Market Structures

 Perfect Competition
Different Form
 Monopolistic Competition
of Market
 Oligopoly
Structures
 Monopoly
 Large Number of Buyers
and Sellers
Perfectly
Competitive Homogenous Products
Market
Price Taker
Examples of Perfectly Competitive Market
Monopoly Market
Characteristics
of Monopoly
Examples of Monopoly
Examples of Monopolistic Competition
  A monopolistic competitive industry has the
following features:

 Many firms.
Characteristics  Freedom of entry and exit.

of  Firms produce differentiated products.

 Firms have price inelastic demand; they are
Monopolistic price makers because the good is highly
differentiated
Competition  Firms make normal profits in the long run but
could make supernormal profits in the short
term
 Firms are allocatively and productively
inefficient.
 OLIGOPOLY
 An oligopoly is an industry dominated by a few large firms.
 PERFECTLY
COMPETITIVE MARKET
Consumer
Surplus,
Producer
Surplus and
Marginal 


Marginal Revenue (MR)= d(TR)/dQ
Marginal Cost (MC)= d(TC)/dQ
Revenue,  Profit (q)= TR-TC= R(q)- C(q)

Marginal Cost  Profit is maximized when an additional

increment to output leaves profit
and Profit unchanged
MR= MC is the profit maximizing
Maximization

condition for any firm
Demand and  Individual Demand Curve is a
Horizontal Straight Line
Marginal  Demand curve also equals the AR and
Revenue For a MR curve
 Market Demand curve however is
Competitive downward sloping

Firm
Demand Curve, Average Revenue and
Marginal Revenue Curve
Short Run Profit Maximizing Condition by
a competitive firm
Competitive Firm Short Run Supply Curve
Long Run Profit Maximization
Session 1 : Introduction to Managerial
Economics

Chhavi Tiwari
PGDHRM2021-23
Email: [email protected]
T.A. Pai Management Institute (TAPMI), Manipal
FUNDAMENTAL
ECONOMIC
PROBLEM
 • Constrained Optimization
• Marginal analysis- Comparing marginal
Introduction benefit and marginal cost
to • Managerial economics applies microeconomic
Economics theory to business problems
• How to use economic analysis to make decisions to
achieve firm’s goal of profit maximization
 • You are interviewing three people for one sales job.
On the basis of your experience and insight, you
An example believe Jane can sell 600 units a day, Joe can sell 450
units a day, and Joan can sell 400 units a day. The daily
salary each person is asking is as follows: Jane, $200;
Joe, $150; and Joan, $100. How would you rank the
three applicants?
 • Labor economics studies how labor
Introduction markets work.
to Labour
Economics • How are wages determined?
• What is the impact of government
intervention in the labour market?
 Positive economics addresses the relatively narrow “What
is?”
• What is the impact of minimum wage on unemployment?
• What is the impact of a tuition assistance program on
Positive college enrollment rates?

versus • What is the impact of unemployment insurance on the

duration of a spell of unemployment?
normative
Normative economics addresses much broader “What should
Economics be?”
• Should there be a minimum wage?
• Should the government subsidize college tuition?
• Should the unemployment insurance system be less
generous?
 MICROECONOMICS AND MACROECONOMICS

• Microeconomics
• Greek for small
• The branch of economics that examines the functioning of the economy at the level of individual
consumers, workers, firms and markets.
• Looks at the individual unit- the household, the firm, the industry. It sees and examines the “trees”.

