Wednesday, September 22, 2010

Cost of Production

Cost of production of the firm will change with the changes in its output. The relation between cost and output is called “cost function”. The cost function of the firm depends upon the production function and the prices of the factors used for production. How much costs the firm will incur on production depend on the level of output. Moreover, the quantity of a product that will be offered by the firm for supply in the market will depend to a great degree upon the costs of production incurred on the various possible level of output.

Short Run and Long Run Costs (Variable and Fixed Costs)

Short run is a period of time within which the firm can vary its output by varying only the amount of variable factors, such as labor and raw materials. In the short run, fixed factors such as capital, equipment, building, top management personnel etc. cannot be varied. The short run is a period of time in which only variable factors can be varied (if level of output increases, the costs of variable factors will increase and vice-versa) while fixed factors remain the same. It means in short run the costs of fixed factors such as rent expenses, insurance expenses, interest expenses, utility expenses, salary expenses etc. do not changes with the level of output. Then per unit fixed costs decreases as the level of output increases and vice-versa. On the other hand, long run is a period of time during which the quantities of all factors, variable as well as fixed, can be adjusted. Thus, in the long run output can be increased by increasing capital, equipment, building etc. It means in the long run all costs are variable. Because level of output can be increased not only by increasing labor and raw materials but also expanding capital, equipment building etc. which remain fixed in short run

Total, Average and Marginal Costs

Total costs of a firm are the sum of its total variable costs and total fixed costs. Thus,

Total costs (TC) = Total variable costs (TVC) + Total fixed costs (TFC)

The total variable cost varies with the changes in output, the total cost of production will also respond to changes in the level of output. The total cost increases as the level of output rises. The variable cost per unit is fixed but total-variable cost is variable.

Average cost (per unit cost) is the total costs divided by the number of output produced. Therefore,

Average cost (AC) = Total costs ÷ Number of output.

Average fixed cost (per unit fixed cost) is the total fixed costs divided by the number of output produced. Therfore,

Average fixed cost (AFC) = Total fixed costs ÷ Number of output.

Average variable cost (per unit variable cost) is the total variable costs divided by the number of output produced. Therefore,

Average variable cost (AVC) = Total variable costs ÷ Number of output.

Marginal cost is the addition to total cost caused by an increment in output. Marginal cost may be defined as the change in total cost resulting from the unit change in the quantity produced. Thus,

Marginal cost (MC) = Change in total costs ÷ Change in the number of output.

Table: Cost of Production

Units of output

Total fixed cost

Average fixed cost

Total variable cost

Average variable cost

Total average cost

Total variable cost

Marginal cost

0

20

-

0

-

20

-

-

1

20

20

20

20

40

40

20

2

20

10

25

12.5

45

22.5

5

3

20

6.67

28

9.33

48

16

3

4

20

5

30

7.5

50

12.5

2

5

20

4

40

8

60

12

10

6

20

3.33

52

8.67

72

12

12

7

20

2.86

100

14.29

120

17.14

36

8

20

2.5

120

15

140

17.5

20

Relationship between Average and Marginal Cost

The relationship between average and marginal cost can be explained in three ways:

· When average cost decreases, marginal cost also decreases and the marginal cost is lower than average cost (See above table).

· When average cost increases, marginal cost also increases and the marginal cost is greater than average cost (See above table).

· When average cost is same, at this point marginal cost is equal to average cost (See above table).

Why Long Run Average Cost Curve is U-Shaped

· As output increases at the beginning, the fixed cost decreases. As a result the average cost decreases.

· As capacity expands in the long-run the firm can use modern equipment which results in low cost.

· For the division of labor, the efficiency and productivity of labor increases, as a result cost decreases.

· Though output increases, the administrative cost does not increases proportionately. For this ultimately average cost decreases.

· The firm gets benefit in case of commercial expenses like purchase discount transportation cost input and output etc. which ultimately decreases average cost.

Saturday, June 5, 2010

Overview of National Income

Definition of National Income:

Traditional Approach:

According to Marshall, “National income is the labor and capital of a country, acting on its natural resources; produce annually a certain net aggregate of commodities, material and immaterial including services of all kinds.”

According to Fisher, “The national income consists solely of services as received by ultimate consumers, whether from their material or from their human environments.”

According to Pigou, “National income is that part of the objective income of the community, including income from abroad which can be measured in money.”

Modern Approach:

According to Siman Kuznets, “National income is the net output of commodities and services flowing during the year from the country’s productive system in the hands of ultimate customers.”

