CA Foundation Study Material – Page 3

CA Foundation Business Economics Study Material – Law of Variable Proportions

January 5, 2022April 26, 2019 by Prasanna

CA Foundation Business Economics Study Material Chapter 3 Theory of Production and Cost – Law of Variable Proportions

Law of Variable Proportions

The Law of Variable Proportions examines the production function i.e. the input-output relation in short run where one factor is variable and other factors of production are fixed.
In other words, it examines production function when the output is increased by varying the quantity of one input.
Thus, the law examines the effect of change in the proportions between fixed and variable factor inputs on output in three stages viz. Increasing returns, diminishing returns and negative returns.

Statement of the Law :-
“As the proportion of one factor in a combination of factors is increased, after a point first the marginal and then the average product of that factor will diminish”. (F. Benhan)

The law operates under some assumptions which are as follows:-

There is only one factor which is variable. All other factors remain constant.
All units of variable factor are homogeneous
It is possible to change the proportions in which the various factors are combined.
The state of technology is given and is constant.

The three stages of the law can be explained with the help of the following schedule and diagram.

CA Foundation Business Economics Study Material - Law of Variable Proportions

Stage I: The Law of Increasing Returns to Factor –

During this stage, total product (TP) increases at an increasing rate upto the point of inflexion ‘I’ and thereafter it increases at diminishing rate.
This is because marginal product (MP) of the variable factor increases upto point ‘M’ on MP curve and then start falling.
Rising MP also pulls up average product (AP), which goes on rising, in the first stage.
Rising AP indicates increase in the efficiency of variable factor i.e. labour.
Stage I ends where AP is maximum and is equal to MP as shown by point ‘C’ in the diagram.

The law of increasing returns operates because of the following two reasons:

1. Indivisibility of fixed factors

Due to indivisibility, the quantity of fixed factors is more than the quantity of variable factors.
So when the quantity of variable factors is increased to work with fixed factors, output increases speedily due to full and effective utilisation of fixed factors.
In other words, efficiency of fixed factors increases.

2. Efficiency of Variable Factor Increases
Due to increase in the quantity of variable factor, it becomes possible to introduce DIVISION OF LABOUR leading to SPECIALISATION. This results in more output per worker.

Stage II: The Law of Diminishing Returns to Factor –

In second stage, TP continues to increase at diminishing rate. It reaches the maximum at point ‘D’ in the diagram, where the second stage ends.
In this stage, both AP and MP of variable factor are falling- though remains positive. That is why this stage is called as the stage of diminishing returns.
At the end of this stage MP becomes, zero as shown by point ‘B’ in the diagram and corresponding to highest point ‘D’ on TP curve.

The law of diminishing returns operate due to the following two reasons:

1. Indivisibility of fixed factors

Once the optimum proportion between indivisible fixed factors and variable factors is reached (as in Stage I) with any further increase in the quantity of Variable factor, the fixed factors become inadequate and are overutilised.
The fine balance between fixed and variable factor gets disturbed. This causes AP and MP to diminish.

2. Imperfect Substitutability of factors

Variable factors are not perfect substitute of fixed factors.
The elasticity of substitution between factors is not infinite.

Stage III: The Law of Negative Returns to Factor –

In third stage, TP falls and so, TP curve slopes downward. MP becomes negative and the MP curve goes below the X-axis. AP continues to fall.
As the MP of variable factor becomes negative, this stage is called the stage of negative returns.
In this stage the efficiency of fixed and variable factors fall and factor ratio becomes highly sub-optimal.

The law of negative returns operate due to the following reasons:

The quantity of the variable factor becomes too excessive compared to fixed factors. They get in each other’s way and so TP falls and MP becomes negative.
Too large number of variable factors also reduce the efficiency of fixed factors.

Conclusion -Where to operate?

A rational firm will not produce either in Stage I or in Stage III.
In stage I, the marginal product of fixed factor is negative as its quantity is more than variable factor.
In stage III, the marginal product of variable factor is negative as its quantity is too large than fixed factor.
Therefore, firm would seek to produce in Stage II where both AP and MP of Variable factor are falling.
At which point to produce in this stage will depend on the prices of factor inputs.

