, given the
technology.
Case 1: Operating at falling segment of LAC.
Observe: MR = LMC at Point E point of equilibrium
O Q* = Equilibrium output
LAC per unit of output: B Q*
Price per unit of output: A Q* (= O P)
per unit of output: A B (AQ* - BQ*)
Total for O Q*: A B C P shaded area
Operating at falling segment of LAC: Market size does not permit to
expand to the minimum point of LAC (Point M)
There is excess capacity.
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&
R
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v
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u
e
s
LMC
LAC
A
B
E
M
P
C
O
Q*
MR
AR (D)
Output
Case 2: Operating at increasing segment of LAC.
MR = LMC at Point E Point of equilibrium
O Q* = Equilibrium level of output
Price per unit of output: AQ*(= O P)
per unit of output: AB (AQ* - BQ*)
Total for O Q*: A B C P Shaded area
Operating at increasing segment of LAC the minimum LAC at M,
earlier to O Q*
Market demand permits to expand output beyond the point of
minimum LAC (M)
Capacity, over utilized.
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&
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e
s
MR
AR (D)
O
P
C
A
E
M
B
LMC
LAC
Q (output)
Q*
Case 3: Operating at minimum point of LAC.
M R = LMC at point E Point of equilibrium
O Q* = Equilibrium level of output
A Q* (= O P): Price per unit of output
E Q* (= O C): LAC per unit of output
A E: per unit of output
A E P C: Total for O Q* level of output (shared area)
Operating at minimum point of LAC
Market size enough to permit the optimum plant size
Optimal capacities utilization.
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u
e
s
MR
AR (D)
P
C
A
E
LMC
LAC
Q (output)
Q*
O
Monopoly & Perfect Competition: Compared
MR = AR = P under P/C. But MR < AR under Monopoly
AR curve is a straight line to the horizontal axis under P/C .
Demand is perfectly elastic.
AR curve is downward sloping under Monopoly Elastic demand.
Monopoly price, higher than competitive price, generally
Monopoly output, lower than competive output
P/C firm: Normal in the LR
M: Supernormal even in the LR
Monopolist: Slow to introduce technological change
P/C: Efficient or exit introduce technological change as and when
possible.
Price Discrimination Under Monopoly (Discriminating Monopolist):
Simple versus discriminating monopoly
S M: Same price for all consumers, in all markets and for all uses of the
same commodity.
D M: Different prices for different consumers, in different markets and
for different uses of the same commodity.
Ex 1: Physicians, Lawyers, Consultants charging different rates for
customers
Ex 2: Railways charging different tariffs for senior citizens, students
and others
Ex 3: Different prices in domestic and international markets
Ex 4: Electricity tariff for commercial purposes and for domestic use.
Some other basis for P.D:
Size discrimination Ex: Retail and wholesale
Sex discrimination
Special service or comfort Ex: In Railways
Age
Quality variation discrimination Ex: Price of deluxe edition and
paper back of a book.
Conditions essential for P.D
Must be a Monopolist: Only a necessary condition
Market segmentation
Different Markets: Separable to prevent resale or reexchange of goods
Different elasticity of demand in different markets. Same price
elasticities in different markets. Reduction in by reducing demand
in the high price markets.
P.D by Degrees:
First Degree P.D (perfect P.D):
Charge different prices to different buyers for each different unit of
the same product. Price charged for each unit, in each buyers case, is
set in accordance with the marginal utility to the buyer and charges
maximum price be is willing to pay for it. The entire consumer surplus
is converted into monopoly revenue and profit.
Difficult to implement.
Second Degree P.D:
Block wise different prices
Blocks: Rich, middle and low income blocks of consumers.
Charge higher price to the rich, lower to middle class and still lower
to the poor. Ex: Public utilities like electricity supply.
Third Degree P.D:
Set different prices in different markets with different demand
curves and elasticities.
Possible in markets separated from each other by geographical
distance, transport barriers, legal barriers etc.
Third Degree P.D: Very practical method.
The practice of P.D in foreign trade is called dumping.
Necessary conditions for Monopoly equilibrium under P.D:
Two separate markets with different elasticities of demand.
MR from all the markets must be the same:
MR
1
= MR
2
= = MRn.
Marginal revenue of all markets must be equal to M C of producing
entire output:
MR
1
= MR
2
= = MRn = MC
MC = M.C of producing entire output.
The Measures of Degree of Monopoly Power:
Triffins cross elasticity criterion: Lower the value of C.E coefficient,
greater the degree of monopoly power. Higher C-E Coefficient smaller
degree of monopoly market power.
Lerner index of M-Power:
Measure M-Power by the deviation between price and MC.
Under Monopoly:
P = A R
A R > M R
M R = M C
P > M C.
Degree of M-Power (M
P
)
MP = P MC , M
P
= Lerner Index
P
Under P/C: MP = O
Larger the value of L-Index, greater the market power.
Recall: Under monopoly: P > MC.
Measure of monopoly power.
Higher the degree of price elasticity of demand for a firms product,
lower is the degree of monopoly power.
Question: When do you expect higher price elasticity of demand?
When there are large number of firms in the industry?
Bains Excess Profit Criterion.
Excess profit profit in excess of opportunity cost.
Higher the excess profit, greater the monopoly power.
M
P
= R OC
R
M
P
= The Degree of Monopoly Power
R = Actual Profit
OC = Opportunity Cost
M
P
= O No Monopoly
Higher the value of M
P
, greater the degree of monopoly power.
Is Bains criterion comparable to that of Lerners index?
Refer Dwivedi (PP 320 321) for other two measures of monopoly
power:
Number of Firms criterion
Concentration Ratio.
4. Pricing and output Determination under Monopolistic Competition:
Features of M/C:
Blend of both competition and monopoly.
Large/many sellers/firms in the market. scope for competition.
Product differentiation: Products similar, but not identical. Product
of each seller branded. Limited degree of monopoly over a group
of consumers.
Product differentiation may be real or imaginary.
Large number of Buyers: But preference for a particular brand.
Free entry: No barriers for entry, but produce a differentiated
product with a new brand name.
Selling Costs: Product differentiation Adversement and other
forms of sales promotion.
Downward sloping demand curve (A R Curve) as under monopoly.
But flatter Demand is more elastic than under monopoly, because
of the availability of close substitutes.
A firm under M/C does not lose all consumers by increasing price as
under P/C. This firm is like a monopolist over a brand loyal
consumers.
Two dimensional competitions: Price Competition and Non-Price
Competition (product variation and selling costs for sales promotion).
The Group:
Non homogeneous products Difficult to define industry.
A group is a cluster of firms producing very related but
differentiated products.
Ex. of product groups: Automobiles, computers, soap, footwear,
cosmetics, vegetable oil etc.