• Macroeconomics
• Macro is Greek for large.
• The branch of economics that examines the economic behavior of the aggregates-income,
employment, output and so on- on a national scale.
• Looks at the whole- the aggregate. It sees and analyses the “forest”.
 SCOPE OF ECONOMICS

Examples of Microeconomics and Macroeconomics Concerns

Division of Production Prices Income Employment
Economics
Microeconomics Production/output Price of individual Distribution of Employment by
in individual goods and services income and individual businesses
industries and wealth and industries
businesses

How much steel Price of medical care Wages in the auto Jobs in the steel
How much office Price of gasoline industry industry
space Price of Food prices Minimum wage No. of employees in a
How many cars Apartment Rent Executive salaries firm
No. of accountants
Macroeconomics National Aggregate price National Income Employment and
Production/Output level Unemployment in
the economy
Total Industrial Output Consumer prices Total wages and
Gross Domestic Producer prices salaries Total number of jobs
Product Rate of inflation Total Corporate Unemployment rate
Growth of output Profit
 • Consumer- What to produce?
Economic
agents • Producers- How to Produce?
• Firms- How much to produce? What price to
charge?
 Theory of Consumption- Preferences, Theory of Production- Cost,
Budget, Utility Maximization Production function, Cost Minimization

Demand Market Supply

Perfect Competition (No Firms with Market Power

Market Power)

Short-run
Long-run
Shut-down (if not covering Oligopoly Monopoly
VC) Entry (Profit) versus Exit
(Losses)
versus continue

Pricing Decisions

Uniform Pricing (MC=MR) Price Discrimination

First Degree Second Degree Third Degree

 • Economics is a science of “choice” between scare
resources and their alternative uses.
• The difference between positive and normative
economics is due to value judgements.
• Microeconomics deals with individual behaviour
KEY while macroeconomics is the study if aggregates
TAKEAWAYS Read:
• https://www.forbes.com/sites/joshbersin/2013/04/05/
can-hr-managers-think-like-
economists/?sh=7605d6e1630d
Session 2: Basics of Demand and
Supply
Chhavi Tiwari
PGDHRM (2021-23), T.A. Pai Management Institute (TAPMI), Manipal
We studied about scarcity of resources in the last class. Can you identify which of the following is NOT an
example of economic scarcity?

A) If Abhaya orders food from Zomato this Saturday, he will not be able to afford buying ice cream.
B) If Riya studies for her economics quiz this evening, she will not have time to walk her dog.
C) If Hyundai increases its production of SUVs this year, it will have to spend more on advertising.
D) If Crossword Bookstores increases the number of titles it carries, it will have to reallocate shelf space to
accommodate the new titles.
Identify the positive statement?
A) The Prime minister of India ought to be elected by a direct vote of the Indian people rather than the
Electoral College.
B) A fundamental assumption of the economic theory of consumer behavior is that consumers always
prefer having more of any good to having less of it.
C) Because many adults cannot afford to go to college, tax credits for tuition should be introduced.
D) all of the above
E) none of the above
 • Quantity demanded (QD): Amount of a good or service
consumers are willing & able to purchase during a given
period of time.

• Factors that can influence demand QD

• Price of good or service (𝑃)
• Incomes of consumers (𝑀)
• Prices of related goods & services (𝑃𝑅 )
DEMAND • Taste pattern of consumers (𝑇)
• Any Other (?)

General Demand function

𝑄𝐷 = 𝑓(𝑃, 𝑀, 𝑃𝑅 , 𝑇, … . . )
 • Law of Demand
• The claim that the quantity demanded of a good falls
when the price of the good rises, other things equal .
• QD increases when P falls & QD decreases when P rises,
all else constant

LAW OF • We can write this relationship between quantity

DEMAND demanded and price as an equation:

QD = QD(P)
 LET’S TRY IT OUT

Price Quantity
• Example:
of pizza of pizza demanded
Kumar’s demand for
₹0.00 16
pizza.
1.00 14
2.00 12
3.00 10
• Notice that Kumar’s 4.00 8
preferences obey the
5.00 6
law of demand.
6.00 4
 KUMAR’S DEMAND SCHEDULE & CURVE
Price of Quantity
Price
Pizza D of pizza
of pizza
₹
$6.00 demanded
₹0.00 16
₹$5.00
1.00 14
₹$4.00
2.00 12
₹$3.00 3.00 10
₹$2.00 4.00 8
5.00 6
₹$1.00
D 6.00 4
₹$0.00
Quantity
0 5 10 15 of Pizzas
MARKET DEMAND VERSUS INDIVIDUAL DEMAND
• The quantity demanded in the market is the sum of the quantities demanded by all buyers at
each price.
• Suppose Kumar and Aisha are the only two buyers in the Pizza market. (𝑸𝑫 = quantity
demanded)
• Market demand curve is the horizontal summation of individual demand curves.

