Fundamental Concepts of Economics

7/31/2019 Fundamental Concepts of Economics

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1. OPPORTUNITY COST :

Since productive resourcesare limited, the production of one commodity can

only be at the cost of another. The commodity that

is sacrificed is the opportunity cost of the

commodity produced. Thus, economist define the

cost of production of a particular product as the

value of the foregone alternative products, that

resource used in its production could haveproduced.

The opportunity cost of a product, istherefore, the opportunity lost of notbein able to roduce some other


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EXAMPLE :If Rs. 20 lakhs are invested in project A

at a 10 per cent rate of return, and if this

amount was not invested in project A, it wouldhave been invested in project B at 9 per rate of

return. Then the opportunity cost of Rs. 20 lakh

in project A is 9 per cent, which is the value of

this amount in its next best alternative use.


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The concept of marginal value is widelyused in economic analysis, for example

marginal utility in consumer analysis, marginal

cost in production analysis and marginalrevenue in pricing theory.

The term marginal refers to the change in

total quality or value due to a one unit change inits determinants.


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For example the change in totalproduct caused as a result of one additional unit

of variable factor employed in combination with

fixed factors is called marginal product.

MP= TPn TPn-1

in the same way marginal cost can (MC)can be defined as the change in total cost as a result

of producing one additional unit of a commodity.

MC= TCn TCn-1


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where, TPn

= Total production at the cost of nunits. TPn-1 = Total production at thecost of n-1 units.

TCn

= Total Cost of producing n units,&

TCn-1= Total cost of producing n-1 units


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Suppose Total Cost (TC) of producing 100units of a commodity is Rs. 2500 and total cost

of 101 units is Rs. 2550.

Then, TCn

=Rs.2550, TCn-1

= Rs. 2500.Then,

MC = Rs. 2550 - Rs.2500

= Rs. 50.


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Similarly, total revenue (TR) of a firmdepends on the total number of units it sells at

some point of time. So MR can be defined as

the change in TR due to the sale of one

additional unit of a product. It can also be

defined as :

MR = TRn TRn-1

Where, TRn= Total Revenue from the sale of nunits,

TRn-1 = Total Revenue from the sale ofn-1

units.


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The Decision Rule :

MR > MCA business activity must be carried out

MR = MC

Profit maximizing output


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The concept of incremental value is similar to

the concept of marginal value but with a

difference.

marginal principle can be applied only whereMC and MR can be calculated precisely. In

general, however, firms find it difficult to estimate

MC & MR. The reason is that most business firmsproduce and sell their products in bulk, not in terms

of units unless, of course, it is the case of

production and sell of such large-unit goods as

airplanes, ships large buildings turbines, etc.


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The incremental principle isapplied to business decisions which

involve bulk production and a large

increase in total cost and total revenue.

Such as increase in total cost and total

revenue is called incremental cost and

incremental revenue respectively, related

to incremental output.


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INCREMENTAL COST : Let us first

explain the concept of incremental cost.Conceptually, incremental costs can be

defined as the costs that arise due to a

business decision.

For example,suppose a firm decides toincrease production by adding a new plant to

the existing capacity. This decision increases

the firms total cost of production from Rs.100 million to Rs. 115 million.

Then Rs. 115 millionRs. 100 million

=Rs. 15 million is the


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COMPONENTS OF INCREMENTAL COST

There are three major Components of

Incremental Cost (IC) :

1. Present Explicit Costs,

2. Opportunity Cost and

3. Future Costs.


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Present Explicit Costs include

a) Fixed Cost : Fixed cost is the cost of theplant and building,

b) Variable cost : Variable cost is the cost

of direct labour and materials andoverheads like electricity and indirect

labour.

Opportunity Cost :Opportunity costrefers to expected income foregone from

the second best use of the resources

involved in the present decision.


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Future Cost : Future costs of a business

decision include depreciation andadvertising costs if the product does notsell as well as expected.


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THE INCREMENTAL REVENUE :

The increase in the total

revenue resulting from a business decision is

called incremental revenue.

