CHAPTER ONE: INTRODUCTION

1.1. What Economics is About

A Definition of Economics

It is often said that money can’t buy happiness. Yet undeniably, people derive both sustenance
and pleasure from material goods. Some of those goods, like clean water or a quiet spot on the
beach, are found in nature. Others, like automobiles and television sets, are produced from
natural resources. All these goods, whether natural or manufactured, have one important
characteristic: their supplies are limited, or scarce.

Scarcity forces societies to confront three critical issues. First, each society must decide what to
produce. All societies convert natural resources, like land, minerals, and labor, into the various
things that people want, like food, clothing, and shelter. When we produce more of one good, we
use up scarce resources, and this reduces our ability to produce other goods. For example, if a
farmer uses an acre of land to produce wheat, he can’t use the same acre to grow corn or
tomatoes, or to graze livestock. He can’t use it as the site for a manufacturing plant or a housing
development. Since resources are scarce, every society must develop procedures for determining
what is and is not produced.

Second, a society must decide how to produce goods. There is usually more than one way to
produce a good. For example, if a farmer uses more fertilizer per acre, he can grow the same
amount of wheat on less land. This decision frees up scarce land, which then becomes available
for other purposes, such as housing or manufacturing. But fertilizer is also scarce. If farmers use
more of it to grow wheat, less will remain for other crops. Since different methods of production
consume different resources, every society must develop procedures for determining how goods
are produced.

Finally, a society must determine who gets what. Every society produces goods so that people
can eat, wear, use, or otherwise consume them. In some cases, a small number of individuals
receive a large share of the goods. Every society must develop procedures for allocating goods
among consumers.

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What is Microeconomics?

Economics is a social science that studies the choices that individuals, businesses, government
and entire society make as they cope with scarcity. Economics is categorized on two broad
categories. These are microeconomics and macroeconomics.

Microeconomics: It is a branch of economic analysis of the economic behavior of individual

decision making units such as individuals, households, business firms, industries or prices of
different goods and services. In other words, microeconomics is concerned with the ‘elements’
of economic activity, the firm and the consumer. It refers to the study of economic motives and
behavior of individual consumers and producers and the principles involved in organizing and
operating the individual firms or industries.
Macroeconomics: It is a branch of economic analysis that examines the economy as a whole or
its basic sub-divisions or aggregates such as the government, household and business sector. It is
the study of the economy as a whole; of total saving, investment and employment in the system.
It deals with the great aggregates and averages of the system rather than with particular parts of it
and attempts to define these aggregates in a useful manner and to examine how they are related
and determined.

Uses of Microeconomic Theory

Why study microeconomics? The simple answer is that microeconomics is extremely useful. It
can help us to make important decisions, and it provides tools for understanding and evaluating
the effects of public policies. In terms of decision making, microeconomics offers a wide variety
of helpful principles. For example, it stresses the importance of approaching every decision in
terms of the trade-offs implied. It also trains us to search for our best choice by thinking on the
margin. It enables us to be an informed voter, to understand society and global affairs, and to
learn a way of thinking.

1.2. The Basics of Demand and Supply

A market is any place people come together to trade. Economists often say that there are two
sides to every market: a buying side and a selling side. The buying side of the market is usually

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referred to as the demand side; the selling side of the market is usually referred to as the supply
side. Let’s begin with a discussion of demand.

What is Demand?

The willingness and ability of buyers to purchase different quantities of a good at different
prices during a specific time period. For example, we can express part of John’s demand for
magazines by saying that he is willing and able to buy 10 magazines a month at $4 per magazine and that
he is and able to buy 15 magazines a month at $3 per magazine.

Remember this important point about demand: unless both willingness and ability to buy are
present, there is no demand, and a person is not a buyer. For example, Ahmed may be willing to
buy a computer but be unable to pay the price; Keraj may be able to buy a computer but be
unwilling to do so. Neither Ahmed nor Keraj demands a computer, and neither is a buyer of a
computer.

The Law of Demand

Will people buy more units of a good at lower prices than at higher prices? For example,
will people buy more shirts at $10 than at $70? If your answer is yes, you instinctively
understand the law of demand. The law of demand states that as the price of a good rises, the
quantity demanded of the good falls, and as the price of a good falls, the quantity demanded of
the good rises, ceteris paribus. Simply put, the law of demand states that the price of a good and
the quantity demanded of the good are inversely related, ceteris paribus.

Quantity demanded is the number of units of a good that individuals are willing and
able to buy at a particular price during some time period.

Ways to Represent the Law of Demand

Demand Schedule. A demand schedule is the numerical representation of the law of demand. A
demand schedule for good X is illustrated below.

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Demand Curve. A (downward-sloping) demand curve is the graphical representation of the
inverse relationship between price and quantity demanded specified by the law of demand. In
short, a demand curve is a picture of the law of demand.

Demand function. A demand function is the mathematical representation of the law of demand.

That is, .

A Change in Quantity Demanded Versus a Change in Demand

A “change in quantity demanded” is not the same as a “change in demand.” Change in quantity
demanded is a movement from one point to another point on the same demand curve caused by a
change in the price of the good/own price while change in demand refers to shift in demand
curve.

The Six Determinants of Demand/Demand Shifters

The determinants of demand are factors that change demand. We already know that quantity
demanded is changed or influenced by price. Demand, on the other hand, is changed by these six
factors: tastes or preferences, income, the substitution effect, the price of complementary goods,
population, and consumer expectations.

1. Preferences/Tastes: People’s preferences affect the amount of a good they are willing to
buy at a particular price. A change in preferences in favor of a good shifts the demand
curve rightward. A change in preferences away from the good shifts the demand curve
leftward.

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 2. Prices of Related Goods: There are two types of related goods: substitutes and
complements. Two goods are substitutes if they satisfy similar needs or desires. For many
people, Coca-Cola and Pepsi-Cola are substitutes. If two goods are substitutes, as the
price of one rises (falls), the demand for the other rises (falls). For instance, higher Coca-
Cola prices will increase the demand for Pepsi-Cola as people substitute Pepsi for the
higher-priced Coke. Other examples of substitutes are coffee and tea, corn chips and
potato chips, two brands of margarine, and foreign and domestic cars.

Complements are two goods that are used jointly in consumption. If two goods are
complements, the demand for one rises as the price of the other falls (or the demand for
one falls as the price of the other rises). For example, higher tennis racket prices will
decrease the demand for tennis balls. Other examples of complements are cars and tires,
light bulbs and lamps, and golf clubs and golf balls.
3. Number of Buyers The demand for a good in a particular market area is related
to the number of buyers in the area: more buyers, higher demand; fewer buyers, lower
demand. The number of buyers may increase owing to a higher birthrate, increased
immigration, the migration of people from one region of the country to another, and so
on.
The number of buyers may decrease owing to a higher death rate, war, the migration of
people from one region of the country to another, and so on.
4. Expectations of Future Price Buyers who expect the price of a good to be higher next
month may buy the good now—thus increasing the current (or present) demand for the
good. Buyers who expect the price of a good to be lower next month may wait until next
month to buy the good—thus decreasing the current (or present) demand for the good.
For example, suppose you are planning to buy a house. One day, you hear that house
prices are expected to go down in a few months. Consequently, you decide to delay your
purchase of a house for a few months. Alternatively, if you hear that prices are expected
to rise in a few months, you might go ahead and purchase a house now.
5. Income As a person’s income changes (increases or decreases), his or her demand for a
particular good may rise, fall, or remain constant. When looking at income, we must
consider the two types of goods:

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  Normal good—any good that consumers purchase more of as their incomes increase.
Examples: luxury cars and gourmet meals.
 Inferior good—any good that consumers purchase less of as their income increases.
Examples: ‘shiro wat’ and plastic foot wears.
The income effect changes demand by allowing consumers to purchase goods they wouldn’t
normally purchase due to a lack of affordability.

Supply
The willingness and ability of sellers to produce and offer to sell different quantities of a good at
different prices during a specific time period.
The Law of Supply
The law of supply states that as the price of a good rises, the quantity supplied of the good rises,
and as the price of a good falls, the quantity supplied of the good falls, ceteris paribus.

Simply put, the price of a good and the quantity supplied of the good are directly related, ceteris
paribus. (Quantity supplied is the number of units sellers are willing and able to produce and
offer to sell at a particular price.)

Determinants of Supply

We know the supply of any good can change. But what causes supply to change? What causes
supply curves to shift? The factors that can change supply include (1) prices of relevant
resources, (2) technology, (3) prices of other goods, (4) number of sellers, (5) expectations of
future price, (6) taxes and subsidies, and (7) government restrictions.

1. Prices of Relevant Resources: Resources are needed to produce goods. For example,
wood is needed to produce doors. If the price of wood falls, it becomes less costly to
produce doors. With lower costs and prices unchanged, the profit from producing and
selling doors has increased; as a result, there is an increased (monetary) incentive to
produce doors. Door producers will produce and offer to sell more doors at each and
every price. Thus, the supply of doors will increase, and the supply curve of doors will
shift rightward. If the price of wood rises, it becomes more costly to produce doors.
Consequently, the supply of doors will decrease, and the supply curve of doors will shift
leftward.

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 2. Technology: technology is defined as the body of skills and knowledge concerning the
use of resources in production. Also, an advance in technology refers to the ability to
produce more output with a fixed amount of resources, thus reducing per unit production
costs. Why? The reason is that lower per-unit costs increase profitability and therefore
provide producers with an incentive to produce more. For example, if corn growers
develop a way to grow more corn using the same amount of water and other resources, it
follows that per-unit production costs will fall, profitability will increase, and growers
will want to grow and sell more corn at each price. The supply curve of corn will shift
rightward.
3. Prices of Other Goods: Think of a farmer who is producing wheat. Suddenly, the price
of something he is not producing (say, corn) rises relative to wheat. It is possible that the
farmer may shift his farming away from wheat to corn. In other words, as the price of
corn rises relative to wheat, the farmer switches from wheat production to corn
production. We conclude that a change in the price of one good can lead to a change in
the supply of another good.
4. Number of Sellers: If more sellers begin producing a particular good, perhaps because of
high profits, the supply curve will shift rightward. If some sellers stop producing a
particular good, perhaps because of losses, the supply curve will shift leftward.
5. Expectations of Future Prices: If the price of a good is expected to be higher in the
future, producers may hold back some of the product today (if possible, but perishables
cannot be held back). Then they will have more to sell at the higher future price.
Therefore, the current supply curve will shift leftward. For example, if oil producers
expect the price of oil to be higher next year, some may hold oil off the market this year
to be able to sell it next year. Similarly, if they expect the price of oil to be lower next
year, they might pump more oil this year than previously planned.
6. Taxes and Subsidies: Some taxes increase per-unit costs. Suppose a shoe manufacturer
must pay a $2 tax per pair of shoes produced. This tax leads to a leftward shift in the
supply curve, indicating that the manufacturer wants to produce and offer to sell fewer
pairs of shoes at each price. If the tax is eliminated, the supply curve shifts rightward.
Subsidies have the opposite effect.

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 7. Government Restrictions: Sometimes, government acts to reduce supply. Consider a
U.S. import quota on Japanese television sets. An import quota, or quantitative restriction
on foreign goods, reduces the supply of Japanese television sets in the United States. It
shifts the supply curve leftward. The elimination of the import quota allows the supply of
Japanese television sets in the United States to shift rightward.
Licensure has a similar effect. With licensure, individuals must meet certain
requirements before they can legally carry out a task. For example, owner-operators of
day-care centers must meet certain requirements before they are allowed to sell their
services. No doubt, this reduces the number of day-care centers and shifts the supply
curve of day-care centers leftward.
1.3. The Market Mechanism/Market Equilibrium
The point at which supply and demand curves intersect is called market equilibrium. The word
equilibrium means balance, a point of harmony, where supply and demand meets. It is when the
quantity demanded equals the quantity supplied. Equilibrium prices are all around us. When you
visit a store, every price you see for a product is an equilibrium price. It is important to
remember that equilibrium prices are not fixed; they fluctuate with the forces of supply and
demand. When there is too much demand (shortage) or too much supply (surplus), we have what
economists refer to as disequilibrium.

When a producer finds itself in disequilibrium, it has two choices: either adjust the price to meet
demand, or adjust output to meet demand. If adjustments are not made in a timely manner, the
firm will no longer be able to produce enough revenue to cover its costs.

When examining both supply and demand, we must construct both a supply and a demand curve
on the same graph. In the following graph market equilibrium point is point E, at which market
supply equals to market demand. The point above the equilibrium point quantity supply is
greater than quantity demand, there is surplus. On the point below the equilibrium point the
demand is greater than the supply, so there is shortage.

You can see that when the supply and demand curves intersect, we have both an equilibrium
price and quantity. Each time the supply or demand curve shifts, a new equilibrium is created.

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Example: Suppose the demand function for corn is and the supply function is
. What is the equilibrium price of corn? What are the amounts bought and sold?

Solution: The equilibrium price in the corn market, which equates the amounts supplied and
demanded, is the solution to the equation , or equivalently

We can derive the amount bought and sold from either the demand or supply function, by
substituting $3 for the price: .

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Effects of Change Demand or Supply on Equilibrium

Effects of Simultaneous Change in Supply and Demand

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 1.4. Elasticity
The general concept of elasticity provides a technique for estimating the response of one variable
to changes in another variable. It has numerous applications in economics.

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CHAPTER TWO: THEORY OF CONSUMER BEHAVIOUR AND DEMAND

1.1. Consumer Preferences and Choices

The underlying foundation of demand is a model of how consumers behave. The individual
consumer has a set of preferences and values whose determinations are outside the realm of
economics. They are no doubt dependent upon culture, education, and individual tastes, among a
plethora of other factors. The measure of these values in this model for a particular good is in
terms of the real opportunity cost to the consumer who purchases and consumes the good. If an
individual purchases a particular good, then the opportunity cost of that purchase is the forgone
goods the consumer could have bought instead.

We develop a model in which we map or graphically derive consumer preferences. These are
measured in terms of the level of satisfaction the consumer obtains from consuming various
combinations or bundles of goods. The consumer’s objective is to choose the bundle of goods
which provides the greatest level of satisfaction as they the consumer define it. But consumers
are very much constrained in their choices. These constraints are defined by the consumer’s
income, and the prices the consumer pays for the goods.

