study material and lots of ebooks

1. ECONOMIC ANALYSIS
Module II: Theory of Production and Cost
EDUCATION HOLE PRESENTS

2. Contents
Demand Analysis.....................................................................................................................................2
Law of demand....................................................................................................................................2
Assumptions........................................................................................................................................3
Exceptions to the law of demand .......................................................................................................3
Geffen goods...................................................................................................................................3
Commodities which are used as status symbols ............................................................................4
Expectation of change in the price of commodity..........................................................................4
Types of elasticity of demand .........................................................................................................4
Price elasticity of demand...............................................................................................................4
Income elasticity of demand...........................................................................................................5
Cross price elasticity of demand.....................................................................................................5
Determinants of Demand ...............................................................................................................5
Measurement of price elasticity of demand:......................................................................................6
Point-price elasticity .......................................................................................................................6
Arc elasticity....................................................................................................................................7
Demand forecasting........................................................................................................................7
Need for Demand Forecasting........................................................................................................7
(1) The purpose of the Short term forecasting:..................................................................................8
(2) The purpose of long- term forecasting:.........................................................................................8
Law of Supply:.................................................................................................................................9
Elasticity’s of supply........................................................................................................................9
Elasticity’s of scale ..........................................................................................................................9
Factors affect the elasticity of supply? .............................................................................................10
Production function..............................................................................................................................10
Law of variable Proportion............................................................................................................11
Cost Concepts ...............................................................................................................................11
Shape of cost curves in short and long run.......................................................................................12
Short-run average variable cost curve (SRAVC)............................................................................12
Short-run average total cost curve (SRATC or SRAC)....................................................................12
Long-run average cost curve (LRAC) .............................................................................................13
Short-run marginal cost curve (SRMC)..........................................................................................13
Long-run marginal cost curve (LRMC)...........................................................................................14

3. Demand Analysis
Demand Demand is the quantity of good and services that customers are willing and able
purchase during a specified period under a given set of economic conditions. The period here
could be an hour, a day, a month, or a year. The conditions to be considered include the price
of good, consumer’s income, the price of the related goods, consumer’s preferences, and
advertising expenditures and so on. The amount of the product that the costumers are willing
to buy, or the demand, depends on these factors. There are two types of demand. The first of
these is called direct demand. This model of demand analysis individual demand for goods
and services that directly satisfy consumers desires. The prime determinant of direct demand
is the utility gained by consumption of goods and services. Consumers budget, product
characteristics, individuals preferences are all important determinants of direct demand. The
other type of demand is called derived demand. Derived demand is the demand resulting
from the need to provide the final goods and services to the consumers. Intermediate goods,
office machines are examples of derived demand. Another good example is mortgage credit.
Mortgage credit demand is not demanded directly, but derived from the demand for housing.
Market demand function: The market demand function for a product is a function showing
the relation between the quantity demanded and the factors affecting the quantity of demand.
A demand function for the good X can be expressed as follows: Quantity of product X
demanded = Qx = f (the price of X, prices of related goods, expectations of price changes,
income, preferences, advertising expenditures and so on. ) For use in managerial decision
making, the relation between quantity of demand and each demand determining variable must
be specified.
Demand Curve: The demand function specifies the relation between the quantity demanded
and all factors that determine demand. But the demand curve expresses the relation between
the price of a product and the quantity demanded, holding constant all the other factors
affecting demand.
Law of demand
The law of demand is an economic law that states that consumers buy more of a good when
its price decreases and less when its price increases (ceteris paribus).
The greater the amount to be sold, the smaller the price at which it is offered must be in order
for it to find purchasers.
Law of demand states that the quantity demanded of a commodity and its price are inversely
related, other things remaining constant. That is, if the income of the consumer, prices of the
related goods, and tastes and preferences of the consumer remain unchanged, the consumer’s
demand for the good will move opposite to the movement in the price of the good.

