Post Graduate Diploma in Business Administration

Semester I

Managerial Economics (Micro)

Chapter I Basics of Economics

Aim
The aim of this chapter is to: define the basic concepts of economics illustrate the definition of scarce resources in terms of individual and nation differentiate between Macroeconomics and Microeconomics

Objectives
The objectives of the chapter are to: introduce the concept of scarce resources in terms of individuals and nation define concepts such as PPF (Production Possibility Frontier) and Opportunity Cost categorise economies like Market Economy and Command Economy

Learning outcome
At the end of this chapter, the students will be able to: understand the application of economics in real life scenario recognize the advantages of Command Economy define Market Economy

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Managerial Economics (Micro)

1.1 Introduction to Economics

The motive behind studying economics could be anything like, to make money, understand and be adept at the concepts of economics for in-general usage, or may be due to curiosity to know how technological revolutions and economic reforms give a new direction to our society. Economics may appear as study of complicated tables, charts, statistics and numbers, but more specifically, it is the study of optimum utilization of scarce resources and constitutes the rational human behavior in the attempt to fulfill needs and wants. With limited resources at hand, a common man, on a daily basis, has to make certain choices in tune with his budget to fulfill wants and needs. Economists are interested in the choices that person makes, and inquire into why, for instance, one might choose to spend ones money on a new DVD player instead of replacing the old TV. Economics, also called Dismal Science, is an in-depth study of certain aspects of society.

1.2 Basics of Economics

Scarcity is the concept between our limited resource and unlimited want and it is different for both individual and for country. Scarce resource for an individual is money, time and skill and for a country it is capital, labor force and technology. All the resources are limited in comparison to all our wants and needs. So individuals and nation must take the decision on what goods and services they can afford. For example, if one chooses to buy an Air Conditioner, as opposed to four air coolers, that means one is in favor of high quality of technology rather than going for large quantity of cheap air coolers. Each individual and nation will have different set of values and due to different level of scarce resources; their decision on utilization of those resources is also different. Furthermore, because of scarcity, people and an economy must decide on how to allocate resources. In other words, we can say that Economics is a study that deals with the decision and allocation of the resources.

1.3 Macroeconomics and Microeconomics

There are two main categories of Economics: Macroeconomics: It is concerned with total output of a nation and the way that nation allocates its limited resources of land, labor and capital in an efficient way. Microeconomics: It is more specific in its approach and is concerned with individuals and firms within the economy. By analyzing human tendency and behaviour, microeconomics shows how individuals respond to changes in price when there is change in demand and supply.

1.4 The Two Basic Concepts of Economics

Production Possibility Frontier (PPF) Opportunity Cost

1.4.1 Production Possibility Frontier (PPF) Under the category of macroeconomics, it represents the point at which an economy is producing goods and services more efficiently, therefore allocating resources in the best way possible. One can clearly understand the concept of PPF with the help of following figure.

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Production Possibility Frontier PPF A B Product A: Wine Y

Fig. 1.1 Production Possibility Frontier Imagine one economy that produces only wine and cotton. According to PPF, points A, B and C all appearing on the curve, represents most efficient use of resources by the economy. Point X represents the most inefficient use of resources, while point Y represents the goal that an economy cannot attain with the present levels of resources. From the chart, we can see that if an economy produces more wine, it must give up some resources used for cotton production. If the economy starts producing more cotton (represented by points B and C), it would have to divert from wine production. If the economy moves from point B to C, wine output significantly reduces with small increase in cotton production. Every nation must find out the ways for optimum allocation of resources so that they can achieve the PPF. If the demand for wine is more then the cost of increasing its output is proportional to the cost of decreasing cotton production.

Product B: Cotton

In another scenario If there is change in technology, while the level of land, labor and capital remains same then the time required in production of cotton and wine will decrease. Point X shows the most inefficient way of utilization of resources. When PPF shifts outward, as shown in Fig. 1.2, then we know that there is a growth in economy. When it shifts inwards, it indicates that the economy is shrinking as a result of decline in efficient allocation of resources. Fig. 1.2 Production Possibility Frontier Shifts Outward
Production Possibility Frontier PPF Shifts Outward A B

Product A: Wine

Product B: Cotton

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An economy producing on the PPF curve is more theoretical than practical. In reality, an economy constantly struggles to reach an optimal production capacity. As scarcity compels an economy to give up one choice for another, the slope of the PPF will always be negative. Hence, if the production of A increases then for B it will decrease or vice versa.