2.1.1. Consumer Preference

Preferences tell us about a consumer’s likes and dislikes. Given any two consumption bundles
(groups of goods) available for purchase, how a consumer compares the goods? Does he prefer
one good to another, or does he indifferent between the two groups? Given any two consumption
bundles, the consumer can either decide that one of consumption bundles is strictly better than
the other, or decide that he is indifferent between the two bundles.
Strict Preference

Given any two consumption bundles and ,if or if he

chooses when is available the consumer definitely wants the X-bundle than
Y-bundle. If the consumer is indifferent between two bundles of goods, we use the symbol ~ and
write ~ . Indifference means that the consumer would be just as satisfied,
according to her own preferences, consuming the bundle as she would be consuming
the other bundle,
If the consumer prefers or is indifferent between the two bundles we say that she weakly prefers
to and write ≥ . These relations of strict preference, weak
preference, and indifference are not independent concepts; the relations are themselves related!

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Assumptions about Preferences
Complete. We assume that any two bundles can be compared. That is, given any x-bundle and
any y-bundle, we assume that (Xl, X2) ≥ (Yl , Y2), or (Yl, Y2) ≥ (Xl, X2), or both, in which case
the consumer is indifferent between the two bundles.
Reflextive. We assume that any bundle is at least as good as itself: (X1, X2) ≥ (X1,X2).
Transitivity: If X≥ Y and Y≥Z, then X≥ Z. In other words, if the consumer thinks that X is at
least as good as Y and that Y is at least as good as Z, then the consumer thinks that X is at least
as good as Z.
More is better than less. Consumers always prefer more of any good to less and they are never
satisfied or satiated. However, bad goods are not desirable and consumers will always prefer less
of them.
2.3. Utility
Utility refers to the degree of benefit or satisfaction/pleasure/happiness/enjoyment that a person
gets from the consumption of goods and services.
In defining strict preference, we said that given any two consumption bundles (X 1,X2) and
(Y1,Y2),the consumer definitely wants the X bundle than the Y bundle if (X 1,X2) > (Y1,Y2).This
means, the consumer preferred bundle (X1,X2) to bundle (Y1,Y2) if and only if the utility of
(X1,X2) is larger than the utility of (Y1,Y2).
Note that:
 Utility is subjective. The utility of a product will vary from person to person. That means,
the utility that two individuals derive from consuming the same level of a product may
not be the same. For example, no-smokers do not derive any utility from cigarettes.
 The utility of a product can be different at different places and time. For example, the
utility that we get from meat during fasting is not the same as any time else.

2.4. Approaches to Measure Utility

There are two major approaches of measuring utility. These are Cardinal and Ordinal
approaches.
2.4.1. The Cardinal Utility Approach

Neo classical economists argued that utility is measurable like weight, height, temperature and
they suggested a unit of measurement of satisfaction called utils. A util is a cardinal number like
1,2,3 etc. simply attached to utility. Hence, utility can be quantitatively measured.

Assumptions of Cardinal Utility theory

1. Rationality of Consumers. The main objective of the consumer is to maximize his/her

satisfaction given his/her limited budget or income. Thus, in order to maximize his/her
satisfaction, the consumer has to be rational. Rationality means behaviour of an economic
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 agent has objectives and involves a prudent choice among alternative means. In other
words, consumer behaviour is not random or arbitrary. It has patterns and can be
explained. Thus, economic investigation is possible and meaningful.

2. Utility is cardinally measurable. According to this approach, the utility or satisfaction

of each commodity is measurable. Money is the most convenient measurement of utility.
In other words, the monetary unit that the consumer is prepared to pay for another unit of
commodity measures utility or satisfaction.
3. Constant marginal utility of money. According to assumption number two, money is
the most convenient measurement of utility. However, if the marginal utility of money
changes with the level of income (wealth) of the consumer, then money cannot be
considered as a measurement of utility.
4. Limited money income. The consumer has limited money income to spend on the goods
and services he/she chooses to consume.
5. Diminishing Marginal Utility (DMU).The utility derived from each successive units of
a commodity diminishes. In other words, the marginal utility of a commodity diminishes
as the consumer acquires larger quantities of it.
6. The total utility of a basket of goods depends on the quantities of the individual
commodities.
If there are n commodities in the bundle with quantities,
X 1 , X 2 ,. . . X n the total utility is
given by:
X 1 , X 2 ...... X n
TU=f ( )

Total and Marginal Utility

[

Total Utility (TU): It refers to the total amount of satisfaction a consumer gets from consuming
or possessing some specific quantities of a commodity at a particular time. As the consumer
consumes more of a good per time period, his/her total utility increases. However, there is a
saturation point for that commodity in which the consumer will not be capable of enjoying any
greater satisfaction from it.
Marginal Utility (MU): It refers to the additional utility obtained from consuming an additional
unit of a commodity. In other words, marginal utility is the change in total utility resulting from
the consumption of one or more unit of a product per unit of time. Graphically, it is the slope of
total utility.
Mathematically, the formula for marginal utility is:

ΔTU
MU =
ΔQ
Where, TU is the change in total utility, and, Q is change in the amount of product
consumed.

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Law of diminishing marginal Utility (LDMU)

The utility that a consumer gets by consuming a commodity for the first time is not the same as
the consumption of the good for the second, third, fourth, etc.
The Law of diminishing marginal utility states that as the quantity consumed of a commodity
increases per unit of time, the utility derived from each successive unit decreases, consumption
of all other commodities remaining constant.
The LDMU is best explained by the MU curve that is derived from the relationship between the
TU and total quantity consumed.

Table 2.1 Hypothetical table showing TU and MU of consuming Oranges (X)

Units of
0 1st 2nd 4th 5th 6th
Quantity(x) 3rd
unit unit
consumed Unit Unit unit Unit Unit

TUX 0 util 10 utils 16 utils 20 utils 22 utils 23 utils 20 utils

MUX - 10 6 4 2 0 -2

As indicated in the above figures, as the consumer consumes more of a good per time period, the
total utility increases, at an increasing rate when the marginal utility is increasing and then
increases at a decreasing rate when the marginal utility starts to decrease and reaches maximum
when the marginal utility is Zero.

The total utility curve reaches its pick point (saturation point) at point A. This Saturation point
indicates that by consuming 5 oranges, the consumer attains its highest satisfaction of 23 utils.
However, consumption beyond this point results in dissatisfaction, because consuming the 6 th
and more orange brings a lesser additional utility than the previous orange. Point B where the
MU curve reaches its maximum point is called an inflexion point or the point of Diminishing
Marginal utility.

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Fig. 2.1 Derivation of marginal utility from total utility

Equilibrium of a Consumer

A consumer that maximizes utility reaches his/her equilibrium position when allocation of
his/her expenditure is such that the last birr spent on each commodity yields the same utility. If
the consumer consumes a bundle of n commodities i.e , he/she would be in
equilibrium or utility is maximized if and only if:

MU X MU X MU X
1
= 2
= .. . .. .. . .= n
=MU m
PX P X2 P Xn
1 Where: MUm –marginal utility of money

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Diagrammatically,

C
PX

MUX

Note that: at any point above point C like point A where , it pays the consumer to
consume more. At any point below point C like point B where the consumer
consumes less of X. However, at point C where the consumer is at equilibrium.

Table2.2 Utility schedule for a single commodity

Quantity of
Total utility Marginal utility
Orange (price=2 )

0 0 - - 1

1 6 6 3 1

2 10 4 2 1

3 12 2 1 1

4 13 1 0.5 1

5 13 0 0 1

6 11 -2 -1 1

For consumption level lower than three quantities of oranges, since the marginal utility of orange
is higher than the price, the consumer can increase his/her utility by consuming more quantities
of oranges. On the other hand, for quantities higher than three, since the marginal utility of
orange is lower than the price, the consumer can increase his/her utility by reducing its
consumption of oranges. Mathematically, the equilibrium condition of a consumer that consumes
a single good X occurs when the marginal utility of X is equal to its market price. MU X = P X .

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Table 2.3 Utility schedule for two commodities

Orange, Price=2birr Banana, Price=4birr

Quantity TU MU MU/P Quantity TU MU MU/P

0 0 - - 0 0 - -

1 6 6 3 1 6 6 6

2 10 4 2 2 22 16 4

3 12 2 1 3 32 10 3

4 13 1 0.5 4 40 8 2

5 13 0 0 5 45 5 1.85

6 11 -2 -1 6 48 3 0.75

As we discussed earlier, utility is maximized when the condition of marginal utility of one
commodity divided by its market price is equal to the marginal utility of the other commodity
MU 1 MU 2
=
divided by its market price i.e. P 1 P2

Thus, the consumer will be at equilibrium when he consumes 2 quantities of Orange and 4
MU orange MU banana 4 8
= = = =2
quantities of banana, because Porange Pbanana 2 4 .

Derivation of the Cardinalist Demand

The derivation of demand curve is based on the concept of diminishing marginal utility. If the
marginal utility is measured using monetary units the demand curve for a commodity is the same
as the positive segment of the marginal utility curve.

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 P1
a

Price
P

P2
c
MUX
O Quantity

P1
Price

P
Demand
P2 Curve
O Quantity
Q1 Q Q2
Figure 2.3 Derivation of Demand curve

2.4.1. The Ordinal Utility Theory

In the ordinal utility approach, utility cannot be measured absolutely but different consumption
bundles are ranked according to preferences. The concept is based on the fact that it may not be
possible for consumers to express the utility of various commodities they consume in absolute
terms, like, 1 util, 2 utils, or 3 utils, but it is always possible for the consumers to express the
utility in relative terms. It is practically possible for the consumers to rank commodities in the
order of their preference as and so on.
Assumptions of Ordinal Utility theory
This approach is based on the following assumptions:
1. The Consumers are rational-they aim at maximizing their satisfaction or utility given
their income and market prices.
2. Utility is ordinal, i.e. utility is not absolutely (cardinally) measurable. Consumers are
required only to order or rank their preference for various bundles of commodities.
3. Diminishing Marginal Rate of Substitution (MRS): The marginal rate of substitution is
the rate at which a consumer is willing to substitute one commodity (X) for another
commodity (Y) so that his total satisfaction remains the same. When a consumer
continues to substitute X for Y the rate goes decreasing and it is the slope of the
indifference curve.

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 4. The total utility of the consumer depends on the quantities of the commodities consumed,
i.e.,
5. Preferences are transitive or consistent:
It is transitive in the senses that if the consumer prefers market basket X to market basket Y, and
prefers Y to Z, and then the consumer also prefers X to Z.
When we said consistent it means that if market basket X is greater than market basket Y (X>Y)
then Y not greater than X (Y not >Y).
The ordinal utility approach is expressed or explained with the help of indifference curves. An
indifference curve is a concept used to represent an ordinal measure of the tastes and preferences
of the consumer and to show how he/she maximizes utility in spending income. Since it uses ICs
to study the consumer’s behavior, the ordinal utility theory is also known as the Indifference
Curve Analysis.
Indifference Set, Curve and Map
[

Indifference Set/ Schedule: It is a combination of goods for which the consumer is indifferent,
preferring none of any others. It shows the various combinations of goods from which the
consumer derives the same level of utility.
Table2.4 Indifference Schedule
Bundle A B C D
(Combination)
Orange(X) 1 2 4 7
Banana (Y) 10 6 3 1
[[

Each combination of good X and Y gives the consumer equal level of total utility. Thus, the
individual is indifferent whether he consumes combination A, B, C or D.

Indifference Curves: an indifference curve shows the various combinations of two goods that
provide the consumer the same level of utility or satisfaction. It is the locus of points (particular
combinations or bundles of good), which yield the same utility (level of satisfaction) to the
consumer, so that the consumer is indifferent as to the particular combination he/she consumes.

By transforming the above indifference schedule into graphical representation, we get an

indifference curve.
Indifference Map: To describe a person’s preferences for all combinations potato and meat, we
can graph a set of indifference curves called an indifference map. In other words it is the entire
set of indifference curves is known as an indifference map, which reflects the entire set of tastes
and preferences of the consumer. A higher indifference curve refers to a higher level of
satisfaction and a lower indifference curve shows lesser satisfaction. IC2 reflects higher level of
utility than that of [Link] consumer has lots of indifference curves, not just one.

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[

10 A
Banana (Y)

Good B
Indifference
B
6 Curve (IC)

C
2 IC3
D IC2
1
IC1

1 2 4 7 Good A
Orange(X)) (X)

[[

Fig2.4 indifference curves and indifference map

Properties of Indifference Curves:

Indifference curves have certain unique characteristics with which their foundation is based.

1. Indifference curves have negative slope (downward sloping to the right) because the
consumption level of one commodity can be increased only by reducing the
consumption level of the other commodity.
2. Indifference curves do not intersect each other. If they did, the point of their
intersection would mean two different levels of satisfaction, which is impossible.
3. A higher Indifference curve is always preferred to a lower one because they contain
more of the two commodities than the lower ones.
4. Indifference curves are convex to the origin.

B
Banana

Banana

E
D IC2
C
A
IC1
X

Orange Orange
Fig.2.5. Positively sloped and intersected indifference curves

21 | P a g e
Indifference curves cannot intersect each other. If they did, the consumer would be indifferent
between C and E, (Right panel of figure 2.5) since both are on indifference curve one (IC 1).
Similarly, the consumer would be indifferent between points D and E, since they are on the same
indifference curve, [Link] transitivity, the consumer must also be indifferent between C and D.
However, a rational consumer would prefer D to C because he/she can have more Orange at
point D (more Orange by an amount of X).

The Marginal rate of substitution (MRS)

Definition: Marginal rate of substitution of X for Y is defined as the number of units of

commodity Y that must be given up in exchange for an extra unit of commodity of X so that the
consumer maintains the same level of satisfaction.

