Economics for Engineers (UCHUT 346)

Module – 1

Economics

Economics originated from the Greek word ‘IOKONOMIA’ which means Household
Management. It is Adam Smith who is considered as Father of Economics > 1776 > ‘Wealth of
Nations’. HE defined economics as “An enquiry into the Economics studies how the society and
individuals use the limited resources to satisfy the unlimited wants.

Scarcity and Choice

Scarcity means that resources are not available in the required quantity to satisfy all the wants
and needs. Since we face Scarcity, people have to make choice between goods and services. In
1932, Lionnel Robinson (‘Nature and significance of Economics’) defined economics as a
“science which studies the human behaviour in relationship with given ends and scarce means”

Economic Problems of an economy

An economy is a system in which people earn their living by performing different economic
activities like production, consumption and investment. Economic problems are reflected in the
form of Central or Basic Problems of an economy. According to Samuelson, there are three
fundamental and interdependent problems in an economic organisation—what, how and for
whom—which are grouped under allocation of resources.

1. Allocation of Resources

(a) What Goods to Produce and How Much to Produce?

Due to limited resources, every economy has to decide what goods to produce and in what
quantities. An economy has to make a choice of the wants which are important for the economy
as a whole. For example, if the economy decides to produce more cloth, it is bound to reduce the
production of food. The reason is that resources used to produce food and cloth are limited and
given. An economy cannot produce more of both food and cloth. Thus, an economy has to
decide what goods it would produce on the basis of availability of technology, cost of
production, cost of supplying and demand for the commodity.

(b) How to Produce?

A technique of production which would maximise output or minimise cost should be used. We
generally consider two types of techniques of production: labour-intensive and capital-intensive
techniques. In labour-intensive technique, more labour and less capital is used. In capital-
intensive technique, more capital and less labour is used. Hence, producers must always produce
efficiently by using the most efficient technology. Thus, every economy has to choose the most
efficient technique of producing a commodity.

c) For Whom to Produce?

This is the question of how to distribute the product among the various sections of the society.
Thus, guiding principle of this problem is output of the economy be distributed among different
sections of the society in such a way that all of them get a minimum level of consumption.

2. Full Utilisation of Resources

It emphasis the fuller and optimal utilization of resources.

3. Economic Efficiency

The aim of an economy, which wants to be economically efficient.

4. Economic Growth

With discovery of new stock of resources or an advancement in technology, the productive

capacity of an economy increases.

Production Possibility Curve

Production possibility curve or frontier (PPF) shows the various alternative combinations of
goods and services that an economy can produce when the resources are all fully and efficiently
employed. PPC shows the obtainable options. There is a maximum limit to the amount of goods
and services which an economy can produce with the given resources and the state of
technology. The resources can be used to produce various alternative goods which are called
production possibilities and the curve showing the different production possibilities is called
production possibility curve.

Production Possibility Schedule and Curve PP schedule refers to tabular presentation of different
possible combinations of two goods that an economy can produce with given resources and
available technology.
Features of Production Possibility Curve

PPC slopes downward. A production possibility curve slopes downward from left to right
because under the condition of full employment of resources, production of one good can be
increased only after sacrificing production of some quantity of the other good. It is so because
resources are scarce.

PPC is concave to the origin. A production possibility curve is concave to the point of origin
because of increasing marginal rate of transformation (MRT) or increasing marginal opportunity
cost (MOC). Slope of PPC is defined as the quantity of good Y given up in exchange for
additional unit of good X.

Marginal opportunity cost is opportunity cost of good X gained in terms of good Y given up. It is
also called Marginal Rate of Transformation (MRT). Concave shape of PPC means that slope of
PPC increase which implies that MRT increases. It means that for producing an additional unit of
a good, sacrifice of units of other good (i.e. opportunity cost) goes on increasing.

Shifts in Production Possibility Curve

With discovery of new stock of resources or an advancement in technology, the productive

capacity of an economy increases. PPC will shift to the right when: (a) new stock of resources is
discovered. (b) There is advancement in technology.