Price and Output Determination: Short and Long Run Equilibrium.
Theory of M/C: Essentially a long run theory.
In the short run: Virtually no difference between monopoly and M/C,
excepting flatter AR & MR curves under M/C.
Short Run Equilibrium.
MR = MC at point E Equilibrium
OQ* = Equilibrium level of output
AQ* (=OP) = Price per unit of output
BQ* (=OC) = AC per unit of output
AB = per unit of output
ABCP = Total for OQ* level of output (shaded area)
A firm under M/C:
Supernormal when: P > AC
Normal when: P = AC
Loss when: P < AC.
May not be operating at the point of minimum AC Excess Capacity
Socially suboptimal level of output.
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P
C
O
A
B
E
M
Q*
MC
AC
MR
AR (D)
Q (output)
Long Run Equilibrium:
LMR = LMC at point E Equilibrium
OQ* = Equilibrium level of output
OP* = Price per unit of output
AQ* = LAC per unit of output
OP* =AQ* No supernormal . Supernormal profits competed away.
Not operating at M i.e minimum average cost, and not producing
socially optimum level of output (OQ**). Excess output capacity
even in the long run (Q* Q**).
h
h
U
n
i
t
C
o
s
t
s
&
R
e
v
e
n
u
e
s
P*
O
A
E
M
Q*
LMC
LAC
LMR
AR (D)
Q (output)
Q**
o Wastes of M/C: Excess output capacity
Waste through advertisements, fancy packaging etc
Wastes due to freedom of choice of consumers for variety
Not operating at minimum AC even in the long run
Excess output capacity
Socially suboptimal level of output underemployment of
resources and lesser output.
Wastes due to selling costs
Define Combined Average Costs: Combined AC (ACC) = Production
Cost (APC) + Selling Costs
A firm under M/C has to cover both APC and selling costs to remain in
business.
APC = Average Production Cost Curve
ACC = Average Combined Cost Curve
Vertical distance between APC and ACC: Selling Costs
For OQ* level of output:
CQ* = APC per unit of output
BQ* = ACC per unit of output
BC = Average Selling Cost.
OQ* CD = Total Product Cost
OQ* BA = Total Combined Cost
ABCD = Total Selling Cost.
C
o
s
t
s
O
A
Q*
Q (output)
D
B
C
ACC
APC
Selling Costs
5. Pricing and Output Decisions Under Oligopoly:
Characteristics/Features of Oligopoly Market:
A few sellers or a few big sellers if there are many. Ex: 15 industries
out of 84 surveyed in India have 75% of market share.
Homogeneous or differentiated products
Ex: Oligopoly with homogeneous or almost homogeneous products
(Homogeneous Oligopoly): Steel, Aluminium, Copper etc.
Ex: Oligopoly with differentiated products (Heterogeneous
Oligopoly): Kitchen Appliances, Cigarettes, Specialists in Medical
Service, Five Star Hotels, Management Consultants etc.
Interdependence: In business policies about fixing of price and
determining output.
High cross elasticity of demand: Fear of retaliation by rival firms.
Excessive expenditure on adversement.
Constant struggle to survive: Because of unique competition.
Difficult, but possible entry/exit.
Lack of uniformity in size of firms.
Indeterminate price and output: Interdependence of Oligopoly firms,
derivation of demand curve difficult. But price and output are
derminate under collusive oligopoly.
Ex: OPEC Organization of Petroleum Export Countries.
Oligopoly is a market which contains the features of the most other
market structures, particulars P/C and M/C.
Demand Function for a firm under oligopoly market structure: Major
determining variables:
Product price
Prices of rival firms goods
Advertising budget of rival firms
Style and qualities of rival firms goods
Ex.1: The impact of price reduction on Godrej Refrigerator on Kelvinator
brand.
Ex.2: The impact of price cut by Maruti Udyog on demand for
Ambassodor, Fiat etc.
Reaction of rivals to Godrej and Maruti Udyog.
Sources of Oligopoly:
Huge capital investment. Possible barrier to entry.
Economies of scale. Huge investment cost advantage due to
economies of scale.
Patent rights under differentiated oligopoly. Limited number of
firms under oligopoly.
Control over certain raw materials.
Merger and takeover:
Oligopolistic tendency in modern industries.
The Oligopoly Models:
Complicated behavioural patterns of actions, reactions and
counteractions.
Difficult to undertake a systematic analysis of price and output
determination under oligopoly.
Hence variety of oligopoly models.
MODELS
Perfect Collusion
Model (Cartels)
Non Collusion
Models
Cournot
Model
Cost-based
Pricing
Model
Game
Theory
Fixed Market
Share Model
Residual Market
Share Model
Some of the Major Oligopoly Models:
Perfect Collusion Model:
All firms producing a homogeneous product like Petrole to form a
Cartel.
Ex: O P E C for pricing.
Pricing similar to monopoly with multiplant operations.
One market demand function and as many AC and MC functions as
number of firms in the cartel.
Sum of MC curves of various firms to get combined MC curve
(CMC)
Determine joint maximizing output for the industry by
following the rule: MR = CMC
Given the equilibrium level of output, AR curve would give the
equilibrium price
Decide distribution of output to firms by equating MR to each of the
MC curve
All firms of the cartel sell at the same price, but output and profits
not equal
Cost efficient firms will make more profits than others
To prevent breakdown of the cartel, the more cost efficient firms to
transfer part of their profits to the less efficient firms
The cartel system of pricing can prevail even under differentiated
oligopoly. Analytically, difficult to handle.
Advantages of perfect collusion:
To avoid price wars among rivals
Gain to members of cartel, but higher price to consumers.
Difficulties of perfect collusion:
Problems of high price to consumers and restricted quantity
If number of firms in cartel larger, greater difficulty in arriving at
consensus on output and pricing
Hence cartels, rare.
Cournot Model of Oligopoly:
Behavioural Assumptions:
Only two firms (Duopoly), owning mineral water wells
Wells operated at Zero MC
Demand curve facing both: negatively sloping
Each seller acts on the assumption that his rival will not react to his
decision to change price and output.
But different to accept the assumptions of non-reaction.
Zero MC assumption: Unrealistic.
Cournot Solution: Each seller ultimately supplies one-third of the market
and price charged by both the firms is the same. One-third of the market
remains unsupplied. Stable equilibrium in Cournots Model.
Sweezys Kinked Demand Curve Analysis of Price Stability:
Two segments of kinked d.c or AR curve: Relatively elastic and
inelastic segments.