Number of units of Y given up

MRS X , Y =
Number of units of X gained
It is the negative of the slope of an indifference curve at any point of any two commodities such
as X and Y, and is given by the slope of the tangent at that point:

i.e., Slope of indifference curve

Δy
=MRS X , Y
Δx

Note that (
MRS
X , Y ) measures the downward vertical distance (the amount of y that the
individual is willing to give up) per unit of horizontal distance (i.e. per additional unit of x
ΔY
MRS X , Y =−
required) to remain on the same indifference curve. That is, ΔX because of the
reduction in Y, MRS is negative. However, we multiply by negative one and express
MRS X , Y as
a positive value.

Table2.5 level of consumption of good X and Y

Bundle A B C D
(Combination)
Orange(X) 1 2 4 7
Banana (Y) 10 6 3 1

ΔY 4
MRS X , Y (between po int s A and B= = =4
ΔX 1

In the above case the consumer is willing to forgo 4 units of Banana to obtain 1 more unit of
Orange. The above schedule shows that, as the amount of Y increases, the marginal utility of

22 | P a g e
additional units of Y decreases. Similarly, as the quantity of X decreases, its marginal utility
increases. In addition, the MRS decreases as one move downwards to the right.

The
MRS X , Y is related to the MUx and the MUy is:

MU X
MRS X , Y =
MU Y
2.5. The Budget Line or the Price Line

A consumer while maximizing utility is constrained by the amount of income and prices of
goods that must be paid. This constraint is often presented with the help of the budget line
constructing by alternative purchase possibilities of two goods.

The budget line is a line or graph indicating different combinations of two goods that a
consumer can buy with a given income at a given prices. In other words, the budget line shows
the market basket that the consumer can purchase, given the consumer’s income and prevailing
market prices.
Assumptions for the use of the budget line

In order to draw the budget line facing the consumer, we consider the following assumptions:

1. there are only two goods, X and Y, bought in quantities X and Y;

2. each consumer is confronted with market determined prices, Px and Py, of good X and good Y
respectivley; and
3. the consumer has a known and fixed money income (M).
By assuming that the consumer spends all his/her income on two goods (X and Y), we can
express the budget constraint as:

M =P X X + P Y Y Where, PX=price of good X

PY=price of good Y
X=quantity of good X
Y=quantity of good Y
M=consumer’s money income

This means that the amount of money spent on X plus the amount spent on Y equals the
consumer’s money income. Suppose for example a household with 30 Birr per day to spend on
banana(X) at 5 Birr each and Orange(Y) at 2 Birr each. That is, P X =5 , PY =2 , M =30 birr .
Therefore, our budget line equation will be:
5 X +2 Y =30

Table 2.6 Alternative purchase possibilities of the two goods

Consumption
A B C D E F
Alternatives

23 | P a g e
 Kgs of banana (X) 0 1 2 3 4 6
Kgs of Orange(Y) 15 12.5 10 7.5 5 0
Total Expenditure 30 30 30 30 30 30

At alternative A, the consumer is using all of his /her income for good Y. Mathematically it is the
y-intercept (0, 15). And at alternative F, the consumer is spending all his income for good X.
mathematically; it is the x-intercept (6, 0). We may present the income constraint graphically by
the budget line whose equation is derived from the budget equation.
M=P X X +P Y Y
M− XPX =YPY

By rearranging the above equation we can derive the general equation of a budget line,

M P
Y= − X X
PY PY

M
PY = Vertical Intercept (Y-intercept), when X=0.
PX
−
PY = slope of the budget line (the ratio of the prices of the two goods)

The horizontal intercept (i.e., the maximum amount of X the individual can consume or
purchase given his income) is given by:

M P
− X X =0
PY PY

M P
= X X
PY PY

M
X=
PX

M/PY

M/PX
24 | P a g e
 Fig.2.6. Derivation of the Budget Line

Therefore, the budget line is the locus of combinations or bundle of goods that can be purchased
if the entire money income is spent.
Factors Affecting the Budget Line

Effects of changes in income

If the income of the consumer changes (keeping the prices of the commodities unchanged) the
budget line also shifts (changes). Increase in income causes an upward shift of the budget line
that allows the consumer to buy more goods and services and decreases in income causes a
downward shift of the budget line that leads the consumer to buy less quantity of the two goods.
It is important to note that the slope of the budget line (the ratio of the two prices) does not
change when income rises or falls. The budget line shifts from B to B1 when income decreases
and to B2 when income rises.

M2/Py

Where M2>M>M1

M/Py
B B2

B1

M1/PX M/PX M2/PX

Fig.2.7. Effects of change in income

Effects of Changes in Price of the commodities

 What would happen if price of x falls, while the price of good Y and money incme
remaining constant?
Y

M/py A

Here Px ’ < Px, hence M/Px <M/Px1

25 | P a g e
 B B’ X
M/Px M/Px '

Fig. 2.8. Effect of a decrease in price of x on the budget line

Since the Y-intercept (M/Py) is constant, the consumer can purchase the same amount of Y by
spending the entire money income on Y regardless of the price of X. We can see from the above
figure that a decrease in the price of X, money income and price of Y held constant, pivots the
budget line out-ward, as from AB to AB’.

 What would happen if price of x rises, while the price of good Y and money incme remaining
constant?

Since the Y-intercept (M/Py) is constant, the consumer can purchase the same amount of Y by
spending the entire money income on Y regardless of the price of X. We can see from the
figure below that an increase in the price of X, money income and price of Y held constant,
pivots the budget line in-ward, as from AB to AB’.

M/Py A

B’ B

M/Px1 M/Px2
Fig. 2.9. Effect of an increase in price of x on the budget line

2.6. Optimum of the Consumer

A consumer maximizes the utility by trying to attain the highest possible indifference curve,
given the budget line. This occurs where an indifference curve is tangent to the budget line so
that the slope of the indifference curve ( MRS XY ) is equal to the slope of the budget line
( P X / PY ).

However, the consumer cannot purchase any bundle lying above and to the right of the budget
line. Because indifference curves above the region of the budget line are beyond the reach of the
consumer and are irrelevant for equilibrium consideration
Graphically, the consumer optimum or equilibrium is depicted as follows:

26 | P a g e
 Y
A

B
E
IC4

C IC3

IC2
D
IC1

Figure 2.10. Consumer equilibrium X

At point ‘A’ on the budget line, the consumer gets IC 1 level of satisfaction. When he/she moves
down to point ‘B’ by reallocating his total income in favor of X he/she derives greater level of
satisfaction that is indicated by IC2. Thus, point ‘B’ is preferred to point ‘A’. Moving further
down to point ‘E’, the consumer obtains the greatest level of satisfaction (IC 3) relative to other
indifference curves.
Therefore, point ‘E’ (which represents combination X and Y) is the most preferred position by
the consumer since he/she attains the highest level of satisfaction within his/her reach and point
’E’ is known as the point of consumer equilibrium (or consumer optimum). This equilibrium
occurs at the point of tangency between the highest possible indifference curve and the budget
line. Put differently, equilibrium is established at the point where the slope of the budget line is
equal to the slope of the indifference curve.

2.7. Effects of Changes in Income and Prices on Consumer

A. Changes In Income: Income Consumption Curve and the Engel Curve

If we connect all of the points representing equilibrium market baskets corresponding to all
possible levels of money income, the resulting curve is called the Income consumption curve
(ICC) or Income expansion curve (IEC). The Income Consumption Curve is a curve joining the
points of consumer optimum (equilibrium) as income changes (ceteris paribus). Or, it is the locus
of consumer equilibrium points resulting when only the consumer’s income varies.

27 | P a g e
 Commodity Y

ICC
E3
E2
E1
Commodity X

Engle Curve
Income

I3
I2
I1

X1 X2 X3 Commodity X
Figure2.15 the income –consumption and the Engle curves

From the Income Consumption Curve we can derive the Engle Curve.

The Engle Curve is the relationship between the equilibrium quantity purchased of a good and
the level of income. It shows the equilibrium (utility maximizing) quantities of a commodity,
which a consumer will purchase at various levels of income; (ceteris paribus) per unit of time.

B. Changes in Price: Price Consumption Curve (PCC) and Individual Demand

Curve

The price-consumption curve is the locus of the utility-maximizing combinations of products

that result from variations in the price of one commodity when other product prices, the money
income and other factors are held constant.

We can derive the demand curve of an individual for a commodity from the price consumption
curve. Below is an illustration of deriving the demand curve when price of commodity X
decreases from
Px 1 to Px 2 to Px 3 .

28 | P a g e
 Commodity Y
PCC

Commodity X

Px1
Price of X

Px2
Individual demand curve
Px3

X1 X2 X3 Commodity X

Figure2.11. the PPC and derivation of the demand curve

29 | P a g e
CHAPTER THREE: THE THEORY OF PRODUCTION

3.1. Introduction: Definition and Basic Concepts

Production: Production can be defined as a process by which resources/inputs are transformed
into final goods and services (product/output). Input is a factor of production such as labor, land,
capital and entrepreneurial ability) that goes to production process of goods and services. Inputs
are classified in to two fixed and variable.
Fixed inputs: Fixed inputs are those the supply of which cannot be varied over the time period
under consideration.

a) The resources whose use remains the same regardless of the level of production are called
fixed resources.
b) Volume of output does not directly depend up on these resources.
c) Costs corresponding to these resources are known as fixed costs.
d) Fixed resources exist only in the short run and in the long run they are zero. Example: land,
machinery, farm buildings, equipment, implements, livestock etc.
Variable Resources: Variable inputs are those the supply of which can be varied
with the production level in the short run.

a) The resources whose uses vary with the level of production are known as
variable resources.
b) Volume of output directly depends on these resources.
c) Costs corresponding to these resources are known as variable costs.
d) Variable resources exist both in the short run and in the long run.
Examples of variable resources are seeds, fertilizers, plant protection chemicals, feeds,
medicines etc.

Product/output: It is the result of the use of resources. Product is any good or service that

30 | P a g e
comes out of the production process.
Production Function (PF): Production function is a purely technical relation which connects
factor inputs and outputs. It describes the laws of proportion, that is, the transformation of
factor inputs into products (outputs) at any particular time period. The production function
represents the technology of a firm of an industry, or of the economy as a whole. The
production function includes all the technically efficient methods of production.

Production function is a technical and mathematical relationship describing the manner and
the extent to which a particular product depends upon the quantities of inputs or input services,
used at a given level of technology and in a given period of time.

A method of production (process, activity) is a combination of factor inputs required to the

production of one unit of output. Usually a commodity may be produced by various methods of
production. For example, a unit of commodity x may be produced by the following processes:

Capital
LabourUnits
units
A method of production A is technically efficient relative to any other method B, if A uses less
of at least one factor and no more from the other as compared with B. for example, commodity y
can be produced by two methods:

Capital
LabourUnits
units
Method B is technically inefficient as compared with A. the basic theory of production
concentrates only on efficient methods. Inefficient methods will not be used by rational
entrepreneurs.

If process A uses less of some factor(s) and more of some other(s) as compared with any other
process B, then A and B cannot be directly compared on the criterion of technical efficiency.
For example, the activities shown below are not directly comparable.

31 | P a g e
 Capital units
Labour units

Both processes are considered as technically efficient and are included in the production function
(the technology). Which one of them will be chosen at any particular time depends on the prices
of factors. The choice of any particular technique (among the set of technically efficient
processes) is an economic one, based on prices, and not a technical one.

Short Run vs. Long Run

The distinction between the short run and the long run period is based on the difference between
fixed and variable input. Short run is a period of time in which at least one input is fixed. The
long run is a period of time in which all inputs are variable. It is important to note that the
boundary between the short run and the long run is not defined by referring to any calendar
period, such as a year, or a month or a quarter.
3.2. Production in the Short Run: Production with One Variable Input
Production with one variable input (while the others are fixed) is obviously a short run
phenomenon because there is no fixed input in the long run.
Assumptions of short run production analysis
In order to simplify the analysis of short run production, the classical economists assumed the
following:
1. Perfect divisibility of inputs and outputs
This assumption implies that factor inputs and outputs are so divisible that one can hire, for
example a fraction of labor, a fraction of manager and we can produce a fraction of output, such
as a fraction of automobile.
2. Limited substitution between inputs
Factor inputs can substitute each other up to a certain point, beyond which they cannot substitute
each other
3. Constant technology
It assumed that level of technology of production is constant in the short run. Suppose a firm that
uses two inputs: Capital (which is a fixed input) and labor (which is variable input). Given the

32 | P a g e
assumptions of short run production, the firm can increase output only by increasing the amount
of labor it uses. Hence, its production function is
Q = f (L) K - being constant
Where Q is the quantity of production (Output)
L is the quantity of labor used, which is variable, and
K is the quantity of capital (which is fixed)

In the above short run production function, the quantity of capital is fixed. Thus output can
change only when the amount of labor used for production changes. Hence, Q is a function of L
only in the short run.

3.2.1. Total Product, Marginal Product and Average Product

Total product (TP): is the total amount of output that can be produced by efficiently utilizing a
specific combination of labor and capital. It shows the output produced for different amounts of
the variable input, labor.
Marginal Product (MP)

The marginal product of variable input is the addition to the total product attributable to the
addition of one unit of the variable input to the production process, other inputs being constant
(fixed). Before deciding whether to hire one more worker, a manager wants to determine how
much this extra worker (L =1) will increase output, Q. The change in total output resulting
from using this additional worker (holding other inputs constant) is the marginal product of the
worker. If output changes by Q when the number of workers (variable input) changes by ∆L,
the change in output per worker or marginal product of the variable input, denoted as MP L is
found as

MPL =
Thus, MPL measures the slope of the total product curve at a given point. In the short run, the
MP of the variable input first increases reaches its maximum and then tends to decrease to the
extent of being negative. That is, as we continue to combine more and more of the variable
inputs with the fixed input, the marginal product of the variable input increases initially and then
declines.

33 | P a g e
Average Product (AP)
The AP of an input is the ratio of total output to the number of variable inputs.

The average product of labor first increases with the number of labor (i.e. TP increases faster
than the increase in labor), and eventually it declines.

Graphing the short run production curves

The following figure (Figure 3.1) shows that as the number of the labor hired increases (capital
being fixed), the TP curve first rises, reaches its maximum when L 3 amount of labor is employed,
beyond which it tends to decline. If the numbers of workers fall below L 3, the machine is not
fully operating, resulting in a fall in TP below TP 3. Increasing the number of workers above L 3,
rather results in lower total product because it results in overcrowded and unfavorable working
environment.