4. "If the price of the good increases, the quantity demanded decreases, while if price of the
good decreases, its quantity demanded increases."
Assumptions
Every law will have certain limitation or exceptions. While expressing the law of demand, the
assumptions that other conditions of demand were unchanged. If remains constant, the
inverse relation may not hold well In other words, it is assumed that the income and tastes of
consumers and the prices of other commodities are constant. This law operates when the
commodity’s price changes and all other prices and conditions do not change. The main
assumptions are
• Habits, tastes and fashions remain constant
• Money, income of the consumer does not change.
• Prices of other goods remain constant
• The commodity in question has no substitute
• The commodity is a normal good and has no prestige or status value.
• People do not expect changes in the prices.
• Quantity of the commodity remains constant.
• State of wealth of consumer does not change
Exceptions to the law of demand
Generally, the quantity demanded of good increases with a decrease in price of the good and
vice versa. In some cases, however, this may not be true. Such situations are explained below.
Geffen goods
As noted earlier, if there is an inferior good of which the positive income effect is greater
than the negative substitution effect, the law of demand would not hold. For example, when
the price of potatoes (which is the staple food of some poor families) decreases significantly,
then a particular household may like to buy superior goods out of the savings which they can
have now due to superior goods like cereals, fruits etc., not only from these savings but also
by reducing the consumption of potatoes. Thus, a decrease in price of potatoes results in
decrease in consumption of potatoes. Such basic good items consumed in bulk by the poor
families, generally fall in the category of Geffen goods.

5. Commodities which are used as status symbols
Some expensive commodities like diamonds, air conditioned cars, etc., are used as status
symbols to display one’s wealth. The more expensive these commodities become, the higher
their value as a status symbol and hence, the greater the demand for them. The amount
demanded of these commodities increase with an increase in their price and decrease with a
decrease in their price. Also known as a Veblen good
Expectation of change in the price of commodity
If a household expects the price of a commodity to increase, it may start purchasing greater
amount of the commodity even at the presently increased price. Similarly, if the house hold
expects the price of the commodity to decrease, it may postpone its purchases. Thus, law of
demand is violated in such cases.
In the above circumstances, the demand curve does not slope down from left to right instead
it presents a backward sloping from top right to down left as shown in diagram. This curve is
known as exceptional demand curve.
Law of demand explain the inverse relation b/w price of commodity and its demand,
assuming other things remain constant. this negative relation itself implies downward
movement of demand curve from left to right. But basically it happens due to main three
effects or laws: 1. Law of Diminishing marginal utility. (Please connect it to the concept) 2.
Income effect, which simply talk about change in real income (Purchasing Power) of
consumer. Whenever there fall in price of good exist, the purchasing power of consumer gets
increase and thus she wants to purchase more. 3. Substitution effect: for most of the goods
substitutes or similar commodity are available. When there is change in price of one and it
became cheaper as compare to its substitute, some buyer transform from present consumption
towards those goods whose prices falls
Types of elasticity of demand
Price elasticity of demand
Price elasticity of demand measures the percentage change in quantity demanded caused by a
present change in price. As such, it measures the extent of movement along the demand
curve. This elasticity is almost always negative and is usually expressed in terms of absolute
value (i.e. as positive numbers) since the negative can be assumed. In these terms, then, if the
elasticity is greater than 1 demand is said to be elastic; between zero and one demand is
inelastic and if it equals one, demand is unit-elastic.

6. Income elasticity of demand
Income elasticity of demand measures the percentage change in demand caused by a percent
change in income. A change in income causes the demand curve to shift reflecting the change
in demand. Income elasticity of demand is a measurement of how far the curve shifts
horizontally along the X-axis. Income elasticity can be used to classify goods as normal or
inferior. With a normal good demand varies in the same direction as income. With an inferior
good demand and income move in opposite directions
Cross price elasticity of demand
Cross price elasticity of demand measures the percentage change in demand for a particular
good caused by a present change in the price of another good. Goods can be complements,
substitutes or unrelated. A change in the price of a related good causes the demand curve to
shift reflecting a change in demand for the original good. Cross price elasticity is a
measurement of how far, and in which direction, the curve shifts horizontally along the x-
axis. A positive cross-price elasticity means that the goods are substitute goods
Determinants of Demand
When price changes, quantity demanded will change That is a movement along the same
demand curve. When factors other than price changes, demand curve will shift. These are the
determinants of the demand curve.
1. Income: A rise in a person’s income will lead to an increase in demand (shift demand
curve to the right), a fall will lead to a decrease in demand for normal goods. Goods whose
demand varies inversely with income are called inferior goods (e.g. Hamburger Helper).
2. Consumer Preferences: Favourable change leads to an increase in demand, unfavourable
change lead to a decrease.
3. Number of Buyers: the more buyers lead to an increase in demand; fewer buyers lead to
decrease.
4. Price of related goods:
a. Substitute goods (those that can be used to replace each other): price of substitute and
demand for the other good are directly related.
Example: If the price of coffee rises, the demand for tea should increase.
b. Complement goods (those that can be used together): price of complement and demand for
the other good are inversely related.
Example: if the price of ice cream rises, the demand for ice-cream toppings will decrease.