PPC will shift to the left when a) Resources are destroyed because of national calamity like
earthquake, fire, war, etc. (b) There is use of outdated technology.
The Law of Diminishing Marginal Utility
Definition of Utility
The term utility refers to the want satisfying power of a commodity. Utility is essentially a
subjective concept depending upon the intensity of consumer’s desire or want for that
commodity at that time. Thus, utility differs from person to person, place to place and time to
time. Utility is a cardinal concept i.e., it can be measured. Benham formulated the unit of
measurement of utility as utils.

Total Utility (TU)

It is the sum of all the utilities that a consumer derives from the consumption of a certain
amount of a commodity.

TUn = MU1 + MU2 +..... + MUn

Marginal Utility (MU)

It is addition made to the total utility as consumption is increased by one more unit of the
commodity. Mathematically, it is calculated as:

Law of Diminishing Marginal Utility (DMU) / Theory of Consumer Behaviour

• Theory has been developed by Prof. Alfred Marshall

Assumptions of the Theory

➢ Rationality

➢ Commodities should be homogenous and normal

➢ No time gap between the consumption of goods

➢ No change in taste and preferences

➢ No change in price of the commodity

Statement of Theory

• As the consumer consumes more and more units of a same good, the additional utility
(MU) from each additional units goes on decreasing.
Relationship between TU and MU

Units Consumed TU MU
0 0 0
1 10 10
2 18 8
3 24 6
4 27 3
5 29 2
6 29 0
7 27 -2

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Observations:

1. As the consumer has more of the good, the TU increases less than in proportion and the
MU gradually declines but is positive.
2. When TU is maximum, called saturation point, MU is zero.
3. When TU falls, MU becomes negative.
A stage comes when marginal utility becomes zero. At this point total utility becomes maximum.
If the consumer consumes beyond this stage, marginal utility becomes negative and total utility
falls. It means that consumer starts getting disutility i.e., dissatisfaction instead of getting
satisfaction. Since, economists believe that a consumer is a rational being, he wants to maximize
his satisfaction. A consumer would not like to go beyond zero marginal utility.

Consumer’s Equilibrium

A consumer is said to be in equilibrium when he maximizes his satisfaction, given income and
prices of the commodities.

Case I

One Commodity Case

Let us suppose that a consumer has a given income with which he consumes only one
commodity X.

Thus, a consumer is in equilibrium when he satisfies the following condition:

i.e., MU of the good = Price of the product or MUX = PX

Case 2

Two Commodities Case – Law of Equi-Marginal Utility

Consumer’s equilibrium conditions in case of two goods X and Y can be written as:

Demand

✓ Demand is the desire backed by the ability and willingness to pay for a commodity.
✓ Quantity demanded refers to the particular quantity which buyers are willing and able to
buy on a given price during a given period of time.
✓ Demand for a commodity is defined as the quantity of that commodity which a consumer
is willing to buy at a particular price during a particular period of time.

Factors affecting individual demand for a good

1. Price of the Commodity

 There is inverse relationship between price of a commodity and demand for a commodity. In
general, demand for a commodity is more at lower price and less at a higher price and vice versa.
But this relationship does not exist in giffen goods and Veblen goods.
2 . If x is an inferior good then an increase in income causes its demand to decrease. This is
because as income rises, purchasing power rises and consumers substitute more superior goods
for inferior goods. Goods whose demand falls when income rises are called inferior goods.
Example: Coarse cereals.

3. Prices of Other Goods

(a) When X and Z are Substitutes

Substitute goods are those which are an alternative to one another in consumption. Examples are: tea
or coffee; wheat or rice. The demand for a good usually moves in the same direction to a change in
price of its substitutes. Substitute goods are those goods in which rise in price of good lead to rise in
demand of another good.

(b) When X and Z are Complements

Complementary goods are those which are jointly used or consumed together to satisfy a want.
Examples are: tea and sugar; car and petrol. Thus, demand for a good move in the opposite
direction to a change is price of its complementary good. Complementary goods are those goods
in which rise in price of good lead to fall in demand of another good.

4. Consumer’s Tastes and Preferences

Any change in consumer’s tastes causes demand to change. If there is a change in tastes in
favour of a good, then it will lead to increase in demand and any unfavourable change wil lead
to decrease in demand.

