Micro Economics part 2
Micro Economics part 2 is the basic economics that covers Production Function , supply and it’s elasticity that covers the Syllabus of class 11
Production function:
The relationship between physical input and physical output of a firm is generally referred to as production function.
The general form of production function is,
q = f ( x1 ,x2)
where, q = output, x1 = 1 input like labour, x2 = another input like machinery.
Variable factors are those factors, which can be changed in the short run. They vary directly with the output. For example, Labour, raw material, etc.
Fixed factors are factors which cannot be changed in the short run. They do not vary directly with the output. For example, Capital, land, plant and machinery, etc.
A short period is the period of time in which a firm cannot change some of its factors like plant, machinery, building, etc. due to short of time but can change any variable factor like labour, raw material, etc therefore in short run, there will be some factors of production that are fixed at predetermined levels, e.g., a farmer may have fixed amount of land.
A long period is a time period due to change in demand. Here all the factors of production are variable we can change according to requirement of output.
This distinction depends merely upon how quickly factor inputs can be change by producers in an industry.
Short run production function can be defined, when application of one factor is varied while all the other factors are kept fixed (constant). The law that operates here, is known as “law of returns to a factor”.
For example, on 5 acres of land, 1 labour can be employed. So, initially factor ratio will be 5 : 1, when we employ another labour, the factor ratio changes to 5 : 2. So, factor ratio changes during short period.
Long run production function can be defined as, when application of all the factors is varied (changed) in the same factor proportion, the law that operates in such a situation is known as law of returns to scale’.
In this a firm can change all its factors of production including land, labour, machines, building, organization, etc.
In other words, it is a period of time during which supplies can adjust.
Total Product, Average Product And Marginal Product
Total product :
It refers to total volume of goods and services produced by a firm with the given input during a specified period of time.
In a short period of time if a firm wants to increase its total product then it can do so by increasing the variable factors of production only because fixed factors of production remain fixed and cannot be changed with the fluctuation in production.
However, in the long period, increase in all the factors of production can increase level of output. In short run, total product can be increased up to a particular point only because after that point TP starts decreasing.
Total Product, we have to add Marginal Product It is the sum of Marginal product .
Total Product, we can use this formula:
Total product=APL x Units of variable factor AP is average product . It is also called total return to the input
Average product : It is per unit total product of variable factors. It is calculated when total product is divided by number of units of variable factors It is also known as average return to the inputs employed
Average Product=Total Product/Unit of Variable Factor
8. Marginal Product:
It is an addition to the total product when an additional unit of a variable factor is employed.
MP=Change in output /Change in input =Δq/ΔL
4. Total Product, Average Product and Marginal Product with the help of schedule and diagram are as follows:
Scheduled
Fixed factor(Land) : — 1—- 1—–1——1—–1—–1—–1
variable factor(labour) 0—1—–2——3—–4—–5—-6
Total product (TP) 0—10—30—-45—-52—52–48
Marginal product (MP) —–10—20—15—–7—-0– -4
In the above schedule land is made fixed factor as one unit , labour is made variable factor which changes from 0 -6 units as the number of labour increases from 0 to 2 unit TP &MP increases with increases rate than after from 3 and 4unit of labour TP increases with diminishing rate but MP falls at 5th unit of labour MP is Zero but TP is maximum after that TP falls and MP is negative.
Explanation of a Curves
TP increases continuously from points O to M. It increases at an increasing rate (convex shape) from O to N and at a diminishing rate (concave shape) from M to N. TP is maximum at N and remains so upto point N. After point N Total product falls.
MP curve initially rises, reaches its maximum and ultimately declines taking the shape of inverted U Similarly, AP curve first rises, reaches its maximum and then declines taking the shape of an inverted U.
Return to a variable factor states that change in the physical output of a good when only the quantity of one input is increased, while that of other input is kept constant.
Law Of Variable Proportions
The law of variable proportion states that as we increase the quantity of only one input, keeping other inputs fixed, the total product increases at an increasing rate (convex shape) in the beginning, then increases at diminishing rate (concave shape) and after a level of output ultimately falls.
Assumptions of Law of Variable Proportions
(a) Only one input is variable, the other is held constant or fixed.
(b) It is possible to change the proportion in which the factor units are combined.
(c) It assumes a short run.
