ECONOMICS – MODULE 3: SUPPLY AND PRODUCTION
1. SUPPLY
1.1 Law of Supply
Definition:
Other things being equal, the quantity supplied of a commodity
rises when its price rises, and falls when its price falls.
Reason: Higher price gives higher profit → firms produce and
sell more.
Supply Curve Diagram
Movement:
From P1 → P2, Q1 → Q2 (extension of supply)
1.2 Factors Influencing Supply
1. Price of the commodity – direct relation.
2. Prices of inputs (labour, raw materials) – inverse
relation.
3. Technology – better tech increases supply.
4. Number of sellers – more firms → more supply.
5. Price of related goods – if price of substitute rises,
supply decreases.
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6. Government policies – taxes reduce supply; subsidies
increase supply.
7. Natural factors – weather, disasters.
8. Expectations about future prices.
2. THEORY OF PRODUCTION
2.1 Production Function
Definition:
A relationship showing maximum output obtained from a set
of inputs in a given technology.
General form:
Q=f(L,K)
Where:
L = Labour
K = Capital
Q = Output
2.2 Production Function with One Variable Input
(Short-Run; Capital fixed, Labour variable)
2.3 Law of Variable Proportions
Also called Law of Diminishing Returns.
Three stages:
Sta
MPL APL Meaning
ge
Increasing
I ↑ ↑
returns
II ↓ Max Diminishing
2
Sta
MPL APL Meaning
ge
returns
Negati Falli Negative
III
ve ng returns
Diagram: Law of Variable Proportions
Example (Numerical Table)
Labour Total Output MP
(L) (Q) L
1 10 10
2 25 15
3 40 15
4 50 10
5 55 5
6 52 -3
3. RETURNS TO SCALE (Long-Run)
Inputs change proportionately.
Types
1. Increasing Returns to Scale (IRS)
Input ↑ 10% → Output ↑ >10%
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2. Constant Returns to Scale (CRS)
Input ↑ 10% → Output ↑ 10%
3. Decreasing Returns to Scale (DRS)
Input ↑ 10% → Output ↑ <10%
4. PRODUCTION WITH TWO VARIABLE INPUTS
Two inputs: Labour (L) and Capital (K)
4.1 Isoquants
Definition: Curve showing combinations of L and K that
produce same output.
Isoquant Map
Properties:
Downward sloping
Convex to origin
Do not intersect
Higher isoquant → higher output
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4.2 Iso-cost Line
Shows all combinations of L & K that a firm can buy with a
given cost.
Formula:
C=wL+rK
Where
w = wage
r = interest rate on capital
Iso-cost Line Diagram
4.3 Producer’s Equilibrium
Occurs where:
Isoquant = tangent to Iso-cost line
MRTS = ratio of factor prices
Diagram of Producer’s Equilibrium
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Least-Cost Factor Combination – Minimum Cost for
producing the given level of output
Optimal Factor Combination – Maximum quantity of
production with given budget.
5. OLIGOPOLY – COLLSUSIVE (CARTELS, PRICE
LEADERSHIP)
5.1 Collusive Oligopoly
A few firms cooperate instead of competing.
Types:
1. Cartels – firms jointly set prices/output (e.g., OPEC).
2. Price Leadership – one dominant firm sets price →
others follow.
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6. ECONOMIES OF SCALE & SCOPE
6.1 Economies of Scale
Long-run average cost (LRAC) falls as output rises.
Types:
1. Internal Economies
Technical
Managerial
Financial
Marketing
R&D
Risk-bearing
2. External Economies
Industrial clusters
Skilled labour pool
Shared infrastructure
6.2 Economies of Scope
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Producing two or more products together reduces cost.
Example:
Tata Steel producing both steel plates and bars.
7. THEORY OF COSTS
7.1 Classification of Costs
Fixed Cost (FC)
Variable Cost (VC)
Total Cost (TC = FC + VC)
Average Cost
Marginal Cost
Opportunity Cost
Sunk Cost
Social Cost vs Private Cost
7.2 Short-run Cost Curves
Shapes
AVC, ATC → U-shaped
MC cuts AVC & ATC at their minimum points
AFC → downward sloping
Diagram: Short-run Cost Curves
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7.3 Long-Run Cost Curves
LRAC = envelope of SRACs
U-shaped because of economies & diseconomies of scale.
7.4 Revenue Curves
Under Perfect Competition
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AR = MR = Price (horizontal line)
Under Imperfect Competition
AR downward sloping
MR below AR
✅ QUESTION BANK (With Bloom’s Levels)
A. 3-MARK QUESTIONS (BL1 – BL3)
BL1 – Remembering
1. Define Law of Supply.
2. What is a Production Function?
3. What are isoquants?
4. Define Economies of Scale.
5. What is Marginal Cost?
BL2 – Understanding
6. Explain Law of Variable Proportions.
7. State the assumptions of iso-cost lines.
8. Differentiate between increasing and decreasing returns
to scale.
9. Explain price leadership in oligopoly.
10. Distinguish between AC and MC.
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BL3 – Applying
11. Plot an arbitrary isoquant with 4 input combinations.
12. Show the effect of subsidy on supply with a diagram.
13. Draw AFC, AVC, ATC using assumed numbers.
14. Apply Law of Supply to a petroleum price rise
scenario.
15. Identify two industries showing economies of scope.
B. 10-MARK QUESTIONS (BL3 – BL5)
BL3 – Applying
1. Using a numerical table, explain the three stages of the
Law of Variable Proportions.
2. Construct cost curves for FC = ₹10,000 and VC
increasing at constant rate.
BL4 – Analyzing
3. Analyse returns to scale using Cobb-Douglas function:
0.4 0.6
Q=4L K
4. Compare competitive pricing vs cartel pricing in
oligopoly.
BL5 – Evaluating / Creating
5. “A firm should always operate in Stage II of production.”
Evaluate.
6. Critically examine the role of economies of scale in Indian
manufacturing.
7. Using real industrial examples, evaluate the relevance of
isoquant analysis in engineering decisions.
C. NUMERICAL QUESTIONS
1. Elasticity of Supply
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Price increases from ₹20 to ₹25
Supply increases from 100 to 140
Compute elasticity using percentage method.
2. Law of Variable Proportions Table
Given L = {1,2,3,4,5}
Q = {20, 45, 70, 85, 90}
Find MPL, identify stages.
3. Cost Curves
Given:
FC = 500
VC/unit = 20
Find:
TC
AVC
AC
MC
for output = 1 to 10 units.
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