1.4.2 Opportunity Cost Opportunity cost is the value of what is given up in order to have something else. It is unique for each individual and determined by his or her needs, wants, time and resources (income). It is an important part of PPF because a country will decide how to best allocate its resources according to its opportunity cost. For example, assume that an individual has a choice between two telephone services. If he or she were to buy the most expensive service, that individual may have to reduce the number of times he or she goes to the movies each month. Giving up these opportunities to go to the movies may be a cost that is too high for this person, leading him or her to choose the less expensive service. Opportunity cost is different for each individual and nation. Thus, what is valued more than something else will vary among people and countries when decisions are made about how to allocate resources.

1.5 Market Economy

Market Economy is a type of economic system in which the trading and exchange of goods and services and information takes place in a free market, and hence it is also called as free market economy. Free market is based on law of supply and demand and prices of goods and services. Producers decide which goods are to be produced in what quantity, depending on consumer demand. For example, for years 2004-07, there was a huge rush in IT sector because of demand for IT professionals. There was phenomenal growth in various IT sector with many IT education firms flourishing to cater the needs. This shows how the demand factor influenced the economy. In the year 2009, there was a sharp decline in growth of various industries, which resulted in recession in all sectors. Eventually, the demand for IT professional also declined. For this reason, market economy is also called as Demand Driven Economy.

1.6 Command Economy

An economy which is controlled by the government is called Command Economy. Here, the decisions what, when, how and from whom to produce etc. are taken by the centralized authority. Some of the advantages of command economy are: In a command economy, government can utilize land, labor and capital to fulfill its economic and political agendas. So the private players are reluctant to invest in command economy. For example, cholera is a widespread common disease in continents like Africa and Asia. Some of the worlds major pharmaceutical industries like Pfizer and Novartis are not ready to invest in research of Cholera, because people of Africa and Asia are not in a position to pay full price of drugs. In a command economy, the state can take the initiative for R&D for the treatment.

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Summary
This chapter covered the basics of economics like PPF (Production Possibility Frontier) and Opportunity Cost. In reality, an economy constantly struggles to reach an optimal production capacity. As scarcity compels an economy to give up one choice for another, the slope of the PPF will always be negative. It also covered the scarce resource and its utilization in terms of individual and nation. Scarce resource for an individual is money, time and skill and for a country it is capital, labor force and technology. It discussed the concept of Macroeconomics and Microeconomics and the difference between them. Macroeconomics is concerned with total output of a nation and the way that nation allocates its limited resources of land, labor and capital in an efficient way. Microeconomics is more specific in its approach and is concerned with individuals and firms within the economy. By analyzing human tendency and behaviour, microeconomics shows how individuals respond to changes in price when there is change in demand and supply. Lastly, it covered the meaning and concept of Market Economy and Command Economy. Market Economy is a type of economic system in which the trading and exchange of goods and services and information takes place in a free market, and hence it is also called free market economy. An economy which is controlled by the government is called Command Economy. Here, the decisions on what, when, how and from whom to produce etc. are taken by the centralized authority.

References
Rittenberg, L., Tregarthen, T., 2008. Principles of Microeconomics, Available at: < www.flatworldknowledge. com/node/28303#web-28303>. [Accessed 28 October 2010]. Samuelson, P. A. , 2002. Economics, Massachusetts Institute of Technology. Tata McGraw-Hill Publishing Co. Ltd.

Recommended Reading
Ben Bernanke, 2009. Principles of Microeconomics, Marginal Decision Rule, Tata McGraw Hill Publication. Dr. D.M Mithani, 2008. International Economics, Institute of Business Study and Research, Himalaya Publishing House Pvt. Ltd. N. Gregory Mankiv, Economic: Principles and Applications, Cengage Learning Products, Canada, Nelson Education Pvt. Ltd.

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Managerial Economics (Micro)

Chapter II Demand Supply Analysis

Aim
The aim of this chapter is to: explain the concept and change in Demand and Supply on equilibrium price and quantity elucidate the Price Elasticity of Demand and Price Elasticity of Supply highlight the impact of tax on price and quantity of goods

Objectives
The objectives of this chapter are to: define the concept of Demand and supply explain the law of demand and the law of supply illustrate the demand and supply curves and their impact on Economy enlist various factors affecting Demand and Supply explain the role of the government in setting price explain the impact of tax on price and quantity of goods by taking various types of Demand and Supply concept

Learning outcome
At the end of this chapter, the students will be able to: understand the application of economics in real life scenario the concepts of surpluses and shortages and the pressure on price they generate understand the concepts of Price Elasticity Demand and Price Elasticity Supply

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2.1 Introduction
In a market economy, individual consumers make plans of consumption and individual firms make plans of production, based on changes in market prices. Economists use the term invisible hand to describe the frequent exchanges in the market because everyone (no matter consumer or producer) takes the market price as a signal on trade and makes exchanges with private property rights. The price system works in market economy only if there is a free choice within the market. The following explains how the market price is determined by the interaction of producer (supply) and consumer (demand). In economics, demand consists of some of the major concepts like: Demand is relative to the concept of price. It refers to both, the ability to pay and the willingness to buy, by the consumer. For example, Toyota is planning its production strategy it wants to know the demand for cars in India. After a survey, they found out that there are almost 250 million Indians willing to have a car. But that doesnt mean that the demand for their car is 250 million. People can purchase the car as per their capability and their income. Demand is a flow concept, which means that the change in price will lead to change in demand for goods. Demands are quantitative expressions of preferences and it is useless to speak demand without referring to price and time.

