3_economics of supply & production

8/6/2019 3_economics of Supply & Production

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ECONOMICS OF SUPPLY & PRODUCTION

Chapter 3


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SUPPLY SIDE OF MARKET

Factors Determining Supply:Product Price

Factor Productivities or Technology

Factor Prices

Prices of other products related in productionWeather, Strikes and other short-run forces

Firms expectations about future prospects forprices, costs, sales and the sale of economy in

generalNumber


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Elasticity of SupplyDegree of responsiveness of suply to a given

change in price

Measured by dividing the percentage change

in quantity supplied of a good by thepercentage change in its price


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Types of Elasticity of

Supply

When Elasticity of Supply is It is known as

Equal to Zero Perfectly Inelastic

Equal to Infinity Perfectly elastic supply

Equal to One Unitary elastic supply

More than one but not infinity Relatively Elastic Supply

Less than one but not zero Relatively inelastic supply


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Types of Supply ElasticityPerfectly Inelastic:

As a result of change in price, the quantity

supplied of a good remains unchanged.Elasticity of supply is zero or the good has

perfectly inelastic supply.

The vertical supply curve shows that

irrespective of price change, the quantitysupplied remains unchanged.


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Types of Supply ElasticityRelatively Less Elastic Supply

As a result of change in the price of a good its

supply changes less than proportionatelyRelative change in quantity supplied is less

than the relative change in the price.


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Types of Supply ElasticityRelative Greater Elastic Supply:

Elasticity of supply is greater than 1

Quantity supplied changes substantially inresponse to a small change in price

Relative change in quantity supplied isgreater than the relative change in price


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Types of Supply ElasticityUnit Elastic

Relative change in quantity supplied is

exactly equal to the reltive change in theprice.

Coefficient of elasticity of supply is equal toone.

Relative change in the quantity supplied isequal to the relative change in the price


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Types of Supply ElasticityPerfectly Elastic Supply

Supply elasticity is infinite when nothing is

supplied at a lower price but a small increasein price causes supply to rise from zero to anindefinitely large amount

Indicates that producers will supply any

quantity demanded at that price


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Supply Elasticities-Lessons

to Manager

Changes in Marginal Cost of Production:

Elasticity of supply depends on increasing outputwithout any raise in input costs

With increase in production, if marginal cost goesup, elasticity of supply would be less to that extent

With increase in output, marginal cost of productionrises. This results in less elastic supply in short run.

Long-run supply curve is more elastic, than theshort-run supply curve

Industry with decreasing returns will be moreelastic in long run than in short run

Industry with increasing returns will be less elasticin the long run


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to ManagerResponse of the Producers

Supply elasticity depends on the responsiveness ofproducers to change its price

If supplier is reluctant to increase prices, the quantitysupplied will not result in increase in prices

Profit maximizing producer would increase quantityfollowing a rise in price.

Producers not keen on profit-maximizing may not raisesupply in response to rise in price

Farmers in developing countries respond negatively to

rise in price of commodities. They deliberately producelesser quantities to keep the prices high. High pricescompensate in meeting their fixed costs of production.


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to ManagerAvailability of infrastructure facilitiesand other inputs for expanding output:The extent of increase in supply depends on the availability

of infrastructure facilities and availability of inputs required.

Ban on import of critical raw-material cannot support

increase in supplyNon-availability or short-supply of skilled manpower

In case of perishable goods, sound infrastructure to movegoods faster across the markets

Shortage of power supply, unfriendly government policy

etc.


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to Manager

Possibilities of substitution ofone product for others:Change in quantity supplied of a product due to

change in its price, depends on substitution of one

product for othersIf price of wheat rises, the farmers will try to shift all

resources such as land, ferilizers away from otherproducts such as pulses towards production ofwheat

Greater the possibility of shifting the resources,greater would be the elasticity of supply (of wheat)


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to Manager

The Length of Time Length of time required by the supplier to respond to agiven change in price also impacts supply elasticity

Longer the time required to respond, greater would bethe elasticity of supply

Market Period: Very short period is available andmore production is not possible. This is a case ofperfectly inelastic supply

