Economics-HS-201 Microeconomics - PPT1-11

Economics: HS -201
Why to Study Economics?

 To learn how to avoid being deceived by
economists
 Economics as a discipline exists because

resources are limited
Economics and Choice
 Economics is the study of how individuals and
society manages its scarce resources.
 “Economics is the study of how people and

society choose to employ scarce resources
that could have alternative uses in order to
produce various commodities and to distribute
them for consumption , now and/or in the
future among various persons and groups in
the society” by Samuelson and Nordhaous
How Economists Think
 The first step in this process is to identify the
fundamental economic problem: scarcity.
 What goods and services will be

produced and in what quantities?
 How will they be produced?
 Who will consume them?
Decision Makers
 Households are groups of people that live
together.
 Firms are organizations that use resources
to produce goods and services.
 Government is an organization that sets laws

and rules, taxes, spends, and provides public
services.
How Economy Works…
What Economists Do
 Uses abstract models to help explain how a complex,
real world operates.
 Develops theories, collects, and analyzes data to
evaluate the theories.
 Economic questions can be divided into two big
groups: microeconomics and macroeconomics.
Microeconomics focuses on the individual parts of the
economy.
 How households and firms make decisions and how
they interact in specific markets
Macroeconomics looks at the economy as a whole.
 Economy-wide phenomena, including inflation,
unemployment, and economic growth
Economic Science and
Economic Policy
 Economic science is the attempt to understand

the economic world. Science makes predictions.
 Economic policy is the attempt to improve the
economic world. Policy makes prescriptions.
 Policies made without science usually will not be
very good.
Economic Science is Young
 Economics as a science is just over 200 years old.
 Adam Smith’s The Wealth of Nations (1776) marks the
beginning of our subject.
 It began with Aristotle but got mixed up with ethics in
the Middle Ages. Adam Smith separated it from ethics,
and Walrus mathematized it. Alfred Marshall tried to
narrow it, and Keynes made is fashionable. Robbins
widened it, and Samuelson dynamized it, but modern
science made it statistical and tried to confine it again.
 Compared to physics and chemistry, however, we are
newcomers.
Suggested Books
 Koutsoyiannis, A., “Modern Microeconomics”, Second
Edition, Macmillon
 Salvatore, D., “Principles of Microeconomics”, Fifth
Edition, Oxford University Press
 Mankiw, N.G., “Principles Of Microeconomics”, Sixth
Edition, Cengage Learning India
Demand and Supply
Demand
 Demand vs. Need
 Effective Demand
 Desire to have a good/commodity
 Willingness to pay
 Ability to pay
Factors Affecting Demand
Demand and Law of Demand
 Demand is a multivariate concept
 Qd = f(Px, I, PR, TC, PC, IF, PF, NC, DC)
 Law of Demand
 A relationship between price and quantity
demanded in a given time period, ceteris
paribus.
Demand Schedule
Demand Curve
QX = a - bPX
Law of Demand
 An inverse relationship exists between the

price of a good and the quantity
demanded in a given time period, ceteris
paribus.
 Mathematically: QX = a - bPX
 Reasons:
 substitution effect
 income effect
Market Demand Curve
 Market demand is the horizontal summation of
individual consumer demand curves
a b p m
p p
q q q
Change in Quantity Demanded vs.
Change in Demand
Change in quantity demanded Change in demand
p1 b
p a b1
p a
q q1
q1 q
A movement along a demand Change in demand refers
curve is referred to as a change to a shift in the whole
in the quantity demanded curve
Shifts in the demand curve
D0 D1
 Such an increase in demand
can be caused by:
• A rise in the price of a
Price
substitute
• A fall in the price of a
complement
• A rise in income
Quantity
• A redistribution of income
towards those who favour
 When the demand the commodity
curve shifts from D to
• A change in tastes that
D1 more is demanded
favours the commodity.
at each price.
Shifts in the demand curve
 Such a decrease in demand
D can be caused by:
D
0
2
 A fall in the price of a
substitute
Price
 A rise in the price of a

complement, a fall in income
 A redistribution of income
away from groups that favour
the commodity
Quantity
 A change in tastes that dis-

 When the demand curve favours the commodity.
shifts from D0 to D2 less is
demanded at each price.
Note
 We are interested in developing a theory
of how products get priced.
 ‘How will the quantity of a product
demanded vary as its own price varies?’
 A basic economic hypothesis is that the lower

the price of a product, the larger the quantity
that will be demanded, other things being
equal.
Supply
We now look at the supply side of markets. The suppliers
are firms, which are in business to make the goods and
services that consumers want to buy.
 Economic theory gives firms several attributes.
 Firstly, each firm is assumed to make consistent decisions, as
though it was run by a single individual decision-maker.
 Secondly, firms hire workers and invest capital and
entrepreneurial talent in order to produce goods and services
that consumers wish to buy.
 Thirdly, firms are assumed to make their decisions with a
single goal in mind: to make as much profit as possible.
The nature and determinants of supply
 The amount of a product that firms are able and willing
to offer for sale is called the quantity supplied.
 Supply is a desired flow: how much firms are willing to
sell per period of time.
 Three major determinants of the quantity supplied in a
particular market are:
 The price of the product;
 The prices of inputs to production;
 The state of technology.
 The expectations of producers,
 The number of producers, and
 The prices of related goods and services

Supply schedule
Supply
 The relationship that exists between the price of
a good and the quantity supplied in a given time
period, ceteris paribus.
QX = a + bPX
Law of supply
 A direct relationship exists between the price of a
good and the quantity supplied in a given time
period, ceteris paribus.
 Mathematically: QX = a + bPX
 The law of supply is the result of the law of
increasing cost.
 As the quantity of a good produced rises, the marginal
cost rises.
 Sellers will only produce and sell an additional unit of a
good if the price rises above the marginal cost of
producing the additional unit.
The market supply curve is the horizontal summation of the
supply curves of individual firms
Change in supply vs. change in
quantity supplied
Change in quantity supplied Change in supply
a
p1 p
b b1
p a
q q1 q q1
Shifts in the Supply Curve
S0
S1
• A shift in the supply

curve from S0 to S1
indicates more is
supplied at each price.
Quantity
• Such an increase in supply can be caused by:

• Improvements in the technology of producing the commodity
• A fall in the price of inputs that are important in producing
the commodity
Shifts in the Supply Curve
S2
S0
• A shift in the supply

curve from S0 to S2
indicates less is
supplied at each price.
Quantity
• Such a decrease in supply can be caused by:
• A rise in the price of inputs that are important in producing the
commodity.
• Changes in technology that increase the costs of producing the
commodity (rare).
Price Determination
Price determination
How demand and supply interact to determine price
The concept of a market

 A market may be defined as an area over which
buyers and sellers negotiate the exchange of
some product or related group of products.
 It must be possible, therefore, for buyers and
sellers to communicate with each other and to
make meaningful transactions over the whole
market.
Market equilibrium
Determination of the Equilibrium Price
• Equilibrium price is where the
QX = a + bPX demand and supply curves
intersect, point E in the figure.
E At all prices above equilibrium
p •
there is excess supply and

downward pressure on price.
QX = a - bPX
• At all prices below equilibrium
o there is excess demand and
q upward pressure on price.
QdX = QsX a – bPX = a + bPX

Market equilibrium
Price (Rs) Demand Supply
8.00 6,000 18,000
7.00 8,000 16,000
6.00 10,000 14,000
5.00 12,000 12,000
4.00 14,000 10,000
3.00 16,000 8,000
2.00 18,000 6,000
1.00 20,000 4,000
• The equilibrium price in the market is 5.00 where demand and supply are
equal at 12,000 units
• If the current market price was 3.00 – there would be excess demand for
8,000 units, creating a shortage.
• If the current market price was 8.00 – there would be excess supply of 12,000
units.
Instability in Price
 If the price exceeds the  If the price is below
equilibrium price, a the equilibrium a
surplus occurs: shortage occurs:
Excess Supply
p1
p E
p
E p1
Excess Demand
Rise and Fall in Demand
Demand rises Demand falls
p1 E1 p E
p p1 E1
E
q q1 q1 q
An increase in demand A decrease in demand
raises both price and lowers both price and
quantity quantity
Rise and fall in Supply
Supply rises Supply falls
E E1
p p1
p1 E1 p E
q q1 q1 q
An increase in supply A decrease in supply
raises quantity but lowers quantity but
lowers price raises price
Price ceiling
• Price ceiling - legally
mandated maximum price
E • Purpose: keep price below the

market equilibrium price
p
• Examples:
p1 • Rent controls
• Price controls during
wartime
• Gas price rationing in 1970s
Price floor
• Price floor - legally
mandated minimum price
• Designed to maintain a price
p1
above the equilibrium level
p • Examples:
E
•Agricultural price supports
•Minimum wage laws
Elasticity of Demand
• The demand and supply analysis helps us to
understand the direction in which price and quantity
would change in response to shifts in demand or
supply.
• What economists would like to know is ‘what will
happen to demand when price, income, price of the
related goods changes?’
• How the sensitivity of quantity demanded to a change in

price is measured by the elasticity of demand and what
factors influence it.
• How elasticity is measured at a point or over a range.
• How income elasticity is measured and how it varies with
different types of goods.
Defining & Measuring Price Elasticity of Demand
• Demand elasticity is measured by a ratio: the
percentage change in quantity demanded divided by
the percentage change in price that brought it about.
Percentage change in quantity demanded

Price elasticity of demand =
Percentage change in price
GOOD A Original New % Change Elasticity
Quantity 100 95 -5%

(Q1) (Q2) -5%/10%
10% = -0.5%
Price 1 1.10
(P1) (P1)
Measuring Elasticity of Demand
Measuring Elasticity
Percentage ARC Point

Method Method Method
 P ∆Q 
=
∆Q P
× ∆Q( P1 + P2 ) =e p lim  × 
ep
∆P Q ep = 
∆P →0 Q ∆P 
∆P(Q1 + Q2 )
P ∆Q 
e p =  lim 
Q ∆P → 0 ∆P 
P dQ
e=p ×
Q dP
Measuring Elasticity of Demand
D
∆Q P
=
ep ×
∆P Q
1 P
=
ep × P R
Slope Q
1 P
=ep ×
PD PR Q
D1
PR OP
=
ep × 0 Q
Quantity
PD OQ
Lower Segment
=
PR OP
×
ep =
ep
PD OQ Upper Segment
OQ OP OP This ratio is zero where the
ep = × ⇒ curve intersects the quantity
PD OQ PD
axis and ‘infinity’ where it
OP RD1 intersects the price axis.
=
ep =
PD RD
Vertical axis formula PR is Parallel to OD1 in ODD1
Elasticity along a Linear Demand Curve
D
– Perfectly inelastic
(Elasticity=0)
– Inelastic (0<Elasticity<1)
D1
– Unit elastic (Elasticity=1)
0 Quantity
– Elastic (1<Elasticity< ∞)
– Perfectly elastic
(Elasticity=∞ )
Elastic and Inelastic
D1
Price
Price
Elasticity = 0 Elasticity = ∞
12 12 D2
6 6
Quantity Quantity
Perfectly Inelastic Perfectly Elastic

