8/7/19

§ LECTURE 1 - INTRODUCTION

AGENDA § Prof. THIAGU RANGANATHAN

• SCARCITY, CHOICE, AND OPPORTUNITY COSTS

• OPTIMIZATION

• MARGINAL ANALYSIS

• EQUILIBRIUM

SCARCITY, CHOICE AND OPPORTUNITY COSTS

§ This course is a study of behaviour of consumers, firms, and markets

§ It will deal with the choices these economic agents make, the context in which
they make these choices, and the implications of these on society

§ The Course will also introduce you to the interventions that the
Regulator/Government can make in the markets when they ‘fail’

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SCARCITY, CHOICE AND OPPORTUNITY COSTS

§ What is the opportunity cost of you attending a two year PGP course in IIM
Nagpur?

§ What is the opportunity cost of you not sitting through placements?

§ If you start a manufacturing firm after your MBA, spend Rs. 1 crore on inputs and
earn Rs. 1.08 crores in Revenues, what is your accounting profit? What is your
economic profit?

§ Do you think there were more entrepreneurs from the past batches of older
IIMs(A,B,C) than the present batch? Why?

More on Opportunity Costs

§ Do you think MBA will sought out more when economy is in good shape or when it is in a bad
shape?
§ Hint: The number of applicants to MBA Programs for class of 2008-09 increased over the previous
year by 79% in the US, 77% in the UK, and 69% in the other European programs
§ Eisenhower’s ‘chance for peace’ speech from 1953:
The cost of one modern heavy bomber is this:
- a modern brick school in more than 30 cities.

- It is two electric power plants, each serving a town of 60,000 population.

- It is two fine, fully equipped hospitals.
- It is some 50 miles of concrete highway.
- We pay for a single fighter plane with a half million bushels of wheat.
- We pay for a single destroyer with new homes that could have housed more than 8,000 people.

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SCARCITY, OPPORTUNITY COSTS, AND CHOICE FOR THE

FIRM AND A CONSUMER
25

20
• Scarcity is reflected by the fact that the points beyond
the production possibility frontier (for the firm) and the
Apple iPods

15
budget line (for the consumer) are unattainable
10

5 • Opportunity cost is reflected in two ways:

0 • Making more or consuming more of one product
0 2 4 6
comes at the cost of making less or consuming less
Apple Watches
of the other product.
• Any point inside the PPF curve or the budget line is
9 inefficient as we forego opportunity of making more
8
7 of at least one product
6
5
Shoes

4 • In this context choices are made by consumers and

3 firms on the boundary. Even on the boundary, there are
2
1 multiple choices. Our course is about studying how firms
0
0 5 10 15 20 25 30
and consumers choose a particular point on the
Shirts boundary

OPTIMIZATION

§ Firms are assumed to maximize profits; Consumers are

assumed to maximize their level of satisfaction; They
choose alternatives that will maximize their net benefits

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Marginal Analysis

Control
§ As a manager, what is the value of the
Variabl Gross Total Net Marginal Marginal Net Marginal control variable you will finalize upon?
e Revenue Costs Revenue Revenue Costs Benefits

0 0 0 0 --- --- ---

1 90 10 80 90 10 80 § As a manager, you will want to push

2 170 30 140 80 20 60 yourself till you receive a marginal
benefits that exceeds you marginal
3 240 60 180 70 30 40 costs
4 300 100 200 60 40 20

5 350 150 200 50 50 0

6 390 210 180 40 60 -20

§ In deciding on which control variable to
change (participation), the manager has
7 420 280 140 30 70 -40 to consider net revenue while to decide
8 440 360 80 20 80 -60
how much of the selected variable to
change (extent), the manager should
9 450 450 0 10 90 -80 use marginal analysis
10 450 550 -10 0 100 -100

EQUILIBRIUM

§ Equilibrium arises as you are not the

only one optimizing in an economy

§ An analogy for equilibrium is the

checkout lines in a supermarket

§ People will avoid queues with longer

wait times and move to queues with
shorter wait times. At equilibrium, you
will not expect people to move
between queues

Source: David Acemoglu, David Laibson and John A. List. (2016). Microeconomics. Pearson Education
Limited Global Edition

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SUMMARY

Consumers
maximize
their levels
of
Opportunity satisfaction
• Time, Money, and other Costs Markets allow
resources are scarce
• While we do so, we interaction of
• We make choices in
presence of this scarcity account for opportunity the two and
costs (cost of the best
foregone alternative)
we obtain an
equilibrium

Scarcity
Producers
maximize
their profits

§ LECTURE 2 - MARKET EQUILIBRIUM AND GOVERNMENT INTERVENTIONS

AGENDA § Prof. THIAGU RANGANATHAN

• DEMAND

• SUPPLY

• EQUILIBRIUM

• EFFICIENCY
Mantri Cards

• GOVERNMENT INTERVENTIONS

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DEMAND – Law of Demand

§ Law of Demand: Price and Quantity

PRICE
Demanded are inversely related. As
price increases quantity demanded
A D1 will decrease (keeping other things
constant)

D0 § Keeping other things constant, when

price changes there is a movement
B along the demand curve (movement
from A to B)

§ When other factors change, the

demand curve shifts (change in
QUANTITY demand with the shift from D0 to D1

DEMAND – Factors Influencing Demand

§ The other factors include:

PRICE
§ Income
§ When demand increases with income, it is
D1 called a normal good
§ When demand decreases with income, it is
called an inferior good
§ Prices of Substitutes and Complements
D0
§ As prices of substitutes increases
(decreases), the demand for a product
increases (decreases)
§ As prices of complements increases
(decreases) the demand for the product
decreases (increases)
§ Advertising and Consumer Tastes
§ Population
QUANTITY
§ Consumer Expectations
§ Other Factors

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DEMAND - Example

§ Example:
PRICE § Consider the demand for coffee (in Tonnes):
!"&# $ $ %% =12000 - 3'" # $ $ %% +4'( %) -1*+ %) , +2- . %) ,
Where !"#$$%%
& is the amount of Coffee (in
Tonnes) demanded in a year, '"#$$%% is the
Price of Coffee (in Rs./Kg), '(%) is the Price of
Tea (in Rs./Kg), *+%), is the average annual
income of the individuals in the country, and
D0 -.%), is the number of minutes of Coffee
Advertisements shown in the TV in a year

§ How much coffee will be demanded

when the price of tea is 75, the price
of coffee is 200, Income is 10000, and
Advertisements is 2000?
QUANTITY § If the quantity demanded increased to
6000, what was the change in Price
(keeping other things constant)?

