MICRO ECONOMICS-SEM-1 UNIT-1 NATURE OF ECONOMICS Under this, we generally discuss whether Economics is science or art or both and if it is a science whether it is a positive science or a normative science or both. Economics - As a science and as an art: Often a question arises - whether Economics is a science or an art or both. (a) Economics is a science: A subject is considered science if It is a systematised body of knowledge which studies the relationship between cause and effect. It is capable of measurement. It has its own methodological apparatus. It should have the ability to forecast. If we analyse Economics, we find that it has all the features of science. Like science it studies cause and effect relationship between economic phenomena. To understand, let us take the law of demand. It explains the cause and effect relationship between price and demand for a commodity. It says, given other things constant, as price rises, the demand for a commodity falls and vice versa. Here the cause is price and the effect is fall in quantity demanded. Similarly like science it is capable of being measured, the measurement is in terms of money. It has its own methodology of study (induction and deduction) and it forecasts the future market condition with the help of various statistical and non-statistical tools. But it is to be noted that Economics is not a perfect science. This is because Economists do not have uniform opinion about a particular event. The subject matter of Economics is the economic behaviour of man which is highly unpredictable. Money which is used to measure outcomes in Economics is itself a dependent variable. It is not possible to make correct predictions about the behaviour of economic variables. (b) Economics is an art: Art is nothing but practice of knowledge. Whereas science teaches us to know art teaches us to do. Unlike science which is theoretical, art is practical. If we analyse Economics, we find that it has the features of an art also. Its various branches, consumption, production, public finance, etc. provide practical solutions to various economic problems. It helps in solving various economic problems which we face in our day-to-day life. Thus, Economics is both a science and an art. It is science in its methodology and art in its application. Study of unemployment problem is science but framing suitable policies for reducing the extent of unemployment is an art. SCOPE OF MANAGERIAL OR BUSINESS ECONOMICS Managerial economics is a developing science which generates the countless problems to determine its scope in a clear-cut way. From the following fields, we can examine the scope of business economics. 1. Demand analysis and forecasting. The foremost aspect regarding scope is demand analysis and forecasting. A business firm is an economic unit which transforms. productive resources into saleable goods. Since all output is meant to be sold, accurate estimates of demand help a firm in minimising its costs of production and storage. A firm must decide its total output before preparing its production schedule and deciding on the resources to be employed. Demand forecasts serves as a guide to the management for maintaining its market share in competition with its rivals, thereby securing its profit. 2. Cost and production analysis. A firm's profitability depends much on its costs of production. A wise manager would prepare cost estimates of a range of output, identify the factors causing variations in costs and choose the cost-minimising output level, taking also into consideration the degree of uncertainty in production and cost calculations. Production process are under the charge of engineers but the business manager works to carry out the production function analysis in order to avoid wastages of materials and time. Sound pricing policies depend much on cost control. The main topics discussed under cost and production analysis are: Cost concepts, cost-output relationships, Economies and Diseconomies of scale and cost control.

3. Pricing decisions, policies and practices. Another task before a business manager is the pricing of a product. Since a firm's income and profit depend mainly on the price decision, the pricing policies and all such decisions are to be taken after careful analysis of the nature of the market in which the firm operates. The important topics covered in this field of study are : Market Structure Analysis, Pricing Practices and Price Forecasting. 4. Profit management. Each and every business firms are tended for earning profit, it is profit which provides the chief measure of success of a firm in the long period. Economists tells us that profits are the reward for uncertainity bearing and risk taking. A successful business manager is one who can form more or less correct estimates of costs and revenues at different levels of output. The more successful a manager is in reducing uncertainity, the higher are the profits earned by him. It is therefore, profit-planning and profit measurement constitute the most challenging area of business economics. 5. Capital management. Still another most challenging problem for a modern business manager is of planning capital investment. Investments are made in the plant and machinery and buildings which are very high. Therefore, capital management require top- level decisions. It means capital management i.e., planning and control of capital expenditure. It deals with Cost of capital, Rate of Return and Selection of projects. 6. Inventory management: A firm should always keep an ideal quantity of stock. If the stock is too much, the capital is unnecessarily locked up in inventories At the same time if the level of inventory is low, production will be interrupted due to non-availability of materials. Hence, a firm always prefers to have an optimum quantity of stock. Therefore, managerial economics will use some methods such as ABC analysis, inventory models with a view to minimising the inventory cost. 7. Linear programming and theory of games : Linear programming and theory of games have came to be regarded as part of managerial economics recently. 8. Environmental issues: There are certain issues of macroeconomics which also form a part of managerial economics. These issues relate to general business, social and political environment in which a business enterprise operates. 9. Business cycles: Business cycles affect business decisions. They refer to regular fluctuations in economic activities in the country. The different phases of business cycle are depression, recovery, prosperity, boom and recession. Thus, managerial economics comprises both micro and macro-economic theories. The subject matter of managerial economics consists of all those economic concepts, theories and tools of analysis which can be used to analyse the business environment and to find out solution to practical business problems. DIFFERENCE BETWEEN BUSINESS ECONOMICS AND ECONOMICS Economics is the social science that studies the production, distribution, and consumption of goods and services. Economics aims to explain how economies work and how economic agents interact. Economic analysis is applied throughout society, in business and finance but also in crime, education, the family, health, law, politics, religion, social institutions, and war. Economic textbooks distinguish between microeconomics ("small" economics), which examines the economic behavior of agents (including individuals and firms) and "macroeconomics" ("big" economics), addressing issues of unemployment, inflation, monetary and fiscal policy. Business economics (also called managerial economics), is a branch of economics that applies microeconomic analysis to specific business decisions. As such, it bridges economic theory and economics in practice. It draws heavily from quantitative techniques such as regression analysis and correlation, Lagrangian calculus (linear). If there is a unifying theme that runs through most of business economics it is the attempt to optimize business decisions given the firm's objectives and given constraints imposed by scarcity, for example through the use of operations research and programming.

MICRO Vs. MACRO ECONOMICSMicro Economics: 1. Micro Economics studies the problems of individual economic units such as a firm, an industry, a consumer etc. 2. Micro Economic studies the problems of price determination, resource allocation etc. 3. While formulating economic theories, Micro Economics assumes that other things remain constant. 4. The main determinant of Micro Economics is price. Macro Economics: 1. Macro Economics studies economic problems relating to an economy viz., National Income, Total Savings etc. 2. Macro Economics studies the problems of economic growth, employment and income determination etc. 3. In Micro Economics economic variables are mutually inter-related independently. 4. In Micro Economics economic variables are mutually inter-related independently. OPPORTUNITY COST

Opportunity cost is the cost of any activity measured in terms of the value of the best alternative that is not chosen (that is foregone). It is the sacrifice related to the second best choice available to someone, or group, who has picked among several mutually exclusive choices.[1] The opportunity cost is also the cost of the foregone products after making a choice. Opportunity cost is a key concept in economics, and has been described as expressing "the basic relationship between scarcity and choice".[2] The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently.[3] Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output foregone, lost time, pleasure or any other benefit that provides utility should also be considered opportunity costs. Explicit costs Explicit costs are opportunity costs that involve direct monetary payment by producers. The opportunity cost of the factors of production not already owned by a producer is the price that the producer has to pay for them. For instance, a firm spends $100 on electrical power consumed, their opportunity cost is $100. The firm has sacrificed $100, which could have been spent on other factors of production. Implicit costs Implicit costs are the opportunity costs that involve only factors of production that a producer already owns. They are equivalent to what the factors could earn for the firm in alternative uses, either operated within the firm or rent out to other firms. For example, a firm pays $300 a month all year for rent on a warehouse that only holds product for six months each year. The firm could rent the warehouse out for the unused six months, at any price (assuming a year-long lease requirement), and that would be the cost that could be spent on other factors of production. TIME VALUE OF MONEY The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. The time value of money is the central concept in finance theory.For example, $100 of today's money invested for one year and earning 5% interest will be worth $105 after one year. Therefore, $100 paid now or $105 paid exactly one year from now both

have the same value to the recipient who assumes 5% interest; using time value of money terminology, $100 invested for one year at 5% interest has a future value of $105.[1]This notion dates at least to Martn de Azpilcueta (14911586) of the School of Salamanca. The method also allows the valuation of a likely stream of income in the future, in such a way that the annual incomes are discounted and then added together, thus providing a lump-sum "present value" of the entire income stream. All of the standard calculations for time value of money derive from the most basic algebraic expression for the present value of a future sum, "discounted" to the present by an amount equal to the time value of money. For example, a sum of FV to be received in one year is discounted (at the rate of interest r) to give a sum of PV at present: PV = FV rPV = FV/(1+r). MARGINALISM Marginalism refers to the use of marginal concepts in economic theory. Marginalism is associated with arguments concerning changes in the quantity used of a good or service, as opposed to some notion of the over-all significance of that class of good or service, or of some total quantity thereof. Market Forces and Equilibrium Summary: Explains market equilibrium and the relation between market demand and supply. Details how market forces determinepricing. Market equilibrium is the situation where, at a certain price level, the quantity demanded by consumers and the quantity supplied by producers of a particular commodity are equal. This means that the market is completely clear of excess supply and demand, and there isn't any tendency for change to either price or quantity. At market equilibrium, consumers are willing to pay the market pricefor the commodity in question and producers are willing and able to sell their goods at that market priceand at that quantity. The price mechanism is a device used to determine the equilibriumprice and equilibrium quantity of goods and also demonstrates how market forces work to achieve market equilibrium. The price mechanism assumes that there is no intervention on the part of the government and the market structure is a pure.