5. Future Expectations of Buyers

Future expectation is also one of the factors which cause change in demand. If it is expected by
the consumer that the price of the commodity will rise in future, he will start buying more units
of the commodity in the present, at the existing price.

6. Size of Population
DX = f (PX, PZ,Y, T, E, N, Yd )

DX = Demand for commodity X

PX = Price of commodity X
PZ = Prices of related goods
Y = Income of consumer
T = Taste and preferences of consumer
E = Future expectation
N = No. of consumers
Yd = Distribution of income

Law of Demand
The law of demand states that if remaining things are constant then as price of a commodity
increases demand for the commodity decreases and as price of a commodity decreases demand
for the commodity increases.
DX = f (PX), ceteris paribus

DX = Quantity demanded of good X, PX = Price of the good X

The Demand Schedule and the Demand Curve

Demand Schedule It is a tabular presentation showing the different quantities of a good that
buyers of the good are willing to buy at different prices during a given period of time.

Demand Curve The graphical representation of the demand function is called a demand curve.

Changes in Demand
2 types of changes in demand
1. Change in demand due to change in price – Expansion and Contraction of Demand –
Movement along demand curve
2. Change in demand due to factors other than price – Increase and Decrease in demand
– Shift in demand curve

Movement: Change in Quantity Demanded

A movement along the demand curve is caused by a change in the price of the good,
other things remaining constant. It is also called change in quantity demanded of the
commodity. Movement is always along the same demand curve, i.e., no new demand
curve is drawn. Movement along a demand curve can bring about:
(a) Expansion of demand, or (b) Contraction of demand

Extension of Demand or Contraction of Demand.

Expansion or Extension of demand refers to rise in demand due to fall in the price of the
good. Contraction of demand refers to fall in demand due to rise in the price of the good.

Point A on the demand curve d is the original situation. An upward movement from point
A to a point such as point B shows contraction or lesser quantity demanded at a higher
price. Downward movement from point A to a point such as point C shows expansion or
more quantity demanded at a lower price.

Shift: Change in Demand

A shift of the demand curve is caused by changes in factors other than price of the good.
A change in factors causes shift of the demand curve. It is also called change in demand.
In a shift, a new demand curve is drawn. A shift of the demand curve can bring about: (a)
Increase in demand, or (b) Decrease in demand.
 (a) Increase in Demand: It refers to more demand at a given price. The causes of
increase in demand are: (i) Increase in the income of the consumers in case of normal
goods. (ii) Decrease in the income of the consumers in case of inferior goods. (iii)
Increase in the price of substitute goods. (iv) Fall in the price of complementary
goods. (v) Consumers’ taste becoming stronger in favour of the good.
(b) Decrease in Demand: It refers to less demand at the given price. It occurs due to
unfavourable changes in factors other than the price of the good.

Elasticity of Demand

• It refers to the degree of responsiveness change in qty demanded of a commodity due to

change in price or any other factors.
• It was put forward by Alfred Marshall
• 3 Types of elasticity of demand
✓ Price Elasticity
✓ Income Elasticity
✓ Cross Elasticity

Price elasticity of demand

It measures the responsiveness of demand of a good to a change in its price. Types of price
elasticities of Demand

1. Perfectly elastic demand

2. Perfectly inelastic demand
3. Unit elastic demand / Unitary elastic demand
4. Elastic demand / More elastic demand
 5. Inelastic demand / Less elastic demand

1. Perfectly Elastic Demand (eD= ∞)

When the demand for a commodity rises or falls to any extent without any change in price, the
demand for the commodity is said to be perfectly elastic. It is an ideal and imaginary situation.

2. Perfectly Inelastic demand

Perfectly inelastic demand (eD = 0) When the demand of a commodity does not change as a
result of change in its price, the demand is said to be perfectly inelastic. The perfectly inelastic
demand curve is a vertical line parallel to y-axis. As it is clear from the diagram, price may be
OP or OP1 or OP2 , but the demand will be constant at OQ. In other words, there is no effect of
changes in the price on the quantity demanded. It exists in case of essentials like life saving
drugs.