2.2 Demand Schedule and Concept

A demand schedule for cars in India at different prices is shown below. Here, the demand is totally based upon price of the car. Price (Rs) 2,50,000 3,50,000 5,50,000 7,00,000 Demands (Units) 50 40 30 20

Table 2.1 Demand Schedule and Concept

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The following Demand Curve shows the relationship of above mentioned data. Y 700 650 550 450 Demand Curve 350 250 0 20 30 40 50 Quantity Demanded (Units) X

Price (Thousands)

Fig. 2.1 Demand Curve X-axis shows quantity of demand in units and Y-axis shows prices in rupees. Normally, the demand curve is downward-sloping. It means that higher the price level, fewer are the takers for goods and if the price decreases, the quantity of demand increases.

2.2.1 Market Demand Curve The Market Demand Curve is obtained by plotting the graph of sum of the individual demand curve of a particular good in the market, at the same price, within a time period. This technique is also called as Horizontal Summation. Price (per unit) 30 20 15 12 10 Quantity Demanded Market Mary (i.e. Tom + Mary) 1 3 3 7 5 11 7 15 9 19

Tom 2 4 6 8 10

Table 2.2 Market Demand Curve

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Demand Curve for Tom

Demand Curve for Mary

Market Demand Curve

30

30

30

20

20

20

10

10

10

10

10

15

20

Fig. 2.2 Market Demand Curve The slope implies that price and quantity are inversely related. 2.2.2 Law of Demand In economics, the relationship between price and quantity is called as Law of Demand. If price of any goods or services increases then the demand for that will decrease and vice versa. Though, Giffen goods are an exception where Law of Demand doesnt work. A Giffen good is one which people consume more of as price rises. In such situation, cheaper close substitutes are not available. Because of the lack of substitutes, the income effect dominates, leading people to buy more of the good, even as its price rises. Some types of premium goods, for e.g. expensive French wines, BMW cars are sometimes claimed to be Giffen goods. It is said that, decrease in the price of such high status goods can reduce its demand, as they are no longer perceived to be exclusive or of high status.

2.3 Price Elasticity of Demand

It measures the rate of quantity demanded due to price change The formula for PEoD (Price Elasticity of Demand) is PEoD = (% Change in Quantity Demanded)/ (% Change in Price) % Change in Quantity Demand = [QDemand (New) QDemand(Old)] / QDemand(Old) % Change in Price = [Price (New) Price (Old)] / Price (Old) 2.3.1 Types of Demand The given table describes the various types of demand: Types of demand Elastic Demand Inelastic Demand Unit Elastic Demand Perfectly Elastic Demand Perfectly Inelastic Demand Description Here the price elasticity of demand is more than 1 Here the change in demand is less in comparison to change in price that means price elasticity of demand is less than 1 Here change in demand and price, both are equal Here the value for price elasticity of demand is infinity Here demand doesnt change with change in time Table 2.3 Types of Demand

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2.4 Factors Affecting Demand

Factors which affect demand of goods are mentioned below: Description with Examples Consumers switch towards the substitute product when there is a price reduction in the regular product they use. For example, previously there was a difference in price and usage of mobile phone Price of substitute product and landline. The main objective behind phone is communication but mobile phone is also useful for other multipurpose activities. So, the demand for landline phone came down in comparison to mobile phone. This is one of the most important aspects which affect the demand for goods in market. Income of consumer Increase in income of a consumer lead to increase in demand for normal goods. It refers to the subjective choice of a consumer. The demand of a product may be Preference of consumer affected by knowledge, friends, education and culture. The demand for different product varies as per the seasons. For example demand of Weather fluctuation AC is more during the time of summer but in off seasons the price is less as compared to summer. Table 2.4 Factors Affecting Demand Factors

2.5 Concept of Supply

Supply consists of some of the major concepts like: It refers to both, the ability to sell (produce) and the willingness to sell by the producer(s). Supply implies an effective supply. Supply can be shown by a supply schedule, which illustrates the maximum quantity supplied at different prices. Supply is also a flow concept. Time is an important factor affecting the condition of supply.