(d) The state of technology is given and remains unchanged.
(e) Price of factors of production do not change.
It can be explained with the help of schedule and diagram:
Scheduled
Fixed factor(Land) : — 1—- 1—–1——1—–1—–1—–1
variable factor(labour) 0—1—–2——3—–4—–5—-6
Total product (TP) 0—10—30—-45—-52—52–48
Marginal product (MP) —–10—20—15—–7—-0– -4
In the above schedule land is made fixed factor as one unit ,variable factor changes/ increases TP first increases with increasing rate and MP also increases , after that from 3 rd and 4th unit TP increases with diminishing Rate Mp falls but at 5th unit TP is maximum than after falls and at this point MP is zero and finally become negative.
4. Explanation of Each Phase
Phase I: Phase of increasing return or Increasing Return to factor
It is called the stage of increasing returns. The total product increases at an increasing rate (convex shape) up to point M. The marginal physical product of labour (MP) is increasing and reaches its highest point MJ vertically downwards to point M.(c) Point M is called the point of inflexion. At point M, the curvature of the TPP curve changes. It stops increasing at an increasing rate and starts to increase at a diminishing rate.
In the first stage, firm is moving towards achievement of ideal combination of factors in which TP is increasing at an increasing rate at every level of output. So, instead of stopping its production, the firm will continue employing additional units of a variable factor.
Phase II:
Stage of Diminishing Returns or Diminishing Return to factor
The total product (TP) continues to increase, but at a diminishing rate (concave shape) and eventually becomes the highest. MP is diminishing but is positive.
The stage comes to an end,
when Marginal Product (MP) = Zero and Total Product (TP) is maximum and constant.
The firm would like to operate in the second phase because TP is maximum and there is proper utilization of fixed factor.
Phase III: Phase of Negative returns or Negative Return to factor
In this stage the total product declines in absolute terms. The marginal product becomes negative.
The firm cannot operate in the third stage where MP is negative and TP starts declining as we are moving beyond the optimum degree of specialisation.
There are causes for the operation of increasing returns
Proper utilisation of the fixed factor .In the initial stage of production the units of variable input i.e., labour) is so less that fixed inputs cannot be effectively utilized.
Proper utilization of the fixed factor can be attained when more and more units of variable factor (labour units) are applied to the fixed factor (land), the fixed factor will be used intensively and output will increase rapidly.
Indivisibility of fixed factor means that due to technological requirements a minimum amount of fixed factor must be employed, whatever the level of output, i.e., fixed factor cannot be divided into smaller units therefore as more units of variable factors are employed with an indivisible fixed factor, output increases due to fuller and more effective utilization of the fixed factor.
Specialisation and division of labour In the beginning there was only one labour working on all the 5 acres of land ploughing, watering, etc.As the number of labour increases, each worker specialised in a particular activity leads to specialisation of the variable units and this resulted in increased output.
Reasons for diminishing returns:
The non-optima! combination of variable factor with the fixed factor When a given quantity of a fixed factor is combined with more and more units of variable factor, the additional units of variable factor will have smaller and smaller quantity of fixed factor to work with them.
As many workers share the same fixed factor, the share of each would obviously fall. Therefore, the cooperation of the fixed factor is not available to the same extent. Thus, an increase in the variable factor would add less and less to total output.
(b) Imperfect Substitutes:
Diminishing return to factor occurs because variable factor and fixed factor are imperfect substitutes to each other. There is a limit to which variable factor can be applied to fixed factor and that limit depends upon the efficiency of fixed factor.
So, variable factor and fixed factor are imperfect substitutes to each other.
Reasons for Negative returns:
Scarcity of Fixed Factor
During a short period, there is a limitation that we cannot change the fixed factor. So, variable factor can be change upto a certain limit and that limit depends upon the efficiency of fixed factor. If we cross that limit, the total product starts falling.
(b) Efficiency of Variable Factor Fall
In this stage the amount of variable factor becomes excessive relative to the fixed factor. This happens when too many LABOUR are engaged in cultivating on a given piece of land. They cause overcrowding and chaos and thus hamper each other’s work.
In such a case, the contribution of additional labour to production is bound to be negative. Thus, the marginal returns become negative and the total returns start diminishing.
