Module 3

Consumer and Producer Behaviour

Utility
It is a measure of satisfaction an individual gets from the
consumption of the commodities. In other words, it is a measurement
of usefulness that a consumer obtains from any good. A utility is a
measure of how much one enjoys a movie, favorite food, or other
goods.
 Indifference curve
An indifference curve is a graph that shows the different combinations
of two goods or services that provide a consumer with the same level
of satisfaction.
It's a tool used in economics and business to understand consumer
behavior.
Consumer's Equilibrium
Consumer's Equilibrium means a state of maximum satisfaction.
A situation where a consumer spends his given income purchasing
one or more commodities so that he gets maximum satisfaction and
has no urge to change this level of consumption, given the prices of
commodities, is known as the consumer's equilibrium.
consumer equilibrium using indifference curve
analysis
Consumer's equilibrium refers to a situation when a
consumer maximizes his satisfaction, spending his
given income across different goods and services.
In terms of IC analysis, a consumer attains equilibrium
when:
(i) IC and the budget line are tangent (a line or plane
that intersects a curved surface at exactly one
point)to each other, i.e. when the slope of IC equals
the price ratio of the goods.
(ii) IC is convex to the origin, at the point of
equilibrium.
In fig. AB is the budget or price line. IC1,IC2 and IC3 are indifference curves. A
consumer can buy any of the combinations, A, B, C, D and E of good X and good Y
shown on the price line AB. He cannot attain any combination on IC3 as it is
above the price line AB. He can buy those combinations which are not only on
the price line AB but also coincide with the highest indifference curve which
is IC2 in this case. Out of A, B, C, D and E combinations, the consumer will be in
equilibrium at combination 'E' because at this point, the price line (AB) is tangent
to the highest indifference curve IC2. No doubt, the consumer can buy `C' or D'
combinations as well but these will not give him maximum satisfaction as they
are situated on lower indifference curve IC1. It means that the consumer's
equilibrium point is the point of tangency of price line and indifference curve.

At equilibrium, Slope of indifference curve = Slope of budget or price line

Also, at point E, IC2 is convex to the origin. Accordingly, equilibrium is stable. In a
state of equilibrium, the consumer is buying OL amount of good Y and OM
amount of good X. It is here that he is maximizing his satisfaction. Any departure
from this point would only mean lesser satisfaction.
 Isoquant curve
An Isoquant curve is a curve that shows various combinations of
two factors of production that a firm can use in order to get the
same total output.
The term Isoquant is derived from the Greek word ‘iso" which means
equal, and ‘quant’ which means quantity. That is why the isoquant
curve is also called an equal product curve or a
production indifference curve.
 Properties of Isoquants
• An isoquant slopes downward from left to right.
The higher and more to the right an isoquant is on a graph, the higher the level of
output it represents.
• Two isoquants can not intersect each other.
• An isoquant is convex to its origin point.
An isoquant must always be convex to the origin.
This is because: of the operation of the principle of diminishing marginal rate of
technical substitution. MRTS is the rate at which marginal unit of an input can be
substituted for another input making the level of output remain the same.
• An isoquant is oval-shaped.
 Isoquant curve VS Indifference curve
(i) The isoquant curve is related to the producer, whereas the
indifference curve is related to the consumers' choices.
(ii) The isoquants show the firms' production functions, whereas the
indifference curve shows the consumers' utility functions.
 Iso-cost line
An iso-cost line is a graph showing various possible combinations of
inputs (labor and capital) that can be purchased for an estimated total
cost.
Any combination of inputs on an iso-cost line provides the same total
cost for the output.
 Iso-quant curve & Iso-cost lines
Iso-quant curve shows combinations of inputs employable to produce
a certain output.
Iso-cost lines portray cost combinations of two inputs like capital and
labor which produce the same amount of output.
Consumer surplus is the benefit or good feeling of getting a good deal.
For example, let's say that you bought an airline ticket for a flight for Rs. 4000, but
you were expecting and willing to pay Rs. 6000 for one ticket. The Rs. 2000
represents your consumer surplus
Producer surplus example: a manufacturer makes circuit boards (for electronic
devices) for Rs 100 each and sells them for Rs 200. The Rs 100 extra is their
producer surplus.
• Increasing Returns To Scale
• Increasing returns to scale happens when the change in
the inputs of production with a small amount leads to the
changes and output of production at a higher amount.
Suppose the firm has changed its input level by two
times, but the output level of the firm changed four
times.
• Under increasing returns to scale, when the input
increases by 20%, the output increases by 40%.
• Increasing returns to scale is achieved due to the
economy of scale.
• Constant Returns to Scale
• Constant returns to scale mean changes in the input level
will lead to changes in the output level with the same
proportion. Suppose the firm has changed its input level by
two times, then the output level of that firm will also be
changed by 2 times.
• Under constant returns to scale, all the factors of production
are increased at the same time, and this results in a steady
growth in the output level of the production process.
• Constant returns to scale lead to, suppose, a change in input
increased by 20% the output will also be changed by 20%.
• Reasons
• Here the production of a Firm reaches a point, where the
resources of the economy are utilized optimally.
• Here the output level equals the input level
• Diminishing Returns To Scale
• Diminishing returns to scale means an increase in the input will
lead to a decrease in the output of the production process.
Suppose the firm has made an increase in the input level five
times, but this will lead to a decrease in the output level by
two times.
• Here the firm's efficiency starts to decrease, which leads to a
decrease in the output level.
• Reasons for the same.
Diminishing returns to scale might happen due to a lack of
coordination.
Or it might happen when the size of the firm is so huge as it is
difficult to manage.
In case of diminishing returns to scale, if the input is increased
by 30%, this will lead to a decrease in the output level by 15%.
 Law of variable proportion
“If a producer increases the units of a variable factor while keeping
other factors fixed, then initially the total product increases at an
increasing rate, then it increases at a diminishing rate, and finally starts
declining.”
 Explain the law of variable proportion with the help of total and
marginal physical product curves schedule.