2.5.1 Supply Schedule and Concept A supply schedule, as shown below, gives the numerical data regarding price of goods and total unit producers are ready to produce and sell at that price. Price (Rs. 000) 230 220 210 200 Units (in 000) 100 90 80 70

Table 2.5 Supply Schedule

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Supply curve shows the relationship of above mentioned data. Y

230 Price (Rupees) 220 210 200 0

Supply Curve

50

60 70 80 Quantity Supplied (Units) Fig. 2.3 Supply Curve

90

100

2.5.2 Market Supply Curve It refers to supply of goods by all producers or firms in the market, within a time period. The example below gives a supply schedule in a market consisting of only 2 firms, B & N. Price (per unit) 10 18 28 40 50 Quantity Supplied Market N (i.e. B + N) 3 5 5 9 8 14 10 18 11 21

B 2 4 6 8 10

Table 2.6 Market Supply Curve Like the market demand curve, the market supply curve is obtained by summing up the individual supply curves in the market. The technique is also known as Horizontal Summation.

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Supply curve for B

Supply curve for N

Market Supply Curve

50

50

50

30

30

30

10

10

10

10

11

10

15

20

Fig.2.4 Market Supply Curve 2.5.3 Law of Supply The direct relationship between price and quantity supplied is called Law of Supply. In other words, if the price is high then supply is also high or vice versa. 2.5.4 Price Elasticity of Supply Price Elasticity of Supply measures the rate of response to quantity demand due to price change. It is denoted as PEoS (Price Elasticity of Supply). PEoS = (% Change in Quantity Supplied)/ (% Change in Price) % Change in Quantity Supplied = [QSupply(New) QSupply(Old)] / QSupply(Old) 2.5.5 Types of Supply Types of supply Elastic Supply Inelastic Supply Description Here the Price Elasticity of Supply is more than 1 but less than infinity. Change in supply is more than proportionate to change in the price of goods. When the Price Elasticity of Supply is in between 0 and 1, supply is inelastic in nature. It means change in supply will be less than proportionate to change in the price of goods. When the coefficient is equal to one, supply is called unit elastic. When Price Elasticity of Supply is equal to infinity, it is called as perfectly Elastic Supply When Price Elasticity of Supply is equal to zero, it is called as perfectly Inelastic Supply Table 2.7 Types of Supply

Unit Elastic Supply Perfectly Elastic Supply Perfectly Inelastic Supply

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2.5.6 Factors affecting Supply Factors which affect supply of goods are mentioned in the following table. Factors Input cost Technology Weather Description with Examples Price of input cost like labor, machines, etc. have a greater impact on supply side. For example, if the input cost is more for any organization then the supply of product is reduced. Technology enhances the production of goods. If advanced and efficient technology is used in any organization, then supply of the product will more. Weather usually affects the agricultural goods and also products like AC, water heaters, etc. Table 2.8 Factors affecting Supply

2.6 Equilibrium in Demand and Supply

Equilibrium is a price where there is no surplus and deficit of goods. That means total demand and total supply in market is equal. One can understand the concept easily with the help of following example. Price 5.0 4.5 4.0 3.5 3.0 2.5 2.0 Demand 5000 6000 7000 8000 9000 10000 11000 Supply 7000 8000 9000 8000 7000 8000 8000 Surplus/Deficit 2000 2000 2000 Nil -2000 -2000 -3000

Table 2.9 Equilibrium in Demand and Supply From the above table we can see that, there is only one point i.e., 3.5 where both demand and supply is equal.

As per the Table 2.9 the graph is mentioned below. Y Demand Curve Supply curve E

Price

3.5

Equilibrium Point

8000 Quantity

Fig. 2.5 Equilibrium in Demand and Supply

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2.7 Equilibrium as per the change in Demand and Supply

There are four possible conditions for equilibrium Increase in Demand Decrease in Demand Increase in Supply Decrease in Supply Increase in Demand The demand curve move towards right due to increase in demand. It will have an impact on current equilibrium. New equilibrium for increased demand will have the higher price. For example, there is a demand for 200 motor bikes, each costing Rs.30, 000. Due to increase in population, the demand for motorbikes increases from 200 to 500. This increased demand changed equilibrium price level from Rs. 30,000 to Rs. 50,000.
Increased Demand Y E1 E0 D1 0 200 500 X D2 S

50,000 Price 30,000

Quantity

Fig. 2.6 Increase in Demand Curve Decrease in Demand The demand curve moves towards left due to decrease in demand. In the same example given above, if the demands for motor bikes decreases the equilibrium price will also decrease as shown in Fig. 2.7.
Decreased Demand Y Price 30,000 20,000 D2 0 100 200 Quantity X D1 S

