Discussion Unit A: Theoretical Foundation of Consumer

Behaviour:

1. Cardinal and Ordinal numbers and C and O Utility Concepts

• Cardinal numbers:
1, 2, 3, 4, - - - - -

o The number 2 is twice the site of number 1

o Measure utility of commodities A & B by utilis:
A: 20 utils
B: 40 utils
⇒ B Yields twice the utility of it.

• Ordinal numbers:
I, II, III, . . . . . . . .
o II > I, but II less than III
o Don’t know, by how much size relation of number not known
o Rank utility, and explain consumer behaviour without the
assumption of measurable utility.

2. The Marshallian Cardinal Utility Theory:

• Assumptions:
o Maximization of satisfaction.

o Rationality: Buys the commodity yielding highest amount of

utility per rupee.

o Utility is cardinally measurable. Measurable by the price that

the consumer is prepared to pay.

o Utility function exists:

TU = ƒ (G, S)
∂ TU = M U of G, S
∂G
∂ TU = M U of S, G
∂S

o Constant marginal, utility of money: Sine, money is used as a

measure of utility.

o Diminishing M U.

• Law of Diminishing M U:

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 No. of
oranges TU MU
consumed
0 0 -
1 20 20
2 35 15
3 45 10
4 50 5
5 53 3
6 55 2
7 56 1
8 56 0
9 55 -1
10 53 -2

o Develop both TU and MU curves from this data.

o Observe how behaviour of TU and MU related.

o The LDMU:
As an individual increases consumption of a given product
(say orange) holding consumption of other products constant,
MU derived from consumption eventually diminishes.

o What are the implications of this law to a business manager?

• Consumer Equilibrium and the Marshallian Proportionality Rule:

MUA = MUB ……… = MUZ = K
PA PB PZ

o Can we say that K is the MU of money i.e MUM?

o How does a consumer behaviour when:

MUA ≥ MUB ?
PA < PB

• LDMU and Demand Curve:

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 o Co ↑ MU ↓ → P ↓ D ↑
Co ↓ MU ↑ → P ↑ D ↓

o Hence inverse relationship between P and Quantity

demanded.

o Consumer Equilibrium:
MUX = PX

o If MU of X is measured in terms of money, then the MU curve

becomes the demand curve of the good.
P
MU/Price
P1
P2 MU/Demand
O Q
Q1 Q2
⇒ At P1 → Q1
At P2 → Q2

o MU curve could enter IV Quadrant whether D. C could enter IV

Quadrant?

3. Ordinal Utility Theory: The Hicksian Theory of Indifference

Curve

• Assumptions of O. U Theory:

 U is Ordinal:

o Measurement of U → Unrealistic and not needed to explain

consumer behaviour.
o Ordinal ranking to rank preferences according to the
satisfaction of each basket.

 Rationality:

o Maximize satisfaction, given income and product prices.

 The Axiom of consistency and transitivity:

o Consistency: of A > B, then B > A

o Transitivity: of A > B, B > C, then A > C.

 Axiom of non – satiability:

Page 3 of 30
 The Consumer: Not oversupplied with either commodity.
Consumers do not have enough of all things.

• Indifference Schedule and Indifference Curve:


Units Units
Combinatio Total
of of
n Utility
X Y
A 25 3 U1

B 15 6 U1

C 8 9 U1

D 4 17 U1

E 2 30 U1
o Five different combinations of X & Y yielding the same
level of satisfactory (U1)  Indifferent towards different
combinations.

 Indifference Curve: Diagramatic representation of indifference

schedule.

Y
30  E

Y 25
of 20  D
ts
15 C
Uni 
10 B

5 A IC1 (U1)
O  X
5 10 15 20 25
Units of X

Indifference Map:
Y

Page 4 of 30
 IC3
IC2
IC1
IC0
O X

o IC0 → U0
IC1 → U1
IC2 → U2  Different satisfaction levels
IC3 → U3
o U 3 > U2 > U1 > U0

• Properties of I. Curves:

 Negative Slope:
Along an IC: -(MUX) (∆X) = (MUY) (∆Y)
- MUX = ∆X = MRS = Slope of an IC
MUY ∆Y

o Why not positive slope? Why not horizontal? Why not vertical?