Price Kumar’s 𝑸𝒅 Aisha’s 𝑸𝒅 Market 𝑸𝑫

₹0.00 16 + 8 = 24
1.00 14 + 7 = 21
2.00 12 + 6 = 18
3.00 10 + 5 = 15
4.00 8 + 4 = 12
5.00 6 + 3 = 9
6.00 4 + 2 = 6
 THE MARKET DEMAND CURVE FOR PIZZA

P D P 𝑄𝐷 (Market)
₹
$6.00
₹0.00 24
₹
$5.00
1.00 21
₹
$4.00 2.00 18
₹
$3.00 3.00 15
4.00 12
₹
$2.00
5.00 9
₹
$1.00 6.00 6
D
₹
$0.00 Q Mathematically, a linear demand
0 5 10 15 20 25 curve be represented as;
𝑄𝐷 = 𝑎 − 𝑏𝑃 Rate of
Intercept change
 DEMAND CURVE SHIFTERS

• Income of the consumer changes

• Normal goods : Quantity demanded (𝑄𝐷 ) increases with increase in income Demand Curve
Shifters: INCOME
• Inferior goods : Quantity demanded (𝑄𝐷 ) decreases with increase in income

• Price of related goods

• Substitute goods: Two goods are substitutes if an increase in the price of one causes an
increase in demand for the other.
• Complimentary goods: Two goods are complements if an increase in the price of one
causes a fall in demand for the other.

• Taste/ Preference

• Expectations
SUMMARY: VARIABLES THAT INFLUENCE DEMAND

Variable A change in this variable…

Price …causes a movement
along the D curve
# of buyers …shifts the D curve
Income …shifts the D curve
Price of
related goods …shifts the D curve
Tastes …shifts the D curve
Expectations …shifts the D curve
SESSION 3: BASICS OF DEMAND
AND SUPPLY

Chhavi Tiwari
 • The quantity supplied of any good is the amount
that sellers are willing and able to sell.

• Law of supply: the claim that the quantity supplied

of a good rises when the price of the good rises, other
SUPPLY things equal

• Supply curve: Supply curve is the relationship

between the quantity supplied and the price;

• 𝑄𝑆 = 𝑄𝑆 (𝑃)
 THE SUPPLY SCHEDULE

• Example:
Dominos’ supply of pizzas. Quantity
Price
of pizzas
of pizza
supplied
₹0.00 0
▪ Notice that Dominos’ 1.00 3
supply schedule 2.00 6
obeys the 3.00 9
law of supply. 4.00 12
5.00 15
6.00 18
 DOMINOS’ SUPPLY SCHEDULE & CURVE
Price Quantity
P S of of pizzas
₹
$6.00 pizzas supplied

₹
$5.00
₹0.00 0
1.00 3
₹$4.00
2.00 6
₹$3.00 3.00 9
₹$2.00 4.00 12
5.00 15
₹
$1.00
6.00 18
S
₹
$0.00 Q
0 5 10 15
 MARKET SUPPLY VERSUS INDIVIDUAL SUPPLY

• The quantity supplied in the market is the sum of

the quantities supplied by all sellers at each price.
• Suppose Dominos and Pizza Hut are the only two sellers in this market. (𝑸𝑺 = quantity
supplied)
• Market supply curve is the horizontal summation of individual supply curves