•Implies that quantity demanded •Implies that if price changes by any
remains constant when price percentage quantity demanded will
changes occur. fall to 0.
•Price elasticity of demand = 0
•Price elasticity of demand = ∞
Price
Price
D3
0<Elasticity<1 1<Elasticity< ∞
12 12 D4
6 6
Quantity Quantity
Inelastic Elastic
• Implies the percentage change in •Implies the percentage change in
quantity demanded is less than quantity demanded is greater than
the percentage change in price. the percentage change in price.
• Price elasticity of demand > 0 •Price elasticity of demand > 1
and < 1 and < ∞
•Implies that the

Price
Elasticity = 1
percentage change
in quantity
12 demanded equals
the percentage
change in price.
Unit Elasticity
•Price elasticity of
6 demand = 1
1 2 3 Quantity
The Factors that Influence the
• The closer the substitutes for a good, the
more elastic is demand.
• The higher the proportion of income spent
on a good, the more elastic is demand.
• The greater the time elapsed since a price
change, the more elastic is demand.
A product with close substitutes tends to have an elastic demand;
one with no close substitutes tends to have an inelastic demand.
Some Real-World Price Elasticities
of Demand
Good or Service Elasticity
Elastic Demand
Metals 1.52
Electrical engineering products 1.30
Mechanical engineering products 1.30
Furniture 1.26
Motor vehicles 1.14
Instrument engineering products 1.10
Professional services 1.09
Transportation services 1.03
Inelastic Demand
Gas, electricity, and water 0.92
Oil 0.91
Chemicals 0.89
Beverages (all types) 0.78
Clothing 0.64
Tobacco 0.61
Banking and insurance services 0.56
Housing services 0.55
Agricultural and fish products 0.42
Books, magazines, and newspapers 0.34
Food 0.12
Application
• Business decisions; Revenue, Profit
• Economic Policies; Minimum Support Price,
Ceiling price
• Government Policies; Taxation
• Trade; Import commodities with more
elastic demand, Export commodities
with less elastic demand
Elasticity and Total Revenue
• Total revenue = Price x Quantity

• Marginal Revenue = ΔTR/ΔQ
∆Q P
• Price elasticity of demand: =
ep ×
∆P Q
• What happens to total revenue if the
price rises?
Elasticity and Total Revenue
P Q Ep TR=P.Q MR= ΔTR/ΔQ

6 0 ∞ 0 ---
5 100 -5 500 5
4 200 -2 800 3
3 300 -1 900 1
2 400 -0.5 800 -1
1 500 -0.2 500 -3
0 600 0 0 -5
TR
MR>0 MR<0
EP > 1 EP < 1
A reduction in price will
lead to:
– an increase in TR when
demand is elastic. QX
– a decrease in TR when EP = 1 MR=0
PX
demand is inelastic.
EP > 1
– an unchanged level of EP = 1
total revenue when
demand is unit elastic. EP < 1
QX
MRX
Elasticity and Marginal Revenue
TR = P.Q
d ( P.Q )
MR =
dQ
dP  dP Q   1 
MR = P + Q. = P 1 + ∗  = P 1 + 
dQ  dQ P   Ep 
Defining & Measuring Income Elasticity of Demand
The responsiveness of demand for a product to changes in

income is termed income elasticity of demand, and is defined as
Percentage change in quantity demanded

Income elasticity of demand =
Percentage change in Income
∆Q I I dQ
=
ei × or e=
i ×
∆I Q Q dI
 A good is a normal good if income elasticity > 0.
 A good is an inferior good if income elasticity < 0.
 A good is a luxury good if income elasticity > 1.
 A good is a necessity good if income elasticity < 1 and < 0.
Income Elasticity of Demand
qm
Positive income elasticity
Quantity
Zero income
elasticity Negative income elasticity
[inferior good]
y1 y2 Income
0
•Normal goods have positive income elasticities. Inferior goods have negative
elasticities.
•Nothing is demanded at income less than y1, so for incomes below y1 income
elasticity is zero.
•Between incomes of y1 and y2 quantity demanded rises as income rises, making
income elasticity positive.
•As income rises above y2, quantity demanded falls from its peak at qm, making
income elasticity negative.
Some Real-World Income Elasticities
of Demand
Defining & Measuring Cross Elasticity of Demand
The responsiveness of quantity demanded of one product to

changes in the prices of other products is often of considerable
interest.
Percentage change in quantity demanded of X

Cross elasticity of demand =
Percentage change in Price of Y
∆Qx Py e=
Py dQx
×
=
exy × or xy
∆Py Qx Qx dPy
 Products are substitute if cross elasticity > 0.

 Products are complimentary if cross elasticity < 0.
Some Real-World Cross Elasticities
of Demand
Summary
Price Elasticity of demand
Perfectly inelastic, Inelastic , Unit elastic,
Elastic , Perfectly elastic
Income Elasticity of demand

Normal , Inferior, Luxury, Necessity
Cross Elasticity of demand

Substitute , Complimentary
Examples
Q1. Find the elasticity if the demand function is
Q = 25 – 4P + P2 where Q is the demand for commodity at
price P. Find out elasticity at (i) P = 4, (ii) P = 8, (iii) P = 5
Ans: (i) P = 4, ep = 0.64 (inelastic)

(ii) P = 8, ep = 1.7 (elastic)
(iii) P = 5 ep = 1 (unitarily elastic)
Q2. The demand function is given X = 10 – P at X = 4, P = 6.

If the price increased by 5% determine the percentage
decrease in demand and hence an approximation to the
elasticity of demand.
Ans: Decrease in demand is 7.5% and elasticity is 1.5

Examples
Q3. If the current demand for economics books is 10,000 per year
for a publishing house. The elasticity of demand is 0.75. The price
increased by Rs 50 per book, calculate the change in the quantity
of books demanded where price is Rs 150.
Ans: ∆Q = 2500
Q4. Suppose demand for cars in a city as a function of income is
given by the following equations. Q = 20,000 + 5M, where Q is
quantity demanded and M is Per capita income. Find out income
elasticity of demand when per capita annual income is Rs 15,000.
Ans: ei= 0.8 (Normal)
Q5. Suppose the following demand function for coffee in terms of
price of tea is given Qc = 100 + 2.5Pt. Find out the cross elasticity
of demand when price of tea rises from Rs 50 per 250gm pack to
Rs 55 per 250gm pack.
Ans: ect= 0.51(Substitute)
Consumer Behavior
Consumer Behavior
• Demand analysis starts with the behavior of
the consumer
• Individual consumer’s demand is derived from
his utility function
• Rational consumer tries to maximize his utility
• Axiom of Utility Maximization
• Cardinalist Approach
• Ordinalist Approach
Cardinal Utility Theory
Concepts
• Utility: level of happiness or satisfaction associated
with alternative choices
• Total utility: the level of happiness derived from
consuming the good
• Marginal utility: the additional utility that is received
when an additional unit of a good is consumed
Change in total utility ∂U
MU= Or
Change in quantity ∂Qx
Cardinal Utility Theory TUx
Concepts
Qx TUx MUx
0 0 ....
1 10 10
Quantity
2 16 6
3 20 4
4 22 2 MUx
5 22 0
6 20 -2
Quantity
Diminishing Marginal Utility
• As consumption of a good or service increases, the
incremental (or marginal) satisfaction we get from
consuming one more unit decreases.
• This decrease is called the principle of diminishing
marginal utility.
• Law of diminishing marginal utility - marginal utility
declines as more of a particular good is consumed in
a given time period, ceteris paribus
• Even though marginal utility declines, total utility still
increases as long as marginal utility is positive. Total
utility will decline only if marginal utility is negative
Equilibrium of the Consumer
Assumptions
• Rationality : Consumer aims at the maximization of his utility
subject to constraint his income
• Cardinal Utility : Utility is measured by monetary units that
the consumer is prepared to pay for another unit of the
commodity
• Constant Marginal Utility of Money: Unit of measurement is
that it be constant
• Diminishing Marginal Utility: The utility gained from a
successive units of a commodity diminishes.
=
• Total Utility is Additive: U U1 ( x1 ) + U 2 ( x2 )........U n ( xn )
Single Commodity Model : The consumer can either buy
Commodity (x) or retain his money income (Y)
The Utility function is U = f (Qx )
If the consumer buys Qx his expenditure is PxQx
The consumer seeks to maximize the difference between his utility
and expenditure
U − Px Qx
∂U ∂ ( Px Qx )
− =
0
∂Qx ∂Qx
∂U
= Px Or MU x = Px
∂Qx
Derivation of the Demand Curve
Condition for the equilibrium MU x = Px
MUx
Quantity
Quantity
If there are more commodities, the condition for the
equilibrium of the consumer is the equality of the
ratios of the marginal utilities of the individual
commodities to their prices
MU x MU y MU n
= = .........
Px Py Pn
Qx Tux Mux Mux/Px Qy Tuy Muy Muy/Py
0 0 - - 0 0 - -
1 50 50 8.33 1 75 75 25.00
2 88 38 6.33 2 117 42 14.00
3 121 33 5.50 3 153 36 12.00
4 150 29 4.83 4 181 28 9.33
5 175 25 4.17 5 206 25 8.33
6 196 21 3.50 6 225 19 6.33
7 214 18 3.00 7 243 18 6.00
8 229 15 2.50 8 260 17 5.67
9 241 12 2.00 9 276 16 5.33
10 250 9 1.50 10 291 15 5.00
Suppose the price of X is 6 and price of Y is 3
Critique of the Cardinal Approach
• Utility can not be measured objectively

• Constant utility of money is unrealistic
• Money can not be used as a measuring-rod since
its own utility changes
Ordinal Utility Theory
Assumptions
• Rationality : Consumer aims at the maximization of
his utility subject to constraint his income
• Ordinal Utility : Consumer can rank his preferences
• Diminishing Marginal Rate of Substitution
• Total Utility is Additive
• Consistency and transitivity of choice
If A > B then B ≯ A
If A > B, and B > C, then A > C
Preferences: What the Consumer Wants
A consumer’s preference among consumption bundles
Case 1 Case 2
Pizza (X) Pepsi (Y) Pizza (X) Pepsi (Y)
A 1 12 A1 2 24
B 2 8 B1 4 16
C 3 5 C1 6 10
D 4 3 D1 8 6
E 5 2 E1 10 4
A consumer’s preference among consumption bundles

may be illustrated with indifference curves.
Figure 1 The Consumer’s Preferences
Quantity
of Pepsi
A A1
Indifference curve
B1
B
C1
C D1
E1 I2
D
E
,I1
0 Quantity
of Pizza
Representing Preferences with Indifference Curves
• The Consumer’s Preferences
– The consumer is indifferent, or equally happy, with
the combinations shown at points A, B, and C
because they are all on the same curve.
• The Marginal Rate of Substitution
– The slope at any point on an indifference curve is
the marginal rate of substitution.
• It is the rate at which a consumer is willing to trade one
good for another.
• It is the amount of one good that a consumer requires as
compensation to give up one unit of the other good.
Properties of Indifference Curves
• Higher indifference curves are preferred to

lower ones.
• Indifference curves do not cross.
• Indifference curves are downward sloping and
convex to the origin.
• Property 1: Higher indifference curves are

preferred to lower ones.
– Consumers usually prefer more of something to
less of it.
– Higher indifference curves represent larger
quantities of goods than do lower indifference
curves.
Figure 2 The Consumer’s Preferences
Quantity
of Pepsi
A
C D1
I2
D
Indifference
E
curve, I1
0 Quantity
of Pizza
• Property 2: Indifference curves do not cross.