D
P K
D
O Q (output)
DD = Demand Curve
OP = Price per unit of output
K = Kink on the d.c
DK = Elastic segment of d.c
KD = Inelastic segment of d.c
DC=AR curveKinked AR Kinky MR curve (Discontinuous MR
curve)
Indeterminate: To sell at the prevailing price or to increase
Raising of price: Reduction in demand due to elastic nature of
demand loss of market to rivals who would not raise their prices
Lowering of price: An immediate retaliation by rivals. Hence not
much of increase in his sales with price reduction
Price rigidity over a period of time due to price interdependence
implied in Kinky d.c (AR curve).
The K D Curve: Does not deal with price and output determination
Once a price quantity combination is determined, an oligopolistic firm
does not find it profitable to raise prices
Price rigidity
Desirable to maintain price and output at the existing level.
S Model does not explain how one price is determined. It explains
stability of output and price
S Model: Does not pass the test of empirical verification.
Monopoly prices: Found to be more stable than oligopoly prices.
Tacit Collusion Models: Leader Follower Models
Based on agreement: Live and Let Live.
Two versions of leader follower model
Fixed Market Share Model (Efficient Firm Model)
Residual Market Share Model (Dominant Firm Model).
Fixed M Share or Efficient Firm Model:
Elect the efficient firm as the leader
Follower firms to take a fixed share of the total market
The residual to the leader.
Residual M Share or Dominant Firm Model:
Elect the dominant firm as the leader
Leader to set the price
Allow each follower to sell as much as he wishes
Leader to inherit the residual market only
Strategy possible under homogeneous oligopoly
(Ex: Steel, Aluminium).
Cost Based Pricing Model:
When failed to form a Cartel or to agree on leader follower model,
go for Cost Based Pricing Model or Game Theory Model
Under C B P Model, each oligopolist to recognize mutual inter
dependence
Each firm not to aim at profit maximizing price for itself
Each firm to determine floor price based on its A C, and experiments
with alternative margins over cost
Depending on competition from rivals, raise or lower its price. No
equilibrium price for any oligopolists product.
Game Theory:
Oligopolists to set their prices through the business game they play
An extreme case of non-cooperation among rivals
Each firm decide its business strategy by ascertaining the alternative
strategies of its rivals
Depending on the strategies each adopt, there will be pay-offs (say
market share).
Concluding Remarks:
Difficult to determine profit-maximizing prices under oligopoly.
Instead of competing through price, compete through non-price
means-product quality, service to the customers, fancy packaging,
selling on credit, guarantee against their products.
Good things about oligopoly:
Availability of variety of products
R & D activities to face competition from rivals.
Undesirable things about oligopoly
Socially suboptimal output: P > MC
Excess capacity: P > min AC
Wastes through promotional activities.
Pricing Methods In Practice:
Profit Maximizing Price: MR = MC
But difficult to follow this Rule: Difficult to get accurate knowledge of
demand and cost conditions facing the firm
Hence to follow alternative pricing methods.
PRICING METHODS
Cost Competition Demand Strategy
Based Based Based Based
Full Cost Marginal Going Sealed Dual Price Price Price
Cost Plus Cost Rate Bid Pricing Disoci- Penetra- Skim
minoty tion -ming
Cost Based Pricing: Three Methods
Full Cost or Break Even Pricing
P = ATC (AC)
Cost Plus Pricing or Mark Up Pricing or Full Cost Pricing
P = AC + mark up (Fair profit i.e a fixed percentage)
Marginal Cost Pricing:
P = MC
C Based Pricing: Ignores consumers preference and demand. Do
not realize difficulties of estimating cost. But, simple and acceptable.
o Competition Based Pricing: Two Methods
Going Rate Methods: Pricing according to the prevailing prices of
comparable products. Price: Less than AC or more than AC.
Sealed Bid Pricing Method:
Ex: Construction activities and disposal of used products.
Prospective buyers (sellers) to quote their prices through a sealed
cover
Open the bids in sealed covers in the presence of all the competitors
Usually, to accept the one who quotes the least in case of buyers and
most in case of sellers.
o Demand Based Pricing:
Dual Pricing and Price Discrimination: Possible when the market of a
commodity is distinctly divisible into two or more segments. Each
segment with different price elasticities of demand.
o Strategy Based Pricing: Two Methods of Pricing a New Product
Price Penetration: To sell more of a new product, low price (even less
than cost of production) in the beginning. Jack up the price once product
credibility is established.
Ex: Rin Washing Soap
Low price in the beginning. Now quite an expensive brand.
Price Skimming Method:
Price a new product high in the beginning
Reduce price gradually as it faces dearth of buyers
Ex: Fancy products, but of poor quality.
o Bains Limit Pricing Theory
A monopolist or an oligopolist to charge a price lower than the profit
maximizing price to discourage new firms entering the market.
But difficult for incumbents to make credible commitment to limit prices.
o Peak Load Pricing: Ex. Telephone Service higher rates during the peak load
period and lower rates during period of peak.
o Prudent Producer: To follow a good mix of various pricing methods,
depending on the situation.
6. Alternative Theories of Firm:
Consider some models/theories of firms economic behaviour.
Three broad groups of theories of firm:
Economists Theory of Firm
Behavioural Models of Firm
Managerial Models of Firm
All the three groups are mutually related.
Economists Theory of Firm:
A firm: Transforms inputs/factors into products
A firm: Rational economic unit
Aims at profit maximization
Perfect knowledge about market conditions
Max Rule: MR = MC.
But: 1) Firms: Aim at satisfactory level of profit
2) The assumption of certainty: Not tenable
3) Perfect knowledge assumption: Not tenable.
Behavioural Models of Firm:
o Underplay the economic content of the firm.
o Consider the behaviour content to explain firms conduct and
performance.
o Ex: Simons Behavioural Model of Rational Choice, Banmols Sales
Maximizing Firm, Stack-lebergs Reaction Oriented Firm, Cyert and
March Behavioural Model.
o Critical Ideas of Behaviourist Model:
A firm: Coalition of various vested interest groups: Different
departments, different levels of management, different groups of
workers, shareholders, suppliers, consumers etc.
Multiple objective of the firm:
Production Goal: Output to be in certain satisfactory range
Sales: Satisfactory levels of sales
Market Share: Satisfactory size of market
Profit Goal: Still import, but one of the multiple goals.
Study of human behaviour in terms of their relationship with the
environment.
Behaviour: Compromise between conflicting views and interests.
Hence satisfying behaviour:More realistic than maximizing behaviour
Managerial Models of Firm:
Consider the difference between organization behaviour and
managerial behaviour.
Organization: An entity.
Professional Managers: Individual personalities.
Organizational Goals: Aim at profit, net worth, growth and
diversification.
Managers: Aim at pay, perks, promotions job security and career
progression.
Managers: One of the vested interest groups. But there are others like
owners, workers, suppliers, financiers and so on.