(c) Efficiency of Fixed Factor Fall
Too much of a variable factors may also lead to the inefficiency of the fixed factor as well. In case of machine, which is a fixed factor, too much of labour may cause lot of wear and tear of machinery, frequent breakdowns and excessive cost of maintenance.
This is bound to affect total production adversely. In such a situation it is advisable to reduce the units of the variable factor than to increase it with a view for getting maximum production.
Law Of Diminishing Marginal Returns
1. The Law of diminishing marginal return states that when we applied more and more units of variable factor to a given quantity of fixed factor, total product increases at a diminishing rate and marginal product falls.
2. Law of diminishing marginal returns is a classical theory and classical economists treated it as a separate Law. But according to modern economists, this law indicates just one aspect (aspect of diminishing returns) of law of variable proportion.
schedule
fix factor (land ) | 1 — 1—– 1—- 1 —- 1 —–
labour /variable | 1 2 3 4 5
TP | 12 22 30 36 40
MP | 12 10 8 6 4
In the above schedule and diagram when more units of variable factor are employed with a given quantity of fixed factor TP increases at a diminishing rate or MP goes on falling. That is why shape of MP curve is a downward sloping
Relation between TP and MP
i) As long as TP increases with increasing rate MP rises
ii)When TP increases with diminishing rate MP falls
iii) When TP is maximum MP is zero
iv) When TP falls MP is negative
Relation between AP and MP
i) When MP rises AP also rise but with less rate
ii) When AP is maximum AP= MP
iii)When MP is less than AP ,it falls with higher rate than MP
SUPPLY AND THE ELASTICITY OF SUPPLY
Stock is total quantity of a particular commodity that is available with the firm at a particular point of time .
Supply is the quantity of a commodity that a firm is willing and able sale, at particular price during a given period of time. This is also called Individual supply
In other words, supply is the part of stock which is actually brought in the market for sale.
Stock can never be less than supply.
For example, a seller has a stock of 1000kg of rice in the godown. If the seller is willing to sell 30 kg at a price of Rs. 80 per kg, then supply of 30 kg is a part of total stock of 1000kg of rice.
Market supply is the quantity of a commodity that all firms in the market are willing and able to sale at given price during a given period of time.
4. Factors affecting personal (individual) supply:
Price of the commodity:
There is Positive relationship between price of the commodity and supply of that commodity. It means, with the rise in price of the commodity, the supply of that commodity also rises and vice-versa.
Price of the factors of production:
This effect the supply as price of factors (rent, wages, interest, profit) constitutes the cost of production of a commodity .
An increase in the price of a factor of production may lead to fall in production of a commodity shifting the supply curve to the left.
On the other hand a producer may supply more of a commodity at a given price if the prices of factors fall shifting the supply curve to the right.
State of technology:
When technological progress takes place in the firm, then cost of production will decrease, which leads to increase in the profit margin of the firm supply of commodity increases thereby shifts the supply curve rightward.
Supply of those goods being produced with old and inferior technology which increase in cost of production therefore decrease the output and shift the supply curve to the left.
Tax Policy:
Tax that the government imposes per unit sale of output. For example, suppose that the tax imposed by the government is Rs 3.
Then, if the firm produces and sells 40 units of the goods, the total tax that the firm must pay to the government is 40×3 = 120 if the unit tax increases, the firm’s cost of production increases which will shift the supply curve leftward.
Similarly, if the unit tax decreases, the firm’s cost of production decreases, which will shift the supply curve rightward.
Price of other goods:
Suppose a firm produces more than one product with its given resources. An increase in the price of other goods induces the firm to produce more of other goods to earn more profit and less of goods whose prices remained unchanged.
Objective of the firm:
Sometimes a firm may be induced to increase supply of a commodity for more profit but because its supply is a source of prestige/to capture the market a firm may increase production just to achieve the goal of maximum sale or maximum employment.
5. Factors affecting Market supply:
(a) Price of the commodity
(b) Price of the factors of production
(c) State of technology
(d) Unit tax
(e) Price of other goods
(f) Objective of the firm
(g) Number of firms in the market:
When the number of firms in the industry increases, market supply also increases due to large number of producers producing that commodity, market supply will decrease, if some of the firms start leaving the industry due to losses.
