RAPID REVISION
BUSINESS ECONOMICS
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Production Function
Production Function is the functional/technical/engineering relationship between physical inputs
(factors of production), and physical outputs (quantity of goods/services produced).
Features: Substitutability, Complementarity, Specificity or Specialisation
Assumptions: related to a particular unit of time, factors of production are divisible, technical
knowledge remains constant, producer is using the best technique available.
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Short-run and Long-run Production Function
Basis of Difference Short run Production Function Long run production function
Meaning One factor is variable, while others are All factots are variable.
fixed.
Factor ratio Capital-labour ratio changes with change in Does not change
output
Also known as Variable proportion type of production Fixed proportion type of production function
function
Entry and exit of there are barriers for firms to enter and to Firms can easily enter and exit
firms shut down but cant exit
Scale of No change Changes with the change in output
Production
Law operates Law of variable proportion Law of returns to scale
Expression Qx = f(L, K¯) Qx = f(L, K)
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Forms of Production Function
Linear When output are increased in the same proportion with the increase in all
Homogeneous inputs. The degree of production function is equal to one.
Production Function
Cobb Douglas Production Function
▪ Given by Paul H. Douglas and C.W. Cobb.
▪ It is a linear homogeneous production function of degree one or unit elasticity of substitution.
▪ It takes into account two inputs (labor and capital)
▪ and these inputs can be used as a substitute of each other, but to a limited extent only.
Q = ALa Cβ
Labour contributed about 3/4th and Capital about1/4 th
a+β >1 Increasing returns to scale. in the Manufacturing Production
a+ β =1 Constant returns to scale.
a+β <1 Decreasing returns to scale.
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Cobb Douglas Production Function
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Forms of Production Function
Constant Elasticity Any change in the input factors, results in the constant change in the
of Substitution output. elasticity of substitution is constant and may not necessarily be
Production Function equal to one or unit. Also known as Homohighplagic production function.
It is Fixed Proportion Production Function. In this ixed quantity of inputs is
Leontief Production
used to produce the fixed quantity of output. All the factors of production are
Function
fixed and cannot be substituted for one another.
Variable Production
required quantity of output can be achieved through the combination of
Function different quantities of factors of production (substituting other factor/
factors in its place).
➢ Total Production: TP is the total output resulting from the efforts of all the factors of production.
TP = ∑MP
➢ Average product or average physical product (APP): TP/Units of variable input (labor)
➢ Marginal Production (MP): addition or the increment to the total product when one more unit of the
variable input is employed. MP= ∆TP/∆ N
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Law of Returns to scale
In the long run, all factor inputs in the production function can be changed.
It explain the relationship between output and the scale of inputs in the long-run when all the
inputs are increased in the same proportion.
▪ Increasing Return to Scale - If the output of a firm increases more than in proportionate to an
increase in all inputs.
▪ Constant Return to Scale when all inputs are increased by a certain percentage the output
increases by the same percentage. Also called 'Linear Homogeneous Production Function’.
▪ Diminishing Returns to scale: When output increases in a smaller proportion than the increase
in inputs
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Law of Variable Proportion
▪ This Law operates only in the short—run
▪ The law of variable proportion states that as the quantity of one
factor is increased, keeping the other factors fixed, the marginal
product of that factor will eventually decline.
▪ This Law is also called— Law of return to factor, Law of
Proportionality, Law of Diminishing Returns, Law of Diminishing
Marginal Physical Productivity.
▪ Assumptions- state of technology will be constant, one factor is
variable and other are fixed , Homogeneous factor units, Only
physical input and output are considered.
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Law of Variable Proportion
1. Increasing returns
• TP increases at an increasing
rate, MP and AP also rises
• Stage ends when AP reaches
highest point
2. Diminishing returns
• TP increases at diminishing
rate,
• Both AP and MP diminishes
• Stage ends when TP reaches
maximum and MP=0
• Producer prefers to operate at
this stage.
1. When AP rises then MP also rises but MP>AP.
3. Negative returns 2. When AP is maximum then MP =AP or say MP
• TP declines curve cuts the AP curve at its maximum point
• AP also declines 3. When AP falls then MP also falls but MP<AP.
• MP becomes negative 4. There may be a situation when MP decreases
and AP increases but opposite never happened.
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Economies and Diseconomies of Scale
Economies of Scale - cost advantage experienced by a firm when it increases its level of output. The
greater the quantity of output produced, the lower the per-unit fixed cost, also result in a fall in
average variable costs.