According to Lipsey, “National income refers to the total market value of all goods and services produced in the economy during some specified period of time and to the total of all incomes earned over the same period of time.”

According to Samuelson, “National income is the money measure of the overall annual flow of goods and services in an economy.”


Gross National Product (GNP):

GNP is the total measure of the flow of goods and services at market value resulting from current production during a year in a country, including net income from abroad. GNP includes four types of final goods and services: 1) Consumers’ goods and services to satisfy the immediate wants of the people; 2) Gross private domestic investment in capital goods; 3) Goods and services produced by the Government; 4) Net income from abroad (the difference between value of exports and imports of goods and services).

Approaches of GNP

Three approaches are employed for estimating GNP:

  1. Income approach
  2. Expenditure approach
  3. Value added approach

Since the gross income equals the gross expenditure, GNP estimated by all these methods would be the same with appropriate adjustments.

Income approach to GNP:

The income approach to GNP consists of the remuneration paid in terms of money to the factors of production annually in a country. Thus, GNP is the sum total of the following items:

GNP = Wages and salaries + Rents + Interest + Dividends + Undistributed corporate profits + Mixed incomes + Direct taxes + Indirect taxes + Depreciation + Net income earned from abroad.

Expenditure approach to GNP:

From the expenditure viewpoint, GNP is the total sum of expenditure incurred on goods and services during one year in a country. It includes the following items:

GNP = Private consumption expenditure + Gross domestic private investment + Net foreign investment + Government expenditure on goods and services.

Value Added Approach to GNP:

In calculating GNP the money value of final goods and services produced at current process during a year is taken into account. This is one of the ways to avoid double counting. But it is difficult to distinguish properly between a final product and an intermediate product. For instance, raw-materials, semi-finished products, fuel and services, etc. are sold as inputs by one industry to the other. They may be final goods for one industry and intermediate for others. So, to avoid duplication, the value of intermediate products used in manufacturing final products must be subtracted from the value of total output of each industry in the economy. Thus the difference between the value of material outputs and inputs at each stage of production is called the value added. If all such differences are added up for all industries in the economy, we arrive at the GNP by value added. Its calculation is shown in Table – 1:

Industry

1

Total output ($ crore)

2

Intermediate purchase ($ crore)

3

Value Added ($ crore)

2 - 3

Agriculture

30

10

20

Manufacturing

70

45

25

Others

55

25

30

Total

155

80

75

The table is constructed on the supposition that the entire economy for purpose of total production consists of three sectors. They are agriculture, manufacturing and others, consisting of the tertiary sector. Out of the value of total output of each sector is deducted the value of its intermediate purchases (or primary inputs) to arrive at the value added for the entire economy. Thus the value of total output of the entire economy as per table is $155 crores and the value of its primary inputs come to $80 crores. Thus the GNP by value added is $75 crores ($155 minus 80 crores).

GNP at Market Prices:

GNP at market prices is the total measure of the flow of goods and services at market value resulting from current production during a year in a country, including net income from abroad. GNP includes four types of final goods and services: 1) Consumers’ goods and services to satisfy the immediate wants of the people; 2) Gross private domestic investment in capital goods; 3) Goods and services produced by the Government; 4) Net income from abroad (the difference between value of exports and imports of goods and services).

GNP at Factor Cost:

GNP at factor cost is the sum of the money value of the income produced by and accruing to the various factors of production in one year in a country. It includes all items includes the income approach to GNP less indirect taxes. GNP at market prices always includes indirect taxes levied by the Government on goods which raises their prices. But GNP at factor cost is the income which the factors of production receive in return for their services alone. It is the cost of production. Thus GNP at market prices is always higher than GNP at factor cost. Therefore, in order to arrive at GNP at factor cost, we deduct indirect taxes from GNP at market prices. Again it often happens that the cost of production of a commodity to the producer is higher than the price of a similar commodity in the market. In order to protect such producers, the Government helps them by granting monetary help in the form of a subsidy equal to the difference between the market price and cost of production of the commodity. As a result the price of the commodity to the producer is reduced and equals the market price of similar commodity. For example, the market price of rice is $30 per kg but it costs to the producers in certain areas is $35. The Government gives a subsidy of $5 per kg to them in order to meet their cost of production. Thus in order to arrive at GNP at factor cost, subsidies are added to GNP at market prices.

GNP at factor cost = GNP at market prices – Indirect taxes + Subsidies.