Marginal product curve increases until L1 number of labor and reaches its maximum at L1, and
then it tends to fall. The MP L is zero at L3 (when the TP is maximal); beyond which its value
assumes zero indicating that each additional worker above L 3 tends to create over crowded
working condition and reduces the total product. Thus, in the short run, the marginal product of
successive units of labor hired increases initially, but not continuously, resulting in the limit to
the total production. Geometrically, the MP curve measures the slope of the TP. The slope of the
TP curve increases (MP increases) up to L 1, it decreases from L1 to L3 and it becomes negative
beyond L3.
The Law of Diminishing Marginal Returns (LDMR): Short –Run Law of Production
The LDMR states that as the use of an input increases in equal increments (with other inputs
being fixed), a point will eventually be reached at which the resulting additions to output
decreases. When the labor input is small (and capital is fixed), extra labor adds considerably to
output, often because workers get the chance to specialize in one or few tasks. Eventually,
however, the LDMR operates (e.g. it starts operating when the 4 th unit of labor is employed):
when the number of workers increases further, some workers will inevitably become ineffective
and the MPL falls (this happens when the number of workers exceeds L1 in fig 3.1)

34 | P a g e
 Note that diminishing marginal returns results from limitations on the use of other fixed inputs
(e.g. machinery), not from decline in worker quality.

Labor Total product Average Marginal Stage of

product product production
0 0 0 - Stage I
1 3 3 3
2 8 4 5
3 12 4 4
4 15 3.7 3 Stage II
5 17 5.4 2
6 17 2.8 0
7 16 2.2 -1 Stage III
8 14 1.75 -2
Output The average product curve increases up to
L2, beyond which it continuously declines.
The AP curve can be measured by the slope
a
of rays originating from the origin to a point
on the TP curve. For example, the APL at
TP3
L2 is the ratio of TP2 to L2. This is
TP2 TP identical to the slope of ray a.

TP1

Units of labor (variable input)

L1 L2 L3
APL, MPL

35 | P a g e
 Stage I Stage II stage III

APL

Units of labor (variable input)

L1 L2 L3
MPL

Fig 3.1 Total product, average product and marginal product curves

3.3. Efficient Region of Production in the Short-Run

Production can be divided it into three ranges called stages of production.
 Stage I – ranges from the origin to the point of equality of the APL and MPL.
 Stage II – starts from the point of equality of MP L and APL and ends at a point where
MP is equal to zero.
 Stage III – covers the range of labor over which the MPL is negative.

Now, which stage of production is efficient and preferable?

Obviously, a firm should not operate in stage III because in this stage additional units of variable
input are contributing negatively to the total product (MP of the variable input is negative)
because of overcrowded working environment i.e., the fixed input is over utilized.

Stage I is also not an efficient region of production though the MP of variable input is positive.
The reason is that the variable input (the number of workers) is too small to efficiently run the
fixed input; so that the fixed input is underutilized (not efficiently utilized)
Thus, the efficient region of production is stage II. At this stage additional inputs are contributing
positively to the total product and MP of successive units of variable input is declining
(indicating that the fixed input is being optimally used). Hence, the efficient region of production
is over that range of employment of variable input where the marginal product of the variable
input is declining but positive.

36 | P a g e
 3.4. Long Run Production: Production with Two Variable Inputs

Remember that long run is a period of time (planning horizon) which is sufficient for the firm to
change the quantity of all inputs. For the sake of simplicity, assume that the firm uses two inputs
(labor and capital) and both are variable.

The firm can now produce its output in a variety of ways by combining different amounts of
labor and capital. With both factors variable, a firm can usually produce a given level of output
by using a great deal of labor and very little capital or a great deal of capital and very little labor
or moderate amount of both.

Isoquants
An isoquant is a curve that shows all possible efficient combinations of inputs that can yield
equal level of output. If both labor and capital are variable inputs, the production function will
have the following form.
Q = f (L, K)
Given this production function, the equation of an isoquant, where output is held constant at q is

Thus, isoquants show the flexibility that firms have when making production decision: they can
usually obtain a particular output (q) by substituting one input for the other.

Fig 3.2 Isoquant and isoquant map.

Isoquants show the fact that long run
production process is very flexible. A
Capital
firm can produce q1 level of output by
using either 3 capital and 1 labor or 2
3 capital and 3 labor or 1 capital and 6

q3 labor or any other combination of

labor and labor on the curve. The set
2 q2
of isoquant curves q1 q2 & q3 are
1 q1
1 called isoquant map.
Labor
1 3 6

37 | P a g e
Properties of Isoquants
Isoquants have most of the same properties as indifference curves. The biggest difference
between them is that output is constant along an isoquant whereas indifference curves hold utility
constant. Most of the properties of isoquants results from the word ‘efficient’ in its definition.
1. Isoquants slope down ward. Because isoquants denote efficient combination of inputs
that yield the same output, isoquants always have negative slope. Isoquants can never be
horizontal, vertical or upward sloping. If for example, isoquants have to assume zero
slopes (horizontal line) only one point on the isoquant is efficient.
2. The further an isoquant lays away from the origin, the greater the level of output it
denotes since higher isoquants (isoquants further from the origin) denote higher
combination of inputs.
3. Isoquants do not cross each other. This is because such intersections are inconsistent
with the definition of isoquants.
Consider the following figure.

Capital Fig 3.3. Efficiency requires that

isoquants do not cross each other,
Q=20 q=50 because the point of their intersection
implies that there is inefficiency at this
point.

K*

L*

This figure shows that the firm can produce at either output level (20 or 50) with the same
combination of labor and capital (L* and K*). The firm must be producing inefficiently if it
produces q = 20, because it could produce q = 50 by the same combination of labor and capital
(L* and K*). Thus, efficiency requires that isoquants do not cross each other.

38 | P a g e
The Slope of an Isoquant: Marginal Rate of Technical Substitution (MRTS)

The slope of an isoquant (-ΔK/ΔL) indicates how the quantity of one input can be traded off
against the quantity of the other, while output is held constant. The absolute value of the slope
of an isoquant is called marginal rate of technical substitution (MRTS). The MRTS shows the
amount by which the quantity of one input can be reduced when one extra unit of another input is
used, so that output remains constant. MRTS of labor for capital, denoted as MRTS L, K shows
the amount by which the input of capital can be reduced when one extra unit of labor is used, so
that output remains constant.
This is analogues to the marginal rate of substitution (MRS) in consumer theory. MRTS L, K
decreases as the firm continues to substitute labor for capital (or as more of labor is used). In
fig.3.2. to increase the amount of labor from 1 to 3, the firm reduces 1 unit of capital (ΔK=1), to
increase labor from 3 to 6, the firm reduce 1 unit of capital (ΔK=1), and so on. Hence, the firm
reduces lower and lower number of capital for the successive one unit of labor.

The reason is that when the number of capital is large and that of labor is low, the productivity of
capital is relatively lower and that of labor is higher (due to the law of diminishing marginal
returns). Thus, at this point relatively large amount of capital is required to replace one unit of
labor (or one unit of labor can replace relatively large amount of capital). As the employment of
labor increases and that of capital decreases (as we move down ward along the isoquant), quite
the reverse will happen. That is, productivity of capital increases and that of labor decreases.
Hence, the amount of capital that needs to be reduced increase when one extra labor is used
decreases. The fact that the slope of an isoquant is decreasing makes an isoquant convex to the
origin.
MRTS L, K (the slope of isoquant) can also be given by the ratio of marginal products of
factors.
That is,

The Efficient Region of Production: Long Run

39 | P a g e
In principle the marginal product of a factor may assume any value, positive, zero or negative.
However, the basic production theory concentrates only on the efficient part of the production
function, i.e. over the range of output over which the marginal product of factors are positive and
declining. In the short run production function efficient region of production prevails in stage
two (stage II), where MPL >0, but declining.

Similarly, efficient region of production in the long run prevails when the marginal product of all
variable inputs is positive but decreasing. Graphically this can be represented by the negatively
slopped part of an isoquant. The locus of points of isoquants where the marginal products of
factors are zero form the ridge lines. The upper ridge line implies that the MP of capital is zero.
MPK is negative for all points above the upper ridge line and positive for points below the ridge
line. The lower ridge line implies that the MP L is zero. For all points below the lower ridge line
the MPL is negative and positive for points above the line. Production techniques are technically
efficient inside the ridge lines symbolically; in the long run efficient production region can be
illustrated as:
∂ MPL
MPL >0, but ∂ L <0
∂ MPk
, but ∂ K <0
Graphically, efficient region of production is shown as follow:

40 | P a g e
The Long Run Law of Production: The Law of Returns to Scale
The laws of production describe the technically possible ways of increasing the level of
production. Output may increase in various ways. In the long run output can be increased by
changing all factors of production. This long run analysis of production is called Law of returns
to scale.
In the short run output may be increased by using more of the variable factor, while capital (and
possibly other factors as well) are kept constant. The expansion of output with one factor (at
least) constant is described by the law of variable proportion or the law of (eventually)
diminishing returns of the variable factor.
Laws of Returns to Scale: Long Run Analysis of Production
In the long run all inputs are variable. Expansion of output may be achieved by varying all
factors of production by the same proportion or by different proportions. The term returns to
scale refers to the change in output as all factors change by the same proportion. Suppose
initially the production function is
Q0 = f (L, K)
If we increase all factors by the same proportion t, we clearly obtain a new level of output Q*
where, Q* = f (tL, tK)

41 | P a g e
For a Cobb-Douglas production function
, and it is a measure of returns to scale.
 If , we say that there is constant returns to scale.
 If , we have decreasing returns to scale.
 If , we have increasing returns to scale.
Equilibrium of the Firm: Choice of Optimal Combination of Factors of Production

Though different combinations of labor and capital on a given isoquant yield the same level of
output, the cost of these different combinations of labor and capital could differ because the
prices of the inputs can differ.

Thus, isoquant shows only technically efficient combinations of inputs, not economically
efficient combinations. Technical efficiency takes in to account the physical quantity of inputs
whereas economic efficiency goes beyond technical efficiency and seeks to find the least cost (in
monetary terms) combination of inputs among the various technically efficient combinations.
Hence, technical efficiency is a necessary condition, but not a sufficient condition for economic
efficiency. To determine the economically efficient input combinations we need to have the
prices of inputs.

To determine the economically efficient input combination, the following simplifying

assumptions hold true:

Assumptions

1. The goal of the firm is maximization of profit (∏ ¿¿) where ∏ ¿ R−C

Where ∏ ¿¿-Profit, R-revenue and C-is cost outlay.
2. The price of the product is given and it is equal to .

3. The prices of inputs are given (constant).Price of a unit of labor is and that of capital .

Now let’s construct the isocost line, because optimal input is defined by the tangency of the
isoquant and isocost line.

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Isocost Line
Isocost lines have most of the same properties as that of budget lines, an isocost line is the locus
of points denoting all combination of factors that a firm can purchase with a given monetary
outlay, given prices of factors.

Suppose the firm has C amount of cost out lay (budget) and prices of labor and capital are w and
r respectively.

Capital
The equation of the firm’s isocost line is given

C/r as: are

quantities of capital and labor respectively.

Given the cost outlayC , the maximum amounts

Isocost line of capital and labor that the firm can purchase
C C
are equal to r and w respectively. The
straight line that connects these points is the
Labor
iso-cost line.
C/w

This figure shows that the optimal

combination of inputs ( L1 and K 1 ) is
Capital
defined by the tangency of the iso-
cost line (AB) and the highest
possible isoquant ( X 2 ), at point E.
A At this point the slope of iso-cost line
w
Q3 ( r ) is equal to the slope of isoquant
K1 E
MP L
Q2 X 2 ( MP K ).The second order
condition is also satisfied by the
43 | P a g e
convexity of the isoquant.
 Q1

L1 B Labor

At the point of tangency (e) the slope of the isocost line (w/r) is equal to the slope of the
isoquant (MPL/MPK). This constitutes the first condition for equilibrium. The second condition
is that the isoquants be convex to the origin. In summary: the conditions for equilibrium of the
firm are:

(a) Slope of isoquant = Slope of isocost

w MPL X / L
   MRS L , K
r MPK X / K

(b) The isoquants must be convex to the origin, if the isoquant is concave the point of tangency
of the isocost curves does not define an equilibrium position.

Isoquant X2
e2
e1

0 e2 L Fig. 4

Output X2 (depicted by the concave isoquant) can be produced with lower cost at e 2 which lies on
a lower isocost curve than e. (with concave isoquant we have a corner solution).

CHAPTER FOUR: THEORY OF COSTS OF PRODUCTION

4.1. Introduction

In Chapter 3, we examined the firm’s production technology— the relationship that shows how
factor inputs can be transformed into outputs. Now we will see how the production technology,
together with the prices of factor inputs, determines the firm’s cost of production.

Given a firm’s production technology, managers must decide how to produce. As we saw, inputs
can be combined in different ways to yield the same amount of output. For example, one can

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produce a certain output with a lot of labor and very little capital, with very little labor and a lot
of capital, or with some other combination of the two. In this chapter we see how the optimal—
i.e., cost-minimizing—combination of inputs is chosen. We will also see how a firm’s costs
depend on its rate of output and show how these costs are likely to change over time.

We begin by explaining how cost is defined and measured, distinguishing between the concepts
of cost used by economists, who are concerned about the firm’s future performance, and by
accountants, who focus on the firm’s financial statements. We then examine how the
characteristics of the firm’s production technology affect costs, both in the short run, when the
firm can do little to change its capital stock, and in the long run, when the firm can change all its
factor inputs.

4.2. Definition and Measurement of Costs

Before we can analyze how firms minimize costs, we must clarify what we mean by cost in the
first place and how we should measure it. What items, for example, should be included as part of
a firm’s cost? Cost obviously includes the wages that a firm pays its workers and the rent that it
pays for office space. But what if the firm already owns an office building and doesn’t have to
pay rent? How should we treat money that the firm spent two or three years ago (and can’t
recover) for equipment or for research and development?

To produce goods and services, firms need factors of production or simply inputs. To acquire
these inputs, they have to buy them from resource suppliers. Cost is, therefore, the monetary
value of inputs used in production of an item.

