REFERENCE NOTES FOR ASSIGNMENT 5
Price elasticity of demand
A measure of the extent to which the quantity demanded of a good changes
when the price of the good changes.
To determine the price elasticity of demand, we compare the percentage
change in the quantity demanded with the percentage change in price
[REFER PPT NOTES ]
ASIGNMENT 6
diminishing returns, also called law of diminishing returns or principle of diminishing
marginal productivity , economic law stating that if one input in the production of a commodity
is increased while all other inputs are held fixed, a point will eventually be reached at which
additions of the input yield progressively smaller, or diminishing, increases in output.
In the classic example of the law, a farmer who owns a given acreage of land will find that a
certain number of labourers will yield the maximum output per worker. If he should hire more
workers, the combination of land and labour would be less efficient because the proportional
increase in the overall output would be less than the expansion of the labour force. The output
per worker would therefore fall. This rule holds in any process of production unless the
technique of production also changes.
Early economists, neglecting the possibility of scientific and technical progress that would
improve the means of production, used the law of diminishing returns to predict that as
population expanded in the world, output per head would fall, to the point where the level of
misery would keep the population from increasing further. In stagnant economies, where
techniques of production have not changed for long periods, this effect is clearly seen. In
progressive economies, on the other hand, technical advances have succeeded in more than
offsetting this factor and in raising the standard of living in spite of rising populations.
diminishing marginal returns, its easy to remember if you imagine an arch.
an example would be, if there is a land, and if a farmer,(which is labor) plants a crop, the result
would be the number of crop planted and the profit you get from the crop if he sells it. if he
invest and bought a tractor and the land remains constant, meaning its still the same size,
productivity and profit will increase. if he buys another tractor, the profit will not increase the
same as before when he first bought the first tractor, In fact his profit will decrease. Like an arch
increasing your factor increases production, but there will be a point that it will not be increasing
anymore.
It is also known as law of Diminishing Marginal Utility - DMU [Link]'s assume you are very
hungry. You get a loaf of bread with some good gravy. You eat it fast and relish it. You are
given one more loaf, you eat that too. When a third loaf is given your hunger is almost satiated
and you eat it slowly. When a fourth loaf is given, you are too full and don"t feel like eating it.
Here you got the maximum returns in your first loaf and thereafter the returns started coming
down and finally if you are given a fifth loaf - you don't even want to see it. No returns.
The Law Of Diminishing Marginal Returns
Total Product (TP) This is the total output produced by workers
Marginal Product (MP) This is the output produced by an extra worker
Definition: Law of Diminishing Marginal Returns
According to business dictionary
A concept in economics that if one factor of production (number of workers, for example) is
increased while other factors (machines and workspace, for example) are held constant, the
output per unit of the variable factor will eventually diminish.
Although the marginal productivity of the workforce decreases as output increases, diminishing
returns do not mean negative returns until (in this example) the number of workers exceeds the
available machines or workspace. In everyday experience, this law is expressed as "the gain is
not worth the pain."
· Diminishing Returns occurs in the short run when one factor is fixed (e.g. Capital)
· If the variable factor of production is increased, there comes a point where it will become less
productive and therefore there will eventually be a decreasing marginal and then average product
· This is because if capital is fixed extra workers will eventually get in each other’s way as they
attempt to increase production. E.g. think about the effectiveness of extra workers in a small
café. If more workers are employed production could increase but more and more slowly.
· This law only applies in the short run because in the long run all factors are variable
· Assume the wage rate is £10, then an extra worker Costs £10.
· The Marginal Cost (MC) of a sandwich will be the Cost of the worker divided by the number of
extra sandwiches that are produced
· Therefore as MP increases MC declines and vice versa
· A good example of Diminishing Returns includes the use of chemical fertilizers- a small
quantity leads to a big increase in output. However, increasing its use further may lead to
declining Marginal Product (MP) as the efficacy of the chemical declines.
Difference between Diminishing Returns and Diseconomies of scale.
Diminishing returns relates to the short run – higher SRAC. Diseconomies of scale is concerned
with long run. (higher LRAC)
Assignment 7
Different Types of Costs with Examples - From M to W?
(A) Actual Cost
Actual cost is defined as the cost or expenditure which a firm incurs for producing or
acquiring a good or service. The actual costs or expenditures are recorded in the books of
accounts of a business unit. Actual costs are also called as "Outlay Costs" or "Absolute
Costs" or "Acquisition Costs".
Examples: Cost of raw materials, Wage Bill etc.
(B) Opportunity Cost
Opportunity cost is concerned with the cost of forgone opportunities/alternatives. In other
words, it is the return from the second best use of the firms resources which the firms
forgoes in order to avail of the return from the best use of the resources. It can also be said
as the comparison between the policy that was chosen and the policy that was
rejected. The concept of opportunity cost focuses on the net revenue that could be
generated in the next best use of a scare input. Opportunity cost is also called as
"Alternative Cost".
If a firm owns a land, there is no cost of using the land (ie., the rent) in the firms
account. But the firm has an opportunity cost of using the land, which is equal to the rent
forgone by not letting the land out on rent.