 Convex X to the origin:

o Marginal rate of substitution (MRS) between two goods

decreases as a consumer moves along a given I. C.  The
slope of an I. C curve decreases as we move from point E to A
 DMRS.

o Consider the following indifference schedule:

MRS
Apples Bananas
Combination ∆Y
(X) (Y)
∆X
a 1 12 -
b 2 8 - 4/1 = - 4
c 3 5 - 3/1 = - 3
d 4 3 - 2/1 = - 2
e 5 2 - 1/1 = - 1
 DMRS: The consumer assigns a lesser and lesser
significance of the extra unit of a commodity in a larger stock,
and relatively a higher significance for the one which is a

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 smaller stock. Movement from a to e  quantity of X becomes
larger and that of Y smaller. → Each time, the consumer will
sacrifice a lesser and lesser amount of Y in exchange for X.

o Why not an Indifference curve be concave to the origin?

o Why not an I. C a straight line?

 I. Cs do not intersect:

A
 IC2 (U2)

IC1 (U1)
X
U2 > U1, but at A, U2 = U1
o Can one I. C tangent to another?

 Upper I. Cs represent a higher level of satisfaction than the lower

ones.

 b
c
 d
Y* a 
IC2
IC1

X
X*
o Vertical movement from a to b  More of Y, same
amount of X
o Horizontal movement from a to d: Same amount of Y,
more of X
o Diagonal: Larger quantity of X & Y.

• Budgetary constraint and Budget Line:

 B = PY Y + PX X = Exp. on Y + Exp. on X

 Solving for Y:
Y = B - PX X → Eqn. for B. Line
PY PY

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 o B = Qy that can be purchased
PY When QX = ?

o B = QX …………… ?
PX

o Slope of B. Line: dY = - PX
dX PY
→ Price ratios of two commodities.

o Diagram:

Y
B/PY


B
QY A B. L or Price Line

O  X
QX B/PX
 B.L: The market opportunities available to consumer, given
his income and the prices of X and Y.
 Feasibility Area: Budget line and area under B. L (A)
 Non-feasibility Area: Area beyond the B. L (Ex. B).

 Shifts in B. L: B = PYY + PXX

__ __
o PY, PX, B↓ B↑  Parallel shift in B. L no
change in slope
__ __
o PY, B, PX↑ PX↓  Change in slope of B.L. But
shift in B.L?
__ __
o PX, B, PY↑ PY↓  Change in slope of B.L. But
shift in B.L?

o PX and PY change proportionately

 No. Change in slope
 P↓ PY↓  An increase in B
 P↑ PY↑  A decrease in B.

o PX and PY change disportionately

o Draw diagrams to illustrate all these cases.

 Total Effect of a Price Change = I.E + S.E
__ __

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 o Let PY↓, B and PX
o Buy more of Y
o Reasons: S.E: Substitute cheaper Y for X
__
I.E: With B, PY↓ → Real I↑ Inducement to buy more of
Y
(of Y is a …………. Good).

• The consumer’s Equilibrium

o I. Map: Preference of taste factors
o B.L or P.L: Power to satisfy them
o The point of consumer equilibrium or utility maximizing
rule:

Y
B/P
Y Q


 P
IC4(U4)
R IC3(U3)

IC2 (U2)
IC1(U1)
O  X
B/PX
 Q, P, R: 3 of the infinite number of attainable
combinations on B.L
 Q: Move towards right → point P on U3
Move towards left: Lower IC
 R: Move upward to hit point P
Shift from U2 to U3
 Point of C Equilibrium at P
 IC3 (U3) tangent to B.L
 Slope of IC (U3) = slope of BL
 MRSXY = Price Ratio
 MRSXY: Rate at which consumer is willing to substitute X
for Y
 Price Ratio: Rate at which he can substitute X for Y
 Point P: Two sets of forces those of the market operating
through BL and those of tastes operating through IC are
brought into balance.

o MRSXY = Price Ratio

∆X = - MUX = - PX  Slope of IC = Slope of BL

∆Y MUY PY

MUX = MUY  Does this imply the Marshallian

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 PX PY Proportionality Rule?
• Deriving Demand Curve from Price Consumption Curve
(PCC):

 P C C:

o Keep money income (M) constant

o Keep price of Y constant
o Allow decrease in PX.