SUPPLY – Law of Supply

§ Law of Supply: Price and Quantity

PRICE
Supplied are directly related. As price
S0 increases quantity supplied will
increase (keeping other things
D
constant)

C S1 § Keeping other things constant, when

price changes there is a movement
along the supply curve (movement
from C to D)

§ When other factors change, the

supply curve shifts (change in
QUANTITY supply with the shift from S0 to S1 )

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SUPPLY – Factors Influencing Supply

§ The other factors include:

PRICE

S0 § Input Prices

§ Technology or Government Regulations

S1
§ Number of Firms

§ Producer Expectations

§ Other Factors

QUANTITY

SUPPLY - Example

§ Example:
PRICE § Consider the supply of Burgers in a month
(in lakhs):
'
!"#$%&$ =2000 + 4("#$%&$ -2()*&+,
'
Where !"#$%&$ is the amount of Burgers (in
lakhs) supplied in a month, ("#$%&$ is the
S0 Price of Burger (in Rs.),()*&+, is the Price of
Wheat Flour (in Rs./Kg)

§ How much burgers will be supplied

when the price of burger is 75, and
that of wheat is 25?
§ If the price of wheat becomes Rs.50
QUANTITY
per kg, what is the price at which the
supply will remain the same as
above?

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EQUILIBRIUM – Movement along a Curve

§ Competitive markets converge to an

PRICE
S equilibrium at which quantity supplied
and quantity demanded are the same
(Point E)
PH
F G

PE E § At a price higher than this one (PH ),

firms would want to supply more than
I
what the consumers demand and this
PL will create a surplus (Qc-QA ). Prices will
H reduce in response to this surplus
D

§ At a price lower than this one (PL ),

QA QB QE QCQD consumers will demand more good
QUANTITY than what will be supplied by the firms
and this will create a shortage (QD-QB ).
Prices will increase in response to this
shortage

EQUILIBRIUM – Shift of a Curve

PRICE S1 § Consider a market in equilibrium

S0

§ Consider a scenario where a change

in market conditions leads to a shift
PA
F in supply curve towards left. Eg: Blight
PE
G
E disease in apple orchards impacts the
supply of apple

§ The supply curve shifts first. At the

current equilibrium, there is a
QB QA QE shortage (QE-QB ). The price rises in
QUANTITY
response to that to PA at which price
the quantity demanded equals
quantity supplied

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EFFICIENCY – Consumer and Producer Surplus

S
§ Consumer surplus is the excess of
PRICE consumers willingness to pay over the
A market valuation
§ Producer Surplus is the excess of
P E
market price over the reservation
price of the suppliers
§ In Equilibrium (E), the Consumer
D Surplus is given by A(APE) while
producer surplus is given by A(FPE).
F
The sum of these two is the total
Q
surplus.
QUANTITY
§ An Efficient market is the one that
maximizes the total surplus

GOVERNMENT INTERVENTION – Price Floor

§ Price Floor is the minimum price that

PRICE
S the commodity can be traded in the
market
PF
F G § When the Government sets a price floor
above the equilibrium price, there is
PE E
excess supply in the market
§ A typical example is the Minimum
Support Price of agricultural commodity
set by the Government or Minimum
H
D
Wages for Employees
§ In a scenario like Minimum Support
QA
Price, the Government might have to
QE QC
QUANTITY procure the excess supply unsold in the
market and the costs to the
Government in those cases will be
FGQAQB

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SUMMARY

§ Supply Equals Demand at

S
PRICE S
PRICE

Equilibrium and the Total Surplus

A
A

is Maximum at this Equilibrium B J G

P E
E

§ At other points, the producer

H
D
D

surplus or consumer surplus could I

be higher, but the total surplus

F
E

will be lesser causing deadweight

QH QB QL
QUANTITY QH QB

loss
QUANTITY
EQUILIBRIUM
DEADWEIGHT LOSS

S
PRICE
S
PRICE

§ Government interventions like

price floors and ceilings could
J PF
PD F G

PE E cause losses in efficiency, but PE E

might be required for equity

purposes and also at times when
PC I PG

correction is needed for

H
D
D H

Externalities
QA QE QC
QUANTITY
QB QE QD
QUANTITY

PRICE CEILING PRICE FLOOR

EFFICIENCY – Deadweight Loss

§ When markets are not in equilibrium,

PRICE
S
there is loss of efficiency, referred to
A as deadweight loss
B J G

E § At point B, the consumer surplus is

A(ABJ), producer surplus is A(IEBJ)
C and the deadweight loss to society is
H A(EIJ)
D
I

F § At point C, the consumer surplus is

QH QB
QUANTITY
A(CAGH), the producer surplus is
A(FCH) and the deadweight loss to
society is A(EGH)

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GOVERNMENT INTERVENTION – Price Ceiling

§ Government interventions can affect

PRICE
S
market efficiency in unexpected
manner
J § A typical intervention is when the
PD
Government imposes a price ceiling
PE E
§ A typical example is the rent control
PC I where the rents for the households
H
are capped at PC. At this price, there
D is a shortage of houses (QD-QB) and
also a welfare loss given by A(HEJ)

§ This could lead to either hidden deals by

QB QE QD lessors with people who wish to pay rents
QUANTITY more than the ceiling price. It could also
lead to owners shifting the maintenance
expenditure to lessees