– Points A and B should make the consumer equally
happy.
– Points B and C should make the consumer equally
happy.
– This implies that A and C would make the
consumer equally happy.
– But C has more of both goods compared to A.
Figure 3 The Impossibility of Intersecting Indifference Curves
Quantity
of Pepsi
0 Quantity
of Pizza
Copyright©2004 South-Western
• Property 3: Indifference curves are down ward

sloping and convex to the origin.
– People are more willing to trade away goods that
they have in abundance and less willing to trade
away goods of which they have little.
– These differences in a consumer’s marginal
substitution rates cause his or her indifference
curve to bow inward.
Marginal Rate of Substitution
Pizza (X) Pepsi (Y) MRSxy
A 1 12 ---
B 2 8 4
C 3 5 3
D 4 3 2
E 5 2 1
Diminishing marginal rate of substitution: The rate of

substitution declines as consumption for X per unit
increases
Figure 4 Down ward sloping Indifference Curves
Quantity
of Pepsi
12 A
MRS = 4
B
8
1
D
3 E
MRS = 1
2
1
Indifference
curve
0 1 2 4 5 Quantity
of Pizza
Relationship between MRS and MU
U ( x, y ) = a
∂U ∂U
dx + dy =
0
∂x ∂y
dy  ∂U ∂U 
= − 
dx  ∂x ∂y 
= −  MUx 
dy
dx 
 MUy 
MRS xy = −  MUx 

 MUy 

Two Extreme Examples of Indifference Curves
• Perfect substitutes
• Perfect complements
• Perfect Substitutes
– Two goods with straight-line indifference curves are
perfect substitutes.
– The marginal rate of substitution is a fixed number.
Figure 5 Perfect Substitutes and Perfect Complements
(a) Perfect Substitutes
6
CD of brand X
I1 I2 I3
0 1 2 3 CD of brand Y
• Perfect Complements
– Two goods with right-angle indifference curves are
perfect complements.
Figure 5 Perfect Substitutes and Perfect Complements
(b) Perfect Complements
Left
Shoes
I2
7
5 I1
0 5 7 Right Shoes
The Budget Constraint: What the
Consumer Can Afford
• The budget constraint depicts the limit on the
consumption “bundles” that a consumer can
afford.
– People consume less than they desire because their
spending is constrained, or limited, by their
income.
The budget constraint shows the various combinations

of goods the consumer can afford given his or her
income and the prices of the two goods.
The Consumer’s Budget Constraint
Assuming Per unit price of Pepsi 2 and Per unit Price of Pizza 10
Consumer Can Afford
• The Consumer’s Budget Constraint
– Any point on the budget constraint line indicates
the consumer’s combination or tradeoff between
two goods.
– For example, if the consumer buys no pizzas, he
can afford 500 pints of Pepsi (point B). If he buys no
Pepsi, he can afford 100 pizzas (point L).
– Alternately, the consumer can buy 50 pizzas and
250 pints of Pepsi.
Figure 6 The Consumer’s Budget Constraint
Quantity
of Pepsi
B
500
C
250
Consumer’s
budget constraint
L
0 50 100 Quantity
of Pizza
Consumer Can Afford
• The slope of the budget constraint line equals
the relative price of the two goods, that is, the
price of one good compared to the price of the
other.
• It measures the rate at which the consumer
can trade one good for the other.
Figure 7: Slope of the Budget Line
Quantity
of Pepsi
B
500
Px Qx + Py Qy =
M Px Qx + Py Qy =
M
OB
Slope =
OL
M Py
Slope = Consumer’s
M Px budget constraint
Px
Slope = −
Py L
0 100 Quantity
of Pizza
Optimization: What The Consumer Chooses
• Consumers want to get the combination of

goods on the highest possible indifference
curve.
• However, the consumer must also end up on or
below his budget constraint.
Figure 8 The Consumer’s Equilibrium
Quantity
of Pepsi
= =
E MRS xy P=
x Py MU x MU y
Optimum
E
Y B
A
I3
I2
I1
Budget constraint
0 X Quantity
of Pizza
The Consumer’s Optimal Choices
• Combining the indifference curve and the

budget constraint determines the consumer’s
optimal choice.
• Consumer optimum occurs at the point where
the highest indifference curve and the budget
constraint are tangent.
• The consumer chooses consumption of the two
goods so that the marginal rate of substitution
equals the relative price.
Mathematical derivation of the Equilibrium
Given the market prices and his income, the consumer
aims at the maximization of his utility.
Maximize U = f ( q1 , q2 ,........qn )
n
Subject to ∑q p
i =1
i i = q1 p1 + q2 p2 + ...... + qn pn = Y
Rewrite the constraint ( q1 p1 + q2 p2 + ...... + qn pn − Y ) =

0
in the form
Multiply the constraint by a constant λwhich is Lagrangian multiplier
λ ( q1 p1 + q2 p2 + ...... + qn pn − Y ) =
0
Composite
function
φ =U − λ (q1 p1 + q2 p2 + ...... + qn pn − Y )
Differentiating ∂φ ∂U
the composite = − λ ( P1 ) =0 ……… 1
function with ∂q1 ∂q1
respect to q1,
∂φ ∂U
q2….qn = − λ ( P2 ) =0 ……… 2
∂q2 ∂q2
∂φ ∂U
= − λ ( Pn ) =0 ……… 3
∂qn ∂qn
∂φ
=
−(q1 p1 + q2 p2 + ...... + qn pn − Y ) =
0 ..4
∂λ
∂U ∂U ∂U
Solving
= λ=P1 , λ P2 ,.......
= λ Pn
EQ1…EQ2…. ∂q1 ∂q2 ∂qn
EQ3
∂U ∂U ∂U
= MUq=
1, MUq=
2 ,...... MUqn
∂q1 ∂q2 ∂qn
MUq1 MUq2 MUqn
= ......
P1 P2 Pn
MUx MUy
=
Px Py
Equilibrium MUx Px
condition
= = MRS xy
MUy Py
Utility function of an consumer is given by
Example
x y 4 . Find out the

3 1
= U f=( x, y ) 4
optimal quantity of the two goods , if price of x

is Rs 6/- per unit and price of y is Rs 3/- per unit
and the income of the consumer is Rs 120/-
Solution 3 1
Maximize U = x 4
y 4
Subject to 6x + 3y =
120
Composite 3 1
function φ x y
= 4 4
− λ (6 x + 3 y − 120)
Ans: x = 15 and y = 10
How Changes in Income Affect the Consumer’s
Choices
How a consumer’s purchases react to changes in

income with relative prices held constant
• An increase in income shifts the budget constraint

outward.
• The consumer is able to choose a better

combination of goods on a higher indifference
curve.
An Income-consumption Line
Quantity of Y
Income-consumption line
E3
E2
E1
I3
I2
I1
0 Quantity of X
Income-consumption Line
• This line shows how a consumer’s purchases react to
changes in income with relative prices held constant.
• Increases in income shift the budget line out parallel to
itself, moving the equilibrium from E1 to E2 to E3.
• The income-consumption line joins all these points of
equilibrium.
• If a consumer buys more of a good when his or her
income rises, the good is called a normal good.
• If a consumer buys less of a good when his or her
income rises, the good is called an inferior good.
Figure 9 An Inferior Good
Quantity
of Pepsi New budget constraint
1. When an increase in income shifts the

3. . . . but budget constraint outward . . .
Initial
Pepsi
optimum
consumption
falls, making
New optimum
Pepsi an
inferior good.
Initial
budget I1 I2
constraint
0 Quantity
of Pizza
2. . . . pizza consumption rises, making pizza a normal good . . .
How Changes in Price of a Commodity Affect
the Consumer’s Choices
a
The Price-consumption Line
Price-consumption
Quantity of Y
line
E1
E2 E3
I3
I2
I1
o
Q1 b Q2 Q3 c d
Quantity of X
The Price-consumption Line
• This line shows how a consumer’s purchases react to a
change in one price, with money income and other
prices held constant.
• Decreases in the price of food (with money income and
the price of clothing constant) pivot the budget line
from ab to ac to ad.
• The equilibrium position moves from E1, to E2 to E3.
• The price-consumption line joins all such equilibrium
points.
Derivation of an Individual’s Demand Curve
A price-consumption line provide the information needed to draw a
demand curve
Price BL IC Equilibrium Qx
P1 ab IC1 E1 OQ1
P2 ac IC2 E2 OQ2
P3 ad IC3 E3 OQ3
a
Quantity of Y
Price-consumption line
E2
E1
E0
I2
I0 I1
b c d
0 Q1 Q2 Q3
Quantity of X
Price of X
P1 x
y
P2 Demand curve
P3 z
0 Q1 Q2 Q3
Quantity of X
Price Effect = Income Effect + Substitution Effect
• A Change in Price: Substitution Effect

• A price change first causes the consumer to move
from one point on an indifference curve to another
on the same curve.
• Illustrated by movement from point A to point B.
• A Change in Price: Income Effect
• After moving from one point to another on the
same curve, the consumer will move to another
indifference curve.
• Illustrated by movement from point B to point C.
Figure 10 Income and Substitution Effects
Quantity
of Pepsi
New budget constraint
C New optimum
Income
effect B
Initial optimum
Substitution Initial
effect budget
constraint A
I2
I1
0 Quantity
Substitution effect of Pizza
Income effect Copyright©2004 South-Western
Price Effect = Income Effect + Substitution Effect
• Normal good
• The substitution effect is always negative
• The income effect is negative for normal goods
PE(-) = IE (-) + SE (-)
• Inferior goods
• The substitution effect is always negative,
• The income effect is positive for inferior goods
PE(-) = IE (+) + SE (-) but (IE<SE)
• Giffen goods
• The substitution effect is always negative,
• The income effect is positive for inferior goods
PE(+) = IE (+) + SE (-) but (IE > SE)
Consumer Surplus and Tax
Incidence
Revisiting the Market Equilibrium
• Do the equilibrium price and quantity

maximize the total welfare of buyers and
sellers?
• Market equilibrium reflects the way markets
allocate scarce resources.
• Whether the market allocation is desirable can
be addressed by welfare economics.
Welfare Economics
• Welfare economics is the study of how the

allocation of resources affects economic well-
being.
• Buyers and sellers receive benefits from taking
part in the market.
• The equilibrium in a market maximizes the
total welfare of buyers and sellers.
Welfare Economics
• Consumer surplus measures economic welfare
from the buyer’s side.
• Willingness to pay is the maximum amount that a
buyer will pay for a good.
• It measures how much the buyer values the good
or service.
Consumer surplus is the buyer’s willingness to
pay for a good minus the amount the buyer
actually pays for it.
Consumer Surplus
The market demand curve depicts the various quantities that
buyers would be willing and able to purchase at different prices.
Willingness Quantity
Buyer to Pay Price Buyers Demanded
A 100 More than 100 None 0
B 80
80 to 100 A 1
C 70
D 50 70 to 80 A and B 2
50 to 70 A,B, and C 3
Less than 50 A, B, C, and D 4

