AGR 212 Agricultural Economics, Extension & Rural Sociology PDF

**AGR 212: Introduction to Agricultural Economics, Extension and Rural Sociology** **Learning Outcomes** At the end of the course students should be able to: 1\. explain basic economic theories, construct the supply and demand curves and use these to determine market equilibrium; 2\. discuss the...

**AGR 212: Introduction to Agricultural Economics, Extension and Rural Sociology** **Learning Outcomes** At the end of the course students should be able to: 1\. explain basic economic theories, construct the supply and demand curves and use these to determine market equilibrium; 2\. discuss the basic workings of the economy, national income determination from the output and income perspectives, and the condition for equilibrium of the national economy; 3\. define the concepts of international trade and balance of payment; 4\. discuss the process of money creation and banking in the national economy; 5\. explain the concept of welfare economics; 6\. define and make valid comparison on agricultural extension methodologies world over; 7\. categorize the major rural social institutions, processes, and the need for social changes in rural communities; and 8\. explain the dynamics of leadership for social changes. **Course Contents** - The nature of economics and economic problems. - Scope of agricultural economics and methods. - The concept of opportunity cost; supply and demand and their application to agricultural problems. - Production functions, cost analysis and functions. - Concept of elasticities. - Type of markets, perfect competition, monopoly, oligopoly etc. - Price theory and some applications. - The components of agriculture in national income. - Aggregate income, expenditure, investment, interest rate, savings, employment. - Inflation; international trade, commodity agreements, and balance of payments. - Money and banking. The need for agricultural extension in Nigeria and in the world, basic philosophies behind agricultural extension work. The institutional setting of agricultural extension. Basic concepts and principles of rural sociology. Importance of rural communities and institutions, social stratification, social processes, and social changes in rural areas. Emergence and functions of leadership in rural communities. The extension agent and the rural community. Communication techniques and strategies of change. Agricultural extension teaching methods, aids, and their use. **DEFINITION AND NATURE & SCOPE OF ECONOMICS --** Economics is the science that deals with production, exchange and consumption of various commodities in economic systems. It shows how scarce resources can be used to increase wealth and human welfare. The central focus of economics is on scarcity of resources and choices among their alternative uses. The resources or inputs available to produce goods are limited or scarce. This scarcity induces people to make choices among alternatives, and the knowledge of economics is used to compare the alternatives for choosing the best among them. For example, a farmer can grow paddy, sugarcane, banana, cotton etc. in his garden land. But he has to choose a crop depending upon the availability of irrigation water. Two major factors are responsible for the emergence of economic problems. They are: i) the existence of unlimited human wants and ii) the scarcity of available resources. The numerous human wants are to be satisfied through the scarce resources available in nature. Economics deals with how the numerous human wants are to be satisfied with limited resources. Thus, the science of economics centres on want - effort - satisfaction. Economics not only covers the decision making behaviour of individuals but also the macro variables of economies like national income, public finance, international trade and so on. **A. DEFINITIONS OF ECONOMICS** Several economists have defined economics taking different aspects into account. The word 'Economics' was derived from two Greek words, oikos (a house) and nemein (to manage) which would mean 'managing an household' using the limited funds available, in the most satisfactory manner possible. **i) Wealth Definition** Adam smith (1723 - 1790), in his book "An Inquiry into Nature and Causes of Wealth of Nations" (1776) defined economics as the science of wealth. He explained how a nation's wealth is created. He considered that the individual in the society wants to promote only his own gain and in this, he is led by an "invisible hand" to promote the interests of the society though he has no real intention to promote the society's interests. Criticism: Smith defined economics only in terms of wealth and not in terms of human welfare. Ruskin and Carlyle condemned economics as a 'dismal science', as it taught selfishness which was against ethics. However, now, wealth is considered only to be a mean to end, the end being the human welfare. Hence, wealth definition was rejected and the emphasis was shifted from 'wealth' to 'welfare'. **ii) Welfare Definition** Alfred Marshall (1842 - 1924) wrote a book "Principles of Economics" (1890) in which he defined "Political Economy" or Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of well being". The important features of Marshall's definition are as follows: a\) According to Marshall, economics is a study of mankind in the ordinary business of life, i.e., economic aspect of human life. b\) Economics studies both individual and social actions aimed at promoting economic welfare of people. c\) Marshall makes a distinction between two types of things, viz. material things and immaterial things. Material things are those that can be seen, felt and touched, (E.g.) book, rice etc. Immaterial things are those that cannot be seen, felt and touched. (E.g.) skill in the operation of a thrasher, a tractor etc., cultivation of hybrid cotton variety and so on. In his definition, Marshall considered only the material things that are capable of promoting welfare of people. **Criticism:** a\) Marshall considered only material things. But immaterial things, such as the services of a doctor, a teacher and so on, also promote welfare of the people. b\) Marshall makes a distinction between (i) those things that are capable of promoting welfare of people and (ii) those things that are not capable of promoting welfare of people. But anything, (E.g.) liquor, that is not capable of promoting welfare but commands a price, comes under the purview of economics. c\) Marshall's definition is based on the concept of welfare. But there is no clear-cut definition of welfare. The meaning of welfare varies from person to person, country to country and one period to another. However, generally, welfare means happiness or comfortable living conditions of an individual or group of people. The welfare of an individual or nation is dependent not only on the stock of wealth possessed but also on political, social and cultural activities of the nation. **iii) Welfare Definition** Lionel