Fig. 2.7 Decrease in demand curve

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Increase in supply The supply curve will shift rightward with increase in supply. This will lead to increase in quantity demand and increase in price, as shown Increase in Supply Y S1

S2

Price

D Quantity

Fig. 2.8 Increase in Supply Curve Decrease in Supply The supply curve will shift leftward with decrease in supply. This will lead to decrease in quantity demand and increase in price, as shown. Decrease in Supply Y S2 S1

Price

D 0 Quantity Fig. 2.9 Decrease in Supply

Table 2.10 shows the changes in price and quantity when there is a change in demand and supply. Change in Supply Increases Decreases Increases Decreases Change in Demand Decreases Increases Increases Decreases Change in Price , or no change , or no change Change in Quantity , or no change , or no change

Table 2.10 Demand and Supply (Source: The McGraw-Hill Companies, Inc.)
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2.8 Role of Government in Setting Price

In most of the markets, prices are free to rise or fall as per the demand from consumers. Sometimes it happens that the price in market is either too high or too low. At this point, the Government plays a crucial and applies some legal limits on how high or how low may price go, as high price may be unfair to the buyer and low price may be unfair to the seller. Two basic concepts, called Price Ceiling and Price Floor are used for high and low price, respectively. If the price of a product is unfairly high, the government can set a price ceiling, or legal maximum price a seller may charge for a product. Similarly if the price of a product is unfairly low, the government can set a price floor or minimum fixed price that sellers can charge. In price ceiling, the consumers can afford some essential goods or services that they could not afford at the equilibrium price as it was too high before, which can create shortage of goods.
Price Ceiling Y S

2.50 Price 2 Shortage D

QS QO Quantity

Qd

Fig. 2.10 Price Ceiling The main goal of price floor is to provide a sufficient income to a certain group of resource suppliers or producers, so that people from all classes and group can afford the goods or services which will create surplus of goods. Price Floor Y Surplus 3 S

2.50

D 0 Qd QO QS X

Fig. 2.11 Price Floor

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2.9 Tax Impact on Price or Quantity of Goods

Table shows the tax impact on goods in various situations. Various Demand and Supply Tax paid by Description The entire tax is absorbed by supplier as demand is perfectly elastic in nature. The supplier cannot increase the price of the good because any hike in price will reduce demand to Zero. Graph
S1 P Tax D S2

Perfectly Elastic Demand

Supplier

S1 S2

Perfectly Inelastic Demand

Buyer

The entire tax portion is absorbed by buyer . In this case, demand remains constant irrespective of price of goods.
0

Tax

D1

D2

Perfectly Elastic Supply Buyer

The entire tax portion is absorbed by buyer . Suppliers are ready to sell at a specific price and any tax burden on them will lead supply to Zero.
0

Tax

D2 P D1

Perfectly Inelastic Supply

Supplier

The suppliers are ready to supply goods irrespective of price. They will pay for entire tax portion.
0

Tax

Table 2.11 Tax Impact on Price or Quantity of Goods

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Managerial Economics (Micro)

Summary
This chapter covered the concept of Demand, Demand Curve and Market Demand. The entire demand concept is based on price, if the price of a commodity increases, then the demand will decrease and vice versa. It also discussed Law of Demand and Price Elasticity of Demand. The Market Demand Curve is obtained by plotting the graph of sum of the individual demand curve of a particular goods in the market, at the same price, within a time period. It included various factors of demand which affects the economy of an individual. It discussed Supply, Supply Curve and Market Supply. The direct relationship between price and quantity supplied is called Law of Supply. In other words, if the price is high then supply is also high or vice versa. It also covered Law of Supply and Price Elasticity of Supply. It elaborated the main concept of equilibrium as per change in demand and supply and also the role of the government in setting prices. Two basic concepts, called Price Ceiling and Price Floor are used for high and low price, respectively. If the price of a product is unfairly high, the government can set a price ceiling, or legal maximum price a seller may charge for a product. Similarly if the price of a product is unfairly low, the government can set a price floor or minimum fixed price that sellers can charge. Lastly, it covered the impact of taxes on price and quantity demand.

References
Rittenberg, L. and Tregarthen, T. (2010). Principles of Microeconomics, Available at: <http://www.web-books. com/eLibrary/NC/B0/B63/018MB63.html.> [Accessed 25 October 2010]. Swanson, M. 2010. Diminishing Marginal Utility, Available at: <www.ehow.com/how_5993061_calculatediminishing-marginal-utility.html> [Accessed 25 October 2010]. Total Utility and Marginal Utility, (August 29 2009), Available at: <www.info-village.info. www.info-village. info/total-utility-and-marginal-utility> [Accessed 25 October 2010]. Marx, K., (1865). Value, Price and Profit. Available at: <

http://www.marxists.org/archive/marx/works/1865/value-price-profit/index.htm>

Recommended Reading
Bernanke, B., (2009). Principles of Microeconomics, Marginal Decision Rule, Tata McGraw Hill Publication. Mithani, D., 2008. International Economics. Institute of Business Study and Research, Himalaya Publishing House Pvt. Ltd.