Future Expectation regarding price:
If sellers expect a rise in price in near future, current market supply will decrease in order to raise the supply in future at higher prices and if the sellers fear that the prices will fall in the future, they will increase the present supply to avoid losses in future.
Means of transportation communication:
Proper infrastructural development, like improvement in the means of transportation and communication, helps in maintaining adequate supply of the commodity.
Supply function shows the relationship between quantity supplied for a particular commodity and the factor influencing it.
Individual supply function .
It tells the relationship between the supply of commodity and other factors such as price , technology.
S = f ( Px, Po, Pf,———-)
Px= Price of the given commodity x.
P0 = Price of other goods.
Pf = Prices of factors of production.
St= State of technology.
T = Taxation policy.
O = Objective of the firm.
Market supply function is the functional relationship between market supply and factors affecting the market supply of a commodity, market supply is affected by all the factors affecting the individual supply
In addition, it is also affected by some other factors like number of firms, future expectations regarding price and means of transportation and communication.
Market supply function is expressed as, Sx = f(Px, P0, Pf, St, T, O, N, F, M)
Where, Sx = Market supply of given commodity x.
Px= Price of the given commodity x.
P0 = Price of other goods.
Pf = Prices of factors of production.
St= State of technology.
T = Taxation policy.
O = Objective of the firm.
N = Number of firms.
F = Future expectation regarding price of given commodity x.
M = Means of transportation and communication.
Supply schedule is a table showing various quantities of a commodity offered for sale corresponding to different possible prices of that commodity.
Supply schedule is of two types:
(a) Individual supply schedule
(b) Market supply schedule.
Individual supply schedule refers to the supply schedule of an individual firm in the market.
Table shows a hypothetical supply schedule for commodity ‘x’.
price of commodity X quantity supplied in units
5 25
10 50
15 75
20 100
As seen in the schedule, quantity supplied of commodity x increases with the increase in price. The producer is willing to sell 50 units of x at a price of 10. When the price rises to 20, supply also rises to 100 units.
11. Market supply schedule refers to supply schedule of all the firms in the market producing a particular commodity. It is obtained by adding all the individual supplies at each and every level of price.
Market supply is calculated as, SM= Sa+ Sb + …. Where Sm is the market supply and Sa + Sb+ … are the individual supply of supplier A, supplier B and so on.
Let us understand the derivation of market supply schedule with the help of Table (Assuming that there are only 2 producers A and B in the market).
price of commodity Supply of commodity x Market supply
in Rs Sa Sb Sm= Sa+ Sb
10 80 70 150
20 175 125 300
As seen in table market supply is obtained by adding the supplies of suppliers A and B at different prices. At price of Rs. 10 market supply is 150 units. When price rises to Rs. 20, market supply rises to 300 units. So, market supply schedule also shows the direct relationship between price and quantity supplied.
Supply curve is a graphical representation of supply schedule. It shows direct relationship between price and quantity supplied, keeping other factor constant.
Supply curve is of two types
(a) Individual Supply Curve
(b) Market Supply Curve
Individual supply curve is a graphical representation of individual supply schedule.
With the help of information given in supply schedule (see table), the supply curve for an individual firm can be drawn as shown in figure:
In figure, quantity supplied is taken on the horizontal axis and price on the vertical axis. At each possible price, there is a quantity, which the firm is willing to sell.
Point ‘A’ shows that 10 units are supplied at the price of Rs. 20. Point ‘B’ shows that 20 units are supplied at Rs. 40. and so on
By joining all the points , we get a curve
that slopes upward. The supply curve SS slopes upward due to positive relationship between price and quantity supplied.
Market supply curve
It is a graphical representation of market supply schedule. It is obtained by horizontal summation of individual supply curves.
Let us graphically convert the market supply schedule (table) into a market supply curve (see figure)
As seen in the diagram, quantity supplied is shown on the horizontal axis and price on the vertical axis. and SB are the individual supply curves.
Market supply curve is obtained by horizontal summation of the individual supply curves. At the price of Rs. 200 per unit both the firms will supply a total number of 6 units. When price rises to Rs. 400 per unit, market supply rises to 12 units.
Market supply curve is also positively sloped due to positive relationship between price and quantity supplied. Quantity Supplied
Market supply curve is flatter than all individual supply curves. It happens because with a rise in price, the proportionate rise in market supply is more than the proportionate rise in individual supplies.