Short Run: It can supply smaller additional quantitiesby varying only few of the variables. Here it is

relatively less elastic. Long Run: Firms can adjust all factors of production

and even new firms will enter or leave industry,resulting long-term supply curve more elastic


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PROCUTION & COST

CONCEPTS-REVIEW


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ISOQUANTThe term isoquant means same or equalquantity

An isoquant schedule consists of alternativecombinations of the inputs (say capital K,

and labour L) which yield a given quantity ofoutput of a good (say X)

An isoquant curve (usually called only anisoquant) is a graphic counterpart of an

isoquant schedule

It is a locus of all the combinations of theinputs which produce a given output


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Isoquant ScheduleCombination Units of

Capital

Units of

Labour

Output of

good X

Marginal Rate of

Technical

Substitution(DL/DK)

1 2 50 400

2 3 45 400 5.0

3 5 40 400 2.5

4 8 35 400 1.7

5 12 30 400 1.25

6 17 25 400 1.0

7 23 20 400 0.8

8 30 15 400 0.7

9 38 10 400 0.6


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Isoquants

We have a set of three

hypothetical isoquant curvesnumbered 1, 2 and 3

Input labour (L) is measuredalong X-axis and input capital(K) is measured along Y-axis

Each isoquant is a locus of the

alternative combinations of twoinputs capital (K) and labour (L)which yield a given quantity ofoutput of good X

each of the three isoquantscontains three parts, the part in which it is concave to X-

axis and is moving away from Y-axis,

the part in which it is downwardsloping and is convex to the origin,and

the part in which it is convex to X-axisand is upward sloping


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ISOQUANTS -

ASSUMPTIONS

Both output and inputs are measured in physical quantities. The isoquantrepresents their physical relationship. The prices of inputs and output arenot brought into picture.

Good X is produced with the help of only two inputs, say capital (K) andlabour (L).

Both inputs are subject to diminishing marginal physical productivity.With an increase in the quantity of an input, its marginal productivity cannot only fall to zero, it can even become negative. This assumption isdropped only for illustrating special cases.

Both inputs are perfectly divisible. This implies that the quantities of theinputs can be varied in extremely small amounts.

Technologically, inputs can be combined only within a certain range.Accordingly, a proportionate increase in inputs may or may not result in a

proportionate increase in output.


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Marginal Rate of Technical Substitutionof L for K (MRTSL,K)

This concept is a measure of the rate at which one input canbe substituted by another without changing the total output.

If the firm adds DL to input L and discards a correspondingquantity DK of K, such that there is no change in output,then marginal rate of technical substitution of L for K(MRTSL,K) is defined as DK/DL.

In addition, MRTSL,K is also equal to MPL/MPK, that is, theratio of the marginal productivity of the two inputs

Addition in output on account of increasing L is given byDL.MPL while the corresponding reduction in output equals

DK.MPk, that is, DK.MPk = DL.MPL , so that DK/DL =MPL/MPK

MRTSL,K is also equal to the slope of the tangent drawn tothe isoquant at the relevant point


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MRTSL,K

Take a point P on theisoquant, then MRTSL,K isthe slope of the tangent ABto it

Similarly, if we move frompoint P to point P, that is, ifwe consider an increase ininput L by an amount DLwith a correspondingreduction in K by anamount DK, then MRTSL,Kis given by DK/DL

P

P


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Properties of IsoquantsA typical isoquant has three regions, on account of diminishing

marginal productivity of both inputs.

When marginal productivity of both inputs is positive but diminishing, theisoquant has a negative slope and is also convex to the origin as in the caseof indifference curves). In this region MRTSL , K falls as we move from left toright, and its sign is negative. At the left-most end of this region, (point R),MPK touches zero, and MRTSL,K approaches infinity. The tangent to isoquantat this point becomes parallel to Y-axis. Similarly, at the right-most end of thisregion (point S), MPL touches zero, and MRTSL,K declines to zero. The slope ofthe tangent to isoquant at this point is zero and it is parallel to X-axis.