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Chapter III Analysis of Consumer Choice

Aim
The aim of this chapter is to: define the Utility Theory and its two basic approaches explain the relationship between Demand and the Utility Theory introduce the basics of Marginal Utility, Total Utility and the Law of Diminishing Marginal Utility

Objectives
The objectives of this chapter are to: enlist two approaches of Utility Theory called Cardinal Approach and Ordinal Approach explain the concept of Marginal Utility and Total Utility discuss the fundamentals of Budget Constrain

Learning outcome
At the end of this chapter, the students will be able to: discuss the fundamentals of Budget Constrain and also explain the utility gained by spending an additional rupee apply the concepts of Marginal Utility and Law of Diminishing Marginal Utility in real life scenario understand the relationship between Demand Curve and Marginal Utility

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3.1 Introduction
Why do people buy goods and services? The answer could be, all the goods and services provide satisfaction to people, and economists call this satisfaction as utility. People have unlimited demands but limited resources and the consumption patterns differ as per the individual income level. The buying patterns maximize the satisfaction level and people will prefer one good over the other.

3.2 Utility Theory

Utility is an abstract concept rather than a concrete, observable quantity. We prefer goods/services having a higher satisfaction level in comparison to the ones with lower satisfaction level. In real sense there is no particular formula or measurement for utility. It varies from person to person. There are two approaches to utility Cardinal Approach - Here utility can be measured numerically. Ordinal Approach - Here also utility can be measured numerically but in the rank format. For example, utility of the available goods like chocolate, junk foods and rice are here: Goods Chocolate Junk Foods Rice Cardinal (Numerical) 15 10 8 Table 3.1 Utility of Goods 3.2.1 Total Utility (TU) Total utility is the aggregate of some of the satisfaction or benefits that the individual gains by consuming a given amount of goods and services in an economy. Consumption of more amounts of goods and services up to certain extent is acceptable, beyond which a saturation point will be reached which may reduce the total utility. For example, if a person consumes five units of commodity and derives U1, U2, U3, U4 and U5 utility from the successive units of goods, then his total utility (TU) will be, TU = U1 + U2 + U3 + U4 + U5 3.2.2 Marginal Utility (MU) Marginal utility is the additional satisfaction or amount of utility gained from each extra unit of consumption. Although total utility increases as more goods are consumed, marginal utility usually decreases with each additional increase in the consumption of good. This decreasing part is called Law of Diminishing Marginal Utility. There is a certain limit of satisfaction level, beyond which a consumer will no longer enjoy the same pleasure as compared to previous one. For example, during summers, you returned home from shopping at around 3 p.m. and wish to quench your thirst with chilled water. The first glass of water that you consume will give you the utility of 100, but the next glass of water will have utility of 75. This utility comes down to 10 when you go for third glass of water. So the marginal utility of chilled water decreased gradually from 100 to 75 to 10. The concept of Total Utility and Marginal Utility can be understood more clearly with the help of Table 3.2. Ordinal (Rank) 1st 2nd 3rd

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Number of Glass Marginal Utility Total Utility 1 100 100 2 75 175 3 10 185 Table 3.2 Marginal Utility From the above table, one can figure out that, marginal utility comes down with an additional consumption while total utility goes up. The Law of Diminishing Marginal Utility helps an economist to understand the law of demand and the negative slope of the demand curve. The less something is had, the more satisfaction is gained from each additional unit consumed and the marginal utility gained from that product is high because of higher willingness to pay for it. The formula for marginal utility (MU) is, MU = Change in Total Utility / Unit Change in Consumption The marginal utility comes to zero when the total utility is maximum. The relationship between marginal utility and total utility is explained with the help of following (Table 3.3 and Fig. 3.1) graph and schedule. Number of Apples Consumed 0 1 2 3 4 5 6 Marginal Utility 0 7 4 2 1 0 -1 Total Utility 0 7 11 13 14 14 13

Table 3.3 Marginal and Total Utility From the above table (Table-3.3), when a person does not consume any apple, he gets no satisfaction. Total utility becomes zero. When he consumes one apple per day, total utility become seven. In case he consumes second apple then the marginal utility will increase to four. Thus, giving him total utility of 11. The marginal utility will fall to two when the total utility is 13 i.e., (7 + 4 + 2). If consumer takes fifth apple, then his marginal utility will fall to zero and the total utility is maximum i.e.,14. If sixth apple is consumed, the marginal utility is reduced to negative (13 14 = -1).