We can identify two types of cost of production: social cost and private cost.
Social cost: is the cost of producing an item to the society. This cost is realized due to the fact
that most resources used for production purpose are scarce and some production process, by their
nature, emit dangerous chemicals, bad smell, etc to surrounding society.

Private cost: This refers to the cost of producing an item to the individual producer. Private cost
of production can be measured in two ways: economic costs and accounting costs.

i) Economic cost: Cost to a firm of utilizing economic resources in production.

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In economics the cost of production to the individual producer includes the cost of all inputs used
for the production of the item.

The producer may buy part of the inputs from the market. The actual or out- of- pocket
expenditures that the firm incurs to purchase these inputs from the market are called explicit
costs.
But, the producer can also use his/ her own inputs which are not purchased from the market for
the production purpose. The estimated cost of the non- purchased inputs are called implicit
costs.
Thus, in economics the cost of production includes the costs of all inputs used in the production
process whether the inputs are purchased from the market or owned by the firm himself that is:

ii) Accounting Cost: Actual expenses plus depreciation charges for capital equipment.

For accountant, the cost of production includes the cost of purchased inputs only. Accounting
cost is the explicit cost of production only. Moreover, accountant’s doesn’t consider the cost of
production from the opportunity cost of the resources point of view.

Opportunity Cost: Opportunity cost is the cost associated with opportunities that are forgone
by not putting the firm’s resources to their best alternative use. This is easiest to understand
through an example. Consider a firm that owns a building and therefore pays no rent for office
space. Does this mean the cost of office space is zero? The firm’s managers and accountant
might say yes, but
an economist would disagree. The economist would note that the firm could have earned rent on
the office space by leasing it to another company. Leasing the office space would mean putting
this resource to an alternative use, a use that would have provided the firm with rental income.
This forgone rent is the opportunity cost of utilizing the office space. And because the office
space is a resource that the firm is utilizing, this opportunity cost is also an economic cost of
doing business.

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Sunk Costs: Although an opportunity cost is often hidden, it should be taken into account when
making economic decisions. Just the opposite is true of a sunk cost: an expenditure that has been
made and cannot be recovered. A sunk cost is usually visible, but after it has been incurred it
should always be ignored when making future economic decisions.

Because a sunk cost cannot be recovered, it should not influence the firm’s decisions. For
example, consider the purchase of specialized equipment for a plant. Suppose the equipment can
be used to do only what it was originally designed for and cannot be converted for alternative
use. The expenditure on this equipment is a sunk cost. Because it has no alternative use, its
opportunity cost is zero. Thus it should not be included as part of the firm’s economic costs. The
decision to buy this equipment may have been good or bad. It doesn’t matter. It’s water under the
bridge and shouldn’t affect current decisions.

4.3. Cost Function

Cost function shows the algebraically relation between the cost of production and various factors
which determine it. Among others, the cost of production depends on the level of output
produced, technology of production, prices of factors, etc. hence; cost function is a multivariable
function. Symbolically,

Graphically, cost functions can be illustrated by using a two- dimension diagrams. To do so, first
we observe the relationship between the total cost of production and the level of output (the most
factor determining the cost of production), by assuming that all other factors are constant. Then,
the impact of change in “other factors” such as technology on the cost of production will be
handled by shifting the total cost curves upward or down- ward.

4.4. Short Run vs. Long Run Costs

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Economics theory distinguishes between short run costs and long run costs. Short run costs are
the costs over a period during which some factors of production (usually capital equipment and
management) are fixed. The long- run costs are the cost over a period long enough to permit the
change of all factor of production.

Short Run Costs of the Traditional Theory

To produce more output in the short run, a firm must employ more labor, which means that it
must increase its costs. We describe the relationship between output and cost by using three cost
concepts:
 Total costs (TC)
 Average costs
 Marginal costs
Total costs: In the traditional theory of the firm, total costs are split into two groups: total fixed
costs and total variable costs:
TC = TFC + TVC
Where – TC is short run total cost
TFC is short run total fixed cost
TVC is short run total variable cost
By fixed costs, we mean a cost which doesn’t vary with the level of output. Variable costs, on
the other hand, include all costs which directly vary with the level of output.

Total fixed cost (TFC)

Graphically, TFC is denoted by a straight line parallel to the output axis. The point of
intersection of the TFC line with the cost axis (vertical axis) shows the amount of the fixed. For
example if the level of fixed cost is $ 100, it can be shown as.

Total Variable Cost (TVC)

The total variable cost of a firm has an inverse s- shape. The shape indicates the law of variable
proportions in production. According to this law, at the initial stage of production with a given
plant, as more of the variable factor (s) is employed, its productivity increases. Hence, the TVC

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increases at a decreasing rate. This continues until the optimal combination of the fixed and
variable factors is reached. Beyond this point, as increased quantities of the variable factors(s)
are combined with the fixed factor (s) the productivity of the variable factor(s) declined, and the
TVC increases by an increasing rate. Thus, the TVC has an inverse s-shape due to the law of
diminishing marginal returns. Graphically, the TVC looks the following.

Total Cost (TC)

The total cost curve is obtained by vertically adding the TFC and the TVC i.e., by adding the
TFC and the TVC at each level of output. The shape of the TC curve follows the shape of the
TVC curve. i.e. the TC has also an inverse S-shape. But the TC curve doesn’t start from the
origin as that of the TVC curve. The TC curve starts from the point where the TFC curve
intersects the cost axis.

Figure 4.1. The TFC, TVC

and TC curves. TVC AND
TC have an inverse S-
shape. The vertical distance
between them (TFC) is
constant.

Output per day

Per Unit Costs (average costs)
From total costs we can derive per-unit costs. These are even more important in the short run
analysis of the firm. Average fixed cost (AFC) - is found by dividing the TFC by the level of
output.

That is
Graphically, the AFC is a rectangular hyper parabola. The AFC curve is continuously decreasing
curve, but decreases at a decreasing rate and can never be zero. Thus, AFC gets closer and closer

49 | P a g e
to zero as the level of output increases, because a fixed amount of cost is being divided by
increasing level of output.

C Fig 4.2 the average fixed

cost curve is derived from
the total fixed cost, and it
represents the slope of
straight lines drawn from the
origin to a given point on the
TFC curve.
AFC

Average Variable Cost (AVC)

The AVC is similarly obtained by dividing the TVC with the corresponding level of output.

Graphically, the AVC at each level of output is derived from the slope of a line drawn from the
origin to the point on the TVC curve corresponding to the particular level of output.

The following graph clearly shows the process of deriving the AVC curve from the TVC curve.

C TVC C

AVC
d

50 | P a g e
 d
a

b c b c
a

Q
0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

Panel A Panel B
Fig 4.3: Iin the figure above, the AVC at Q1 from panel A is given by the slope of the ray 0a, the AVC at
Q2 is given by slope of the ray 0b, and so on. The slope of the rays decreases until Q 3 and starts to rise
beyond Q3.

Marginal Cost (MC)

The marginal cost is defined as the additional cost that the firm incurs to produce one extra unit
of the output. The MC is the change in total cost which results from a unit change in output i.e.
MC is the rate of change of TC with respect to output, Q or simply MC is the slope of TC
function and given by:

In fact MC is also the rate of change of TVC with respect to the level of output.

, since

Given the inverse S-shaped TC (or TVC) curve, the MC curve is U-shaped. That is, given
inverse S-shaped TC or TVC curve, the slope of the TC or TVC curve (i.e. MC) initially
decreases, reaches its minimum and then starts to rise.

From this, we can logically infer that the reason for the U-shaped ness of MC is also the law of
variable proportion. That is, had the TC or TVC curve not been inverse S-shaped, the MC curve
have would never assumed the U-shape, and obviously, the TC or TVC is inverse S-shaped due
to the law of variable proportions. See Figure 4.7 below.

51 | P a g e
The Relationship between AVC, ATC and MC

Given ATC = AVC + AFC, AVC is part of the ATC. Both AVC and ATC are U – shaped,
reflecting the law of variable proportions, however, the minimum of ATC occurs to the right of
the minimum point of the AVC (see the following figure). This is due to the fact that ATC
includes AFC which continuously decreases as the level of output increases.

After the AVC has reached its lowest point and starts rising, its rise is over a certain range is
more than offset by the fall in the AFC, so that the ATC continues to fall (over that range)
despite the increase in AVC. However, the rise in AVC eventually becomes greater than the fall
in AFC so that the ATC starts increasing. The AVC approaches the ATC asymptotically as
output increases (See Figure 4.4).

C C

TC
MC
52 | P a g e
 S

Q Q

Qs Qs
Panel-1 Panel-2

C Fig 4.4: The AVC curve reaches its minimum point at Q1

AC
MC

AVC

AFC

Q
Q1
Q2

Finally, the MC curve passes through the minimum point of both ATC and AVC curves. Now,

i) when MC<AC, the slope of AC is negative, i.e. AC curve is decreasing (initial

stage of production)
ii) When MC >AC, the slope of AC is positive, i.e. the AC curve is increasing
(after optimal combination of fixed and variable inputs).

53 | P a g e
 iii) When MC = AC, the slope of AC is zero, i.e. the AC curve is at its minimum
point.
The relationship between AVC and MC can be shown in a similar fashion.

4.2. Production and Costs in the Long Run

This section discusses long-run costs. As noted, in the long run, there are no fixed inputs and no
fixed costs. Consequently, the firm has greater flexibility in the long run than in the short run.
(Because we discuss both short-run and long-run average total cost curves, we distinguish
between them with prefixes: SR for short run and LR for long run.).

The Expansion Path and Long-Run Costs

The curve passing through the points of tangency between the firm’s isocost lines and its
isoquants is its expansion path. The expansion path describes the combinations of labor and
capital that the firm will choose to minimize costs at each output level. As long as the use of both
labor and capital increases with output, the curve will be upward sloping. In this particular case
we can easily calculate the slope of the line. As output increases from 100 to 200 units, capital
increases from 25 to 50 units, while labor increases from 50 to 100 units. For each level of
output, the firm uses half as much capital as labor. Therefore, the expansion path is a straight line
with a slope equal to

In (a), the expansion path (from the origin through points A, B, and C) illustrates the lowest cost
combinations of labor and capital that can be used to produce each level of output in the long run
—i.e., when both inputs to production can be varied. In (b), the corresponding long-run total cost
curve (from the origin through points D, E, and F) measures the least cost of producing each
level of output.

Figure 4.5: Expansion

path and long-run TC
curve.

54 | P a g e
Long-Run Average Total Cost Curve

Figure 4.6 shows the relationship between short-run and long-run cost. Assume that a firm is
uncertain about the future demand for its product and is considering three alternative plant sizes.
The short-run average cost curves for the three plants are given by SAC 1, SAC2, and SAC3. The
decision is important because, once built, the firm may not be able to change the plant size for
some time.

Figure 4.6 illustrates the case in which there are three possible plant sizes. If the firm expects to
produce q0 units of output, then it should build the smallest plant. Its average cost of production

55 | P a g e
would be $8. (If it then decided to produce an output of q1, its short run average cost would still
be $8.) However, if it expects to produce q2, the middle-size plant is best. Similarly, with an
output of q3, the largest of the three plants would be the most efficient choice.

What is the firm’s long-run average cost curve? In the long run, the firm can change the size of
its plant. In doing so, it will always choose the plant that minimizes the average cost of
production.

The long-run average cost curve is given by the crosshatched portions of the short-run average
cost curves because these show the minimum cost of production for any output level. The long-
run average cost curve is the envelope of the short-run average cost curves—it envelops or
surrounds the short-run curves.

Now suppose that there are many choices of plant size, each having a different short-run average
cost curve. Again, the long-run average cost curve is the envelope of the short-run curves. In
Figure 4.6 it is the curve LAC. Whatever the firm wants to produce, it can choose the plant size
(and the mix of capital and labor) that allows it to produce that output at the minimum average
cost.
The long-run average cost curve exhibits economies of scale initially but exhibits diseconomies
at higher output levels.

To clarify the relationship between short-run and long-run cost curves, consider a firm that wants
to produce output q1. If it builds a small plant, the short-run average cost curve SAC 1 is relevant.
The average cost of production (at B on SAC1) is $8. A small plant is a better choice than a
medium-sized plant with an average cost of production of $10 (A on curve SAC2). Point B would
therefore become one point on the long-run cost function when only three plant sizes are
possible. If plants of other sizes could be built, and if at least one size allowed the firm to
produce q1 at less than $8 per unit, then B would no longer be on the long-run cost curve.

In Figure 4.6, the envelope that would arise if plants of any size could be built is U-shaped. Note,
once again, that the LAC curve never lies above any of the short-run average cost curves. Also
note that because there are economies and diseconomies of scale in the long run, the points of

56 | P a g e
minimum average cost of the smallest and largest plants do not lie on the long-run average cost
curve.

Finally, note that the long-run marginal cost curve LMC is not the envelope of the short-run
marginal cost curves. Short-run marginal costs apply to a particular plant; long-run marginal
costs apply to all possible plant sizes. Each point on the long-run marginal cost curve is the
short-run marginal cost associated with the most cost-efficient plant. Consistent with this
relationship, SMC1 intersects LMC in Figure 4.6 at the output level q0 at which SAC1 is tangent
to LAC.

57 | P a g e
 CHAPTER FIVE
PRICE AND OUTPUT DETERMNATION UNDER PERFECT
COMPETTION
5.1. Perfect Competition
When you hear that word, you may think of an intense, personal rivalry, like that between two
boxers competing in a ring or two students competing for the best grade in a small class. But
there are other, less personal forms of competition. If you took the SAT exam to get into college,
you were competing with thousands of other test takers in rooms just like yours, all across the
country. But the competition was impersonal: You were trying to do the best that you could do,
trying to outperform others in general, but not competing with any one individual in the room. In
economics, the term “competition” is used in the latter sense. It describes a situation of diffuse,
impersonal competition in a highly populated environment. Thus, perfect competition is a market
structure characterized by a complete absence of rivalry among the individual firms.

Assumptions

The model of perfect competition was constructed based on the following assumptions or
imaginations.