Economies of scale occur within a firm (internal economies of scale) or within an industry (external
economies of scale).
Sources of Internal Economies– Managerial economies, financial economies, risk bearing, better
utilization of inputs, economies of inventory, risk economies. Sources of external economies- Better
transportation & Marketing Facilities, Economies of Information, Development of Skilled Labor,
Economies of Localization, Cheaper Inputs Growth of Ancillary Industries
Diseconomies of Scale - occur when organization grows excessively large and average costs of the
organization increases.
Sources of Internal diseconomies- Technical diseconomies, organization diseconomies, purchasing
diseconomies, monopoly diseconomies, financial diseconomies.
Sources of external diseconomies- diseconomies of pollution, limited natural resources, High Factor
Prices, Scarcity of Inputs, Strains on Infrastructure
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Isoquant or Iso Product Curve
▪ It shows various combinations of two factors that yielding the same level of output.
▪ Also known as Equal- product, Iso-product and Production Indifference curves.
▪ Like, indifference curves, Iso- quant curves also slope downward from left to right. It is
indicated by Marginal Rate Of Technical Substitution (MRTS).
▪ MRTS refers to the rate at which one input factor is substituted with the other to attain a
given level of output.
▪ Iso-quant map shows the family of Iso-quant curves.
▪ Assumptions- only two factors of production, two factors can substitute each other up to certain
limit., Labor and capital are divisible, technology is given and unchanged, producer is rational
Isoquant Schedule Isoquant Curve Isoquant Map
Output of
Units of Units of Cloth
Combi Capital Labor (meters MRTS
nations (K) (L) )
A 9 5 100 --
B 6 10 100 3:5
C 4 15 100 2:5
D 3 20 100 1:5
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Properties of Iso-Product Curves
▪ Isoquants are convex to origin, due to diminishing trend of MRTS.
▪ Isoquants are negatively sloped, i.e. downwards from left to right.
▪ Isoquant do not touch either of the axis
▪ Higher Isoquant represents higher level of output.
▪ Isoquants are non—intersecting and need not be parallel.
Exceptions or Types of Iso Quant Curve
When factors have perfect substitutability than MRTSLK = Linear Iso-quant
Constant = 1 and slope has an angle of 45º with each axis. Curve
When factors are perfect complementary to each other Right Angle Iso-
isoquant is a right angled curve. Also known as also quant Curve
known as Leontief Iso- quant.
When there is a limited substitutability between the
factors of production than iso-quant curve is kinked Kinked iso-quant
shaped. also known as Activity Analysis Programming Iso- Curve
quant Or Linear Programming Iso-quant.
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Iso-Cost or Iso Cost line
▪ Iso-cost lines graphically represents all the combinations of the inputs which the firm can achieve
with a given budget. It represents price of the factors.
▪ The slope of the isocost line is the ratio of the input prices of labor and capital
▪ Higher isocost lines represent higher outlays
An iso-cost line may shift due to two reasons. They are
1.Change in total outlay to be made by the firm – Parallel Shift
2.Change in price of a factor-input – Swings or Rotates
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Product Optimization - Iso-costs and Iso-quants
▪ Iso-costs and Iso-quants can together help us to determine the optimum production for a firm.
▪ Production optimization can be achieved in two ways : maximize the production for a given
outlay(cost constraint) or minimize the cost of producing a given level of output(output
constraint).
▪ Producer will try to produce a given level of output with least-cost combination of factors.
▪ Least cost combination for a given isoquant is at the point of tangency of the isoquant with
the isocost line.
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Theory of Cost : Short run and Long run Cost Curves
Cost analysis refers to the study of behaviour of cost in relation to one or more production criteria (size
of output, scale of operations, prices of factors of production and other relevant economic variables).
Types of Cost in Short- Run Types of Cost in Long- Run
1. Total fixed cost (TFC) 1. Long run Total cost (LTC)
2. Total Variable Cost (TVC) 2. Long run Average cost (LAC)
3. Total Cost (TC) 3. Long run Marginal cost (LMC)
4. Average fixed cost (AFC)
5. Average Variable Cost (AVC)
6. Average Total Cost (ATC OR AC)
7. Marginal Cost (MC)
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Short Run Cost
❑ Total Fixed Cost - does not change with an increase or decrease in output. Parallel to X-axis. Even
at zero output-fixed cost remain the same in the short run. e.g. rent and insurance
❑ Total Variable Costs - change with changes in level of output. It has inverse ‘s’ shape and start
from origin.- upward slopping. Initially it is fatter and later on steeper. Initially TVC increases at
decreasing rate but after some time it increases at increasing rate (determined by law of variable
proportion) e.g. raw material, power etc.