LECTURE 3 - RESPONSIVENESS OF DEMAND

AGENDA Prof. THIAGU RANGANATHAN

• ELASTICITY

• OWN PRICE ELASTICITY OF DEMAND

• CROSS-PRICE ELASTICITY OF DEMAND

• INCOME ELASTICITY OF DEMAND

• OTHER ELASTICITY OF DEMAND

• TAX INCIDENCE

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ELASTICITY

§ Elasticity measures the responsiveness of a particular variable to a change in

another variable

§ For instance, the own-price elasticity of demand measures the responsiveness

of quantity demanded to a change in price while own-price elasticity of supply
measures the responsiveness of quantity supplied to a change in price

§ The concept of elasticity allows you to answer questions like the following:
§ If as a chair manufacturing small firm, would a Rs. 200 price cut in chairs increase my
revenue?
§ If we do cut prices by Rs. 100, do we have inventories to meet the increased demand? If we
do not, how do we have to increase production?
§ If the incomes of the households increases by 5%, what is the expected increase in our
demand?

OWN PRICE ELASTICITY OF DEMAND

§ Own price elasticity of demand measures the responsiveness of quantity

demanded to a change in price

§ Own price elasticity of demand for quantity X is given by

% DQxd dQxd Px
e PQ =
d
x
=
x
% DPx dPx Qx

§ If own price elasticity of demand for a product is -2.12, it would mean that a
percentage increase (decrease) in price from the current one will decrease
(increase) demand by 2.12%

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OWN PRICE ELASTICITY OF DEMAND

12
Un
10 El a Ela itary
stic
sti
c
8
Quantity Price Total Revenue Own Price Elasticity
In e
Price

6
l as 0 10 0 ---
tic
4
1 9 9 -9
2

0 2 8 16 -4
0 2 4 6 8 10 12
Quantity 3 7 21 -2.33

4 6 24 -1.5
30

5 5 25 -1
25

20 6 4 24 -0.67
Revenue

15 7 3 21 -0.43
10
8 2 16 -0.25
5
9 1 9 -0.11
0
0 2 4 6
Quantity
8 10 12
10 0 0 ¥

OWN PRICE ELASTICITY OF DEMAND

12
§ In extreme cases, demand is perfectly
10
inelastic (top graph) or perfectly
8 elastic (bottom graph)
Price

$%
§ The !"## value for a perfectly
2

0
0 1 2 3 4 5 6 elastic demand
¥ is , while that of
Quantity
a perfectly inelastic curve is 0.
6

4 § Consider demand for life-saving

drugs, Demand for first-day first show
Price

2 tickets among hardcore Rajini fans,

1
etc.,
0
0 2 4 6 8 10 12
Quantity

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POINT ELASTICITY AND ARC ELASTICITY

§ Consider movement along the

Own Price demand curve from point 4 to 5. This
Point Price Quantity
Elasticity
(Point)
Own Price Elasticity
(Arc)
can be looked at in 2 ways.
1 18 0 --- --- § For a decline of price from 12 to 10,
2 16 3 -8.00 -17.00 the demand increases from 9 to 12.
In this case the reference point is 4.
3 14 6 -3.50 -5.00
The point elasticity calculated will be
4 12 9 -2.00 -2.60 -1.25
5 10 12 -1.25 -1.57
§ For an increase of price from 10 to
6 8 15 -0.80 -1.00
12, the demand decreases from 12
7 6 18 -0.50 -0.64 to 9. In this case, the reference point
8 4 21 -0.29 -0.38 is 5. The point elasticity calculated
will be -1.67
9 2 24 -0.13 -0.20

10 0 27 ¥ -0.06

POINT ELASTICITY AND ARC ELASTICITY

§ Arc elasticity is a measure that is

Own Price independent of the direction of the
Point Price Quantity
Elasticity
(Point)
Own Price Elasticity
(Arc)
movement. It is also useful when
there are very few data points related
1 18 0 --- ---
to price and quantity demanded
2 16 3 -8.00 -17.00

3 14 6 -3.50 -5.00

4 12 9 -2.00 -2.60 § The formula for calculating arc

5 10 12 -1.25 -1.57
elasticity is:
6 8 15 -0.80 -1.00 d æ Q -Q ö æ P2 - P1 ö
e PQ = ç
x 2 1
÷ ç ÷
è (Q2 + Q1 ) / 2 ø è ( P2 + P1 ) / 2 ø
x
7 6 18 -0.50 -0.64

8 4 21 -0.29 -0.38

9 2 24 -0.13 -0.20

10 0 27 ¥ -0.06

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FACTORS AFFECTING OWN PRICE ELASTICITY

§ Available Substitutes
§ More the substitutes available for the good, more elastic will be the demand
§ Implication à Elasticity of a broadly defined commodity group will be less than the narrowly
defined commodity group. Example: Demand for pulses will be less elastic than that of
demand for red gram (tur dal). Demand for food will be less elastic than the demand for
pulses.

§ Time
§ Demand tends to be more inelastic in the short term than in the long term

§ Expenditure Share
§ Good that comprise a relatively small share of expenditure tend to be more inelastic than
goods for which consumers spend a sizeable share of their incomes
§ Example: Demand for salt

CROSS PRICE ELASTICITY OF DEMAND

§ Cross price elasticity of demand measures the responsiveness of a demand for

a particular commodity to the changes in price of another commodity

§ Cross price elasticity of commodity X to the price of commodity Y is given

by:
% DQxd dQxd Py
e Qxd
Py = =
% DPy dPy Qx

§ The cross price elasticities for substitutes will be positive, the same for
complements will be negative, and it will be 0 for unrelated commodities

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INCOME ELASTICITY OF DEMAND

§ Income Elasticity of Demand measures the responsiveness of a particular

commodity to the changes in Income

§ Income elasticity of commodity X to income is given by:

% DQxd dQxd M
eM
d
Q
= x
=
% DM dM Qx

§ The income elasticity of a normal good is positive while that of an inferior

good is negative. A commodity with income elasticity greater than +1 can be
considered as a luxury good

OTHER ELASTICITY OF DEMAND

§ We could also consider elasticities of demand to other factors as demand is

impacted by factors other than the commodity’s own price, price of its
complements and supplements, and the income

§ One such factor is advertising and cross-advertising. The elasticity of demand

for a commodity to its advertising and advertising of its
substitutes/complements can be calculated to know the responsiveness of
demand to advertisement

§ The estimate for advertising elasticity of demand can be given as:

% DQxd dQxd Ax
e AQ =
d
x
=
x
% DAx dAx Qx

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TAX INCIDENCE

§ What is an Excise Duty? How is it

different from a sales tax?