Conflicts of managers interests with others: organisation to satisfy
all coalition partners, instead of maximizing any goal variable.
Ex: Marris Model of Managerial Enterprise and Williamsons Model of
Managerial Discretion.
Some Important Models of Firm Behaviour:
1. Baumols Theory of Sales Revenue Maximization:
o Sales maximization rather than profit maximization as the goal.
o Modern Business: Management separated from ownership. Hence
Managers discretion to pursue goals other than profit maximization.
o Managers: Choose sales maximizations.
o Why Sales Maximization Goal:
To financial institutions: Sales as index of firms performance.
Salaries and slack earnings of top management: Linked more closely to
sales than to profits
Sales maximization: Positively linked to market share
Profits known at the end of the year. Hence sales: A better performance
indicators.
Baumol considers both static and dynamic models with and without
advertising.
2. Marriss Theory of Maximization of Growth Rate:
Maximize the firms balanced growth rate of demand for the firms
product and of the growth of its capital supply.
Define growth rate maximization as follows:
Gr = G
D
= G
C
Gr = Firms growth rate
G
D
= Growth rate of demand for firms product
G
C
= Growth rate of capital supply to the firm.
A firm achieves a balanced growth rate when the growth rate of
demand for its product equals the growth rate of capital supply to the firm.
Maximize firms growth rate subject to two constraints viz managerial
constraints (managers ability to achieve efficiency and managers own
job security) and financial constraints (conflict between managers own
utility function and owners own utility function).
Managers Utility Function: Um = f (Salary, Power, Status, Job Security)
Owners U Function: Uo = f (Profit, Capital, Output, Market Share,
Public Reputation)
Observe divergence between Um and Uo. But convergence into one
variable viz a steady growth in the size of the firm.
For Managers: G
D
, important, For Owners: GC, important
Um = f (G
D
)
Uo = f (G
C
).
Under Oligopolistic Condition: Interdependence of firms decision.
When all firms try to maximize their growth rate simultaneously,
limitation on the growth in demand for firms product and the supply of
capital.
3. Williamsons Model: Maximization of Managerial Utility Function.
Recall: In modern business companies, management separated from
ownership.
Owners look for high dividends, interested in profit maximization.
Managers have different motives: Their own interest.
Since management is divorced from ownership, managers set the goals
of the firm they manage.
Managers: To maximize their own utility function rather than
maximizing profit.
Managerial utility function:
Max. Um = f (S, M, I
D
), subject to a minimum profit
S = Staff Salary
M = Managerial Emoluments
I
D
= Discretionary Investment
S, M & I
D
are important decision variables in managerial utility
function (Um).
I
D
= o T
= Actual Profit, o = Owners Minimum Profit, T = Tax Payment
I
D
= Balance of actual profit available for the purpose of
discretionary investment (I
D
)
I
D
=
D
= Discretionary Profit.
Simple Version of Williamsons Model:
Recall: Um = f (S, M, I
D
)
Assume: M = O
Um = f (S,
D
), since I
D
=
D
Substitutability between S and
D
S can be increased only by reducing
D
and vice versa
Select an optimum combination of S &
D
point of firms
equilibrium
Model holds good: When rivalry (from other firms) is not strong.
Cannot deal satisfactorily with the problem of interdependence as
under oligopoly.
4. The Behavioural Model of Cyert and March:
This Model: An extension of Simons hypothesis of firms satisfying
behaviour model.
Recall: A firm is a coalition of different but related interest groups:
Owners, managers, workers, input suppliers, customers, bankers and
tax authorities.
All these groups have their own interests.
Conflicting interests/goals.
Managers to formulate a goal for the firm that reconciles the conflicting
interests, by considering aspiration levels of partners.
Hence top management to set the following 5 diversified goals
Production goal
Inventory goal
Sales goal
Market share
Profit goal.
Top management to achieve an overall satisfactory performance, called
satisfying behaviour.
Question: How does a firm read its equilibrium level in its satisfying
behaviour? The model is silent about this question.
Conclusion:
Conventional Theory of Firm: Maximizing Goal. Has greater
explanatory and predictive power.
Alternative Theories of Firm: Not much of empirical evidence available.
Still in the stage of testable hypothesis.
Not possible to replace totally the conventional theory of firm,
emphasizing profit maximization behaviour.
MODULE 4: Macro Economic System and its Management.
1. Macro Economic Concerns:
Micro vs Macro Economics.
Major Building Blocks of Macro Economics:
1) AD & AS
2) Four Sectors: HHS, BS, GS & FTS
3) Two Markets: Commodity Market and Money Market.
Specific issues to be addressed in Macro Economics:
o Rising Prices
o Rising Unemployment
o Falling GDP
o Balance of Payments Crisis.
Tools of Macro Economic Policy and Management:
o Fiscal Policy
o Monetary Policy
o Other Policies: Trade, Price and Labour Policies.
2. The Key Macro Economic Concepts:
Aggregate Supply (AS) Curve:
o Describes, for each given price level, the quantity of output
firms are willing to supply.
o AS: Upward Sloping Firms willing to supply more output at
higher prices.
P
AS
O Y
Output
o ADC: Shows the combinations of the price level and level of
output at which the goods and money markets are
simultaneously in equilibrium.
P
r
i
c
e
L
e
v
e
l
o ADC: Downward Sloping At higher prices, reduction in the Value of
money supply, demand for output is reduced.
P
AD
O Y Output
o Equilibrium level of output and the equilibrium price level.
AS
P
0
E
AD
O Y
Y
0
Output
P
0
= Equilibrium Price Level, Y
0
= Equilibrium Level of Output.
P
r
i
c
e
L
e
v
e
l
P
r
i
c
e
L
e
v
e
l
Shifts in ADC and ASC:
Case 1:A Rightward shift in ADC due to an increase in nominal money stock
AS
P
1
E
1
P
0
E
AD
1
AD
O Y
Y
0
Y
1
Output
Observe new point of equilibrium (E
1
) and new levels of equilibrium
price (P
1
) and output (Y
1
).
P
r
i
c
e
L
e
v
e
l
Case 2: A leftward shift in ASC due to oil price hike or due to drought.
P
AS
1
AS
P
1
E
1
P
0
E
AD
O Y
Y
1
Y
0
Output
Observe an increase in P and decrease in output.
P
r
i
c
e
L
e
v
e
l
The Keynesian and Classical ASC:
o Short run horizontal ASC (The Keynesian):
P
O Y Output
The Classical vertical ASC:
Output
ASC: Shifts right right due to growth of output overtime.
P
r
i
c
e
L
e
v
e
l
P
r
i
c
e
L
e
v
e
l
A S
AS AS*
P
Y
O
Y* Y**
Assumption:
Unemployment
of resources
Assumption: Full
employment of
resources
Consider shifts in AD due to an increase in money supply (monetary
expansion) and an increase in government expenditure (G)fiscal expansion.