1. Large number of sellers and buyers.

The presence of a great many independent participants on each side of the market, none of whom
is large in relation to total industry sales or purchases, normally guarantees that individual
participants’ actions will not significantly affect the market price and overall industry output. In
a market with many firms, each firm recognizes that its impact on the overall market is
negligible, and consequently does not view other firms as personal rivals.

2. Products of the firms are homogeneous/ standardized/identical.

All the firms in the industry must be producing a standardized or homogeneous product. In
consumers’ eyes, the goods produced by the industry’s firms are perfect substitutes for one
another. This assumption allows us to add the outputs of the separate firms and talk meaningfully
about the industry and its total output. It also contributes to the establishment of a uniform price
for the product. One farmer will be unable to sell corn for a higher price than another if the

58 | P a g e
products are viewed as interchangeable, because consumers will always purchase from the lower
priced source.

When differences among firms’ products matter to buyers, the market is not perfectly
competitive. For example, most consumers perceive differences among the various brands of
coffee on the supermarket shelf and may have strong preferences for one particular brand.
Coffee, therefore, fails the standardized product test of perfect competition. Other goods and
services that would fail this test include automobiles, colleges, and magazines.

3. Free entry and exit of firms

Industry adjustments to changing market conditions are always accompanied by resources

entering or leaving the industry. As an industry expands, it uses more labor, capital, and so on;
resources enter the industry. Similarly, resources leave a contracting industry. A perfectly
competitive market requires that there is no differential impediment across firms in the mobility
of resources into, around, and out of an industry. This condition is sometimes called free entry
and exit. A perfectly competitive market has no significant barriers or special costs to
discourage new entrants. Any firm wishing to enter can do business on the same terms as firms
that are already there.

In many markets, however, there are significant barriers to entry. For example, local zoning laws
may place strict limits on how many businesses—movie theaters, supermarkets, hotels—can
operate in a local area. The brand loyalty enjoyed by existing producers of breakfast cereals,
instant coffee, and soft drinks would require a new entrant to wrest customers away from
existing firms—a very costly undertaking.
4. Negligible Transaction Costs
Perfectly competitive markets have very low transaction costs. Buyers and sellers do not have to
spend much time and money finding each other or hiring lawyers to write contracts to execute a
trade. If transaction costs are low, it is easy for a customer to buy from a rival firm if the
customer’s usual supplier raises its price.

59 | P a g e
 5. The goal of all firms is profit maximization.

Of course, firms can have different objectives. Some firms may have the aim of making their
product wise, others may want to maximize their sales even by cutting price, etc. But, in this
model, it is assumed that the goal of all firms is to maximize their profit and no other goal is
pursued.

6. No government regulation
By assumption, there is no government intervention in the market. That is there is no tax,
subsidy etc.

7. Perfect knowledge

In perfect competition, both buyers and sellers have all information relevant to their decision to
buy or sell. For example, they know about the quality of the product, and the prices being
charged by competitors. In most agricultural and commodities markets—wheat, copper, crude
oil, or platinum—traders are well informed in this way. In most other types of markets, buyers
and sellers are reasonably well informed. For example, if you buy a shirt at the Gap, you have a
very good idea what you are getting, and you can easily find out the prices being charged for
similar items in other stores.

Probably no industry completely satisfies all four conditions. Agricultural markets come close,
although government involvement in such markets keeps them from fully satisfying the above
conditions. Most industries satisfy some conditions well but not others. Even though the number
of market participants in the gasoline retailing business is large and entry into the business is
fairly easy, for example, not all gasoline brands are the same. Some brands have higher octane
and more detergents, and are better for the environment. Certain stations are closer to particular
consumers and thereby more convenient, or offer better complements such as full service, food-
marts, and pumps that allow customers to pay for their purchases by inserting a credit card.
Moreover, consumers are rarely perfectly informed about the prices all retailers are charging.

60 | P a g e
In reality, perfectly competitive markets are scarce if not none. But since the theory of perfectly
competitive market helps as a bench mark to analyze the more realistic markets, it is very
important to study it.
5.2. Demand and Revenue Functions under Perfect Competition
Due to the existence of large number of sellers selling homogenous products, each seller is a
price taker in perfectly competitive market. That is, a single seller cannot influence the market
by supplying more or less of a commodity. Thus firms operating in a perfectly competitive
market are price takers and sell any quantity demanded at the ongoing market price. Hence, the
demand function that an individual seller faces is perfectly elastic (or horizontal line). Given the
horizontal demand function at the ongoing market price, the total revenue of a firm operating
under perfect competition is given by the product of the market price and the quantity of sales,
i.e., TR = P*Q
Graphically,

Fig 5.1 The demand curve of a perfectly competitive firm.

61 | P a g e
 The marginal revenue (MR) and average revenue (AR) of a firm operating under perfect
competition are equal to the market price. To see this, let’s find the MR and AR functions from
TR functions.

By definition, MR is the change in total revenue that occurs when one more unit of the output is
dTR
MR= =P
sold, i.e. dQ .Hence MR=P. Average revenue is the TR divided by the quantity of
TR P . Q
AR= = =P
sales. i.e. Q Q Hence, AR = P.

Graphically, the TR curve is as shown below.

TR
Fig 5.2 the total revenue of firm
_ operating in a perfectly competitive

TR=PQ
TR=PQ market
The marginal revenue (MR) and
average revenue (AR) of a firm
operating under perfect competition
are equal to the market price.

5.3. Short Run Equilibrium of the Firm

A firm is said to be in equilibrium when it maximizes its profit ( ). Profit is defined as the
difference between total cost and total revenue of the firm:

Under perfect competition, the firm is said to be in equilibrium when it produces that level of
output which maximizes its profit, given the market price. Thus, determination of equilibrium of
the firm operating in a perfectly competitive market means determination of the profit
maximizing output since the firm is a price taker.

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The level of output which maximizes the profit of the firm can be obtained in two ways: total
approach and Marginal approach.

a. Total Approach

Figure 5.3 shows how we identify the most profitable level of output by using the total revenue
and total cost curves. The total revenue curve is a new relationship, but it is a relatively simple
one when we are dealing with a competitive firm. With the price per unit constant, total revenue
rises in proportion to output and is, therefore, drawn as a straight line emanating from the origin.
Its slope, showing how much total revenue rises when output changes by one unit, is marginal
revenue.

In terms of Figure 5.3, the firm wishes to select the output level where total revenue exceeds
total cost by the largest possible amount—that is, where profit is greatest. This situation occurs at

output , where total revenue, , exceeds total cost, , by AB. The vertical distance AB is
total profit at q1. At lower and higher output levels, total profit is lower than AB. Note that at a

lower output level, , for example, the TR and TC curves are diverging (becoming farther
apart) as output rises, indicating that profit is greater at a higher output. This reflects the fact that
marginal revenue (the slope of TR) is greater than marginal cost (the slope of TC) over this

range. At , when the curves are farthest apart (with revenue above cost), the slopes of TR and
TC (the slope of TC at B is equal to the slope of bb) are equal, reflecting an equality between
marginal revenue and marginal cost.

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Fig:5.3 The profit maximizing output level is q1 because it is at this output level that the vertical
distance between the TR and TC curves (or profit) is maximum. For all output levels below q 0
and above q3 profit is negative because TC is above TR.

b. Marginal Approach

In this approach the profit maximizing level of output is that level of output at which:
and MC is increasing.
This approach is directly derived from the total approach. In figure 5.3, the vertical distance
between the TR and TC curve is maximum where a straight line parallel to the TR curve is
tangent to the TC curve. Or simply, the vertical distance between the TC and TR curves is
maximum at output level where the slope of the two curves is equal. The slope of the TR curve

64 | P a g e
constant and is equal to the MR or market price. Similarly, the slope of the TC curve at a given
level of output is equal to the slope of the tangent line to the TC curve at that level of output,
which is equal to MC. Thus the distance between the TR and TC curves (Õ) is maximum when
MR equals MC. Graphically, the marginal approach can be shown as follows.

Fig 5.4: The profit maximizing output is , where MC=MR and MC curve is increasing. The
maximum profit that the firm earns is the shade area, ABCD.

Mathematical derivation of the equilibrium condition

Profit (Õ) = TR-TC
To determine the profit maximizing output we find the first derivative of the Õ function and
equate the result to zero.

d ∏ dTR dTC
= − =0
dQ dQ dQ
= MR – MC = 0
= MR = MC ----------------------------------- (First order condition necessary condition)

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 The equality of MC and MR is a necessary, but not sufficient condition. The sufficient condition
for maximization of II is that the second derivative of the function should be less than zero
(or negative) i.e.

d2 ∏ d 2 TR d 2 TC
<0 2
− 2
<0
dQ 2 Ú dQ dQ
d 2 TR dMR d 2 TR
= , thus
dQ 2 dQ dQ2 is the slope MR. Since MR is horizontal (or constant), the slope of
d 2 TC dMC d 2 TC
is equal dQ and thus, dQ
2 2
MR is equal to zero. Likewise, dQ is the slope of MC,
which is not constant

d 2 TR d2 TC
2
<
Thus, dQ dQ 2 means 0 < Slope of MC or MC is increasing……………. Sufficient
condition
Thus, the condition for profit maximization under perfect competition is
MR= MC………………….necessary condition and
MC is increasing…………. sufficient condition
The fact that a firm is in the short run equilibrium does not necessarily mean that the firm gets
positive profit. Whether the firm gets positive or zero or negative profit depends on the level of
ATC at equilibrium. Accordingly,
 If the ATC is below the market price at equilibrium, the firm earns a positive profit.
 If the ATC is equal to the market price at equilibrium, the firm gets zero profit.
 If the ATC is above the market price at equilibrium, the firm earns a negative profit.
Note that a firm may continue production even while incurring a loss (when TC > TR) as long as
. The price level is known as shut-down price to mean that the firm should
shut-down the business if P<AVC.

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 N
umerical Example

Suppose that the firm operates in a perfectly competitive market. The market price of his product
is$10. The firm estimates its cost of production with the following cost function:

A) What level of output should the firm produce to maximize its profit?
B) Determine the level of profit at equilibrium.
C) What minimum price is required by the firm to stay in the market?
Solution

Given: p=$10
A) The profit maximizing output is that level of output which satisfies the following
condition
MC=MR & MC is rising
Thus, we have to find MC& MR first
 MR in a perfectly competitive market is equal to the market price. Hence, MR=10
dTR
MR=
Alternatively, dq where
d (10 q )
MR= =10
Thus, dq

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 2 3
dTC d (10 q−dq +q )
= =10−8 q+3 q2
MC= dq dq
 To determine equilibrium output just equate MC& MR
And then solve for q.

Now we have obtained two different output levels which satisfy the first order (necessary)
condition of profit maximization i.e. 0 & 8/3
 To determine which level of output maximizes profit we have to use the second order test at the
two output levels i.e. we have to see which output level satisfies the second order condition of
increasing MC.
 To see this first we determine the slope of MC
dMC
Slope of MC = dq = -8 + 6q
ö At q = 0, slope of MC is -8 + 6 (0) = -8 which implies that marginal cost is
decreasing at q = 0. Thus, q = 0 is not equilibrium output because it doesn’t satisfy
the second order condition.
ö At q = 8/3, slope of MC is -8 + 6 (8/3) = 8, which is positive, implying that MC is
increasing at q = 8/3
Thus, the equilibrium output level is q = 8/3

B) Above, we have said that the firm maximizes its profit by producing 8/3 units. To determine
the firm’s equilibrium profit we have calculate the total revenue that the firm obtains at this level
of output and the total cost of producing the equilibrium level of output.
TR = Price * Equilibrium output
= $ 10 * 8/3= $ 80/3
TC at q = 8/3 can be obtained by substituting 8/3 for q in the TC function, i.e.,
TC = 10 (8/3) – 4 (8/3)2 + (8/3)3 » 23.12
Thus the equilibrium (maximum) profit is

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Õ = TR – TC
= 26.67 – 23.12 = $ 3.55
C) To stay in operation the firm needs the price which equals at least the minimum AVC. Thus
to determine the minimum price required to stay in business, we have to determine the minimum
AVC.
AVC is minimal when derivative of AVC is equal to zero
dAVC
That is: dQ = 0
Given the TC function: TC = 10q – 4q2 +q3, there is no fixed cost i.e. TC is equal to the TVC.
Hence, TVC = 10q – 4q2 + q3
TVC 10 q−4 q2 +q3
AVC = q = q = 10 – 4q + q2

dAVC d (10−4 q+q2 )

=0 =0
dq – dq
= -4 + 2q = 0
– q = 2 i.e. AVC is minimum when output is equal to 2 units.
The minimum AVC is obtained by substituting 2 for q in the AVC function i.e., Min AVC = 10
– 4 (2) + 22 = 6
Thus, to stay in the market the firm should get a minimum price of $ 6.
5.4. The Perfectly Competitive Firm and Resource Allocative Efficiency
Producing a good—any good—until price equals marginal cost ensures that all units of the good
are produced that are of greater value to buyers than the alternative goods that might have been
produced. Stated differently, a firm that produces the quantity of output at which price equals
marginal cost ( ) is said to exhibit resource allocative efficiency.

Does the perfectly competitive firm exhibit resource allocative efficiency? We know two things
about this type of firm: First, the perfectly competitive firm produces the quantity of output at

which , and, second, for this firm . If the perfectly competitive firm produces

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the output at which and if for this firm , then it follows that the firm

produces the output at which . In short, the perfectly competitive firm is resource
allocative efficient.

Also, for a perfectly competitive firm, profit maximization and resource allocative efficiency are
not at odds. The perfectly competitive firm seeks to maximize profit by producing the quantity
of output at which and, because for the firm , it automatically accomplishes
resource allocative efficiency ( ) when it maximizes profit ( ).
5.5. The Short Run Supply Curve of the Firm and the Industry
5.5.1. The Short Run Supply Curve of the Firm

Short-run supply curve of perfectly competitive firm is a graph of the systematic relationship
between a product’s price and a firm’s most profitable output level. The part of the MC curve
lying above the minimum point on the AVC curve identifies the firm’s most profitable output at
prices above a shutdown price. Below the shutdown price, the firm will be better off shutting
down. Above the shutdown price, the firm maximizes profit by producing where price equals
marginal cost. Because the MC curve slopes upward, the firm increases output at a higher price.
The solid, dark curve represents the competitive firm’s short-run supply curve. Generally, the
short run supply curve of a perfectly competitive firm is that part of MC curve which lies above
the minimum average variable cost (shutdown point).