§ What is its impact of such an

increase in tax on the price?

§ Will an increase in excise duty by Rs.

1 increase the price by Rs.1 or
lesser?

§ Who pays for it? The consumer or

the producer or both?

TAX INCIDENCE

S1
§ Consider an initial equilibrium point E
with initial supply curve S0 and a
PRICE
S0
demand curve D0
A
§ An increase in tax will decrease the
supply and the prices will increase.
P1
P E § In a case where the supply curve
P1-T moves to S1, the consumer bears an
increase in price of P1-P and the
D0
supplier bears the remaining brunt of
P-P1-T
D1
F
§ Which of the curves D0 or D1
Q
QUANTITY represent the demand for
petrol/diesel better?

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SUMMARY
OWN PRICE ELASTICITY INCOME ELASTICITY
% DQxd dQxd Px % DQxd dQxd M
eP Qxd
eM
d
= = Q
=x
=
x
% DPx dPx Qx % DM dM Qx

OWN PRICE ELASTICITY (ARC

ELASTICITY ADVERTISING ELASTICITY
% DQxd dQxd Ax
e AQ =
d

Qxd æ Q2 - Q1 ö æ P2 - P1 ö x
=
eP =ç ÷ ç ÷
x
% DAx dAx Qx
è (Q2 + Q1 ) / 2 ø è ( P2 + P1 ) / 2 ø
x

S1

S0

CROSS PRICE ELASTICITY

PRICE
A

TAX
% DQxd dQxd Py
P1

e PQ =
d P

INCIDENCE
E
x
= P1-T
y
% DPy dPy Qx D0

D1
F
QL
QUANTITY

ELASTICITY OF SUPPLY

§ Elasticity of supply measures the responsiveness of quantity supplied to

various factors

§ Own-price elasticity of supply measures responsiveness of the quantity supplied

to its own price. Elasticity of supply could also be estimated for factors like
inputs, technology, taxes, weather, etc.,

§ Do you think rainfall elasticity of supply of agricultural commodities is positive

or negative? Is it high or low? To bring it to desirable levels, what needs to be
done?

§ Elasticity of supply could be measured as a point elasticity or arc elasticity

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REVIEW – CONSUMER SURPLUS

60 • If I am the only service

P = 50 - 0.4Q
50
Total Benefit = 0.5*40*100+10*100=Rs. 30
Payment = 100*10=Rs. 10
Mobile Charges (P/Minute)
provider and provide a
package deal worth Rs. 29 for
100 minutes of talk time in a
month, Will the consumer buy

40 Consumer Surplus = Rs. 20

my package?

30 • If I am the only service

provider provide a deal which
20 will charge the consumer a
fixed fee of Rs. 19 and an
airtime charge of 10 p/min,
10
will the consumer buy at this
price?
0
0 20 40 60 80 100 120 140
Minutes

§ LECTURE 4 - THEORY OF CONSUMER DEMAND

AGENDA § Prof. THIAGU RANGANATHAN

• THE APPROACH

• CONSUMER PREFERENCES

• INDIFFERENCE MAPS

• UTILITY

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APPROACH
Consum ers
m axim ize
their levels
Opportunity of
satisfaction
• Time, Money, and other Costs Markets
resources are scarce
• While we do so, we allow
• We make choices in
presence of this account for opportunity interaction
scarcity costs of the two
and we
obtain an
Scarcity equilibrium
Producers
m axim ize
their
profits

• Consumers have preferences which

follow certain regularities
Consumers • These preferences are
maximize their mathematically represented using
levels of utility and consumers maximize their
satisfaction
utility
• Utility maximization happens subject
to consumer’s budget constraints

CONSUMER PREFERENCES

§ Assumption 1: Consumer preferences are complete

§ Assumption 2: More is better (Non-satiation)

§ Assumption 3: Diminishing Marginal Rate of Substitution

1st chocolate

§ Assumption 4: Transitivity. If you prefer a blue pen to a red pen and prefer
red pen to a green pen, you will prefer blue pen to a green pen
2nd chocolate

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INDIFFERENCE MAPS

§ An indifference curve defines the

combination of goods that give same
CHOCOLATES
level of satisfaction to the consumer;
that is, the consumer is indifferent
between different combinations of the
goods on the same indifference curve
A(1,2)

C(2,2) § Indifference maps are set of

indifference curves for a consumer
B(2,1) I2

I1 § The indifference curve I1 indicates that

the consumer is indifferent between
consuming 1 apple and 2 chocolates or
2 apples and 1 chocolate. The
Indifference map indicates that the
APPLES consumer prefers point C to any point
in curve I1

INDIFFERENCE MAPS – Non-satiation

§ A Consumer will prefer more to less

CHOCOLATES

§ This translates to a consumer

D(3,3) preferring indifference curves farther
A(1,2)
I3 from the origin
C(2,2)

B(2,1) I2
§ In our example, the consumer will
I1 prefer any point on I2 to a point on
I1 and any point on curve I3 to a
point in I1 or I2. The consumer will
choose C over A/B and D over
APPLES
A/B/C

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INDIFFERENCE MAPS – Diminishing Marginal Rate of

Substitution

§ The Marginal Rate of Substitution is the

value of the slope of the indifference
CHOCOLATES 8
A(1,7)
curve
7

6
3
5 B(2,4) § It is the rate at which the consumer is
willing to substitute one good for other
maintaining the same level of
4