M
e
om
Inc
y
E1 E3 PCC
E2
ne
 IC3
Mo 
IC1 IC2

O
X
X1 N1 X2 N 2 X3
N3
Quantity of X consumed.

o Original BL: MN1 →Quantity of X bought X1 →Point of

equilibrium: E1
o Allow PX↓ → New BL: MN2 → Q of X bought: X2 → New point of
equilibrium: E2
o Allow further fall in PX↓ → New BL: MN3→ Q of X bought: X3 →
New point of equilibrium: E3
o Connect successive equilibrium points E1, E2 and E3: called
PCC
o Thus, PCC is a locus of points of equilibrium on indifference
curves, resulting from the change in the price of a commodity.
In this case, PCC shows the change in consumption basket
due to fall in PX.

 Derive individual consumer demand curve for commodity X from

PCC.

PX

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 P

O X
X1 X2 X3
D for X
o Slope of B. Line: MN1 → Quantity of X bought: X1

o Fall in PX → New BL: MN2 → Q of X bought: X2

o Further fall in PX → New BL: MN3 → Q of X bought: X3

→ When price consumption relations are taken out and
plotted separately, that gives the demand curve depicting
inverse relationship between price and quantity
demanded, ORC.

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 Discussion Unit B
1. The Revealed Preference Theory

1. The Marshallian Cardinal approach to Demand Theory: Based on Cardinal

Measurement of utility.
• The Hicksian ordinal approach: Based on relative or ordinal or
introspective measurement of U. But non-observable.
• The RPT of Samuelson: Based on “actual”, behaviour of the consumer
2. The RPT based on the following assumptions
• Rationality: Consumer prefers a large basket of goods to the smaller
ones
• Transitivity: A,B,C, alternative basket of goods
APB
BPC
⇒ APC
• Consistency: APB, then B is not preferred to A
⇒ Strong ordering
⇒ Makes definitely one and only choice → Reveals his specific preference
• Effective price inducement: Consumer can be induced to buy a
particular collection by providing him sufficient price incentive.
• Positive income – Elasticity of Demand: Recall: Income – demand
function cases of normal, inferior and neutral good.
⇒ Negative Income Elasticity or Zero Income Elasticity is ruled out
3. Diagrammatic Exposition of RPT:
• Two commodities: X & Y
• Prices of X and Y: Given

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 • Has a given money income
Y
M•
∆ OMN: Comsumer’s choice triangle
•B •D
Units of Com Y

Y1
•A
•C

X1 N
0 • X
Units of Com X
• MN: BL
 Choice of commodity combination A: oY1 & oX1
⇒ Prefers A to any other feasible combination on MN
⇒ B or any other combination on MN: Not preferred.
⇒ His preference is revealed for A.
 Any other point:
Point C: Smaller and cheaper basket of X & Y
Point D: Larger and more expensive basket
Hence A is a preferred combination.
4. Derivation of Inverse Relationship between P & Q (Law of Demand) from
RPT:

Comm Y

M1

M2

•C
•A
•B

0 •
X1 X2 X3 N1 N2 N3
Comm X

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 Fig: SE & IE Effects: Revealed Preference Approach

• M1N1 = initial budget

• A = Choice at point A: with Ax1 of Y and 0X1 of X
• Know: All the points on M1N1, feasible combinations of X and Y
• But: Prefers A to all the other feasible bundles.
Let: Px↓, Py M → New B.L , M1 N3.
• But: Shift from A and C due to effects of price change viz income and
substitution effects
• Decompose total effect of price change into substitution and income
effects.
• M2 N2 : BL passing through point A.
⇒ Adjustment budget → point A with AX1 of Y and 0X1 of X still available
• Consumer: Not to choose any point between A and M2; because inferior
to bundle represent by Point A.
: Not to choose any other point say B on AN2 segment of the BL
: If continues to buy basket at point A ⇒ S.E is zero
: If chooses point B, SE = X1 X2
⇒D for X ↑ with a Px ↓ → Samuel Son’s Fundamental Demand Theorem.
⇒ Law of D is established
• The income effect: X2 to X3
• The S.E : X1 to X2
• Total effect of price change: X1 X3 = X1 X2 + X2 X3 → Move from point
A to point C
• RPT considers only the case of normal goods.