Case 1: The Keynesian Case:
Case 2: The Classical Case:
If prices fixed(P
0
)horizontal supply curve, economy would move to
E
11
The Keynesian Equilibrium.
P
r
i
c
e
L
e
v
e
l
P
r
i
c
e
L
e
v
e
l
E
E
1
P
Y
O
Y
0
Y
1
A S
AD
1
P
Y
O
Y* Output
AD
Output
P
1
P
0
AS
E
1
E E
11
AD
1
AD
An increase in
output, but no
change in
price level
An increase in
P, but no
change in
output
Long run, medium run and short run situations:
o Long run: Growth of productive capacity.
o MR: Output determined by a given productive capacity. Prices
determined by fluctuations in AD.
o SR: AD determines the use of available productive capacity.
o Medium run: AS and AD Diagram:
The position of ASC depends on productive capacity of the economy.
The position of ADC depends of monetary and fiscal policies.
P
r
i
c
e
L
e
v
e
l
Y
0
Y
O
Output
P
0
AS
AD
P
o Long run AS AD Diagram:
Vertical ASC: Assumption Full employment of resources.
ADC with ve slope.
Output determined by AS alone, prices determined by both AS and
AD.
Given vertical ASC, high inflation rate due to changes in AD alone.
Changes in AD due to changes in monetary and fiscal policies.
P
r
i
c
e
L
e
v
e
l
Y
0
Y
O
Output
P
0
AS
AD
P
o Short Run AS AD Diagram:
Assumptions: Prices constant horizontal AS curve.
AD: Determines level of output and employment.
P
r
i
c
e
L
e
v
e
l
Y
0
Y O
Output
P
0
AS
AD
P
Growth of output (say GDP), Inflation and unemployment:
o Potential output (Trend level of real GDP): Max amount of output that
an economy can produce while maintaining price stability.
o Output fluctuates around potential output or the trend level of real
GDP.
o Output Gap (O G) = PO AO
PO = Potential Output
AO = Actual Output.
>
o O G = O ?
<
o Inflation and output gap:
= Pt Pt-1 = Inflation rate
Pt-1
<
= O ?
>
Inflation rate and output gap: Inverse relationship?
o Rate of unemployment and rate of inflation:
o Unemployment rate and GDP relationship: Okuns Law
o U E R (%) = No. Unemployed X 100
Labour Force
o Labour Force = No. Employed + No. Unemployed.
R
a
t
e
o
f
c
h
a
n
g
e
i
n
I
n
f
l
a
t
i
o
n
G
r
o
w
t
h
R
a
t
e
o
f
r
e
a
l
G
D
P
O
O
Philips Curve
U E Rate (%)
Change in unemployment rate (%)
Inverse relationship.
Vital link between output
and labour market.
3. National Income Accounting:
Formal structure for Macroeconomic Models:
o Production Side: AS
o Demand Side: AD
A measure of overall price level: Study of inflation.
A measure of performance of Macroeconomy: GDP The most
comprehensive measures of total output in the economy.
Two definitions of GDP:
o GDP: Market value of all final goods and services and total
expenditure on nations output.
o GDP: Sum of all factor payments Total income.
Two amplifications to the definition of GDP:
o Value of output currently produced
o Include only the value of final goods and services value of
intermediate goods not included.
Value of output = 20
Value of income = 20.
Product
Sale
Value
(Rs./Unit)
Value added
by each industry
(Rs.)
Income
generated
Bread
Baking industry
20 9 9
Flour
Milling industry
11 5 5
Wheat
Agriculture
6 5 5
Fertilizers, seeds etc.
Chemical industry
1 1 1
Total 38 20 20
Compare this with two definitions of GDP.
Three Methods of Measuring National Output:
Income Received Approach:
Y = Y
+ Y
+ Y
i
+ Y
R
+ Y
D
Expenditure Approach:
Y = C + I + G + X M
Aggregate Demand.
Value of Product Approach:
Y = P
1
Q
1
+ P
2
Q
2
+ - - - + P
n
Q
n
n
= P
i
Q
i
i=1
Nominal and Real GDP:
NGDP: GDP at current prices
Why change in NGDP from 1.50 to 6.25?
Quantity effect
Price effect.
Commodity
1992 1998
Q P NGDP Q P NGDP
X 1 1.00 1.00 2 2 4.00
Y 1 0.5 0.50 3 0.75 2.25
1.50 6.25
To make valid comparisons between 1992 and 1998, compute GDP at
constant prices called Real GDP.
Change in GDP in 1998 due to price increase is eliminated by estimating
GDP at constant prices viz price of 1992.
GDP Deflator: A useful measure of inflation.
GDPD = (NGDP) 1998 = 6.25 = 1.785
(RGDP) 1998 3.50
= 1998 GDP at current prices
1998 GDP at constant prices
GDPD: Measures the change in prices 79% increase in NGDP is due to
inflation.
Commodity Q (1998) P (1992) RGDP (1998)
X 2 1.00 2.00
Y 3 0.50 1.5
Total 3.50
Other Measures of National Output/Income
o GNP = GDP + factor payments from abroad factor payments to
abroad
o NDP = NNP = GDP Depreciation
o NI = NDP = NNP indirect business taxes (Sales Tax, Excise Tax,
Custom Duties)
o PI = NI Corporate Social Insurance Contributions + Dividends
+ Government Transfer Payments + Personal Interest Income
o DPI = PI Personal Income Tax and Non-Tax Payments.
4. Building Blocks of Macroeconomics:
A D and A S
Four Sectors: Household, Business, Government and Foreign Trade
Sectors
Two Markets: Commodity Market and Money Market
Simultaneous equilibrium both in C M and M M.
5. Macroeconomic Models: Two, Three and Four Sector Models:
Divide economy into four sectors:
Household sector : C
Business sector : I
Government sector : G
Foreign trade sector : X & M.
Two Sector Macroeconomic Model:
Assumptions:
Only two sectors: Household and Business Sectors
Investment already given.
The Model:
Y = C + I - - - - - - - - - (1)
C = a + bY - - - - - - - - - (2)
I = Io - - - - - - - - - (3)
Y = N.I
C = Consumer expenditure
I = Investment expenditure, independent of current income.
I
Io I = Io
O Y
o Value of output = AD
o Exogenous variable: I
o Endogenous Variables: Y & C
Consumption Function:
C = f (Y) C = a + bY: Linear function
Mathematically: a = intercept b = slope
Economic interpretation:
C = a, when Y = o
a is the minimum amount of consumer expenditure, even when Y = 0
b = MPC = The increase in C per unit of increase in Y
dc = b C = b
dY Y
o < b < 1
Consumption demand increases with the level of income.