3 2
C(3,2)
satisfaction
2
1 C(4,1)
1
§ The indifference curves exhibit a
diminishing marginal rate of
0
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5
substitution. The amount of good X
APPLES
that a consumer is willing to give up to
obtain another unit of Y reduces as
amount of Y increases

INDIFFERENCE MAPS – Transitivity

§ Transitivity implies that if the

CHOCOLATES 8 consumer prefers a consumption
7
bundle A to B and bundle B to C,
then the consumer will prefer bundle
6
A to C
5

3
§ Transitivity implies that the
2 indifference curves do not intersect
1

0
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5
§ The intersection point is common to
APPLES
both curves which means all the
points should lie on a single curve

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INDIFFERENCE MAPS – Perfect Substitutes

§ The indifference curve of perfect

substitutes will be linear
8
COCA COLA
7

6
§ Consider an example where the
consumer perceives coca cola and
5

thums up as perfect substitutes

4

1
§ The consumer’s indifference map
shows that the consumer derives
0
0 1 2 3 4 5 6 7 8

satisfaction from more of the colas,

THUMS UP but is indifferent between whether
one cola or other makes up the total
number

INDIFFERENCE MAPS – Perfect Complements

§ The indifference curve of perfect

complements will be kinked at 90
LEFT GLOVE 6 degrees
5

4
§ Consider an example of satisfaction
3 from a right glove and a left glove
2

1
§ The consumer’s indifference map
0
0 1 2 3 4 5 6
shows that the consumer derives
satisfaction from a pair of gloves, 2
RIGHT GLOVE pairs and 3 pairs of gloves. The
consumer’s satisfaction will not
increase with a glove for a single
hand

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UTILITY

§ Utility is a mathematical representation

CHOCOLATES
of consumer’s preferences

§ If the preferences of the consumers

follow the properties that were
A(1,2) discussed, then the consumer’s
preferences could be mathematically
C(2,2) represented using an utility function

B(2,1) I2
§ Instead of talking in terms of
I1 preferences, we could state in terms of
utility as follows: The consumer derives
the same utility from consuming 2
apples and 1 chocolates or 1 apple
and 2 chocolates. Also, the consumer
APPLES will derive more utility from consuming
2 apples and 2 chocolates

UTILITY

§ In the example of apples and

CHOCOLATES bananas, the utility function of the
consumer can be represented by
Sqrt(Apples * Chocolates)

A(1,2)

C(2,2)
§ The utility of a consumer is same for
an indifference curve

B(2,1) I2

I1 § In the curve I1, the utility of the

consumer is sqrt(2) or 1.414 at any
point. Similarly, in the indifference
curve I2, the utility of the consumer
APPLES is 2.

25
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DIMINISHING MARGINAL UTILITY

TOTAL UTILITY MARGINAL UTILITY FROM 35.00

TOTAL UTILITY
CHOCOLATES CONSUMING ONE MORE
(4) 4* A * C
APPLES APPLE 30.00

4 1 8.00 8.00 25.00

4 2 11.31 3.31 20.00

4 3 13.86 2.54 15.00

4 4 16.00 2.14 10.00

4 5 17.89 1.89 5.00

4 6 19.60 1.71
0.00
4 7 21.17 1.57 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

4 8 22.63 1.46
9.00
4 9 24.00 1.37 MARGINAL UTILITY
8.00

4 10 25.30 1.30 7.00

4 11 26.53 1.23 6.00

4 12 27.71 1.18 5.00

4.00
4 13 28.84 1.13
3.00
4 14 29.93 1.09
2.00
4 15 30.98 1.05 1.00

4 16 32.00 1.02 0.00

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

MARGINAL RATE OF SUBSTITUTION AND MARGINAL

UTILITY

§ Marginal rate of substitution can also § The utility in any of the indifference
be expressed as the ratio of marginal curve is given by
utility of two commodities
U = U ( A, C )

§ Differentiating both the sides we get

§ Marginal Rate of Substitution is given
by ¶U ( A, C ) ¶U ( A, C )
0= dA + dC
dC ¶A ¶C
MRS =
dA
0 = MU A dA + MU C dC
dC MU A
=-
dA MU C

26
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SUMMARY
CHOCOLATES
35.00
TOTAL UTILITY
30.00

25.00

20.00
A(1,
2) C(2,2) 15.00

10.00

B(2,1) I2 5.00

I1 0.00
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
%& !)'
APPLES !"# = =−
%' !)& 9.00
MARGINAL UTILITY
8.00
CHOCOLATES 8
7.00
A(1,7)
7
6.00
6
3 5.00
5 B(2,4)
4.00
4
3.00
3 2
C(3,2) 2.00
2
1 C(4,1) 1.00
1
0.00
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5

APPLES

§ LECTURE 5 - THEORY OF CONSUMER DEMAND

AGENDA § Prof. THIAGU RANGANATHAN

• BUDGET CONSTRAINTS

• UTILITY MAXIMIZATION

• INCOME EFFECT

• PRICE EFFECT AND DEMAND CURVE

• GIFFEN GOOD

27
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BUDGET CONSTRAINTS

§ Budget constraint reduces the

consumer to select a bundle of goods
that is affordable
140

50 A + 25C = 3000
120
C = 120 - 2 A
100 BUDGET LINE

§ The combinations of bundles the can 80 OPPORTUNITY SET

be bought with the income forms the
consumer’s opportunity set/budget set 60

40

20

0
0 10 20 30 40 50 60 70

§ Budget line defines all the combination

of goods that exhaust the consumers’
income

BUDGET CONSTRAINTS

§ The maximum affordable quantity of

140 X is 60 when the consumer exhausts
50C + 25 A = 3000 the whole income on commodity X
120
C = 120 - 2 A
100 BUDGET LINE
80
§ The maximum affordable quantity of
Y is 120 when the consumer exhausts
60