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The curve showing total utility and marginal utility is plotted in the figure below.
Point where Total Utility is Maximum 16 b a c 8 d 4 M TU

Total Utility / Marginal Utility

12

0 -2

3 4 Apples consumed (per day)

6 MU

Fig. 3.1 Total Utility 3.2.3 Budget Constrain The Total Utility Curve in the Fig. 3.1 reaches maximum at the point M where the value is 14. We assume that the goal of each consumer is to maximize the total utility. But, in general, it is not really possible. Consumption is based upon the income level and every individual has some budget constrain which represents the combination of goods and services that an individual can purchase given current prices. If a consumer decides to spend more on one good, he or she must spend less on another in order to satisfy the budget constrain. The utility gained by spending another rupee on a good (x) can be calculated by dividing marginal utility of the goods by its price (P), i.e., MUx / Px

Y Y MU Marginal Utility MU1 MU2 MU3 0 Q1 Q2 Quantity (a) Q3 X P1 Price P2 P3 0 Q1 Q2 Q 3 Quantity (b) X
Cu rv e m De d an De m an d r Cu ve

Fig. 3.2 Relation between Marginal Utility and Demand Curve

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As per the Law of Diminishing Marginal Utility, an increase in quantity consumed results in a decreasing marginal utility. Thus, the consumer needs to increase the consumption of goods. The left hand side of Fig. 3.2 shows the Diminishing Marginal Utility of goods. The next diagram shows the demand curve in terms of price and quantity. The price of goods OP1 equilibrium is possible at quantity OQ1 where MU1 = OP1. Now suppose price comes down to OP2, then the equilibrium will definitely change. Marginal utility will be definitely less than the MU1. So we can state this as, Quantity Increase Demand Decline Price Decline Marginal Utility Decline

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Managerial Economics (Micro)

Summary
This chapter covered the concept of Utility Theory which defines the satisfaction level of consumer when they consume any goods or services. Secondly, it elaborated the concept of Utility and terms Marginal Utility, Total Utility and Law of Diminishing Marginal Utility. It discussed the Budget Constrain and the concept behind it. Lastly, it discussed the relationship between Demand Curve and Marginal Utility in terms of graphical representation. It also covered how the price of a commodity changes its marginal utility.

References
Rittenberg, L. and Tregarthen, T. (2010). Principles of Microeconomics. Available at: <http:// www.web-books. com/eLibrary/NC/B0/B63/018MB63.html> [Accessed 25 October 2010] Swanson, M., (May 5, 2010). Diminishing Marginal Utility, Available at: <www.ehow.com/how_5993061_ calculate-diminishing-marginal-utility.html> [Accessed 25th October 2010] Total Utility and Marginal Utility, (August 29 2009). Available at: <www.info-village.info. www.info-village. info/total-utility- and-marginal-utility> [Accessed 25 October 2010].

Recommended Reading
N. Gregory Mankiw, 2008. Economics: Principles and Applications, Cengage Learning Products, Canada, Nelson Education Pvt. Ltd. Paul A. Samuelson, 2002. Economics, Massachusetts Institute of Technology, Tata McGraw-Hill Publishing Company.

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Chapter IV Production Analysis

Aim
The aim of this chapter is to: elucidate the meaning of production introduce the concept of Production Function explain Production Factor

Objectives
The objectives of the chapter are to: enlist various factors of production explain Short Run Production Function explain Marginal Product curve and average product curve

Learning outcome
At the end of this chapter, the students will be able to: understand how various production factors will be utilized economically for production purpose explain fixed production factor and variable production factor elucidate the production Function concept in real time

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Managerial Economics (Micro)

4.1 Introduction
The processes and methods which convert tangible inputs (manpower, raw materials, and semi finished goods) and intangible inputs (ideas, information) into goods and services is called as production. Wages in China are relatively low for both skilled and unskilled labor to produce any goods. Where as, in United States the labor cost is very high so they use more machinery and less labor. All types of production require the choices in the use of Factors of Production. This chapter gives the analysis of such choices. The analysis of production and cost begins with a period called Short Run. The Short Run is defined in economics as, a period of time where at least one factor of production or variable is fixed i.e. it cannot be changed. For example, the various capital inputs like plant and machinery is fixed and that can be changed by supplier by altering the variable inputs such as labor, components, raw materials and energy inputs.