Price Dominos’ 𝑸𝒔 Pizza Hut 𝑸𝒔 Market 𝑸𝑺

₹0.00 0 + 0 = 0
1.00 3 + 2 = 5
2.00 6 + 4 = 10
3.00 9 + 6 = 15
4.00 12 + 8 = 20
5.00 15 + 10 = 25
6.00 18 + 12 = 30
 THE MARKET SUPPLY CURVE

𝑸𝑺
P P
S (Market)
₹
$6.00
₹0.00 0
₹
$5.00 1.00 5
₹
$4.00 2.00 10
₹
$3.00 3.00 15
4.00 20
₹$2.00
5.00 25
₹
$1.00 6.00 30
S
₹
$0.00 Q Mathematically, a linear supply
0 5 10 15 20 25 30 35 curve be represented as;
𝑄𝑆 = 𝑐 + 𝑑𝑃
 SUPPLY CURVE SHIFTERS

• Input prices change: Supply Curve Shifters: Input Prices

• Technology
• Expectations
SUPPLY CURVE SHIFTERS: INPUT PRICES

P S S’
Suppose the
₹$6.00 price of bread
falls.
₹$5.00
At each price,
₹$4.00 the quantity of
pizzas supplied
₹$3.00
will increase
₹$2.00 (by 5 in this
₹$1.00 example).
S S’
₹$0.00 Q
0 5 10 15 20 25 30 35
Slide 27
SUMMARY: VARIABLES THAT INFLUENCE SELLERS

Variable A change in this variable…

Price …causes a movement

along the S curve
Input Prices …shifts the S curve
Technology …shifts the S curve
# of Sellers …shifts the S curve
Expectations …shifts the S curve
 MARKET MECHANISM: EQUILIBRIUM

P Equilibrium condition:
₹$6.00 D S P has reached
₹$5.00 the level where
quantity supplied equals
₹$4.00
quantity demanded
₹$3.00
𝑄𝐷 = 𝑄𝑆
₹$2.00

₹$1.00

₹$0.00 Q
0 5 10 15 20 25 30 35
 EQUILIBRIUM PRICE AND EQUILIBRIUM QUANTITY:
Equilibrium Price: the price that equates quantity supplied with quantity demanded
Equilibrium Quantity : quantity at which demand, and supply are equal
P
₹$6.00 D S
P 𝑸𝑫 𝑸𝑺
₹$5.00
₹0 24 0
₹$4.00 1 21 5
₹ $3.00 2 18 10
3 15 15
₹ $2.00
4 12 20
₹ $1.00
5 9 25
₹$0.00 Q 6 6 30
0 5 10 15 20 25 30 35
 SURPLUS (EXCESS SUPPLY):
when quantity supplied is greater than quantity demanded

P Example:
₹
$6.00 D Surplus S If P = ₹ 5,
₹
$5.00 then
₹
$4.00 QD = 9 pizzas

₹
$3.00 and
QS = 25 pizzas
₹
$2.00
₹
resulting in a
$1.00
surplus of 16 pizzas
₹
$0.00 Q
0 5 10 15 20 25 30 35
 SURPLUS (EXCESS SUPPLY):
when quantity supplied is greater than quantity demanded

P Facing a surplus,
₹
$6.00 D Surplus S sellers try to increase
₹
$5.00 sales by cutting price.
₹
$4.00 This causes
𝑸𝑫 to rise and 𝑸𝑺 to fall…
₹
$3.00
₹
$2.00 …which reduces the
₹ surplus.
$1.00
₹
$0.00 Q
0 5 10 15 20 25 30 35
 SURPLUS (EXCESS SUPPLY):

when quantity supplied is greater than quantity demanded

P Facing a surplus,
₹
$6.00 D Surplus S
sellers try to increase
₹
$5.00 sales by cutting price.
₹
$4.00 This causes
₹
$3.00 QD to rise and QS to fall.
₹
$2.00 Prices continue to fall
until market reaches
₹
$1.00
equilibrium.
₹
$0.00 Q
0 5 10 15 20 25 30 35
 SHORTAGE (EXCESS DEMAND):
when quantity demanded is greater than quantity supplied