3. Unit Elastic Demand (eD = 1)

When percentage change in demand is equal to the percentage change in price, the demand for
the commodity is said to be unitary elastic. The unitary elastic demand curve shows that when
price falls from OP to OP1 , demand rises from OQ to OQ1 . The change in demand (QQ1 ) is
equal to the change in price (PP1 ). It exists in case of normal goods.
 4. Elastic (or more than unit elastic) Demand (1 < eD < ∞)
When a change in price leads to a more than proportionate change in demand, the
demand is said to be elastic or more than unit elastic. The elastic demand curve shows
that when price falls from OP to OP1 , demand rises from OQ to OQ1 . The change in
demand (QQ1 ) is more than the change in price (PP1 ). It exists in case of luxuries.

5. Inelastic (or less than unit elastic) Demand (0 < eD < 1)

When a change in price leads to a less than proportionate change in the demand, the demand is
said to be less elastic or inelastic. The inelastic demand curve shows that change in quantity
demanded (QQ1 ) is less than change in price (PP1 ). It exists in case of necessities like food,
fuel, etc.

Measurement of Price Elasticity of Demand by Percentage Method

Percentage method is also called proportionate method. The absolute value of the coefficient of
elasticity of demand ranges from zero to infinity. According to this method, eD is calculated by
the following formula

• A consumer spends 40 on a good at a price of 1 per unit and 60 at a price of 2 per unit.
What is the price elasticity of demand? What kind of good it is? What shape its demand
curve will take? Ans: 0.25 (The good has an inelastic demand. It is a
necessity like food, fuel etc. The demand curve for this good is steep.)
• When the price of a commodity falls by 2 per unit, its quantity demanded increases by 10
units. Its price elasticity of demand is (–) 1. Calculate its quantity demanded at the price
before change which was 10 per unit. Ans: 50 Units
• The quantity demanded of a commodity falls by 5 units when its price rises by 1 per unit.
Its price elasticity of demand is (–) 1.5. Calculate the price before change if at this price
quantity demanded was 60 units. Ans 18 Rs
• The market demand for a good at a price of 10 per unit is 100 units. When its price
changes its market demand falls to 50 units. Find out the new price if the price elasticity
of demand is (–)2. Ans: 12.50 rs
• If the elasticity of demand for salt is zero and a household demands 2 kg. of salt in a
month at 5 per kg, how much will it demand at 7.50 per kg? Ans: 2 Kg

Supply

Supply refers to the quantities of a commodity which a seller offers for sale at a particular
price in a given period of time. It refers to the desired qty of commodity that the seller
offers for sale in the market. Supply of a commodity means quantity of the commodity
which a firm is willing to sell at a given price during a particular time.

Factors affecting supply of a commodity

 1. Price of the Commodity

At a higher price, producer offers more quantity of the commodity for sale and at a lower
price, less quantity of the commodity is offered for sale. There is a direct relationship
between price and quantity supplied as shown by law of supply.

2. Price of Related Good

Supply of a commodity depends upon the prices of its related goods, especially substitute
goods. If the price of a commodity remains constant and the price of its substitute good Z
increases, the producers would prefer to produce substitute good Z. As a result, the
supply of commodity X will decrease and that of substitute good Z will increase. This
will shift the supply curve of good X leftward. Thus, an increase in the price of substitute
good will lead to decrease in supply curve of the other good and vice-versa.

3. State of Technology

If there is a change in the technique of production leading to a fall in the cost of

production, supply of commodity will increase.

4. Prices of Inputs

An increase in input price or cost will shift the supply curve to the left (decrease in
supply) and vice-versa.

5. Government Policy

Government’s policy also affects the supply of a commodity. If heavy excise taxes are
imposed on a commodity, it will discourage producers and as a result, its supply will
decrease.

Supply function

Supply function is a functional relationship between quantity supplied of a commodity

and factors affecting it.

SX = f (PX, PZ, T, C, GP)

where,

SX = Supply of commodity X

f = function of
PX = Price of commodity X

P = Price of related good, Z

T = Technological changes

C = Cost of production or price of inputs

GP = Government policy or excise tax rate.