Having reached the left-most end of the central region of the isoquant, ifinput K is increased still further, MPk becomes negative. As a result, to keepoutput unchanged, an addition to K has to be accompanied by an increase inL also. Accordingly, the isoquant slopes upwards with concavity towards X-axis (the labour-axis). In this region, MRTSL,K has a positive sign and itsnumerical value falls as we increase both inputs.

Having reached the right-most end of the central region of the isoquant, ifinput L is increased still further, MPL becomes negative. As a result, to keepoutput unchanged, an addition to L has to be accompanied by an increase inK. Accordingly, the isoquant slopes upwards with a convexity towards labour-axis (X-axis). In this region, MRTSL,K has a positive slope and its numericalvalue increases as we increase both inputs.


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Properties of Isoquants An isoquant is a continuous curve. This property follows

from the assumption that both inputs are perfectlydivisible.

An isoquant which is farther away from the originrepresents greater output because, in its convexsection, marginal productivity of both inputs is positive.

However, the absolute difference in their output in notindicated by their physical distance.

As in the case of indifference curves, no two isoquantsintersect each other. They also need not be parallel toeach other, either horizontally or vertically. Similarly,no two isoquants can touch each other - that is, theycannot have any common point. This result followsbecause a given combination of inputs is assumed toresult only in one given output.

ilib i f h i


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Equilibrium of the FirmIso-cost Line A firm is assumed to pursue the objective of maximising profit. It aims at minimising per unit cost of output which is the same thing as

maximising output per unit of cost

The use of isoquants in the determination of a firms equilibriumnecessitates the use of firms isocost line as well

We measure units of input capital (K) along Y-axis and units of labour (L)

along X-axis An isocost line represents a set of combinations of inputs L and K which the

firm can acquire for a given total cost or budget.

if PK and PL are respective prices of the two inputs, K and L and the firm isto incur a total cost TC, then the equation of the isocost line is given by,

TC = K.PK + L.PL

where K stands for the quantity of capital employed by the firm and L denotesthe quantity of labour input used by it.


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Equilibrium of theFirm

Since the firm can buy, at the most TC/ PK,amount of K, therefore, the starting point ofthe isocost line on Y axis is given by thedistance (TC / PK) from origin O.

Similarly, it touches X-axis at a distance of(TC/ PL) from the origin. It is a straight linewith a negative slope (PL / PK). For example,if TC = 300, PK = 10, and PL = 15, the firmcan buy at the most 30 units of capital or 20units of labour

The isocost line is, therefore, a straight line(such as RS), which is the locus of inputcombinations like (0K +20L), (1k + 19.3L),(2K + 18.7L), (3K + 18L), ..(30K + 0L)

It has a constant negative slope with anumerical value of (30/20 = 1.5)

The market allows the firm to choose anycombination of inputs K and L along theisocost line. It does not permit the firm tomove to the right side of this line. And thefirm, on grounds of its economic rationality,

does not move to the left of it. Theequilibrium position of the firm liessomewhere on the isocost line only.


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Equilibrium atTangency

The fact that the isocost line of thefirm is a straight line with a

negative slope and the middleregion of each isoquant is convex tothe origin, ensures that the isocostline is tangent to one and only oneisoquant

Further, it is this point of tangencywhich determines the equilibriumposition of the firm. RS is the

isocost line of the firm.As the firm moves from point Rtowards point S, it successivelyshifts from a lower isoquant to ahigher one

At point E, it is tangent to isoquant3 which is the highest which themarket allows the firm

In case, the firm moves furthertowards S, it slides to a lowerisoquant. Thus, at E firm reaches asituation of maximum output with agiven cost-the position of maximumprofits


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COST CONCEPTSOUTLAY COSTS AND OPPORTUNITY

COSTSOutlay costs involve financial expenditure at

some time and hence are recorded in the booksof account

Opportunity costs relate sacrificed alternatives;they are not recorded in the books of account in

general


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COST CONCEPTSDirect costs and Indirect Costs

Direct costs are costs that are readily identifiedand are traceable to a particular product,

operation or plant

Indirect costs are not readily identifiable withany specific goods, services, operations etc.,but are charged on jobs or products in standard

accounting practice. (Eg. Expenditure onelectricity)


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FIXED AND VARIABLE

COSTSFixed costs are not a function of output, they do

not vary with output up to a certain level ofactivity

Fixed costs cannot be avoided. These costs arefixed as long as operations are going on. They canbe avoided only when the operations are closed.