The law of variable proportions states that if we go on

using more and more units of a variable factor (labour)
with a fixed factor (land), the total physical product
increases at an increasing rate in the beginning, then
increases at a diminishing rate after a level of output
and ultimately it falls. In accordance with law, the
marginal physical product initially increases. It then
starts falling but remains positive, and ultimately
becomes negative. The following schedule and diagram
illustrate the law:
The schedule and diagram show that there are three phases
of the law of variable proportions. In phase I, TPP increases at
an increasing rate and MPP rises. In phase II, TPP increases at
decreasing rate and MPP falls but remains positive. In phase
III, TPP starts falling and MPP becomes negative. Phase I is up
to point M and phase II is from point M to point T. Phase III is
after T.
 What are Economies of Scale?

Economies of scale occur when the average cost of making a

product decreases as the scale of production increases. In
simpler terms, the more a company produces, the less it costs
to make each individual unit.
When companies operate on a larger scale, they can spread
their fixed costs (like rent or machinery) over a greater
number of units. Leading to cost savings. These savings can
be passed on to consumers through lower prices or reinvested
to fuel further growth.
Types of Economies of Scale
A. Internal Economies of Scale
Internal economies of scale arise from factors within a single
company. These factors can lead to cost advantages and efficiency
gains. Here are a few key examples:
1.Technical Economies of Scale. Companies can achieve technical
economies of scale in a few ways. By using advanced machinery,
technology, and specialized tools. For example, investing in modern
equipment can improve operations. Or budgeting software can reduce
production costs in the long run.
2.Purchasing Economies of Scale: When businesses buy materials in
large amounts, they often get discounts . Bulk buying can help reduce
average costs and improve profitability. Outsourcing non-core
functions such as payroll services can offer savings and improve
efficiency.
3. Managerial Economies of Scale: As companies grow larger, they can
enjoy managerial economies of scale. This includes improving decision-
making processes, division of labor, and specialized roles. By managing
resources and delegating tasks, companies can achieve better
coordination and efficiency.
4. Financial Economies of Scale: Larger enterprises often enjoy better
access to capital and lower borrowing costs. This lets them to get loans at
favorable interest rates. They can also negotiate favorable terms with
financial institutions.
B. External Economies of Scale
External economies of scale are industry- wide factors that reduce
costs for all firms in that sector . Here are a couple of examples:
1.Specialized Labor. When there is a pool of specialized talent
available, companies can tap into this resource. They can enjoy
reduced training costs and increased productivity.
2.Infrastructure and Networking. Access to well-developed
infrastructure, such as transportation is helpful. It can offer cost
advantages to businesses within a specific region. Networking and
knowledge sharing among companies nearby can also lead to
collaboration and innovation. Paving the way for efficiency and
lower average costs.
Sources of Economies of Scale
• A. Internal Sources of Economies of Scale
1.Large-scale Production. A primary source of economies of scale is producing goods or
providing services on a larger scale. As production increases, fixed costs, such as rent and
equipment, get spread out over a greater number of units. This leads to reduced average
costs per unit and improved profitability.
2.Specialization and Division of Labor. By specializing roles and production processes,
companies can achieve economies of scale. When employees focus on specific areas where they
excel, they become more skilled and efficient in their tasks. This specialization leads to higher
productivity, reduced errors, and lower costs.
3. Technological Advancements. Using advanced technology and automated
systems impacts economies of scale. Adding efficient machinery and innovative
tools in the production process can streamline operations. It can also help reduce
waste and enhance productivity.
• B. External Sources of Economies of Scale
1.Access to Specialized Resources. External economies of scale come from factors outside a
company’s control but within its industry. Skilled employees contribute to higher productivity
levels, improved quality, and cost savings.
2.Infrastructure and Networking. Infrastructure can benefit many companies operating within
a particular area. Sharing resources like warehouses or distribution centers can lower costs
for all businesses involved.
 Isoquant curve
An Isoquant curve is a curve that shows various combinations of
two factors of production that a firm can use in order to get the same
total output.
The term Isoquant is derived from the Greek word ‘iso" which means
equal, and ‘quant’ which means quantity. That is why the isoquant curve
is also called an equal product curve or a production indifference curve.
 Properties of Isoquants
