Mangerial Economics

Managerial Economics
Meaning
Managerial economics is defined as the study of
economic theories, logic and tools of economic
analysis that are used in process of business
decision-making.

In other words economic theories and techniques
of economic analysis are applied to analyze
business problems, evaluate business
opportunities with a view to arrive at appropriate
business decision.
.
Managerial Decision Areas
Assessment of Investible funds
Selecting Business areas
Choice of Product
Determining optimum Output
Determining input-Combination of the
product
Sales promotion
Application of
Economic Concepts
and Theories in
Decision Making
Use of Quantitative
Methods
Mathematical tools
Statistical Tools
Econometrics
Application of Economic Concepts, Theories and analytical Tools to find
Optimum Solution to Business Problems
Why Economics?
Biology contributes to medical profession.
Physics to Engineering.
Economics to Managerial profession.
Achieve objective of the firm
Constraints is limited resources

Application of Economics to Decision
Making
I. Determining and defining the objective to be
achieved.
II. Collection and analysis of business related data
and other information(Economic, social,
Political and technological environment.).
III. Inventing the possible courses of action
IV. Select the possible action from the given
alternatives.
II and III are crucial in decision making

Example Launching a product
Production Related issues and
Sales related issues.
Production Related issues
Available techniques of Production.
Cost of Production
Supply position of inputs
Price structure of inputs
Cost structure of competitive products
Availability of foreign exchange if inputs are
available.
Sales related issues
Market size, general market trends and
demand prospectus for the product
Trends in Industry
Competitors
Pricing of product
Pricing strategy of competitors
Degree of competition
Supply position of complementary goods
Scope of Managerial Economics
Economics applied to the analysis of business
problems and decision making.

Area of business issues to which economic
theories can be directly applied are broadly
divided into
1. Micro Economics (Operational and internal
issues)
2. Macro Economics (Environmental and external
issues)
Operational or Internal issues
What to produce Nature of product or Business
How much to produce Size of firm
How to produce Choice of technology
How to price the commodity
How to promote sales
How to face price competition
How to manage profit and capital
How to manage an inventory
Environmental or External issues
The type of economic system in the country
Trends in GDP, Prices, Saving and Investment Employment,
etc.
Trends in Financial System Banks, Financial and Insurance
companies
Trends in Foreign Trade
Government Economic policies
Social Factors like value system, property rights, customs
and habits.
Socio-economic organization like trade unions, consumers
associations, Consumer co-operatives and producers
unions.
Political environment
Degree of Globalization and Influence of MNCs
Micro Economic Issues
What to produce
How much to produce
How to produce
How to price the commodity
How to promote sales
How to face competition
How to decide on new investment
How to manage profit and capital
How to manage an inventory

Examples of Economic Theories
Theory of Demand
It deals with the consumer behaviour
How do the consumer decides to buy the
commodity
How do they decide on Quantity
When do they stop consuming
How consumer behave on Price
It helps in making choice in commodity, optimum
level of production and price
Theory of Production and Decision
Making

It explains the relationship between inputs
and output.
Under what conditions the cost increases or
decreases
Helps to decide the optimum size of the firm
Size of total output and amt of capital and
labour to be employed given the objective
Market structure and Pricing theory
How price is determined.
When price discrimination is desirable,
feasible and profitable.
How advertising will be helpful to increase
sales.
Thus pricing and production decision will help
to determine the optimum size of the firm.

Profit analysis and Management
Elements of risk is always there even if most
efficient techniques are used.

It guide the firm to measure and manage
profit, to make the allowance of risk premium,
to calculate the pure return on capital and
also future profit.
Theory of Capital and investment
decision
It contribute to deciding choice of project,
maintaining capital, capital budgeting, etc
Macro economic Issues
Trends in Economics:
Level of GDP
Investment climate
Trends in National Output and employment
Price trends
Issues related to Foreign Trade
Trends in International Trade
Trends in International Prices
Exchange rates
Prospectus in International Market

Issues related to Government Policies:
Monetary Policy
Fiscal Policy
Foreign Trade Policy
Environmental Policy etc
Other Topics related to Managerial
Economics
Mathematical Tools
Economic theories for Decision Making
Economic concepts (Cost, Price, Demand etc.)
Ascertaining the variables which is relevant.
Relationship between the two or more
variables.
What is Demand ?
When the desire for a commodity is backed by the
willingness and the ability to spent adequate
sums of money, it becomes demand or effective
demand in the economic sense of the curve. Only
desire for commodity or having money for the
same cannot give rise to its demand
Marshall
Demand for a product refers the amount of it
which will be bought per unit of time at a
particular price.
9/13/2013 group 2 sec c 23
RELATIVE CONCEPT
Demand is the relative concept i.e. it is related
to price and time:
1. The demand for rice is 100Kg
2. The demand for rice at Rs 5/- per Kg is 100Kg
per day.
Second statement is complete because it
mentions the price and time period, becoz
demand varies from time and price.
The demand refers to the quantity of it
purchased at a given price, during a specific
time period.
Determinants of Demand
1. Price of the product.
2. Income and wealth distribution.
3. Tastes, habits and preferences.
4. Relative prices of other goods
Substitute products.
Complementary products.
5. Consumers satisfaction.
6. Quantity of money in circulation.
7. Utility of the commodity.
8. Quality.
9. Expectation regarding future price.
10. Number consumers, time and place: Transport, communication and
market facilities will increase the consumers
11. Advertisements effects.

12. Growth of population.

13. Level of taxation.

14. Climatic or weather conditions.

15. Special occasions.

16. Technology.

17. Psychology of the consumers:

Bandwagon effect: Demand arises becoz others have it others,
Snob effect: Demand arises becoz when it is not commonly
demanded,
Demonstration effect: Copying the others.

INDIVIDUAL DEMAND
Price per unit Demand for commodity X
50 10
40 20
30 30
20 40
10 50
05 60
It is the tabular representation of the various quantities of a
commodity demanded by an Individual at a different prices during a
given period of time
Individual Demand
MARKET DEMAND
Price per Unit Qty Demanded
A B C
Total market
Demand(A + B + C)
50 10 12 15 37
40 20 22 25 67
30 30 32 35 97
20 40 42 45 127
10 50 52 55 157
Demand and Demand Curves (d)
The market demand curve is the horizontal sum of the
demand curves of all individuals.
Market dd curve is also negatively sloped because 1.
Individual dd curves are downward sloping 2. At high
prices some buyers will exit the market
MARKET DEMAND
Generalized demand function
The generalized demand function just set forth is expressed in the
most mathematical form.

Economist and market researchers often expressed generalized
demand function in a linear functional form.

The following equation is an example of a linear form of the
generalized demand function:

Qd = a + bP + cM + dPR + eT + fPe + gN

Where the Variables are (P,M,PR,T,Pe,N).

And a,b,c,d,e,f and g are parameters.
Generalized demand function
The intercept a shows the value of Qd when the
variables P,M,PR,T,Pe,N are all simultaneously
equal to zero.
The other parameter a,b,c,d,e,f and g are called
slope parameters.
They measure the effect on quantity demanded
of changing one of the variables while holding
rest of it as constant.
E.g. b measures the change in Qty dd per unit
change in price
i.e b = Qd/ P.
Summary of Generalized demand
function
Variable Relation to quantity demanded Sign of Slope
parameter
P INVERSE Negative
M Direct for normal goods
Inverse for inferior goods
Positive
Negative
PR Direct for substitute goods
Inverse for the complementary
goods
Positive
Negative

T Direct Positive
Pe Direct

Positive
N Direct

Positive

Demand functions
The relation between price and quantity
demanded per period of time, when all other
factors that affect demand held constant is
called as demand function or simply demand.
It can be expressed as
Qd = f (P)

illustration
Generalized demand function is
Qd = 1800 20P + 0.6M 50PR
To derive a demand functions
Qd = (P)
The variables M and PR must be assigned fixed
value.
Suppose M = 20000, PR = 250
Substitute the value in generalized demand
function.
Qd = 1800 20P- 0.6(20000) 50(250)
= 1800 20P + 12000 12500
= 1300 20P
The intercept parameter 1300 is the amount of the
good consumers would demand if price is zero.

The slope of the demand function is -20 and
indicates that a Rs 1 increase in price causes qty dd to
decrease by 20 units.
Qd = 1300 20 (1)
= 1300 -20 = 1280
Demand Schedule
0
10
20
30
40
50
60
70
0 200 400 600 800 1000 1200
P
r
i
c
e

Demand
Demand function
Qd = 1300 20P
The Law of Demand
Other factors remaining same (habits, tastes etc.) as
price decreases demand increases and vice versa
Marshall

Ceteris paribus, higher the price of a commodity,
smaller is the quantity demanded and lower the price,
larger the quantity demanded.
Demand Schedule (Hypothetical)
Price of commodity (in Rs) Quantity demanded (unit per
week)
5
4
3
2
1
100
200
300
400
500
Quantity demanded
(Q)
Q
1
Q
2
P
1
P
2
E
1
E
2
0
D
D
Price(P)
P
1
- old price
P
2
- new price
Q
1
old quantity
demanded
Q
2
new quantity
demanded
DD demand curve

A Linear Demand Curve
Demand Curve
Characteristics of A Typical Demand Curve
Drawn by joining different loci.

Downward sloping.

Reciprocal relationship between price and quantity
demanded ( P 1/Q
d
)

Linear Non - linear
Assumptions (Other things)
a) No change in consumers income.
b) No change in consumers preferences.
c) No change in the fashion.
d) No change in the price of related goods :
Substitute goods.
Complementary goods.
e) No expectation of future price changes or shortages.
f) No change in size, age, composition and sex ratio of
the population.
g) No change in the range of goods available to the
consumers.
Contd
h) No change in the distribution of income and
wealth.
i) No change in the government policy.
j) No change in weather conditions.
EXCEPTION TO LAW OF DEMAND
Giffens Paradox: Giffen gods are inferior
goods. When the price rises the real income of
the consumer rises and he will move to a
superior goods. This is also called as Giffens
paradox.
Qualitative changes: It may increase qty with
the increase in the price.
Price illusion: Higher the price better is the
quality.
Prestige goods: Purchased by the rich people.
Demonstration effect: Imitating others or
Snob appeal
Fashion:
Necessaries:

Movement along the curve
OR
Change in quantity demanded
Extension of demand
With a decrease in price, there is increase in the
quantity demand of the product.