(C) Sunk Cost
Sunk costs are those do not alter by varying the nature or level of business activity. Sunk
costs are generally not taken into consideration in decision - making as they do not vary
with the changes in the future. Sunk costs are a part of the outlay/actual costs. Sunk costs
are also called as "Non-Avoidable costs" or "Inescapable costs".
Examples: All the past costs are considered as sunk costs. The best example is amortization
of past expenses, like depreciation.
(D) Incremental Cost
Incremental costs are addition to costs resulting from a change in the nature of level of
business activity. As the costs can be avoided by not bringing any variation in the activity
in the activity, they are also called as "Avoidable Costs" or "Escapable Costs". More ever
incremental costs resulting from a contemplated change is the Future, they are also called
as "Differential Costs"
Example: Change in distribution channels adding or deleting a product in the product line.
(E) Explicit Cost
Explicit costs are those expenses/expenditures that are actually paid by the firm. These
costs are recorded in the books of accounts. Explicit costs are important for calculating the
profit and loss accounts and guide in economic decision-making. Explicit costs are also
called as "Paid out costs"
Example: Interest payment on borrowed funds, rent payment, wages, utility expenses etc.
(F) Implicit Cost
Implicit costs are a part of opportunity cost. They are the theoretical costs ie., they are not
recognised by the accounting system and are not recorded in the books of accounts but are
very important in certain decisions. They are also called as the earnings of those employed
resources which belong to the owner himself. Implicit costs are also called as "Imputed
costs".
Examples: Rent on idle land, depreciation on dully depreciated property still in use,
interest on equity capital etc.
(G) Book Cost
Book costs are those business costs which don't involve any cash payments but a provision
is made in the books of accounts in order to include them in the profit and loss account and
take tax advantages, like provision for depreciation and for unpaid amount of the interest
on the owners capital.
(H) Out Of Pocket Costs
Out of pocket costs are those costs are expenses which are current payments to the
outsiders of the firm. All the explicit costs fall into the category of out of pocket costs.
Examples: Rent Payed, wages, salaries, interest etc
(I) Accounting Costs
Accounting costs are the actual or outlay costs that point out the amount of expenditure
that has already been incurred on a particular process or on production as such accounting
costs facilitate for managing the taxation need and profitability of the firm.
Examples: All Sunk costs are accounting costs
(J) Economic Costs
Economic costs are related to future. They play a vital role in business decisions as the
costs considered in decision - making are usually future costs. They have the nature similar
to that of incremental, imputed explicit and opportunity costs.
(K) Direct Cost
Direct costs are those which have direct relationship with a unit of operation like
manufacturing a product, organizing a process or an activity etc. In other words, direct
costs are those which are directly and definitely identifiable. The nature of the direct costs
are related with a particular product/process, they vary with variations in them. Therefore
all direct costs are variable in nature. It is also called as "Traceable Costs"
Examples: In operating railway services, the costs of wagons, coaches and engines are
direct costs.
(L) Indirect Costs
Indirect costs are those which cannot be easily and definitely identifiable in relation to a
plant, a product, a process or a department. Like the direct costs indirect costs, do not
vary ie., they may or may not be variable in nature. However, the nature of indirect costs
depend upon the costing under consideration. Indirect costs are both the fixed and the
variable type as they may or may not vary as a result of the proposed changes in the
production process etc. Indirect costs are also called as Non-traceable costs.
Example: The cost of factory building, the track of a railway system etc., are fixed indirect
costs and the costs of machinery, labour etc.
Controllable Costs
Controllable costs are those which can be controlled or regulated through observation by an
executive and therefore they can be used for assessing the efficiency of the executive. Most of
the costs are controllable.
Example: Inventory costs can be controlled at the shop level etc.
(N) Non Controllable Costs
The costs which cannot be subjected to administrative control and supervision are called non
controllable costs.
Example: Costs due obsolesce and depreciation, capital costs etc.
(O) Historical Costs and Replacement Costs.
Historical cost or original costs of an asset refers to the original price paid by the management to
purchase it in the past. Whereas replacement costs refers to the cost that a firm incurs to replace
or acquire the same asset now. The distinction between the historical cost and the replacement
cost result from the changes of prices over time. In conventional financial accounts, the value of
an asset is shown at their historical costs but in decision-making the firm needs to adjust them to
reflect price level changes.
Example: If a firm acquires a machine for $20,000 in the year 1990 and the same machine costs
$40,000 now. The amount $20,000 is the historical cost and the amount $40,000 is the
replacement cost.
(P) Shutdown Costs
The costs which a firm incurs when it temporarily stops its operations are called shutdown
costs. These costs can be saved when the firm again start its operations. Shutdown costs include
fixed costs, maintenance cost, layoff expenses etc.
(Q) Abandonment Costs
Abandonment costs are those costs which are incurred for the complete removal of the fixed
asset from use. These may occur due to obsolesce or due to improvisation of the
firm. Abandonment costs thus involve problem of disposal of the asset.
(R) Urget Costs and Postponable Costs
Urgent costs are those costs which have to be incurred compulsorily by the management in order
to continue its operations. If urgent costs are not incurred in time the operational efficiency of the
firm falls.