Net National Product (NNP):

GNP includes the value of total output of consumption goods and investment goods. But the process of production uses up a certain amount of fixed capital. Some fixed equipment wears out, its other components are damaged or destroyed, and still others are rendered obsolete through technological changes. All this process is termed as depreciation or capital consumption allowance. In order to arrive at NNP, we deduct depreciation from GNP. The word “net” refers to the exclusion of that part of total output which represents depreciation.

So, NNP = GNP – Depreciation.

NNP at Market Prices:

Net National Product at market prices is the net value of final goods and services evaluated at market prices in the course of one year in a country. If we deduct depreciation from GNP at market prices, we get NNP at market prices = GNP at market prices – Depreciation.

NNP at Factor Cost:

Net National Product at factor is the net output evaluated at factor prices. It includes income earned by factors of production through participation in the production process such as wages and salaries, rents, profits, etc. This measure differs from NNP at market prices in that indirect taxes are deducted and subsidies are added to NNP at market prices in order to arrive at NNP at factor cost. Thus,

NNP at factor cost = NNP at market prices – Indirect taxes + Subsidies (or)

NNP at factor cost = NNP at market prices – Depreciation - Indirect taxes + Subsidies (or)

NNP at factor cost = GNP at factor cost – Depreciation.

Consumption Function

The consumption function or propensity to consume refers to income-consumption relationship. It is a functional relationship between two aggregates, i.e., total consumption and gross national income. Symbolically, the relationship is represented as:

C = f(Y)

Where,

C = Consumption

Y = Income

f = Functional Relationship.

Thus the consumption function indicates a functional relationship between C and Y, where C is the dependent and Y is independent variable, i.e., C is determined by Y. In fact, consumption function or propensity to consume is a schedule of the various amounts of consumption expenditure corresponding to different levels of income.

Assumption of Consumption Function

1. It is assumed that habit of the people regarding spending does not change or that the propensity to consume remains the same. Normally, the propensity to consume does remain the same; it is more or less stable. This means that we assume that only income changes, whereas the other variables like income distribution, price movements, growth of population, etc. remain more or less constant.

2. The second assumption is that the conditions remain normal; for instance there is no hyperinflation or there is no war or other abnormal conditions.

3. In an economy, where the government interferes with consumption or productive enterprise, the law will not hold good. In that case, the government may check consumption even when income increases. If a country is very poor, the question of choosing between consumption and saving does not really rise. This law can, therefore, apply to a free economy and in peace time and over a short period.

Features of Consumption Function:

1. When income increases, consumption expenditure also increases but by a smaller amount. The reason is that as income increases, our wants are satisfied side by side, so that the need to spend more on consumer goods diminishes. It does not mean that the consumption expenditure falls with the increase in income. In fact, the consumption expenditure increases with increase in income but less than proportionately.

2. The increased income will be divided in some proportion between consumption expenditure and saving. This follows from the above feature because when the whole of increased income is not spent on consumption, the remaining is saved. In this way, consumption and saving move together.

3. Increase in income always leads to an increase in both consumption and saving. This means that increased income is unlikely to lead either to fall in consumption or saving than before. This is based on the above features because as income increases consumption also increases but by a smaller amount than before which leads to an increase in saving. Thus with increased income both consumption and saving increase.


Average Propensity to Consume (APC) and Marginal Propensity to Consume (MPC):

The average propensity to consume may be defined as the ratio of consumption expenditure to any particular level of income. It is found by dividing consumption expenditure by income or APC = C ÷ Y. It is expressed as the percentage or proportion of income consumed. The APC at various income levels is shown in Table. The APC declines as income increases because the proportion of income spent on consumption decreases.

The marginal propensity to consume may be defined as the ratio of the change in consumption expenditure to the change in income or as the rate of change in the average propensity to consume as income changes. It is found by dividing change in consumption expenditure by a change in income or MPC = ΔC ÷ ΔY. The MPC at various income levels is shown in Table. The MPC declines as income increases because the proportion of income spent on consumption decreases.

Average Propensity to Save (APS) and Marginal Propensity to Save (MPS):

Saving is defined as the part of income which is not consumed because income is either consumed or saved. Thus,

Y = C + S

S = Y – C

Average propensity to save is the proportion of income that is saved (not consumed). Mathematically, APS = S + Y. Average propensity to consume falls as income increases. This implies that average propensity to save will increase as income rises. The APS at various income levels is shown in Table.

There is an important relationship between average propensity to consume and average propensity to save. We know,

C + S = Y

Dividing both sides by income Y, we get,

C ÷ Y + S ÷ Y = Y ÷ Y

APC + APS = 1

Marginal propensity to save may be defined as the ratio of the change in savings to the change in income or as the rate of change in the average propensity to save as income changes. It is found by dividing change in saving by a change in income or MPS = ΔS ÷ ΔY. The MPS at various income levels is shown in Table. The MPS increases as income increases because the proportion of income saving increases.