Other things being constant (Ceteris Paribus), based on price of the commodity; then it is known as Law of Supply.
It means quantity supplied of the commodity rises due to rise in price of the commodity and vice-versa.
Ceteris Paribus means:
(i) Price of other commodity remains constant.
(ii) Technology of production should not change.
(iii) Cost of production remains constant.
(iv) Taxation policy of the government should not change.
(v) Objective of the firm remains constant.
Law of supply It explains only the effect of change in price on the quantity supplied. It states nothing about the effect of change in quantity supplied on the price of the commodity.
The schedule and diagram are as follows:( the schedule and curve of Indvidual as given above)
Movement Along The Supply Curve Or Change In Quantity Supplied:
It is based on law of supply which states that quantity supplied of the commodity changes due to the change in price of the commodity. The change in quantity supply due to the change in the price of the commodity is known as Movement along the supply curve. It may be of two types; namely,
(a) Expansion in supply (increase in quantity supplied)
(b) Contraction in supply (decrease in quantity supplied)
Expansion in supply (increase in quantity supplied or upward movement along supply curve): states that quantity supplied of a commodity rises due to the rise in price of the commodity. The rise in quantity supplied due to the rise in price of the commodity is known as expansion in supply. In the given diagram price is measured on vertical axis whereas quantity supplied is measured on horizontal axis.
A producer is supplying OA quantity at OP price. But, due to the rise in price from OP to OP1, the quantity supplied increases from OQ to OB; which is known as expansion in supply.
Contraction in supply (decrease in quantity supplied or Downward movement along Supply Curve):
It is based on law of supply which states that quantity supplied of a commodity falls to the fall in the price of the commodity. The fall in the quantity supplied due to the fall in price of the commodity is known as contraction in supply.
In the given diagram, quantity supplied is measured on horizontal axis and price is measured on vertical axis. A producer is supplying OQ quantity at OP price, due to fall in price from OP to OP1, the quantity supply falls from OQ to OQ1, which is called contraction in supply.
Shift In Supply Curve Or Change In Supply:
1. It is based on factor other than price. If supply changes due to the change in the factors other than price, then it is known as shift in supply curve.
2. It may be of two types:
(a) Increase in supply (b) Decrease in supply
(a) Increase in supply:
An increase in supply means that producers supply more at a given level
of price of a commodity.
(ii) It’s conditions are:
• Fall in the prices of remuneration of factors of production.
• Fall in the prices of other commodities.
• Improvement in technology.
• Taxation policy of government falls.
• Change in objective of producer (inducing them to increase supply at the same price. In the given diagram price is measured on vertical axis whereas, quantity supplied is measured on horizontal axis. A producer is supplying OQ quantity at OP price.
But, due to the changes in the factors other than price, the supply curve shifts rightward from S1S1 to S2S2
With the rightward shift in supply curve from S1S1 to S2S2, the quantity supplied rises from OQ to OQ1; which is known as increase in supply.
(b) Decrease in Supply:
(i) A decrease in supply means that producers now supply less at a given level of price of a commodity.
(ii) It’s conditions are:
• Rise in the prices of remuneration of factors of production.
• Rise in the prices pf other goods.
• When the technology becomes outdated.
• Taxation policy of government rises.
• Change in objective of producer (inducing them to decrease supply at the same price).
(iii) In the given diagram, quantity supplied is measured on horizontal axis whereas price is measured on vertical axis. A producer is supplying OQ quantity at OP price.
But, due to changes in the factors other than price the supply curve shifts leftward from S1S1 to S2S2
With the leftward shift in the supply curve from SS to
S2S2 the quantity supplied falls from OQ to OQ1, which is known as decrease in supply.
Causes And Exceptions To The Law Of Supply
It is because of the following reasons:
Change in stock: With the increase in the price of the commodity sellers are ready to sell more from their old stock of goods. On the other hand, when price of a commodity decreases, sellers would like to increase their stock to avoid losses.
Profit and loss: With the rise in price producers generally increase their production in view of higher profit possibilities and vice-versa.
Entry or exit of firms: (i) When the price of a commodity increases, new firms enter into the industry with the view to earn profits which in turn increases the supply.(ii) when price starts falling, marginal firms (or inefficient firms) leave the market to avoid expected losses which thereby decreases the supply.