Variable costs are a function of output in the

production period. Wages and cost of raw materialare variable costs. Variable costs vary directly andsometimes proportionately with output.


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SHORT RUN COSTSThe term short run does not represent a fixed time period.

It is a functional concept and represents that time intervalover which the firm is not able to alter every input

It is stuck with some fixed inputs also. It means thatirrespective of the volume of output, the firm must incur afixed amount of expenditure on these factors. These are,therefore, termed fixed costs

Correspondingly, expenditure incurred on variable factors

are known as variable costs and they change with the levelof output.

It is obvious that total cost (TC) is the summation of totalfixed costs (TFC) and total variable costs (TVC)


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Average andMarginal Cost of

a Firm


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Average Cost of a Firm Average Fixed Cost (AFC) Curve : Since total fixed costs do not change with

output, therefore, average fixed cost (AFC) declines with increase in the level ofoutput and tends to infinity when output reaches zero. For a single unit of output,AFC equals TFC. At one end, this curve approaches Y-axis, without ever touchingit, with a reduction in output; and at the other, it approaches X-axis, without evertouching it, with an increase in output.

Average Variable Cost (AVC) Curve : As we have seen above, with a givenplant, returns to variable factors pass through three phases of increasing,

constant and diminishing returns. Accordingly, AVC curve is a U-shaped one. Inthe initial stages, it slopes downwards with an increase in output. However, thereduction in average variable cost slows down till AVC stops declining further andbecomes constant. This is followed by the phase in which AVC curve slopesupwards on account of diminishing returns.

Total Average Cost, or just Average Cost (ATC or AC) Curve : This curverepresents the average of all costs incurred by the firm for a given output and is

the summation of AFC and AVC. Graphically, it is obtained by vertical addition ofthe AFC and AVC curves. AC curve lies above AVC curve. At each point, its verticaldistance from AVC curve is exactly equal to the distance of AFC curve from X-axis. AC curve is U-shaped and with increasing output, its vertical distance fromAVC keeps declining


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MARGINAL COSTOF FIRM

Marginal cost is addition to total cost on account of theproduction of an additional unit. Symbolically, it is TCN -

TCN-1. However, it should be noted that in the shortrun, the firm cannot vary its fixed factors.

Therefore, its costs can change only on account of achange in variable costs. Therefore, in the short run, MCgets defined as VCN - VCN-1. For this reason, MC curveis related to only AVC curve.

When AVC is decreasing, MC is less than it and MC

curve lies below AVC curve. However, when the rate offall of AVC slows down, MC curve reaches its lowestvalue and starts increasing and meets AVC curve at thelowest point of the latter. In other words, when AVC isconstant, MC is equal to it. In the next phase, when AVCcurve slopes upwards, MC curve rises faster than theformer and lies above it.

MC curve need not intersect AC curve at the lowest

point of the latter. Whether it does so or not woulddepend upon the rate at which AVC increases comparedwith the rate at which AFC decreases. MC curve willintersect AC curve at its lowest point only if the rate ofincrease in AVC equals that of fall in AFC.


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Long Run Costs


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Example:Daimler Chrysler own the following brands:

Purchasing economies of scale can be achieved by bulk

buying parts that can be used across all brands such as

Wiper Blades
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Diseconomies of ScaleThere are limits to the amount a business can

grow

If businesses grow to large they start to sufferfrom Diseconomies of Scale

These diseconomies happen because thelarger the business the more difficult it

becomes to manage


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Some common

diseconomies of scale:1. Decision making

2. Managerial problems

3. Communication problems

4. Co-ordination/control problems

5. Staffing problems


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Case Study: Deepak Nitrate Ltd &Dharamsi Morarjee Chemical Company

Product: Resorcinal a high value additiveused in manufacture of tyres

Background: High energy tariffs and steepdrop in import duties necessitated the two

companies to come together to processResorcinal. Manufacture of Resorcinal involvestwo processes viz.,