Example:
P
₹
$6.00 D S If P = ₹1,
₹
$5.00 then
₹
$4.00 𝑸𝑫 = 21 pizzas

₹
$3.00 and
𝑸𝑺 = 5 pizzas
₹
$2.00
resulting in a
₹
$1.00
shortage of 16
₹
$0.00 Shortage Q pizzas
0 5 10 15 20 25 30 35
 SHORTAGE (EXCESS DEMAND):
when quantity demanded is greater than quantity supplied

P Facing a shortage,
₹
$6.00 D S sellers raise the price,
₹
$5.00 causing QD to fall
₹
$4.00 and QS to rise,
₹
$3.00 …which reduces the
₹
shortage.
$2.00
₹
$1.00
Shortage
₹
$0.00 Q
0 5 10 15 20 25 30 35
 SHORTAGE (EXCESS DEMAND):

when quantity demanded is greater than quantity supplied

P Facing a shortage,
₹
$6.00 D S sellers raise the price,
causing QD to fall
₹
$5.00
and QS to rise.
₹
$4.00
Prices continue to rise
₹
$3.00 until market reaches
₹
$2.00 equilibrium.
₹
$1.00
Shortage
₹
$0.00 Q
0 5 10 15 20 25 30 35
SUPPLY AND DEMAND IN THE LABOUR MARKET

the firm’s demand for labor is a derived

demand, a demand derived from the desires
of consumers.
 INTERVENTIONS?

• Price controls:
• Price Ceiling: a legal maximum on the price of a good or service Example: rent control

• Price Floors: a legal minimum on the price of

a good or service Example: minimum wage
SESSION 4: DEMAND AND SUPPLY

Chhavi Tiwari
 INTERVENTIONS?

• Price controls:
• Price Ceiling: a legal maximum on the price of a good or service Example: rent control

• Price Floors: a legal minimum on the price of

a good or service Example: minimum wage
 HOW PRICE FLOORS AFFECT MARKET OUTCOMES

The eq’m wage ($6) is labor

below the floor and W surplus S
therefore Price
$7.25
floor
illegal.
The floor is a binding $6.00
constraint on the wage,
causes a surplus (i.e.,
unemployment).
D
L
400 550

Minimum Wage: Market for Labour

 REVIEW QUESTIONS

2. Use supply and demand curves to illustrate how each of the following events would
affect the price of butter and the quantity of butter bought and sold:
a. An increase in the price of margarine
b. An increase in the price of milk
c. A decrease in average income levels
 CHAPTER 2- PROBLEM. 1

• Suppose the demand curve for a product is given by Q = 300 - 2P + 4I, where I is average income
measured in thousands of dollars. The supply curve is Q = 3P - 50.
a. If I = 25, find the market-clearing price and quantity for the product.
• Given I = 25, the demand curve becomes Q = 300 − 2P + 4(25), or Q = 400 − 2P. Set demand equal to supply
and solve for P and then Q:
• 400 - 2P = 3P - 50
P = 90
Q = 400 - 2(90) = 220.
 CHAPTER 2- PROBLEM. 1

• Suppose the demand curve for a product is given by Q = 300 - 2P + 4I, where I is average income
measured in thousands of dollars. The supply curve is Q = 3P - 50.
b. If I = 50, find the market-clearing price and quantity for the product.
Given I = 50, the demand curve becomes Q = 300 - 2P + 4(50), or Q = 500 - 2P. Setting demand equal to supply,
solve for P and then Q:
500 - 2P = 3P - 50
P = 110
Q = 500 - 2(110) = 280.
 CHAPTER 2- PROBLEM. 6

Scenario:

The rent control agency of New York City has found that aggregate demand is 𝑄𝐷 = 160 – 8𝑃.
Quantity is measured in tens of thousands of apartments. Price, the average monthly rental rate, is
measured in hundreds of dollars. The agency also noted that the increase in Q at lower P results from
more three-person families coming into the city from Long Island and demanding apartments. The city’s
board of realtors acknowledges that this is a good demand estimate and has shown that supply is

𝑄𝑆 = 70 + 7𝑃.
 CHAPTER 2- PROBLEM. 6

a. If both the agency and the board are right about demand and supply, what is the free-market price?
What is the change in city population if the agency sets a maximum average monthly rent of $300
and all those who cannot find an apartment leave the city?
Solution:
Equilibrium Condition : Demand = Supply, 𝑄𝐷 = 𝑄𝑆 .