4.2 Short Run Production Function

Firms use production factor to produce products. The relationship between production factor and output is called as Production Function. For example, TATA requires 100 pounds of plastics and 50 man hours to make one unit of car. Then the production function will be; 1unit = f (50 man hours + 100 pounds of plastics) We can say it as, Quantity = f (Labor man hours + Capital used)

4.2.1 Total, Marginal and Average Product A total product curve shows the quantity of outputs that can be obtained from different amount of variable factor of Production, assuming that the Factors of Production are fixed. In Fig. 4.1, when the Total Product (TP) curve is between 0 and 3, which means the labor required is 0 and 3 units per day, the curve becomes steeper. When the curve is between 3 and 7 workers, the curve continues to slope upward but afterward the slope diminishes. After 7th labor the production starts to decline and the curve slopes downward. The slope of Total Product Curve for labor is equal to change in output (Q) divided by change in units of labor (L). Slope of the Total Product Curve = Q/ L 12 10
Production per day E D Total product C B F G H I

8 6 4 2 A

0 1

2 3 4 5

Units of labor per day

6 7 8

Fig. 4.1 Total Production Curve Source: Principles of Microeconomics Factors of Production: In economics Factor of Productions are any commodity or services used to produce goods and services
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The slope of Total Product curve for any variable factor is a measure of change in output associated with change in amount of variable factor, with all other factors held constant. The amount by which output rises with addition of one extra unit of a variable factor is the Marginal Product of the variable factor like labor. We can also derive Marginal Product of Labor (MPL), from mentioned formula below; MPL = Q /L

Where, Q = Change in Output L = Change in units of Labor We can also define Average Product of variable factor, which is the output per unit of variable factor. The Average Product of Labor (APL) is the ratio of output to the number of units of labor. APL = Q / L

Where, Q = Number of output L = Number of units of Labor In Fig. 4.2, the Marginal Product rises as the slope of the total curve increases, falls as the slope of the Marginal Product curve declines and reaches Zero when the Total Product curve achieve the maximum value. When the Total Product curve moves downward it becomes negative. Also, one can notice that the Marginal Product curve intersects the Average Product curve at maximum point on Average Product curve. When marginal product is above average product, then average product is rising and when marginal product is below average product, the average product is falling. For example, as a student you can use your own experience to understand the relationship between marginal and average values. Your Grade Point Average (GPA) represents the average grade you have earned in all your course work so far. When you take an additional course, your grade in that course represents the marginal grade. What happens to your GPA when you get a grade that is higher than your previous average? It rises. What happens to your GPA when you get a grade that is lower than your previous average? It falls. If your GPA is a 3.0 and you earn one more B, your marginal grade equals your GPA and your GPA remains unchanged. 12 10
Production per day Panel (a)

slope = 0.3

Marginal product avarage product

4 3 2 1 0

-0.5

slope = 1.0

slope = 2.0

slope = 4.0

slope = 2.0

Total product

Panel (b) Avrage product Marginal product

slope = 10

slope = 0.7

Units of labor per day

Fig. 4.2 Relationship between TP, MP and AP Source: Principle of Microeconomics

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slope = 0.5

G H

Managerial Economics (Micro)

Summary
Firstly, the chapter covered the meaning of production and factors of production. Factors of production are divided into two parts, fixed production factor and variable production factor. Secondly, it defines the Short Run production of organization. Short Run production means at least one factor of production is fixed. In Short Run, production function is also defined which is the relationship between production factor and output. Thirdly, it discussed the relationship between Total Product, Marginal Product and Average Product. Total product curve is defined as the change in output divided by units change in labor. The amount by which output rises by addition of an extra unit of variable factor is called as Marginal Product curve. Similarly, Average Product curve is the ratio of output to the number of units of labor. The Marginal Product curve rises as the slope of Total Product curve increases. Marginal Product Curve declines and reaches Zero when the Total Product curve achieves maximum value. When the Total Product curve moves downward, the Marginal Product curve becomes negative. The Average Product curve rises with the rise in Marginal Product curve.

References
Bernanke, B., 2009. Principles of Microeconomics, Marginal Decision Rule. Tata McGraw Hill Publication, p150-153. Rittenberg, L., Tregarthen, T. 2008. Principles of Microeconomics. Available at: <http://www.flatworldknowledge. com>. [Accessed on: 30th October 2010].

Recommended Reading
Dr. Mithani, D. M., 2008, Institute of Business Study and Research, Himalaya Publishing Housing Pvt. Ltd., p412-415. N. Gregory Mankiw, 2008. Economic: Principles and Applications, Cengage Learning Products, Canada, Nelson Education Pvt. Ltd. Samuelson, P., 2002. Economics, Massachusetts Institute of Technology. Tata McGraw-Hill Publishing Company.

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