Example: Cost of material, labour, fuel etc
Postponable costs are those which if not incurred in time do not effect the operational efficiency
of the firm. Examples are maintenance costs.
(S) Business Cost and Full Cost
Business costs include all the expenses incurred by the firm to carry out business activities. Costs
Include all the payments and contractual obligations made by the firm together with the book
cost of depreciation on plant and equipment.
Full costs include business costs, opportunity costs, and normal profits. Opportunity costs is the
expected return/earnings from the next best use of the firms resources like capital, land and
building, owners efforts and time. Normal profits is necessary minimum earning in addition to
the opportunity costs, which a firm must receive to remain in its present occupation.
(T) Fixed Costs
Fixed costs are the costs that do not vary with the changes in output. In other words, fixed costs
are those which are fixed in volume though there are variations in the output level.. If the time
period in volume under consideration is long enough to make the adjustments in the capacity of
the firm, the fixed costs also vary.
Examples: Expenditures on depreciation costs of administrative, staff, rent, land and buildings,
taxes etc.
(U) Variable Costs
Variable Costs are those that are directly dependent on the output ie., they vary with the variation
in the volume/level of output. Variable costs increase in output level but not necessarily in the
same proportion. The proportionality between the variable costs and output depends upon the
utilization of fixed facilities and resources during the production process.
Example: Cost of raw materials, expenditure on labour, running cost or maintenance costs of
fixed assets such as fuel, repairs, routine maintenance expenditure.
(V) Total Cost, Average Cost and Marginal Cost
Total cost (TC) refers to the money value of the total resources/inputs required for the production
of goods and services by the firm. In other words, it refers to the total outlays of money
expenditure, both explicit and implicit, on the resources used to produce a given level
output. Total cost includes both fixed and variable costs and is given by TC = VC + FC
Average Cost (AC) , refers to the cost per unit of output assuming that production of each unit
incurs the same cost. It is statistical in nature and is not an actual cost. It is obtained by dividing
Total Cost(TC) by Total Output(Q)
AC= TC/Q
Marginal costs(MC), refers to the additional costs that are incurred when there is an addition to
the existing output level of goods ans services. In other words, it is the addition to the Total
Cost(TC) on account of producing additional units.
(W) Short Run Cost and Long Run Cost
Both short run and long run costs are related to fixed and variable costs and are often used in
economic analysis.
Short Run Cost: These costs are which vary with the variation in the output with size of the
firm as same. Short run costs are same as variable costs. Broadly, short run costs are associated
with variable inputs in the utilization of fixed plant or other requirements.
Long Run Cost: These costs are which incurred on the fixed assets like land and building, plant
and machinery etc., Long run costs are same as fixed costs. Usually, long run costs are
associated with variations in size and kind of plant.
Economies of Scale, Diseconomies of Scale, and Constant Returns to Scale
Economies of scale, diseconomies of scale, and constant returns to scale are all related terms that
describe what happens as the scale of production increases. It is important to understand the
concepts of these returns to scale because they can be an important factor in determining the
optimal and equilibrium size of firms. From that decision, the structure of industries and their
prices and output levels can also be determined appropriately. Therefore, these factors provide
major implications for public policy. Particularly, in case where they lead to the development of
natural monopolies, these companies can claim themselves to be prevented from government
attempts to break them up.
As can be seen in above graph, as the output(production) increases, long run average total cost
curve decreases in economies of scale, constant in constant returns to scale, and increases in
diseconomies of scale
For example, a factory initially expanding its output experiences decreasing long run average
cost. This situation is economies of scale and there are lots of real world examples of
international companies building large plant to take advantage of this situation. However, as a
company passes a certain point it reaches the stage when an increase in output leading increase in
average cost. This situation is diseconomies of scale. And, sometimes the technology in an
industry allows a firm to produce different levels of output at the same minimum average cost
and this condition can be understood as a constant return to scale.
Economies of scale
This term characterizes a production process in which an increase in the number of units
produced causes a decrease in the average cost of each unit. It is also called as increasing returns
to scale as it refers to the situation in which the cost of producing an additional unit of output,
which is the marginal cost of a product decreases as the volume of its production increases. It
could also be defined as the situation in which an equal percentage increase in all inputs results
in a greater percentage increase in output.
An example of an economy of scale would be the production of any established manufacutred
good would decrease with the increase in quantity produced due to the cheaper procurement of
the materials needed for production.
Constant returns to scale
It refers to a technical property of production that examines changes in output subsequent a
proportional change in all inputs (where all inputs increase by a constant). If output increases by
that same proportional change then there are constant returns to scale (CRTS), sometimes
referred to simply as returns to scale.
Diseconomies of scale
A term used to describe processes that do not conform to the definition of economies of scale
due to the costs for production does not decrease with the increased production. This can happen
for several reasons. First this can happen due to the prodcution rates for the creation of parts for a
product may take a set amount of time therefore increasing production would still be dependent
on that part for completetion. The other reason diseconomies of scale can occur is from the
increased shipping costs due to distance or weight.
A good example of diseconomies of scale would be the phamacutical industry due to their high
research and development costs of producing a new drug.
[Link]