3. Exceptions to law of supply are:
Future expectations:(i) The law will not apply if there are future expectations for further change in prices if sellers expect further fall in prices in future, they would be ready to sell more even at low prices.
Agricultural goods: The supply of agricultural goods depends more on natural factors such as drought, floods, natural calamities etc. and less on their prices.
Perishable goods: The supply of perishable goods, like milk, vegetables, fish, eggs, etc. is also not affected by their prices. Sellers cannot hold these goods for long.
Rare articles:(i) Some precious and rare goods also, the law of supply does not apply.(ii) Artistic goods of high quality and poems written by top class poets come under this categoiy. Their supply cannot be increased even when their prices rise.
Backward countries:
(i) The law of supply loses its applicability in backward countries where production and supply cannot be increased merely because of rise in prices.
(ii) Here resources which are urgently required for production are lacking.
Elasticity Of Supply And Price Elasticity Of Supply(PES/ES)
The degree of responsiveness of quantity supplied due to the changes in determinants of supply (price of other commodity, price of factors of production, technology, etc.) is known as elasticity of supply.
The degree of responsiveness of quantity supplied due to the changes in price of the commodity is known as price elasticity of supply. It is quantitative statement, i.e., it tells us the magnitude of the change in quantity supplied as a result of change in price. when the price remain same but supply increases continuously than Es=∞ (graph 1) 
when % change in quantity supplied by produce more than change in price than supply elasticity is more than 1 ( graph 2 ) when % change in quantity supplied is equal to % change in price than Es=1 (graph 3) when % change in quantity supplied is zero than Es= o (graph 4) when % change in quantity supplied is less than the % change in price Es<1 (graph 5)
3. Percentage method/flux method for calculating price elasticity of supply:
According to this method, elasticity is measured as the ratio of percentage change in the quantity supplied to percentage change in the price.
Percentage change in quantity supplied = (Δq×100)÷q
percentage change in price (Δp ×100)÷p
(c)Price elasticity of supply (ES) =[(Δq×100)÷q]/[(Δp ×100)÷p]
Es= Δq×p/Δp×q
6.Factors Affecting Price Elasticity of Supply:
(a) Nature of the commodity: Elasticity of supply to some extent depends upon the nature of the commodity.
(i) For perishable goods have inelastic supply (because their supply cannot be increased or decreased) while the supply of durable goods is elastic the supply of agricultural goods is inelastic while it is elastic in case of industrial goods.
(b) Cost of production
If cost of production rises rapidly with the increase in output, there is less incentive to raise the supply with the increase in price therefore supply will be inelastic if cost of production increases slowly with the rise in output, supply will increase with the rise in prices. In this case, supply will be more elastic.
Time period
In the market period, supply of a commodity is perfectly inelastic as supply cannot be changed immediately with the change in price.
In the short period, supply is relatively less elastic as firm can change the supply by changing the variable factors.
In the long period, supply is more elastic as all the factors can be changed and supply can be easily adjusted as per changes in price.
Technique of production
If simple techniques of production are employed in the production of a commodity, its supply will be elastic, it becomes very difficult to change supply under complex techniques of production.
Availability of resources and facilities
(i) The production of a commodity requires adequate resources and other facilities like irrigation, power, transportation, banking, etc. The producers feel handicapped in their absence or shortage. Hence, supply becomes inelastic, if these resources and facilities are easily and adequately available, producers can easily respond to any change in price.
7. Time Horizons And Supply Curve
Time period which is available to a firm to adjust its supply also plays an important role in the shapes of supply curves.
(a) Short period:supply is relatively less elastic as firm can change the supply by changing the variable factors only, as fixed factors cannot be change during short period.
The supply curve during short period is inelastic, i.e., percentage change in quantity supplied is less than percentage change in price as shown in the adjacent figure.
(b) Long period: supply is more elastic as all the factors can be changed and supply can be easily adjusted as per changes in price.
The supply curve during long period is elastic, i.e., percentage change in quantity supplied is greater than percentage change in price as shown in the adjacent figure.
Very short period : It becomes very difficult for a firm to increase its production level even if price of its commodity has increased because factor inputs like new machinery, technical labour, etc. do not become available immediately individual and market supply curve will take the shape of vertical line parallel to Y-axis Es= 0