The law of supply

Law of supply derives the relationship between price and quantity supplied. According to
the law of supply, other things remaining the same, quantity supplied of a commodity is
directly related to the price of the commodity. In other words, other things remaining the
same, when price of a commodity rises, its quantity supplied increases and when the price
falls, quantity supplied also falls.

Symbolically, the law of supply is expressed as:

SX = f (PX), ceteris paribus

The Supply Schedule and the Supply Curve

Supply schedule is a tabular statement that gives the law of supply, i.e., it gives the
different quantity supplied of a commodity at different prices per unit of time.
Supply curve shows graphically the relationship between quantities supplied of a commodity to
its price. The curve shows positive or direct relationship between the price and quantity supplied
of the commodity. With rise in price, the curve rises upward from left to the right.

Changes in Supply

2 types of changes in Supply

• Change in supply due to change in price – Expansion and Contraction of supply –
Movement along supply curve
• Change in supply due to factors other than price – Increase and Decrease in supply –
Shift in supply curve

Change in Quantity Supplied (Movement along the supply curve)

A movement along the supply curve is caused by changes in the price of the good, other
things remaining constant. It is also called change in quantity supplied of the commodity.
In a movement, no new supply curve is drawn. Movement along a supply curve can bring
about:
(a) Expansion or extension of supply, or

Expansion or extension of supply refers to rise in supply due to rise in price of the good.
Contraction of supply refers to fall in supply due to fall in price of the good.
Expansion and contraction of Supply

Point A on the supply curve is the original situation. An upward movement from point A
to a point such as C shows expansion or more supply at a higher price. A downward
movement from point A to a point such as point B shows contraction or less supply at a
lesser price.

Change in Supply (Shift in supply curve)

A change (or shift) in supply curve is caused by changes in factors other than the price of
the good. A change in many factors causes shift in the supply curve. It is also called
change in supply. In a shift, a new supply curve is drawn.
A shift of the supply curve can bring about: (a) Increase in supply, or (b) Decrease in
supply.

Increase in Supply (i.e., Rightward shift in supply curve) When supply of a commodity
rises due to favourable changes in factors other than price of the commodity, it is called
increase in supply. Increase in supply means more quantity supplied at the same price. It
also means that same quantity supplied at a lower price.
 SS is the original supply curve. An increase in supply is shown by rightward shift of the
supply curve from SS to S1 S1 .

Decrease in Supply
(i.e., leftward shift in supply curve) When supply of a commodity falls due to
unfavourable changes in factors other than its price, it is called decrease in supply.
Decrease in supply means less quantity is supplied at the same price. It also means that
same quantity is supplied at a higher price.

In the figure, SS is the original supply curve. A decrease in supply is shown by leftward
shift of the supply curve from SS to S1 S1 .

Elasticity of supply
Alfred Marshall developed the concept of elasticity of supply. Price elasticity of supply is
defined as the responsiveness of quantity supplied of a commodity to changes in its own
price.

Different types of elasticity of supply

1. Perfectly elastic supply
2. Perfectly inelastic supply
3. Unit elastic supply / Unitary elastic supply
4. Elastic supply / More elastic supply
5. Inelastic supply / Less elastic supply

Perfectly Elastic Supply (eS = ∞).

Supply of a commodity is said to be perfectly elastic when its supply expands (rises) or
contracts (falls) to any extent without any change in the price. The coefficient of eS = ∞
(infinity). The perfectly elastic supply curve is SA which is a horizontal line.

Perfectly Inelastic Supply (eS = 0).

When supply of a commodity does not change irrespective of any change in its price, it
is called perfectly inelastic supply. In this case, eS = 0. The supply curve, S3R, is a
vertical line showing that quantity supplied is fixed at OS3 units irrespective of the price.

Unitary Elastic Supply (eS = 1)

Supply of a commodity is said to be unitary elastic if percentage change in supply equals
the percentage change in price. In this case, the coefficient of eS is equal to one. The
unitary elastic supply curve is OC which is a straight positively sloping line from the
origin.
 Elastic Supply (1 < eS < ∞)
When percentage change in supply is more than the percentage change in price, supply is
said to be elastic or more than unitary elastic. In this case, the value of the eS is more
than one.

