Business Economics

Q1:

Cost is the most important factor for an organisation/ firm or an economy as a whole.
An organisation cannot make profits if the costs are not calculated accurately. Costs
differ from one organisation to another, depending on the nature and size of the
business. Cost refers to the expenditure an organisation incurs while producing
goods and services which are also know an output. There are various costs which an
organisation incurs and important objective are set and decisions are made
depending on these costs. Cost analysis helps an organisation to identify weak
areas, minimise cost of production, find the cost of operations, and know the price
margin for selling the product in the market.

To understand cost in deeper sense, we need to understand various types of costs

as mentioned below:

1. Opportunity cost- An organisation using its limited resource for alternative use
of that resource to maximise its profits is known as opportunity cost.
2. Explicit costs- These are actual costs. Interest and rent paid, raw material
purchased etc..., come under the explicit costs.
3. Implicit costs- These are costs which are not recorded in the books of accounts.
Salary not paid by the employer to the employee while the employee is on leave,
in this case the implicit costs of the employee is salary which he could have
earned if leave was not taken. ( reference- example taken from Business
economics book, page 239)
4. Accounting costs- These costs are recorded in the books of account of an
organisation and these are costs which are incurred while purchasing raw
material, salaries and machinery purchase.
5. Economic costs- These costs are incurred while purchasing one alternative over
the other.
6. Business costs- These costs are costs which include all the expenses which
occur while carrying out a business. It is similar to Explicit costs and include all
the payments made b business and is registered in the books of accounts. Profit
or loss can be calculated taking into account the business costs.
7. Full cost- These include fixed and variable costs, business costs, opportunity
costs and profit.
8. Fixed costs- These are costs which do not change with changes in output. Even
if the output is zero, fixed costs are still incurred by the organisation.
9. Variable costs- These costs are directly dependent on the organisations output
level. These costs change with a change in output level. Increase in output leads
to buying of more raw materials, hence cost of buying of raw material is a
variable cost.
 10. Incremental costs- These are additional costs which occur due to a change in
nature of business activity. These costs can be avoided by the organisation. If an
organisation increases the time of work and output the cost will increase, which
would be the incremental costs for the organisation, hence variable costs are
included in incremental cost.

Quantity Total fixed cost Total Variable cost Total cost Average Marginal Cost
cost
FC+VC TC/Q Change in TC/
Change in Q
25 10 18 10+18= 28 28/25= 1.12 -
26 10 20 10+20= 30 30/26= 1.15 2/1= 2
27 10 21 10+21= 31 31/27= 1.14 1/1= 1

Meaning of the abbreviations used in the above table:

 FC stand for Fixed cost

 VC stands for Variable cost
 TC stands for Total cost
 Q stands or Quantity
 MC stand for Marginal cost
 AC stand for Average cost

Formulas used in the above table to find the various costs with changing quantity are
mentioned below:

 Total cost= Fixed cost + Variable cost

 Average cost= Total cost/ Quantity
 Marginal costs= change in total cost/ change in quantity

In the above table we can see that the quantity and the variable cost are changing
which affects the total cost, average and the marginal cost. Keeping in mind the table
above, we can analyse the below:

Total cost is calculated by adding the fixed and variable costs which is incurred by
the organisation while producing the desired output. In the above scenario the total
costs have changed as additional raw material, electricity, labour would have been
used while producing the additional quantity. We can see that the quantity and
variable costs are changing, this happens when the company increases the output
level which requires additional raw material, increased working hours, increase
labour charges, increased electricity bills which affects the total cost.

Average cost is calculated by dividing the total cost with the quantity/ units produced.
Average costs of the goods produced will also change as the quantity/unit produced
is increased. In the above table the quantity of units produced has increased and
hence the average cost has also changed. We can also find out average fixed cost
and average variable cost by using the similar formula, in case of fixed cost, the fixed
cost is divided by the output and to get the average variable cost, average variable
cost is divided by the output. This helps an organisation decided the price of a
product and also maximise its profits.

Marginal cost refers to change in cost of production for making an additional unit.
Marginal costs are calculated once the breakeven point has been achieved and the
fixed costs are absorbed of the units produced. Marginal costs helps to organisation
to know at what point the can achieve the economies of scale. In the above table the
marginal cost is also changing with an increase in quantity.