Sulfonation (combining benzene and sulphuric

acid)Fusion (process of mixing sulfonatedproduct

with caustic soda to form resarcino


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Solution required: To be able to sell belowRs.300/Kg in domestic market

Strategy to economise:

With Dharmas having the capacity tomanufacture sulphuric acid, it will be involvedin the first stage and sell the sulforated

mixture to Deepak Nitrate for themanufacture of the final product

Case Study: Deepak Nitrate Ltd &Dharamsi Morarjee Chemical Company


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Case Study: Deepak Nitrate Ltd & DharamsiMorarjee Chemical Company

Both companies will share the final product depending on thecurrent production status

Dharmsi will shut down its existing fusion process unit andconcentrate only on Sulfornation

Deepak Nitrate will stop its Sulforanation facility

R&D activities will be focussed on the respective areas.Deepak Nitrates manufacturing facility is located in Pune and

Dharamsi s plant is at Roha

Conclusion: Arrangement enabled both companies to sellproducts at cheapest prices.


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ECONOMIES OF SCOPEEconomies of scope deals with reducing perunit cost of goods produced.

Per unit costs depend on

Changes in factor input or returns to scale andNumber of goods produced by a firm or

economies of scope

Reduction of a firms per unit cost by producingtwo or more goods jointly rather thanseparately is a result of economies of scope


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Measurement of

Economies of ScopeSC = C(Q1) + C(Q2) C(Q1,Q2) /C(Q1) +

C(Q2)

Where

C(Q1, Q2) = the firms cost of jointly producingthe goods in the respective quantities

C(Q1) = the cost of producing good 1 alone and

C(Q2) = the cost of producing good2


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Economies of Scope -

ExamplesBroad-banding

Multiple products produced by sameequipment


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SC = C(Q1) + C(Q2) C(Q1,Q2) /C(Q1) +C(Q2)

SC = (12 + 8 -17) / 12 + 8) = 0.15 (or 15%cost savings in comparision to separaeproduction)

Economies of Scope-

Example


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DIFFERENCE BETWEEN

SCALE AND SCOPE PARADIGMEconomies of Scale Economies of Scope

Old style technology Computer Technology

Standardisation Diversification

Cost advantage from volume Cost advantage from variety

Separable variable costs Joint Costs

Task specialisation Multi-mission companies

Work as a social activity Unmanned system

Expensive flexibility Profitable flexibility

Large plant Disaggregated capacity


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Internal and External

EconomiesInternal Economies Those Specifically related to

the business itself eg:-

1. Production

2. Purchasing

3. Marketing

4. Financial5. Managerial

6. Risk spreading

External Economies

Benefits the whole industry

and not specific firms

1. Skilled labour in the area

2. Better road and railnetworks

3. Improves the reputation ofthe area

4. Attracts other businesses


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Internalized External

EconomyEg: A railway line being laid close to an

existing factory


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Externalized Internal

DiseconomyPassing on private

discomforts topublic

Chemical PlantPollutants


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LARGE & SMALL FIRMS Economies &Diseconomies

Large Firms Small Firms

Technology:High capital intensive technique isused

Technology used is normally basedon cost linked to capitalization

Faces risk of recession- losses dueto huge investment

Labour intensive techniques isused, avoids risk of diseconomies

Huge capital investment required Prefers to start small

Small firms offer advantages like skill information, family jobs,flexibility, independent and prompt decision making

Survival of small firms along side large firms happens in acompetitive industry


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RETURN (Physical)

MONEY COSTS IMPLICATIONS

Economies of scale (volume) Economies of scope (variety)

INTERNAL EXTERNALINTERNAL EXTERNAL

ECONOMIES

-Technical-Financial

-Commercial

-Managerial

-Risk

-Diversifying

-Misc.Categories

DISECONOMIES


-Commercial

-Managerial

-Risk

-Diversifying

-Misc.Categories

ECONOMIES


-Commercial

-Managerial

-Risk

-Diversifying

-Misc.Categories

DISECONOMIES


-Commercial

-Managerial

-Risk

-Diversifying

-Misc.Categories

3_economics of supply & production

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