Inelastic Supply (0 < eS < 1)

When percentage change in quantity supplied is less than percentage change in price,
supply is said to be inelastic or less than unitary elastic.

Meaning of Equilibrium

The term equilibrium means the state in which there is no tendency on the part of consumers and
producers to change. The two factors determining equilibrium price are demand and supply.
Equilibrium Price Equilibrium price is the price at which the sellers of a good are willing to sell
the same quantity which buyers of that good are willing to buy. Thus, equilibrium price is the
price at which demand and supply are equal to each other.
Market Equilibrium

Equilibrium price is determined by the equality between demand and supply. At this price,

Quantity demanded = Quantity supplied

Equilibrium between Demand and Supply

The forces of demand and supply determine the price of a commodity. Equilibrium price will be
determined where quantity demanded is equal to quantity supplied. This is called market price.
This price has a tendency to persist. If at a price the market demand is not equal to market supply
there will be either excess demand or excess supply and the price will have tendency to change
until it settles once again at a point where market demand equals market supply. A demand and
supply schedule and curve will show the determination of equilibrium price.
In Table 11.1, demand and supply of the commodity at different prices are shown. The
equilibrium price is fixed at 6 where the quantity demanded and the quantity supplied are equal,
i.e., equal to 3000 units.

From the figure, quantity demanded and supplied is measured on the x-axis and price on the y-
axis. DD is the downward sloping demand curve and SS is the upward sloping supply curve.
Both these curves intersect each other at point E which is the equilibrium point and it implies
that at price of 6, demand is for 3000 units and supply is also of 3000 units. Thus, equilibrium
price is 6. If price is 4, there will be an excess demand of 4000 units. There will be competition
among buyers. It will push up the price. Rise in price will result in fall in market demand and rise
in market supply. This reduces the excess demand. The changes continue till price settles at
equilibrium level. If price is 7, there will be an excess supply of 2000 units. There will be
competition among sellers. This will reduce the price. Fall in price will result in rise in demand
and fall in supply. These changes continue till price settles at equilibrium price. Thus, market
equilibrium is a situation of zero excess demand and zero excess supply.

Effects of changes in demand and supply on equilibrium price

Increase in Demand

When demand of a commodity increases, while supply remains constant, equilibrium price will
increase. At the same time, quantity sold and purchased will also increase. This is shown in Fig.
11.2. In the original situations, the DD and SS curves intersect at point E to give equilibrium
price as OP and output as OQ. Chain Effects of Excess Demand: Keeping supply constant, if the
demand increases, the demand curve shifts from DD to D1 D1 . This creates an excess demand
of EA units at the given price, OP.

If the demand of a commodity decreases, while supply remains constant, the equilibrium price
and output will fall. In Fig. 11.3, quantity demanded and supplied is shown on the x-axis and
price of commodity on the y-axis. DD is the original demand curve. SS is the original supply
curve. E is the equilibrium point. Decrease in demand is given by leftward shift of DD curve to
D1 D1 . This creates excess supply of AE units at price OP.

Increase in Supply

If the supply of a commodity increases, while demand remains constant, equilibrium price will
fall. This is shown in Fig. 11.4. In the figure, quantity demanded and supplied is shown on the x-
axis and price of commodity on the y-axis. DD is the original demand curve. SS is the original
supply curve. E is the original equilibrium point. SS increases to S1 S1 . It creates excess supply
of EB at the given price OP.

Decrease in Supply

If the supply of a commodity decreases, while demand remains constant, equilibrium price will
increase. There will be excess demand of EB units at price OP.
Production

Production is defined as the transformation of inputs into output. Production includes not only production of
physical goods like cloth, rice, etc., but also production of services like those of a doctor, teacher, lawyer,
etc.

Production Function

The term production function means physical relationship between inputs used and the resulting output. A
production function is an expression of quantitative relation between change in inputs and the resulting
change in output. It is expressed as:

Q = f (i1, i2 .......... in)

Where Q is output of a specified good i1, i2 ........ i n are the inputs usable in producing this good.
To simplify let us assume that there are only two inputs, labour (L) and capital (K), required to produce a
good. The production function then takes the form:

Q = f (K, L)

Short-run and Long-run Production Function

There are two types of production function:

(a) Short-run Production Function.