Q2:

Marginal rate of substitution means the rate at which a particular commodity is

substituted for another commodity achieving the same level of satisfaction. As per
the ordinal utility approach MRS decreases which states that the quantity of a
commodity an individual is willing to give up for an additional unit of other commodity
continues to decrease with each substitution. In graphical terms it is represented as
an indifference curve. The indifference shows different quantities of two goods,
points between which a consumer is indifferent. The indifferent curve also states that
different combinations of two goods provide equal utility to a consumer.

The concept of Marginal rate of substitution is realistic and scientific than the theory
of utility. It does not measure the utility of a commodity in isolation without reference
to other commodities but takes into consideration the combination of related goods
to which a consumer is interested to purchase. The advantage of Marginal rate of
substitution is that it is relative and not absolute and is free from assumptions.

When the consumer allots a budget the marginal utility per unit of money spent is
equal for each good, hence utility is maximised. The consumer would cut his/her
spend on the good with lower marginal utility per unit of money and increase
spending on the other good, in case of no equality. To decrease the marginal rate of
substitution, the consumer must buy more of the good for which he/she wishes the
marginal utility to fall for, as this is due to the law of diminishing marginal utility.

Good and services can be continuously be divided as per the standard assumption
of neo-classical economics, irrespective of the direction of exchange, and will
correspond to the slope of indifference curve. MRS is different at each point along
the indifference curve. At the equilibrium point the marginal rate of substitution are
identical.

Combination Units of X Units of Y Change in X Change in Y MRS

 A 25 3 - - -
B 20 5 20-25= -5 5-3= 2 -5/2= -2.5
C 16 10 16-20= -4 10-5= 5 -4/5= -0.8
D 13 18 13-16= -3 18-10=8 -3/8= -0.3
E 11 28 11-13= -2 28-18= 10 -2/10= -0.2

Abbreviations used in the above table:

MRS is Marginal rate of substitution.

Formula to calculate marginal rate of substitution:

Marginal rate of substitution= Change in Y/ change in X.

Explanation of the answer for the above table:

 In the table given above, all the five combinations of good X and good Y give
the same satisfaction to the consumer. If he chooses first combination, he
gets 25 units of good X and 3 units of good Y.

 In the second combination, X unit of good is reduce to 20 and is getting 2

additional units of good Y to maintain the same level of satisfaction. The MRS
is therefore, 2:5.

 In the third combination, the consumer gets 5 additional units of good Y and
reduces C unit to 16. The MRS is 0:8.

 Likewise, the consumer keeps moving from 4th to 5th combination, the MRS
of good X falls for good Y falls to 0:2. This illustrates the diminishing marginal
rate of substitution.

The table also indicates that the rate at which the consumer substitutes Y for X is
greater in the beginning, but slowly the rate of substitution begin to fall.

The above table indicates that this is the diminishing marginal rate of substitution,
which shows the consumers’ willingness to part with one commodity X to get an
additional unit of another commodity Y. The amount of good Y is increasing as the
consumer is giving up good X to attain the same level of satisfaction.

Diminishing marginal rate of substitution states that the exchange rate should
decrease as the amount of consumption of the other good goes up. Various factors
give rise to diminishing marginal rate of substitution which is mentioned below:

 As the consumer continues to consume a particular good which provides

completely satisfaction, slowly the want for that particular commodity goes on
declining. This is when the consumer looks for a substitute which provides the
same level of satisfaction.
  Goods are imperfect substitutes of each other, If they are perfect substitutes
of each other, then they can be regarded as same good and not counted as
two.

Q3 A:

Income of a consumer is an important factor for demand of a product. As the income

increases the demand for a product also increases. The responsiveness of quantity
demanded with respect to income of consumers is called the income elasticity o
demand (reference- Business Economics book, page number 146).

Definition by Richard G. Lipsey, “The responsiveness of demand to change in

income is termed as income elasticity of demand” (reference- Business economics
book, page number 147).

