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Lecture 3

Nature of Economic ProfitEconomic RelationshipsDemand & Supply

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NATURE AND FUNCTION OF PROFIT

Difference between the revenues earned from thesale of goods and services and the costs incurred inearning these revenues

Profit = Revenues Costs

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Revenues and CostsRevenue is the income earned by a firmthrough its normal course of business

Costs Explicit costs are the actual out of pocket

expenditures of the firm to purchase/ hire theinputs it requires in production

Implicit costs refer to the value of the inputsowned and used by the firm in its own productionprocesses

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Definitions of Profit

Accounting/Business Profit: Total revenueminus the explicit or accounting costs ofproduction.

Economic Profit: Total revenue minus theexplicit and implicit costs of production.

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Example:A graduate turns down a job offer at Rs. 60,000 per year to starthis own venture. He is considering investing Rs. 200000 of his ownmoney, which has been in a bank account earning 5% per year. Theprojected income statement for the year as prepared by anaccountant is:

Income statement prepared by an accountant:

(in Rs)

Sales 90,000Less cost of goods sold 40,000Gross Profit 50,000

Less: Advertising 10,000

Depreciation 10,000Utilities 3,000Property Tax 2,000

Misc. expenses 5,000 30,000

Net accounting profit 20,000

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Implicit costs

Rs.200000 invested in business can earninterest in the bank account @ 5% per year

Annual wage of a graduate being Rs.60000 peryear

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Income statement prepared by an economist:(in Rs)

Sales 90,000Less cost of goods sold 40,000

Gross Profit 50,000Less: Advertising 10,000

Depreciation 10,000Utilities 3,000Property Tax 2,000

Misc. expenses 5,000 30,000Net accounting profit 20,000

Net economic profit -50,000

Less: Implicit costs:Return on 200000of invested capital 10,000Forgone wages 60,000

70,000

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Economic Relationships

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Economic Relationships

y = f(x)

y = f(x,z,w)

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Total Product - total number of goods produced during aspecified period of time using a particular input

Average product - the average output per unit of inputused

AP = TP / L

Marginal product - is the change in the TP correspondingto one unit change in the input.

MP = D TP / D L

TOTAL AVERAGE MARGINAL

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Number o Total Average MarginalWorkers Product Product Product

(L) (Q) (AP) (MP)0 0 0 0

1 2 2.0 2

2 5 2.5 3

3 9 3.0 4

4 14 3.5 5

5 22 4.4 8

6 40 6.7 18

7 57 8.1 17

8 63 7.9 69 64 7.1 1

10 63 6.3 -1

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Number o Total Average MarginalWorkers Product Product Product

(L) (Q) (AP) (MP)0 0 0 0

1 2 2.0 2

2 5 2.5 3

3 9 3.0 4

4 14 3.5 5

5 22 4.4 8

6 40 6.7 18

7 57 8.1 17

8 63 7.9 69 64 7.1 1

10 63 6.3 -1

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Number o Total Average MarginalWorkers Product Product Product