CA Foundation Business Economics Study Material – Meaning of Production

January 5, 2022April 25, 2019 by Prasanna

CA Foundation Business Economics Study Material Chapter 3 Theory of Production and Cost – Meaning of Production

Meaning of Production

Production is one of the important economic activity that takes place in any economy apart from consumption and investments.
An individual firm is the micro-economic unit which undertake the production of goods and services.
A firm’s survival depends upon whether it is able to achieve optimum efficiency in production by minimizing the cost of production.
Production is the transformation of resources into goods and services. In other words, production is the act of transformation of INPUTS into OUTPUT which satisfies the wants of some people.
E.g.- Inputs of sugarcane, capital and labour are used to produce SUGAR.
Production also includes production of SERVICES like those of lawyers, teachers, doctors, etc.
The amount of goods and services that an economy is able to produce determines whether it is rich or poor. A country like U.S.A. is a rich country as its production level is high.
Man cannot create or destroy matter.
In Economics, the term production means creation of economic utilities in the matter i.e. in the things that already exist.
Thus, production means creation of those goods and services which have economic utilities i.e. exchange value.
According to James Bates and J.R. Parkinson, “Production is the organized activity of transforming resources into finished products in the form of goods and services; and the objective of production is to satisfy the demand of such transformed resources.”
Professor J. R. Hicks has defined production “as any activity whether physical or mental, which is directed to the satisfaction of other people’s wants through exchange.”
The definition indicates that the term production covers the whole process from creation of utilities till the satisfaction of human wants.

Utilities may be created or added in many ways, such as :-

1. Form Utility

It is created by changing the form of raw materials into finished goods for man’s use.
E.g. converting raw cotton into cotton fabric.
Form utility is created by manufacturing industries.

2. Place Utility

It is created by transporting goods from one place to another.
E.g. when goods are taken from factory to marketplace, place utility is created.
Transport services are involved in creation of place utility.

3. Time Utility

It is created by making things available when they are required.
E.g. Banks create time utility by granting overdraft facilities.

4. Service Utility (Personal Utility)

It is created by providing personal services to the customers by professionals likes lawyers, doctors, bankers, shopkeepers, teachers, transporters, etc

CA Foundation Business Economics Study Material – Business Cycle

January 5, 2022April 25, 2019 by Prasanna

CA Foundation Business Economics Study Material Chapter 5 Business Cycle

All countries have gone through fluctuations in economic activities i.e. ups and downs in its economic activities. In other words, every country passes through a pattern where there are period of economic growth, followed by periods of slowing growth and even failing growth. There are periods of prosperity followed by downturns. Thus,

“The Business Cycle is the periodic fluctuations in economic activity measured by change in Real GDP.”

Although these economic fluctuations are recurrent and occur periodically, they are not at regular interval and are not of same length.

Phases of Business Cycle

A business cycle passes through the following four distinct phases:

Expansion/Boom/ Recovery/ Upswing
Peak/Boom/Prosperity
Contraction/Recession/ Downswing
Trough/Depression

The following figure shows the four stages of the business cycle.
CA Foundation Business Economics Study Material Business Cycle

In the figure above the four phases business cycles are shown. The broken line represents long time growth trend or potential GDP. It shows rising trend of growth over a period of time. The figure starts from Trough when the overall economic activities ie. level of production and employment are at the lowest level. With increase in the economic activities the economy moves into Expansion Phase. But expansion phase cannot continue indefinitely, and after reaching Peak, economy starts contracting i.e. Contraction Phase sets in and continue till it reaches the lowest turning point called Trough. Here cycle completes and new cycle starts.

Expansion

In the expansion phase, there is increase in OUTPUT and EMPLOYMENT. Expansion phase is characterized by-

increase in national output,
increase in employment,
increase in aggregate demand,
increase in capital i.e. investments,
increase in consumer spending,
increase in sales, profits, stock prices, & expansion of bank credit.
increase in standard of living.

There is no INVOLUNTARY UNEMPLOYMENT and whatever unemployment exist is only of FRICTIONAL or STRUCTURAL in nature.
The growth ultimately slows down and reaches its peak.

Peak

Peak phase of the cycle is the highest point. The economy is producing at its maximum level. The economy becomes overheated i.e. unsustainable. The expansion phase ends here. The prices of inputs increase, resulting higher cost of production, leading to higher output prices. Higher output price leads to increased cost of living. Fixed income earners and consumers suffer. Economic growth stabilizes at peak an then starts the downswing.

Contraction

In contraction phase. There is fall in OUTPUT and EMPLOYMENT levels. Contraction phase is characterized by—

fall in the level of investments,
fall in the level of production and employment,
fall in the incomes of people,
demand and consumption of both capital goods and consumer goods fall,
bank credit, shrinks as investments fall,
stock prices fall,
firms become pessimistic about future,
there is lot of excess production capacity in industries.

