No one knows what you can do until you tires

Lecture 8
Covers: Product- product relationship: Meaning-
production possibility curve-marginal rate of product
transformation- Enterprise relationship: joint products-
complementary –supplementary- competitive products
function - Principle of Equi- marginal Returns -Principle of
Opportunity cost and Minimum loss principle. Law of
Comparative Advantage
 PRODUCTION POSSIBILITY CURVE (ISO-RESOURCE CURVE)
The production possibility curve or product transformation curve is the locus of maximum
amounts of two products, say Y1 and Y2, that can be produced from a given quantity of
resources (X(0) Y = f (Y , X(0) ) or Y = f ( Y , X(0) )
1 2 2 1

MRPS=
two products are combined in fixed proportions and the production of
Joint Products
one without the other is impossible
Y1
Y1

C
B

Y2 Y2
0 0 Fig. 12.1 (b) Joint Products
Fig. 12.1 (a) Joint Products
Competitive Products:
output of one product can be increased
only by reducing the output of the other
product

Two competitive products can substitute each other either at a

constant or increasing or decreasing rate

Decreasing RPT exists between two products, every unit

addition of one product, say Y2 replaces less and less of other
product, Y1
An increasing rate of product transformation between two
products occurs when both products are produced in the stage of
decreasing returns. RPT curve is concave towards the origin.

Constant RPT exists between two products, every unit addition

of one product, say Y2 replaces same proportion of product, Y1
Y1

Y2
0 Fig. 12.2 (a) Decreasing RPT Y2Y1
Y1

Y2

0 Fig. 12.2 (b) Increasing RPT Y2Y1

Y1

Y2
0 Fig. 12.2 (c) Constant RPT Y2Y1
 Complementary Products

An increase in one product causes an increase in the second product,

when the total amount of inputs used on the two are held constant

Complementary usually occurs when one of the products produces an input used by the
other product; eg. Legum-cash crop rotation
Supplementary Products

The supplementary relationship between products depends

upon amount of use left in the resource
 Marginal Rate of Product Substitution or Rate of Product Transformation
the rate of change in quantity of one output (Y1) as a result of unit increase in the
other output (Y2), given that the amount of the input used remains constant.

RPT is nothing but the slope of production possibility or opportunity curve.

This is due to decreasing marginal physical products displayed by the

production functions
Iso Revenue Line: the ratio of prices for two competing products
Y2 axis is always equal to TR/PY2 output prices ratio is the slope of
Y1
point on the Y1 axis equal TR/PY1 the iso revenue line= -ve
As total revenue increases, the iso
Change in

revenue line moves away from the origin

Py1

Y2
0 Change in Py1

Fig. 12.5 Iso Revenue line

 Revenue Maximizing Combination of output

Py1(ΔY1) = - Py2(ΔY2 ).

the increase in revenue due to adding a minute quantity of Y2 is exactly

equal to the decrease in revenue caused by the reduction in Y1.

Py1 (ΔY1) > - Py2 (ΔY2) Y2 should be decreased in favour of Y1

Y2
Production possibility
curve

Iso Revenue
Line

Y1
0 Fig. 12.6 Maximum Revenue Yielding Combination
 Opportunity cost and Marginal criterion for Resource Allocation

Maximum revenue from a limited amount of input was shown to occur when

and this could be written as follow Py1 (ΔY1) = - Py2 (ΔY2), where ΔY1 is negative.

Comparing the Marginal criteria for Resource Allocation and Production possibility curve

Variable Output MPPXY1 VMPXY1 Variable Output MPPXY2 VMPXY2

Input (X) (Y1) @Py1= Input (X) (Y2) @Py2=
Re.1/unit Rs.2/unit
0 0 - - 0 0 - -
1 12 12 12 1 7 7 14
2 22 10 10 2 13 6 12
3 30 8 8 3 18 5 10
4 36 6 6 4 22 4 8
5 40 4 4 5 25 3 6
6 42 2 2 6 27 2 4
7 43 1 1 7 28 1 2
Y2

86.0

Production possibility curve

74.5

7 48.5
4 Output expansion path
35.0
27
31.5 2 Iso Revenue Line
17.5

9.0

Y1
0 9.0 15.5 21.5 25.5
Fig. 12.7. Output Expansion Path
Comparing the Marginal Criteria for Resource Allocation and Production Possibility Curve
Units of Solution equating VMP Solution using production possibility
inputs available curve
Y2 Y1 TR Y2 Y1 TR

2 7 12 26 9 9 27.0
4 13 22 48 15.5 17.5 48.5
7 22 30 74 21.5 31.5 74.5
9 25 36 86 25.5 35.0 86.0
Py1 = Re.1; Py2 = Rs.2.