7. 5. Expectation of future:
a. Future price: consumers’ current demand will increase if they expect higher future prices;
their demand will decrease if they expect lower future prices.
b. Future income: consumers’ current demand will increase if they expect higher future
income; their demand will decrease if they expect lower future income.
Measurement of price elasticity of demand:
Point-price elasticity
One way to avoid the accuracy problem described above is to minimise the difference
between the starting and ending prices and quantities. This is the approach taken in the
definition of point price elasticity, which uses differential calculus to calculate the elasticity
for a small change in price and quantity at any given point on the demand curve:
Ed =
P
Qd
x
dQd
dP
In other words, it is equal to the absolute value of the first derivative of quantity with respect
to price (dQd/dP) multiplied by the point's price (P) divided by its quantity (Qd)
In terms of partial-differential calculus, point-price elasticity of demand can be defined as
follows: let x(p, w) be the demand of goods x1, x2 … … xl as a function of parameters price
and wealth, and let x1(p, w)be the demand for good . l The elasticity of demand for good
x1(p, w)with respect to price pk is
E=
∂x1(p,w)
∂pk
.
pk
x2(p,w)
=
∂logx1(p,w)
∂logpk

8. However, the point-price elasticity can be computed only if the formula for the demand
function, Qd = f(P), is known so its derivative with respect to price, dQd / dP, can be
determined.
Arc elasticity
A second solution to the asymmetry problem of having a PED dependent on which of the two
given points on a demand curve is chosen as the "original" point and which as the "new" one
is to compute the percentage change in P and Q relative to the average of the two prices and
the average of the two quantities, rather than just the change relative to one point or the other.
Loosely speaking, this gives an "average" elasticity for the section of the actual demand
curve— i.e., the arc of the curve—between the two points. As a result, this measure is known
as the arc elasticity, in this case with respect to the price of the good. The arc elasticity is
defined mathematically as
Ed =
p1+p2
2
Qd1+Qd2
2
×
∆Qd
∆P
=
p1+p2
Qd1+Qd2
×
∆Qd
∆P
This method for computing the price elasticity is also known as the "midpoints formula",
because the average price and average quantity are the coordinates of the midpoint of the
straight line between the two given points.
Demand forecasting
Demand forecasting is the activity of estimating the quantity of a product or service that
consumers will purchase. Demand forecasting involves techniques including both informal
methods, such as educated guesses, and quantitative methods, such as the use of historical
sales data or current data from test markets. Demand forecasting may be used in
making pricing decisions, in assessing future capacity requirements, or in making decisions
on whether to enter a new market.
Need for Demand Forecasting
Business managers, depending upon their functional area, need various forecasts. They need
to forecast demand, supply, price, profit, costs and returns from investments.
The question may arise: Why have we chosen demand forecasting as a model? What is the
use of demand forecasting?

9. The significance of demand or sales forecasting in the context of business policy decisions
can hardly be overemphasized. Sales constitute the primary source of revenue for the
corporate unit and reduction for sales gives rise to most of the costs incurred by the firm.
Demand forecasting is essential for a firm because it must plan its output to meet the
forecasted demand according to the quantities demanded and the time at which these are
demanded. The forecasting demand helps a firm to arrange for the supplies of the necessary
inputs without any wastage of materials and time and also helps a firm to diversify its output
to stabilize its income overtime.
The purpose of demand forecasting differs according to the type of forecasting.
(1) The purpose of the Short term forecasting:
It is difficult to define short run for a firm because its duration may differ according to the
nature of the commodity. For a highly sophisticated automatic plant 3 months’ time may be
considered as short run, while for another plant duration may extend to 6 months or one year.
Time duration may be set for demand forecasting depending upon how frequent the
fluctuations in demand are, short- term forecasting can be undertaken by affirm for the
following purpose;
• Appropriate scheduling of production to avoid problems of over production and under-
production.
• Proper management of inventories
• Evolving suitable price strategy to maintain consistent sales
• Formulating a suitable sales strategy in accordance with the changing pattern of demand and
extent of competition among the firms.
• Forecasting financial requirements for the short period.
(2) The purpose of long- term forecasting:
The concept of demand forecasting is more relevant to the long-run that the short-run. It is
comparatively easy to forecast the immediate future than to forecast the distant future.
Fluctuations of a larger magnitude may take place in the distant future. In fast developing
economy the duration may go up to 5 or 10 years, while in stagnant economy it may go up to
20 years. More over the time duration also depends upon the nature of the product for which
demand forecasting is to be made. The purposes are;
• Planning for a new project, expansion and modernization of an existing unit, diversification
and technological up gradation.
• Assessing long term financial needs. It takes time to raise financial resources.
• Arranging suitable manpower. It can help a firm to arrange for specialized labour force and
personnel.