UNIT-2 Cardinal Utility Analysis/Approach: Definition and Explanation: Human wants are unlimited and they are of different intensity. The means at the disposal of a man are not only scarce but they have alternative uses. As a result of scarcity of recourses, the consumer cannot satisfy all his wants. He has to choose as to which want is to be satisfied first and which afterward if the recourses permit. The consumer is confronted in making a choice. For example, a man is thirsty. He goes to the market and satisfy his thirst by purchasing coca cola instead of tea. We are here to examine the economic forces which make him purchase a particular commodity. The answer is simple. The consumer buys a commodity because it gives him satisfaction. In technical term, a consumer purchases a commodity because it has utility for him. We now examine the tools which are used in the analyzes of consumer behavior. Assumptions of Cardinal Utility Analysis: The main assumption or premises on which the cardinal utility analysis rests are as under. (i) Rationality. The consumer is rational. He seeks to maximize satisfaction from the limited income which is at his disposal. (ii) Utility is cardinally measurable. The utility can be measured in cardinal numbers such as 1, 3, 10, 15, etc. The utility is expressed in imaginary cardinal numbers tells us a great deal about the preference of the consumer for a good. (iii) Marginal utility of money remains constant. Another important premise of cardinal utility of money spent on the purchase of a good or service should remain constant. (iv) Diminishing marginal utility. It is also assumed that the marginal utility obtained from the consumption of a good diminishes continuously as its consumption is increased. (v) Independent utilities. According to the Cardinalist school, the utility which is derived from the consumption of a good is a function of the quantity of that good alone. If does not depend at all upon the quantity consumed of other goods. The goods, we can say, possess independent utilities and are additive.

Law of Diminishing Marginal Utility:Definition and Statement of the Law: The law of diminishing marginal utility describes a familiar and fundamental tendency of human behavior. The law of diminishing marginal utility states that: As a consumer consumes more and more units of a specific commodity, the utility from the successive units goes on diminishing.The additional benefit which a person derives from an increase of his stock of a thing diminishes with every increase in the stock that already has.

Law is Based Upon Three Facts:The law of diminishing marginal utility is based upon three facts. First, total wants of a man are unlimited but each single want can be satisfied. As a man gets more and more units of a commodity, the desire of his for that good goes on falling. A point is reached when the consumer no longer wants any more units of that good.Secondly, different goods are not perfect substitutes

for each other in the satisfaction of various particular wants. As such the marginal utility will decline as the consumer gets additional units of a specific good.Thirdly, the marginal utility of money is constant given the consumers wealth.

Explanation and Example of Law of Diminishing Marginal Utility:This law can be explained by taking a very simple example. Suppose, a man is very thirsty. He goes to the market and buys one glass of sweet water. The glass of water gives him immense pleasure or we say the first glass of water has great utility for him. If he takes second glass of water after that, the utility will be less than that of the first one. It is because the edge of his thirst has been blunted to a great extent. If he drinks third glass of water, the utility of the third glass will be less than that of second and so on. The utility goes on diminishing with the consumption of every successive glass water till it drops down to zero. This is the point of satiety. It is the position of consumers equilibrium or maximum satisfaction. If the consumer is forced further to take a glass of water, it leads to disutility causing total utility to decline. The marginal utility will become negative. Schedule of Law of Diminishing Marginal Utility:Units 1st glass 2nd glass 3rd glass 4th glass 5th glass 6th glass Total Utility 20 32 40 42 42 39 Marginal Utility 20 12 8 2 0 -3

From the above table, it is clear that in a given span of time, the first glass of water to a thirsty man gives 20 units of utility. When he takes second glass of water, the marginal utility goes on down to 12 units; When he consumes fifth glass of water, the marginal utility drops down to zero and if the consumption of water is forced further from this point, the utility changes into disutility (-3). Curve/Diagram of Law of Diminishing Marginal Utility:The law of diminishing marginal utility can also be represented by a diagram.

Assumptions of Law of Diminishing Marginal Utility:The law of diminishing marginal utility is true under certain assumptions. These assumptions are as under: (i) Rationality: In the cardinal utility analysis, it is assumed that the consumer is rational. He aims at maximization of utility subject to availability of his income. (ii) Constant marginal utility of money: It is assumed in the theory that the marginal utility of money based for purchasing goods remains constant. If the marginal utility of money changes with the increase or decrease in income, it then cannot yield correct measurement of the marginal utility of the good. (iii) Diminishing marginal utility: Another important assumption of utility analysis is that the utility gained from the successive units of a commodity diminishes in a given time period. (iv) Utility is additive: In the early versions of the theory of consumer behavior, it was assumed that the utilities of different commodities are independent. The total utility of each commodity is additive. 1 1 2 2 3 3 n n U = U (X ) + U (X ) + U (X ). U (X ) (v) Consumption to be continuous: It is assumed in this law that the consumption of a commodity should be continuous. If there is interval between the consumption of the same units of the commodity, the law may not hold good. For instance, if you take one glass of water in the morning and the 2nd at noon, the marginal utility of the 2nd glass of water may increase. (vi) Suitable quantity: It is also assumed that the commodity consumed is taken in suitable and reasonable units. If the units are too small, then the marginal utility instead of falling may increase up to a few units. (vii) Character of the consumer does not change: The law holds true if there is no change in the character of the consumer. For example, if a consumer develops a taste for wine, the additional units of wine may increase the marginal utility to a drunkard. (viii) No change to fashion: Customs and tastes: If there is a sudden change in fashion or customs or taste of a consumer, it can than make the law inoperative. (ix) No change in the price of the commodity: there should be any change in the price of that commodity as more units are consumed.

Law of Equi-Marginal Utility: Definition and Statement of Law of Equi-Marginal Utility:The law of equi-marginal utility is simply an extension of law of diminishing marginal utility to two or more than two commodities. The law of equilibrium utility is known, by various names. It is named as the Law of Substitution, the Law of Maximum Satisfaction, the Law of Indifference, the Proportionate Rule and the Gossens Second Law. In cardinal utility analysis, this law is stated by Lipsey in the following words: The household maximizing the utility will so allocate the expenditure between commodities that the utility of the last penny spent on each item is equal As we know, every consumer has unlimited wants. However, the income this disposal at any time is limited. The consumer is, therefore, faced with a choice among many commodities that he can and would like to pay. He, therefore, consciously or unconsciously compress the satisfaction which he obtains from the purchase of the commodity and the price which he pays for it. If he thinks the utility of the commodity is greater or at-least equal to the loss of utility of money price, he buys that commodity.

Assumptions of Law of Equi-Marginal Utility:The main assumptions of the law of equi-marginal utility are as under. (i) Independent utilities. The marginal utilities of different commodities are independent of each other and diminish with more and more purchases. (ii) Constant marginal utility of money. The marginal utility of money remains constant to the consumer as he spends more and more of it on the purchase of goods. (iii) Utility is cardinally measurable.

(iv) Every consumer is rational in the purchase of goods.

Example and Explanation of Law of Equi-Marginal Utility:The doctrine of equi-marginal utility can be explained by taking an example. Suppose a person has $5 with him whom he wishes to spend on two commodities, tea and cigarettes. The marginal utility derived from both these commodities is as under:

Schedule:Units of Money 1 2 3 4 5 $5 MU of Tea 10 8 6 4 2 Total Utility = 30 MU of Cigarettes 12 10 8 6 3 Total Utility = 30

A rational consumer would like to get maximum satisfaction from $5.00. He can spend money in three ways: (i) $5 may be spent on tea only. (ii) $5 may be utilized for the purchase of cigarettes only. (iii) Some rupees may be spent on the purchase of tea and some on the purchase of cigarettes.