2. Demand Estimation and Forecasting:

2.1 Methods of Estimating Demand Function:

 Why demand estimation in BM?

Page 13 of 30
 • Impact of changes in exercise duty, lower prices, rising GDP
etc on demand for products.

 Consumer interviews (Surveys)

o Interview consumers on their consumption habits
o Census and sample methods
o Information on quantities of the concerned good bought at
different periods at various prices of the product, prices of
related goods, income of the consumer and so on.

 Market Experiments Method:

o Actual Experiment:
Record consumer’s reactions in different shop locations with
respect to income, religion, sex, age group etc.

o Market simulation (Consumer clinic or laboratory experiment)

method:
→ Provide token money to a set of consumers.
→ Vary prices of various goods, their quality, packaging
etc and record shopping behaviour of consumers.
→ Too costly and consumer’s may not take the experiment
seriously.

o Functional forms for estimation: Simple and

Multiple Regression.

 Regression Method:
→ Identify variables which influence demand for a
particular commodity
→ Collect data
→ Select appropriate functional form
→ Estimate the function
Ex: Demand Function for Groundnut Oil
Dg = f (Y, Po, Pv, Pg, U)
Where: Dg = demand for groundnut oil
Y = national income
Po = price of groundnut oil
Pv = price of vanaspathi
Pg = price of pure ghee
U = ‘other’ determinants of g.n.o
→ Time series or cross section data.

2.2 Demand Forecasting

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 D. Forecasting: An estimate of the future
demand, based on laws of probability.

 Levels of D. F:
o Micro Level: Forecast by an individual
business firm.
o Industry Level:
o Macro Level: Ex: Country consumption
function.

 Why D. F?
o Production planning
o Sales forecasting
o To control business and inventory
o To plan long term growth and investment
programmes.
⇒ Demand – led business strategy.

 Demand Forecasting Methods:

o Consumers’ survey

o Experts’ opinion
→Simple expert opinion poll
→Delphi Method: An extension of the
simple expert opinion poll
→Use Delphi Method (DM) to
consolidate the divergent expert
opinion and to arrive at a compromise
estimate of future demand.
→Under DM: Collect opinions from
experts. Instead of taking averages, try

Page 15 of 30
 to match the opinions by bringing
experts to-gether and to arrive at a
consensus.

• Statistical Methods:

 Trend method to extrapolate

Dg = f (T)
Where: Dg = demand for groundnut oil
T = Time (Years)

 Barometric Method of Forecasting

o Meteorologists use the barometer to
forecast weather conditions on the basis
of movements of mercury in the
barometer.
o So use relevant economic indicators such
as GDP, prices, lending rate for loans.

 Econometric Method: Regression Method

o Simple or Bivariate Regression

Technique:
Y = f (X)
Y = Sugar consumed
Y = Population

o Multivariate Regression
Dx = f (Px, Ps, M, A)
Where: Dx = Quantity of x demanded
Px = Price of X
Ps = Price of substitutes

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M = Consumer’s income
A = Advertisement expenditure

Page 17 of 30
3. Returns to Scale:

• To explain the behaviour of output in

response to proportionate and simultaneous
changes in input use ⇒
Expansion/Contraction in the scale of
production.

• Technical possibilities of proportionate and

simultaneous increase in the use of both L &
K:

o Y (output) increases more than

proportionately ⇒ IRS
o Y increases proportionately ⇒ CRS
o Y increases less than proportionately ⇒
DRS
o Y = ƒ (L, K)
o Firm uses L units of Labour in
combination with K units of capital to
obtain an output of Y: L + K → Y

o Let us change both L and K by a

proportion, call it λ.

 By how much Y increases?

 Let output increase by b:

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 λL + λK → bY bY
b=λ⇒ CRS
b>λ⇒ IRS
b<λ⇒ DRS

 Diagram:

IRS (Increasing Slope Curve)

Total output

CRS (Constant
Slope Curve)

DRS (Decreasing Slope Curve)

Units of L & K

 Why IRS?: Due to specialization – use of specialized

labour and machinery (Details later under Economies of
Scale).