40
the whole income on commodity Y
20

0
0 10 20 30 40 50 60 70

§ The slope of the budget line (-PX/PY)

is -2 which represents the Market
Rate of Substitution between goods
X and Y

28
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UTILITY MAXIMIZATION

§ Consider the optimization problem of

140
a consumer
50 A + 25C = 3000
120
C = 120 - 2 A
§ A point F will provide a high utility,
100 A F
but that is out of reach for a
consumer because of her/his scarce
80 B
resources (income)
C
60
§ Points A,B, D and E are attainable,
but the consumer can attain a higher
40
D
20 E utility and choosing any of the points
0 means there is an opportunity cost
0 10 20 30 40 50 60 70 to the consumer
§ Given this, the consumer will choose
point C, where the budget line is
tangent to an indifference curve

UTILITY MAXIMIZATION

§ At the optimal point for the

140 consumer, the slope of the budget
50 A + 25C = 3000 line and the slope of the indifference
curve are the same
120
C = 120 - 2 A
100 dC - PA
Slope = =
dA PC
80

C
60

40

20 § The Marginal Rate of Substitution is

0
thus equal to the Market Rate of
0 10 20 30 40 50 60 70 Substitution MRS = MU A = PA
MU C PC
or
MU A MU C
=
PA PC

29
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UTILITY MAXIMIZATION
U ( A, C ) = 20 AC
50 A + 25C = 3000
MU A = 10 C / A
X Y MUX MUY MUX/PX MUY/PY
§ At the optimal point for the
MU C = 10 A / C
consumer, the slope of the budget
5 110 46.90 2.13 0.94 0.09 line and the slope of the indifference
10 100 31.62 3.16 0.63 0.13 curve are the same
15 90 24.49 4.08 0.49 0.16

20 80 20.00 5.00 0.40 0.20

25 70 16.73 5.98 0.33 0.24 § The Marginal Rate of Substitution is

30 60 14.14 7.07 0.28 0.28
thus equal to the Market Rate of
Substitution or Marginal Rate of
35 50 11.95 8.37 0.24 0.33
Transformation
40 40 10.00 10.00 0.20 0.40 MU A PA
MRS = =
MU C PC
45 30 8.16 12.25 0.16 0.49
or
50 20 6.32 15.81 0.13 0.63
MU A MU C
=
55 10 4.26 23.45 0.09 0.94 PA PC

INCOME EFFECT
50 A + 25C = 2000
C = 80 - 2 A
§ For normal goods, a change in income
will result in change in amount
180 50 A + 25C = 3000 consumed in the same direction
160
C = 120 - 2 A

140
50 A + 25C = 4000
C = 60 - 2 A
§ A reduction in income will shift the
120

100
D budget line towards left
80
C
60

40
B

20 § An increase in income will shift the

0 budget line towards right
0 10 20 30 40 50 60 70 80 90

§ For an inferior good, an increase in

income will be accompanied by a
reduction in consumption

30
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PRICE EFFECT AND DEMAND CURVE

140

120 § The budget line will move inwards if

100 the price of a commodity reduces
80
and move outward if the price of the
commodity decreases
60

40 § From the price effect, we can derive

20 the demand curve for an individual
0 consumer. The sum of individual
0 20 40 60 80 100 120 140 demands is the market demand
80 80

70 70

60 60

50 50

40 40

30 30

20 20

10 10

0 0
0 20 40 60 80 100 120 140 0 20 40 60 80 100 120 140

PRICE EFFECT AS A SUM OF INCOME AND SUBSTITUTION

EFFECT

NORMAL GOOD GIFFEN GOOD

180
§ Substitution effect is found by
160
U ( A, C ) = A * C
assuming that the individual gets a
compensatory income which will help
140
50 A + 25C = 4243
him maintain the same utility as
120 before. For any good, substitution
effect is negative.
100 F (42.4,84.9);U (42.4,84.9) = 42.4*84.9 = 60

80
§ Income effect is found as the change
E (60, 60);U (60, 60) = 60*60 = 60
in consumption due to reduction in
60 this compensatory income. It is also
40
G (30, 60);U (30, 60) = 30*60 = 42.4 negative for normal goods. For Giffen
50 X + 25Y = 3000
good, the income effect is large and
20 25 A + 25C = 3000 significantly positive to overcome the
0
substitution effect and reverse its
0 20 40 60 80 100 120 140 impact.
Both Substitution and Income Effect
Negative for Price Rise

31
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SUMMARY
140

120
MU A PA
100 MRS = =
MU C PC
80
or
60 MU A MU C
=
40 PA PC

20

0
0 10 20 30 40 50 60 70
140 80
70
120
60
100
50
80
40
60 30
40 20

20 10
0
0
0 20 40 60 80 100 120 140
0 20 40 60 80 100 120 140

MANAGERIAL ECONOMICS

LECTURE 6 - PRODUCER THEORY

Prof. THIAGU RANGANATHAN

32
 8/7/19

Welfare Programs – Liconsa case study

§ Conasupo – 1963 to 1999 (Free 1 Kilo Tortilla per day)

§ Liconsa which was under Conasupo now under Ministry of Social Development

§ Solidaridad (sometime between 1988-1994)

§ Progresa – August 1997

§ Opportunidades

§ School breakfast program for low income kids

What is the Crux of the Question

§ In-Kind or In-Cash Subsidy

§ Liconsa – Buy milk and only milk at a subsidized prices (3.5 peso per litre)

§ Opportunidades – Cash grants [Conditional]

LICONSA

Advantages Disadvantages
§ Coverage Problems
§ Assistance to the poor § Four liters of milk may not be that
valuable to some participants
§ For a worthwhile use : Milk
§ Does it impose no cost to the
§ Milk à Nutrition à Health à School à Government? – If free why is Liconsa
Jobs limited to 5 million participants?
§ For an average rural family. Is Liconsa
like a cash transfer?
§ No Longer Corrupt
§ Financially self-supporting
§ Support from the dairy industry

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In-Kind Assistance

§ Assumptions

§ The poor are poorly informed

§ Society has a stake in poor’s choices

§ The poor need allies

Who Benefits from the Scheme

Original Budget Line With Licons a Original Budget Line With Licons a With Income Transfer

311 331

321
301

311

291
301

281 291

281
271

271

261
261

251 251
0 2 4 6 8 10 12 0 2 4 6 8 10 12

34
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Tarriffs

§ World Price = 1517 million pesos/105 million kilos = $14.5 per kilo

§ Tarriff = 1.25 * 14.5 = $18.2 per kilo

§ Domestic Price = $ 32.7 per kilo

§ If no tarriff, what would be the retail price?