• An isoquant slopes downward from left to right.
• The higher and more to the right an isoquant is on a graph, the higher the level of
output it represents.
• Two isoquants can not intersect each other.
• An isoquant is convex to its origin point.
An isoquant must always be convex to the origin.
This is because: of the operation of the principle of diminishing marginal rate of
technical substitution. MRTS is the rate at which marginal unit of an input can be
substituted for another input making the level of output remain the same.
• An isoquant is oval-shaped.
 Iso-cost line
An iso-cost line is a graph showing various possible combinations of
inputs (labor and capital) that can be purchased for an estimated total
cost.
Any combination of inputs on an iso-cost line provides the same total
cost for the output.
Iso-quant curve & Iso-cost lines
Iso-quant curve shows combinations of inputs employable to produce
a certain output.
Iso-cost lines portray cost combinations of two inputs like capital and
labor to produce the output.
Producer’s equilibrium position
with the help of Iso-quant curve
Producer's equilibrium is the optimum combination of inputs to produce
an output by which the producer gets maximum profit.
The producer equilibrium will be at the point where the given iso-cost
line is tangent to the isoquant.
In the figure shown above, the isoquant curve represents targeted
output, i.e. 200 units. Iso-cost lines EF, GH and KP show three
different combinations in which we can utilize the total outlay of
inputs, i.e. capital and labor.
The isoquant curve crosses iso-cost lines on points R, M and T.
These points show how much costs we will incur in producing 200
units. All three combinations produce the same output of 200 units,
but the least costly for the producer will be point M, where iso-cost
line GH is tangent to the isoquant curve.
Points R and T also cross the isoquant curve and equally produce
200 units, but they will be more expensive because they are on the
higher iso-cost line KP. At point R the producer will spend more on
capital, and labour will be more expensive on point T.
Thus, point M is the producer’s equilibrium. It will produce the
same output of 200 units, but will a more profitable combination as
it will cost less. The producer must, therefore, spend OC amount on
capital and OL amount on labour.
Long- run cost function
In economics, the long-run period refers to a time frame where all
inputs to production can be varied.
The long-run cost function, therefore, represents the minimum cost at
which a firm can produce any given level of output under these
conditions.
Total Long-run Costs (TLC)
Nature of TLC: In the long run, all costs are variable. TLC represents the
total expenditure incurred by a firm to produce a specific level of output,
with complete freedom to adjust all inputs.
Components of TLC: It includes costs such as labour, capital, raw materials,
and other operational expenses that a firm can alter over time.
Average Long-run Costs (ALC)
Calculation: ALC is computed by dividing TLC by the quantity of output
produced.
Significance: ALC is critical for understanding the cost per unit of
production and helps in comparing efficiency at different production levels.
Colin is the managerial accountant in charge of Company A, which sells
water bottles. He previously determined that the fixed costs of
Company A consist of property taxes, a lease, and executive salaries,
which add up to $100,000. The variable cost associated with producing
one water bottle is $2 per unit. The water bottle is sold at a premium
price of $12. To determine the break-even point of Company A’s
premium water bottle:

Break Even Quantity = $100,000 / ($12 – $2) = 10,000

Therefore, given the fixed costs, variable costs, and selling price of the
water bottles, Company A would need to sell 10,000 units of water
bottles to break even.
 Uses of Break-Even Analysis/ significance of
Breakeven analysis in managerial decision making
• New business: For a new venture, a break-even analysis is essential.
It guides the management with pricing strategy and is practical
about the cost. This analysis also gives an idea if the new business is
productive.
• Manufacture new products: If an existing company is going to
launch a new product, then they still have to focus on a break-even
analysis before starting and see if the product adds necessary
expenditure to the company.
• Change in business model: The break-even analysis works even if
there is a change in any business model like shifting from retail
business to wholesale business. This analysis will help the company
to determine if the selling price of a product needs to change.
Strategic importance of a break-even analysis
Whether you run a startup or an established business,
conducting a break-even analysis can help ensure that your
business remains viable, is realistic about costs, understands
the sales required to show a profit, and can create a realistic
pricing strategy
Problem
Find out the B. E. P in the following cases:

1. variable cost/unit: 15
Fixed expenses:54000
Selling price/unit:20

2. Fixed factory overhead cost: 60000

Fixed selling overhead cost: 12000
Variable manufacturing cost/unit:12
Variable selling cost/unit:3
Selling price/unit:24