2, 4, 7 and 9 – input availability

27, 48.5, 74.5 and 86 – iso revenue line

geometric approach is more accurate

Optimal criteria of opportunity principle: As long as VMP in one enterprise, that is

sacrificed, equals the VMP in the other enterprise, that is gained, the opportunity costs
for both enterprises are equal and total returns are maximum
 EQUI - MARGINAL PRINCIPLE
MC=MR - input output relationship – economic optimum principle –
under assumption of unlimited availability of variable inputs
Equi-marginal principle: under limited resources
If a scarce resource is to be distributed among two or more uses, the highest total
return is obtained when the marginal return per unit of resource is equal in all
alternative uses
VMPxy1 = VMPxy2 = .... = VMPxyn
where, VMPxy1 is the value of marginal product of X used on product Y1;
Allocation of Limited Variable Input among Three Enterprises (Py1 = Rs2; Py2 = Rs 1; Py3 = Rs 2)
Enterprise I (Maize) Y1 Enterprise II (Sorghum) Y2 Enterprise III (Ragi) Y3
X Y1 VMPXY1 X Y2 VMPXY2 X Y3 VMPXY3
0 0 - 0 0 - 0 0 -
1 10 20 1 18 18 1 7 14
2 18 16 2 31 13 2 13 12
3 24 12 3 42 11 3 18 10
4 29 10 4 51 9 4 22 8
5 33 8 5 58 7 5 25 6
6 36 6 6 64 6 6 27 4
What is the maximum amount of input needed for enterprises I, II and III?
MC=MR
If Px=6.5, VMPx is > Px in 5,5,4 units of Y1, Y2, Y3 respectively
Px=VMPx
Cost is Rs 91 =(5+5+4)x 6.5, as rational manager only use 14 units even under
unlimited resource availability
 Algebraic Example
Corn response to nitrogen production function is: C= 65.54+1.084NC – 0.003NC2. . …...(1)
Sorghum response to nitrogen function is: S = 68.07+0.830NS – 0.002 NS2 . . . . . . (2)
details Corn sorgum
VMPNC =VMPNS (or) Pc MPPnc =Ps MPPns
Land 2AC 1 1
100 kg nitrogen Price Rs/kg 3 2.5
Two inputs - Two outputs

marginal earnings of each input must be the same per unit cost

General condition
Equi - Marginal Principle
In input-output relationship, MC=MR is the economic
principle used to determine the most profitable level
of variable input. But it is under the assumption of
unlimited availability of variable input. Such an
assumption of unlimited resources is unrealistic. So,
in real world situations, the equi-marginal principle is
useful in determining how to allocate limited
resources among two or more alternatives. The
principle says: If a scarce resource is to be distributed
among two or more uses, the highest total return is
obtained when the marginal return per unit of
resource is equal in all alternative uses.
Opportunity Cost

It is an economic concept closely related to the

equi-marginal principle. Opportunity cost recognizes
the fact that every in put has an alternative use.
Once an input is committed to a particular use, it is
no longer available for any other alternative use and
the income from the alternative must be foregone.
Definition : Opportunity cost is defined as the returns
that are sacrificed from the next

best alternative. Opportunity cost is also known as

real cost or alternate cost.
Minimum loss principle

There can be two decision situations:

1) when selling price covers the average total

cost and

2) when selling price is less than average total

cost but more than average variable cost

Law of Comparative Advantage
The Law of Comparative Advantage states that an entity
maximises its resources by producing that which gives
the best return, while delegating production of all other
products and services to other entities more
cost-effective in their production”