P
1
P
2
Q
1
Q
2
E
E`
D
D
Quantity
demanded
Price
Contraction of demand
With a increase in price, there is a decrease in
quantity demanded.
Quantity
demanded
P
2
Q
2
P
1
Q
1
E
E`
Price
SOURCES OF SHIFTS IN THE DEMAND
CURVES
Tastes
Prices of related goods
Income
Demographics
Information
Availability of credit
Changes in expectations
Movement of Demand Curve
OR
Change in demand
Increase in demand:
a) More quantity demanded ------ at a given price.
b) Same quantity demanded ------ at a higher price.
P
1
Q
1
Q
2
a b
D
D
D`
D`
Q
1
P
1
P
2
D
D
D`
D`
a
b
Quantity demanded
Quantity demanded
Pric
e
Price
Decrease in demand :
a) Less quantity demanded ---- at same price.
b) Same quantity demanded ---- lower price.
Q
2
Q
1
P
1
a b
Q1
Quantity demanded

P1
D`
b
D`
D
D
D`
D
D
a
D`
Price
Price
Quantity demanded
P2
Factors And Effects of Change
(increase or decrease) in demand
a) Change in income :
Quantity
demanded
Price
Increase
Quantity
demanded
Price
Decrease
D`
D`
D
D
D
D
D`
D`
b) Change in taste, habit and preference :
D
D
D`
D`
D
D
D`
D`
Quantity
demanded
Price
Quantity
demanded
Price
Positive
Negative
c) Change in fashion and customs :
D
D
D`
D`
D
D
D`
D`
Quantity
demanded
Quantity
demanded
Price
Price
Favorable Unfavorable
g) Change in population :
9/13/2013 group 2 sec c 56
Quantity
demanded
Quantity
demanded
Price
Price
D`
D`
D`
D`
D
D
D
D
Increase Decrease
h) Advertisement and publicity persuasion :
9/13/2013 group 2 sec c 57
Quantity
demanded
Quantity
demanded
Price
Price
D
D
D
D
D`
D`
D`
D`
Aggressive Docile
i) Change in value of money :
Quantity
demanded
Quantity
demanded
Price
Price
D`
D`
D`
D`
D
D
D
D
Deflationary
Inflationary
( Value of money)
( Value of money)
j) Change in level of taxation :
Quantity
demanded
Quantity
demanded
D
D`
D`
D`
D
D`
D
D
Low
High
Price
Price
k) Expectation of future changes in prices :
Quantity
demanded
Quantity
demanded
D`
D`
D`
D`
D
D
D
D
Rise
Fall
Price
Price

Shift in Demand

Price Qd = 1300 20P
(M = 20000) D0
Qd = 1600 20P
(M = 20500) D1
Qd = 1000 20P
(M = 19500) D2
65 0 300 0
60 100 400 0
50 300 600 0
40 500 800 200
30 700 1000 400
20 900 1200 600
10 1100 1400 800
Shift in Demand

Determinants of Demand
Determinants of Demand Demand
Increases
Demand decreases Sign of Slope
parameter
Income (M)
Normal Goods
Inferior goods

M rises
M Falls

M Falls
M rises

C > 0
C < 0
Price of related goods (PR)

Substitute goods
Complement good

PR rises
PR falls

PR falls
PR rises

d > 0
d < 0
Consumer Tastes (T) T rises T falls e > 0
Expected price (Pe) Pe rises Pe Falls f > 0
Number of consumers (N) N rises N Falls g > 0
Supply
The amount of a good or service offered for
sale in a market during a given period of time
(e.g a week, a month) is called quantity
supplied.
Concept of Supply
Supply is defined as the various amounts of
goods and services which the sellers are
willing and able to sell at any given price
during a specific period of time
It is related to time, place and person
The supply of sugar is 50 kg is not a complete
sentence
The supply of a sugar at price Rs 5/- is 50kg.
Per day is the complete sentence
Factors affecting Supply
Price
Price of other commodities
Goals of the producer
State of technology
Cost of production
Climate and forces of Nature
Transport facilities
Taxation: Heavy taxes supply will reduce
Expectation regarding future prices

Self-consumption
Time element: Short period the supply is fixed
and vice
Individual Supply Schedule
Price Per Unit of X Qty. supplied of X
U 5 10
V 10 20
W 15 30
X 20 40
Y 25 50
Z 30 60
Individual supply schedule is a tabular representation of the various
quantities of commodity offered for sale by an individual seller at
different prices during given period of time
Individual Supply Curve
Market supply schedule
It is the tabular representation of the various
qty. of a commodity offered for sale by all the
sellers at different prices during a given period
of time. It is the total supply of a commodity
by all the sellers at different prices
Market supply schedule
Price( Rs ) Qty. supplied of X Market
supply (I +
II+ III)
Seller I Seller II Seller III
U 5 10 20 30 60
V 10 20 25 40 85
W 15 30 30 50 110
X 20 40 35 60 135
Y 25 50 40 70 160
Z 30 60 45 80 185
Market supply Curve
U
V
W
X
Y
Z
0
5
10
15
20
25
30
35
0 50 100 150 200
Price( Rs )
Price( Rs )
Law of Supply
Others things remaining the same , qty.
supplied of a commodity directly varies with
its price. i.e. S= f (p)
SUPPLY SCHEDULE
Price Per Unit of X Qty. supplied of X
U 5 10
V 10 20
W 15 30
X 20 40
Y 25 50
Z 30 60
Supply Curve
Assumption
Price of other commodities remains the same
The cost of production remains the same
The method of production remains the same
No change in the availability of goods
No change in transport facilities
No change in weather condition
No change in tax structure and govt. policies
Goals of producer remains the same
No change in expectation about the price
No natural calamities and no self consumption

Exceptions to the law of supply
Backward bending supply curve

Wage rate ( Rs.) Hours of work Daily Income (Rs.)
5 8 40
7 10 70
10 12 120
12 10 120
Fixed income groups: If person expects the
income of Rs.20 he will save 500 Rs at 4% rate
of interest and at 5% rate he will save Rs. 400
Rs.
Expectation regarding future prices
Need for cash by the seller
Rare collection the supply is permanently
fixed whatever the price.
Self consumption

Movements or variation in Supply
When there is change in supply exclusively
due to change in Price
Shift in supply
When there is a change in supply due to change in factors
other than the Price
Generalized supply function
It shows how the different variables jointly determine the quantity
supplied.
The generalized supply function is expressed mathematically as

Qs = g(P, Pi, Pr, T, Pe, F)

Qs = Qty of goods and service offered for sale
P = Price of goods or service.
Pi = Price of inputs
Pr = Price of goods that are related to production.
T = Level of available technology.
Pr = Expected price of the producer
F = No. of firms in the industry
Generalized supply function
As in case of demand, economists often find
itself to express the generalised supply
function in linear functional form:
Qs = h + kP + lPi+ mPr + nT + rPe + sF
Where P, Pi, Pr, T, Pe, F is a variables affecting
the supply, h is the intercept parameter, and k,
l, m, n, r, and s are the slope parameters.

Relation to Generalised demand function
Variable Relation to Quantity
supplied
Sign of slope parameter
P Direct K = is Positive
Pi Inverse L = is Negative

Pr Inverse for substitute in
production (Wheat and
Corn)
Direct for complement in
production(Oil and Gas)
m = is Negative

m = is Positive

T Direct n = is Positive
Pe Inverse r = is Negative
F Direct S = is Positive
Supply function
Supply function is derived from generalised supply function.
A supply function shows the relation between supply and price.

Qs = g(P, Pi, Pr, T, Pe, F) = g (P)
Illustration
Qs = 50 + 10P 8pi + 5F
Suppose the price of the input is Rs. 50 and there are 90 firms then
the supply function will be

Qs = 50 + 10P -8(50) + 5(90)
= 100 + 10P

The supply schedule with equation can be drawn and is given in
next slide

Qs = 100 +10P
Price Quantity Supplied schedule
65 750
60 700
50 600
40 500
30 400
20 300
10 200
750, 65
700, 60
600, 50
500, 40
400, 30
300, 20
200, 10
0
10
20
30
40
50
60
70
0 200 400 600 800
P
r
i
c
e

Qty Supplied
Price
Shift in Supply
Price Qs = 100 + 10P
Pi = 50, F = 90
Qs = 250 + 10P
Pi = 31.25, F = 90

Qs = -200 + 10P
Pi = 50, F = 30

65 750 900 450
60 700 850 400
50 600 750 300
40 500 650 200
30 400 550 100
20 300 450 0
10 200 350 0
Shift in Supply
Determinants of
supply
Supply Increases Supply Decreases Sign of Slope
parameter
Price of inputs (Pi) Pi falls Pi rises I < 0
Price of goods
related in
Production (Pr)
Substitute good
Complement good

Pr falls
Pr rises

Pr rises
Pr falls

M < 0
M > 0
State of technology
(T)
T rises T falls n > 0
Expected Price (Pe) Pe falls Pe rises r < 0
Number of firms or
productive capacity
in Industry (F)
F rises F falls S > 0
Market Equilibrium
Demand and supply provide an analytical framework for
the analysis of the behaviour of buyers and sellers in
markets.

Demand shows how buyers respond to changes in price
and other variables that determine quantities, buyers are
willing to purchase.

Supply shows how sellers respond to changes in price and
other variables that determine quantities offered for sale.

The interaction of buyers and sellers in the market place
leads to market equilibrium.
Market Equilibrium
Market equilibrium is a situation which at the
prevailing price, consumers can buy all of a
good they wish and producers can sell all of
good they wish.

Market Equilibrium
Price Qs = 100 + 10P
S0
Qd = 1300 20P
D0
Excess
supply ( +)
Excess
Demand ( -)
65 750 0 +750
60 700 100 +600
50 600 300 +300
40 500 500 0
30 400 700 -300
20 300 900 -600
10 200 1100 -900
Qd = Qs
1300 20 P = 100 + 10P
Solving this equation for the equilibrium price,
1200 = 30P
P = 40

Market Equilibrium
Market Equilibrium
At Market clearing price of 40

Qd = 1300 (20 * 40) = 500
Qs = 100 + (10 * 40) = 500

If the price is Rs 50 there is a surplus of 300 units. Using the demand and
supply. equations, when P = 50,

Therefore, When price is Rs 50.

Qd = 1300 (20 * 50) = 300
Qs = 100 + (10 * 50) = 600

There fore when the price is Rs 50
Qs Qd = 600 300 = 300
Changes in Market Equilibrium
Demand Shifts (Supply remains constant)
Supply Shifts (Demand Remains
constant)
Simultaneous Shift in Demand and
Supply
Simultaneous Shift in Demand and
Supply
Predicting the Direction of change in
Airfares (Qualitative analysis)
Suppose you manage a travel department for a U.S. corporation and your
sales force makes heavy use of air travel to call on customers.

The president of the corporation to reduce travel expenditures for 2004.

You need to predict what will happen in future price of airfares in 2004.

The wall street journal recently came with the news.

A number of new, small airlines have recently entered the industry and
others are expected to enter in 2004.

Video-conferencing is becoming a popular, cost effective alternative to
business travel for many U.S. corporation. The trend will cut the price on
teleconferencing rates.
Direction of change in Airfares:
Qualitative Analysis
ELASTICITY OF DEMAND
The degree of responsiveness of Qty.
demanded of a commodity to a change in its
price is known as elasticity of demand.
Ed = % change in qty. dd /% change in
determinant
Elastic: Small change in price brings big
change in demand
Inelastic: Big change in price brings small
change in demand

Kinds of Elasticity
Price Elasticity
Income Elasticity
Cross Elasticity
Arc Elasticity
PRICE EASTICITY OF DEMAND
IT is the degree of responsiveness of qty.
demanded of a commodity to a change in its
price.
Ed = % change in qty. dd /% change in P
Ed = proportionate change in qty. dd
/Proportionate change in P
Ed = Q / Q = Q / Q * P / P
P / P

Definition: Elasticity of Demand
Price elasticity of demand is defined as the
percentage change in quantity demanded
divided by the percentage change in price.
Equation:
Elasticity of Demand =

% change in Qd
% change in Price
Example
Suppose Monginis cake is originally priced at Rs. 10 and the
amount sold is 50 cakes per week. If the price is increased to Rs.
11, then 40 cakes are sold per week. What is the price elasticity
of demand?