Tarriffs

§ World Milk Price = 1517 million pesos/ 1028 l equivalents = $1.48

§ Import tariff = $1.48 * 1.25 = $ 1.85 per litre

§ If no tariff, the price of milk would have been $ 5.2

§ Welfare Costs??

35
 8/7/19

Why only 4 liters?

Subsidy with binding quantity

Subsidy with no quantity limit limit

Price
Demand Curve Price
Demand Curve
Supply
Supply
w/o
C w/o
A subsidy
A subsidy
B
Supply
Supply
with
with
subsidy
subsidy

Quantity
Quantity

Transaction Utility - Thaler

You are lying on the beach on a hot day. All § In both versions the ultimate consumption
you have to drink is ice water. For the last act is the same - drinking one beer on the
hour you have been thinking about how much beach. The beer is the same in each case.
you Would enjoy a nice cold bottle of your
favorite brand of beer. A companion gets up § No "atmosphere" is consumed by the
to go make a phone call and offers to bring respondent.
back a beer from the only nearby place where
beer is sold (a fancy resort hotel) [a small,
run-down grocery store]. He says that the beer
might be expensive and so asks how much
you are willing to pay for the beer. He says
that he will buy the beer if it costs as much
or less than the price you state. But if it costs
more than the price you state he will not buy
it. You trust your friend, and there is no
possibility of bargaining with (the bartender)
[store owner]. What price do you tell him?

36
 8/7/19

APPROACH
Consum ers
m axim ize
their levels
Opportunity of
satisfaction
• Time, Money, and other Costs Markets
resources are scarce
• While we do so, we allow
• We make choices in
presence of this account for opportunity interaction
scarcity costs of the two
and we
obtain an
Scarcity equilibrium
Producers
m axim ize
their
profits

• Producers have to be efficient and maximize

profit
Producers • Efficiency depends on cost of factors of
maximize production. This decision refers to allocation
their profits of labour and capital for cost minimization
• Profit maximization depends on market
structure in which the firm is operating. This
decision is about deciding firm’s supply

PRODCUTION FUNCTION

§ Firms use a technology (production function) to transform inputs (factors of

production) into outputs. The inputs of a firm can be broadly categorized into
three categories:

§ Capital (K): Land, Buildings (factories, stores), and equipment (machines, trucks)

§ Labour (L): labourers (construction workers, assembly-line workers) , skilled workers (architects,
engineers, plumbers, economists), and managers

§ Materials (M): Raw goods (oil, water, wheat), and processed goods (aluminium, paper, plastic,
steel)

§ Production function is the relationship between the quantities of inputs used

and maximum quantity of output that can be produced given the current
knowledge about technology and organization

37
 8/7/19

INPUTS

§ Fixed input is an input whose input does not vary with the production for
some time. The costs for the input do not vary with the level of production

§ Variable input is a factor of production whose quantity can be changed readily

by the firm during the relevant time period

§ Short run is the time in which at least one factor of production cannot be
varied practically

§ Long run is a lengthy enough period of time that all inputs can be varied

SHORT RUN PRODUCTION

Total Average
K L Product Marginal Product Product
3 0 0
3 1 5 5 5
3 2 16 11 8
3 3 31 15 10
3 4 48 17 12
3 5 63 15 13
3 6 75 12 13
3 7 83 8 12
3 8 88 5 11
3 9 90 2 10
3 10 90 0 9
3 11 88 -2 8
3 12 84 -4 7
3 13 78 -6 6

38
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SHORT RUN PRODUCTION

§ Production Function in the short run

100
90
80 TOTAL PRODUCT
70
60
q = f ( K , L)
50
40
30 § Marginal Product of Labour
20
10
Δq
0
0 2 4 6 8 10 12 14 MPL =
LABOUR ΔL
20
MARGINAL PRODUCT
15 § Average Product of Labour
AVERAGE PRODUCT

q
10

5 APL =
0 L
0 2 4 6 8 10 12 14

-5

-10
LABOUR

LONG RUN PRODUCTION

§ In the long run, all the inputs are

Labour, L variable q = f ( K , L)
Capital, K 1 2 3 4 5 6

1 10 14 17 20 22 24

§ Same level of production using very

2 14 20 24 28 32 35
little capital and lot of labour or using
very little labour and a lot of capital
3 17 24 30 35 39 42

4 20 28 35 40 45 49
§ A lumberyard can produce 200 planks
5 22 32 39 45 50 55 with 10 workers using handsaws, 4
workers using handheld power saws, or
6 24 35 42 49 55 60 with 2 workers using bench power saws

39
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ISOQUANTS

§ Isoquant
ISOQUANTS
7
q = f ( K , L)
§ Farther the Isoquant is from the origin,
6

5 more is the production

LABOUR

2 q=35 § Isoquants do not cross

1 q=24
0
0 1 2 3 4 5 6 q=14 7
§ Isoquants slope downward

CAPITAL
§ Slope of the isoquant is the marginal
rate of technical substitution (MRTS)
ΔK MPL
MRTS = =-
ΔL MPK

ISOCOSTS

§ All the input combinations that require

Capital Input (K) the same (iso) total expenditure (cost)
,.
C = wL + rK
+
w
,- / § Slope of the line is given by-
r
+ * § Cost Minimization occurs when the
#$%&'( = Isoquant is tangent to Isocost. At this
+
point, the following condition exists
similar to that of consumer’s utility
0 maximization
MPL MPK
=
!" =100 units w r
§ At point A, the firm will spend more
,- ,. than it will at B, but produce the same
0 as in point B
* *
Labor Input (L)