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Fig,5.5: The short run supply curve of a perfectly competitive firm is obtained by connecting
different equilibrium points.

5.5.2. Short Run Supply Curve of the Industry

The word ’industry’ is defined as group of firms producing homogeneous products. Defining
industry like this, it is a simple matter to derive the short-run market (industry) supply curve. We
horizontally add the short-run supply curves for all firms in the perfectly competitive market or
industry.

Consider, for simplicity, an industry made up of three firms: A, B, and C [see Exhibit (a)]. At a

price of , firm A supplies 10 units, firm B supplies 8 units, and firm C supplies 18 units. One

point on the market supply curve thus corresponds to on the price axis and 36 units (
) on the quantity axis. If we follow this procedure for all prices, we have the
short-run market supply curve. This market supply curve, shown in the market setting in part (b)

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of the exhibit, is used along with the market demand curve to determine equilibrium price and
quantity.

Fig, 5.6 the industry- supply curve is the horizontal summation (at each price) of the supply curves of all

firms in the industry.

5.6. Prefect Competition in the Long Run

The number of firms in a perfectly competitive market may not be the same in the short run as in
the long run. For example, if the typical firm is making economic profits in the short run, new
firms will be attracted to the industry, and the number of firms will increase. If the typical firm is
sustaining losses, some existing firms will exit the industry, and the number of firms will
decrease. We begin by outlining the conditions of long-run competitive equilibrium.

5.6.1. The Conditions of Long-Run Competitive Equilibrium

The following conditions characterize long-run competitive equilibrium:

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 1. Economic profit is zero: Price (P) is equal to short-run average total cost (SRATC).

The logic of this condition is clear when we analyze what will happen if price is above or below
short-run average total cost. If it is above, positive economic profits will attract firms to the
industry to obtain the profits. If price is below, losses will result, and some firms will want to
exit the industry. Long-run competitive equilibrium cannot exist if firms have an incentive to
enter or exit the industry in response to positive economic profits or losses, respectively. For
long-run equilibrium to exist, there can be no incentive for firms to enter or exit the industry.
This condition is brought about by zero economic profit (normal profit), which is a consequence
of the equilibrium price being equal to short-run average total cost.

2. Firms are producing the quantity of output at which price (P) is equal to marginal cost
(MC).

As previously noted, perfectly competitive firms naturally move toward the output level at which

marginal revenue (or price because for a perfectly competitive firm) equals marginal
cost.

3. No firm has an incentive to change its plant size to produce its current output; that is,

at the quantity of output at which .

To understand this condition, suppose at the quantity of output established in

condition 2. If this is the case, the firm has an incentive to change plant size in the long run
because it wants to produce its product with the plant size that will give it the lowest average
total cost (unit cost). It will have no incentive to change plant size when it is producing the
quantity of output at which price equals marginal cost and SRATC equals LRATC.

The three conditions necessary for long-run competitive equilibrium can be stated as:

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In conclusion, long-run competitive equilibrium exists when firms have no incentive to make any
changes. Specifically, long-run competitive equilibrium exists when there is no incentive for
firms to:

1. enter or exit the industry,

2. produce more or less output, and
3. change plant size

5.6.2. The Perfectly Competitive Firm and Productive Efficiency

A firm that produces its output at the lowest possible per-unit cost (lowest ATC) is said to exhibit
productive efficiency. The perfectly competitive firm does this in long-run equilibrium, as shown
in the above Exhibit. Productive efficiency is desirable from society’s standpoint because it
means that perfectly competitive firms are economizing on society’s scarce resources and
therefore not wasting them.

5.6.3. Long-Run Supply (LRS) Curve

The long-run supply curve shows the relationship between market price and market quantity
produced after all long-run adjustments have taken place.

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We know that economic profit will attract the entry of new firms. And an increase in the number
of firms shifts the market supply curve rightward, which drives down the price until the
economic profit is eliminated. But how far must the price fall in order to bring this about? That
is, how far can we expect the market supply curve to shift? That depends on whether or not the
expansion of the industry causes each firm’s cost curves to shift.

a. Constant Cost Industry

In a constant cost industry, in which industry output has no effect on individual firms’ cost
curves, the long-run supply curve is horizontal. In the long-run, the industry will supply any
amount of output demanded at an unchanged price.

b. Increasing-Cost Industry

In an increasing cost industry, a rise in industry output shifts up each firm’s LRATC curve, so
that zero economic profit occurs at a higher price. The long-run supply curve slopes upward.

The long-run supply curve tells us that an increasing cost industry will deliver more output, but
only at a higher price. It also tells us that, if industry output decreases, the price will drop. This is
because a decrease in output would cause each firm’s LRATC curve to shift downward so that
zero profit would be established at a lower price than initially.

c. Decreasing-Cost Industry

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In a decreasing cost industry, a rise in industry output shifts down each firm’s LRATC curve, so
that zero economic profit occurs at a lower price. The long-run supply curve slopes downward.

The long-run supply curve tells us that in a decreasing cost industry, the more output produced,
the lower the price. On the other hand, if industry output were to fall, the price would rise. This is
because a decrease in output would cause each firm’s LRATC curve to shift upward, so that zero
profit would be established at a higher price than initially.

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 CHAPTER SIX

6. PRICE AND OUT PUT DETERMNATION UNDER

MONOPOLY

6.1. Introduction

Monopoly is defined as a market situation in which a single seller sells a product or provides a
service for which there is no close substitute. In monopoly there are no similar products whose
prices or sales will influence the monopolist price or sales. Since there is a single seller in
monopoly market structure, the firm is at the same time the industry.
In the real world, however, most commodities have other commodities, which can substitute one
another. Ethiopian Electric Power Corporation (EELPA) for example is the sole producer of
electricity in the country for both domestic and industrial uses. While the company enjoys
substantial monopoly power in the industrial market for lack of substitutes for electricity, it has
far less than a monopoly position in the supply for electricity for domestic use because in this
market the company has to compete with sellers of generators, charcoal and firewood.
Monopoly power thus cannot be absolute in the real world situation. What we have in the real
world are firms which control significant part of their various markets.

6.2. Common characteristics of monopoly

Monopoly markets share the following common characteristics.
1. Single seller and many buyers
There is a single seller who sells the product to many buyers.
2. Absence of close substitutes
A product produced by a monopolist has no close substitute so that consumers have no
alternative choices to substitute one product for another.
3. Price maker
Facing a down ward sloped demand curve for its product, the monopolist can change its product
price by changing the quantity of the Product supplied. For example, the monopolist can increase
the price of its product by decreasing the quantity of supply.
4. Barrier to entry

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In monopoly, new competitors cannot freely enter in to the market due to some barriers which
can be economical, technical, legal or other type of barriers.

6.3. Causes for the Emergence of Monopoly

There are many reasons which might lead to the existence of monopoly, but the following seem
particularly important: natural monopoly, absolute ownership of natural resources, high initial
cost of establishing the plant, control over the marketing channels, government licensing, patents
and copyright. Let us have a brief look on each of these.
1. Ownership of strategic or key inputs.
A firm may own or control the entire supply of a raw material required for the production of a
commodity. Ambo Mineral Water can be taken as an example. Ambo mineral water has
monopolized the natural mineral water.
2. Exclusive knowledge of production technique.
Most of the beverage (soft drink) companies such as Coca Cola Company have maintained
monopoly power over supply of their product partly due to exclusive knowledge of the
ingredient chemicals required for the production of their product.
3. Patents and copyright
Patents and copyrights are government supported barriers to entry. Patents are granted by the
government for 17 years as an incentive to investors. Authors of books, artistic works (such as
cassette, video, etc) are the best examples of such monopoly.
4. Government Franchise and License “Legal Monopolies”
Another cause for the emergence of monopoly is government franchise. Franchise is a promise
by the government for a firm to prohibit the establishment of another firm (by another person)
that produces the same product or offers the same service as the original one.
5. Natural Monopoly: Economies of scale may operate (i.e. the long run average cost may
fall)
Another cause for the emergence of monopoly is economies of scale (efficiency) in production.
A firm is said to have economies of scale if its long run average cost is declining. In such a
situation, when the incumbent firm observes that new firms are entering into the market, it will
produce large amount of output to minimize its unit cost of production and will charge a lower
price than the new firms to deter entry. Such a monopoly is called natural monopoly.

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 6. High Initial Cost of Establishing Plant

Some products involve very large financial outlays in the establishment of plants before
production can start. This is typical of the aircraft industry in both United Kingdom and United
States for example. The high cost of establishing air craft industry denies the opportunity of
many developing countries in setting up such industries.
7. Control over the Marketing Channels
Some firms become monopolies because of their exclusive control over marketing channels for
certain products. Since it is meaningless to produce a product which cannot be sold, obviously
potential firms which could produce the same product are forced to stay out of the industries
because they will never gain access to the market.

6.3. The Demand and Revenue Curves of the Monopoly Firm

A monopolist firm is at the same time the industry and thus, it faces the negatively sloped
market (industry) demand curve for the commodity. In other words, because a monopolist is the
sole seller of a commodity, it faces a down ward sloping demand curve. This means, to sell more
units of the commodity, the monopolist must lower the commodity price.

Conversely, if the monopolist decides to raise the price of the product, it will reduce the quantity
of supply without worrying about the competitors, who by charging lower prices would capture a
large share of the market (customers) at the expense of him. So the monopolist can manipulate
the price of its commodity by changing the quantity of supply. To sell more units of the
commodity, the monopolist will charge lower price and vice versa. Hence, the demand curve
facing the monopolist is negatively sloped, showing the inverse relationship between market
price and quantity demanded.

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 P1

P2

Q
Q1 Q2

Fig.6.1 the demand curve facing the monopolist firm is down wards sloping.

Mathematically, assuming that the demand curve is linear, it can be written in the following
form. P = a – bQ; Where P – is the market price, Q – is the quantity of sales (quantity
demanded)
a&b – are any positive constants
The total revenue of the monopolist can be obtained by multiply the market price with the
quantity of sales. That is, TR = P.Q
Substituting (a – bQ) for P
TR = (a - bQ) Q
TR = aQ – b Q2
Hence the total revenue curve of the monopolist firm has an inverse U- shape. The total revenue
of a monopolist firm first increases with the quantity of sales (over the elastic range of the
demand curve), reaches its maximum (when the demand curve is unitary elastic), and finally
decreases when quantity of sales increases (over the inelastic range of the demand curve) the
following figure illustrates this fact.

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Price

9
8
7 total revenue
6
5 elastic demand
4
3 unitary elastic
2
1 inelastic demand
0
1 2 3 4 5 6 AR Quantity/Unit of time

Fig: 6.2 the shape of total revenue curve and its relationship with the price elasticity of demand. When
Ep>1 TR and Q have positive relation, at a point where Ep=1, TR curve reaches its maximum and when
EP<1, TR and Q have negative relation.

The MR curve of monopolist firm is down ward sloping (decreases with quantity of sales). The
fact that the monopolist must lower the price to increase its sales causes the MR to be less than
price except for the first unit. This is so because when the firm reduces the commodity price to
sell one more unit all units which would have been sold at the original higher price will now be
sold at the new (lower) price. Hence for a down ward sloping demand curves (in monopoly) the
MR of the firm is less than the market price. Note that the AR of a monopolist is always identical
to the P or demand curve.

Mathematically, it can be shown that MR is less (twice steeper) than the AR or demand curve.
Suppose a monopolist’s demand curve is given by
P = a – bQ
Where a&b - are any positive constants
P&Q – are price and quantity respectively.

TR = P.Q = (a - bQ) Q

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 = aQ – bQ2
By definition MR is change in TR that happens due to a one unit change in quantity of sales.
Symbolically,

dTR d (aQ−bQ2 )
MR= = =a−2 bQ
dQ dQ
Thus, MR = (a – 2bQ) has a slope which equals twice the slope of demand (average revenue)
curves. This implies that MR is less than AR or demand or price.
P

Ep>1

Ep=1

Ep<1

P1
DD

MR
Figure 6.3: The relationship between MR and P. The MR of a monopolist lies below the commodity
price for each unit sold (except the first unit) and it is negative over the inelastic range of the demand
curve.

6.4. Profit Maximization in the Short Run

Under monopoly, the firm is a price maker and has a power to alter the level of output. Thus,
profit maximization under monopoly involves determination of the price and output
combination that yields the firm the maximum possible profit.

The profit maximizing level of output is that level of output at which marginal cost curve cuts
the marginal revenue curve from below. The equilibrium (profit maximum) price is the price
corresponding to the equilibrium price from the demand curve. Consider the following figure:

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 Fig. 6.4 Short- run equilibrium of the monopolist:

Note that, a monopolist charges a price which exceeds the MC of production, unlike the case of
the perfectly competitive firm.
Mathematically, the profit maximizing condition of MR = MC and MC is increasing can be
shown as follows.
∏ = TR – TC
∏ is maximized when

That is,

 MR – MC = 0
 MR = MC ………………………….. first order condition
The second order condition of profit maximization is

That:

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Slope of MR- slope of MC<0
Slope of MC > slope of MR ------- the second order condition

Numerical example

Suppose the monopolist faces a market demand function given by P=40-Q. The firm has a fixed
cost of $ 50 and its variable cost is given as TVC=Q2 determine:
a) the profit maximizing unit of output and price
b) the maximum profit

Solution
Given: p=40-Q
TFC=50
TVC= Q2
a) equilibrium condition is MR=MC, and slope of MC>slope of MR.