160 − 8𝑃 = 70 + 7𝑃
𝑜𝑟 𝑃 = 6
which means the rental price is $600 since price is measured in hundreds of dollars.
𝑄𝐷 = 160 − 8(6) = 112
And
𝑄𝑆 = 70 + 7(6) = 112.
The quantity of apartments rented is 1,120,000 since Q is measured in tens of thousands of apartments.
 CHAPTER 2- PROBLEM. 6

Solution:
If the rent control agency sets the rental rate at $300, the quantity supplied would be 910,000 (QS = 70
+ 7(3) = 91), a decrease of 210,000 apartments from the free-market equilibrium. Assuming three
people per family per apartment, this would imply a loss in city population of 630,000 people.
 CHAPTER 2- PROBLEM. 6

b. Suppose the agency bows to the wishes of the board and sets a rental of $900 per month on all
apartments to allow landlords a “fair” rate of return. If 50 percent of any long-run increases in
apartment offerings come from new construction, how many apartments are constructed?
Solution:
At a rental rate of $900, the demand for apartments would be 160 − 8(9) = 88, or 880,000 units, which
is 240,000 fewer apartments than the original free-market equilibrium number of 1,120,000.Therefore,
no new apartments would be constructed.
 THREE STEPS TO ANALYZING CHANGES IN EQ’M

To determine the effects of any event,

1. Decide whether the event shifts S curve,

D curve, or both.
2. Decide in which direction curve shifts.

3. Use supply—demand diagram to see

how the shift changes eq’m P and Q.
SESSION 5: ELASTICITY OF
DEMAND

Chhavi Tiwari
 • Law of Demand : Direction of relationship
between demand and price
• Elasticity: Magnitude, How sensitive is the
ELASTICITY demand to the changes in the determinants
OF • Elasticity
DEMAND • Percentage change in one variable resulting
from a 1-percent increase in another.
• Elasticity of Demand
• Price elasticity
• Income elasticity
• Cross elasticity
 • Price elasticity of demand
• a measure of how much the quantity
demanded of a good responds to a
PRICE change in the price of that good.
ELASTICITY • percentage change in quantity
OF demanded of a good resulting from a 1-
DEMAND percent increase in its price.
 COMPUTING PRICE ELASTICITY OF DEMAND

• Price elasticity of demand measures how much 𝑄𝐷 responds to a change in P.

• Loosely speaking, it measures the price-sensitivity of buyers’ demand.

Price elasticity of Percentage change in 𝑄𝐷

=
demand Percentage change in P
∆𝑄 ∆𝑃
|𝑒𝑃 | = /
𝑄 𝑃
∆𝑄 𝑃
𝑜𝑟, |𝑒𝑃 | = .
∆𝑃 𝑄

𝜕𝑄 𝑃
𝑒𝑝 = .
𝜕𝑃 𝑄
 PRICE ELASTICITY OF DEMAND

Price elasticity of Percentage change in 𝑸𝑫

=
demand Percentage change in P
P
Example:
P rises
Price elasticity by 10%
P2
of demand P1
equals
D
15% Q
= 1.5 Q2 Q1
10%
Q falls
by 15%
 ARC ELASTICITY