There is an important relationship between marginal propensity to consume and marginal propensity to save. We know, C + S = Y, it follows that any change in income (ΔY) must induce either change in consumption (ΔC) or change in saving (ΔS). Thus,

ΔC + ΔS = ΔY

Dividing both sides by ΔY, we get,

ΔC ÷ ΔY + ΔS ÷ ΔY = ΔY ÷ ΔY

MPC + MPS = 1

Relationship between APC and MPC:

1. If income increases both APC and MPC decreases but APC decreases at slower rate than MPC. (Table)

2. If income decreases both APC and MPC increases but APC increases at slower rate than MPC. (Table)

3. When APC is constant, at that point both APC and MPC are equal. (Table)

Table: Income, Consumption and Saving

Income

(Y)

Consumption

(C)

Saving

(S)

APC(C÷Y)

MPC(ΔC÷ΔY)

APS(S÷Y)

MPS(ΔS÷ΔY)

1000

950

50

0.950

-

0.050

-

1100

1040

60

0.945

0.900

0.055

0.10

1200

1120

80

0.933

0.800

0.067

0.20

1300

1190

110

0.915

0.700

0.085

0.30

1400

1250

150

0.893

0.600

0.107

0.40

1500

1300

200

0.866

0.500

0.134

0.50

Factors Influencing the Consumption (or) Determinants of Propensity to Consume:

Objective Factors:

1. Distribution of income

It will be generally observed that the average and marginal propensity to consume of the poor people are greater than those of the rich. If, for example, additional $500 is given to poor and rich people, the assumption is that of this additional income, poor people will spend a greater proportion than rich people. This is because the poor man has a lot of unsatisfied wants and he is likely to seize every opportunity that comes his way to satisfy them. On the other hand, the rich have already a high standard of living and relatively less urgent wants remain to be satisfied; so that in their case, an addition to their incomes is more likely to be saved than spent on consumption. Consumption is typically the function of the poor and saving typically the function of rich.

2. Fiscal policy

Fiscal policy of the government will also influence the consumption behavior of an economy. A reduction in taxation will have more post-tax incomes with the people and this will stimulate higher expenditure on consumption; an increase in taxes will depress consumption. Of the two types of taxes, that is direct and indirect taxes, the latter will have more immediate effect on consumption than the former, particularly when direct taxes are progressive in nature. Commodity taxes penalize consumer expenditure directly by raising the prices of the commodities while taxes on income reduce consumption only indirectly by reducing the post-tax income of the individual.

3. Rate of interest

Rate of interest also affects the propensity to consume and save. It is generally believed that higher rate of interest includes the people to save more and this results in reducing their propensity to consume. But this is not true in case of all the people. Some individuals are of such a type who wants a certain fixed income in the future. And when the rate of interest raises these individuals consume more and save less because with higher rate of interest they can obtain the given fixed income with lesser savings. Therefore, when the rate of interest raises such individuals save less than before. Thus, it cannot be said with certainty whether with the changes in the rate of interest the propensity to consume of the whole community will change or not.

4. Wind fall gains and losses

Windfall gains and losses also affect the propensity to consume. When the prices of the shares go up, the shareholders begin to think themselves better off and this raises their consumption. On the other hand, when the prices of the shares go down, the shareholders have to suffer sudden losses and they begin to think themselves relatively poorer than before. This induces them to reduce their consumption.

5. Change in expectation

Changes in the expectations of the people also influence the propensity to consume. When people expect that war will break out in near future and they expect prices to go up, then they will try to spend more on goods so as to meet the needs of the immediate future. This raises the consumption function in the current period. On the other hand, when people expect the prices to fall they reduce their current consumption so that they should spend more when the prices actually fall.

Subjective Factors:

Individual Motives

· Building of reserves for unforeseen contingencies as illness or unemployment.

· The desire to provide for anticipated future needs such as daughter’s marriage and son’s education.

· The desire to enjoy an enlarged future income by investing funds out of current income.

· The desire to bequeath a fortune to one’s heirs.

· The enjoyment of a sense of independence.

· The enjoyment of power to do things and to hold one’s head high in the society.

· For some people the satisfaction of pure miserliness.

Business Corporation Motives

· The desire to expend one’s business.

· The desire to face emergencies successfully.

· The desire to demonstrate successful management.

· The desire to ensure sufficient financial provisions against depreciation and obsolescence.