Robbins published a book "An Essay on the Nature and Significance of Economic Science" in 1932. According to him, "economics is a science which studies human behaviour as a relationship between ends and scarce means which have alternative uses". The major features of Robbins' definition are as follows: a\) Ends refer to human wants. Human beings have unlimited number of wants. b\) Resources or means, on the other hand, are limited or scarce in supply. There is scarcity of a commodity, if its demand is greater than its supply. In other words, the scarcity of a commodity is to be considered only in relation to its demand. c\) The scarce means are capable of having alternative uses. Hence, anyone will choose the resource that will satisfy his particular want. Thus, economics, according to Robbins, is a science of choice. **Criticism:** a\) Robbins does not make any distinction between goods conducive to human welfare and goods that are not conducive to human welfare. In the production of rice and alcoholic drink, scarce resources are used. But the production of rice promotes human welfare while production of alcoholic drinks is not conducive to human welfare. However, Robbins concludes that economics is neutral between ends. b\) In economics, we not only study the micro economic aspects like how resources are allocated and how price is determined, but we also study the macro economic aspect like how national income is generated. But, Robbins has reduced economics merely to theory of resource allocation. c\) Robbins definition does not cover the theory of economic growth and development. **iv) Growth Definition** Prof. Paul Samuelson defined economics as "the study of how men and society choose, with or without the use of money, to employ scarce productive resources which could have alternative uses, to produce various commodities over time, and distribute them for consumption, now and in the future among various people and groups of society". The major implications of this definition are as follows: a\) Samuelson has made his definition dynamic by including the element of time in it. Therefore, it covers the theory of economic growth. b\) Samuelson stressed the problem of scarcity of means in relation to unlimited ends. Not only the means are scarce, but they could also be put to alternative uses. c\) The definition covers various aspects like production, distribution and consumption. Of all the definitions discussed above, the 'growth' definition stated by Samuelson appears to be the most satisfactory. However, in modern economics, the subject matter of economics is divided into main parts, viz., i\) Micro Economics and ii\) Macro Economics. Economics is, therefore, rightly considered as the study of allocation of scarce resources (in relation to unlimited ends) and of determinants of income, output, employment and economic growth. **B. SCOPE OF ECONOMICS** Scope means province or field of study. In discussing the scope of economics, we have to indicate whether it is a science or an art and a positive science or a normative science. It also covers the subject matter of economics. **i) Economics - A Science and an Art** a\) Economics is a science: Science is a systematized body of knowledge that traces the relationship between cause and effect. Another attribute of science is that its phenomena should be amenable to measurement. Applying these characteristics, we find that economics is a branch of knowledge where the various facts relevant to it have been systematically collected, classified and analyzed. Economics investigates the possibility of deducing generalizations as regards the economic motives of human beings. The motives of individuals and business firms can be very easily measured in terms of money. Thus, economics is a science. Economics - A Social Science: In order to understand the social aspect of economics, we should bear in mind that labourers are working on materials drawn from all over the world and producing commodities to be sold all over the world in order to exchange goods from all parts of the world to satisfy their wants. There is, thus, a close inter-dependence of millions of people living in distant lands unknown to one another. In this way, the process of satisfying wants is not only an individual process, but also a social process. In economics, one has, thus, to study social behaviour i.e., behaviour of men in-groups. b\) Economics is also an art. An art is a system of rules for the attainment of a given end. A science teaches us to know; an art teaches us to do. Applying this definition, we find that economics offers us practical guidance in the solution of economic problems. Science and art are complementary to each other and economics is both a science and an art. **ii) Positive and Normative Economics** Economics is both positive and normative science. a\) Positive science: It only describes what it is and normative science prescribes what it ought to be. Positive science does not indicate what is good or what is bad to the society. It will simply provide results of economic analysis of a problem. b\) Normative science: It makes distinction between good and bad. It prescribes what should be done to promote human welfare. A positive statement is based on facts. A normative statement involves ethical values. For example, "12 per cent of the labour force in India was unemployed last year" is a positive statement, which could is verified by scientific measurement. "Twelve per cent unemployment is too high" is normative statement comparing the fact of 12 per cent unemployment with a standard of what is unreasonable. It also suggests how it can be rectified. Therefore, economics is a positive as well as normative science. **iii) Methodology of Economics** Economics as a science adopts two methods for the discovery of its laws and principles, viz., (a) deductive method and (b) inductive method. **a) Deductive method:** Here, we descend from the general to particular, i.e., we start from certain principles that are self-evident or based on strict observations. Then, we carry them down as a process of pure reasoning to the consequences that they implicitly contain. For instance, traders earn profit in their businesses is a general statement which is accepted even without verifying it with the traders. The deductive method is useful in analyzing complex economic phenomenon where cause and effect are inextricably mixed up. However, the deductive method is useful only if certain assumptions are valid. (Traders earn profit, if the demand for the commodity is more). **b) Inductive method:** This method mounts up from particular to general, i.e., we begin with the observation of particular facts and then proceed with the help of reasoning founded on experience so as to formulate laws and theorems on the basis of observed facts. E.g. Data on consumption of poor, middle and rich income groups of people are collected, classified, analyzed and important conclusions are drawn out from the results. In deductive method, we start from certain principles that are either indisputable or based on strict observations and draw inferences about individual cases. In inductive method, a particular case is examined to establish a general or universal fact. Both deductive and inductive methods are useful in economic analysis. **iv) Subject Matter of Economics** Economics can be studied through a) traditional approach and (b) modern approach. **a) Traditional Approach:** Economics is studied under five major divisions namely consumption, production, exchange, distribution and public finance. 