From A to B,
P rises 25%, Q falls 33%,
elasticity = 33/25 = 1.33
Demand for
your websites From B to A,
P P falls 20%, Q rises 50%,
B elasticity = 50/20 = 2.50
₹2500
A
₹2000 Mid-point method
D
Q
8 12 ∆𝑄 𝑃(𝐴𝑣𝑔)
|𝑒𝑃 | = .
∆𝑃 𝑄(𝐴𝑣𝑔)
 • If, |𝑒𝑃 |<1 ⟹ percentage change in demand is
less than the percentage change in price.
Demand is inelastic.
PRICE
ELASTICITY • If, |𝑒𝑃 | >1 ⟹ percentage change in demand is
more than the percentage change in price.
OF Demand is elastic.
DEMAND • If, |𝑒𝑃 | =1 ⟹ percentage change in demand is
equal to the percentage change in price.
Demand is unitary elastic.
 • The price elasticity of demand is closely related to
the slope of the demand curve.
• Rule of thumb:
VARIOUS The flatter the curve, the bigger the elasticity.
DEMAND The steeper the curve, the smaller the elasticity.
CURVES • Five different classifications of D curves.…
“PERFECTLY INELASTIC DEMAND” (ONE EXTREME C ASE)
Price elasticity % change in Q 0%
= = =0
of demand % change in P 10%

D curve: P
D
vertical
P1
Consumers’
price sensitivity: P2
none
P falls Q
Elasticity: by 10% Q1
0 Q changes
by 0%
 “INELASTIC DEMAND”
Price elasticity % change in Q < 10%
= = <1
of demand % change in P 10%

D curve: P
relatively steep
P1
Consumers’
price sensitivity: P2
relatively low D
P falls Q
Elasticity: by 10% Q1 Q2
<1
Q rises less
than 10%
 “UNIT ELASTIC DEMAND”

Price elasticity % change in Q 10%

= = =1
of demand % change in P 10%

D curve: P
intermediate slope
P1
Consumers’
price sensitivity: P2
intermediate D

P falls Q
Elasticity: by 10% Q1 Q2
1
Q rises by 10%
 “ELASTIC DEMAND”

Price elasticity % change in Q > 10%

= = >1
of demand % change in P 10%

D curve: P
relatively flat
P1
Consumers’
price sensitivity: P2 D
relatively high
P falls Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
“PERFECTLY ELASTIC DEMAND” (THE OTHER EXTREME)

Price elasticity % change in Q any %

= = = infinity
of demand % change in P 0%

D curve: P
horizontal
P2 = P1 D
Consumers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity
Q changes
by any %
 ELASTICITY ALONG LINEAR DEMAND CURVE

• Linear demand curve : Demand curve that is a straight line

𝑸𝑫 = 𝑎 − 𝑏𝑃
The price elasticity of
demand depends not only
on the slope of the demand
curve but also on the price
and quantity.

The elasticity, therefore,

varies along the curve as
price and quantity change.
Slope is constant for this
linear demand curve.

Near the top, because price

is high and quantity is
small, the elasticity is large
in magnitude.

The elasticity becomes

smaller as we move down
the curve.
 • Necessary versus luxury goods
DETERMINANTS
OF PRICE • Availability of close substitute
ELASTICITY OF • Time horizon
DEMAND
SESSION 6:ELASTICITY OF DEMAND

Chhavi Tiwari
 TOTAL REVENUE AND PRICE ELASTICITY.
C ASE I: DEMAND IS ELASTIC

Elastic demand increased

Demand for
(elasticity = 1.8) P revenue due
your websiteslost
to higher P
If P = ₹ 2000, revenue
due to
Q = 12 and revenue
₹ 2500 lower Q
= ₹ 24000.
₹ 2000
If P = ₹ 2500, D
Q = 8 and
revenue = ₹
20000. Q
8 12

When D is elastic, a price increase causes revenue to fall.