40
 8/7/19

Optimal Input Substitution in Action

Capital Input (K)
I

New cost-minimizing
point due to higher wage

F
B
%& Initial point of cost minimization

A
%$
!"
H J
0 #& #$ G Labor Input (L)

SUMMARY
100
90
ISOQUANTS
7
80 TOTAL PRODUCT
70 6

60 5
50 4
40
3
30
2
20
10 1

0 0
0 2 4 6 8 10 12 14
MPL MPK 0 1 2 3 4 5 6 7

LABOUR =
w r
20
25
MARGINAL PRODUCT
15
20
AVERAGE PRODUCT
10
15

5
10

0
0 2 4 6 8 10 12 14 5

-5
0
0 5 10 15 20 25 30 35 40 45
-10
LABOUR

41
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RETURNS TO SCALE

§ Constant Returns to Scale – When all the inputs are increased by a certain
percentage the output increases by same percentage
f (αK , αL) = αf ( K , L)

§ Increasing Returns to Scale – The output increases more than in proportion to

equal increase in inputs
f (αK , αL) > αf ( K , L)

§ Decreasing Returns to Scale – The output increases less than in proportion to

equal increase in inputs
f (αK , αL) < αf ( K , L)

COBB DOUGLAS PRODUCTION FUNCTION

§ Returns to Scale in a Cobb Douglas Function

q = ALα K β

q (aK , aL) = A(aL)α (aK ) β

q (aK , aL) = a α + β ALα K β = a α + β q

§ The returns to scale of a cobb-douglas production function will depend on the

sum of the powers of labour and capital function

42
 8/7/19

FIRMS & MARKETS

LECTURE 7 - PRODUCER THEORY

Prof. THIAGU RANGANATHAN

SHORT RUN COSTS

§ Fixed Costs (FC) are the costs that do not change with changes in output

§ Variable Costs (VC) are the costs that change with the changes in output

§ Total Costs (TC) are the sum of fixed and variable costs

43
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SHORT RUN COSTS

(5)=20000*(2
(1) (2) (3) (4)=50000*(1) ) (6)=(4)+(5)

Capital Labour Output Variable Total 350000

(K) (L) (Q) Fixed Costs Costs Costs

300000 TOTAL COSTS
2 0 0 100000 0 100000
250000
2 1 76 100000 20000 120000
200000 VARIABLE
2 2 248 100000 40000 140000 COSTS
150000
2 3 492 100000 60000 160000
100000 FIXED COSTS
2 4 784 100000 80000 180000
50000
2 5 1100 100000 100000 200000
0
2 6 1416 100000 120000 220000 0 500 1000 1500 2000 2500

2 7 1708 100000 140000 240000

2 8 1952 100000 160000 260000 QUANTITY
2 9 2124 100000 180000 280000
2 10 2200 100000 200000 300000

SHORT RUN COSTS

ATC, AVC, AFC § Average Fixed Costs

and MC (Rs.) FC
AFC =
A q
Minimum of ATC § Marginal Costs
ΔTC (q )
MC =
Δq

§ Average Variable Costs

VC (q )
AVC =
q
Minimum of AVC
§ Average Total Costs
0 Output
TC (q )
ATC =
q

44
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PERFECT COMPETITION

§ Large Number of Buyers and Sellers

§ Identical Products

§ Full Information

§ Negligible Transaction Costs

§ Free Entry and Exit

PROFIT MAXIMIZATION

§ Two Decisions
§ Output Decision : What is the optimal level q* which maximizes the firms profits?
§ Shutdown Decision: Is it more profitable to produce q* or to shut down and produce no
output?

§ Three aspects of profit maximization

§ The firm sets its output where profits is maximized or loss is minimized
§ The firm sets its output where its marginal profit is zero
§ The firm sets its output where its marginal revenue equals its marginal costs

§ Shut Down Rule

§ The firm shuts down if it can reduce its loss by doing so
§ The firm shuts down only if its revenue is less than its avoidable cost

45
 8/7/19

Competition in the Short Run

Rs. § A profit-maximizing competitive firm

produces the amount of output at
which its marginal cost equals the
market price.

p
Profit

§ The rectangle between price curve

and the average curve indicates the
0 q profit of the firm

Short Run Loss

Rs.

Loss

0 q

46
 8/7/19

SHUT DOWN DECISION

Loss if shut down

Fixed Cost

Loss if produce

0 q

SHORT RUN FIRM SUPPLY CURVE

Rs
Short-run supply
curve for individual firm
!"#

0 q

47
 8/7/19

MARKET SUPPLY CURVE

P
Individual firm’s
supply curve
Market supply
curve
S

$12

$10

0 1 500 Market output Q

LONG RUN AVERAGE TOTAL COST CURVE

LRAC (Rs.)
!"#&
!"#$ '(!#

!"#%

0 )∗ Output

48
 8/7/19

LONG RUN ENTRY AND EXIT

Price
Price

Exit
Entry

D
0 Market 0 Firm’s
Output Q Output q

LONG RUN COMPETITIVE EQUILIBRIUM

Rs

Long-run competitive
equilibrium

0 Firm’s output q

49
 8/7/19

ECONOMIES OF SCALE

§ Economies of scale
§ Portion of the long-run average cost curve where long-run average costs
decline as output increases

§ Diseconomies of scale
§ Portion of the long-run average cost curve where long-run average costs
increase as output increases

§ Constant returns to scale

§ Portion of the long-run average cost curve that remains constant as output
increases.

ECONOMIES OF SCOPE

§ Economies of scope
§ Exist when the total cost of producing !" and !# together is less than the total cost of
producing each of the type of output separately.
$ !", 0 + $ 0, !# > $ !", !#

§ Cost complementarity
§ Exist when the marginal cost of producing one type of output decreases when the output of
another good is increased.
∆*$" !", !#
<0
∆!#

# #
§ $ = 100 − 0.5!" !# + !" + !#

50