Curve/Diagram of Law of Equi-Marginal Utility:The law of equi-marginal utility can be explained with the help of diagrams.

Theory of Ordinal Utility/Indifference Curve Analysis: Definition and Explanation:The indifference curve indicates the various combinations of two goods which yield equal satisfaction to the consumer. By definition: "An indifference curve shows all the various combinations of two goods that give an equal amount of satisfaction to a consumer".

These economist are the of view that it is wrong to base the theory of consumption on two assumptions: (i) That there is only one commodity which a person will buy at one time. (ii) The utility can be measured. Their point of view is that utility is purely subjective and is immeasurable. Moreover an individual is interested in a combination of related goods and in the purchase of one commodity at one time. So they base the theory of consumption on the scale of preference and the ordinal ranks or orders his preferences.

Assumptions:The ordinal utility theory or the indifference curve analysis is based on four main assumptions. (i) Rational behavior of the consumer: It is assumed that individuals are rational in making decisions from their expenditures on consumer goods. (ii) Utility is ordinal: Utility cannot be measured cardinally. It can be, however, expressed ordinally. In other words, the consumer can rank the basket of goods according to the satisfaction or utility of each basket. (iii) Diminishing marginal rate of substitution: In the indifference curve analysis, the principle of diminishing marginal rate of substitution is assumed. (iv) Consistency in choice: The consumer, it is assumed, is consistent in his behavior during a period of time. For insistence, if the consumer prefers combinations of A of good to the combinations B of goods, he then remains consistent in his choice. His preference, during another period of time does not change. Symbolically, it can be expressed as: If A > B, then B > A (iv) Consumers preference not self contradictory: The consumers preferences are not self contradictory. It means that if combinations A is preferred over combination B is preferred over C, then combination A is preferred over combination A is preferred over C. Symbolically it can be expressed: If A > B and B > C, then A > C (v) Goods consumed are substitutable: The goods consumed by the consumer are substitutable. The utility can be maintained at the same level by consuming more of some goods and less of the other. There are many combinations of the two commodities which are equally preferred by a consumer and he is indifferent as to which of the two he receives.

Example:For example, a person has a limited amount of income which he wishes to spend on two commodities, rice and wheat. Let us suppose that the following commodities are equally valued by him: Various Combinations: a) 16 Kilograms of Rice Plus 2 Kilograms of Wheat b) 12 Kilograms of Rice Plus 5 Kilograms of Wheat c) 11 Kilograms of Rice Plus 7 Kilograms of Wheat d) 10 Kilograms of Rice Plus 10 Kilograms of Wheat e) 9 Kilograms of Rice Plus 15 Kilograms of Wheat It is matter of indifference for the consumer as to which combination he buys. He may buy 16 kilograms of rice and 2 kilograms of wheat or 9 kilograms of rice and 15 kilograms of wheat. All these combinations are equally preferred by him. An indifference curve thus is composed of a set of consumption alternatives each of which yields the same total amount of satisfaction. These combinations can also be shown by an indifference curve.

Figure/Diagram of Indifference Curve:The consumers preferences can be shown in a diagram with an indifference curve. The indifference showing nothing about the absolute amounts of satisfaction obtained. It merely indicates a set of consumption bundles that the consumer views as being equally satisfactory.

In fig. 3.1 we measure the quantity of wheat along X-axis (in kilograms) and along Y-axis, the quantity of rice (in kilograms). IC is an indifference curve. It is shown in the diagram that a consumer may buy 12 kilograms of rice and 5 kilograms of wheat or 9 kilograms of rice and 15 kilogram of wheat. Both these combinations are equally preferred by him and he is indifferent to these two combinations. When the scale of preference of the consumer is graphed, by joining the points a, b, c, d, e, we obtain an Indifference Curve IC. Every point on indifference curve represents a different combination of the two goods and the consumer is indifferent between any two points on the indifference curve. All the combinations are equally desirable to the consumer. The consumer is indifferent as to which combination he receives. The Indifference Curve IC thus is a locus of different combinations of two goods which yield the same level of satisfaction.

Marginal Rate of Substitution (MRS):The necessity is to study the behavior of the consumer as to how he prefers one commodity to another and maintains the same level of satisfaction. For example, there are two goods X and Y which are not perfect substitute of each other. The consumer is prepared to exchange goods X for Y. How many units of Y should be given for one unit of X to the consumer so that his level of satisfaction remains the same? The rate or ratio at which goods X and Y are to be exchanged is known as the marginal rate of substitution (MRS). In the words of Hicks: The marginal rate of substitution of X for Y measures the number of units of Y that must be scarified for unit of X gained so as to maintain a constant level of satisfaction. Marginal rate of substitution (MRS) can also be defined as: The ratio of exchange between small units of two commodities, which are equally valued or preferred by a consumer.

Formula:MRSxy = Y X It may here be noted that the marginal rate of substitution (MRS) is the personal exchange rate of the consumer in contrast to the market exchange rate.

Diminishing Marginal Rate of Substitution:In other words, as the consumer has more and more units of good X, he is prepared to forego less and less of good Y. This behavior showing falling MRS of good X for good Y and yet to remain at the same level of satisfaction is known as diminishing marginal rate of substitution.

Diagram/Figure:The concept of marginal rate of substitution (MRS) can also be illustrated with the help of the diagram.

In the fig. 3.3 above as the consumer moves down from combination 1 to combination 2, the consumer is willing to give up 4 units of good Y (Y) to get an additional unit of good X (X). When the consumer slides down from combinations 2, 3 and 4, the length of Y becomes smaller and smaller, while the length of X is remain the same. This shows that as the stock of the consumer for good X increases, his stock of good Y decreases. He, therefore, is willing to give less units of Y to obtain an additional unit of good X. In other words, the MRS of good X for good Y falls as the consumer has more of good X and less of good Y. The indifference curve IC slopes downward from left to the right. This means a negative and diminishing rate of substitution of one commodity for the other.

Importance of Marginal Rate of Substitution (MRS):(i) Measures utility ordinally: The concept of MRS is superior to that of utility concept because it is more realistic and scientific than the theory of utility. It does not measure the utility of a commodity in isolation without reference to other commodities but takes into consideration the combination of related goods to which a consumer is interested to purchase. (ii) A relative concept: The concept of marginal rate of substitution has the advantage that it is relative and not absolute like the utility concept given by Marshall. It is free from any assumptions concerning the possibility of a quantitative measurement of utility.

Budget Line: Definition and Explanation:The understanding of the concept of budget line is essential for knowing the theory of consumers equilibrium. "A budget line or price line represents the various combinations of two goods which can be purchased with a given money income and assumed prices of goods". For example, a consumer has weekly income of $60. He purchases only two goods, packets of biscuits and packets of coffee. The price of each packet of biscuits is $6 and the price of each packet of coffee is $12. Given the assumed income and the price, of the two goods, the consumer can purchase various combination of goods or market combination of goods weekly.

Schedule:The various alternative market baskets (combinations of goods) are shown in the table below: Market Basket Packets of Biscuits Per Week Packets of Coffee Per Week A 10 0 B 8 1 C 6 2 D 4 3

E 2 4 F 0 5 Income $60 Per Week = Packets of Biscuits Costs $6 = Packets of Coffee is Priced $12 Each

(i) Market basket A in the table above shows that if the whole amounts of $60 is spent on the purchaseof biscuits, then the consumer buys 10 packets of biscuits at a price of $6 each and nothing is left to purchase coffee. (ii) Market basket F shows the other extreme. If the consumer spends the entire amount of $60 on the purchase of coffee, a maximum of 5 packets of coffee can be purchased with it at a price of $12 each with nothing left over for the purchase of biscuits. (iii) The intermediate market baskets B to E shows the mixes of packets of biscuits and packets of coffee that the cost a total of $60. For example, in combination of market basket C, the consumer can purchase 6 packets of biscuits and 2 packets of coffee with a total cost of $60.

Budget Line:The budget line is an important element analysis of consumer behavior. The indifference map shows peoples preferences for the combination of two goods. The actual choices they will make, however, depends on their income. The budget line is drawn as a continuous line. It identifies the options from which the consumer can choose the combination of goods.

Diagram/Figure:

In the fig. 3.9 the line AF shows the various combinations of goods the consumer can purchase. This line is called the budget line. The slope of the budget line indicates how many packets of biscuits a purchaser must give up to buy one more packet of coffee. For example, the slope at point B on the budget line is Y / X or two packets of biscuits 1 = packet of coffee. This indicates that a move from B to C involves sacrificing two packets of biscuits to gain an additional one packet of coffee. Since AF budget line is straight, the slope is constant at -2 packets of biscuits per one packet of coffee at all points along the line.