Recall (1), (2) & (3)
Y = C + I - - - - - - - - - - (1)
C = a + bY - - - - - - - - - (2)
I = Io (3)
Substitute (2) and (3) into (1)
Y = (a+bY) + Io
Y bY = a + Io
Y (1-b) = a + Io
Y (E) = 1 [a + Io] - - - - - - (4)
1 b
Equilibrium income: AD = AS
C
o
n
s
u
m
p
t
i
o
n
(
C
)
C = a + bY
Income (Y)
a
O
Ex: C = 50 + 0.8 Y I = Io = 50
Find out Y (E) and consumption expenditure.
Fig: Equilibrium Income under Two Sector Model.
h
45
0
Y (E)
O
a
C
Y
Io
C,I
C + I (AD)
Keynesian Cross
Y = C + I
Can you put numerical values to a, Io and Y(E), using the values from the
previous example?
Investment Income Multiplier:
Y (E) = 1 [a + Io]
1 b
Let I = Change in investment expenditure
Y = Corresponding change in income
Y (E) + Y = 1 [a + Io + I]
1 b
Y (E) + Y = 1 [a + Io ] + 1 I
1 b 1 b
Y = 1 I
1 b
Y = 1 = Investment/Income Multiplier = K.
I 1 - b
K = Ratio of changes in equilibrium income to changes in I
K > o, because o < b < 1
Can you get the value of K, by using:
C = 50 + 0.8 Y
K = ?
Interpretation of value of K?
The Impact of Change in I on Y (E):
Diagramatic Repretation
Fig: Change in equilibrium Income with change in I under Two Sector Model.
h
h
E
1
Y=C+I
C+I
1
(AD
2
), I
1
>I
0
C&I
E
1
C+I
0
(AD
1
)
AD
2
>AD
1
, since
I
1
>I
0
Y
Y(E) Y(E)
a
O
Three Sector Model:
o Government Sector: G, Tx, Tr influence the economy.
Aggregate Demand:
Y = C + I + G - - - - - - (1)
C = a + bYd - - - - - - - (2)
Yd = Y Tx + Tr - - - - - (3)
I = Io - - - - - - - - - - - - - - (4)
G = Go - - - - - - - - - - - - (5)
Tx = Txo - - - - - - - - - - - (6)
Tr = Tro - - - - - - - - - - - (7)
G, Tx & Tr: Fiscal Variables. Endogeneous Variables:
Y, C and Yd
Exogeneous Variables:
I, G, Tx and Tro
Equilibrium Income Equation:
Substitute (3) into (2)
C = a + b (Y Tx + Tr)
C = a + bY bTx + bTr - - - - - (8)
o Substitute (8), (4) and (5), into (1)
Y = a + bY bTx + bTr + Io + Go - - - - - - (9)
Simplify (9)
Y bY = a bTx + bTr + Io + Go
Y (1-b) = a bTx + bTr + Io + Go
Y (E) = 1 [a bTx + bTr + Io + Go) - - - (10)
1-b
Equilibrium Income Equation
Value of Y = AD.
Fig: Equilibrium Income under Three Sector Model.
45
0
h
h
E
2
C+Io+Go
(AD
2
)
C,I&G
E
1
C+Io (AD
1
)
Y
Y(E)
1
Y(E)
2
AS
O
C+Io
Go
Impact Multiplier:
Y = 1 = Investment/Income Multiplier = K
I
I 1-b
Y = 1 = Government Expenditure Multiplier = K
G
G 1-b
Y = -b = Tax Multiplier = K
Tx
Tx 1-b
Y = b = Transfer Payment Multiplier = K
Tr
Tr 1-b
Observations:
K
I
= K
G
Change in G affects Y
K
Tr
> O Tr Y. Tr Y the same way as I.
K
G
> K
Tr
G brings about increased production of goods and services,
whereas transfer payments do not.
K
Tx
< O Tx Y
Tx Y (Argument of supply side Economics)
Symmetry between K
Tx
and Tr
-b = K
Tx
. b = K
Tr
Difference only in sign.
1-b 1-b
Change in Y(E) with change in G:
Diagrammatic Representation:
Fig: Impact of change in G, keeping C & I constant.
45
0
C+Io+G
1
(AD
2
)
C,I&G
C+Io+Go (AD
1
)
Y
Y(E)
Y(E)
1
AS
O
G
1
> G
0
G
6. Aggregate Demand and Aggregate Supply Curves:
Recall the definitions of A D and A S Curves:
A D C:
ADC depicts the level of output (Y) for each given price (P) level.
The level of output (Y) at which commodity and money markets are
in equilibrium.
P and Y are inversely related.
A S C:
ASC depicts the quantity of output (Y) firms are willing to supply at
each given price level.
P and Y are directly related.
P
P*
Output Y*
Y
AD
AS
o The classical AS and AD curves:
Vertical AS curve, because of assumption of full employment of
resources in the long run.
In the long run, output is determined by AS alone, and prices are
determined both both AS and AD.
Inflation, due to rightward shifts in AD, and deflation due to
leftward shifts in AD.
In the classical case, shifts in AD due to change in money supply.
Inflation/deflation due to change in money supply.
P
P
1
Output Yf
Y
AD
1
AS
P
0
O
AD
0
o The Keynesian Case: AD and AS in the Short Run.
Horizontal Supply Curve: Price pegged at a particular level, and
output can take any value.
Downward Sloping AD Curve:
Fluctuations in output due to shifts in AD curve alone.
Prices are unaffected by the level of output in the S. R.
Establishes the dominant role of AD (in the Keynesian
Macroeconomic Model) in influencing output and employment.
P
Output Y0
Y
AD
1
AS P
0
O
AD
0
Y1
7. IS LM Analysis:
Two main markets in Macroeconomic System commodity or goods market
and Money Market.
Commodity Market Equilibrium: Value of national output = Value of
spending by functional sectors.
Money Market Equilibrium: Demand for real money balances = Supply of
real money balances.
Composition of Money Stock.
o M1 = Can be used directly and instantly for making payments.
M1 corresponds mostly closely to the traditional definition of
money as the means of payment M1 is perfectly liquid.
Needed for day to day transactions.
M1 = Currency + demand deposits (non-interest bearing checking
accounts) + travellers checks + other checkable deposits (interest-
earning checking accounts).
o M2 = M1 + claims not instantly liquid (Ex: time deposits, mutual fund
shares etc).
o Now stock of money undergoing change.
o Commodity Market Equilibrium Curve (IS-Curve) and Money Market
Equilibrium Curve: Simultaneous General Equilibrium:
* = Equilibrium rate of interest
Y* = Equilibrium output/income.