Figure 1 The Demand Schedule and the Demand Curve
Price of
Album
100 A ’s willingness to pay
80 B ’s willingness to pay
70 C ’s willingness to pay
50 D ’s willingness to pay
Demand
0 1 2 3 4 Quantity of
Albums
Copyright©2003 Southwestern/Thomson Learning
Figure 2 Measuring Consumer Surplus with the Demand Curve
(a) Price = 80
Price of
Album
100
A ’s consumer surplus (20)
80
70
50
Demand
Albums

Figure 4 Measuring Consumer Surplus with the Demand Curve
(b) Price = 70
Price of
Album
100
A ’s consumer surplus (30)
80
B ’s consumer
70 surplus (10)
Total
50 consumer
surplus (40)
Demand
Albums

Using the Demand Curve to Measure Consumer
Surplus
• The area below the demand curve and above

the price measures the consumer surplus in
the market.
Consumer surplus, the amount that buyers are
willing to pay for a good minus the amount
they actually pay for it, measures the benefit
that buyers receive from a good as the buyers
themselves perceive it.
Figure 5 How the Price Affects Consumer Surplus
(a) Consumer Surplus at Price P

Price
A
Consumer
surplus
P1
B C
Demand
0 Q1 Quantity

Figure 6 How the Price Affects Consumer Surplus
(b) Consumer Surplus at Price P

Price
A
Initial
consumer
surplus
C Consumer surplus
P1
B to new consumers
F
P2
D E
Additional consumer Demand
surplus to initial
consumers
0 Q1 Q2 Quantity

Producer Surplus
• Producer surplus is the amount a seller is paid
for a good minus the seller’s cost.
• It measures the benefit to sellers participating
in a market.
• Just as consumer surplus is related to the
demand curve, producer surplus is closely
related to the supply curve.
The Supply Schedule and the Supply Curve
Seller Cost Quantity

Price Sellers Supplied
W 900
900 or More Z, Y, X, and W 4
X 800
800 to 900 Z, Y, and X 3
Y 600
600 to 800 Z and Y 2
Z 500
500 to 600 Z 1
Less than 500 None 0

Figure 7 Measuring Producer Surplus with the Supply Curve
(a) Price = 600
Price of
House
Painting Supply
900
800
600
500
Z ’s producer
surplus (100)
0 1 2 3 4
Quantity of
Houses Painted
Figure 8 Measuring Producer Surplus with the Supply Curve
(b) Price = 800
Price of
House
Painting Supply
Total
producer
900 surplus (500)
800
600 Y ’s producer
500 surplus (200)
Z ’s producer
surplus (300)
0 1 2 3 4
Quantity of
Houses Painted
Figure 9 How the Price Affects Producer Surplus
(a) Producer Surplus at Price P
Price
Supply
B
P1
C
Producer
surplus
0 Q1 Quantity
Figure 10 How the Price Affects Producer Surplus
(b) Producer Surplus at Price P
Price
Additional producer Supply
surplus to initial
producers
D E
P2 F
B
P1
Initial C
Producer surplus
producer to new producers
surplus
0 Q1 Q2 Quantity
Market Efficiency
Consumer surplus and producer surplus may be used
to address the following question:
– Is the allocation of resources determined by free markets in
any way desirable?
Consumer Surplus
= Value to buyers – Amount paid by buyers
Producer Surplus
= Amount received by sellers – Cost to sellers
Efficiency is the property of a resource allocation of maximizing

the total surplus received by all members of society.
Figure 11 Consumer and Producer Surplus in the Market
Equilibrium
Price A
D
Supply
Consumer
surplus
Equilibrium E
price
Producer
surplus
Demand
B
0 Equilibrium Quantity
quantity
Figure 12 The Efficiency of the Equilibrium Quantity
Price
Supply
Value Cost
to to
buyers sellers
Cost Value
to to
sellers buyers Demand
0 Equilibrium Quantity
quantity
Value to buyers is greater Value to buyers is less

than cost to sellers. than cost to sellers.

Evaluating the Market Equilibrium
• Because the equilibrium outcome is an efficient

allocation of resources, the social planner can
leave the market outcome as he/she finds it.
• This policy of leaving well enough alone goes
by the French expression laissez faire.
Application: The Costs of Taxation
How do taxes affect the economic well-being of
market participants?
• A tax places a wedge between the price buyers pay
and the price sellers receive.
• Because of this tax wedge, the quantity sold falls
below the level that would be sold without a tax.
• The size of the market for that good shrinks.
Figure 13 A Tax on Buyers
Price of
Ice-Cream
Price Cone Supply, S1
buyers
pay C
3.30 Equilibrium without tax
Tax (0.50)
Price 3.00
2.80
A A tax on buyers
without
shifts the demand
tax B curve downward
by the size of
Price Equilibrium the tax (0.50).
sellers with tax
receive
D1
D2
0 90 100 Quantity of
Ice-Cream Cones

Figure 14 A Tax on Sellers
Price of
Ice-Cream A tax on sellers
Price Cone Equilibrium S2 shifts the supply
buyers with tax B curve upward
pay by the amount of
3.30 S1
Tax (0.50) the tax (0.50).
Price 3.00 A
without 2.80 Equilibrium without tax
tax C
Price
sellers
receive
Demand, D1
0 90 100 Quantity of
Ice-Cream Cones
Figure 15 The Effects of a Tax
Price
Supply
Price buyers
Size of tax
pay
Price
without tax
Price sellers
receive
Demand
0 Quantity Quantity Quantity

with tax without tax
Copyright © 2004 South-Western
How a Tax Affects Market Participants
• Tax Revenue
T = the size of the tax
Q = the quantity of the good sold
T × Q = the government’s tax revenue

Figure 16 Tax Revenue
Price
Supply
Price buyers Size of tax (T)

pay
Tax
revenue
(T × Q)
Price sellers
receive
Quantity Demand
sold (Q)
0 Quantity Quantity Quantity

with tax without tax
Figure 17 How a Tax Effects Welfare
Price
A Supply
Price
buyers = PB
pay
B
Price C
without tax = P1
E
Price D
sellers = PS
receive F
Demand
0 Q2 Q1 Quantity

• Changes in Welfare
• A deadweight loss is the fall in total surplus that
results from a market distortion, such as a tax.
• The change in total welfare includes:

• The change in consumer surplus,
• The change in producer surplus, and
• The change in tax revenue.
• This fall in total surplus is called the deadweight loss.
Determinants of the Deadweight Loss
• What determines whether the deadweight loss

from a tax is large or small?
– The magnitude of the deadweight loss depends on how
much the quantity supplied and quantity demanded
respond to changes in the price.
– That, in turn, depends on the price elasticities of supply and
demand.
– With each increase in the tax rate, the deadweight loss of
the tax rises even more rapidly than the size of the tax.
Figure 18 Tax Distortions and Elasticities
(a) Inelastic Supply
Price
Supply
When supply is
relatively inelastic,
the deadweight loss
of a tax is small.
Size of tax
Demand
0 Quantity

(b) Elastic Supply
Price
When supply is relatively

elastic, the deadweight
loss of a tax is large.
Size Supply
of
tax
Demand
0 Quantity

(c) Inelastic Demand
Price
Supply
Size of tax
When demand is
relatively inelastic,
the deadweight loss
of a tax is small.
Demand
0 Quantity

(d) Elastic Demand
Price
Supply
Size
of
tax Demand
When demand is relatively

elastic, the deadweight
loss of a tax is large.
0 Quantity

Figure 22 Deadweight Loss and Tax Revenue from Three Taxes of
Different Sizes
(a) Small Tax

Price
Deadweight
loss Supply
PB
Tax revenue
PS
Demand
0 Q2 Q1 Quantity
Different Sizes
(b) Medium Tax

Price
Deadweight
PB loss
Supply
Tax revenue
PS Demand
0 Q2 Q1 Quantity
Different Sizes
(c) Large Tax

Price
PB
Deadweight
loss
Supply
Tax revenue
Demand
PS
0 Q2 Q1 Quantity
Tax Incidence
• Tax incidence is the manner in which the burden of a

tax is shared among participants in a market.
• Tax incidence is the study of who bears the burden
of a tax.
• Taxes result in a change in market equilibrium.
• Buyers pay more and sellers receive less,
regardless of whom the tax is levied on.
Figure 25 How the Burden of a Tax Is Divided
(a) Elastic Supply, Inelastic Demand
Price
1. When supply is more elastic
than demand . . .
Price buyers pay
Supply
Tax
2. . . . the
incidence of the
Price without tax tax falls more
heavily on
Price sellers consumers . . .
receive
3. . . . than
Demand
on producers.
0 Quantity

Figure 26 How the Burden of a Tax Is Divided
(b) Inelastic Supply, Elastic Demand
Price
1. When demand is more elastic
than supply . . .
Price buyers pay Supply
Price without tax 3. . . . than on

consumers.
Tax
2. . . . the Demand
Price sellers incidence of
receive the tax falls
more heavily
on producers . . .
0 Quantity

Summary
• The greater the elasticities of demand and

supply:
– the larger will be the decline in equilibrium
quantity and,
– the greater the deadweight loss of a tax.
– As the size of the tax rises, tax revenue grows
• The burden of a tax falls more heavily on the side of

the market that is less elastic.
Production Theory
and Estimation
Concepts
Production: transformation of inputs or resources into
outputs of goods and services
Output = f (Land, Labour, Capital, Technology )
INPUTS
Fixed Inputs Variable Inputs

Production
Short Run Long Run

Fixed Inputs and Variable Inputs
Variable Inputs
Concepts
Variable Input - An input whose quantity can be changed in fixed
time period according to the level of production.
Fixed Input - A factor of production (input) that cannot be

changed in a fixed time period.
Short run - Short run is that period of time in which at least one
variable input can be changed. Value of fixed input can't be
changed.
Long run - Long run is that period of time in which both fixed and
variable input can be changed. Value of fixed as well as variable
input can be increases or decreased. Hence there is no fixed
inputs in Long run
Short Run Production Function with One
Variable Input
Q = f (L, K*) Production Matrix
K Q
6 10 24 31 36 40 39
5 12 28 36 40 42 40
4 12 28 36 40 40 36
Capital
3 10 23 33 36 36 33
2 7 18 28 30 30 28
1 3 8 12 14 14 12
1 2 3 4 5 6 L
Labour
Variable Input
L Q MPL APL EL
0 0 - - -
1 3 3 3 1
2 8 5 4 1.25
3 12 4 4 1
4 14 2 3.5 0.57
5 14 0 2.8 0
6 12 -2 2 -1
∆TP
Total Product TP = Q = f(L) Marginal Product MPL =
∆L
Production or MPL
TP EL =
Average Product APL = Output Elasticity APL
L
Variable Input
Variable Input
Law of Variable Proportion
The declining proportion of MPL is reflection of the Law of
Diminishing Return
The relationship between MPL and APL can be used to
define three stages of production for Labour.
Stage 1: from the origin to the point where APL is
maximum (point H’)
Stage 2: from the point where APL is maximum to where
MPL is zero (point H’ to J’)
Stage 3: the range over which MPL is negative
(past point J’)
Optimal Use of the Variable Input
L MPL MR = P MRPL MRCL
2.50 4 $10 $40 $20
3.00 3 10 30 20
3.50 2 10 20 20
4.00 1 10 10 20
4.50 0 10 0 20
Use of Labor is Optimal When L = 3.50
Marginal Revenue MRPL = (MPL)(MR)
Product of Labor
Marginal ∆TC
MRCL =
Cost of Labor ∆L
Optimal Use of Labor MRPL = MRCL
Optimal Use of the Variable Input
Short Run Production Function:
With Two Variable Input
Short Run Production Function with Two
Variable Input
Q = f (L, K, T*) Production Matrix
K Q
6 10 24 31 36 40 39
5 12 28 36 40 42 40
4 12 28 36 40 40 36
3 10 23 33 36 36 33
2 7 18 28 30 30 28
1 3 8 12 14 14 12
1 2 3 4 5 6 L
Variable Input
Q = f (L, K, T*) Production Matrix
K Q
6 10 24 31 36 40 39
5 12 28 36 40 42 40
4 12 28 36 40 40 36
3 10 23 33 36 36 33
2 7 18 28 30 30 28
1 3 8 12 14 14 12
1 2 3 4 5 6 L
Variable Input
L K L K
2 5 4 6
2 4 3 5
3 2 3 4
6 2 4 3
5 3
6 4
Q (28)= f (L, K) Q (36)= f (L, K)