10. • Evolving a suitable strategy for changing pattern of consumption.
Law of Supply:
The Law of Supply states that the producer wants to supply more of his product when there
is an increase in the price of the product. As manufacturers produce more output, their total
costs increase proportionately. The ratio to the total cost and the quantity of the product
increases. This is the firm’s marginal cost of production. As marginal cost is the additional
cost incurred to produce a good, the price of the product also rises and the firms will
definitely charge more for the additional products produced.
Elasticity’s of supply
Price elasticity of supply
The price elasticity of supply measures how the amount of a good firms wish to supply
changes in response to a change in price.[3]
In a manner analogous to the price elasticity of
demand, it captures the extent of movement along the supply curve. If the price elasticity of
supply is zero the supply of a good supplied is "inelastic" and the quantity supplied is fixed.
Elasticity’s of scale
Elasticity of scale or output elasticity’s measure the percentage change in output induced by a
present change in inputs. A production function or process is said to exhibit constant returns
to scale if a percentage change in inputs results in an equal percentage in outputs elasticity
equal to 1). It exhibits increasing returns to scale if a percentage change in inputs results in

11. greater percentage change in output elasticity greater than 1). The definition of decreasing
returns to scale is analogous
Factors affect the elasticity of supply?
• Spare production capacity: If there is plenty of spare capacity then a business can
increase output without a rise in costs and supply will be elastic in response to a
change in demand. The supply of goods and services is most elastic during a
recession, when there is plenty of spare labour and capital resources.
• Stocks of finished products and components: If stocks of raw materials and
finished products are at a high level then a firm is able to respond to a change in
demand - supply will be elastic. Conversely when stocks are low, dwindling supplies
force prices higher because of scarcity in the market.
• The ease and cost of factor substitution: If both capital and labour
are occupationally mobile then the elasticity of supply for a product is higher than if
capital and labour cannot easily be switched. A good example might be a printing
press which can switch easily between printing magazines and greetings cards.
• Time period and production speed: Supply is more price elastic the longer the time
period that a firm is allowed to adjust its production levels. In some agricultural
markets the momentary supply is fixed and is determined mainly by planting
decisions made months before, and also climatic conditions, which affect the
production yield. In contrast the supply of milk is price elastic because of a short time
span from cows producing milk and products reaching the market place.
Production function
In economics, a production function relates physical output of a production process to
physical inputs or factors of production. The production function is one of the key concepts
of mainstream neoclassical theories, used to define marginal product and to distinguished, the
defining focus of economics. The primary purpose of the production function is to address
allocate efficiency in the use of factor inputs in production and the resulting distribution of
income to those factors, while abstracting away from the technological problems of achieving
technical efficiency, as an engineer or professional manager might understand it.
In macroeconomics, aggregate production functions are estimated to create a framework in
which to distinguish how much of economic growth to attribute to changes in factor
allocation (e.g. the accumulation of capital) and how much to attribute to advancing
technology. Some non-mainstream economists, however, reject the very concept of an
aggregate production function.[

12. Law of variable Proportion
The law of variable proportion states that if the input of one resource is increased by equal
increments per unit time while the inputs of other resources kept constant, total product (
output) increases, but beyond certain point the resulting output is increases with reducing
rate.
Assumptions:
1. Constant technology: The law of variable proportions assumes constant techniques of
production. The reson is that if the state of the technology changes then the marginal and
average product may rise instead of diminishing.
2. Short run: The law is specially operates in the short run because here some factors are
fixed and the proportion of the other factors has to be varied. It assume that one factor is
varies while the others are fixed.
3. Homogenous factors: The law is based on the fact that variable resources are applied unit
by unit. and each factor unit is homogeneous in amount or quality.
4. Variable input factors: The law supposes the possibility of the ratio of the fixed factors to
the variable factors being changed. In other word ,it is possible to use various amounts of a
variable factors with fixed factors of production.
Cost Concepts
It is used for analysing the cost of a project in short and long run.
• Types of Cost:
• Total fixed costs (TFC)
• Average fixed costs (AFC)
• Total variable costs (TVC)
• Average variable cost (AVC)
• Total cost (TC)
• Average total cost (ATC)
• Marginal cost (MC)