1.**Consumption**: The satisfaction of human wants through the use of goods and services is called consumption. 2.**Production**: Goods that satisfy human wants are viewed as "bundles of utility". Hence production would mean creation of utility or producing (or creating) things for satisfying human wants. For production, the resources like land, labour, capital and organization are needed. 3\. **Exchange**: Goods are produced not only for self-consumption, but also for sales. They are sold to buyers in markets. The process of buying and selling constitutes exchange. 4\. **Distribution**: The production of any agricultural commodity requires four factors, viz., land, labour, capital and organization. These four factors of production are to be rewarded for their services rendered in the process of production. The land owner gets rent, the labourer earns wage, the capitalist is given with interest and the entrepreneur is rewarded with profit. The process of determining rent, wage, interest and profit is called distribution. 5\. **Public finance**: It studies how the government gets money and how it spends it. Thus, in public finance, we study about public revenue and public expenditure. **b) Modern Approach** The study of economics is divided into: i) Microeconomics and ii) Macroeconomics. 1\. **Microeconomics** analyses the economic behaviour of any particular decision making unit such as a household or a firm. Microeconomics studies the flow of economic resources or factors of production from the households or resource owners to business firms and flow of goods and services from business firms to households. It studies the behaviour of individual decision making unit with regard to fixation of price and output and its reactions to the changes in demand and supply conditions. Hence, microeconomics is also called price theory. 2\. **Macroeconomics** studies the behaviour of the economic system as a whole or all the decision-making units put together. Macroeconomics deals with the behaviour of aggregates like total employment, gross national product (GNP), national income, general price level, etc. So, macroeconomics is also known as income theory. Microeconomics cannot give an idea of the functioning of the economy as a whole. Similarly, macroeconomics ignores the individual's preference and welfare. What is true of a part or individual may not be true of the whole and what is true of the whole may not apply to the parts or individual decision making units. By studying about a single small-farmer, generalization cannot be made about all small farmers, say in Tamil Nadu state. Similarly, the general nature of all small farmers in the state need not be true in case of a particular small farmer. Hence, the study of both micro and macroeconomics is essential to understand the whole system of economic activities. **Scope of agricultural economics and methods** **Nature and Scope of Agricultural Economics** Agricultural Economics, as its title implies is the branch of economics which deals with all aspects of problems related to agriculture. According to Snodgrass and Wallace, "Agricultural economics is an applied phase of the social science of economics in which attention is given to all aspects of problems related to agriculture." Prof. Gray treats agricultural economics as a branch of the general subject of economics. It is only one of the many branches of applied economics such as Industrial Economics, Labour Economics, Monetary Economics, Transport Economics, Public Economics, International Economics, Household Economics, etc. Thus according to Prof. Gray, agricultural economics is only a phase of an immense field called economics in which primary attention is paid to the analysis of the economic problems associated with agriculture, Prof. Gray defines agricultural economics, "as the science in which the principles and methods of economics are applied to the special conditions of agricultural industry." Agricultural economics treats the selection of land, labour, and equipment for a farm, the choice of crops to be grown, the selection of livestock enterprises to be carried on and the whole question of the proportions in which all these agencies should be combined. These questions are treated primarily from the point of view of costs and prices. As we know, economic activities are divided into production, exchange, distribution and consumption, agricultural economics covers all of them what to produce, how to produce, how much to produce, what to sell, where to sell and at what price to sell; what to distribute, among whom to distribute and on what basis to distribute; and what to consume and how much to consume. Specifically, we can say agricultural economics includes the choice of farming as an occupation, the choice between cultivator and animal husbandry, machinery and labour; combination of various factors of production, intensity of cultivation, irrigation, manure, marketing, soil conservation, land revenues system, costs, prices, wages, profits, finance, credit, employment, etc. In all these cases the fundamental problem before the agricultural economist is to recommend the combination of factors of production in ideal proportion under given conditions in the economic interests of the agricultural community. Agricultural economics is concerned with the allocation of resources in the agricultural industry, with the alternatives in production, marketing or public policy. Agricultural economists are concerned with the study of efficiency in farm production, with the returns that will result from employing various quantities and combinations of inputs in farming, and with determining the best farm production alternatives under given physical and economic conditions. They are concerned with the economics of agricultural markets, with the costs of marketing various farm products, and with the alternative steps or changes that may be made in the marketing structure to serve the objectives of society more efficiently. They are interested in analysis of the alternatives in public policy and the economic effects of carrying out a particular programme, such as price support law or a soil conservation programme. Agricultural economists make use of the tools of economic analysis in studying these situations. **Scope of Agricultural Economics** The above definitions indicate the scope of agricultural economics. A common theme of scarcity