*
Output (Income)
Y*
Y
IS
LM
O
R
a
t
e
o
f
i
n
t
e
r
e
s
t
IS Curve Shifters and LM Curve Shifters:
IS Curve Shifters: O R C
I, G and Tx: Major ones
An increase in I, due to optimistic expectations of business firms
R.W.S in IS Curve (IS1). A decrease in I, due to pessimistic
expectations of business firms LWS in ISC (IS2).
Observe: Shifts in points of equilibrium and changes in and Y.
**
Y*
Y
IS
2
LM
0
O
*
***
Y** Y***
IS
0
IS
1
E
2
E
1
E
3
An increase/decrease in G alone:
RW/LW shift in IS Curve
Changes in and Y.
Draw Diagrams
An increase/decrease in Tx alone:
LW/RW shifts in IS Curve
Changes in and Y.
Draw Diagrams
LM Curve Shifts: An Increase/Decrease in Stock of Money
An increase in stock of money alone: RWS in LMC
A decrease in stock of money alone: LWS in LMC
Observe: Shifts in points of equilibrium and changes in and Y.
**
Y*
Y
LM
0
O
*
***
Y** Y**
IS
0
E
2
E
1
E
3
LM
1
LM
2
o Changes in both Fiscal and Monetary Policies.
Fig: Expansionary F P and M P
Fig: Expansionary F S and contractionary M P
Y*
Y
LM
0
O
*
Y*
IS
0
E
2
E
1
LM
1
IS
1
Y
LM
0
O
*
Y*
IS
0
LM
1
IS
1
**
8. Crowding Out In The Classical Macroeconomic Model:
Recall the classical AS and AD curves:
Y* = Full employment level of output output does not change at f. E.
level.
With fiscal expansion (G), AD shifts to right side AD
1
.
With an increase in G, private sector spending less private spending
fallen by precisely the amount that government spending has risen.
Full crowding out effect.
Every rupee increase in G is offset by a rupee reduction in private
spending.
P
Y
AS
O
Y*
AD
P*
AD
1
P**
Output
Crowding out in IS LM Model:
LM
O
Y
0
E
1
IS
Y
1
Y
2
Y
IS
1
E
11
E
0
o Let there be an increase in G Expansionary fiscal policy.
o Rightward shift in IS curve (Commodity Market Equilibrium Curve)
Increase in Y from Y
0
to Y
1
(E
1
= New equilibrium point).
o Increase in from
0
to
1
.
o If remains at
0
, increase in Y from Y
0
to Y
2
. But Y increase from Y
0
to Y
1
only.
o Reason: I crowding out of investment spending.
o Why crowding out effect?
o Expansionary fiscal policy causes to rise, thereby reducing private
spending, particularly investment.
o How to prevent fall in investment by business sector? Keep constant at 0
by shifting LM curve (Money Market Equilibrium Curve) to right side
Increase in Y from Y
0
to Y
2
.
o Message: Expansionary fiscal policy to be accompanied by expansionary
monetary policy to realize the full impact of expansionary fiscal policy.
9. Supply Side Economics:
The Keynesian prescription for changing GDP and Employment:
Management of aggregate demand.
S S Economics: Shift in emphasis from AD to AS.
o Make the suppliers (corporate sector) happy to make the economy
better.
Lower taxes
Less government spending
Less government regulation
Less labour union power in wage determination.
Every thing that promotes profit.
o S.S.E: Possible to lower rates of inflation and unemployment.
o Ex: Lower tax rates
An increase in consumer demand due to increased disposable income
Lower corporate tax rates inducement to increase AS.
o Diagrammatic representations of S.S.E:
o Similarity and dissimilarity between Keynesian prescription and the
S.S.E prescription:
Both Keynesian and S.S.E prescription: Government policy needed.
Difference:
K Model: Emphasise AD Management
SSE Model: Emphasise AS Management.
P
Y
AS
O
Y*
AD
P*
AS
1
P**
Output/R G D P Y**
Lower price level
Higher R G D P
More employment (Recall
Okuns Law).
10. Unemployment:
Unemployment and GDP growth:
Types of U. E:
o Voluntary U. E:
Lack of willingness to accept the available jobs
More of a psychological problem than an economic problem.
o Involuntary U. E:
Lack of jobs
Occurs during the period of economic depression
Also called cyclical U. E or depressionary U. E. Also called
Keynesian unemployment
Deficiency of AD: Cause of this kind of U. E.
Kinds of Involuntary U. E:
Structural U. E:
Deficiency of stock of capital in relation to needs of growing labour
force
Capital formation lags behind availability of labour force.
Seasonal U. E:
Seasonal character of certain production activities like agriculture,
rice mills etc.
Not sufficient work available during slack season.
Frictional U. E:
Out of work, due to lack of perfect mobility of workers
Also called unemployment between jobs
Due to decline in some activities and expansion of some other
activities. Ex: Earthern pot / Vessel makers.
Disguised U. E or underemployment:
Common in overpopulated countries
Low/zero marginal productivity of labour
Underemployment due to underdevelopment
Ex: Labour force in Agriculture: Not fully employed.
11. Inflation: Kinds, Causes and Remedies:
The Concepts:
o Inflation: Persistent general rise in price level or persistent fall in
purchasing power of money.
o Rate of Inflation: The percentage change in overall level of prices.
Recall: =
o Hyper Inflation: Rate of inflation exceeds 50% per month. In 1923, rise in
price by 500% per moth in Germany.
o Deflation: Persistent fall in price level or persistent rise in purchasing
power of money.
o Creeping Inflation: A single digit inflation Encouraging to faster
growth of output.
o Galloping Inflation: Double or treble digit rates per annum say from
20% to 100% per annum.
o Stagflation: Combination of high and accelerating inflation and high
unemployment and low GDP.
Causes and Kinds of Inflation:
May get generated either from demand or supply side or both.
On the demand side: Due to availability of more money income
(expenditure) for a given volume of output.
On the supply side: Due to wagepush, profitpush and supply shocks (like
drought and oil price hike by OPEC).
Price expectations also contribute for inflation: Higher the elasticity of
price expectations, larger the marginal rate of inflation.
Demand Pull Inflation:
AD > AS P due to excess demand
An increase in AD: Due to G , C or I
A diagrammatic representation of D P I:
Observe two segments of AS curve:
First segment: +ve relationship between output (Y) and price level
Second segment: Vertical AS curve
Full employment level of output (Y
F
)
Shift in AD to right side (AD
1
) (Due to an increase in: G or I or
decrease in Tx) P from P
1
to P
2
.
P
Y
AS
O
Y
F
AD
0
P
1
AD
1
P
2
Output
Monetarist view of D P I:
M > M AD P
P S P D
Supply of real money balances >
Demand for real money balances.