Consumer's Equilibrium Through Indifference Curve Analysis: Definition:"The term consumers equilibrium refers to the amount of goods and services which the consumer may buy in the market given his income and given prices of goods in the market". The aim of the consumer is to get maximum satisfaction from his money income. Given the price line or budget line and the indifference map: "A consumer is said to be in equilibrium at a point where the price line is touching the highest attainable indifference curve from below".

Conditions:Thus the consumers equilibrium under the indifference curve theory must meet the following two conditions: First: A given price line should be tangent to an indifference curve or marginal rate of satisfaction of good X for good Y (MRSxy) must be equal to the price ratio of the two goods. i.e. MRSxy = Px / Py Second: The second order condition is that indifference curve must be convex to the origin at the point of tangency.

Assumptions:The following assumptions are made to determine the consumers equilibrium position. (i) Rationality: The consumer is rational. He wants to obtain maximum satisfaction given his income and prices. (ii) Utility is ordinal: It is assumed that the consumer can rank his preference according to the satisfaction of each combination of goods. (iii) Consistency of choice: It is also assumed that the consumer is consistent in the choice of goods. (iv) Perfect competition: There is perfect competition in the market from where the consumer is purchasing the goods. (v) Total utility: The total utility of the consumer depends on the quantities of the good consumed.

Explanation:The consumers consumption decision is explained by combining the budget line and the indifference map. The consumers equilibrium position is only at a point where the price line is tangent to the highest attainable indifference curve from below.

(1) Budget Line Should be Tangent to the Indifference Curve:The consumers equilibrium in explained by combining the budget line and the indifference map.

Diagram/Figure:

In the diagram 3.11, there are three indifference curves IC , IC and IC . The price line PT is tangent to 2 the indifference curve IC at point C. The consumer gets the maximum satisfaction or is in equilibrium at point C by purchasing OE units of good Y and OH units of good X with the given money income. The consumer cannot be in equilibrium at any other point on indifference curves. For instance, point R 1 and S lie on lower indifference curve IC but yield less satisfaction. As regards point U on indifference 3 curve IC , the consumer no doubt gets higher satisfaction but that is outside the budget line and hence not achievable to the consumer. The consumers equilibrium position is only at point C where the price 2 line is tangent to the highest attainable indifference curve IC from below.

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2

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(2) Slope of the Price Line to be Equal to the Slope of Indifference Curve:The second condition for the consumer to be in equilibrium and get the maximum possible satisfaction is only at a point where the price line is a tangent to the highest possible indifference curve from below. In 2 fig. 3.11, the price line PT is touching the highest possible indifferent curve IC at point C. The point C shows the combination of the two commodities which the consumer is maximized when he buys OH units of good X and OE units of good Y. Geometrically, at tangency point C, the consumers substitution ratio is equal to price ratio Px / Py. It implies that at point C, what the consumer is willing to pay i.e., his personal exchange rate between X and Y (MRSxy)is equal to what he actually pays i.e., the market exchange rate. So the equilibrium condition being Px / Pybeing satisfied at the point C is: Price of X / Price of Y = MRS of X for Y The equilibrium conditions given above states that the rate at which the individual is willing to substitute commodity X for commodity Y must equal the ratio at which he can substitute X for Y in the market at a given price.

(3) Indifference Curve Should be Convex to the Origin:The third condition for the stable consumer equilibrium is that the indifference curve must be convex to the origin at the point of equilibrium. In other words, we can say that the MRS of X for Y must be 2 diminishing at the point of equilibrium. It may be noticed that in fig. 3.11, the indifference curve IC is convex to the origin at point C. So at point C, all three conditions for the stable-consumers equilibrium are satisfied. Summing up, the consumer is in equilibrium at point C where the budget line PT is tangent to the 2 indifference IC . The market basket OH of good X and OE of good Y yields the greatest satisfaction because it is on the highest attainable indifference curve. At point C: MRSxy = Px / Py

THEORY OF DEMAND

Meanings and Definition of Demand: The word 'demand' is so common and familiar with every one of us that it seems superfluous to define it. The need for precise definition arises simply because it is sometimes confused with other words such as desire, wish, want, etc. Demand in economics means a desire to possess a good supported by willingness and ability to pay for it. If your have a desire to buy a certain commodity, say a car, but you do not have the adequate means to pay for it, it will simply be a wish, a desire or a want and not demand. Demand is an effective desire, i.e., a desire which is backed by willingness and ability to pay for a commodity in order to obtain it.

Characteristics of Demand:There are thus three main characteristic's of demand in economics. (i) Willingness and ability to pay. Demand is the amount of a commodity for which a consumer has the willingness and also the ability to buy. (ii) Demand is always at a price. If we talk of demand without reference to price, it will be meaningless. The consumer must know both the price and the commodity. He will then be able to tell the quantity demanded by him. (iii) Demand is always per unit of time. The time may be a day, a week, a month, or a year. Example: For instance, when the milk is selling at the rate of $15.0 per liter, the demand of a buyer for milk is 10 liters a day. If we do not mention the period of time, nobody can guess as to how much milk we consume? It is just possible we may be consuming ten liters of milk a week, a month or a year.

Law of Demand: Definition and Explanation of the Law:We have stated earlier that demand for a commodity is related to price per unit of time. It is the experience of every consumer that when the prices of the commodities fall, they are tempted to purchase more. Commodities and when the prices rise, the quantity demanded decreases. There is, thus, inverse relationship between the price of the product and the quantity demanded. The economists have named this inverse relationship between demand and price as the law of demand.

Statement of the Law:"Other things remaining the same, the quantity demanded of a commodity will be smaller at higher market prices and larger at lower market prices". "Other things remaining the same, the quantity demanded increases with every fall in the price and decreases with every rise in the price". In simple we can say that when the price of a commodity rises, people buy less of that commodity and when the price falls, people buy more of it ceteris paribus (other things remaining the same). Or we can say that the quantity varies inversely with its price. There is no doubt that demand responds to price in the reverse direction but it has got no uniform relation between them. If the price of a commodity falls by 1%, it is not necessary that may also increase by 1%. The demand can increase by 1%, 2%, 10%, 15%, as the situation demands.

Assumptions of Law of Demand:There are three main assumptions of the Law: (i) There should not be any change in the tastes of the consumers for goods (T). (ii) The purchasing power of the typical consumer must remain constant (M). (iii) The price of all other commodities should not vary (Po).

Example of Law of Demand:If there is a change, in the above and other assumptions, the law may not hold true. For example, according to the law of demand, other things being equal quantity demanded increases with a fall in price and diminishes with rise to price. Now let us suppose that price of tea comes down from $40 per pound to $20 per pound. The demand for tea may not increase, because there has taken place a change in the taste of consumers or the price of coffee has fallen down as compared to tea or the purchasing power of the consumers has decreased, etc., etc. From this we find that demand responds to price inversely only, if other thing remains constant. Otherwise, the chances are that, the quantity demanded may not increase with a fall in price or vice-versa. Demand, thus, is a negative relationship between price and quantity.

Limitations/Exceptions of Law of Demand:Though as a rule when the prices of normal goods rise, the demand them decreases but there may be a few cases where the law may not operate. (i) Prestige goods: There are certain commodities like diamond, sports cars etc., which are purchased as a mark of distinction in society. If the price of these goods rise, the demand for them may increase instead of falling. (ii) Price expectations: If people expect a further rise in the price particular commodity, they may buy more in spite of rise in price. The violation of the law in this case is only temporary. (3) Ignorance of the consumer: If the consumer is ignorant about the rise in price of goods, he may buy more at a higher price. (iv) Giffen goods: If the prices of basic goods, (potatoes, sugar, etc) on which the poor spend a large part of their incomes declines, the poor increase the demand for superior goods, hence

when the price of Giffen good falls, its demand also falls. There is a positive price effect in case of Giffen goods.

Importance of Law of Demand:(i) Determination of price. The study of law of demand is helpful for a trader to fix the price of a commodity. He knows how much demand will fall by increase in price to a particular level and how much it will rise by decrease in price of the commodity. The schedule of market demand can provide the information about total market demand at different prices. It helps the management in deciding whether how much increase or decrease in the price of commodity is desirable. (ii) Importance to Finance Minister. The study of this law is of great advantage to the finance minister. If by raising the tax the price increases to such an extend than the demand is reduced considerably. And then it is of no use to raise the tax, because revenue will almost remain the same. The tax will be levied at a higher rate only on those goods whose demand is not likely to fall substantially with the increase in price. (iii) Importance to the Farmers. Goods or bad crop affects the economic condition of the farmers. If a goods crop fails to increase the demand, the price of the crop will fall heavily. The farmer will have no advantage of the good crop and vice-versa.