(L) (Q) (AP) (MP)0 0

1 2 2.0 2

2 5 2.5 3

3 9 3.0 4

4 14 3.5 5

5 22 4.4 8

6 40 6.7 18

7 57 8.1 17

8 63 7.9 69 64 7.1 1

10 63 6.3 -1

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TOTAL PRODUCT

0

10

20

30

40

50

60

70

0 1 2 3 4 5 6 7 8 9 10 11 Rate of Labor Input

T o

t a l P

r o d u c

t

AVERAGE & MARGINAL PRODUCT FUNCTIONS

-5

0

5

10

15

20

0 1 2 3 4 5 6 7 8 9 10 11 Rate of Labor Input A

v e r a g e

& M a r g

i n a

l P r o

d u c

t

Average Product

Marginal Product

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TOTAL PRODUCT

0

10

20

30

40

50

60

70

0

1 2 3 4 5 6 7 8 9 10 11 Rate of Labor Input

T o

t a l P

r o d u c

t

AVERAGE & MARGINAL PRODUCT FUNCTIONS

-5

0

5

10

15

20

0 1 2 3 4 5 6 7 8 9 10 11 Rate of Labor Input

A v e r a g e

& M a r g

i n a

l P r o

d u c

t

Average Product

Marginal Product

Slope = 8.1

ESlope = 4

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TOTAL PRODUCT

0

10

20

30

40

50

60

70

0

1 2 3 4 5 6 7 8 9 10 11 Rate of Labor Input

T o

t a l P

r o d u c

t

AVERAGE & MARGINAL PRODUCT FUNCTIONS

-5

0

5

10

15

20

0 1 2 3 4 5 6 7 8 9 10 11 Rate of Labor Input A

v e r a g e

& M a r g

i n a

l P r o

d u c

t

F

Average Product

Marginal Product

Slope = 8.1

ESlope = 4

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DEMAND AND SUPPLY

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BASICS OF DEMAND, SUPPLY AND

EQUILIBRIUM

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DEMAND SIDE OF THE MARKET

Effective DesireDemand for a commodity by a consumption unit isthe quantity it would buy in a given period of time

at a given priceDeterminants of Demandprice of the productlevel of income and wealth

prices of other productstastes and preferencesexpectation of future income

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Individual Consumers Demand Qd X = f(P X, I, P Y, T)

quantity demanded of commodity Xby an individual per time period

price per unit of commodity Xconsumers income

price of related (substitute orcomplementary) commodity

tastes of the consumer

Qd X =

P X =I =

P Y =

T =

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Demand Schedule- A table showing how much of a givenproduct a consumption unit would be able to willingly buyat different prices

Demand Schedule for telephone calls

Price per Calls percall month

P Q0 30

0.5 25

3.5 7

7 3

10 1

15 0

DEMAND SCHEDULE

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Change in Quantity Demanded

Quantity

Price

P0

Q0

P1

Q1

An increase in pricecauses a decrease inquantity demanded.

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Change in Quantity Demanded

Quantity

Price

P0

Q0

P1

Q1

A decrease in pricecauses an increase inquantity demanded.

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Shift in Demand is represented by amovement of the entire demand curve.Factors affecting the demand curve :Change in Buyers Tastes

Change in Buyers IncomesNormal GoodsInferior Goods

Change in the Price of Related GoodsSubstitute GoodsComplementary Goods

SHIFT IN DEMAND CURVE

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Quantity

Price

P0

A decrease in demandrefers to a leftward shiftin the market demandcurve.

Q2 Q0

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SUPPLY SIDE OF THE MARKET

Supply is the amount of product that a firm would bewilling and able to offer for sale at a particular priceduring a given period of time.

Determinants of supplyprice of the productcost of production

price of required inputs

technologiesprices of related products

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Supply schedule- A table showing how much of a productfirms will supply at different prices

Supply Schedule for telephones in a month

Price per productionunit per monthP Q

600 80

500 60400 40

300 20

200 0

SUPPLY SCHEDULE

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Law of SupplyA decrease in the price of a good, all otherthings held constant, will cause a decrease inthe quantity supplied of the good.

An increase in the price of a good, all otherthings held constant, will cause an increase inthe quantity supplied of the good.

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Change in Quantity Supplied

Quantity

Price

P1

Q1

P0

Q0

A decrease in pricecauses a decrease inquantity supplied.

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Change in Quantity Supplied

Quantity

Price

P0

Q0

P1

Q1

An increase in pricecauses an increase inquantity supplied.

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Shift in Supply Curve is represented by amovement of the entire supply curve.

Factors affecting the supply curve

Change in Production TechnologyChange in Input PricesChange in the Number of Sellers

SHIFT IN SUPPLY CURVE

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Quantity

Price

P0

Q1 Q0

An increase in supplyrefers to a rightward shiftin the market supply curve.

SHIFT IN SUPPLY CURVE

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Quantity

Price

A decrease in supply refers

to a leftward shift in themarket supply curve.

P0

Q0 Q2

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Change in price of a good or serviceleads to

Change in quantity demandedmovement along a demand curve

Change in income, preferences, or prices of related goodsand services

leads toChange in demandshift of demand curve

Shift of Demand Versus Movement Along a Demand Curve

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Change in price of a good or serviceleads to

Change in quantity suppliedmovement along a supply curve

Change in costs, input prices, technology, or prices ofrelated goods and services

leads toChange in supplyshift of supply curve

Shift of Supply Versus Movement Along a Supply Curve