Isoquants
Isoquants
Isoquants: all possible combinations of inputs that result in the

production of a given level of output
Economic Region of Production
Economic Region of
Production
At upper ridge line, the marginal product of capital is zero, while the
lower ridge line implies that the marginal product of labour is zero.
The production techniques are technically efficient only in the region
inside the two ridge lines.
Marginal Rate of Technical Substitution
Marginal Rate of Technical
Substitution
MRTS = -∆K/∆L =
MPL/MPK
MRTS: the tradeoffs between factors, such as capital and

labor, that a firm must make in order to keep output constant
Mathematical Derivations
Taking Total Differential of
Q = f ( L, K ) the Production Function
∂Q ∂Q
dQ = dL + dK =0
∂L ∂K
dK ∂Q ∂L
= −
dL ∂Q ∂K
dK MPL
= − = MRTS LK
dL MPK
Isocost Lines
Isocost Lines
AB C = 100, w = r = 10
A’B’ C = 140, w = r = 10
A’’B’’ C = 80, w = r = 10
AB* C = 100, w = 5, r = 10
Isocost line: all the possible combinations of two factors that

can be used at given costs and for a given producer’s budget
Isocost Lines
Isocost lines represent all combinations of two inputs
that a firm can purchase with the same total cost.
=
C wL + rK C = Total Cost
w = Wage Rate of Labor ( L)
C w
K= − L r = Cost of Capital ( K )
r r
Isoquant analysis :The Economically
Efficient Point of Production
MRTS = w/r
Slope of Isoquant =
Slope of Isocost
Mathematical Derivations: Output Maximization
Maximize Q = f ( L, K ) Subject to =
C * wL + rK
Composite function with Lagrangian multiplier
φ =Q + λ (C * − wL − rK )
∂φ ∂Q
Differentiating the
= + λ ( − w) = 0 …1
composite
function with
∂L ∂L
respect to L and K ∂φ ∂Q
and λ = + λ (−r )= 0 …2
∂K ∂K
∂φ
= C * − wL − rK = 0 … 3
∂λ
Mathematical Derivations: Output Maximization
Solving EQ1,
and EQ2
∂Q ∂Q ∂L MPL
= λ w...........
= or λ =
∂L w w
∂Q ∂Q ∂K MPK
= λ r...........
= or λ =
∂K r r
MPL MPK MPL w
Equilibrium = = =
condition w r MPK r
Mathematical Derivations: Cost Minimization
Minimize =
C =
f (Q ) wL + rK Subject to Q* = f ( L, K )
Composite function with Lagrangian multiplier
φ= C − λ[Q * − f ( L, K )]
φ = ( wL + rK ) − λ[Q * − f ( L, K )]
Differentiating the ∂φ ∂f ( L, K ) ∂Q
composite w−λ
= = 0= w−λ …1
function with ∂L ∂L ∂L
respect to L and K ∂φ ∂f ( L, K ) ∂Q
and λ r −λ
= = 0= r −λ …2
∂K ∂K ∂K
∂φ
=
−[Q * − f ( L, K )] =0 …3
∂λ
Mathematical Derivations: Cost Minimization
Solving EQ1,
and EQ2
∂Q ∂Q ∂L MPL
=λ =
w........... or λ =
∂L w w
∂Q ∂Q ∂K MPK
= λ =
r...........or λ =
∂K r r
Equilibrium MPL MPK MPL w
condition = = =
w r MPK r
Examples
Given the following information:
Production function : Q = 100 K
0.5
L0.5
Total Cost : C*=1000,
W (Wage Per Unit of Labour)=30
R (Rent Per Unit of Capital)= 40
Determine the amount of Labour and capital that the firm should
use in order to maximize output and what is the level of output?
Given the following information:

Production function : Q = 100 K 0.5 L0.5
W (Wage Per Unit of Labour)=50
R (Rent Per Unit of Capital)= 40
Determine the amount of Labour and capital that the firm should use in
order to minimize the cost of producing 1118 unit of output and what is
the minimum cost?
Long run Production Function
Returns to Scale: the behavior of the rate of increase in

output (production) relative to the associated increase in
the inputs (the factors of production) in the long run
Production Function Q = f(L, K)

λQ = f(hL, hK)
If output increases by that same proportional change as all
inputs change then there are constant returns to scale (CRS)
If λ = h, then f has constant returns to scale.

If output increases by more than that proportional change in
inputs, there are increasing returns to scale (IRS)
If λ > h, then f has increasing returns to scale.
If output increases by less than that proportional change in

inputs, there are decreasing returns to scale (DRS).
If λ < h, the f has decreasing returns to scale.

Note: A firm's production function could exhibit different types of returns to scale
in different ranges of output. Typically, there could be increasing returns at
relatively low output levels, decreasing returns at relatively high output levels,
and constant returns at one output level between those ranges.
The returns to scale faced by a firm are purely technologically imposed and are
not influenced by economic decisions or by market conditions
Constant Increasing Decreasing

Returns to Scale Returns to Scale Returns to Scale
Empirical Production Functions
Cobb-Douglas Production Function: is a particular functional
form of the production function, widely used to represent the
technological relationship between the amounts of two or more
inputs, particularly physical capital and labor, and the amount of
output that can be produced by those inputs.
Cobb, C. W.; Douglas, P. H. (1928). "A Theory of Production". American Economic Review 18 (Supplement): 139–165
Standard form for production of a single good with two factors, the function is
α β
Q = AK L
where:
Y = total production; L = labor input; K = capital input; A = total factor productivity
•α and β are the output elasticities of capital and labor, respectively. These values
are constants determined by available technology.
Empirical Production Functions
Output elasticity measures the responsiveness of output to a
change in levels of either labor or capital used in production,
ceteris paribus. For example, if α = 0.45, a 1% increase in capital
usage would lead to approximately a 0.45% increase in output.
Further, if
α + β = 1,
the production function has constant returns to scale, meaning
that doubling the usage of capital K and labor L will also double
output Y. If
α + β < 1,
returns to scale are decreasing, and if
α + β > 1,
returns to scale are increasing.
Cobb-Douglas Production Function
Q = AK α Lβ
∂Q Q
=
MP = α AK α −1
=
L β
α
∂K
K
K
∂Q Q
=
MP = β AK L=α β −1
β
∂L
L
L
∂Q K Q K
=
EK =. α=. α
∂K Q K Q
∂Q L Q L
=
EL =. β=
. β
∂L Q L Q
Examples
Q = AK α Lβ
Costs of Production
Concepts
Cost functions show the money cost of producing various
levels of output.
Cost Functions
Short Run Long Run

Cost Functions Cost Functions
Fixed Cost and Variable
Cost
Fixed costs; costs associated with inputs that are fixed in the short
run.
Variable costs; costs associated with inputs that can be varied in
the short run.
Concepts
Opportunity cost
Opportunity cost is the cost of a good or service
as measured by the alternative uses that are
foregone by producing the good or service.
– If 15 bicycles could be produced with the materials
used to produce an automobile, the opportunity
cost of the automobile is 15 bicycles.
• The price of a good or service often may reflect
its opportunity cost.
Concepts
Explicit and Implicit Costs
An explicit cost is a direct payment made to others in the
course of running a business, such as wage, rent and
materials.
An implicit cost, also called an imputed cost, implied

cost, or notional cost, is the opportunity cost equal to
what a firm must give up in order to use factor of
production which it already owns and thus does not pay
rent for.
Concepts
Accounting and Economic Cost
Accounting cost is the concept that goods or services

cost what was paid for them.
Accounting Costs = Explicit Costs
Economic cost is the amount required to keep a

resource in its present use; the amount that it would be
worth in its next best alternative use.
Economic Costs = Explicit + Implicit Costs
Concepts
Sunk Costs are costs that must be incurred no matter
what the decision. These costs are not part of
opportunity costs.
A cost that has already been incurred and thus cannot be recovered.
Sunk costs are sometimes contrasted with prospective costs, which are
future costs that may be incurred or changed if an action is taken. Both
retrospective and prospective costs may be either fixed (continuous for
as long as the business is in operation and unaffected by output
volume) or variable (dependent on volume) costs.
Example: inventory costs or R&D expenses

Table: The Many Types of Cost: A Summary
dTC d ( FC + VC ) dVC
=
MC = =
dQ dQ dQ
Table: Measuring Various Costs
1 2 3 4 5 6 7 8 9
Labour Output TC= AFC= AVC= ATC=
Input (L) (Q) FC VC FC+VC FC/Q VC/Q C/Q MC
0 0 100 0 100 - - - -
1 15 100 30 130 6.7 2.0 8.7 2.0
2 31 100 60 160 3.2 1.9 5.2 1.9
3 48 100 90 190 2.1 1.9 4.0 1.8
4 59 100 120 220 1.7 2.0 3.7 2.7
5 68 100 150 250 1.5 2.2 3.7 3.3
6 72 100 180 280 1.4 2.5 3.9 7.5
7 73 100 210 310 1.4 2.9 4.2 30.0
Note: Per unit cost of labour (w) = 30
Assuming K= 2 and Per unit of cost of capital (r) = 50
dTC d ( FC + VC ) dVC
=
MC = =
dQ dQ dQ
Total Cost Curves
15
TVC
Cost
10
TFC
0 5 10 15
Output
Total Cost Curves
15
TC
TVC
Cost
10
TFC
0 5 10 15
Output
Marginal Cost and Average Costs
1.5
Cost
0.5
AFC
0 5 10 15
Output
1.5
Cost
1
AVC
0.5
AFC
0 5 10 15
Output
1.5
ATC = AFC + AVC
Cost
1 ATC
AVC
0.5
AFC
0 5 10 15
Output
1.5
ATC = AFC + AVC
MC
Cost
1 ATC
AVC
0.5
Minimum
points
AFC
0 5 10 15
Output
Short-Run Cost Curves
• Total fixed cost is constant.
• Total variable cost and total cost both increase with
output.
• Average fixed cost slopes downward.
• The average total cost and average variable cost
curves are U-shaped.
• The marginal cost curve is also U-shaped.
• The MC curve intersects the ATC and AVC at their
respective minimums.
Why the Average Total Cost Curve is U-Shaped
• There are two opposing forces that

guarantee the short-run average total cost
curve will be U-shaped:
– Decreasing average fixed cost
– Eventually increasing average variable cost
caused by diminishing returns
• The shape of the ATC curve combines these
two effects.
Why the Average Total Cost Curve is U-Shaped
TVC wL w w
=
AVC = = =
Q Q Q L APL
APL ↑→ maximum → APL ↓