MOVEMENT ALONG Vs. SHIFT IN DEMAND CURVEChanges in demand for a commodity can be shown through the demand curve in two ways: (1) Movement Along the Demand Curve and (2) Shifts of the Demand Curve.

(1) Movement Along the Demand Curve:Demand is a multivariable function. If income and other determinants of demand such as tastes of the consumers, changes in prices of related goods, income distribution, etc., remain constant and there is a change only in price of the commodity, then we move along the same demand curve. In this case, the demand curve remains unchanged. When, as a result of change in price, the quantity demanded increases or decreases, it is technically called extension and contraction in demand. The demand curve, which represents various price quantity has a negative slope. Whenever there is a change in the quantity demanded of a good due to change, in its price, there is a movement from one point price quantity combination to another on the same demand curve. Such a movement from one point price quantity combination to another along the same demand curve is shown in figure (4.3).

Diagram/Figure:

Here the price of a commodity falls from $8 to $2. As a result, therefore, the quantity demanded increases from 100 units to 400 units per unit of time. There is extension in demand by 300 units. This movement is from one point price quantity combination (a) to another point (b) along

a given demand curve. On the other hand, if the price of a good rises from $2 to $8, there is contraction in demand by 300 units. We, thus, see that as a result of change in the price of a good, the consumer moves along the given demand curve. The demand curve remains the same and does not change its position. The movement along the demand curve is designated as change in quantity demanded.

(2) Shifts in Demand Curve:Demand, as we know, is determined by many factors. When there is a change in demand due to one or more than one factors other than price, results in the shift of demand curve. For example, if the level of income in community rises, other factors remaining the same, the demand for the goods increases. Consumers demand more goods at each price per period of me (rise or Increase in demand). The demand curve shifts upward from he original demand curve indicating that consumers at each price purchase more units of commodity per unit of time. If there is a fall in the disposable income of the consumers or rise in the prices of close substitute of a good or decline in consumer taste or non-availability of good on credit, etc, etc., there is a reduction in demand (fall or decrease in demand). The fall or decrease in demand shifts the demand curve from the original demand curve to the left. The lower demand curve shows that consumers are able and willing to buy less of the good at each price than before.

Diagram/Figure:

In this figure, (4.4) the original demand curve is DD/. At a price of $12 per unit, consumers purchase 100 units. When price falls to$4 per unit, the quantity demanded increases to 500 units per unit of time. Let us assume now that level of income increases in a community. Now consumers demand 300 units of the commodity at price of $12 per unit and 600 at price of $4 per unit. As a result, there is an upward shift of the demand curve DD2. In case the community income falls, there is then decrease in demand at price of $12 per unit. The quantity demanded of a good falls to 50 units. It is 300 units at price of $4 unit per period of time. There is a downward shift of the demand to the left of the original demand curve.

ELASTICITY OF DEMAND TYPES OF Elasticity of Demand:The quantity of a commodity demanded per unit of time depends upon various factors such as the price of a commodity, the money income of the prices of related goods, the tastes of the people, etc., etc. Whenever there is a change in any of the variables stated above, it brings about a change in the quantity of the commodity purchased over a specified period of time. The elasticity of demand measures the responsiveness of quantity demanded to a change in any one of the above factors by keeping other factors constant. When the relative responsiveness or sensitiveness of

the quantity demanded is measured to changes, in its price, the elasticity is said be price elasticity of demand.

(1) Price Elasticity of Demand:Definition and Explanation:The concept of price elasticity of demand is commonly used in economic literature. Price elasticity of demand is the degree of responsiveness of quantity demanded of a good to a change in its price. Precisely, it is defined as: "The ratio of proportionate change in the quantity demanded of a good caused by a given proportionate change in price".

Formula:The formula for measuring price elasticity of demand is: Price Elasticity of Demand = Percentage in Quantity DemandPercentage Change in Price Ed = q X P p Q The elasticity coefficient is greater than one. Therefore the demand for the good is elastic.

Types:The concept of price elasticity of demand can be used to divide the goods in to three groups. (i) Elastic. When the percent change in quantity of a good is greater than the percent change in its price, the demand is said to be elastic. When elasticity of demand is greater than one, a fall in price increases the total revenue (expenditure) and a rise in price lowers the total revenue (expenditure).

When with a percentage fall in price, the quantity demanded increases so much that it results in the increase in total expenditure, the demand is said to be elastic (Ed > 1). For Example:Price Per Unit ($) 20 10 Quantity Demanded 10 Pens 30 Pens Total Expenditure ($) 200.0 300.0

(ii) Unitary Elasticity. When the percentage change in the quantity of a good demanded equals percentage in its price, the price elasticity of demand is said to have unitary elasticity. When elasticity of demand is equal to one or unitary, a rise or fall in price leaves total revenue unchanged.

When a percentage fall in price raises the quantity demanded so much as to leave the total expenditure unchanged, the elasticity of demand is said to be unitary (Ed = 1). For Example:Price Per Pen ($) 10 5 Quantity Demanded 30 60 Total Expenditure ($) 300 300

(iii) Inelastic. When the percent change in quantity of a good demanded is less than the

percentage change in its price, the demand is called inelastic. When elasticity of demand is inelastic or less than one, a fall in price decreases total revenue and a rise in its price increases total revenue. When a percentage fall in price raises the quantity demanded of a good so as to cause the total expenditure to decrease, the demand is said to be inelastic or less than one, i.e., Ed < 1.

For Example:Price Per Pen ($) 5 2 Quantity Demanded 60 100 Total Expenditure ($) 300 200

(2) Income Elasticity of Demand:Income is an important variable affecting the demand for a good. When there is a change in the level of income of a consumer, there is a change in the quantity demanded of a good, other factors remaining the same. The degree of change or responsiveness of quantity demanded of a good to a change in the income of a consumer is called income elasticity of demand. Income elasticity of demand can be defined as: "The ratio of percentage change in the quantity of a good purchased, per unit of time to a percentage change in the income of a consumer".

Formula:The formula for measuring the income elasticity of demand is the percentage change in demand for a good divided by the percentage change in income. Putting this in symbol gives. Ey = Percentage Change in Demand Percentage Change in Income Simplified formula: Ey = q X P p Q.

Types:When the income of a person increases, his demand for goods also changes depending upon whether the good is a normal good or an inferior good. For normal goods, the value of elasticity is greater than zero but less than one. Goods with an income elasticity of less than 1 are called inferior goods. For example, people buy more food as their income rises but the % increase in its demand is less than the % increase in income.

(3) Cross Elasticity of Demand:The concept of cross elasticity of demand is used for measuring the responsiveness of quantity demanded of a good to changes in the price of related goods. Cross elasticity of demand is defined as: "The percentage change in the demand of one good as a result of the percentage change in the price of another good".

Formula:The formula for measuring, cross, elasticity of demand is: Exy = % Change in Quantity Demanded of Good X % Change in Price of Good Y The numerical value of cross elasticity depends on whether the two goods in question are substitutes, complements or unrelated.

Types and Example:(i) Substitute Goods. When two goods are substitute of each other, such as coke and Pepsi, an increase in the price of one good will lead to an increase in demand for the other good. The numerical value of goods is positive. For example there are two goods. Coke and Pepsi which are close substitutes. If there is increase in the price of Pepsi called good y by 10% and it increases the demand for Coke called good X by 5%, the cross elasticity of demand would be: Exy = %qx / %py = 0.2 Since Exy is positive (E > 0), therefore, Coke and Pepsi are close substitutes. (ii) Complementary Goods. However, in case of complementary goods such as car and petrol, cricket bat and ball, a rise in the price of one good say cricket bat by 7% will bring a fall in the demand for the

balls (say by 6%). The cross elasticity of demand which are complementary to each other is, therefore, 6% / 7% = 0.85 (negative). (iii) Unrelated Goods. The two goods which a re unrelated to each other, say apples and pens, if the price of apple rises in the market, it is unlikely to result in a change in quantity demanded of pens. The elasticity is zero of unrelated goods.

Measurement of Price Elasticity of Demand:There are three methods of measuring price elasticity of demand: (1) Total Expenditure Method. (2) Geometrical Method or Point Elasticity Method. (3) Arc Method.