It refers to production in the short-run where there is at least one factor in fixed supply and other
factors are in variable supply. In short-run, production will increase when more units of variable
factors are used with the fixed factor. Fixed factors refer to those factors whose supply cannot be
changed during short-run. For example, land, plant, factory building, minimum electricity bill, etc.

(b) Long-run Production Function.

 It refers to production in the long-run where all factors are in variable supply. In the long-run,
production will increase when all factors are increased in the same proportion. Variable factors refer
to those factors whose supply can be varied or changed. For example, raw materials, daily wages,
etc.

Concepts of Product

Total Physical Product (TPP) or Total Product (TP)

Total Physical Product (TPP) or TP. It is defined as the total quantity of goods produced by a firm with the given
inputs during a specified period of time.

Average Product (AP) or Average Physical Product (APP) Average Product (AP).

It is defined as the amount of output produced per unit of the variable factor (labour) employed.

Marginal Product (MP) or Marginal Physical Product (MPP)

It is defined as the change in TP resulting from the employment of an additional unit of a variable factor (labour).

Law of Variable Proportion

The law of variable proportion is a widely observed law of production which takes place in the short-run.
In the short-run, production can be increased by using more of the variable factor. The law is applicable to
all sectors of an economy.

The law of variable proportion states that as we employ more and more units of a variable input, keeping
other inputs fixed, the total product increases at increasing rate in the beginning then increases at
diminishing rate and finally starts falling.
Three Phases of Production
The three phases can be identified by inspecting the behaviour of MP of variable input in the above table.
MP of variable input rises up to 3 units. This is phase I in which TP increases at an increasing rate. From
4th unit to 8th unit of variable input, MP falls but remains positive. This is phase II in which TP increases at
a decreasing rate. MP of variable input becomes negative from 10th unit. This is phase III in which TP starts
falling. These three phases of the short-run law of production are graphically illustrated by the relationship
between TP and MP curves.

Phase I. Phase of Increasing Returns

It goes from the origin to the point where the MP curve is maximum (i.e., from origin to point B). In this
phase, TP curve is increasing at an increasing rate. MP curve rises and reaches a
maximum. A rational producer will not operate in this phase because the producer can always expand
through phase I. It is a non-economic range.

Phase II. Phase of Diminishing Returns

It is the most important phase out of the three phases. Phase II of production ranges from the point where
MP curve is maximum to the point where the MP curve is zero (i.e., from point B to C). MP curve is
positive but declining. TP curve increases at a decreasing rate and reaches a maximum. A rational producer
will always operate in this phase. The law of diminishing returns operates in phase II.

Phase III. Phase of Negative Returns

It covers the entire range over which MP curve is negative. In this phase, TP curve falls (after point C). A
rational producer will not operate in this phase, even with free labour, because he could increase his output
by employing less labour. It is a non-economic and an inefficient phase.
 Cobb–Douglas production function

Douglas form was developed and tested against statistical evidence by Charles Cobb and Paul Douglas
between 1927–1947; according to Douglas, the functional form itself was developed earlier by Philip
Wicksteed.
In its most standard form for production of a single good with two factors, the function is:

• Y = total production
• L = labour input
• K = capital input (a measure of all machinery, equipment, and buildings; the value of capital input
divided by the price of capital)[
• A = total factor productivity
• α and β are the output elasticities of capital and labor, respectively. These values are constants
determined by available technology.
Output elasticity measures the responsiveness of output to a change in levels of either labor or capital used
in production.

• α + β = 1, Constant Returns to scale - meaning that doubling the usage of capital K and labor L will
also double output Y. Cobb – Douglas production function is a homogenous production function.
• α + β < 1, Returns to scale are decreasing, means that a percentage increase in capital K and
labor L will produce a smaller percentage increase in output Y
• α + β > 1, Returns to scale are increasing, means that a percentage increase in capital K and labor L
will produce a larger percentage increase in output Y