 Why DRS?: With increased scale of operation, increased

problems of co-ordination (Details later under
Economies of Scale).

• Output elasticity and R to S:

α = % change in output (Y)
% change in all inputs (L & K)
α = ∆Y . IO
∆I YO
Case1: α > 1 ⇒ % change in Y >% change in inputs
⇒ IRS
Case2: α = 1 ⇒ % change in Y = % change in inputs
⇒ CRS
Case3: α < 1 ⇒ % change in Y < % change in inputs
⇒ DRS

Page 19 of 30
• R to S In Iso – Quant Framework:

K
3L + 3K → Y1 = 100
6 B 6L + 6K → Y2 = 200
A Y2 = 200⇒ C R S
3
Y1 = 100
O L
3 6

K
⇒?
6 C
A Y2 = 300
3
Y1 = 100
O L
3 6

Page 20 of 30
 K
⇒?
6 D
A Y2 = 1500
3
Y1 = 100
O L
3 6

4. Technology and P.F:

• Technical Change: Economic Interpretation

Y↑, I
Y, I↓

• Technical change for facing global competiveness.

• Labour – intensive technology: L ratio ↑

K

• Capital – intensive technology: L ratio ↓

K

• Neutral technology: L ratio remains constant.

K

• Impact of technology change on TP, MP and AP: TP↑ with same

amount of input. MP↑ and AP↑ with same amount of input.

• Upward shifts in product curves & shifts in iso-quant.

• Embodied technology change & P.F shift: Embodied in inputs (say a

new and more efficient machine).

• Disembodied technology change: P.F shifts due to improved

efficiency in input-combination, and improved managerial efficiency
etc. Do you contest this difference?

5. Economics and Diseconomics of Scale: Real and Pecuniary

Economics.

o Economics of Scale: Decreasing segment of LRAC curve.

o Diseconomics of Scale: Increasing segment of LRAC
curve.

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  Economics of Scale:

o Internal (internal to the firm) Economies:

 Economies of Production: Technological advantages and
advantages of division of labour and specialization.
 Economies in Marketing: Large scale purchase of inputs
and sale of output.
 Managerial Economies: Specialised management in
production, HRD, Marketing, Finance etc.
 Economies in Transport and Storage: Fuller utilization of
transport and storage facilities.
o External or Pecuniary Economies of Scale:
 Large scale purchase of inputs: Concessions and discounts.
 Large scale acquisition of external finance.
 Massive advertisement campaigns.

⇒ Declining portion of LRAC due to economies of scale due to

output expansion.

 Diseconomics of Scale: Rising portion of LRAC curve:

o Overcrowding of labour
o Managerial inefficiencies
o With full in demand for the product, underutilization of
capacity.

 Impact of Technological Change on LRAC Curve.

5.1 Economies of Scope: Multi-Product Firm

o Not the same as economies of scale.

o Many times, companies/firms produce more than one

product to lower the cost of each operation alone.
Ex1: Automobile companies producing cars and trucks ⇒
product diversification.
Ex2: A smaller commuter airline providing cargo services.
Ex3: Use the byproducts arising from the production of the
first product – sugar industry.

o Economies of Scope: Total of point production of cars

and trucks < Total cost of producing cars and trucks
independently by different firms.
TC(C,T) < TC(C) + TC(T) ⇒ Less expensive to produce jointly.

o Diseconomies of Scope: TC(CT) > TC(C) + TC(T) ⇒ Less

expensive to produce independently
o Degree of Economies of Scope:
DES= TC(An)+TC(Bn)-TC(An+Bn)

Page 22 of 30
 TC(An+Bn)
Where
 DES: Degree of Economies of Scope
 TC(An): Total cost of producing An
units of product A separately
 TC(Bn): Total cost of producing Bn
units of product B separately
 TC(An+Bn): Total cost of producing
products A and B jointly i.e producing An units of A and Bn
units of B together.

6. Learning Curves (Experience Curves).

• Decline in AC of inputs with rising cumulative output over time.