of resources and multitude of uses runs through almost all of these definitions. This way agricultural economics is not that different from general economics. All the tools of analysis used in general economics are employed in agricultural economics as well. We have the same branches of agricultural economics i.e. economics of production, consumption, distribution, marketing, financing and planning and policy making as in the case of general economics. A study at the micro and macro level for the agricultural sector is also generally made. Static and dynamic analyses are also relevant for the agricultural sector of the economy. To be more specific, these definitions point out that agricultural economics examines how a farmer chooses between various enterprises e.g., production of crops or raising of cattle and how he chooses various activities in the same enterprise e.g., which crop to grow and which crop to drop; how the costs are to be minimized; what combination of inputs for an activity are to be selected; what amount of each crop is to be produced; what type of commercial relation the farmer have to have with people from whom they purchase their input or to whom they sell their product. Agricultural economics does not only study the behaviour of a farmer at the farm level. This is, in a way, the micro analysis. Agricultural problems have a macro aspect as well. Instability of agriculture and agricultural unemployment are the problems which have to be dealt with, mainly at the macro level. There are the general problems of agricultural growth and the problems like those concerning tenure systems and tenure arrangements, research and extension services which are predominantly macro in character. Such problems their origin, their impact and their solutions are the subject matter of agricultural economics. The scope of agricultural economics is larger than 'mere economizing of resources'. Agriculture is, as we know an important sector, of the overall economy. The mutual dependence of the various sectors of the economy on each other is well established. Growth of one sector is necessary for the growth of the other sectors. As such, in agricultural economics, we study how development of agriculture helps the development of the other sectors of the economy; how can labour and capital flow into the non-agricultural sectors; how agricultural development initiates and sustains the development of other sectors of the economy. This implies that agricultural economics is not only concerned with the use of scarce resources in agriculture proper but also examines the principles regarding the out flow of scare resources to other sectors of the economy and about the flow of these resources from other sectors into the agricultural sector itself. **Nature of Agricultural Economics** Agricultural economics makes use of the principles of general economics. The first point to be noted with regard to the nature of agricultural economics is that, in general, it borrows most of its principles from its parent body of knowledge i.e., the general economics. Even the main branches of agricultural economics are similar to those of general economics. But then a question arises, if the principles of general economics are not different from the principles of agricultural economics, why is there a need for separate study of agricultural economics? The answer lies in the fact that agricultural economics does not merely imply a direct application of principles of economics to the field of agriculture. The principles of economics are too general in nature and the general theory of economics has been considered as an abstraction from reality. Before this theory is applied to agriculture which includes, besides crop production, forestry and animal husbandry, for the purpose of economic analysis its principles have to be modified so that their postulates totally tally with the main features of the agricultural sector. A few examples will make it clear. We study in economic theory, price formation under various market structures e.g., monopoly, perfect competition and oligopoly. So far as agriculture is concerned, it is presumed that as the number of farms is very large and at the same time, their size is relatively small and the crops produced are undifferentiated (homogeneous), perfect competition is likely to prevail in the agricultural produce market. In other words, we shall almost be completely ignoring the study of price formation of agricultural produce under condition of oligopoly or monopolistic competition or monopoly. There is the system of tenancy or crop sharing in agriculture -- a problem particular to agriculture only. Study of this problem will necessitate modification of the principle of resource allocation as propounded in general economics. The modification of the economic principles, required to be made before being applied to agriculture are so large and varied that there is a complete justification for studying agricultural economics as a separate body of knowledge. **Demand and Supply in Agriculture** The **demand** for agricultural products is influenced by many factors, including consumer tastes and preferences. Consumers create and follow eating trends that are influenced by both scientific research and social influences. For example, discovering the health benefits of lean meats increases the demand for chicken and lean cuts of pork and beef, and decreases the demand for meat products high in saturated fats. Other dietary trends such as gluten-free and low-carb diets increase the consumption (demand) of related commodities and potentially decrease the demand for others.  Social influences also play a role in creating demand for agricultural goods. For example, some consumers prefer buying food labeled and produced in a specific way, such as free-range eggs, grass-fed beef, organic milk, etc. The number of buyers in a market impacts demand too.** **The more buyers in a market, the greater potential for demand. Consumer income also plays a role in potential demand.** **With some products, an increase in consumers\' income leads to greater consumption. Similarly, a decrease in consumers\' income can lead to a decrease in the consumption of non-essential foods. Availability of related goods also impacts demand.** **Many agricultural products have similar substitutes. For example rather than drinking cow milk, a consumer may drink soy, almond, or rice milk based upon the cost, availability, and preference of one milk over the other. **Supply** is determined by the available amount of a commodity at a particular time. An increase in production costs may decrease supply. For example, if feed costs go up, farmers may sell their livestock earlier or decrease the size of their herd to reduce their expenses. Doing so will decrease the overall supply. Technology on the farm can increase agricultural supply if it improves overall production efficiency. For example, improving varieties of wheat through artificial selection and plant breeding can allow a farmer to harvest more wheat on the same amount of land, thus increasing the supply. Other factors impacting supply include taxes, subsidies, the cost of related commodities, and the number of sellers in a specific market. An increase in the demand for a product without an increase in the supply will lead to a higher market price. An increase in the supply of a product without an increase in demand will lead to a lower price for the product. **What is opportunity cost?