❑ Total Cost - sum of fixed and variable cost. TC = TFC+TVC
▪ Changes in TC are determined by TVC
▪ TC curve is upward sloping starting from y-axis - inverted ‘s’ shaped
Semi Variable cost - costs which are neither perfectly
variable, nor absolutely fixed in relation to the changes
in the size of output. They are known as semi-variable
costs.
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Short Run Cost curves
❑ Average fixed cost = Per unit FC TFC/Q. The general shape of the AFC curve is downward
sloping (goes on diminishing with the increase in output but it never becomes zero, it does not
touch the X-axis) It is not 'U' shape. This curve is also called Rectangular Hyperbola.
❑ Average variable cost = Per unit VC TVC/Q. The curve will first fall, then reach a minimum and
then rise again. 'U' shape
❑ Average total cost or Average cost = Per unit TC TC/Q or AFC+AVC. The ATC curve first falls,
reaches it’s minimum and then rises. 'U' shape due to law of variable proportions.
❑ Marginal Cost - MC= Change in Total Cost / Change in Qty. produced or MC = Change Total
Variable Cost / Change Qty. produced. U shaped.
❑ Short term average cost also known as Plant Curves
Relationship between AC and MC
• When AC falls, MC < AC.
• When AC is minimum, MC = AC. MC cuts AC from below
• MC increases slightly earlier than AC.
• When AC decreases, MC > AC. MC Curve rises steeply
than AC.
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Short Run Cost curves
❑ Average fixed cost = Per unit FC TFC/Q. The general shape of the AFC curve is downward
sloping (goes on diminishing with the increase in output but it never becomes zero, it does not
touch the X-axis) It is not 'U' shape. This curve is also called Rectangular Hyperbola.
❑ Average variable cost = Per unit VC TVC/Q. The curve will first fall, then reach a minimum and
then rise again. 'U' shape
❑ Average total cost or Average cost = Per unit TC TC/Q or AFC+AVC. The ATC curve first falls,
reaches it’s minimum and then rises. 'U' shape due to law of variable proportions.
❑ Marginal Cost - MC= Change in Total Cost / Change in Qty. produced or MC = Change Total
Variable Cost / Change Qty. produced. U shaped.
❑ Short term average cost also known as Plant Curves
Relationship between AC and MC
• When AC falls, MC < AC.
• When AC is minimum, MC = AC. MC cuts AC from below
• MC increases slightly earlier than AC.
• When AC increases, MC > AC. MC Curve rises steeply
than AC.
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Long Run Cost curves
❑ Long run Total Cost (LTC)-total cost incurred for the production of a given level of output. shape of
the long-run total cost curve is S-shaped, always less than or equal to short run total cost.
❑ Long run Average Cost (LAC) per unit cost incurred by a firm i.e. long run total costs divided by the
level of output. LAC Curve is derived as an envelop / tangent of all SAC Curves. U—Shaped Curve,
due to the operation of Law of Returns to Scale. Also known as envelop and planning curve
❑ Long run Marginal Cost (LMC) added cost of producing an additional unit of a commodity. U shape,
The LMC is derived from the points of tangency between LAC and SAC.
Economies Diseconomies
Economies Diseconomies of scale of scale
of scale of scale
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Revenue Concepts
Revenue is sales receipts or sales proceeds.
Total Revenue - total money received from the sale of all units of the product. TR = P x Q
Average Revenue - average sales receipts AR = TR/Q, always equal to price.
Marginal Revenue - change in TR resulting from the sale of an additional unit of a commodity. MR =
Change in TR/ Change in Qty. sold or MR = TRn – TRn-1/ Qn –Qn-1
Relationship between AR, MR and TR
When price remains constant:
▪ AR=MR,
▪ TR increases but the rate of increase will be constant
When price falls with raise in output:
▪ AR and MR slopes downwards from left to right, and
▪ MR and AR both decline, but MR falls rapidly than AR.
▪ AR Curve is flatter than MR.
▪ MR can be zero and even negative, while AR will never
cross below the X axis.
▪ TR increases when MR is positive
▪ TR is maximum when MR is zero
▪ TR falls when MR is negative
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Revenue and Cost Relationship
▪ A firm should produce at all if TR > TVC (Price i.e. AR > AVC)
▪ If TR = TVC, firm's maximum loss will be equal to its Fixed Cost.