% Change in Price = [(11-10)/10]*100 = 10%

% Change in Quantity Demanded = [(40-50)/50]*100 = 20 %
(ignoring the negative sign)

Elasticity = 20/10 = 2

Even a very small change in price has lead a high-proportional
fall in quantity demanded.
TYPES OF PRICE ELASTICITY OF
DEMAND
TYPES OF PRICE ELASTICITY OF
DEMAND
The Farmers Dilemma
For many crops, a strange situation arises a bad crop year
results in a good year for farm incomes, and a good crop year
results in a bad year for farm incomes. How can this be?
Price elasticity gives us the answer:
Bad crop year: supply decreases, prices for farm products rise, but
quantity demanded doesnt fall very much. The quantity demanded
of farm products is not very responsive to changes in prices
Good crop year: supply increases, prices for farm products fall, but
quantity demanded doesnt increase very much. The quantity
demanded of farm products is not very responsive to changes in
prices
It is easy to show this with a graph. But first we need yet
another concept: Total Revenue = Price x Quantity

Measurement of price elasticity of
demand
Percentage Method

Total outlay Method

Geometric Method

Percentage Method or Ratio Method

It is the ratio of % change in Demand to a %
change in Price.
Ed = % Q OR Q * P = P * Q
% P Q P Q P
Unit elastic Ed =1
Relatively Elastic Ed >1
Relatively Inelastic Ed <1

Total Outlay Method or Revenue Or Expenditure
Method
Price (Rs) QTY. DD (units) Total Outlay (Rs) Elasticity
50 5 250 Relatively elastic
Ed > 1
40 10 400
30 20 600 Unit Elastic Ed = 1
20 30 600
10 40 400 Relatively inelastic
Ed < 1
5 50 250
Geometric Method Or Exact Method
Ed = Lower segment of demand curve
Upper segment of demand curve
Ed at pt A = DA/DA = 1
Ed at pt B = DB/DB = 1/3 < 1
Ed at pt C = DC/DC =9/3 > 1

Other concepts of Elasticity of Demand
Income Elasticity of Demand = Q * Y
Y Q
Ed = % change in qty. dd /% change in Y
Cross Elasticity of Demand = Q x * P y
P y Q x
Arc elasticity of Demand =
Q x P
Q1+ Q2 P1+ P2
Factors Influencing Elasticity
Nature of commodity: Necessary or luxurious
goods
Availability of substitutes:
Number of Uses of a commodity:
Multipurpose elastic and vice-versa.
Income:
Proportion of Expenditure: A small prop. Of
exp demand is elastic.
Time period:

Height of Price and Range of Price change:
Very low or very High price demand is
inelastic; Diamonds or salt but moderately
priced goods have elastic demand.
Urgent or postponement:
Durability of commodity: Short run Inelastic ,
but long run elastic Perishable goods is elastic.
Habits and customs:
Complementary goods: Inelastic

Recurring Demand: Relatively elastic
Demonstration effect:

Significance of elasticity of Demand
Useful to Producer and monopolist:
Useful to the govt.
Factor pricing:
Importance to trade unionist:
International Trade:
Useful to policy Makers: Prices of agricultural
goods , Fiscal and monetary policies etc.
THEORY OF PRODUCTION

The fundamental questions that managers are faced
with are
How can production optimized or cost minimize?
How does output respond to change in quantity of
inputs?
How does technology matter in reducing the cost of
production?
How can the least- cost combination of inputs be
achieved?
Given the technology, what happens to the rate of
return when more plants are added to the firm?

Input and output
An input is simply anything which the firm buys for in
its production or other processes.
Inputs are classified as
1) Fixed inputs: A fixed input is one whose supply is
inelastic in the short-run. In technical sense, a fixed
factor is one that remains fixed (or constant) for a
certain level of output.

2) Variable inputs: A variable input is defined as one
whose supply in the short-run is elastic, e.g., labour
and raw material, etc. all the users of such factors can
employ a larger quantity in the short-run as well as in
the long-run.

Short-run and Long-run Production
The short-run refers to a period of time in which the supply
of certain inputs (e.g. plant, building, machinery etc.) is
fixed or inelastic.
In the short-run therefore, production of a commodity can
be increased by increasing the use of only variable inputs
like labour and raw materials.
Variable Input: labor force, Fixed Input: machinery, plant
size, raw materials.

Long-run refers to a period of time in which the supply of
all the inputs is elastic, but not enough to permit a change
in technology.
That is, in the long-run, all the inputs are variable.
Corresponds to the planning stage
Production Function
The total amount of output produced by a firm is a
function of the levels of input usage by the firm.

Relation Between Input and Output the maximum
amount of output that can be obtained per period of
time given the factor inputs is captured by the
production function.

Describes purely Technological Relationship.

Flow Concept.

Production Function
A real-life production function is generally very
complex.
Q = f(LB, L, K, M, T, t)
where LB = land and building L= labour, K= capital, M=
raw materials, T= technology and t= time.

The economists have however reduced the number of
input variables used in a production function to only
two, viz., capital(K) and labour(L), for the sake of
convenience and simplicity in the analysis of input-
output relations.

Production Function
Also, technology (T) of production remains constant
over a period of time.
That is why, in most production functions, only labour
and capital are include
As such, the general form of its production function
for coal mining firm may be expressed as
Qc = f (K, L)
Where Qc = the quantity of coal produced per time
unit,
K = capital, and L = labour.

Production Function
The short-run production function or what
may also be termed as single variable input
production function, can be expressed as
Q = f (K, L) where K is a constant (1a)
For example, suppose a production function is
expressed as
Q = bL
Where b = gives constant returns to
labour.

Total, Average and Marginal Product
Total Product: Total Output Produced during
some period of Time by all Factors of
Production employed during that Period.

Total Product (TP) function In the Short Run
captures relationship between the amount of
labor and the level of output, ceteris paribus
Total Product
Quantity of
Labour
Total
Product
0 0
5 50
10 120
15 180
20 220
25 250
30 270
35 275
40 275
45 270
Variation of Output (One
fixed, one variable factor),
with Capital fixed at say 5
Units
Average Product
AP is merely the Total product per Unit of the
Variable Factor
AP = TP / L
Average Product
Quantity of
Labour
Total
Product
Average
Product
0 0
5 50 10.00
10 120 12.00
15 180 12.00
20 220 11.00
25 250 10.00
30 270 9.00
35 275 7.86
40 275 6.88
45 270 6.00
Marginal Product (MP)
The additional output that results from the
use of an additional unit of a variable input,
holding other inputs constant.

Measured as the ratio of the change in output
(TP) to the change in the quantity of labor (or
other variable input) used
MP = A in Output / A in Labour

Marginal Product
Quantity of
Labour
Total
Product
Change
in TP
Marginal
Product
0 0
5 50 50 10
10 120 70 14
15 180 60 12
20 220 40 8
25 250 30 6
30 270 20 4
35 275 5 1
40 275 0 0
45 270 -5 -1
Marginal Product (Continued)
Note that the MP is positive when an increase
in labor results in an increase in output; a
negative MP occurs when output falls when
additional labor is used.

Production Function
In the long -term production function, both K and
L are included and the function takes the
following form.
Q = f (K, L) (1b)
Consider, for example, the Cobb-Douglas
production function-the most famous and widely
used production function given in the form of
an equation as
Q = (1.2)
(where K= capital, L= Labour, and A , a and b, are
parameters and b =1 a).

Production Function
Production function (1.2) gives the general form of
Cobb-Douglas production function.
The numerical values of parameters A, a and b, can be
estimated by using actual factory data on production,
capital and labour.

Suppose numerical values of parameters are estimated
as A=50, a=0.5 and b=0.5.

Once numerical values are known, the Cobb-Douglas
production function can be expressed in its specific
form as follows.

Production Function
This production function can be used to
obtain the maximum quantity (Q) that can be
produced with different combinations of
capital (K) and Labour (L).

The maximum quantity of output that can be
produced from different combinations of K
and L can be worked out by using the
following formula.

Production Function
For example, suppose K = 2 and L = 5. Then

And if K = 5 and L = 5, then

Similarly, by assigning different numerical values to K
and L, the resulting output can be worked out for
different combinations of K and L and a tabular form of
production function can be prepared.

Similarly, by assigning different numerical values to K and L, the resulting output can be worked out for
different combinations of K and L and a tabular form of production function can be prepared.
It is important to note that the four combinations of K and L
10K + 1L
5K + 5L
2K + 5L and
1K + 10L produces the same output

SHORT-RUN THEORY OF PRODUCTION

Long-run and short-run production:
fixed and variable factors
The law of diminishing returns
The short-run production function:
total physical product (TPP)
average physical product (APP)
marginal physical product (MPP)
the graphical relationship between TPP, APP and MPP
Wheat production per year from a particular farm (tonnes)
Number of
Workers (Lb)
TPP APP
(=TPP/Lb)
MPP
(=ATPP/ALb)
(a) 0 0 -
3
1 3 3
7
2 10 5
(b) 14
3 24 8
12
(c) 4 36 9
4
5 40 8
2
6 42 7
(d) 0
7 42 6
-2
8 40 5

0
10
20
30
40
0 1 2 3 4 5 6 7 8
Wheat production per year from a particular farm
Number of farm workers
T
o
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n
e
s

o
f

w
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a
t

p
r
o
d
u
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e
d

p
e
r

y
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a
r

Number of
workers
0
1
2
3
4
5
6
7
8
TPP
0
3
10
24
36
40
42
42
40
0
10
20
30
40
0 1 2 3 4 5 6 7 8
T
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p
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p
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TPP
0
10
20
30
40
0 1 2 3 4 5 6 7 8
T
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p
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p
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TPP
a
b
Diminishing returns
set in here
0
10
20
30
40
0 1 2 3 4 5 6 7 8
T
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s

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TPP
a
b
d
Maximum output
0
10
20
30
40
0 1 2 3 4 5 6 7 8
Number of
farm workers (L)
T
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s

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TPP
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
T
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s

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Number of
farm workers (L)
ATPP = 7
AL = 1
MPP = ATPP / AL = 7
0
10
20
30
40
0 1 2 3 4 5 6 7 8
T
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s

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TPP
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
T
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MPP
Number of
farm workers (L)
Number of
farm workers (L)
0
10
20
30
40
0 1 2 3 4 5 6 7 8
T
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s

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TPP
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
T
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p
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a
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APP
MPP
APP = TPP / L
Number of
farm workers (L)
Number of
farm workers (L)
0
10
20
30
40
0 1 2 3 4 5 6 7 8
T
o
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s

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TPP
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
T
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p
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a
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APP
MPP
b
Diminishing returns
set in here
Number of
farm workers (L)
Number of
farm workers (L)
b
0
10
20
30
40
0 1 2 3 4 5 6 7 8
T
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TPP
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
T
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p
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a
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APP
MPP
b
d
d
Number of
farm workers (L)
Number of
farm workers (L)
Maximum
output
b
0
10
20
30
40
0 1 2 3 4 5 6 7 8
T
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TPP
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
T
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p
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a
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APP
MPP
b
b
d
d
Number of
farm workers (L)
Number of
farm workers (L)
Slope = TPP / L
= APP
c
c
Iso-quants
An iso-quant is a curve or line that has
various combinations of inputs that
yield the same amount of output.
Production function
Here we will assume output is made with the inputs capital and labor. K =
amount of capital used and L = amount of labor. The production function is
written in general as Q = F(K, L) sometimes we put a y instead of Q,
where Q = output, and F and the parentheses are general symbols that
mean output is a function of capital and labor.
The output, Q, from the production function is the maximum output that
can be obtained form the inputs.