** Opportunity cost is the estimated return of investments you *don\'t* make compared to the expected return of investments you *do* make. It\'s an important factor to consider when allocating time or resources to any type of project (essentially, \"would my time or money be better spent elsewhere?\").  **Why is opportunity cost important?** Opportunity cost is one of the first terms that is introduced to students of economics, but it\'s not always well-known outside of those circles. For ecommerce merchants, who come from a variety of backgrounds and have different sets of skills and experiences, the concept may be totally unknown. There\'s good news, though. The principles behind opportunity cost are being applied in some fashion by many store owners, even if they\'ve never heard of the term itself. In the long view, understanding opportunity cost is an important part of making smart business decisions. Here\'s a look at the technical and practical definitions of the term, as well as how it applies specifically to ecommerce and the people who run online stores. **The technical definition** One textbook definition of opportunity cost is provided by the Merriam-Webster dictionary, which says the term refers to \"the added cost of using resources (as for production or speculative investment) that is the difference between the actual value resulting from such use and that of an alternative (as another use of the same resources or an investment of equal risk but greater return)\" (1). In abstract, technical terms, this is a strong definition - but it means little to those who aren\'t students of economics or consistently involved in a related field. A more approachable definition is to call opportunity cost the difference between a chosen action, such as a purchase or investment, and the other seemingly viable opportunities that are also available. The cost in this case is the lost potential for a positive outcome, which is discarded or lost because the decision-maker has chosen a different purchase, strategy or other economic decision because there are only limited economic resources available. **Examples** A concrete example of opportunity cost can make the idea easier to understand. Consider the owner of a building who decides that her vacant first-floor space will become a restaurant. The opportunity cost of making such a decision is that the space can no longer be used for a different purpose, such as a retail store or an office space that\'s rented to another party. Another example uses a farmer to display the same concept. Once a farmer chooses a crop - for example\'s sake, cucumbers - the limited resource of available land can no longer be used to grow another crop, such as potatoes or carrots (2). The opportunity cost of growing cucumbers on a finite piece of farming land is that other crops can\'t be grown at the same time. Opportunity cost is tied to the concept of risk, and can be viewed through that lens. Opportunity cost is, in many ways, another way of describing the relative risks of choosing one option over another. The risk of one option providing a better or worse return than another is at the heart of the concept. One important part of the overall concept to note is that opportunity cost may end up being positive or negative. In the example above, the farmer may have made the right decision, making more money by selling and otherwise using his cucumber crop than he would have with the potatoes or carrots. The converse is also true. Various market factors during the course of the growing season could make potatoes especially valuable and bring cucumbers below their normal price. The other crucial component of opportunity cost is that it doesn\'t only apply to financial concerns. While money is often the thing in mind when the various options are considered, other resources such as time and labor can be involved as well. For example, the financial cost of the farmer planting two different crops may be the same, but one could involve significantly more labor in terms of planting or harvesting. The opportunity cost of the more labor-intensive crop is more time spent working in the field, as opposed to the other option. **The practical applications** Opportunity cost is a useful and proven method for considering different business decisions before they happen. While no one has perfect knowledge of what will happen in the future, weighing the expected results of a variety of options and considering both the positives and negatives is a responsible approach to decision-making. Because every commercial entity and enterprise, from first-time owners of ecommerce stores to the world\'s largest businesses, has a limited amount of resources, the concept of opportunity cost is an important one Production and costs are fundamental concepts in economics that are closely related to each other. Production refers to the process of transforming inputs (such as labor, capital, and raw materials) into outputs (goods or services) that satisfy human wants and needs. Costs, on the other hand, represent the [expenses](https://testbook.com/key-differences/difference-between-accrued-expenses-and-accounts-payable) incurred by firms in the production process, including both explicit costs (such as wages, rent, and materials) and implicit costs (such as the opportunity cost of using owner-supplied resources). Understanding production and costs is essential for firms in making [production decisions](https://testbook.com/ugc-net-commerce/product-decisions), [pricing strategies](https://testbook.com/ugc-net-commerce/pricing-strategies), and [profit maximization](https://testbook.com/ugc-net-commerce/profit-maximisation). Additionally, analyzing production and costs provides insights into economic efficiency, resource allocation, and market competitiveness. Production and costs are very important topic to be studied for the commerce related exams such as the [UGC-NET Commerce Examination](https://testbook.com/ugc-net/commerce-syllabus). **Decoding the Concepts of Production and Costs** ------------------------------------------------- After having a detailed understanding of [consumer behaviour](https://testbook.com/ugc-net-commerce/consumer-behaviour), it\'s time to shift our focus towards the behaviour of a producer or a manufacturer. The process of transforming inputs into outputs is known as production, and it\'s performed by firms or manufacturers. A firm procures various inputs such as labour, machinery, raw materials, land, and so