Example : Suppose that after theinstallation of the new plant, the total production

increases and the firm is able to sell the

incremental product. As a result, the firms total

sales revenue increases, let us suppose, from

Rs. 130 million to Rs. 150 million.Rs. 150 million - Rs. 130 million

=Rs. 20 million is the incremental revenue.


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The contribution of a business decision canbe defined as the difference between theincremental revenue and the incrementalcost associated with that particular decision.Contribution analysis is generally applied to

analyse the contribution made by a business

decision to overhead costs and revenue to work

out the net result of that particular businessdecision.


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There are three major Components of

Incremental Cost (IC) :

1) Present Explicit Costs :

Fixed Cost, &

Variable cost.2) Opportunity Cost and

3) Future Costs.


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The relevant incremental revenue includes

Explicit Present Revenue,

A Possible Opportunity Revenue, &A Possible Future Revenue

It is a useful technique for taking a decision on :Whether or not to accept a project,

Whether or not to introduce a new project,

Whether or not to accept a fresh order,

Whether or not to add an additional plant,

Whether to make or to buy and so on.


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The Use of the Contribution analysis:

The Use ofthe Incremental Concept in business

decision is called incremental reasoning.

The incremental reasoning is used inaccepting or rejecting a business proposition

or option. For instance, suppose that in our

example, the firm is considering whether ornot to install a new plant.


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As noted above , the firm estimates anincremental cost of installing a new plant at Rs.

15 million and an incremental revenue of Rs. 20

million. The incremental revenue exceeds the

incremental cost by Rs. 5 million which means

a 33.33 per cent return on the investment in the

new plant. The firm will accept the proposition

of installing a new plant.


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The equi-marginal principle wasoriginally associated with consumptiontheory and the law is called the law ofequi-

marginal utility. The law ofequi-marginal utilitystates that a utility maximising consumer

distributes his consumption expenditure

between various goods and services he/she

consumes in such a way that the marginal utility

derived from each unit of expenditure on

various goods and service is the same . This

pattern of consumption expenditure

Th l f i i l i i l


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The law of equi-marginal principle was over

time applied by business managers to

allocation of resources between their alternative

uses with a view to maximise profit in case afirm carries out more than one business activity.

Example : Suppose a firm has a total capital

of Rs. 100 million which it has the option ofspending on three projects A, B, and C. Each of

these projects requires a unit expenditure of Rs.

10 million.

UNITS OF MARGINAL PRODUCTIVITY (MP )


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UNITS OFEXPENDITUR

E(RS. 10

MILLION )

MARGINAL PRODUCTIVITY (MP )

PROJECT A PROJECT B PROJECT C

Ist 501 403 354

2nd 452 306 307

3rd 355

4th 10 15

5th 10 0 12

209

208

2010


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Of the total finances of Rs. 100 million, a

profit maximizing firm would invest Rs. 40

million in project A, Rs. 30 million each in

project B & CThis pattern of investment maximizes

the firms productivity gains.


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This principle suggests that a profit

maximizing firm allocates its resources in a

proportion such that :

MPA = MPB = MPC = = MPN

If the cost of the project (COP) varies from

project to project, then resources are so

allocated that MP per unit of COP is the same.

MPA MPB MPC MPN

COPA COPA COPA COPA


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All business decisions are taken with acertain time perspective. All business decisions

do not have the same time perspective. Some

have short-run outcome or pay off, therefore,involve short-run time perspective.

For example, a decision to buy explosivematerial for manufacturing crackers involves

short run demand prospects.


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There are, however, a large number of

business decisions which have long run

repercussions, e.g., investment in plant,

building , machinery, land, spending on labour

welfare activities, expansion of the scale of

production, introduction of a new product andadvertisement.

The introduction of a new product may notbe profitable in the short run but may prove

very profitable in the long-run.


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For example, the introduction of a newlydesigned laptop computer - a book size laptop

priced at Rs. 10,000 may not succeed in the

market quickly and smoothly. It may be difficult

to even cover the variable costs because

potential buyers may be uncertain about itsusefulness, quality , serviceability and cost of

operation. But in the long run, it may enjoy a

roaring business.


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Fundamental Concepts of Economics

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