On the next screen we will see some isoquants. Note: on a given curve L
and K change while Q is fixed.
ISOQUANT- ISOCOST ANALYSIS
Iso-quants
their shape
diminishing marginal rate of substitution
isoquants and returns to scale
isoquants and marginal returns
Iso-costs
slope and position of the isocost
shifts in the isocost
Units
of K
40
20
10
6
4
Units
of L
5
12
20
30
50
Point on
diagram
a
b
c
d
e
a
Units of labour (L)
U
n
i
t
s

o
f

c
a
p
i
t
a
l

(
K
)

An isoquant
0
5
10
15
20
25
30
35
40
45
0 5 10 15 20 25 30 35 40 45 50
Units
of K
40
20
10
6
4
Units
of L
5
12
20
30
50
Point on
diagram
a
b
c
d
e
a
b
Units of labour (L)
U
n
i
t
s

o
f

c
a
p
i
t
a
l

(
K
)

An isoquant
0
5
10
15
20
25
30
35
40
45
0 5 10 15 20 25 30 35 40 45 50
An isoquant
Units
of K
40
20
10
6
4
Units
of L
5
12
20
30
50
Point on
diagram
a
b
c
d
e
a
b
c
d
e
Units of labour (L)
U
n
i
t
s

o
f

c
a
p
i
t
a
l

(
K
)

0
5
10
15
20
25
30
35
40
45
0 5 10 15 20 25 30 35 40 45 50
MRTS

The slope of the isoquant defines the substitutability
between two factors of inputs (capital and labor). This is
known as the marginal rate of technical substitution
(MRTS) and is presented mathematically as:
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14 16 18 20 22
U
n
i
t
s

o
f

c
a
p
i
t
a
l

(
K
)

Units of labour (L)
g
h
AK = 2
AL = 1
isoquant
MRS = 2
MRS = AK / AL
Diminishing marginal rate of factor substitution
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14 16 18 20
U
n
i
t
s

o
f

c
a
p
i
t
a
l

(
K
)

Units of labour (L)
g
h
j
k
AK = 2
AL = 1
AK = 1
AL = 1
Diminishing marginal rate of factor substitution
isoquant
MRS = 2
MRS = 1
MRS = AK / AL
0
10
20
30
0 10 20
An isoquant map
U
n
i
t
s

o
f

c
a
p
i
t
a
l

(
K
)

Units of labour (L)
I
1
0
10
20
30
0 10 20
I
2
U
n
i
t
s

o
f

c
a
p
i
t
a
l

(
K
)

Units of labour (L)
An isoquant map
I
1
0
10
20
30
0 10 20
I
2
I
3
U
n
i
t
s

o
f

c
a
p
i
t
a
l

(
K
)

Units of labour (L)
An isoquant map
I
1
0
10
20
30
0 10 20
I
2
I
3
I
4
U
n
i
t
s

o
f

c
a
p
i
t
a
l

(
K
)

Units of labour (L)
An isoquant map
I
1
0
10
20
30
0 10 20
I
1
I
2
I
3
I
4
I
5
U
n
i
t
s

o
f

c
a
p
i
t
a
l

(
K
)

Units of labour (L)
An isoquant map
The laws of returns to scale
The laws of returns to scale explain the
behavior of output in response to a
proportional and simultaneous change in
inputs, increasing inputs proportionately and
simultaneously is, in fact, an expansion of the
scale of production.

Three technical possibilities
Total output may increase more than
proportionately.

Total output may increase proportionately and

Total output may increase less than
proportionately

kinds of returns to scale
Increasing returns to scale;

Constant returns to scale, and

Diminishing returns to scale.

Increasing returns to scale
When inputs, K and L are increased at a
certain proportion and output increase
more than proportionately, it exhibits
increasing returns to scale.
The increasing returns to scale is illustrated
in fig.

Product lines
Q = 50
Q = 25
Q = 10
B
C
c
b
a
4K

3K

2K

1K

1L 2L 3L 4L Labour (L)
Fig. I ncreasing Returns to Scale
The movement from point a to b on the line
OB means doubling the inputs.

It can be seen in fig that input combination
increases from 1K + 1L to 2K + 2L.

As a result of doubling the inputs, output is
more than doubled; it increases from 10 to 25
units e.g. an increase of 150%.

Similarly, the movement from point b to point
c indicates 50% increase in inputs as a result of
which the output increases from 25 units to 50
units i.e. by 100%.
O
Capital (K)
Economies of scale
The scale of production has an very important bearing
on the cost of production.

It is the manufacturers common experience that larger
the scale of production, the lower generally is the
average cost of production.

That is why the entrepreneur is tempted to enlarge the
scale of production so that he benefit from the
resulting economies of scale.

There are two types of Internal and External
Economies.
Internal Economies of Scale
These are those economies in production, those in
production costs, which accrue to the firm itself when it
expands its output or enlarges its scale of production.

The internal economies arise within a firm as a result of its
own expansion of the industry.

The internal economies are simply due to the increase in
the scale of production.

They arise from the use of the methods which small firms
do not find it worthwhile to employ.
Three reasons for increasing returns to
scale
Technical and managerial indivisibilities:
Certain inputs, particularly mechanical equipments and
managers, used in the process of production are available in a
given size.

Such inputs cannot be divided into parts to suit small scale of
production.

Because of indivisibility of machinery and managers, given the
state of technology, they have to be employed in a minimum
quantity even if scale of production is much less than the capacity
output.

Therefore, when scale of production is expanded by increasing all
the inputs, the productivity of indivisible factors increases
exponentially because of technological advantage. This results in
increasing returns to scale.
Internal Economies
Labour Economies: Division of Labour, this will increase the
efficiency, saves time and promote skill information.

Technical economies: Modern machinery.

Marketing Economies: Buying inputs at large qty when it
expands the output. Small firms are deprived of these
benefits.

The cost of marketing the product is also reduced providing
thereby the economies of large scale transportation.
Per unit advertisement cost is reduced.
Higher degree of specialization (Managerial
economies)
The use of specialized labour suitable to a particular
job and of a composite machinery increases
productivity of both labour and capital per unit of
inputs.
Financial economies: The finance will be available at
competitive rate and at easy terms. Can also raise
money from the market, because of its goodwill.
Risk Bearing Economies: Can diversify the risk by
selling products in different parts of the world.
Dimensional relations
For example, when the length and breadth of a
room (15 x 10 =- 150 Sq. ft.) are doubled then
the size of the room is more than doubled; it
increases to 30 x 20 = 600 sq. ft.

In accordance with this dimensional relationship,
when the labour and capital are doubled, the
output is more than doubled and so on.

External Economies
These are those economies which accrue to
each member firm as a result of the expansion
of the industry as a whole.
External Economies
Availability of raw-material and machineries at lower price: Expansion of
the industry may results in the availability of inputs like raw-material and
other equipments at lower prices.

Technical external economies: Since the growth of industry enables the
firm to use the new technical know-how employing thereby improved
machinery and other inputs.

Development of Skill labour: By training and development of the industry.

The growth of subsidiary industry: Will supply the raw-material.

Transport and marketing facilities:

Information Service: Will disseminate information, technical knowledge
and R and D

Constant returns to scale
When the increase in output is proportionate to the
increase in inputs it exhibits constant returns to scale.
Fig. Constant Return to Scale
Capital (K)
10 1 1 + L K
20 2 2 + L K
30 3 3 + L K
Product lines
Q = 30
Q = 20
Q = 10
B
c
b
a
4K

3K

2K

1K

1L 2L 3L 4L
Labour (L)
Decreasing Return to Scale
When economies of scale reach their limits and
diseconomies are yet to begin, returns to scale
become constant.

For example, doubling of coal mining plant may
not double the coal deposits.

Similarly doubling the fishing fleet may not
double the fish output because availability of fish
may decrease in the ocean when fishing is carried
out on an increased scale.
Product lines
Labour (L)
Fig. Decreasing Return to Scale Scale
Q = 24
Q = 18
Q = 10
B
C
4K

3K

2K

1K

1L 2L 3L 4L
Capital (K)
Decreasing Return to Scale
c
b
a
INTERNAL DISECONOMIES
Large scale production firms faces a problem of
management and control over the production unit.

Lack of proper coordination and supervision of
different departments. So growth of the firm beyond
the limit will bring more problems.

The increase in the scale of output beyond its optimum
size creates the managerial structure inflexible and
cumbersome which ultimately reduces efficiency of the
management
External Diseconomies
Constraints in the Supply of raw-material.

Demand for labour will increase due to
growth of industry.

Instabilities of demand for the product
Economies of Scope
When the cost efficiencies in production allow
the firm to produce a variety of products
rather than a single product in large volume, it
can be referred to the Economies of Scope.

This allows product diversification in the same
scale of plant and with the same technology.
Returns to Scale (Summary)
When the % change in output > % change in inputs
E.g. a 30% rise in factor inputs leads to a 50% rise in output
Long run average total cost will be falling
Decreasing returns to scale
When the % change in output < % change in inputs
E.g when a 60% rise in factor inputs raises output by only 20%
Long run average total cost will be rising
Constant returns to scale
When the % change in output = % change in inputs
E.g when a 10% increase in all factor inputs leads to a 10% rise in total output
Long run average total cost will be constant
Cost

By "Cost of Production" is meant the total sum of money
required for the production of a specific quantity of
output. In the word of Gulhrie and Wallace:

"In Economics, cost of production has a special meaning.

It is all of the payments or expenditures necessary to
obtain the factors of production of land, labor, capital and
management required to produce a commodity.

It represents money costs which we want to incur in order
to acquire the factors of production".
Cost of Production

The following elements are included in the cost of production:

(a) Purchase of raw machinery,
(b) Installation of plant and machinery,
(c) Wages of labor,
(d) Rent of Building,
(e) Interest on capital,
(f) Wear and tear of the machinery and building,
(g) Advertisement expenses,
(h) Insurance charges,
(i) Payment of taxes,
(j) In the cost of production, the imputed value of the factor of
production owned by the firm itself is also added,
(k) The normal profit of the entrepreneur is also included In the cost of
production.
FIXED, VARIABLE, AND INCREMENTAL
COSTS
Fixed costs: unaffected by changes in activity
level over a feasible range of operations for the
capacity or capability available.
Typical fixed costs include:
insurance and taxes on facilities
general management and administrative salaries
license fees
interest costs on borrowed capital.
Fixed costs will be affected When:
large changes in usage of resources occur
plant expansion or shutdown is involved
FIXED, VARIABLE AND INCREMENTAL
COSTS
Variable costs: associated with an operation
that vary in total with the quantity of output
or other measures of activity level.
Example of variable costs include :
costs of material and labor used in a product or
service, because they vary in total with the number
of output units -- even though costs per unit
remain the same.
Example 2.1
FIXED,VARIABLE AND INCREMENTAL
COSTS
Incremental cost: additional cost that results from increasing
output of a system by one (or more) units.

Incremental cost is often associated with go / no go
decisions that involve a limited change in output or activity
level.