on.. These inputs are then utilized to produce output, which can be consumed by customers or used by other firms for further production. For example, a bakery uses flour, yeast, water, a baking oven and the labour of its employees to produce bread. An apple orchard owner uses labour, land, apple seeds, water, fertilizers, and machinery to produce apples. A smartphone manufacturer uses various inputs like silicon, labour, factory land, and other materials to produce smartphones. To simplify, we make certain assumptions. Production is instantaneous in our model, meaning there is no time gap between the combination of the inputs and the production of the output. We often use the terms supply and production interchangeably. To procure these inputs, a firm must pay, which is known as the cost of production. Once the output is produced, it\'s sold in the market, generating revenue for the firm. The difference between the cost and the revenue is the firm\'s profit. We assume that a firm\'s goal is to maximize its profit. In this chapter, we will explore the relationship between inputs and outputs. **Theory of Production and Costs** ---------------------------------- The theory of production and cost is a fundamental concept in economics that examines how firms produce goods and services, the factors influencing production decisions, and the costs incurred in the production process. Here\'s a breakdown of the theory: ### **Theory of Production** The theory of production focuses on the relationship between inputs (such as labor, capital, and raw materials) and outputs (goods or services) produced by a firm. Key concepts include: - Production Function: The mathematical relationship between inputs and outputs, which describes how inputs are combined to produce output. Common production functions include the Cobb-Douglas function, the CES (constant elasticity of substitution) function, and the Leontief function. - Marginal Product of Labor and Capital: The additional output produced by one additional unit of labor or capital, holding other inputs constant. Marginal product eventually diminishes due to the law of diminishing marginal returns. - Isoquants: Curves representing various combinations of inputs that yield the same level of output. Isoquants help firms determine the most efficient input combinations for a given level of output. ### **Theory of Costs** The theory of costs examines the expenses incurred by firms in the production process. Key concepts include: - Total Cost: The sum of all costs incurred by a firm, including both explicit costs (e.g., wages, rent, materials) and implicit costs (e.g., opportunity cost of owner-supplied resources). - Fixed Costs and Variable Costs: Fixed costs remain constant regardless of the level of output, while variable costs change with the level of output. Total costs equal the sum of fixed and variable costs. - Marginal Cost: The additional cost incurred by producing one additional unit of output. Marginal cost intersects both average total cost and average variable cost at their respective minimum points. - Economies of Scale and Diseconomies of Scale: Economies of scale occur when increasing production scale leads to lower average costs per unit of output, while diseconomies of scale occur when further increases in production scale lead to higher average costs per unit of output. ### **Optimization of Production and Costs** - Firms aim to optimize production and costs to maximize profits. This involves minimizing costs for a given level of output or maximizing output for a given level of costs. Optimization strategies include choosing the optimal input combination, determining the optimal level of output, and identifying cost-minimizing production techniques. **Relationship between Cost and Production Function** ----------------------------------------------------- The relationship between cost and the production function is fundamental in economics and revolves around how inputs are combined to produce outputs and the costs incurred in the production process. Here\'s a closer look at this relationship: - **Inputs and Outputs:** - The production function describes how inputs, such as labor and capital, are transformed into outputs, such as goods or services. It illustrates the technological relationship between inputs and outputs and shows the maximum quantity of output that can be produced with given inputs. - The production function can be represented mathematically, often as a function of labor (L) and capital (K), such as Q = f(L, K), where Q represents output and L and K represent the quantities of labor and capital inputs, respectively. - **Costs and Inputs:** - Costs in the production process are incurred due to the use of inputs. These costs include both explicit costs (e.g., wages, rent, raw materials) and implicit costs (e.g., opportunity cost of owner-supplied resources). - The costs incurred by a firm depend on the quantities of inputs used in the production process. For example, if a firm hires more labor or uses more capital, its costs will increase. - **Marginal Analysis:** - Marginal analysis examines the additional cost of producing one more unit of output or the additional output generated by using one more unit of input. - Marginal cost (MC) is the additional cost incurred by producing one more unit of output. It is related to the slope of the total cost curve and is influenced by changes in input prices and productivity. - Marginal product (MP) is the additional output produced by using one more unit of input. It is related to the slope of the production function and reflects the productivity of inputs. - **Optimization:** - Firms seek to optimize their production and costs to maximize profits. This involves minimizing costs for a given level of output or maximizing output for a given level of costs. - The optimal input combination is determined by comparing the marginal product of each input to its price (in the case of explicit costs) or its opportunity cost (in the case of implicit costs). **Concept of Elasticities** **What is Elasticity?