TR=P.Q = (40-Q) Q =40Q- Q2

TC=TFC+TVC =50 + Q2

Now,

dTC d(50+ Q 2 )
MC= = =2 Q
dQ dQ

MR=MC 40-2Q=2Q
40=4Q
Q=10

dTR
Second order condition: slope of MR= =−2
dQ
dMC
MC= =2
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 Slope of

dMC dMR (the second order condition is met)

>
dQ dQ
Thus, the profit maximizing level of output is 10 and the profit maximizing price is obtained by
substituting the profit maximizing quantity (10) in the demand function.
Hence, P = 40 – Q
P = 40 – 10 = 30
b) The maximum profit is the level of profit obtained from selling 10 units at $ 30 each.
∏ = TR – TC
But TR = P.Q
= $ 30 * 10 = $ 300
TC = 50 + Q2 = 50 + 102 = $ 150
The maximum ∏ is thus $ 300 - $ 150 = $ 150.

Note: There is no unique supply curve under monopoly. In monopoly supply price is not
unique. A given quantity could be supplied at different prices and different quantities can be sold
at the same price, depending on market demand and marginal revenue. Hence there is no one to
one correspondence between P and Q under monopoly.
6.5. Long – Run Equilibrium under Monopoly
A monopolist maximizes its long run profit when it produces and sells that output level
where LMC = MR , slope of LMC being greater than the slope of MR at the point of
intersection, and the optimal plant size is the one whose SAC curve is tangent to the LAC at
the point corresponding to long run equilibrium output. Let’s illustrate the equilibrium
situation graphically.

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 SMC1
P1
C SAC1 LAC

SMC2 LMC

Pe SAC2

MR
DD

Q
Q1 Qe

Fig 6.6 Suppose initially the monopolist builds the plant size having the costs SAC1 and SMC1 the
equivalence of SMC1 and MR leads into producing and marketing output levels Q1 and P1, making a unit
profit of P1 – C, since the monopolist is making a positive profit, it decide to continue its operation and
looks for a more profitable plant size in the long run. This long run plant is attained when LMC = MR,
and the corresponding output level and price are Qe and Pe respectively.

Finally, it should be noted that there is no certainty in the long run that the monopolist will reach
the optimal plant size (minimum LAC), as in perfectly competitive case. The monopolist may
reach optimal plant size or even may exceed the optimal size if the market demand allows him
(or if there is enough demand which absorb that level of output).

6.5. Ways to Reduce Market Power

To reduce the negative impact on society, governments often try to limit the market power of
monopolists. Some popular measures include:

a. Price regulations. If it can be known what market price would have been under perfect
competition, or if the cost of production is known, the government can decide on a price
ceiling at that price. Thereby, the equilibrium point is moved to the optimal point from
society’s viewpoint. It is, however, very difficult to estimate the optimal price.

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 b. Increase competition. If the monopoly has been created through political decisions, the
regulation can be changed.

6.6. Price Discrimination

Price discrimination refers to the charging of different prices for the same good. But not all price
differences are price discrimination. If the costs of offering a certain uniform commodity
(service) to different group of customers are different (say due to difference in transport costs),
price of the commodity may differ for each group owing to this cost difference. But this cannot
be considered as price discrimination. A firm is said to be price discriminating if it is charging
different prices for the same commodity without any justification of cost differences.

Necessary conditions for price discrimination

For a firm to effectively practice price discrimination the following necessary conditions should
be fulfilled.
1. There should be effective separation of markets for different classes of consumers, so that
buyers of low price market cannot resale the commodity in high price market.
2. The second necessary condition to successfully practice price discrimination is that the
price elasticity of demand should be different in each sub market.
3. Lastly, the market should be imperfectly competitive.
Degrees (types) of price discrimination

The degree of price discrimination refers to the extent to which a seller can divide the market and
can take advantage of it in extracting the consumer surplus. In economics literature, there are
three degrees of price discrimination.
a) First degree price discrimination (Perfect price discrimination)
This is a price discrimination in which the monopolist attempts to entirely take away the
consumers surplus. Ideally, a firm would like to charge each customer the maximum price that
the customer is willing to pay for each unit bought. We call this maximum price the consumer’s
reservation price and obviously, the consumers’ reservation prices are different due to the
differences in their economic status or the value they attach to a commodity. The practice of
charging each customer his/her reservation price is called first degree price discrimination.

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Perfect price discrimination is efficient as it maximizes the total welfare, where welfare is
defined as the sum of consumer surplus and producer surplus. That is, there is no welfare loss
associated with first degree price discrimination equilibrium. The problem with perfect price
discrimination is that it hurts consumers because the monopolist will take the entire of the
consumer surplus. The other problem with perfect discrimination is that it involves high
transaction costs; it is too difficult and costly to gather information about each customer’s price
sensitively.

b) Second degree price discrimination (block pricing)

The act of charging different prices for different quantities of purchases is called second degree
price discrimination or sometimes called quantity discrimination. In second degree price
discrimination the price various only with quantity: all customers pay the same price for a given
quantity.

In second degree price discrimination, the monopolist attempts to take the major part of the
consumer surplus instead of the entire of it.
Block pricing can feasibly be implemented where:
The number of consumers is large and price rationing can be effective e.g. electricity
and telephone services.
the demand curves of all customers are identical and
a single rate is applicable for a large number of buyers.

c) Third degree price discrimination (multi-market price discrimination)

Typically, a firm does not know the reservation price for each of its customers. But, the firm may
know which groups of customers are likely to have higher reservation prices than others. In such
a situation the firm may divide potential customers in to two or more groups and set a different
price for each group. Such an action of charging different prices in different markets is called
third degree price discrimination. All units of the good sold to customer with in a group (in one
market) are sold at a single price, but prices will differ among the different groups or markets.

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 CHAPTER SEVEN
PRICE AND OUTPUT DETERMINATION UNDER MONOPOLISTIC
COMPETITION AND OLIGOPOLY
7.1. Monopolistic Competition

In many industries, the products that firms produce are differentiated. For one reason or another,
consumers view each firm's products as different from those of other firms. Product differentiation is
the major characteristic of monopolistically competitive market structure. A monopolistically
competitive market combines the characteristics of competitive and monopoly markets.

The following are some of the basic assumptions of a monopolistic competition market:

 There is a large number of sellers and buyers in market

 The products of the sellers are differentiated, yet they are close substitutes of one another.

 There is free entry and exit of firms in the market

 The goal of the firm is profit maximization both in the short run and long run

 The prices of factors of production (labor, capital, etc) and technology are given

The Demand Curve: since each firm produces a differentiated product, it holds the monopoly

power over its own products and the firm has some power to influence the market price of its

products.

Equilibrium Conditions in Monopolistically Competitive Market

Product differentiation allows each firm to change different prices. There will be no unique

equilibrium price, but an equilibrium cluster of prices, reflecting the preferences of consumers for

the products of the various firms in the group. When the market demand shifts or cost conditions

change in a way affecting all firms, then the entire cluster of prices will rise or fall simultaneously.

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7.2. Oligopoly

Oligopoly is a form of market structure in which a few sellers sell homogeneous or differentiated

products. An oligopoly is an industry with small number of sellers. How small is small cannot be

decided in theory but only in practice. Nevertheless, in principle, the criterion is whether firms take

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in to account their rivals’ actions in deciding upon their own action or not. In other words, the

essence of oligopoly is recognized interdependence among firms.

Characteristics of Oligopoly Market

The basic characteristics of oligopolistic market structure are the following:

A. Keen (or intense) competition between firms: The number of firms is small enough that each

seller takes into account the actions of other firms in its pricing and output decisions. In other

words, each firm keeps a close watch on the activities of the rival firms and prepares itself with a

number of aggressive and defensive marketing strategies.

B. Interdependence: the nature and degree of competition makes firms interdependent in respect of

decision making.

C. Barrier to entry: in oligopoly market firms are small enough in number implies there is barrier

for new firms to enter into the market. Some common barriers to entry are economies of scale,

patent rights, and control over important inputs by existing firms.

In general unpredictable action and reaction will make it difficult to analyze oligopoly market. Firms

may come ‘in collusion with each other’ or ‘may try to fight each other on the death.’ Accordingly

we can classify oligopoly market structure as:

 Non-collusive Oligopoly and

 Collusive Oligopoly

A) Non- Collusive Oligopoly

Oligopoly firms may cooperate (collude) or may not cooperate (no- collusion) in some activities

with respect to their businesses depending on their interest and agreement. If firms do not cooperate,

their decision-making process is analyzed using the non- collusive model. Under this model we have

the Cournot's duopoly model, the 'kinked- demand' model, Bertrand Duopoly model and

Stackelberg’s Duopoly model.

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 B) Collusive Oligopoly

Sometimes firms form collusion each other in many actions to avoid uncertainty or competition

among themselves. This collusion helps the oligopolist firms to act like a monopoly. The two main

types of collusion, cartels and price leadership.

1. Cartels

Cartels imply direct agreements among the competing oligopolist with the aim of reducing the
uncertainty arising from their mutual interdependence. Based on this objective, the general purpose
of cartels is to centralize certain managerial decisions and functions of individual firms with a view
to promoting commons benefits.

There is one typical example of cartels i.e., OPEC (Oil and Petroleum Exporting Countries). These
countries (or oil producing firms) form the organization called OPEC and this OPEC acts as decision
maker and all firms are governed under it.
The two typical Services of a cartel are
A) Fixing price for joint maximization of firms profit and
B) Market- sharing between its members firms. Now let us look these two functions one by one
A) Cartels aiming at joint profit maximization
For the purpose of this analysis we concentrate on a homogenous or pure oligopoly, i.e., all firms
produce a homogenous products. The equilibrium analysis is similar to that of the multi-plant
monopolist. The cartel ( the central agency ) acting as a multi- plant monopolist, will set the profit
maximizing price defined by the intersection of the industry MR and MC curves of firms as shown
below.

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 a- Firm 1
b- Firm 2 c- Industry
MR

For simplicity we assume that there are only two firms in the cartel, firm 1 and firm 2. Given the
market demand D in figure c the monopoly solution, which maximizes joint profits, is determined by
the intersection of MC and MR, at point e. The total output is X=X 1 +X2 and sold at price P. Now
once the central agency decides these variables (P and X) it allocates the production among firms 1
and firm 2 as a monopolist would do, i.e., by equating the common MR to the individual MCs’.

Since all firms have the same price P, their MRs, are also the same. Therefore at equilibrium points,
i.e., at point e, MC=MR and at point e 2 MC2=MR. Thus firm 1 produces X1 and B produces X2. The
firm with the lower cost produces a larger amount of output but the distribution of profits is decided
by the central agency of the cartel.

B) Market - Sharing Cartels

As noted above the second service of the cartel is to share the market between its members. There
are two basic methods for sharing the market: non - price competition and determination of
quotas.
Non - price competition agreements: firms agree on a common price, at which each of them can sell
any quantity demanded. The agreed price must be such as to allow some profits to all members. In
this type of agreement firms cannot sell at lower price but they can use different kinds of selling
activities (e.g. changing style, package, etc). In other words by using these selling activities firms
can have a larger share of the market- called non price competition.

This form of cartel is indeed ' loose', in the sense that it is more unstable than the cartel aiming at
joint profit maximization. Because, since there are cost differences among firms, the low cost firms
will have a strong incentive to break the agreement and sell at lower price or to cheat the other

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members by secret price concessions to the buyers. Then the price war and instability of the
agreement occur.
Sharing the market by agreement on quotas: if all firms have identical costs, the monopoly solution
will emerge with the market being shared equally among the firms. But if costs are different, the
quotas and shares are determined by bargaining power (or skill) of firms.
2. Price Leadership

Price leadership is another form of collusion. In this form of coordination one firm sets the price and
the other follows it. There are various forms of price leadership .The most common types of
leadership are price leaderships by a low- cost firm and price leadership by a large (dominant)
firm.

a. The Model of the Low -Cost Price Leader

Due to economies of scale, efficiency, etc. a firm in the oligopoly market can be a low- cost firm.
Thus this firm takes the lead to charge price of the commodity and other firms will follow the action.
To look the model, let us assume there are two firms, which produce a homogenous product at
different costs. The firms may have equal markets (figure 1) or they may have unequal markets
(figure 2) according to their agreement as shown below.

As you observe in the figures below, firm A is the low- cost firm and it takes a lead to charge price
and the high cost firm (i.e., firm 2) will follow this price. In figure 1 firm A, a leader, determines its
price PA that maximizes its profit at the output level (x1) where MCA= MR and firm B, the follower
takes this price PA through it does not maximize its profit by producing X2 (at X2, MCB > MRB).

Here you should note that since both firms sell the same amount at the same price, both firms have
the same demand curve d and one marginal revenue curve MR1= MR2 in figure1 below. The market
demand curve is D. In figure1 both firms will sell the same quantity X 1 =X2 at the same price P A.
However, firm B's profit maximizing price and output would be P B and XBe respectively. At price PA
the
market
demand
is X = X1 +
X2 .

Figure 1 Figure 2
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In figure 2 since both firms have not equal market share their demand and marginal revenue curves
are different. Here also firm A, the leader, decides price P A according to the marginal rule MR A =
MCA, maximizes it’s Profit by selling X A, but firm B taking this price P A will sell XB, not
maximizing profit. As in figure1 firm B could maximize profit if it charged price P B. To avoid price
war firm B accepts the price set by firm A, PA.

b. Price leadership by the dominant firm

In this model it is assumed that there is a large dominant firm which supplies a large proportion of
the total market, and some smaller firms, each of them having a small market share. Thus if this
dominant firm increases or decreases price the other firms will follow it. The dominant firm sets its
price so as to maximize its profit (the point where its MR=MC) but the followers may or may not
maximize their profits depending on their cost structures.

Now let us look a mathematical model how a dominant firm sets its profit maximizing price and
output. Here we represent the market demand by D and the total output that is supplied by the
smaller firms by S then the output sold by the dominant firm will be
X= D - S
Let us assume S= aP and D=b – cP
Using the above function, the dominant firm’s demand function is
X=D-S
X = b - cP - aP

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X = b – (c + a)P,
The inverse demand function is
(c + a)P = b - X
P=b–X
(c + a)

Total revenue of the dominant firm will be:

If the cost function of the dominant firm is given as C = dX
It will maximizes its own profit as TR - TC

Then to determine its profit maximizing level of out put the dominant firm will set the first
derivative of its profit function with respect to X must be equal to zero. After determining this level
of output the dominant firm will set at what price will it sell the product. And the small firms will
follow this decided price by the dominant firm. And this is called price leadership by a dominant
firm.
A Summary of Market Structure

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