There is large scale involuntary unemployment.

A severe contraction or recession of economic activities pushes the economy into Depression.

Trough and Depression

The lowest level of economic activity is called trough or depression. All economic activity touch the bottom and the phase of trough is reached. Trough is the turning point into expansion. Increased investments lead to increase in consumption. Therefore, industries expand production and start using their idle production capacity and rate of unemployment falls. With this the cycle is complete.

It is very difficult to predict turning points of business cycles. Changes in different economic activities is used to measure the business cycle and to predict in which direction the economy is headed. There are three types of economic indicators, depending on their timing namely—

Leading Indicators,
Lagging Indicators, and
Coincident Indicators

Leading Indicators signal future changes

Leading Indicators change before the economy itself changes Le. change prior to large economic adjustments.
E.g.– changes in stock prices, profit margins and profits, the house market, manufacturing activity, etc. Leading Indicators should be used with caution as they may not be always accurate.
Lagging Indicators usually change after the economy as a whole changes i.e. after the real output changes. Lagging Indicators are useful to confirm the business cycle.
E.g.– unemployment, the consumer price index, interest rates, lending by banks, etc.
Coincident Indicators also called Concurrent Indicators occur at about the same time with business cycle movements. They give us idea about current state of economy.
E.g.– GDP, inflation, industrial output, personal income, etc.

Features of Business Cycles

Business cycles occur periodically. They do not show same regularity, duration and intensity.
The length of different phases of business cycles is not definite and hence do not show smoothness and regularity.
Business cycles do not bring about changes in one industry or sector but occur simultaneously in all industries and sectors. Further, it passes from one industry to another.
Fluctuations take place not only in the level of output but also in other related variables like consumption, employment, investment, interest rates and price level.
Cyclical fluctuations affect adversely the consumption of durable goods like capital goods, scooters, cars, houses, refrigerators, etc. Their demand falls. As a result investments become unstable.
However, consumption of non-durable goods and services does not vary much during different phases of business cycle. .
Business cycles causes lot of uncertainty for businessmen and forecasting becomes difficult. Profits fluctuate.
Business cycles affect the inventories of goods. During depression inventories start accumulation more than the desired level. This results reduction in the production. When recovery starts, inventories are below the required level.
Business cycles are international in character.

Causes of Business Cycles

Business Cycles may occur due to internal and external causes or a combination of both.

Internal Causes (Endogenous Factors): Internal causes of business cycle are those, which are built within the economic system. They are—

1. Fluctuations in Effective Demand:
Fluctuations in economic activities is due to fluctuations in aggregate effective demand. When aggregate demand falls, it results in lower output, income and employment. This causes a downward spiral. Increase in aggregate demand causes conditions of expansion and boom.

2. Fluctuations in Investments:
Investments fluctuate because of changes in profit expectations of entrepreneurs. High investments brings increase in aggregate demand and thus result in upswing and vice versa.

3. Variations in government spending:
Fluctuations in government spending affects the economic activities and results in business fluctuations.

4. Money Supply:
According to Hawtrey and Friendman, business cycles relate to fluctuations in money and credit supply. Cheap money policy leads to expansion of money and credit supply resulting in increased economic activities and vice versa. .

5. Monetary and Fiscal Policies:
Monetary and Fiscal Policies also cause business cycles. Expansionary policies, like low interest rates, rates increased government spending and tax cuts boost economic activities. It there is inflation opposite will be done resulting in showing down of economy.

6. Psychological Factors:
According to Pigou, business cycles appear because of the optimistic and pessimistic mood of the business community. It business community is optimistic about future market conditions, they make investments. Here, the expansion phase starts ultimately leading to boom and vice versa.

7. Other Factors:
According to Schumpeter, business cycles occur due to innovations that take place from time to time in economic system. (Innovation Theory)
According to Nicholas Kaldor, the present fluctuations in prices are responsible for fluctuations in output and employment in future (Cobweb Theory)

External Causes (Exogenous Factors):

1. Wars:
During war time, all the available resources are used up for the production of arms and ammunitions. This results in the fall of production of capital and consumer goods. This in turn causes fall in income, profits and employment and contraction in economic activities take place which may lead to depression.

2. Post War Reconstruction:
After war, the level of consumption and investment goes upward. Both the government and individuals are involved in construction. E.g.- houses, roads, bridges, communication, etc. The economy picks up resulting in higher output, employment and income.

3. Technology:
Another cause of business is scientific development leading to improved technology. Adoption of new technology for production of new and better goods and services require huge investments. Increased investments increases employment income and profits this gives boost to the economy.