EXAMPLE: the incremental cost of driving an automobile might
be Rs 10 / mile. This cost depends on:
1. mileage driven;
2. mileage expected to drive;
3. age of car;
SUNK COST AND OPPORTUNITY COST
A sunk cost is one that has occurred in the
past and has no relevance to estimates of
future costs and revenues related to an
alternative course of action;

An opportunity cost is the cost of the best
rejected ( i.e., foregone ) opportunity and is
hidden or implied;
What is opportunity cost?
Andy had $65.00 to
spend at the toy
store. The
basketball net cost
$50.00, so he had
to buy that instead
of the skateboard,
which cost $75.00.
Sara had enough
money for either
the rabbit or the
bike. She decided
to buy the bike
because then she
could ride bikes
with her friends
after school.

Opportunity cost is
the process of
choosing one good or
service over another.
The item that you
dont pick is the
opportunity cost. The
rabbit is Saras
opportunity cost and
the skateboard is
Andys opportunity
cost.
Opportunity
Costs
Purchases
Social Cost
Building a new railway $100 million
Creating pollution nearby (e.g. cutting trees,
noises) $5 million
Social cost of building highway
= private cost + external cost
= $105 million

Historical Costs and Replacement
Costs.

Historical cost or original costs of an asset refers to the original
price paid by the management to purchase it in the past.

Whereas replacement costs refers to the cost that a firm incurs to
replace or acquire the same asset now.

The distinction between the historical cost and the replacement
cost result from the changes of prices over time.

In conventional financial accounts, the value of an asset is shown at
their historical costs but in decision-making the firm needs to adjust
them to reflect price level changes.

Example: If a firm acquires a machine for $20,000 in the year 1990
and the same machine costs $40,000 now. The amount $20,000 is
the historical cost and the amount $40,000 is the replacement cost.

Cost Concepts
I. Total Costs (TC)
whatever total cost is for any level of output
sum of all costs
Two Sub-Components:

(A)Total Fixed Costs TFC (Overhead Costs)
do not vary with output
come from fixed inputs
(B) Total Variable Costs TVC
vary with output
come from variable inputs
Note: TC = TFC + TVC
Cost Concepts
Cost($)
Output (or TP or
Q)
Graph of Total Cost Concepts
TC
TVC
TFC
(TFC)
0
10
20
30
40
0 1 2 3 4 5 6 7 8
T
o
n
n
e
s

o
f

w
h
e
a
t

p
e
r

y
e
a
r

TPP
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
T
o
n
n
e
s

o
f

w
h
e
a
t

p
e
r

y
e
a
r

APP
MPP
b
b
d
d
Number of
farm workers (L)
Number of
farm workers (L)
Slope = TPP / L
= APP
c
c
Cost Concepts
II. Average Total Costs (ATC)
Total Cost Per Unit of Output
Two Sub-Components:
Q
TC
ATC =
(A) Average Fixed Cost:
Q
TFC
AFC =
(B) Average Variable Cost:
Q
TVC
AVC =
Two
Average
Costs!!
Note: ATC = AFC + AVC
Cost Concepts
III. Marginal Costs (MC) : Increase in Total Cost that
results from an increase in output
Q
TC
MC
A
A
=
Cost Concepts
Cost($)
Output
Graph of Average & Marginal Cost Concepts
AVC
AFC
ATC
MC
Q
2

Q
1

Cost Concepts
(1) When marginal is below average average is falling.
(2) When marginal is above average average is rising.
(3) When marginal is equal average average is at its lowest
point.
Note : There is a certain correspondence between product
concepts and cost concepts.
Summary of Relationship Between Marginal Cost & Average Cost
When AVC is at its minimum, AP will be at its maximum.
When MC is at a minimum, MP will be at its maximum.
(See diagram in book.)
200
Long-Run Average Cost Curve
(No distinction between fixed and variable in Long-Run)
Total Costs per
Unit($)
(LRAC)
Q (Output)
Plots the relationship between the lowest attainable Average Cost and
output when both capital (or plant size) and labor can be varied.
LRAC
0
C
1

Q
1

C
2

Q
2

Attainable
Costs
Unattainable
Costs
Relationship Between SATC & LRAC
Short-Run & Long-Run Costs
Average
Costs per
Unit ($)
Q (Output)
0
S
A
T
C
1

S
A
T
C
2

S
A
T
C
3

LRAC
LMC
S
M
C
1

Relationship Between SATC & LRAC
Short-Run & Long-Run Costs
Average
Costs per
Unit ($)
Q (Output)
0
LRAC
X
X
min

X
X = minimum point
Long-Run Average Cost Curve
Slope of LRAC
Costs per
Unit
Q (Output)
LRAC
0 Q
m

0 to Q
m
: Economies of Scale Q
m
Rightward: Diseconomies of Scale
* Q
m
is the most efficient point doubly efficient:
(1) It represents the lowest possible costs for its production level (like all
points on LRAC curve).
(2) It is the output level that has absolutely lowest costs of all output
levels.
Other Possible Shapes for LRAC
Constant Returns to Scale :
LRAC curve is horizontal
Average Cost
per Unit ($)
Q (Output)
LRAC
0
Average Cost
per Unit ($)
Q (Output)
LRAC
0
OR
Doubling Input spending
always leads to a doubling of
output.
Other Possible Shapes for LRAC
Continually Decreasing Costs
Average Cost
per Unit ($)
Q (Output)
LRAC
0
Decreasing
Cost!!!
Minimum Efficient Scale
Definition :
The smallest quantity of output at which long-
run average cost reaches its lowest level.
A Perfectly Competitive Market
For a market to be perfectly competitive, six
conditions must be met:
1. Both buyers and sellers are price takers a price taker is
a firm or individual who takes the price determined by
market supply and demand as given
2. The number of firms is large any one firms output
compared to the market output is imperceptible and
what one firm does has no influence on other firms
A perfectly competitive market is a market in which
economic forces operate unimpeded
A Perfectly Competitive Market
3. There are no barriers to entry barriers to entry are social,
political, or economic impediments that prevent firms from
entering a market
4. Firms products are identical this requirement means that
each firms output is indistinguishable from any other firms
output
5. There is complete information all consumers know all
about the market such as prices, products, and available
technology
6. Selling firms are profit-maximizing entrepreneurial firms
firms must seek maximum profit and only profit

Total Revenue of a Competitive Firm
Total revenue for a firm is the selling price
times the quantity sold.
TR = P Q

Average Revenue of a Competitive Firm
Average revenue is the revenue per unit sold
P = AR.
This is simply because all units sold are sold at the
same price.
Average Revenue =
Total revenue
Quantity
Price Quantity
Quantity
Price
=

=
Marginal Revenue of a Competitive Firm
Marginal Revenue is the increase () in total
revenue when an additional unit is sold.
MR = ATR / AQ
Revenue of a Perfectly Competitive Firm
Total Revenue: The amount of money received when the
firm sells the product, i.e.,
Total Revenue = Price of the product Quantity of the product sold
TR = P Q
Since the firm is a price taker under perfect competition, it
sells each additional unit of the product for the same price.
Average Revenue = Total Revenue/Quantity sold
AR = TR/Q = P
Marginal Revenue = Additional revenue earned from
selling an additional unit of the product.
MR = TR/Q = P
Thus, for a competitive firm AR = P = MR
Total Revenue: PQ
TP = Q P TR AR MR
0 3 0 0 0
10 3 30 3 3
25 3 75 3 3
50 3 150 3 3
70 3 210 3 3
85 3 255 3 3
95 3 285 3 3
100 3 300 3 3
101 3 303 3 3
95 3 285 3 3
85 3 255 3 3
The Revenue of a Competitive Firm
In perfect competition, marginal revenue
equals price: P = MR.
We saw earlier that P = AR
Therefore, for all firms in perfect competition,
P = AR = MR
9.4 Profit Maximization (SR): TR and TC
approach
What Is Perfect Competition?
Figure illustrates a firms revenue concepts.
Part (a) shows that market demand and market supply
determine the market price that the firm must take.
What Is Perfect Competition?
A perfectly competitive firms goal is to make
maximum economic profit, given the constraints it
faces.
So the firm must decide:
1. How to produce at minimum cost
2. What quantity to produce
3. Whether to enter or exit a market
We start by looking at the firms output decision.

Profit Maximization by the Competitive Firm:
Approach I: Total Profit = TR TC
0.00
50.00
100.00
150.00
200.00
250.00
300.00
350.00
0.00 20.00 40.00 60.00 80.00 100.00 120.00
Output
TC, TR, & Profit
TC TR
L TP = Q TR TC Profit
0 0 0 80 -80
1 10 30 105 -75
2 25 75 130 -55
3 50 150 155 -5
4 70 210 180 30
5 85 255 205 50
6 95 285 235 50
7 100 300 255 45
8 101 303 280 23
9 95 285 305 -20
10 85 255 330 -75
On the Diagram, the profit maximizing level of output is the level where
the vertical difference between the TR and TC is the largest.
With P = Rs 3/unit, profits are maximized by producing 95 units of output.

The Firms Output Decision
Profit-Maximizing Output
A perfectly competitive firm chooses the output
that maximizes its economic profit.
One way to find the profit-maximizing output is to
look at the firms the total revenue and total cost
curves.
Figure on the next slide looks at these curves
along with the firms total profit curve.

Part (a) shows the total
revenue, TR, curve.
Part (a) also shows the total
cost curve, TC, which is like
the one in previous Slides.
Total revenue minus total cost
is economic profit (or loss),
shown by the curve EP in part
(b).
At low output levels,
the firm incurs an
economic lossit cant
cover its fixed costs.
At intermediate output
levels, the firm makes an
economic profit.
At high output levels,
the firm again incurs
an economic loss
now the firm faces
steeply rising costs
because of
diminishing returns.
The firm maximizes its
economic profit when it
produces 9 sweaters a day.
Max Profit
Max Output
Approach I: Total Profit = TR TC
Input (L) TP (Q) AP (Q/L) MP TC TR Profit
0 0 0.00 80 0 -80
1 10 10.00 10 105 30 -75
2 25 12.50 15 130 75 -55
3 50 16.67 25 155 150 -5
4 70 17.50 20 180 210 30
5 85 17.00 15 205 255 50
6 95 15.83 10 235 285 50
7 100 14.29 5 255 300 45
8 101 12.63 1 280 303 23
9 95 10.55 -6 305 285 -20
10 85 8.50 -10 330 255 -75
S
t
a
g
e

I
S
t
a
g
e

I
I
S
t
a
g
e

I
I
I
Approach II: MR = MC
Most managers do not make decisions looking at TR and TC.
Most decisions are made at the margin.
The output level that will maximize profit is determined by
comparing the amount that each additional unit of output adds
to TR and TC.
Recall, Marginal Cost (MC) represents additional cost from
producing an additional unit of output; and Marginal Revenue
(MR) represents addition to TR from selling (producing) an
additional (one more) unit of output, which is equal to the
price of that output.
Thus, MC and MR can be used to determine profit maximizing
level of output.
Approach II: MR = MC
The firm will continue to expand production until MR is equal to MC, i.e., profit
is maximized when MR = MC.
With P being Rs 3/unit, profits are maximized by producing 95 units of output.