13. Fixed Costs (FC) Fixed Cost denotes the costs which do not vary with the level of
production. FC is independent of output. Eg: Depreciation, Interest Rate, Rent, Taxes  Total
fixed cost (TFC): All costs associated with the fixed input.  Average fix
output: AFC = TFC /Output
Variable Costs (VC) Variable Costs is the rest of total cost, the part that varies as you
produce more or less. It depends on Output. Eg: Increase of output with labour.  Total
variable cost (TVC): All costs associated with the variable input.  Average var-
cost per unit of output: AVC = TVC/ Output
Total costs (TC) The sum of total fixed costs and total variable costs: TC = TFC + TVC
Average Total Cost Average total cost per unit of output: ATC =AFC + AVC ATC = TC/
Output
. Marginal Costs The additional cost incurred from producing an additional unit of output:
MC = ∆ TC ∆ Output MC = ∆ TVC ∆ Output
• 8. Typical Total Cost Curves  TVC,TC is always increasing: First at a decreasing
rate.  Then at an increasing rate
Shape of cost curves in short and long run
In economics, a cost curve is a graph of the cost of production as a function of total quantity
produced. In a free market economy ,productively efficient firms use these curves to find the
optimal point of production, where they make the most profits .There are various types of
cost curves, all related to each other. The two basic categories of cost curves are total and per
unit or average cost curves.
Short-run average variable cost curve (SRAVC)
Average variable cost (which is a short-run concept) is the variable cost (typically labor cost)
per unit of output: SRAVC = wL / Q where w is the wage rate, L is the quantity of labor
used, and Q is the quantity of output produced. The SRAVC curve plots the short-run average
variable cost against the level of output, and is typically U-shaped.
Short-run average total cost curve (SRATC or SRAC)

14. The average total cost curve is constructed to capture the relation between cost per unit of
output and the level of output.
Short-run total cost is given by
STC = PKK+PLL,
Where PK is the unit price of using physical capital per unit time, PL is the unit price of labor
per unit time (the wage rate), K is the quantity of physical capital used, and L is the quantity
of labor used. From this we obtain short-run average cost, denoted either SATC or SAC, as
STC / Q:
SRATC or SRAC = PKK/Q + PLL/Q = PK / APK + PL / APL,
Where APK = Q/K is the average product of capital and APL = Q/L is the average product of
labor. Short run average cost equals average fixed costs plus average variable costs. Average
fixed cost continuously falls as production increases in the short run, because K is fixed in the
short run. The shape of the average variable cost curve is directly determined by increasing
and then diminishing marginal returns to the variable input (conventionally labor).
Long-run average cost curve (LRAC)
The long-run average cost curve depicts the cost per unit of output in the long run—that is,
when all productive inputs' usage levels can be varied. All points on the line represent least-
cost factor combinations; points above the line are attainable but unwise, while points below
are unattainable given present factors of production..
Short-run marginal cost curve (SRMC)
A short-run marginal cost curve graphically represents the relation between marginal (i.e.,

15. incremental) cost incurred by a firm in the short-run production of a good or service and the
quantity of output produced. This curve is constructed to capture the relation between
marginal cost and the level of output, holding other variables, like technology and resource
prices, constant. The marginal cost curve is U-shaped.
Long-run marginal cost curve (LRMC)
The long-run marginal cost curve shows for each unit of output the added total cost incurred
in the long run, that is, the conceptual period when all factors of production are variable so as
minimize long-run average total cost. Stated otherwise, LRMC is the minimum increase in
total cost associated with an increase of one unit of output when all inputs are variable.
The long-run marginal cost curve is shaped by economies and diseconomies of scale, a long-
run concept, rather than the law of diminishing returns, which is a short-run concept. The
long-run marginal cost curve tends to be flatter than its short-run counterpart due to increased
input flexibility as to cost minimization. The long-run marginal cost curve intersects the long-
run average cost curve at the minimum point of the latter.