(1) Total Expenditure Method/Total Revenue Method:The price elasticity can be measured by noting the changes in total expenditure brought about by changes in price and quantity demanded.

(2) Geometric Method/Point Elasticity Method:"The measurement of elasticity at a point of the demand curve is called point elasticity". The point elasticity of demand method is used as a measure of the change in the quantity demanded in response to a very small changes in price. The point elasticity of demand is defined as: "The proportionate change in the quantity demanded resulting from a very small proportionate change in price". Graph/Diagram:

(ii) Measurement of Elasticity on a Non Linear Demand Curve: If the demand curve is non linear, then elasticity at a point can be measured by drawing a tangent at the particular point. This is explained with the help of a figure given below:

In figure 6.10, the elasticity on DD/ demand curve is measured at point C by drawing a tangent. At point C: Ed = BM = BC = 400 = 2 (>1). MO CA 200

(3) Arc Elasticity:Normally the elasticity varies along the length of the demand curve. If we are to measure elasticity between any two points on the demand curve, then the Arc Elasticity Method, is used. Arc elasticity is a measure of average elasticity between any two points on the demand curve. It is defined as: "The average elasticity of a range of points on a demand curve". Formula: Arc elasticity is calculated by using the following formula: Ed = q X P1 + P2 p q1 + q2 Here: q denotes change in quantity. p denotes change in price. q1 signifies initial quantity. q2 denotes new quantity. P1 stands for initial price. P2 denotes new price.

Graphic Presentation of Measuring Elasticity Using the Arc Method:

IMPORTANCE OF ELASTICITY OF DEMANDThe concept of elasticity of demand is of great importance in practical life. Its main points are given as under: 1. Useful for Business: It enables the business in general and the monopolists in particular to fix the price. Studying the nature of demand the monopolist fixes higher prices for those goods which have inelastic demand and lower prices for goods which have elastic demand. In this way, this helps him to maximise his profit. 2. Fixation of Prices: It is very useful to fix the price of jointly supplied goods. In the case of joint products like paddy and straw, the cost of production of each is not known. The price of each is then fixed by its elastic and inelastic demand. 3. Helpful to Finance Minister: It helps the Finance Minister to levy tax on goods. After levying taxes more and more on goods which have inelastic demand, the Government collects more revenue from the people without causing them inconvenience. Moreover, it is also useful for the planning. 4. Fixation of Wages: It guides the producers to fix wages for labourers. They fix high or low wages according to the elastic or inelastic demand for the labour.

5. In the Sphere of International Trade: It is of greater significance in the sphere of international trade. It helps to calculate the terms of trade and the consequent gain from foreign trade. If the demand for home product is inelastic, the terms of trade will be profitable to the home country.

DEMAND FORECASTINGForecasting simply refers to estimating or anticipating future events. It is an attempt to foresee the future by examining the past. Thus demand forecasting means estimating or anticipating future demand on the basis of past data. Objectives of Demand Forecasting A. Short Term Objectives 1. To help in preparing suitable sales and production policies. 2. To help in ensuring a regular supply of raw materials. 3. To reduce the cost of purchase and avoid unnecessary purchase. 4. To ensure best utilization of machines. 5. To make arrangements for skilled and unskilled workers so that suitable labour force may be maintained. 6. To help in the determination of a suitable price policy. 7. To determine financial requirements. 8. To determine separate sales targets for all the sales territories. 9. To eliminate the problem of under or over production. B. Long term Objectives 1. To plan long term production. 2. To plan plant capacity. 3. To estimate the requirements of workers for long period and make arrangements. 4. To determine an appropriate dividend policy. 5. To help the proper capital budgeting. 6. To plan long term financial requirements. 7. To forecast the future problems of material supplies and energy crisis. ME T H O D S O F DEMAND FORECASTING (FOR ESTABLISHED PRODUCTS) There are several methods to predict the future demand. All methods can be broadly classified into two. (A) Survey methods, (B) Statistical methods (A)Survey methods Under this method surveys are conducted to collect information about the future purchase plans of potential consumers. Survey methods help in obtaining information about the desires, likes and dislikes of consumers through collecting the opinion of experts or by interviewing the consumers. Survey methods are used for short term forecasting. Important survey methods are (a) consumers interview method, (b) collective opinion or sales force opinion methodic) experts opinion method, (d) consumers clinic and (f) end use method. (a) Consumers' interview method (Consumers survey): Under this method, consumers are interviewed directly and asked the quantity they would like to buy. After collecting the data, the total demand for the product is calculated. This is done by adding up all individual demands. Under the consumer interview method, either all consumers or selected few are interviewed. When all the consumers are interviewed, the method is known as complete enumeration method. When only a selected group of consumers are interviewed, it is known as sample survey method

Advantages 1. It is a simple method because it is not based on past record. 2. It suitable for industrial products. 3. The results are likely to be more accurate. 4. This method can be used for forecasting the demand of a new product. Disadvantages 1. It is expensive and time consuming. 2. Consumers may not give their secrets or buying plans. 3. This method is not suitable for long term forecasting. 4. It is not suitable when the number of consumer is large. (b)Collective opinion method: Under this method the salesmen estimate the expected sales in their respective territories on the basis of previous experience. Then demand is estimated after combining the individual forecasts (sales estimates) of the salesmen. This method is also known as sales force opinion method. Advantages This method is simple. 1. It is based on the first hand knowledge of Salesmen. 2. This method is particularly useful for estimating demand of new products. 3. It utilises the specialised knowledge of salesmen who are in close touch with the prevailing market conditions. Disadvantages 1. The forecasts may not be reliable if the salespeople are not trained. 2. It is not suitable for long period estimation. 3. It is not flexible. (c)Experts' opinion method: This method was originally developed at Rand Corporation in 1950 by Olaf Helmer, Dalkey and Gordon. Under this method, demand is estimated on the basis of opinions of experts and distributors other than salesmen and ordinary consumers. This method is also known as Delphi method. Delphi is the ancient Greek temple where people come and prey for information about their future. Advantages 1. Forecast can be made quickly and economically 2. This is a reliable method because estimates are made on the basis of knowledge and experience of sales experts. 3. The firm need not spare its time on preparing estimates of demand. 4. This method is suitable for new products. Disadvantages 1. This method is expensive. 2. This method sometimes lacks reliability Statistical Methods Statistical methods use the past data as a guide for knowing the level of future demand. Statistical methods are generally used for long run forecasting. These methods are used for established products. Statistical methods include: (i) Trend projection method, (ii) Regression and Correlation, (iii) Extrapolation method, (iv) Simultaneous equation method, and (v) Barometric method. (i)Trend projection method: Future sales are based on the past sales, because future is the grand-child of the past and child of the present. Under the trend projection method demand is

estimated on the basis of analysis of past data. This method makes use of time series (data over a period of time). We try to ascertain the trend in the time series. The trend in the time series can be estimated by using any one of the following four methods: (a) Least-square method, (b) Free- hand method, (c) Moving average method and (d) semi-average method. (ii) Regression and Correlation: These methods combine economic theory and statistical technique of estimation. Under these methods the relationship between the sales (dependent variable) and other variables (independent variables such as price of related goods, income, advertisement etc.) is ascertained. Such relationship established on the basis of past data may be used to analyse the future trend. The regression and correlation analysis is also called the econometric model building. (iii) Extrapolation: Under this statistical method, the future demand can be extrapolated by applying Binomial expansion method. This method is used on the assumption that the rate of charge in demand in the past has been uniform. (iv) Simultaneous equation method.-This involves the development of a complete econometric model which can explain the behaviour of all the variables which the company can control. This method is not very popular. (v) Barometric technique: This is an improvement over the trend projection method. According to this technique the events of the present can be used to predict the directions of change m the future. Here certain economic and statistical indicators from the selected time series are used to predict variables. Personal income, non-agricultural placements, gross national income, prices of industrial materials, wholesale commodity prices, industrial production, bank deposits etc. are some of the most commonly used indicators. Advantages of Statistical Methods 1The method of estimation is scientific 2Estimation is based on the theoretical relationship between sales (dependent variable) and price, advertising, income etc. (independent variables) 3These are less expensive. 4Results are relatively more reliable. Disadvantages of Statistical Methods 1These methods involve complicated calculations. 2These do not rely much on personal skill and experience. 3These methods require considerable technical skill and experience in order to be effective.