0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
0.00 20.00 40.00 60.00 80.00 100.00 120.00
Output
MR, MC, & Profit
MR MC
L Q TR MR TC MC Profit
0 0 0 80 -80
1 10 30 3 105 2.50 -75
2 25 75 3 130 1.67 -55
3 50 150 3 155 1.00 -5
4 70 210 3 180 1.25 30
5 85 255 3 205 1.67 50
6 95 285 3 235 3.00 55
7 100 300 3 255 5.00 45
8 101 303 3 280 25.0 23
9 95 285 3 305 -4.17 -20
10 85 255 3 330 -2.50 -75
Marginal Analysis and Supply Decision
The firm can use marginal analysis to determine the
profit-maximizing output.
Because marginal revenue is constant and marginal
cost eventually increases as output increases, profit is
maximized by producing the output at which marginal
revenue, MR, equals marginal cost, MC.
Figure on the next slide shows the marginal analysis
that determines the profit-maximizing output.
At high output levels,
the firm again incurs
an economic loss
now the firm faces
steeply rising costs
because of
diminishing returns.
The firm maximizes its
economic profit when it
produces 9 sweaters a day.
If MR > MC, economic
profit increases if
output increases.
If MR < MC, economic profit
decreases if output
increases.
If MR = MC, economic profit
decreases if output changes
in either direction, so
economic profit is
maximized.
Determining Profits Graphically: A Firm with Profit
AVC
MC
Q
P
ATC
Find output where
MC = MR, this is the profit
maximizing Q
P = D = MR
MC = MR
Q
profit max

Find profit per unit where
the profit max Q
intersects ATC
ATC at Q
profit max

P
ATC
Profits
Since P>ATC at the
profit maximizing quantity,
this firm is earning profits
Determining Profits Graphically:
A Firm with Zero Profit or Losses
AVC
MC
Q
P
ATC
MC = MR
Q
profit max

ATC at Q
profit max

P
=ATC
P = D = MR
Since P=ATC at the
this firm is earning
zero profit or loss
Find output where
maximizing Q
the profit max Q
intersects ATC
Determining Profits Graphically: A Firm with Losses
AVC
MC
Q
P
ATC
MC = MR
Q
profit max

ATC at Q
profit max

P
ATC
P = D = MR
Since P<ATC at the
this firm is earning losses
Find output where
maximizing Q
the profit max Q
intersects ATC
Losses
Determining Profits Graphically:
The Shutdown Decision
AVC
MC
Q
P
ATC
Q
profit max

P
Shutd
own

P = D = MR
The shutdown point is the
point below which the firm
will be better off if it shuts
down than it will if it stays in
business
If P>min of AVC, then the
firm will still produce, but
earn a loss
If P<min of AVC, the firm will
shut down
If a firm shuts down, it still
has to pay its fixed costs
Short-Run Market Supply and
Demand
The market (industry) supply curve is the horizontal
sum of all the firms marginal cost curves
While the firms demand curve is perfectly elastic, the
industrys demand curve is downward sloping
The market supply curve takes into account any
changes in input prices that might occur
ATC
Profits
Short-Run Market Supply and Demand Graph
P
Q
Market
Supply
P
Market
Demand
P
Q
P
P = D = MR
MC
ATC
Q
profit max

Market Firm
Long-Run Competitive Equilibrium
Profits create incentives for new firms to
enter, market supply will increase, and the
price will fall until zero profits are made
At long run equilibrium, economic profits are zero
The existence of losses will cause firms to leave the
industry, market supply will decrease, and the price will
increase until losses are zero
Normal profit is the amount the owners would have received
in their next best alternative
Zero profit does not mean that the entrepreneur does not
get anything for his efforts
Economic profits are profits above normal profits
Graph
P
Q
P = D = MR
MC
SRATC
LRATC
At long-run equilibrium,
economic profits are zero
SR Profits
Market Response to an Increase in Demand Graph
P
Q
S
0(SR)

P
0

D
0

P
Q
P
0

MC
ATC
Q
0,2

Market Firm
S
1(SR)

D
1

P
1

1
P
1

1 1
Q
1

2
2 2
Q
0

Q
1
Q
2

1
1 2
2
S
(LR)

Long-Run Market Supply
If the long-run industry supply curve is upward
sloping, the market is an increasing-cost industry
If the long-run industry supply curve is perfectly elastic,
the market is a constant-cost industry
If the long-run industry supply curve is downward
sloping, the market is a decreasing-cost industry
In the short run, the price does more of the adjusting, and
in the long run, more of the adjustment is done by
quantity
Monopoly
Only one seller of a particular product

Characteristics of Monopoly
Single Producer
No close substitute
Inelastic demand curve
Price Maker
Barriers to entry
Legal restrictions or barriers to entry of other
firms
Control over key raw material
Examples: Public utilities telephones and
electricity etc.
Total Revenue
Can you work out the demand, total revenue and marginal revenue functions
from this information?
Output Price
= AR
TR MR TC MC ATC Profit
0 36 0 47 47
1 33 33 33 48 1 48.00 15
2 30 60 27 50 2 25.00 10
3 27 81 21 54 4 18.00 27
4 24 96 15 62 8 15.50 34
5 21 105 9 78 16 15.60 27
6 18 108 3 102 24 17.00 6
7 15 105 3 142 40 20.29 37
8 12 96 9 196 56 24.75 102
9 9 81 15 278 80 30.89 197
TR
Price
Q
Q
TR
Demand and Total Revenue
AR = D
0
0
6 3
3 6
9
6
3
Graph B
Graph A
D
TR
P,MR
Q
Q
Marginal Revenue
Q2
MR
AR = D
A
B
C
0
0
Q1
A
C
Graph B
Graph A
X
TR
Profit Maximizing Output Decision
under Monopoly in the Short-run

The Total Curves Approach

Profit maximization output
decision rule for a monopolist
depends on two considerations.

One, whether there is any
output level at which TR
exceeds the TVC. If not, the
profit maximizing strategy is
to shut down.

If there are output levels at
which TR > TVC, the
monopolist will produce
where the vertical distance
between TR and TC is at its
maximum.
$
TR
TC
TVC
Q
Profit Maximizing Output Decision
under Monopoly in the Short-run

The Total Curves Approach

In this case, the vertical
distance between TR and TC
is at maximum at the Q
*
level
of output.

Note that at Q
*
units of
output, TR and TC curves
have the same slope, i.e.,
MR = MC. (This is called
the Necessary Condition of
profit maximization)

Further, the slope of MC
exceeds that of the MR (MC
has a positive slope and MR
has a negative slope). (This
is called the Sufficient
Condition of profit
maximization)
$
TR
TC
TVC
Q Q
*

Finding P
m
and Q
m
MC
Price
Quantity of output
Market Demand
MR
P
m
Q
m
MC = MR
Cost data will determine
a monopolists profit.
Misconceptions of Monopoly Pricing
Not highest price
Total profit
Possibility of losses

LO2
10-249
Higher prices often yield smaller-than-
maximum total profit.

The highest price possible is not ideal because it
results in lower output and reduces total revenue.

The monopolist seeks to maximize total profit,
not unit profit.
A monopolist suffers from weak demand, bad
market conditions or resource cost increases.

Thus, profit is not always guaranteed.
A monopolist suffers from weak demand, bad
market conditions or resource cost increases.

Thus, profit is not always guaranteed.
Compared to pure competition, a monopoly
lacks productive efficiency and allocative
efficiency.
It is considered inefficient.

A monopolist charges a higher price and sells
a smaller level of output than firms in a purely
competitive industry.
Because the monopolists MR curve lies below
demand and it produces output where MR =
MC, price exceeds MC.

In pure competition, entry and exit of firms
ensure that P = MC = min. ATC.
Inefficiency of Pure Monopoly
Pure Competition Pure Monopoly
Price
Price
Quantity
Quantity
P
c
D
D
Q
c
S = MC
P
c
MC
Q
c
MR
Q
m
P
m
P = MC = min. ATC
MR = MC
Inefficiency of Pure Monopoly
Monopoly Equilibrium
Price
Quantity of output
Market Demand
MR
P
m
Q
m
MC = MR
Cost data will determine
a monopolists profit.
ATC
Perfect (Pure) Competition Equilibrium
P
Q
Market
Supply
P
Market
Demand
P
Q
P
P = D = MR
MC
ATC
Q
profit max

Market Firm
Output and Price Determination
LO2
Steps for Graphically Determining the Profit-Maximizing Output, Profit-Maximizing Price,
and Economic Profits (if Any) in Pure Monopoly
Step 1 Determine the profit-maximizing output by finding where MR=MC.
Step 2
Determine the profit-maximizing price by extending a vertical line upward
from the output determined in step 1 to the pure monopolists demand
curve.
Step 3
Determine the pure monopolists economic profit by using one of two
methods:
Method 1. Find profit per unit by subtracting the average total cost of the
profit-maximizing output from the profit-maximizing price. Then multiply
the difference by the profit-maximizing output to determine economic
profit (if any).
Method 2. Find total cost by multiplying the average total cost of the
profit-maximizing output by that output. Find total revenue by multiplying
the profit-maximizing output by the profit-maximizing price. Then subtract
total cost from total revenue to determine the economic profit (if any).
10-257
200
175
150
125
25
100
75
50
P
r
i
c
e
,

C
o
s
t
s
,

a
n
d

R
e
v
e
n
u
e

1 2 3 4 5 6 7 8 9 10
Quantity
Output and Price Determination
LO2
0
D
MR
ATC
MC
MR=MC
A=94
Economic
Profit
P
m
=122
10-258
LO2
0
P
r
i
c
e
,

C
o
s
t
s
,

a
n
d

R
e
v
e
n
u
e

Quantity
D
MR
ATC
MC
MR=MC
Loss
AVC
P
m
Q
m
V

A

10-259
Fig.: Super normal profit Fig.: Normal profit
Comparison of Short-run and Long-run
Monopoly with Different Cost
Condition

Price Discrimination
It refers to discrimination of price for different
consumers on the basis of their income or
purchasing power, geographical location, age, sex,
colour, marital status, quantity purchased, time of
purchase etc. for eg:-

Physicians and hospitals
Merchandise sellers
Railways and Airlines
Cinema shows or musical concerts
Domestic and foreign markets

Necessary conditions
Different Markets must be separable for a seller

The Elasticity of demand must be different in
different markets

There must be imperfect competition in the
market

Profit maximizing output should be larger than the
quantity demanded in a single market or section
of consumers
First Degree of Price Discrimination
Costs / Revenue
Output / Sales
S
D Q
P
0
Second Degree of Price Discrimination
Costs / Revenue
Output / Sales
S
D
Q
P
0
P3
P2
P1
Q3 Q2 Q1
Third Degree or
Perfect Price Discrimination
Third degree price discrimination refers to a discriminatory pricing by which a
monopolist sells his good at different prices in different markets, but keeps the
price uniform within each separate market.

In the figure below, the two markets are identified separately. The MR
t
is the MR
for the firm and is obtained by summing the MR
1
and MR
2
horizontally.

$/unit $/unit $/unit
Q Q Q
MR
1

D
1

MR
2
D
2
MR
t

Market 1 Market 2
Firm
Third Degree or
The MR
t
(MR for the firm) shows the additional revenue the firm can secure by
selling an additional unit of the output either in Market 1 or Market 2, whichever
has a higher MR.

To maximize profit, the monopolist must produce Q
t
the level of output at
which MR
t
= MC.