AVC ↓→ minimum → AVC ↑
∆TVC ∆ ( wL) w( ∆L) w w

=
MC = = = =
∆Q ∆Q ∆Q ∆Q ∆L MPL
MPL ↑→ maximum → MPL ↓

MC ↓→ minimum → MC ↑
Product Curves and Cost Curves
How are the product curves related to the cost curves?
Average product and marginal product
AP
4
MP
2
Rising MP and Falling MP and Falling MP and
falling MC: rising MC: rising MC:
rising AP and rising AP and falling AP and
falling AVC falling AVC rising AVC
0 1 2
Labor
Product Curves and Cost Curves
Average product and marginal product 12
9
MC
6
AVC
3
2
Maximum MP and Maximum AP and
minimum MC minimum AVC
0 4 10
Labor
Cost Curves and Product Curves
• There are two factors that determine a
firm’s cost curves:
– Its technology
– Its product curves
• Marginal product and marginal cost move
in opposite directions.
• Average product and average cost move in
opposite directions, too.
Shifts in the Cost Curves
• The position of a firm’s short-run cost curves depend on
technology and the prices it pays for inputs.
• If technology changes or if factor prices change, the firm’s
costs change and its cost curves shift.
• A technological change that increases productivity shifts the
product curves upward and shifts the cost curves
downward.
• An increase in factor prices increases costs and shifts the
cost curves upward.
• Changes in fixed cost only affect the fixed and total cost
curves.
• Changes in variable cost shifts the variable, total, and
marginal cost curves.
Long run Cost Curves
In the long-run there are no fixed inputs, and therefore no
fixed costs. All costs are variable.
Technical efficiency – as few inputs as possible are used to

produce a given output. Technical efficiency is efficiency
that does not consider cost of inputs.
Economically efficient – the method that produces a given

level of output at the lowest possible cost. It is the least-cost
technically efficient process.
Long run Cost Curves
In the long run, a firm has many sizes to choose from.
The short run requires that scale be fixed— only one or a

few resources can be changed.
The law of diminishing marginal productivity does not hold

in the long run. All inputs are variable in the long run.
The term “plant size” to talk about having a particular

amount of fixed inputs. Choosing a different amount of
plant and equipment (plant size) amounts to choosing an
amount of fixed costs.
Fixed costs as being associated with plant and equipment.
Bigger plants have larger fixed costs.
A Typical Long-Run Average Total Cost
Total Costs Total Cost Total Costs = Average Total
Quantity of Labor of Machines TCL + TCM Costs = TC/Q
11 381 254 635 58

12 390 260 650 54
13 402 268 670 52
14 420 280 700 50
15 450 300 750 50
16 480 320 800 50
17 510 340 850 50
18 549 366 915 51
19 600 400 1,000 53
20 666 444 1,110 56
A Typical Long-Run Average Total Cost Curve
64
62
Costs per unit
60 Average
58 total cost
56
54
52
50
48
11 12 13 14 15 16 17 18 19 20 Quantity
Economies and Diseconomies of Scale
64 Economies Constant Diseconomies

62 of Scale returns of Scale
to Scale
Costs per unit
60 Average
58 total cost
56
54
52
50
48
11 12 13 14 15 16 17 18 19 20 Quantity
Economics of Scale
• Scale means size.
• Economies of scale: the decrease in per unit costs as
the quantity of production increases and all
resources are variable
• Diseconomies of scale: the increase in per unit costs
as the quantity of production increases and all
• Constant returns to scale: unit costs remain constant
as the quantity of production is increased and all
Economies of Scale
• Economies of scale – long run average total costs
decrease as output increases.
• An indivisible setup cost is the cost of an indivisible
input for which a certain minimum amount of
production must be undertaken before the input
becomes economically feasible to use.
Causes: Labor Specialization; Management Specialization; Efficient Use
of Capital; Efficient Use of By-Products
• The cost of a blast furnace or an oil refinery is an

example of an indivisible setup cost.
Diseconomies of Scale
• Diseconomies of scale refer to decreases in
productivity which occur when there are equal
increases of all inputs (no input is fixed).
– Diseconomies of scale occur on the right side of the long-
run average cost curve where it is upward sloping,
meaning that average cost is increasing.
Causes: Worker Alienation; Communication Problems;
Coordination and Control Problems
• Constant returns to scale is where long-run average

total costs do not change as output increases.
• It is shown by the flat portion of the LRATC curve.
Minimum Efficient Scale
• The minimum efficient scale (MES) is the minimum
point of the long-run average-cost curve; the output
level at which the cost per unit of output is the
lowest.
• The minimum efficient level of production is the
amount of production that spreads setup costs out
sufficiently for firms to undertake production
profitably.
• The MES varies considerably across industries.
A Typical Long-Run Average Total Cost Curve
Costs
per unit
60
Long-run
average total
Minimum
efficient cost (LRATC)
55 level of
production
50
Q
11 14 17 20
ATC falls because ATC is constant ATC rises because
of economies because of constant of diseconomies
of scale returns to scale of scale
13-31
The Envelope Relationship
• Long-run costs are always less than or equal to short-run
costs because:
• In the long run, all inputs are flexible
• In the short run, some inputs are fixed
• There is an envelope relationship between long-run and

short-run average total costs. Each short-run cost curve
touches the long-run cost curve at only one point.
• In the short run all expansion must proceed by

increasing only the variable input
– This constraint increases cost
Long-Run and Short-Run Cost Curves
The Envelope of
Short-Run Average Total Cost Curves
Costs
per unit
LRATC
SRATC4
SRATC1
SRMC1 SRMC4 The long-run average
SRATC2
SRMC2 SRATC3 total cost curve (LRATC)
SRMC3
is an envelope of the
short-run average total
cost curves (SRATC1-4)
Q
Summary: Long-Run Average Total Cost
• Long-run average total cost (LRATC): the lowest-cost
combination of resources with which each level of
output is produced when all resources are variable.
• The long-run average total cost curve gets its shape

from economies and diseconomies of scale.
– If producing each unit of output becomes less costly there
are economies of scale.
– If producing each unit of output becomes more costly
there are diseconomies of scale.
– If unit costs remain constant as output rises there are
constant returns to scale.
Profit Maximization
Profit Maximization
Profit maximization is the short run or long run process by which
a firm determines the price and output level that returns the
greatest profit.
• Concepts: Cost and Revenue
• The total revenue–total cost perspective relies on the fact that
profit equals revenue minus cost and focuses on maximizing
this difference
• The marginal revenue–marginal cost perspective is based on
the fact that total profit reaches its maximum point where
marginal revenue equals marginal cost.
Profit Maximization
To obtain the profit maximizing output quantity
Profit = Total revenue (TR)

- Total cost (TC)
=π TR(Q) − TC (Q)
π P(Q).Q − TC (Q)
Profit Maximization
The necessary condition for choosing the level of q that
maximizes profits can be found by setting the derivative of the
π function with respect to q equal to zero
dπ dTR dTC
= − =0
dQ dQ dQ
dTR dTC
= = orMR MC
dQ dQ
d 2π d 2TR d 2TC
= − <0
dQ 2 dQ 2
dQ 2
d 2TR d 2TC
2
< Slope of MC > Slope of MR
dQ dQ 2
Profit Maximization
1. MR = MC
2. Slope of MC > Slope of MR
Costs and
Revenue
Marginal cost
F
Demand
E
Marginal revenue
0 QMAX Quantity
Profit
P= a − bQ
= P.=
TR Q aQ − bQ 2
dTR
= MR= a − 2bQ
dQ
Profit Maximization: Choice requires
balance at the margin
In general marginal benefit must equal marginal cost at a decision-maker’s
best choice whenever a small increase or decrease in her action is possible
Marginal Revenue and Price
• An increase in sales quantity (∆Q) changes revenue

in two ways:
– Firm sells ∆Q additional units of output, each at a price
of P(Q). This is the output expansion effect: P∆Q
– Firm also has to lower price as dictated by the demand
curve; reduces revenue earned from the original Q units
of output. This is the price reduction effect: Q∆P
Marginal Revenue and Price
Competitive Firm Monopoly Firm
P= a − bQ
TR = P.Q
= P.=
TR Q aQ − bQ 2
d ( P.Q )
= P= MR dTR
= MR= a − 2bQ
dQ dQ
Price reduction
effect of output
expansion: Q∆P.
Non-existent
when demand is
horizontal
Output expansion effect: P∆Q

Profit Maximization: Choice requires balance at
the margin
Costs and
Costs and
Revenue The firm maximizes Revenue
profit by producing
the quantity at which
marginal cost equals MC
Profit- Marginal cost
marginal revenue. P B
maximiz
ing price
E AC profit Average cost
P P=AR= MR E
profit
C B Average
cost D C
Demand
Marginal revenue
0
0 QMAX Quantity
QMAX Quantity
Competitive Firm Monopoly Firm

Profit Maximization: Example
• If the demand function faced by a firm is Q
= 90 − 2 P
or P
= 45 − 0.5Q and the cost function TC =Q 3 − 8Q 2 + 57Q + 2
– Find out the profit maximizing level of output and profit
– Find out the revenue maximizing level of output
• If the demand function faced by a firm is = Q 100 − P

and the cost function TC= 1/ 3Q 3 − 7Q 2 + 111Q + 50
– Find out the profit maximizing level of output and profit
– Find out the revenue maximizing level of output
– Do you find any differences between profit maximizing
level of output and revenue maximizing level of output
Market Structures
Market Structure
Determinants of market structure
• Number of Buyers and Sellers
• Control over price
• Control over supply/output
• Nature of the product – homogenous (identical),
differentiated?
• Freedom of entry and exit
• Degree of competition in the industry
Market Structure
Perfect Competition Perfect Market
Monopolistic Competition
Oligopoly
Imperfect Market
Duopoly
Monopoly
Perfect Competition
Features:
• Large number of buyers and sellers –
• No individual seller can influence price
• Homogenous product – identical so no consumer preference
• Sellers are price takers – have to accept the market price
• Perfect information available to buyers and sellers
• Free entry and exit to industry
Examples of perfect competition:

Financial markets – stock exchange, currency markets, bond
markets?; Agriculture? What Extent?
Perfect Competition
Advantages of Perfect Competition:
• High degree of competition helps allocate resources
to most efficient use
• Price = marginal costs=marginal revenue
• Normal profit made in the long run
• Firms operate at maximum efficiency
• Consumers benefit
What happens in a competitive environment?
• New idea? – firm makes short term abnormal profit
• Other firms enter the industry to take advantage of
abnormal profit
• Supply increases – price falls
• Choice for consumer
• Price sufficient for normal profit to be made but no more!
Monopoly
Features:
• High barriers to entry
• Firm controls price OR output/supply
• Abnormal profits in long run
• Possibility of price discrimination
• Consumer choice limited
• Prices in excess of MC
Why Monopoly Exists:
• Legal: from the ownership of a patent or a copyright,
• Technological, from a secret method of production,
- due to large size, age, or good reputation,
• Natural: Iron Ore, Gas
• Government Regulatory : Gas, Electricity, Rail
Advantages and Disadvantages of Monopoly
Advantages:
• May be appropriate if natural monopoly
• Encourages R&D
• Encourages innovation
• Development of some products not likely without some
guarantee of monopoly in production
• Economies of scale can be gained – consumer may benefit
Disadvantages:
• Exploitation of consumer – higher prices
• Potential for supply to be limited - less choice
• Potential for inefficiency – complacency over controls on
costs
Monopolistic Competition
Features:
• Many buyers and sellers
• Products differentiated
• Relatively free entry and exit
• Each firm may have a tiny ‘monopoly’ because of the
differentiation of their product
• Firm has some control over price
Examples: Restaurants, professions – solicitors, plumbers,

Building firms –etc.
Oligopoly – Competition amongst the few
Features:
• Industry dominated by small number of large firms
• Many firms may make up the industry
• Products could be highly differentiated – branding or
homogenous
• Abnormal profits
• High degree of interdependence between firms
Examples:Supermarkets; Banking industry; Chemicals; Oil

Medicinal drugs; Broadcasting
Measuring Oligopoly: Concentration ratio – the proportion of
market share accounted for by top X number of firms:
E.g. 5 firm concentration ratio of 80% - means top 5 five firms
account for 80% of market share
Duopoly
Features:
• Industry dominated by two large firms
• Possibility of price leader emerging – rival will follow
price leaders pricing decisions
• Abnormal profits likely
Examples:
• Visa and Mastercard are the two largest payment processors in the
world. Because their competitors are so small in comparison, Visa and
Mastercard may be considered a duopoly.
• Airbus and Boeing in the market for large commercial airplanes
• Intel and AMD in X86 CPU market
Price and Output under Perfect
Competition
Perfect Competition
• Perfect competition arises when:
• There are many firms, each selling an identical
product.
• There are many buyers.
• There are no restrictions on entry into the
industry.
• Firms in the industry have no advantage over
potential new entrants.
• Firms and buyers are completely informed
about other firms’ prices.
Perfect Competition
Market Structure and Firm Behaviour
• Competitive behaviour refers to the extent to which individual firms
compete with each other to sell their products.
• Competitive market structure refers to the power that individual
firms have over the market - perfect competition occurring where
firms have no market power and hence no need to react to each
other.
Perfectly Competitive Markets
• The theory of perfect competition is based on the following
assumptions: firms sell a homogenous product; customers are well
informed; each firm is a price-taker; the industry can support many
firms, which are free to enter or leave the industry.
Elasticity of Industry and Firm Demand
• Since each firm produces a small fraction of total industry output
and the products are identical, no firm has any control over price.
• Firms are price takers in perfectly competitive markets. A price

taker is a firm that cannot influence the price of a good or service.
• A price taker firm faces a demand curve that is perfectly elastic

(horizontal) because the product from firm A is a perfect
substitute for the product from firm B.
• However, the market demand curve will still slope downward;

elasticity will be positive, but not infinite.
The Demand Curve for a Competitive Industry
and for One Firm
Price
5 5
4 S
4
E Dfirm
3 3
2 2
1 1
D
60
100 200 300 400 10 20 30 40 50
Quantity [millions of tons] Quantity [thousands of tons]
[i] Competitive industry’s demand curve [ii] Competitive firm’s demand curve
The Demand Curve for a Competitive Industry
and for One Firm
• The industry’s demand curve is negatively sloped, the firm’s
demand curve is virtually horizontal.
• The competitive industry has output of 200 million tonnes
when the price is 3.
• The individual firm takes that market price as given and
considers producing up to say, 60,000 tonnes.
• The firm’s demand curve in part (ii) is horizontal because any
change in output that this one firm could manage would
leave price virtually unchanged at 3.
Revenue Concepts for a Price-taking Firm
Quantity sold Price TR = p*q AR = TR/q MR = ∆TR/∆q
(Units)
(q) (Rs/p) (Rs) (Rs) (Rs)
10 3.00 30.00 3.00

3.00
11 3.00 33.00 3.00
3.00
12 3.00 36.00 3.00
3.00
13 3.00 39.00 3.00
• The table shows the calculation of total (TR), average (AR), and marginal revenue
(MR) when market price is 3.00.
• For example when sales rise from 11 to 12 units, revenue rises form 33 to 36 making
marginal revenue equal to 3.
• The table illustrates the general result that when price is fixed average revenue,
marginal revenue, and price are all equal.
Economic Profit and Revenue
• Total revenue (TR)
– Value of a firm’s sales
– TR = P × Q
• Marginal revenue (MR)
– Change in total revenue resulting from a one-unit increase
in quantity sold.
d ( P.Q )
– MR = = P= MR
dQ
• Average revenue (AR)
– Total revenue divided by the quantity sold — revenue per
unit sold.
– AR = TR/Q = (PxQ)/Q = P
• In perfect competition, Price = MR = AR

Revenue Curve for a Firm
TR
AR = MP = p
3 39
30
0 10 0 10 13
Output
Output
[i] Average and marginal revenue [ii] Total revenue
• Because price does not change as the firm varies its output, neither
marginal nor average revenue varies with output -both are equal to
price.
• When price is constant, total revenue is a straight line through the origin
whose constant positive slope is the price per unit.
Short-run Equilibrium
• Any firm maximizes profits producing the output where its marginal
cost curve intersects the marginal revenue curve from below - or by
producing nothing if average cost exceeds price at all outputs.
• A perfectly competitive firm is a quantity-adjuster, facing a perfectly
elastic demand curve at the given market price and maximizing
profits by choosing the output that equates its marginal cost to
price.
• The supply curve of a firm in perfect competition is its marginal cost
curve, and the supply curve of a perfectly competitive industry is
the sum of the marginal cost curves of all its firms.
• The intersection of this curve with the market demand curve for
the industry’s product determines market price.
Long-run Equilibrium
• Long-run industry equilibrium requires that each individual firm be
producing at the minimum point of its LRAC curve and be making
zero profits.
The Allocative Efficiency of Perfect Competition

• Perfect competition produces an optimal allocation of resources
because it maximizes the sum of consumers’ and producers’ surplus
by producing equilibrium where marginal cost equals price.
Total Cost and Revenue Curves and Profit
TC
TR
Price
• At each output the vertical
distance between the TR and TC
curves shows by how much total
revenue exceeds or falls short of
total cost.
• The gap is largest at output qE
which is the profit-maximizing
output.
0 qE
Output
The Short-run Equilibrium of a Firm in Perfect
Competition
AVC
Price MC
per
unit
p=MR=AR
q2 qE q1
Output
Price, Average Total Cost, and Profit
• Price is total revenue per unit, or average

revenue (P=AR=TR/Q)
• Average total cost is total cost per unit
(ATC=TC/Q).
• Profit = TR - TC
• Profit per unit=(TR-TC)/Q=(TR/Q) - (TC/Q)
= (P - ATC)
• That means total profit = (P - ATC)*Q
Alternative Short-run Equilibrium Positions for
a Firm in Perfect Competition
Price per unit
Loss
Price per unit

Break Even
[i] [ii]
SRATC MC MC
SRATC
E E
p1 p2
SARVC
0 q1 Output 0 q2 Output
Profit
[iii]
Price per unit
MC
SRATC
E
p3
0 q3
Output
Profits and Losses in the Short-Run
• If price equals average total cost (P=ATC), a

firm breaks even.
• If price exceeds average total cost (P>ATC), a

firm makes an economic profit.
• If price is less than average total cost (P<ATC),

a firm incurs an economic loss.
The Firm’s Decisions in Perfect Competition
[Loss] • Whether to produce or

to shut down.
Price per unit
SRATC
MC • If the decision is to
produce, what quantity
to produce.
E
p1
• Price is not a decision
SARVC
because firm is a price
taker.
0 q1 Output
A Firm’s Shut-down Point
Marginal revenue & marginal cost
MC
3.5
ATC
3.0
AVC
2.5
2.0
7 9 10
Quantity
MC = Supply
3.5
ATC
a
3.0 MR1=P1=3.0
AVC
2.5 b MR2=P2=2.5
c
2.0 MR3=P3=2.0
Shutdown 7 8 9
point
Quantity
MC
3.5
3.0
Shutdown AVC
point
c
2.0 MR0=P0=2.0
7 9 10
Quantity
Temporary Plant Shutdown
• A firm cannot avoid incurring its fixed costs but it
can avoid variable costs.
• A firm that shuts down and produces no output
incurs a loss equal to its total fixed cost.
• A firm’s shutdown point is the level of output and
price where the firm is just covering its total
variable cost.
• In other words, if its losses are bigger than its
fixed costs, the firm will shut down.
The Supply Curve for a Price-taking Firm
MC S
E3 p3
5 5
E2 p2
Price per nut
4 4
AVC
E1 p1
3 3
E0
p0
2 2
1 1
q0 q1 q2 q3
Output Quantity
[i] Marginal cost and average variable cost curves [ii] The supply curve
The Firm’s Short-Run Supply Curve
• A perfectly competitive firm’s short-run supply curve

shows how its profit-maximizing output varies as
market price changes.
• Since price must equal marginal cost, the marginal
cost curve is also the supply curve.
• However, only the portion of the marginal cost curve
above the minimum average variable cost curve is
relevant.
The Firm’s Short-Run Supply Curve
• Fixed costs must be paid in the short-run.
• Variable-costs can be avoided by laying off
workers and shutting down.
• Firms shut down if price falls below the
minimum of average variable cost.
Production Decisions
• When price is below the minimum point of the AVC

curve, the firm will shut down and supply zero
output.
• When price is above the lowest point of the AVC
curve, the firm will produce the level of output where
price equals marginal cost.
• The short-run supply curve is therefore the MC curve
above the AVC curve.
Output, Price, and Profit in the Long Run
• In short-run equilibrium, a firm might make an
economic profit, incur an economic loss, or break even
(make a normal profit). Only one of these situations is
a long-run equilibrium.
• In the long run either the number of firms in an
industry changes or firms change the scale of their
plants.
Economic Profit and Economic Loss as Signals
• If an industry is earning above normal profits
(positive economic profits), firms will enter the
industry and begin producing output.
– This will shift the industry supply curve out, lowering price
and profit.
• If an industry is earning below normal profits
(negative economic profits), some of the weaker
firms will leave the industry.
– This shifts the industry supply curve in, raising price and
profit.
Entry and Exit
Price
S1 S0 S2
23
20
17
D1
6 7 8 9 10
Quantity
Long-Run Equilibrium
• In long-run equilibrium, firms will be
earning only a normal profit. Economic
profits will be zero.
• Firms will neither enter nor exit the
industry.
• In long run equilibrium, P=MC and P=ATC.
Thus, P=MC=ATC.
• Because MC=ATC, ATC must be at its
minimum.
Long-Run Equilibrium
Industry Firm
Price and Cost