4. Natural Factors:
Weather cycles causes fluctuations in agricultural output. If in any year, weather is good the output of agriculture sector will increase. This will also increase the demand for industrial goods and vice versa.

5. Population Growth:
If the population growth rate is higher than the economic growth rate, income level will be low. This will result is lower savings and investments and therefore, lower income and employment.

Relevance of Business Cycles in Business Decision Making

Understanding the business cycle is important for all types of business enterprises because it affects the demand for their product and in turn their profits.
Knowledge of business cycles, its phases and characteristics help the business enterprises to frame appropriate policies. E.g.-New opportunities for investment, employment and production opens up at the time of prosperity. So understanding the economic environment is important white making business decisions.
Business managers have to advantageously respond in complex time during the whole business cycle through boom, downswing, recession and recovery to arrive at sound strategic environment.
We have seen that business cycles do not affect all the sector uniformly. Some business are more vulnerable white others are not or less vulnerable to changes in business cycle. Businesses like fashion retailers, electrical goods, restaurants, constructors, advertising, foreign tour operators, etc. are directly linked with economic growth. Such business are called cyclical businesses. So during recession such businesses slump and vice versa.
The phase of the business cycle is important to decide on entry into the market by a new firm or to decide about launch of a new product.

CA Foundation Business Economics Study Material – Concepts of Product

January 5, 2022April 25, 2019 by Prasanna

CA Foundation Business Economics Study Material Chapter 3 Theory of Production and Cost – Concepts of Product

Product i.e. output refers to the volume of goods produced by a firm in a particular period of time.
There are three concepts relating to the physical production by factors namely-

Total Product (TP),
Average Product (AP), and
Marginal Product (MP).

1. Total Product (TP):

The total output produced by all the factors per unit of time is called total product.
Total product increases with an increase in the variable factor input.
Column Nos. (1) and (2) of the following table shows a total product schedule.

2. Average Product (AP):

The. average product means the total product per unit of a variable factor.
In other words, it is the total product divided by the number of units of a variable factor.<
Column No. (3) of the following table shows the average product of variable factor.

3. Marginal Product (MP):

The marginal product means addition made to total product by the use of an extra unit of variable factor.
It may be stated as-
MP_n = TP_n – TP_n-1
where,
MP_n = Marginal product when ‘n ’ units of variable factors are used
TP = Total Product
n = number of units of variable factors used.
Marginal Product may also be defined as the change in total output due to use of additional unit of variable factor

Where –
Δ = a small change Column No. (4) of the following table shows the marginal product schedule.

Table: Product Schedule

Units of Variable	Total Product (TP) factor E.g. LABOUR	Average Product (AP)	Marginal Product (MP)
1	10	10	10
2	30	15	20
3	60	20	30
4	80	20	20
5	90	18	10
6	90	15	0
7	85	12.1	-5

Average product and Marginal product are related to one another.

(i) – When average product of the variable factor is rising, marginal product of the variable factor is more than its average product.
– So when average product curve is rising, the marginal product curve will lie somewhere above it.

(ii) – When average product of the variable factor is falling, marginal product of the variable factor is less than its average product.
– So when average product curve is falling, the marginal product curve will lie somewhere below it.

(iii) – When average product of the variable factor is maximum and constant, marginal product is equal to average product.
– In other words, the marginal product curve cuts the average product curve at its maximum point.

CA Foundation Business Economics Study Material – Fixed Inputs (Fixed Factors) and Variable Inputs (Variable Factors)

January 5, 2022April 25, 2019 by Prasanna

CA Foundation Business Economics Study Material Chapter 3 Theory of Production and Cost – Fixed Inputs and Variable Inputs

Fixed Inputs (Fixed Factors) and Variable Inputs (Variable Factors)