** ----------------------- Elasticity is an economic concept that describes the responsiveness of one variable to changes in another variable. In business and economics, elasticity is usually used to describe how much demand for a product changes as its price increases or decreases. This is referred to as price elasticity of demand. Price elasticity of demand refers to the degree to which individuals, consumers, or producers change their demand---or the amount supplied---in response to price or income changes. Price elasticity of demand is expressed as a percentage; it is the percentage change in the quantity demanded of a good or service divided by the percentage change in the price. ### **Key Takeaways** - Elasticity is an economic concept that describes the responsiveness of one variable to changes in another variable. - In business and economics, elasticity is usually used to describe how much demand for a product changes as its price increases or decreases, called the price elasticity of demand. - If demand for a good or service is relatively static (does not change) even when the price changes, demand is said to be inelastic; food and prescription drugs are examples of inelastic goods. - When a product is elastic, a change in price quickly results in a change in the quantity demanded; examples of elastic goods include clothing and electronics. - Cross elasticity measures the change in demand for one good given price changes in a different, related good. **How Elasticity Works** ------------------------ When a product is elastic, a change in price quickly results in a change in the [quantity demanded](https://www.investopedia.com/terms/q/quantitydemanded.asp): There is an increase in demand when the price decreases and a decrease in demand when the price increases. Spa days, for example, are highly elastic because they aren\'t a necessary good; an increase in the price of trips to the spa will lead to a greater decline in the demand for such services. Conversely, a decrease in the price will lead to a greater than proportional increase in demand for spa treatments. When a good is inelastic, there is little change in the quantity of demand even when the price of the good changes. For example, insulin is a highly inelastic product. For people with diabetes who need insulin, the demand is so great that price increases have very little effect on the quantity demanded. Price decreases also do not affect the quantity demanded; most of those who need insulin aren\'t holding out for a lower price. If the market price of an elastic good decreases, firms are likely to reduce the number of goods or services they are willing to supply. If the market price goes up, firms are likely to increase the number of goods they are willing to sell. **Types of Elasticity** ----------------------- ### **Elasticity of Demand** The quantity demanded of a good or service depends on multiple factors, such as price, income, and preference. Whenever there is a change in these variables, it causes a change in the quantity demanded of the good or service. [Price elasticity of demand](https://www.investopedia.com/ask/answers/012615/what-types-consumer-goods-demonstrate-price-elasticity-demand.asp) is an economic measure of the sensitivity of demand relative to a change in price. It is a measure of the change in the quantity demanded due to the change in the price of a good or service. ### **Income Elasticity** [Income elasticity](https://www.investopedia.com/terms/i/incomeelasticityofdemand.asp) of demand refers to the sensitivity of the quantity demanded to changes in the [real income](https://www.investopedia.com/terms/r/realincome.asp) of consumers, keeping all other things constant. The formula for calculating income elasticity of demand is the percent change in quantity demanded divided by the percent change in income. ### **Cross Elasticity** The [cross elasticity](https://www.investopedia.com/terms/c/cross-elasticity-demand.asp) of demand is an economic concept that measures the responsiveness in the quantity demanded of one good when the price for another good changes. Also called cross-price elasticity of demand, this measurement is calculated by taking the percentage change in the quantity demanded of one good and dividing it by the percentage change in the price of the other good. ### **Price Elasticity of Supply** [Price elasticity of supply](https://www.investopedia.com/ask/answers/040615/how-does-price-elasticity-affect-supply.asp) measures the responsiveness to the supply of a good or service after a change in its market price. According to basic economic theory, the supply of a good will increase when its price rises. Conversely, the supply of a good will decrease when its price decreases. **Factors Affecting Demand Elasticity** --------------------------------------- There are three main factors that influence price elasticity of demand. ### **Availability of Substitutes** In general, the more good [substitutes](https://www.investopedia.com/terms/s/substitute.asp) there are, the more [elastic the demand](https://www.investopedia.com/terms/p/priceelasticity.asp) for a good will be. For example, if the price of a cup of coffee went up by \$0.25, consumers might replace their morning caffeinated beverage with a cup of caffeinated tea. This means that coffee is an elastic good because a small increase in price will cause a large decrease in demand as consumers start buying more tea than coffee. However, if the price of caffeine itself were to go up, we would probably see little change in the consumption of coffee or tea because there may be few good substitutes for caffeine. Most people, in this case, might not willingly give up their morning cup of caffeine, no matter the price. Therefore, it can be assumed that caffeine is an inelastic product. While a specific product within an industry can be elastic due to the availability of substitutes, an entire industry itself tends to be inelastic. ### **Necessity** If a good or service is needed for survival or comfort, people will continue to pay higher prices for it. For example, people need to use transportation, usually cars, to get to work. Therefore, even if the price of gas doubles (or triples), people will still need to fill up their tanks. ### **Time** The third influential factor is time. For instance, if the price of cigarettes goes up to \$8 per pack, consumers with very few available substitutes will most likely continue buying their daily cigarettes. This means that [tobacco](https://www.investopedia.com/terms/t/tobacco-tax.asp) is an inelastic good; the price change will not have a significant influence on the quantity demanded (in part, due to the addictive nature of nicotine). However, if a person who smokes cigarettes finds that they cannot afford to spend the extra \$8 per day and begins to reduce their tobacco consumption over a period of time, the price of cigarettes for that consumer becomes elastic in the long run. The Importance of Price Elasticity in Business ---------------------------------------------- Understanding whether or not the goods or services of a business are elastic is integral to the success of the company. Companies with high elasticity ultimately compete with other businesses on price and are required to have a high volume of sales transactions to remain [solvent](https://www.investopedia.com/terms/s/solvency.asp). Firms that are inelastic, on the other hand, have goods and services that are necessary for consumers and enjoy the luxury of setting higher prices. Beyond prices, the elasticity of a good or service directly affects the customer retention rates of a company. Businesses often strive to sell goods or services that have [inelastic demand](https://www.investopedia.com/ask/answers/012915/what-effect-price-inelasticity-demand.asp); doing so means that customers will remain loyal and continue to purchase the good or service even in the face of a