S0 LMC
Price
LATC
MR0
P0 P0
D0
Q0 Quantity q0 Quantity
0
Consumers’ and Producers’ Surplus
S
Price
E
Consumer surplus Market price
p0
Producers surplus
Total variable cost
0
q0
Quantity
Consumers’ and Producers’ Surplus
• Consumers’ surplus is the area under the demand curve and
above the market price line.
• The equilibrium price and quantity are p0 and q0.
• The total value that consumers place on q0 units of the product
is given by the sum of the dark yellow, light yellow, and light
blue areas.
• The amount that they pay is p0q0, the rectangle that consists of
the light yellow and light blue areas.
• The difference, shown as the dark yellow area, is consumers’
surplus.
• The difference, shown as the light yellow area, is producers’
surplus.
E Competitive market price

p0 3
4
2 D
0 q1 q0 q2
Quantity
• At the competitive equilibrium E consumers’ surplus is the dark yellow
area above the price line.
• Producers’ surplus is the light yellow area below the price line.
• Reducing the output to q1 but keeping price at p0 lowers consumers
surplus by area 1.
• It lowers producers’ surplus by area 2.
• Assume that producers are forced to produce output q2 and to sell it to
consumers, who are in turn forced to buy it at price p0.
• Producers’ surplus is reduced by area 3 (the amount by which variable
costs exceed revenue on those units).
• Consumers’ surplus is reduced by area 4 (the amount by which
expenditure exceeds consumers’ satisfactions on those units).
• Only at the competitive output, q0, is the sum of the two surpluses
maximized.
Summary
• The impact of the product market on firms’ prices and output choices
is determined by the nature of the product and the market structure
in which they operate.
• In perfect competition firms produce a homogeneous product and
are price-takers in their output markets.
• All profit-maximising firms choose their output to equate marginal
cost and marginal revenue.
• Under perfect competition marginal cost will equal the market price,
and so the supply curve of firms is determined by the marginal cost
curve.
• Perfect competition maximizes benefits that consumers receive from
the output.
Price and Output under Monopoly
Monopoly
Features:
• Firm controls price OR output/supply
• Abnormal profits in long run
• Possibility of price discrimination
• Consumer choice limited
• Prices in excess of MC
Why Monopoly Exists:
• Legal: from the ownership of a patent or a copyright,
• Technological, from a secret method of production,
- due to large size, age, or good reputation,
• Natural: Iron Ore, Gas
• Government Regulatory : Gas, Electricity, Rail
Monopoly
A Single-Price Monopolist
• A monopoly is an industry containing a single firm.
• The monopoly firm maximises its profits by equating marginal
cost to marginal revenue, which is less than price.
• Production under monopoly is less than it would be under
perfect competition, where marginal cost is equated to price.
A Multi-Price Monopolist: Price Discrimination
• If a monopolist can discriminate among either different units or
different customers, it will always sell more and earn greater
profits than if it must charge a single price.
• For price discrimination to be possible, the seller must be able
to distinguish individual units bought by a single buyer or to
separate buyers into classes among whom resale is impossible.
Monopoly
Long-run Monopoly Equilibrium
• A monopoly can earn positive profits in the long run if there
are barriers to entry.
• These may be man-made, such as patents or exclusive
franchises, or natural, such as economies of large-scale
production.
The Allocative Inefficiency of Monopoly

• Monopoly is allocatively inefficient.
• By producing less than the perfectly competitive output it
transfers some consumers’ surplus to its own profits and also
causes deadweight loss of surplus that would have resulted
from the output that is not produced.
Total, Average and Marginal Revenue
Price Quantity Total Marginal
Revenue Revenue
p=AR q TR=p*q MR = ∆TR/∆q
p0
(Rs) (Rs) (Rs) (Rs)
p1
9.10 9 81.90
8.10 Reduction Addition to
9.00 10 90.00 in revenue revenues
7.90
8.90 11 97.90
q0 q1 Quantity
• The revenue from the extra unit sold is shown as the medium blue area.
• The loss in revenue is shown as the dark blue area.
• Marginal revenue of the extra unit is equal to the difference between the
two areas.
Revenue curves and Demand elasticity
Elasticity
greater P= a − bQ
10 than one η>1
Unity elasticity = P.=
TR Q aQ − bQ 2
η=1
dTR
Elasticity = MR= a − 2bQ
between dQ
zero and one
AR 0 < η <1
5
50 100
-10 MR
Quantity
250 • Rising TR, positive MR, and
TR elastic demand all go
Rs together.
• Falling TR negative MR and
inelastic demand all go
0 50 100 Quantity
together.
Price, Average Total Cost, and Profit
• Average total cost is total cost per unit

(ATC=TC/Q).
• Profit = TR - TC
• Profit per unit=(TR-TC)/Q=(TR/Q) - (TC/Q)
= (P - ATC)
• That means total profit = (P - ATC)*Q
• To determine the profit-maximizing price (where MC = MR),
one first finds that output and then extends a vertical line up to
the demand curve.
The Equilibrium of a Monopoly
•The monopoly produces
the output q0 where
MC marginal revenue equals
marginal cost (rule 2).
ATC •At this output, the price of
p0 p0 (which is determined by
the demand curve)
c AVC exceeds the average
0
variable cost (rule 1).
•Total profit is the profit
per unit of p0-c0 multiplied
by the output of q0, which
is the yellow area.
MR
D = AR
0 q0 Quantity
Profit-maximizing quantity
Alternative Short-run Equilibrium Positions for
a Firm in Monopoly
Profit
Break Even
Price MC
Price MC
ATC
A ATC
PM
Profit
B PM
CM
MR D MR D
0 QM Quantity Loss 0 QM Quantity
Price MC ATC
B
CM
Loss A
PM
MR D
0 QM Quantity
No Supply Curve under Monopoly
• The demand curves D’ and D’’ both
have marginal revenue curves that
D” intersect the marginal cost curve at
output q0.
p1
p0
MC
MR” MR’ D’
Quantity
0 q0
The same output at different prices
• But because the demand curves are different, q0 is sold at:

• p0 when the demand curve is D’ and at p1 when the demand curve is D’’.
• Thus under monopoly there is no unique relation between price and the
quantity sold.
Long-run Monopoly Equilibrium
•A monopoly can earn
MC positive profits in the long
run if there are barriers to
ATC entry.
p0
•These may be man-made,
such as patents or
c
0
AVC exclusive franchises, or
natural, such as economies
of large-scale production.
MR
D = AR
0 q0 Quantity
Profit-maximizing quantity
The Price-Discriminating Monopolist
• Price discrimination is the ability to charge different prices
to different customers.
• In order to price discriminate, a monopolist must be able to:
• Identify groups of customers who have different elasticities
of demand;
• Separate them in some way; and
• Limit their ability to resell its product between groups.
• A price-discriminating monopolist can increase both output
and profit.
• It can charge customers with more inelastic demands a
higher price and more elastic demands a lower price.
For perfectly price-discriminating monopolist, P = AR = MR.

The Price-Discriminating Monopolist
pm MR
1
pd
S = MC
2 3
0 qm qd qc
Quantity
Thus, it will produce the same quantity as will a perfectly competitive firm.
For perfectly price-discriminating monopolist, P = AR = MR.
The Price-Discriminating Monopolist in Real World
• Movie theaters give senior citizens and child

discounts.
• All airline Super Saver fares include Saturday night
stopovers.
• Automobiles are seldom sold at their sticker price.
• Theaters have midweek special rates.
• Retail tire stores run special sales about half the
time.
• Restaurants generally make most of their profit on alcoholic drinks and
just break even on food.
• College-town stores often give students discounts.
Monopoly is allocatively inefficient
MC
Price
Monopolist
36 price(MR=MC)
30
24 Competitive price
18 (MR=MC=P)
12
6
D
0
1 2 3 4 5 6 7 8 9 10
6
MR
12
• By producing less than the perfectly competitive output it transfers

some consumers’ surplus to its own profits and also causes
deadweight loss of surplus that would have resulted from the output
that is not produced.
The Welfare Loss from Monopoly
Price
MC
PM
C
D
PC
B
MR D
0
QM QC Quantity
•The monopolist's MR is below its price, thus its equilibrium output is

different from a competitive market.
•The welfare loss of a monopolist is represented by the triangles B and D.
Summary
• A monopolist sets marginal cost equal to marginal
revenue, but marginal cost is less than price.
• Output is lower under monopoly than under perfect
competition.
• Profit can be increased for a monopolist if it is possible
to charge different prices to different customers or in
separate markets.
• Pure profits exist in the long run under monopoly, so
long as there are entry barriers.

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Economics: HS -201

Why to Study Economics?

 Economics as a discipline exists because

 “Economics is the study of how people and

 What goods and services will be

 Government is an organization that sets laws

 Economic science is the attempt to understand

 Demand is a multivariate concept

 Qd = f(Px, I, PR, TC, PC, IF, PF, NC, DC)

 An inverse relationship exists between the

 A rise in the price of a

 A change in tastes that dis-

 A basic economic hypothesis is that the lower

 The prices of inputs to production;

 The state of technology.

 The expectations of producers,

 The number of producers, and

 The prices of related goods and services

• A shift in the supply

• Such an increase in supply can be caused by:

• A shift in the supply

The concept of a market

there is excess supply and

QdX = QsX a – bPX = a + bPX

E • Purpose: keep price below the

• How the sensitivity of quantity demanded to a change in

Percentage change in quantity demanded

GOOD A Original New % Change Elasticity

Quantity 100 95 -5%

Percentage ARC Point

Perfectly Inelastic Perfectly Elastic

•Implies that the

• Total revenue = Price x Quantity

P Q Ep TR=P.Q MR= ΔTR/ΔQ

The responsiveness of demand for a product to changes in

Percentage change in quantity demanded

The responsiveness of quantity demanded of one product to

Percentage change in quantity demanded of X

 Products are substitute if cross elasticity > 0.

Income Elasticity of demand

Cross Elasticity of demand

Ans: (i) P = 4, ep = 0.64 (inelastic)

Q2. The demand function is given X = 10 – P at X = 4, P = 6.

Ans: Decrease in demand is 7.5% and elasticity is 1.5

Condition for the equilibrium MU x = Px

• Utility can not be measured objectively

A consumer’s preference among consumption bundles

• Higher indifference curves are preferred to

• Property 1: Higher indifference curves are

• Property 2: Indifference curves do not cross.

• Property 3: Indifference curves are down ward

Diminishing marginal rate of substitution: The rate of

(a) Perfect Substitutes

(b) Perfect Complements

The budget constraint shows the various combinations

• Consumers want to get the combination of

• Combining the indifference curve and the

Rewrite the constraint ( q1 p1 + q2 p2 + ...... + qn pn − Y ) =

Multiply the constraint by a constant λwhich is Lagrangian multiplier

x y 4 . Find out the

optimal quantity of the two goods , if price of x

How a consumer’s purchases react to changes in

• An increase in income shifts the budget constraint