There are various types of income elasticity of demand which are explained below:

1. Positive income elasticity of demand- A proportionate income increase of

a consumer which leads to increase in demand of a product, the income
elasticity of demand is said to be positive.
2. Unitary income elasticity of demand- A proportionate income increase of a
consumer which leads to an equal change in demand for a product, the
income elasticity is said to be unitary.
3. Less than unitary income elasticity of demand- A proportionate change in
consumers income causing comparatively less increase in demand of a
product, the income elasticity is said to be less than unitary income elasticity
of demand
4. More than unitary income elasticity of demand- - A proportionate change
in consumers income causes large increase in demand of a product, the
income elasticity is said to be more than unitary income elasticity of demand.
5. Negative income of elasticity of demand- A proportionate change in
income of a consumer which leads to reduction in demand of a product, the
income elasticity is said to be negative income elasticity of demand. This is
possible due to low quality of goods.
6. Zero income elasticity of demand- A proportionate income increase of a
consumer which does not lead to any change in demand of a product, it is
said to be zero income elasticity of demand.

Formula to calculate the income elasticity of demand:

 Ey= percentage change in quantity demanded/ percentage change in income

Abbreviations used for calculations:

 Q= original quantity
 Q1= new quantity
 Y= original income
 Y1= new income
  Ey= income elasticity

Given that:

 Q= 40
 Q1= 50
 Change in quantity demanded= Q1-Q which is 10
 Y= Rs 20,000
 Y1= Rs 350,00
 Change in income= Y1-Y which is Rs 15,000
 Ey= 10/15000 X 20000/40
 Ey= 0.33 ˂ (1)

As we see with the above example that the income of an individual increases from
Rs. 20000 to Rs 35000, his demand for clothes also increase from 40 units to 50
units. The income elasticity demand in this case is 0.33 which is lesser than 1 (0.33
˂ 1). Hence we can say that this is a case of less than unitary income elasticity of
demand.

Q3 B:

The cross elasticity of demand refers to a proportionate change in demand of a good

result in the change of price of a related good. It is measured by percentage change
in quantity demanded for a particular good that occurs in response to percentage
change in price of the second good. Organisations use cross elasticity of demand to
establish prices to sell its products. Prices of a product which do not have a
substitute are sold at a higher price in the market.

Definition by Ferguson- “ The cross elasticity of demand is the proportional change

in quantity demanded of a good X divided b the proportional change in the price of
the related good Y.” (Reference- Business Economics book, page number 152)

There are three types of Cross elasticity of demand which are mentioned below:

1. Positive cross elasticity of demand- Increase in price of a related product

results in an increase in the demand of a main product is said to be positive
cross elasticity of demand. Cross elasticity of demand for substitute goods is
always positive as the demand for one particular product increases if the price
of the other related product increases.
2. Negative cross elasticity of demand- Increase in price of a related product
results in decrease in demand of the main product is said to be negative
elasticity of demand. Cross elasticity of demand for complementary goods is
always negative as a product which is closely associated with the main
product and necessary for the consumption of the main product may decrease
because of the demand for main product is also dropped.
 3. Zero elasticity of demand- No change in demand of the main product with a
proportionate change in the price of a related product is said to be zero
elasticity of demand.

Formula to calculate the cross elasticity of demand:

 Ec= Percentage change in quantity demanded of X/ Percentage change in

price of Y.

Abbreviations used for calculations:

 X= Tea
 Qx= original quantity= 300
 Qx1= new quantity demanded= 450
 Change in quantity demanded= Qx1- Qx (450-300) which is 150
 Y= Coffee powder
 Py= original price of Y demanded= Rs 25
 Py1= new quantity demanded= Rs 30
 Change in price of coffee powder= Rs (30-25) which is Rs 5
 Ec= 150/ 5 X 25/300
 Ec= 2.5

In the above calculation the price of coffee powder increased by Rs 5, due to which
the demand for tea increased to 450 units, this clearly states that it is a positive
elasticity of demand. Here 2.5 ˃ 1 which is positive elasticity of demand, as price of
coffee increases, the quantity demanded for tea (a substitute beverage) increases as
consumers would always prefer a less expensive product which will satisfy their
needs.