• Take 1,000 hours to assemble the 100th aircraft, but only 700 hours
to assemble 200th aircraft workers and managers become more
efficient with passage of time.

AC

 F

 G
Learning Curve

O Cumulative
Qt 2Qt Total Output

o Otth output (like 100th aircraft)

o 2Qtth output (like 200th aircraft)

• Economies of Scale: Declining AC of input due to output expansion.

• But Learning Curve: Cumulative experience and decling AC of input
for different units of output.
• Learning Curve: Experienced in manufacturing airplanes,
appliances, ship building, refined petroleum products and operation
of power plants.
• Learning Curve: Used to forecast the requirement of personnel,
machinery and raw materials and scheduling product and
determining the price at which to sell output.
Ex: Texas instruments has followed an aggressive price policy for
computer chips, based on the learning curve.

Page 23 of 30
 Comparison of E of S and Learning Curve:
Know:
o Technical Progress: Downward shift in LRAC Curve.
o Managers and workers gaining experience: Downward shift in
LRAC Curve.

Page 24 of 30
 LRAC

A LRACt
LRACt+1

O Output
Qt Qt+1

 Observations:
o Two periods: t and t+1
o Qt and Qt+1 levels of output during t and t+1
o LRAC at t: OC for Qt level of output
o LRAC at t+1: OB
⇒ Lower LRAC during t+1 period
⇒ BC = Unit cost saving.
o Expand output from Qt to Qt+1
⇒ Economics of Scale:
LRAC at Qt+1: OA
OA < OB < OC
o Learning Curve Effect: BC
o E of Scale Effect: AB
o Downward shift due to learning and movement along a given
LRAC curve due to E of scale
o Remember: Downward shift in LRAC curve (AC reductions)
may be due to Learning Experience, Economies of Scale,
technology and input price decline.

 Hold other things constant to sort out net effect of L.C (Previous
Diagram)

7. X – Efficiency:

• Efficiency in production ⇒ Cost Economy

• Any improvement in efficiency → downward shift in cost
functions
• Cost reduction: Possible through minimizing wastage of
resources
• X-efficiency: Firm’s ability to monitor and control production unit
to minimize the wastage of resources
• X-efficiency: A function of management to minimize the wastage
of resources

Page 25 of 30
 • New Managerial Approaches: Six-Sigma Methodology (Adopted
by Motorola, GE and others) to achieve X-efficiency so as to
minimize waste and to attain zero defect level of the business
firm.

8. Cost – Volume – Profit Analysis: Break – Even Point and

Operating Leverage.

• Examine the relationship among TR, TC and total profit at various

levels of output (Q).

• C – V – P analysis or B – E – A: used by business executives to

determine volume of sale required for the firm to break even and
the total profits and losses at other sales levels. At what output level
B – E, Losses and Profits?

• Use C – V – P or B – E Analyse.

• B – E Analysis: Linear Cost and Revenue Function

CF: TC = 100 + 10 Q
RF: TR = 15 Q.
→ 100 = TFC
V.C varies with output (Q) and varies at a constant rate of 10 per
unit.
→ Sale Price = 15

 Algebraic Calculation of B – E – P:
→ TR = TC
→ 15Q = 100 + 10Q
→ Q = 20 ⇒ 20 is the B – E output
→ Beyond 20: operating profit
→ Below 20: operating loss.

 Diagrammatic Representation:
Costs
Revenue TR
Operating Π
700 Π>0 TC
600 TVC
500
400 Operating

300 loss B
200
100 Π<0 TFC

O Q (output)
10 20 30 40

o TFC = 100

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 o TVC: Variable Cost
o TC = TC function i.e TFC + TVC
o TR = Total Revenue: P.Q
o Point B: Point of intersection between TR & TC lines Q=20, B.E
level of output
o Thus Point B: B – E – Point
o Below Q=20, TC > TR ⇒ operating loss
o Above Q=20, TR > TC ⇒ operating profit
o B.E.P: TR=TC ⇒ Π=0 ⇒ losses cease to ever and profits yet to
begin.

 Limitation of L – C and L – R functions

o C and Revenue functions may be non – linear: Because AVC
and price of output vary at different rates with variations is
output.
o Under non – linear conditions, there might be two B – E points,
instead of one.