Milton Friedman:
Inflation is always and every where a monetary phenomenon. It can
be produced only by a more rapid increase in the quantity of money
than in output.
Cost Push Inflation:
No increase in AD, still P when wage rate without any corresponding
increase in productivity.
Wage push inflation.
Aggressive increase in wage rates and or material prices.
o Diagrammatic representation of Cost-push inflation:
o Profit-push inflation under monopolistic and oligopolistic market
situations cost-push inflation occurs due to non-wage factors also.
P
Y
AS
1
O
Y**
AD
0
P*
AS
0
P**
Output Y*
Effects of Inflation:
o Erosion of real income or purchasing power
o Effects on debtors and creditors
o Effects on fixed income group (pensioners)
o Effects on wealth holders of cash, deposits etc
o Effects on government income: An increase in tax income both personal
and corporate income taxes
o Inflation and labour productivity: Inflation Labour unrest Low labour
productivity
o Inflation and Marketing:
Consumers, becoming more sensitive to rise in price
A reduced rate of growth in real demand for goods and services
A shift in expenditure away from non-essential goods and services.
o Inflation and interest rate: Inflation High rate of interest.
Control of Inflation:
o Monetary Policy: Use bank rate policy, open market operations, cash reserve
ratio and selective credit controls to control inflation.
Credit Squeeze.
o Fiscal Policy: Reducing Budget Deficit
G Tx
o Income Policy: Wage Control
o Price Control: of essential commodities
o Increase utilization of productive capability to raise A S
o Enlarge imports to tide over shortage of some commodies
All these measures to bridge the gap between AS and AP.
o Indexation: Make adjustments in monetary returns to offset losses in real
income due to inflation (Indexing introduced in Brazil for wages etc.).
MODULE 5: Indian Economy
1. Economic Reforms and Structural Adjustments In India Since 1991.
1.1 Paradigm Shifts In Macroeconomic Policy:
Adam Smith: Laissez faire Market Economy
Alfred Marshall: Glorification of capitalism and market economy
Karl Marx: Destruction of capitalistic system and market economy
J. M. Keynes: Market economy with government interference
1950s and 1960s: Planning and public sector fundamentalism
1970s: Decade of the development of the poor
1980s onwards: Revival of market economy paradigm Back to
Adam Smith?
1.2 Four Decades of Economic Policy Regime In India: 1950 1990:
Planning Public Sector Regulation Fundamentalism
Planning: A panacea
Public sector dominance
Protection of agriculture, industry and trade
Self reliance and import substitution
Inward looking development strategy.
Performance Record During Old Policy Regime:
Respectable GDP growth
Good performance in agriculture: Green Revolution
India: On the industrial map of the world
Development of science and technology and a large pool of
scientific and technological manpower
But three dark spots of development.
1.3 Economic Reforms During 1980s: The First Wave:
Improvement in productivity
Absorption of modern technology
Fuller utilization of production capacity
Larger scope to private sector
Foreign equity capital
Remove controls and restrictions gradually.
1.4 Economic Reforms Since 1991: The Second Wave:
U turn from planning Public Sector Fundamentalism to Market-
Private Sector Fundamentalism.
Huge budget deficit
Balance of payments crisis: Foreign exchange reserves (About $15
billion) to meet two weeks imports
Low global credit rating
Over 13 rate of inflation
Western ideologies and propaganda
Collapse of planned economies in the Soviet Block
Problem of demand management in developed economies
Prescriptions of IMF & World Bank
Ideology of Indian elite
Disenchantment with 40 years of inward looking development strategies
Hence change of track in July, 1991.
1.5 Contours of New Economic Policy Since July, 1991:
Stabilization and Demand Management:
Reduce budget deficit
Control inflation
Reduce deficit in balance of payments.
Structural Adjustment Programme (SAP) and Supply Management:
Liberate economic agents
Delicense, dereserve and deprotect industry, agriculture and trade
Dismantle import license
Reduce tariff rates and remove quantitative restructions
Privatize and allow FDI
Disinvest in public sector industries
Reduce taxes
Allow market forces to govern Exchange Rates.
1.6 Performance of Indian Economy Since 1991:
Major Performance Variables:
GDP growth rate
Employment generation
Reduction of population living below poverty line
Promotion of equity leading to a better deal for the poor and less well-
off sections of our society
Reduction in regional disparities between the rich and the poor states
of India.
GDP Growth Rate:
1993 94 to 1997 98: More than 7% growth rate per annum.
GDP growth rate slowed down after:
2000 01: 5.2%
2001 02: Around 5%
2002 03: 4.3
After: Some recovery
Alternatively:
1980/81 1990/91: 5.6% GDP growth rate
1990/91 2000/01: 5.6% GDP growth rate
Question: Has E.R accelerated GDP growth rate substantially.
Economic Reforms and Employment Growth
Rate of unemployment: 6.03% (1993 94)
Rate of unemployment: 7.32% (1999 00)
Employment Elasticity of Output:
1980s and early 1990s: 0.52%
Late 1990s: 0.16
Job creation per unit of output has decreased
Downsizing of public sector
Increased capital intensity per unit of output
Growth pattern moving in favour of capital intensive sectors.
Economic Reforms and Reduction of Poverty
Poverty reduction over 1983 to 1990/91: 3.1% per annum
Poverty reduction in 1990s: 1% per annum
In rural sector the rate of reduction in poverty: Almost zero and in
urban sector higher rate of reduction in poverty RuralUrban divide.
Neglect of Agriculture Sector
The emphasis of reform process, more on service and manufacturing sectors
and lesson agricultural sector.
3.8% growth rate in agriculture during eighties and 1.73% during
nineties.
HD Report (2003): Indias rank 127th out of 175 Countries.
Foreign Exchange Reserves: $5.83 billion in 1990 91. Now: $143 billions.
Rate of inflation: From about 13% in 1990 91 to a little over 4% now.
Economic Reforms and increased development disparities between states.
Economic Reforms: Mixed Results.
LPG regime: Profit motive dominant, equity goal less emphasised.
To illustrate:
Millions of Indians are connected to the internet, but millions more are
not yet connected to fresh water: India accounts for 30% of the Worlds
software engineers but also 25% of the Worlds malnourished.
India has one of the Worlds largest reservoirs of technical personnel
but also the Worlds largest pool of illiterates and poor people.
Paradox: Proud of 311 Indian billionaries? But about 300 million
people below poverty line
A Country of super rich and super poor.
Hence the Challenge:
Tap the benefits of LPG regime, but address the problems of equity
such as unemployment, poverty and inequalities.
Any development paradigm which ignores the many poor for the
few rich is not sustainable.
Remember: Micro level success stories would obscure the macro
picture the picture of dark spots of Indian development.