price increase. **Examples of Elasticity** -------------------------- There are a number of real-world examples of elasticity that consumers interact with on a daily basis. One interesting, modern-day example of the price elasticity of demand is the surge pricing of the ride-sharing service, Uber. Uber uses a \"surge-pricing\" algorithm when there is an above-average number of users requesting rides in the same geographic area. The company applies a price multiplier, which allows Uber to raise prices in real time, according to demand. The COVID-19 pandemic also impacted the price elasticity of demand for some industries. Outbreaks of COVID-19 cases in meat processing facilities across the U.S., in addition to the slowdown in international trade, led to a domestic meat shortage. This caused import prices to rise 16% in May 2020, the largest increase on record since 1993. The oil industry was also impacted by the COVID-19 pandemic. Although oil is generally very inelastic, because of a historic drop in global demand for oil during March and April, along with increased supply and a shortage of storage space, on April 20, 2020, crude petroleum traded at a negative price in the futures market. In response to this dramatic drop in demand, OPEC+ members elected to cut production by 9.7 million barrels per day through the end of June, the largest production cut in history.2 **What Is Meant by Elasticity in Economics?** --------------------------------------------- Elasticity refers to the measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants. Goods that are elastic see their demand respond rapidly to changes in factors like price or supply. Inelastic goods, on the other hand, retain their demand even when prices rise sharply (e.g., gasoline or food). **Are Luxury Goods Elastic?** ----------------------------- Luxury goods often have a high price elasticity of demand because they are sensitive to price changes. If prices rise, people quickly stop buying them and wait for prices to drop. **What Are the 4 Types of Elasticity?** --------------------------------------- The four types of elasticity are demand elasticity, income elasticity, cross elasticity, and price elasticity. **What Is Price Elasticity?** ----------------------------- Price elasticity measures how much the [supply or demand of a product changes](https://www.investopedia.com/ask/answers/042315/how-does-price-elasticity-change-relation-supply-and-demand.asp) based on a given change in price. **What Is the Elasticity of Demand Formula?** --------------------------------------------- The elasticity of demand can be calculated by dividing the percentage change in the quantity demanded of a good or service by the percentage change in its price. **The Bottom Line** ------------------- Elasticity is an economic concept that measures how responsive one economic variable is to changes in another. It\'s often used to describe how demand for a product changes in relation to price changes, which is known as price elasticity of demand. When demand for a good or service is relatively static (it doesn\'t change), even when the price changes, demand is said to be inelastic; If a good or service is needed for survival or comfort, people will continue to pay higher prices for it. Caffeine and gas are examples of inelastic goods. When a product is elastic, a change in price quickly results in a change in the quantity demanded. Clothing and electronics are examples of elastic goods. **Types of Market Structures** ------------------------------ A variety of market structures will characterize an economy. Such market structures essentially refer to the degree of competition in a market. There are other determinants of market structures such as the [nature](https://www.toppr.com/guides/business-studies/business-services/nature-and-types-of-services/) of the goods and [products](https://www.toppr.com/guides/business-studies/marketing/product/), the number of sellers, number of consumers, the nature of the product or service, economies of scale etc. We will discuss the four basic types of market structures in any economy. One thing to remember is that not all these types of market structures actually exist. Some of them are just theoretical concepts. But they help us understand the principles behind the classification of market structures. ### 1\] Perfect Competiton In a perfect competition market structure, there are a large number of buyers and sellers. All the sellers of the market are small sellers in competition with each other. There is no one big seller with any significant influence on the market. So all the firms in such a market are price takers. There are certain assumptions when discussing the perfect competition. This is the reason a [perfect competition](https://www.toppr.com/guides/fundamentals-of-economics-and-management/forms-of-market/pricing-perfect-competition/) market is pretty much a theoretical concept. These [assumptions](https://www.toppr.com/guides/reasoning-ability/statements/statements-and-assumptions/) are as follows, - - - - ### ### 2\] Monopolistic Competition This is a more realistic scenario that actually occurs in the real world. In monopolistic competition, there are still a large number of buyers as well as sellers. But they all do not sell homogeneous products. The products are similar but all sellers sell slightly differentiated products. Now the consumers have the preference of choosing one product over another. The sellers can also charge a marginally higher price since they may enjoy some market power. So the sellers become the price setters to a certain extent. For example, the market for cereals is a [monopolistic competition](https://www.toppr.com/guides/business-economics-cs/analysis-of-market/monopolistic-competition/). The products are all similar but slightly differentiated in terms of taste and flavours. Another such example is toothpaste. ### 3\] Oligopoly In an [oligopoly](https://www.toppr.com/guides/business-economics-cs/analysis-of-market/oligopoly/), there are only a few firms in the market. While there is no clarity about the number of firms, 3-5 dominant firms are considered the norm. So in the case of an oligopoly, the buyers are far greater than the sellers. The firms in this case either compete with another to collaborate together, they use their market influence to set the prices and in turn maximize their profits. So the consumers become the price takers. In an oligopoly, there are various barriers to entry in the market, and new firms find it difficult to establish themselves. ### 4\] Monopoly In a monopoly type of market structure, there is only one seller, so a single firm will control the entire market. It can set any price it wishes since it has all the market power. Consumers do not have any alternative and must pay the price set by the seller. Monopolies are extremely undesirable. Here the consumer lose all their power and market forces become irrelevant. However, a pure monopoly is very rare in reality.