▪ Profitable for the firm to increase output whenever MR > MC and decrease output whenever MR <
MC and the firm should continue production till MR = MC and MC curve should cut to MR from
below (Equilibrium position)
Equilibrium Position – optimum output level Profit/Loss at Equilibrium Point
that the firm should try to operate
If AR > AC – Super normal profits or
Economic Profits or abnormal profits
Equilibrium position does not mean that the If AR = AC – Normal profits. .E.P (Break-
Firm is making profits. The actual position of even-Point) means No Loss No Profit. It is
profits can be known only on the basis of AR called Marginal Firm.
and AC Curves If AR <AC – Firms making losses(economic
losses)
If AR<AVC – Shutdown Point
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MR, AR, TR and Elasticity of Demand
MR, AR, TR and Elasticity of Demand
▪ Marginal Revenue = Average Revenue (E – 1/E)
▪ If E = 1, Then MR = 0
▪ If E > 1, Then MR will be Positive
▪ If E < 1, Then MR will be Negative
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Market structure
Market is a place where Buyers and Sellers meet.
Elements - Buyers and Sellers, Product or Service, Bargaining for a Price, Knowledge about market
conditions, and One Price for a Product or Service at a given time
Types of Market
▪ Perfect Competition: Many Sellers selling identical products to many Buyers.
▪ Monopoly: Single Seller sells a product which has no close substitute for many Buyers.
▪ Monopolistic Competition: Many Sellers offering differentiated products to many Buyers.
▪ Oligopoly: A Few Sellers selling competing products to many Buyers.
▪ Duopoly: Duopoly is a market situation in which there are only two Firms in the market. It is a
sub—set of Oligopoly
▪ Monopsony: Monopsony is a market characterized by a Single Buyer of a product or service. It is
mostly applicable to Factor Markets in which a Single Firm is the only Buyer of a Factor.
▪ Oligopsony: Oligopsony is a market characterized by a small number of large buyers. It is also
mostly relevant to Factor Markets.
▪ Bilateral Monopoly: It is a market structure in which there is only a Single Buyer and a Single
Seller. Thus, it is a combination of Monopoly Market and a Monopsony Market.
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Perfect Competition
▪ Large number of Buyers & Sellers
▪ Homogeneous Goods produced by different firms
▪ Every Firm is free to enter and exit, at any point of time
▪ There is a perfect knowledge, on the part of Buyers and Sellers
▪ There are adequate Transportation facilities for the movement of goods from one center to
another.
▪ Goods are dealt on at a uniform price throughout the market at a given point of time
▪ All Firms individually are Price Takers. They have to accept the price determined by the market
forces of Demand and Supply.
▪ Buyers have no preference as between different Sellers (since product is homogeneous) and Sellers
are indifferent as to whom they sell (since price is uniform)
▪ There is perfect mobility of factors of production.
▪ In Perfect Competition, D = AR = MR = Price.
▪ Demand curve perfectly elastic.
▪ Short Run - Super profits, Normal Profits,
Losses, Shut Down Point (AR<AVC)
▪ Long Run – Normal Profits
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Monopoly
▪ There is only one Seller and many buyers
▪ Since there is only one Seller, and he constitutes the entire Industry.
▪ Monopolist sells a product which has no close substitute. – Cross Elasticity – zero or small
▪ there are strong barriers to entry of new Firms.
▪ Monopoly firm has market power and is itself a price-maker
▪ Price discrimination is present
▪ Price Elasticity of Demand is less than one(inelastic), faces a downward sloping demand curve.
▪ Relationship between AR & MR under Monopoly: a) Both AR and MR are negatively sloped
(downward sloping) curves. b) MR Curve lies half—way between the AR Curve and the Y—axis, i.e. it
cuts the horizontal line between Y axis and AR into two equal parts. c) AR cannot be zero, but MR
can be zero or even negative.
▪ Short Run - Super profits, Normal Profits, Losses, Long Run – Super normal profits
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Monopoly
Why Monopoly exists? Strategic Control over scarce resources, acquiring control over a unique
product , Patents and Copyrights given by Government, Substantial Goodwill enjoyed by a Firm,
Natural Monopoly due to very large economies of scale, Legal and Regulatory Requirements, Very high
initial start—up costs
Kinds of Monopoly: Simple (charges a single price to all the customers),Discriminating (charges
different prices to a different group of customers), Pure/Absolute (single seller with no competitors),
Imperfect ( limited degree of Monopoly), Natural(established due to natural causes) Legal (acquires
Monopoly due to legal provisions), Private (monopoly firm owned and operate by private individuals),
Public/Industrial(monopoly firm owned and operated by public or state government),
Technological(firm enjoys monopoly due to technical superiority)
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Price Discrimination
When the firm charge different prices to different customers for the same commodity.