Q Q Q
MR
1

D
1

MR
2
D
2
MR
t

MC
Q
t

Market 1
Market 2
Firm
Third Degree or
The monopolist must now allocate this output between Markets 1 and 2 in
such a way as to equalize the MR in the two markets.
This is the case at Q
1
level of output in Market 1 and Q
2
level of output in
Market 2.
Note that Q
1
+Q
2
= Q
t
(This is necessarily true because MR
t
curve is
obtained as the summation of MR
1
and MR
2
)

Q Q Q
MR
1

D
1

MR
2
D
2
MR
t

MC
Q
t
Q
2
Q
1

Market 2 Market 1 Firm
Third Degree or
The prices charged in the two markets are P
1
in Market 1 and P
2
Market 2
as determined from their respective AR curves.
Note that the monopolist is charging a higher price in Market 1 than in
Market 2.
That is because demand in Market 1 is relatively inelastic and demand in
Market 2 is relatively elastic.
Q Q Q
MR
1

D
1

MR
2
D
2
MR
t

MC
Q
t
Q
2
Q
1

Market 2 Market 1 Firm
P
1

P
2

Relatively Inelastic Relatively Elastic
Third Degree of Price Discrimination
Costs / Revenue
Output / Sales Output / Sales Output / Sales
QA QB
Q
0 0 0
MRB
ARA
MRA
ARB
Market A
MC
MR
AR=D
Total Market Market B
PA
PB
Various types of Price discrimination

Personal price discrimination: It may be personal based on the income of
the customer. For example, Doctors and Lawyers charge different fees
from different customers on the basis of their income. Higher fees are
charged to rich persons and lower to the poor.

Geographical or Local discrimination: There is geographical price
discrimination when a monopolist sells in one market at a higher price
than in the other market. For example, in a posh locality, a beauty parlor
may be charging more while charging lower rate for the same service in a
common locality.

Discrimination on the basis of Nature of the Product: Different prices are
charged when there is a difference in the quality of the product. For
example, Unbranded products, like open tea, are sold at lower prices than
branded tea like Brooke Bond or Tata tea.

Discrimination on the basis of Age, Sex and Status: Here different
prices are charged on the basis of age, sex and status of consumers.
For example, railways fare for children and senior citizens are
different, various states in India there is no fees for girls in schools
and in case of Toll tax all MLAs, MPs and Ministers are exempted.

Discrimination on the basis of Time: Different rates may be
charged for a service depending upon time. For example, Telephone
STD call rates at day time and night. Besides, advertising rates on TV
based on prime time and non prime time.

Discrimination on the basis of Use of product / Service: Prices
differ according to the use to which the product is utilized. For
example, electricity per Unit rates are different for users as
domestic use, Farm use and industrial use.

Monopolistic competition
The model of monopolistic competition
describes a common market structure in
which firms have many competitors, but each
one sells a slightly different product.
Monopolistic competition as a market
structure was first identified in the 1930s by
American economist Edward Chamberlin, and
English economist Joan Robinson.

Characteristics

1. Large Number of Sellers
2. Product Differentiation
3. Freedom of Entry and Exit
4. Selling Cost
5. Absence of Interdependence
Large numbers of firms are different in their size.
Each firm has its own production and marketing
policy.
So no firm is influenced by other firm.
All are independent.

6. Two Dimensional Competition

Monopolistic competition has two types of
competition aspects viz.
Price competition i.e. firms compete with each
other on the basis of price.
Non price competition i.e. firms compete on
the basis of brand, product quality
advertisement.

7. Concept of Group

In place of Marshallian concept of industry,
Chamberlin introduced the concept of Group
under monopolistic competition.
An industry means a number of firms
producing identical product.
A group means a number of firms producing
differentiated products which are closely
related.

8. Falling Demand Curve

In monopolistic competition, a firm is facing
downward sloping demand curve i.e. elastic
demand curve. It means one can sell more at
lower price and vice versa.

Output, Price, and Profit of a
Monopolistic Competitor
A monopolistically competitive firm prices in
the same manner as a monopolistwhere MC
= MR.
But the monopolistic competitor is not only a
monopolist but a competitor as well.
A Monopolistically
Competitive Firm: Above Normal Profit
A Monopolistically
Competitive Firm: Economic Loss
A Monopolistically
Competitive Firm: Normal Profit
Entry and Normal Profit
Output, Price, and Profit of a
Monopolistic Competitor
At equilibrium, ATC equals price and economic
profits are zero.
This occurs at the point of tangency of the ATC
and demand curve at the output chosen by
the firm.
Monopolistic Competition
MC
ATC
MR D
Q
M
P
M

Price
0 Quantity
Comparing Perfect and Monopolistic
Competition
Both the monopolistic competitor and the
perfect competitor make zero economic profit
in the long run.
Perfect Competition and
Monopolistic Competition Compared
Monopolistic Competition Compared
with Perfect Competition Graph
Outcome:
Monopolistic competition
output is lower and
price is higher than
perfect competition
In monopolistic competition
in the long run, P > min ATC,
In perfect competition in the
long run, P = min ATC
Q
P
ATC
Q
MC

MC
D
MC

MR
MC

P
MC

P
PC

D
PC

Q
PC

16-287
Comparing Monopolistic Competition with
Monopoly
For a monopolistic competitor in long-run
equilibrium, (P = ATC) (MC = MR)
No long-run economic profit is possible in
monopolistic competition because there are no
significant barriers to entry
It is possible for the monopolist to make economic
profit in the long run because of the existence of
barriers to entry
16-288
1. Few Sellers : An oligopoly market is characterized by
a few sellers and their number is limited . (usually not
more than 10) Oligopoly is a special type of imperfect
market. It has a large number of buyers but a few
sellers.

2. Homogeneous or Differentiated Product : The
Oligopolists produce either homogenous or
differentiated products. Products may be differentiated
by way of design , trademark or service
3. Interdependence : The most important feature of the
Oligopoly is the interdependence in decision making of
the few firms which comprise the industry.

The reactions of the rival firms may be difficult to guess.
Hence price is indeterminate under Oligopoly.

4. High Cross Elasticities : The cross elasticity of
demand for the products of oligopoly firms is very high.
Hence there is always the fear of retaliation by rivals.
Each firm is conscious about the possible action and
reaction of competitors while making any change in
price or output
6. Competition : Competition is unique in an
oligopoly market. It is a constant struggle
against rivals.

7. Different size : The size of firm in an oligopoly
market. It is a constant struggle against rivals.

8. Group Behaviour : Each Oligopolist closely
watches the business behaviour of other
Oligopolists in the industry and designs his
moves on the basis of some assumptions of their
behaviour .

9. Uncertainty : The interdependence of other
firms for ones own decision creates an
atmosphere of uncertainty about price and
output

10. Price Rigidity : In an oligopoly market
each firm sticks to its own price to avoid a
possible price war. The price remains rigid
because of constant fear of retaliation from
rivals.

Examples of Oligopoly

National markets for aluminum, cigarettes, electrical
equipment, filmed entertainment, ready-to-eat cereals,
etc.
Local retail markets for gasoline, food, specialized services,
etc.

Oligopoly and Advertising
The Largest U.S. Advertisers, 2005
Company
Advertising Spending
Millions of $
Proctor and Gamble
General Motors
Time Warner
Verizon
AT&T
Ford Motor
Walt Disney
Johnson & Johnson
GlaxoSmithKline
DaimlerChrysler
$4609
4353
3494
2484
2471
2398
2279
2209
2194
2179
Oligopoly and Advertising
Worlds Top 10 Brand Names
GLOBAL PERSPECTIVE
Coca-Cola
Microsoft
IBM
General Electric
Intel
Nokia
Toyota
Disney
McDonalds
Mercedes-Benz
Prices are more stable in oligopoly than
in any other market structure
When prices are stable we say prices are
sticky difficult to move-.
Informal collusion is an important reason
why prices are sticky in oligopoly.
Another is the kinked demand explanation.
The Kinked Demand Model
Developed to explain why prices in
oligopoly markets tend to be sticky.
We observed that changes in costs were only
rarely met by changes in oligopoly prices
We also observed that when prices did change,
they were large in magnitude.
Kinked Demand Model of Oligopoly
A firm realizes that its price drops are more
likely to be matched by rivals than its price
increases
The Kinked Demand Model of
Oligopoly
We assume that firms follow the following
strategy:

If I increase my price
My competition will not increase their price
and I
would lose sales.
If I decrease my price
My competition will also decrease their price
and I
would gain very few if any additional sales.
The Kinked Demand Model
If I increase my price
say by 10%, no one follows
and I lose sales
If I decrease my price
by 10%, everyone follows
and I gain little or nothing at
all!
Quantity
demanded drops
by 20%
Quantity
demanded
increases 5%
Q
0

P
1

D
0

Q
1

P
0

P
0

D
0

Q
0
Q
1

P
1

P
0

D
0

Q
0

MR
0

MR
1

D
1

Above P
0
demand is more elastic
Above P
0
MR looks like this
Below P
0
demand is less elastic
Below P
0
MR looks like this
Ignore the lower part of D
0
and MR
0

Ignore the upper part of D
1
and MR
1

Note: this Kink in demand,
translates into a gap in the
MR line
Two Traditional Oligopoly Models
The Kinked Demand Curve Model
In the kinked demand curve model of oligopoly,
each firm believes that if it raises its price, its
competitors will not follow, but if it lowers its price
all of its competitors will follow.
Figure 13.11 shows
the kinked demand
curve model.
The firm believes that
the demand for its
product has a kink at
the current price and
quantity.
Above the kink, demand is relatively elastic
because all other firms prices remain unchanged.
Below the kink, demand is relatively inelastic
because all other firms prices change in line with
the price of the firm shown in the figure.
The kink in the demand
curve means that the MR
curve is discontinuous at
the current quantity
shown by that gap AB in
the figure.
Fluctuations in MC that
remain within the
discontinuous portion
of the MR curve leave
the profit-maximizing
quantity and price
unchanged.
For example, if costs
increased so that the
MC curve shifted
upward from MC
0
to
MC
1
, the profit-
maximizing price and
quantity would not
change.
The beliefs that generate the kinked demand
curve are not always correct and firms can figure
out this fact.
If MC increases enough, all firms raise their prices
and the kink vanishes.
A firm that bases its actions on wrong beliefs
doesnt maximize profit.
The Kinked Demand
Model
For prices above the current
price
P
0

D
Demand is more elastic
For prices below the current
price
Q
0

MR
MR
Marginal Revenue is flatter
Demand is less elastic
Marginal Revenue is steeper
Why are prices
sticky under
oligopoly?
D
Q
0

MR
MR = MC
MC
0

MC
1

MC
2

MR = MC
0

P
0

MR = MC
1

P
1 =

P
2

Q
1

If Costs increase within the
MR gap
Price does not change
Price changes only when
MC shifts out of the MR
gap
Interdependence and Uncertainty
The centralized cartel is the case of centralized
decision making, with the organization determining
price and output quotas.
Objectives:
1) minimize industry costs for any given output (produce where all firms have the
same MC).
2) restrict output and maximize industry-wide profits. Sum MXC curves to find
industry-wide S curve. Equate that to MR, and sell from the related demand curve.
Each firm produce the quota where short-run industry MC = industry MR
Theory of Cartels
CARTEL

A cartel is an official agreement between several
firms in an oligopoly. The agreement sets the
price all firms will charge and often specifies
quotas or market shares of the various
firms. Cartels are illegal in most countries of the
world.
OPEC is a major example of a cartel. It exists
because it is beyond the control of an individual
country.

a) Decrease competition, achieve monopoly-like behavior
b) Decrease uncertainty
c) Decrease ease of entry
Motivations for Collusion
Case of the centralized cartel...
(perfect collusion)
Collusion
Decision making is carried on by the central organization. It sets price and output. (The
ideal case is illegal in the U.S. and seldom reached, probably, elsewhere.)
Objective: Minimize industry costs for any given output. Allocate
quotas to members so the MC of each producing firm at its quota
output is equal to MC of every other firm.
0 X
$
0 X
Rs
0 X
Rs
D
MR
AC
b