UNIT-3Meaning of Production Production is the conversion of input into output. The factors of production and all other things which the producer buys to carry out production are called input. The goods and services produced are known as output. Thus production is the activity that creates or adds utility and value. In the words of Fraser, "If consuming means extracting utility from matter, producing means creating utility into matter". According to Edwood Buffa, Production is a process by which goods and services are created" Basic Concepts in Production Theory The firm is an organisation that combines and organises labour, capital and land or raw materials for the purpose of producing goods and services for sale. The aim of the firm is to maximise total profits or achieve some other related aim, such as maximising sales or growth. The basic production decision facing the firm is how much of the commodity or services to produce and how much labour, capital and other resources or inputs to use to produce that output most efficiently. To answer these questions, the firm requires engineering or technological data on production possibilities (the so called production function) as well as economic data on input and output prices. Production refers to the transformation of inputs or resources into outputs of goods and services. For example: IBM hires workers to use machinery, parts and raw materials in factories to produce personal computers. The output of a firm can either be a final commodity (such as personal computer) or an intermediate product such as semiconductors (which are used in the production of computers and other goods). The output can also be a service rather than a good. Examples of services are education, medicine, banking, communication, transportation and many others. To be noted is, that production refers to all of the activities involved in the production of goods and services, from borrowing to set up or expand production facilities, to hiring workers, purchasing ra"w materials, running quality control, cost accounting and so on, rather than referring merely to the physical transformation of inputs into outputs of goods and services. Factors of Production As already stated, production is a process of transformation of factors of production (input) into goods and services (output). The factors of production may be defined as resources which help the firms to produce goods or services. In other words, the resources required to produce a given product are called factors of production. Production is done by combining the various factors of production. Land, labour, capital and organisation (or entrepreneurship) are the factors of production (according to Marshall). We can use the word CELL to help us remember the four factors of production: C. capital; Entrepreneurship; L land: and L labour. Characteristics of Factors of Production 1.The ownership of the factors of production is vested in the households. 2.There is a basic distinction between factors of production and factor services. It is these factor services, which are combined in the process of production. 3.The different units of a factor of production are not homogeneous. For example, different plots of land have different level of fertility. Similarly labourers differ in efficiency. 4.Factors of production are complementary. This means their co-operation or combination is necessary for production. 5.There is some degree of substitutability between factors of production. For

example, labour can be substituted for capital to a certain extent. Production Function Production is the process by which inputs are transformed in to outputs. Thus there is relation between input and output. The functional relationship between input and output is known as production function. The production function states the maximum quantity of output which can be produced from any selected combination of inputs. In other words, it states the minimum quantities of input that are necessary to produce a given quantity of output. The production function is largely determined by the level of technology. The production function varies with the changes in technology. Whenever technology improves, a new production function comes into existence. Therefore, in the modern times the output depends not only on traditional factors of production but also on the level of technology. The production function can be expressed in an equation in which the output is the dependent variable and inputs are the independent variables. The equation is expressed as follows: Q= f (L, K, Tn) Where, Q = output L = labour K = capital T = level of technology n = other inputs employed in production. There are two types of production function - short run production function and long run production function. In the short run production function the quantity of only one input varies while all other inputs remain constant. In the long run production function all inputs are variable. Law of Variable Proportion The law of variable proportion is the modern approach to the 'Law of Diminishing Returns (or The Laws of Returns). This law was first explained by Sir. Edward West (French economist). Adam Smith, Ricardo and Malthus (Classical economists) associated this law with agriculture. This law was the foundation of Recardian Theory of Rent and Malthusian theory of population. The law of variable proportion shows the production function with one input factor variable while keeping the other input factors constant. The law of variable proportion states that, if one factor is used more and more (variable), keeping the other factors constant, the total output will increase at an increasing rate in the beginning and then at a diminishing rate and eventually decreases absolutely. According to K. E. Boulding, "As we increase the quantity of any one input which is combined with a fixed quantity of the other inputs, the marginal physical productivity of the variable input must eventually decline". Assumptions of the Law The law of variable proportion is valid when the following conditions are fulfilled: 1.The technology remains constant. If there is an improvement in the technology, due to inventions, the average and marginal product will increase instead of decreasing. 2.Only one input factor is variable and other factor are kept constant. 3.All the units of the variable factors are identical. They are of the same size and quality. 4.A particular product can be produced under varying proportions of the input combinations. 5.The law operates in the short run.

Importance of the Law of Variable Proportion The law of variable proportion is one of the most fundamental laws of Economics. The law of variable proportion is applicable not only to agriculture but also to other constructive industries like mining, fishing etc. It is applied to secondary or tertiary sectors too. This law helps the management in the process of decision making. LAWS OF RETURNS TO SCALE The law of variable proportion analyses the behaviour of output when one input factor is variable and the other factors are held constant. Thus it is a short run analysis. But in the long run all factors are variable. When all factors are changed in same proportion, the behaviour of output is analysed with laws of returns to scale. Thus law of returns to scale is a long run analysis. In the long period, output can be increased by varying all the input Factors this law is concerned, not with the proportions between the factors of production, but with the scale of production. The scale of production of the firm is determined by those input factors which cannot be changed in the short period. The term return to scale means the changes in output as all factors change in the same proportion. The law of returns to scale seeks to analyse the effects of scale on the level of output. If the firm increases the units of both factors labour and capital, its scale of production increases. The return to scale may be increasing, constant or diminishing. We shall now examine these three kinds of returns to scale. Increasing Returns to Scale When inputs are increased in a given proportion and output increases in a greater proportion, the returns to scale are said to be increasing. In other words, proportionate increase in all factors of production results in a more than proportionate increase in output It is a case of increasing returns to scale. For example, if the inputs are increased by 40% and output increased by 50%, return to scale are increasing (= >1). It is the first stage of production. If the industry is enjoying increasing returns, then its marginal product increases. As the output expands, marginal costs come down. The price of the product also comes down. Constant Return to Scale When inputs are increased in a given proportion and output increases in the same proportion, constant return to scale is said to prevail. For example, if inputs are increased by 40% and output also increases by 40%, the return to scale are said to be constant ( = 1). This may be called homogeneous production function of the first degree. In case of constant returns to scale the average output remains constant. Constant returns to scale operate when the economies of the large scale production balance with the diseconomies. Decreasing Returns to Sale Decreasing returns to scale is otherwise known as the law of diminishing returns. This is an important law of production. If the firm continues to expand beyond the stage of constant returns, the stage of diminishing returns to scale will start operate. A proportionate increase in all inputs results in less than proportionate increase in output, the returns to scale is said to be decreasing. For example, if inputs are increased by 40%, but output increases by only 30%, ( = < 1), it is a case of decreasing return to scale. Decreasing return to scale implies increasing costs to scale. Production Function with Two Variable Inputs So far we have assumed that the firm is increasing output either by using more of one input (in

laws of return) or more of all inputs (in laws of returns to scale). Let us now consider the case when the firm is expanding production by using more of two inputs (varying) that are substitutes for each other. A production function with two variable inputs can be represented by isoquants. Isoquant is a combination of two terms, namely, iso and quant. Iso means equal. Quant means quantity. Thus isoquant means equal quantity or equal product. Isoquants are the curves which represent the different combination of inputs producing a particular quantity of output. Any point on the isoquant represents or yields the same level of output. Thus isoquant shows all possible combinations of the two inputs (say labour and capital) capable of producing equal or a given level of output. Isoquants are also known as iso product curves or equal product curves or production indifferent curves. An isoquant may be explained with the following example: Equal Product Combinations Combination A B C D Units of labour 20 15 11 8 Units of Capital TotalOutput 1 1000 2 3 4 1000 1000 1000

E 6 5 1000 In the above schedule, there are five possible combinations. All the five combinations yield the same level of output i.e. 1000 units. 20 units of labour and 1 unit of capital produce 1000 units. 15 units of labour and 2 units of capital also produce 1000 units and so on. All combination are equally likely because all of them produce the same level of output i.e. 1000 units. Now if plot these combination of labour and capital, we shall get a curve. This curve is known as an isoquant. In the below diagram units of capital are measured on horizontal axis and units of labour on vertical axis. The five combinations are known as A, B, C, D and E. After joining these points, we get the iso product curve IQ. Here we assume that the level of technology remains constant. We also assume that the input can be substituted for each other. If quantity of labour is reduced, the quantity of capital must be increased to produce the same output. Thus an isoquant shows various combinations of the two inputs in the existing state of technology which produce the same level of output.

UNIT-4 Concept of Economic Costs:We have discussed the important types of cost which a firm has to face. The cost of production from the point of view of an individual firm is split up into the following parts.

(1) Explicit Cost:Explicit cost is also called money cost or accounting cost. Explicit cost represents all such expenditure which are incurred by an entrepreneur to pay for the hired services of factors of production and in buying goods and services directly. In other words, we can say that they are the expenses which the business manager must take into account of because they must actually be paid by the firm.