• B – E – Analysis: Non – Linear Cost and Revenue

Functions.
Costs
and
Revenue
TC

B2

B1 TR


A TFC

O Q (output)
Q1 Q2
o TFC = Total Fixed Cost (OA)
o TVC = TC – TFC = The vertical distance between TC and TFC
o TC = Total Cost = TFC + TVC
o B1 & B2: Points of intersection between TR & TC ⇒ TR = TC
o B1: Lower B – E point at Q1 output level
B2: Upper B – E point of Q2 output level
⇒ Firm, producing more than OQ1 and less than OQ2 will make
profit
⇒ Profitable range of output:
More than OQ1
Less than OQ2.
⇒ Producing less than OQ1
more than OQ2
→ losses.
o Contribution Analysis:

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 Recall: IC = Incremental Cost of a business decision
IR = Incremental Revenue from a business decision.
 “Contribution”: TR – TVC, TFC not considered
 At B – E Point
“Contribution” = Fixed Costs.

• Uses of B – E Analysis:

o To Know: Level of sales required to cover all costs

o To Know: What happens to overall profitability, when the
company incurs higher or lower fixed or variable costs
o To Know: Between two alternative investments, which one
offers the greater margin of profit
o To Know: What happens to overall profitability when a new
product is introduced
o To forecast Π, when revenue and cost estimates are available.
o To Know: Margin of safety
o Useful for production planning
o Useful for deciding when to start paying dividend to its share
holders.

9. Degree of operating leverage:

 Percentage change in profits that results from percentage

change in number of units sold i.e elasticity of profit with respect
to output sold.

∆Π
DOL = %∆Π = Πo = ∆Π . Qo
%∆Q ∆Q ∆Q Πo
Qo

10. Estimation of Cost Function:

 Forward Planning: Basis for decision – making.

 SR Cost Function: Necessary for the firm determing the optimum

level of output and the price to charge.

 LRC Function: Essential in planning for the optimal scale of plant

for the firm.

 Methods for obtaining appropriate information of its future cost –

output relationship.

o Engineering Method:

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  Based directly on the production function, input prices
and the optimum input combination for producing a given
quantity of output.
 Using this information, engineers provide least – cost
estimates.
 Based on given technology and input prices.
 When technology and input prices are changing, difficult
to obtain accurate estimates.

• Survivorship Method (Survival Technique)

 Classify various firms of an industry into size groups: small,

medium and large

 Most efficient size group: share in the industry in creases

 Least efficient size group: share in the industry decreases

Industry Share (%)

 Site group Base Year Current Year
S 10 12
M 30 50
L 60 38

⇒ M – Size group: Most efficient

L – Size group: Most inefficient
⇒ Competition will eliminates inefficient firms
⇒ Firms with lower average cost will survive.

 Limitation: The method does not yield the cost function. Does
not allow the measurement of degree of economies and
diseconomies of scale.

• Statistical Method: Regression Method

 Short Run Cost Function:

C = TC = f (Q)
C = total cost = TFC + TVC
Q = output

 Linear Cost Function:

TC = a + b Q
TC = 100 + 0.5 Q
∴ TFC = 100
TVC = 0.5 Q
Let Q = 10
TVC = (0.5) (10) = 5

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 TC = 100 + 5 = 105
AC = -----------------
MC = ----------------

 Quadratic Cost Function:

TC = a + b Q + CQ2
TC = 100 + 60Q + 3Q2, TFC = 100

 Cubic Cost Function:

TC = a + b Q – CQ2 + dQ3
TC = 100 + 60Q – 5Q2 + 0.7 Q3, TFC = 100

 Long Run Cost Functions:

o To determine the “best” scale of plant for the firm to build in
order to minimize the cost of producing the anticipated level
of output in the long run.
o Can use either time series data or cross section data.
o Can estimate L – R Cost Functions with engineering and
survival techniques.

 Managerial Uses of Estimated Cost Functions:

o To determine the optimum scale or size of the fixed plant and
equipment.
o To determine the optimum output for a given plant size.
o To determine the supply schedule/curve.

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