MC
b

MC
a

AC
a

MC
Firm A Firm B Industry
Q
c
Q
b
Q
a

The key to a very high price is the inelasticity of demand.
The cartels inelastic demand depends upon:
world Ed for the product
E of supply of competing non-cartel producers
the cartels share of the world market
A successfully high price starts all these factors gradually working against the cartel.
The world searches for substitute, non-cartel producers to try to increase supplies
and decrease the cartels market share.
Theory of Cartels
Motivation for Independent
Action
If a single firm can successfully break away from the cartel, and gain more customers
by lowering price and increasing sales beyond its former quota, it increases profits. If
everybody breaks, the old pre-cartel problems reappear.
0 X
Rs
0 X
Rs
0 X
Rs
D
MR
AC
b

MC
b

MC
a

AC
a

MC
Firm A Firm B Industry
Q'
a
Q
c
Q
b
Q
a

MR'
D'
Cartels: Collusion among oligopolists--agreement to
restrict selling competition.
Centripetal and centrifugal forces of cartels--
reason for their expected short mortality.
OPEC was slow in validating
that prediction.
International Cartels
Four Market Models
LO1
Characteristics of the Four Basic Market Models
Characteristic
Pure
Competition
Monopolistic
Competition Oligopoly Monopoly
Number of firms A very large
number
Many Few One
Type of product Standardized Differentiated Standardized or
differentiated
Unique; no
close subs.
Control over price None Some, but within rather
narrow limits
Limited by mutual
inter-dependence;
considerable with
collusion
Considerable
Conditions of
entry
Very easy, no
obstacles
Relatively easy Significant obstacles Blocked
Nonprice
competition
None Considerable emphasis on
advertising, brand names,
trademarks
Typically a great
deal, particularly
with product
differentiation
Mostly public
relation
advertising
Examples Agriculture Retail trade, dresses, shoes Steel, auto, farm
implements
Local utilities
Production function
To illustrate the law of diminishing returns, let
us assume
i) that a firm (say, the coal mining firm in our
earlier example) as a set of mining
machinery as its capital (K) fixed in the short-
run and
ii) It can employ only more mine workers to
increase its coal production.
Thus, the short run production function for
the firm will take the following form.

constant ), Q
c
K f(L =
Let us assume also that the labour output relationship in coal production is given by
a hypothetical production function of the following form.
constant L, Q
3
c
K 10 15L L
2
+ + =
Given the production function, we may substitute
different numerical values of L in the function and
work out a series of Q
c
i.e.

The quantity of coal that is produced with
different number of workers.

For example, if L = 5, then by substitution, we get

Q
c
= -5
3
+ 15 x 5
2
+ 10 x 5 = -125 + 375 + 50 = 300

What we need now is to work out marginal
productivity of labour (MP
L
) to find the trend in
the contribution of the marginal labour and
average productivity of labour (AP
L
) to find the
average contribution of labour.

Marginal Productivity of Labour (MP
L
) can be
obtained by differentiating the production
function. Thus, can be
written as

10 30 3
2
+ + =
c
c
= L L
L
Q
MP
L
constant L), (Q
3
c
K 10 15L L
2
+ + =
Alternatively, where labour can be increased at
least by one unit (MP
L
) can be obtained as
MP
L
= TP
L
- TP
L-1

Average Productivity of Labour (APL) can be
obtained by dividing the production function by
L. Thus,

10 15
10 15
2
3 3
+ + =
+ +
= L L
L
L L L
AP
L
No of Workers
(N)
Total Product
(TP
L
) (tones)
Marginal
Product* (MP
L
)
Average product
(AP
L
)
Stages of
production(based on
MP
L
)
1 2 3 4 5
1
2
3
4
5
6
24
72
138
216
300
384
24
48
66
78
84
84
24
36
46
54
60
64
I
Increasing
returns
7
8
9
10
462
528
576
600
78
66
48
24
66
66
64
60
II
Diminishing
Returns
11
12
594
552
-6
-42
54
46
III
Negative returns
0
100
200
300
400
500
600
700
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22
T
o
t
a
l

P
r
o
d
u
c
t

T
P

L

Labour
Total Product (TPL) (tones)
-60
-40
-20
0
20
40
60
80
100
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22
A
P

a
n
d

M
P

Labour
Marginal Product* (MPL)
Average product (APL)
GAME THEORY
STRATEGIC DECISION MAKING
What is Game Theory?
GT is an analytical tool for social sciences that
is used to model strategic interactions or
conflict situations.

Strategic interaction: When actions of a player
influence payoffs to other players
GT: science or art?
GT is the science of rational behavior in
interactive situations.

Good strategists mix the science of GT with
their own experience.
How to use GT
Explanation: What is the game to be played?
Prediction: What outcome will prevail?
Advice or prescription: Which strategies are
likely to yield good results in which situations?
Why is GT important?
Facilitates strategic thinking.
Provides a standard taxonomy that is needed for a
scientific approach in analyzing strategic interactions.
Helps confirm long held beliefs.
Provides new insights.
To be literate in the modern age, you need to have a
general understanding of GT. P.Samuelson
Where can we use GT?
Any situation that requires us to anticipate our rivals
response to our action is a potential context for GT.
Games: Checkers, poker, chess, tennis, soccer etc.
Economics: Industrial Organization, Micro/Macro/
International/Labor/Natural resource Economics, and
Public Finance
Political science: war/peace (Cuban missile crisis)
Law: Designing laws that work
Biology: animal behavior, evolution
Information systems: System competition/evolution
Where can we use GT? (cont.)
Business:
Games against rival firms:
Pricing, advertising, marketing, auctions, R&D, joint
ventures, investment, location, quality, take over etc.
Games against other players
Employee/employer, managers/stockholders
Supplier/buyer, producer/distributor, firm/government
Some Terminology
Strategy
Payoffs
Rationality
Common knowledge of rules
Equilibrium
GAME THEORY
GAME :It is any situation in which (the participants)
take strategic decesions.

i.e. Decesions that takes into account each others
actions and responses.
E.g. Games include firms competiting with each other
at an auction for a work of art.
Strategic decesions results in pay-offs to the players

GAME THEORY
Pay-offs: Outcomes that generate rewards or benefits.

For price setting firms ,the pay-offs are profits.

For bidders at the auctions, the winners pay-offs is
her consumers surplus i.e. the value she placed on
the art work, less the amt she must pay .

GAME THEORY
A key objective of game theory is to
determine the optimal strategy for
each player.

A strategy is a rule or plan of action
for playing the game.

GAME THEORY
E.G of strategy

For price setting Firms

A strategy might be I will keep my price high as long
as my competitors do the same ,but once the
competitor lower his price I will lower mine even
more
GAME THEORY

For Bidders

A strategy might be I will make a first bid of Rs. 2000
to convince the other bidders that I am serious about
winning ,but I will drop out if the other bidders push
the price above Rs 5000
The optimal strategy for the player is the one that
maximizes her expected pay offs .

(Possible outcomes of the game is pay-offs matrixs)
Non co-operatives vs. Co-operative
Games
Co-operative Game : It is a game
where players can negotiate bindings
contracts that allow them to plan
joint strategies .

Non co-operative strategies : It is
situation in which the two players
take each others likely behaviour
into account when independently
taking the decesions

Co-operative Game

-> Bargaining between buyer and Seller over the price Of
a pen.

If the pen costs Rs.100 to produce and the buyer values
the pen of Rs.200

A co-operative Solution to the game is possible

An agreement to sell the pens at any price between
Rs.101 and Rs.199 will maximize the Sum of the buyer's
consumer surplus and the seller's profit .
This will make both the parties better off

Non co-operative game

-> Two competing firms take each other's likely
Behaviour into account When independently Setting
their prices

-> Each firm knows that by undertaking the price
reduction can capture more market Share

-> But it is risk setting off a price war

Dominant Strategies

Some questions'

Q1) How can we decide on the best Strategy
for playing a game ?

Q2) How can we determine game's likely outcome?

-> Some Strategies may be successful if its competitors make certain Choices
but fail if they make Other choices

-> There may some Strategies may be successful regardless of what
competitors do.
i.e. the concept of Dominant strategy
i.e. optimal no matter what the opponent does
Dominant Strategies

Duopoly

-> suppose Firm A and B sell competiting products
and are deciding whether to undertake advertisement
or not

-> Each firms will be affected by its competitors
decision.

Payoff Matrix
Firm B
Advertise Dont Advertise
Advertise 10 ,5 15 ,0
Firm A
Dont Advertise 6 ,8 10 ,2
GAME THEORY
First number in each cell is the pay off to A Second
number in each cell is the payoff to B outcomes
-> Both the firm decide to advertise
i.e. 10 ,5

-> If the firm A advertises & B does not
i.e. 15, 0

-> Firm A doesn't advertise and firm B Advertise
i.e. 0, 8

-> Firm A and B doesn't advertise
i.e. 10 ,2

GAME THEORY
-> Firm A will advertise no matter what the B does
-> Firm B will also advertise no matter What the Firm A does

->The outcome for this game is that both firm will advertise.

-> Both the firm have dominant Strategies

* unfortunately not every game has a dominant strategy for each
player

Modified advertising game

Suppose Payoff matrix Change
Firm B
Advertise Dont Advertise
Advertise 10 ,5 15 ,0
Firm A
Dont Advertise 6 ,8 20 ,2
GAME THEORY
Now Suppose both the firms make their own
decesions at the same time. What should firm A
do ?

-> If neither firm advertises, Firm B will again
earn profit of 2, but Firm A will earn profit of 20

Perhaps Firm A's ads are largely defensive and
expensive

-> But Firm A has no dominant strategy. It's
optimal decision depends on what Firm B does .

GAME THEORY
-> To make decision Firm A must put itself in Firm's B
shoes
i.e. what decision is best from Firm B's point of
view

B's point

-> If firm A advertises & B advertise
10, 5

-> firm A advertises B does not
15, 0

GAME THEORY
-> If Firm A doesn't advertise B earn 8 if it advertises
and 2 if it doesn't

-> Firm A conclude that Firm B will advertise

-> firm A will advertise (there by 10 instead of 6 )

-> Equilibrium is that both Firms will advertise (logical
outcome)

Difference
Dominants Strategies: I am doing the best I can
no matter what you do . Youre doing the best
you can no matter what I do.

Nash Equilibrium: I m doing the best, I can given
what u are doing .u are doing the best u can given
what I m doing.

The Prisoner's Dilemma

-> Each prisoner is told that if he and his accomplice
Confess their imprisonment will be only five years
but if only one confesses and the other remains
silent, the who confesses will get only one year Jail
and other will get ten years.

-> If both remain silent they will get 2yrs of jail.


Prisoner B
Silent Confess
Silent 2,2 10 ,1
Prisoner A
Confess 1,10 5,5

-> Both the prisoner's would confess thus serve five years imprisionment.

-> Each of the prisoners knows that the dominant Strategy of the opponent is
to confess

-> hence each will Confess

-> The dominant Strategy of this type is a special case of' Nash equilibrium

-> Similarly if either A or B adopts maxmin or minmax Strategy, then outcome
in both the cases would be the same.

Mangerial Economics

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