Comparison	Fixed Inputs	Variable Inputs
(i) Meaning	The factors which cannot be easily and quickly changed and require long time to make adjustment in them with the changes in the level of output are called fixed inputs or fixed factors of production. In other words, factor inputs whose quantity does not vary from day-to-day are called as fixed inputs.	The factors which can be easily and quickly changed and readily adjusted with the changes in the level of output are called variable inputs or variable factors of production. In other words, factor inputs whose quantity may vary from day-to-day are called as variable inputs.
(ii) Examples	Examples of fixed inputs – buildings, machinery, plant, top management, etc. It requires long time to make variations in them. E.g. To construct a new factory building with a larger area and capacity.	Examples of variable inputs – ordinary labour, raw-material, power, fuel chemicals, etc. It can be readily changed.
(iii) Relation with Output	Fixed inputs do not vary with the level of output. Its quantity remains the same, whether the output is more or less or zero in SHORT RUN	Variable inputs vary directly with the level of output. Such factors are required more, when output is more; less, when output is less and zero, when output is zero in SHORT RUN.
(iv) Cost	The cost of the fixed inputs is called FIXED COST. In the short run the firm has to bear the fixed cost even if the output is zero. Since the quantity of fixed inputs remains the same, fixed cost remains the same whatever be the level of output.	The cost of the variable inputs is called VARIABLE COST. Since variable inputs vary directly with the level of output, variable costs are also positively related with output. If output is zero, variable cost is also zero. If output is increased variable cost also increases and vice-versa.

Short Run (Short Period) & Long Run (Long Period)

Comparison	Short Run	Long Run
(i) Meaning	The short run is defined as the period of time in which some factors of production or at least one factor is fixed i.e. does not vary with output. Thus, in the short period some factors are FIXED FACTORS E.g. Factory building, machinery, management, etc. and some are VARIABLE FACTORS E.g. Labour, raw-material, power, fuel, etc.	The long run is defined as the period of time in which all factors may vary. In the long run, all factors become variable and so there is no distinction between fixed and variable factors.
(ii) Scale of Production OR Size of the Firm	In the short run, the output is produced with a GIVEN SCALE OF PRODUCTION i.e. the size of plant or firm (and so the production capacity) remains unchanged. Hence, production can be increased or decreased only by changing the amount of variable factors.	In the long run, the output is produced with the CHANGE IN THE SCALE OF PRODUCTION i.e. the size of plant or firm can be increased (and so the production capacity). Hence, production can be increased by varying all factors i.e. fixed factors (of short period) as well as variable factors.
(iii) Production Law	The production function which is studied in the short run period is called as the Law of Variable Proportions.	The production function which is studied in the long run period is called as the Law of Returns to Scale.
(iv) Decisions about Change in factors	The decisions to change the amount of variable factors (like raw material, labour, etc.) are taken very frequently depending upon changes in demand of the commodity. Hence, short run is the ‘ACTUAL PRODUCTION PERIOD’ during which some factors are fixed while some are variable. Thus, firms operate in the short run period.	The decisions to change the amount of fixed factors i.e. scale of production or to close down the firm are taken only once in a while. Hence, long run is the ‘PLANNING PERIOD’. Thus, firms plan in the long run period.
(v) Nature of Supply	In the short run period, supply can be adjusted upto a limited extent as per changes in demand. In other words, supply is relatively inelastic.	In the long run period, supply can be fully adjusted as per changes in demand. In other words, supply is relatively elastic.
(vi) Nature of Cost	In short run period, cost is classified as FIXED COST and VARIABLE COST. Fixed cost is the cost of fixed inputs and Variable cost is the cost of variable inputs. Fixed cost is the main feature of short run period	In long run period ALL COSTS ARE VARIABLE. Variable cost is the main feature of long run period.
(vii) Effect on Price	In short-run, the price determination of a commodity is more influenced by – (a) The demand forces than supply forces because supply in short-run is relatively inelastic, and (b) The UTILITY of the commodity. The short-run price is called SUB-NORMAL PRICE	In long-run, the price determination of a commodity is more influenced by- (a) The supply forces than demand forces because supply in long-run is relatively elastic, and (b) The COST OF PRODUCTION of the commodity. The long-run price is called NORMAL PRICE.
(viii) Average Cost Curve	The short-run average cost curve is ‘U’ shaped. Its U-shape is explained with the Law of Variable Proportions.	The long-run average cost curve is also U shaped. But its U- shape is not as prominent as short-run average cost curve. Its U-shape is explained with the Law of Returns to Scale. Long-run average cost curve is also called ‘PLANNING CURVE’ and ‘ENVELOPE CURVE’.
(ix) Profit of Firms	In the short-run period – The firms under perfect competition on being at equilibrium may earn normal profits, super normal profits or incur losses; The monopoly firm on being at equilibrium may earn normal profits, super normal profits or incur losses; The firms under monopolistic competition on being at equilibrium may earn normal profits, super normal profits or incur losses.	In the long run period- The firms under perfect competition earn only NORMAL PROFITS and operate at optimum level. The monopoly firm can earn SUPER NORMAL PROFITS and operate at sub-optimum level. The firms under monopolistic competition earn only NORMAL PROFITS and operate at sub-optimum level.