Example:The explicit cost includes wages and salary payments, expenses on the purchase of raw material, light, fuel, advertisements, transportation, taxes and depreciation charges.

(2) Implicit Cost:The implicit costs are the imputed value of the entrepreneur's own resources and services. Implicit costs can be defined as: "Expenses that an entrepreneur does not have to pay out of his own pocket but are costs to the firm because they represent an opportunity cost".

Example:For instance, if a person is working as a manager in his own firm or has invested his own capital or has built the factory at his own land, the reward of all these factors of production at least equal to their transfer prices is, included in the expenses of a business. Implicit costs, thus, are the alternative costs of the self-owned and self-employed resources of a firm. The total costs of a business enterprise is the sum total of explicit and implicit costs. If the implicit costs are not included in the firm's total cost, the cost of the firm will be understated and it will result in serious error.

(3) Real Cost:Real costs are the pains and inconveniences experienced by labor to produce a commodity. These costs are not taken in the costing of a commodity by the firm. Real cost has been defined differently by different economists. Classical economists understood by real costs the pains and sacrifices of labor. Alfred Marshall calls real cost as social cost and describes it: "Real costs of efforts of various qualities and real costs of waiting". The Austrian School of Economists have criticized the meaning given to real cost by the classical economists and new classical economists. They say that to give a subjective value to cost is a hopeless task as when real cost is expressed in terms of sacrifices or pains, it is not amenable to precise measurement and thus it fails to explain the phenomenon of prices.

(4) Opportunity Cost:The concept of opportunity cost has a very important place in economic analysis. It is defined as: "The value of a resource in its next best use. It is the amount of income or yield that could have been earned by investing in the next best alternative".

Example:The opportunity cost of a good can be given a money value. For instance, a labor is working in a factory and is getting $2000 P.M. The entrepreneur is paying him this amount because he can earn this amount in the next best alternative employment. If he pays less than this amount, he will move to next best alternative occupation, where he can get $2000 P.M. So in order to obtain a productive service say labor in the present occupation, the cost should be equal to the amount which he can get in some alternative occupation. Similarly, a piece of land or capital must be paid as much as they could earn in their next best alternative use. The total alternative earnings of the various factors employed in the production of a good constitute the opportunity cost of a good. In a money economy, opportunity or transfer cost is defined as the amount of money which a firm must make to resource suppliers m order to attract these resources away from alternative lines of production. In the words of Lipsay: "The opportunity cost of using any factor is what is currently foregone by using it"

Concept of Cost of Production: Definition and Meaning:By "Cost of Production" is meant the total sum of money required for the production of a specific quantity of output. In the word of Gulhrie and Wallace: "In Economics, cost of production has a special meaning. It is all of the payments or expenditures necessary to obtain the factors of production of land, labor, capital and management required to produce a commodity. It represents money costs which we want to incur in order to acquire the factors of production". In the words of Campbell: "Production costs are those which must be received by resource owners in order to assume that they will continue to supply them in a particular time of production".

Elements of Cost of Production:The following elements are included in the cost of production: (a) Purchase of raw machinery, (b) Installation of plant and machinery, (c) Wages of labor, (d) Rent of Building, (e) Interest on capital, (f) Wear and tear of the machinery and building, (g) Advertisement expenses, (h) Insurance charges, (i) Payment of taxes, (j) In the cost of production, the imputed value of the factor of production owned by the firm itself is also added, (k) The normal profit of the entrepreneur is also included In the cost of production.

Normal Profit:By normal profit of the entrepreneur is meant in economics the sum of money which is necessary to keep an entrepreneur employed in a business. This remuneration should be equal to the amount which he can earn in some other alternative occupation. If this alternative return is not met, he will leave the enterprise and join alternative line of production.

Types/Classifications of Cost of Production:Prof, Mead in his book, "Economic Analysis and Policy" has classified these costs into three main sections:

(1) Production Costs:It includes material costs, rent cost, wage cost, interest cost and normal profit of the entrepreneur.

(2) Selling Costs:It includes transportation, marketing and selling costs.

(3) Sundry Costs:It includes other costs such as insurance charges, payment of taxes and rate, etc., etc.

Analysis of Short Run Cost of Production: Definition of Short Run:Short run is a period of time over which at least one factor must remain fixed. For most of the firms, the fixed resource or factors which cannot be increased to meet the rising demand of the good is capital i.e., plant and machinery. Short run, then, is a period of time over which output can be changed by adjusting the quantities of resources such as labor, raw material, fuel but the size or scale of the firm remains fixed.

Definition of Long Run:In the long run there is no fixed resource. All the factors of production are variable. The length of the long run differs from industry to industry depending upon the nature of production. For example, a balloon making firm can change the size of firm more quickly than a car manufacturing firm.

Categories/Types of Costs in the Short Run:The total cost of a firm in the short run is divided into two categories (1) Fixed cost and (2) Variable cost. The two types of economic costs are now discussed in brief.

(1) Total Fixed Cost (TFC):Total fixed cost occur only in the short run. Total Fixed cost as the name implies is the cost of the firm's fixed resources, Fixed cost remains the same in the short run regardless of how many units of output are produced. We can say that fixed cost of a firm is that part of total cost which does not vary with changes in output per period of time. Fixed cost is to be incurred even if the output of the firm is zero. For example, the firm's resources which remain fixed in the short run are building, machinery and even staff employed on contract for work over a particular period.

(2) Total Variable Cost (TVC):Total variable cost as the name signifies is the cost of variable resources of a firm that are used along with the firm's existing fixed resources. Total variable cost is linked with the level of output. When output is zero, variable cost is zero. When output increases, variable cost also increases and it decreases with the decrease in output. So any resource which can be varied to increase or decrease with the rate of output is variable cost of the firm. For example, wages paid to the labor engaged in production, prices of raw material which a firm. incurs on the production of output are variable costs. A firm can reduce its variable cost by lowering output but it cannot decrease its fixed cost. These expenses remain fixed in the short run. In the long run there are no fixed resources. All resources are variable. Therefore, a firm has no fixed cost in the long run. All long run costs are variable costs.

(3) Total Cost (TC):Total cost is the sum of fixed cost and variable cost incurred at each level of output. Total cost of production of a firm equals its fixed cost plus its: Formula: TC = TFC + TVC Where: TC = Total cost. TFC = Total fixed cost. TVC = Total variable cost.

Explanation:Short run costs of a firm is now explained with the help of a schedule and diagrams.

Schedule:(in Dollars) Total Fixed Units of Output (in Hundred) Cost 0 1 2 3 4 5 6 1000 1000 1000 1000 1000 1000 1000 Total Variable Cost 0 60 100 150 200 400 700 Total Cost 1000 1060 1100 1150 1200 1400 1700

7 1000 1100 2100 The short run cost data of the firm shows that total fixed cost TFC (column 2) remains constant at $1000/regardless of the level of output. The column 3 indicates variable cost which is associated with the level of output. Total variable cost is zero when production is zero. Total variable cost increases with the increase in output. The variable does not increase by the same amount for each increase in output. Initially the variable cost increases by a rd smaller amount up to 3 unit of output and after which it increases by larger amounts.

Column (4) indicates total cost which is the sum of TFC + TVC. The total cost increases for each level of th output. The rise in total cost is more sharp after the 4 level of output. The concepts of costs, i.e., (1) total fixed cost (2) total variable cost and (3) total cost can be illustrated graphically.

(i) Total Fixed Cost Curve/Diagram:

In this diagram (13.1) the total fixed cost of a firm is assumed to be $1000 at various levels of output. It remains the same even if the firm's output is zero.

(ii) Total Variable Cost Curve/Diagram:

In the figure (13.2), the total variable cost curve (TVC) increases with the higher level of output. It starts from the origin. Then increases at a diminishing rate up to the 4th units of output. It then begins to rise at an increasing rate.

Total Cost Curve Curve/Diagram:

In the figure (13.3), total cost curve which is the sum of the total fixed cost and variable cost at various levels of output has nearly the same shape. The difference between the two is by only a fixed amount of $1,000. The total variable cost curve and the total cost curve begin to rise more rapidly as production is increased. The reason for this is that after a certain output, the business has passed its most efficient use of its fixed costs machinery, building etc., and its diminishing return begins to set in.

Analytical Importance of Fixed and Variable Costs:In the time of distinction between fixed cost and variable cost is a matter of degree, it all depends upon the contracts of a firm and .the period of time under consideration. For example, if a firm makes contract with the labor for a certain period, then the firm has to bear the cost of the labo