Objectives - To earn Maximum Profit To Dispose of Surplus stock, To enjoy Economies of Scale, To
capture foreign markets , To secure equity thorough pricing
Degrees of Price Discrimination
▪ First Degree: Producer charges the maximum price that each buyer is willing to pay and he
captures all the consumer surplus. Also known as perfect price discrimination.
▪ Second Degree: involves charging consumers a different price for the amount or quantity
consumed.
▪ Third Degree: monopolist divides the entire market into submarkets and different prices are
charged in each submarket.
Conditions of Price Discrimination
▪ Seller must have control over the supply (monopoly power)
▪ Seller should be able to divide the market into at least two sub-markets (or more) (market
Imperfections)
▪ Price-elasticity of the product must be different in different markets.
▪ Buyers from the low-priced market should not be able to sell the product to buyers from the high-
priced market.(Prevention of resale)
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Monopolistic Competition
▪ Large number of sellers and buyers
▪ Free entry and exit of firms
▪ Each firm produces different brand or variety of the same product. The varieties produced are
very close substitutes of one another.
▪ These types of market sellers try to compete on basis other than price, and it is called non-price
competition.
▪ High selling cost
▪ Every firm is price maker and price taker of his own product.
▪ Factors of production are completely not mobile.
▪ Demand curve faced by a firm is negatively slope
▪ AR and MR: Both downward sloping, AR will be greater than MR but both AR and MR will be more
elastic than monopoly market.
▪ Short Run - Super profits, Normal
Profits, Losses
▪ Long Run – Normal Profits
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Oligopoly
▪ Few producers of a product
▪ selling homogeneous or differentiated but close substitutes products – High Cross Elasticity
▪ Importance of advertising and selling costs
▪ Firms avoid price-wars but are engaged in non-price competition
▪ Kinked demand curve / Indeterminateness of demand curve
▪ Interdependence among firms.
▪ Few Barriers to Entry of Firms
Types of Oligopoly
Open – New firms can enter the market and compete with existing firms, Closed – Entry into the
market is restricted. Collusive – firms cooperate with each other, Competitive – invariable compete
with each other. Partial - one large firm dominates the industry. Full –no price leadership in the
market. Syndicated –When only a very small group or an individual firm controls the sale of products.
Organized – When all the firms work together to fix output, sale, prices, etc
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Kinked Demand Curve
▪ Developed by Paul M. Sweezy in 1939
▪ Dual demand curve based on the likely reactions of other firms.
▪ This model of oligopoly suggests that prices are rigid/stable and that firms will face different effects
for both increasing price or decreasing price.
▪ The kink in the demand curve occurs because rival firms will behave differently to price cuts
and price increases.
▪ If a firm raises prices, others wont follow then firm loses, so demand is very responsive or elastic If
a firm lowers prices, other firms followfirm doesn’t gain much business. demand is fairly
unresponsive or inelastic
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Price Leadership under Oligopoly
Price leadership is situation in which a market leader sets the price of a product or services and
competitors feel compelled to match that price.
Barometric Price Leadership Price is set by a large, old and experienced firm and thus
considered as a leader of all followers
Low Price Leadership One firm with low level of cost of production sets the price and
other high-cost firms follow it.
Dominant Price Leadership One firm dominant the entire industry by producing a
substantially large proportion of product of the entire market
Aggressive Price Leadership One well established and large firm plays the role of a leader by
following aggressive price policies and forces the other firms of
the industry to follow his decisions on price.
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Pricing Strategies
Price Skimming : Pricing strategy in which a firm charges a high initial price and then gradually
lowers the price to attract more price-sensitive customers. used by a first mover who faces little to no
competition.
Penetration Pricing: setting an initially low price, used to quickly gain market share, used by new
entrants into a market. Also called predatory pricing.
Peak Load Pricing: Charging a high price during demand peaks, and a lower price during off-peak
time periods, used in the case of non-storable goods, marginal cost is also high during the peak
periods
Dynamic Pricing : businesses set flexible prices for products or services based on current market
demands.
Transfer Pricing: price charged for the goods and services supplied by one division to the other
division of the same company. Every division of the enterprise tries to maximize their function of
profitability MC=MR is justified.
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