 CASE II. DEMAND IS INELASTIC

Now, demand is
inelastic:
. increased
elasticity = 0.82
revenue due to
P higher P
If P = ₹2000,
Q = 12 and
revenue = ₹2500
₹24000. ₹2000
If P = ₹ 2500, D
Q = 10 and
revenue = ₹
25000. Q
10 12
When D is inelastic, a price increase causes revenue to rise.
 PROBLEM

Two friends Ravi and Vijay go to petrol pump. Ravi wanted to buy 100 Rs.
Petrol whereas Vijay wanted to buy 100 Litres of petrol. Calculate each
friend’s price elasticity.
 INCOME ELASTICITY

• Income elasticity of demand: measures the response of 𝑸𝑫 to a change in

consumer income

Income elasticity of Percent change in 𝑸𝑫

demand =
Percent change in income

𝑑𝑄/𝑄 𝑑𝑄 𝑀
η= = .
𝑑𝑀/𝑀 𝑑𝑀 𝑄

• For normal goods, higher income raises the quantity demanded. Hence, for
normal goods, income elasticity > 0.
• For inferior goods, higher income lowers the quantity demanded. Hence, for
inferior goods income elasticity < 0.
 INCOME ELASTICITY: CH. 4 EXERCISE 10

a. Bill spends all his income on books and coffee. He finds $20 while rummaging through
a used paperback bin at the bookstore. He immediately buys a new hardcover book of
poetry.

Solution: Books are a normal good since his consumption of books increases with income.
Coffee is a neutral good since consumption of coffee stayed the same when income
increased.

b. Bill loses $10 he was going to use to buy a double espresso. He decides to sell his new
book at a discount to a friend and use the money to buy coffee.

Solution: When Bill’s income decreased by $10 he decided to own fewer books, so books
are a normal good. Coffee appears to be a neutral good because Bill’s purchase of the
double espresso did not change as his income changed.
 ONE MORE PROBLEM: CHAPTER 4. EXERCISE 8

Judy has decided to allocate exactly $500 to college textbooks every year, even
though she knows that the prices are likely to increase by 5 to 10 percent per year
and that she will be getting a substantial monetary gift from her grandparents next
year. What is Judy’s price elasticity of demand for textbooks? Income elasticity?

Solution: Judy will spend the same amount ($500) on textbooks even when prices
increase. We know that total revenue (i.e., total spending on a good) remains constant
when price changes only if demand is unit elastic. Therefore Judy’s price elasticity of
demand for textbooks is –1. Her income elasticity must be zero because she does not plan
to purchase more books even though she expects a large monetary gift (i.e., an increase
in income).
 CROSS PRICE ELASTICITY

Cross-price elasticity of demand: measures the response of demand 𝑸𝑫

for one good to changes in the price of another good

Cross-price elasticity % change in 𝑸𝑫 for good Y

of demand =
% change in price of good X

𝜕𝑄𝑌 /𝑄𝑌 𝜕𝑄𝑌 𝑃𝑋

𝑒𝑐 = = .
𝜕𝑃𝑋 /𝑃𝑋 𝜕𝑃𝑋 𝑄𝑌

Whether the cross-price elasticity is a positive or negative number depends on

whether the two goods are substitutes or complements.
For substitutes, cross-price elasticity > 0
For complements, cross-price elasticity < 0
 CROSS PRICE ELASTICITY: REVIEW Q. 11, CH.2

Suppose the demand curve for a product is given by Q = 10 − 2P + 𝑃𝑠 , where P is the price of the product and 𝑃𝑠
is the price of a substitute good. The price of the substitute good is $2.00.

a. Suppose P = $1.00. What is the price elasticity of demand? What is the cross-price elasticity of demand?

Solution:

Quantity demanded when P = $1.00 and 𝑃𝑠 = $2.00. 𝑄 = 10 − 2(1) + 2 = 10

𝜕𝑄 𝜕𝑄
= −2, =1
𝜕𝑃 𝜕𝑃𝑠

𝜕𝑄 𝑃 1
Price elasticity of demand = 𝑒𝑝 = 𝜕𝑃 . 𝑄 =(−2). 10 = −0.2

𝜕𝑄 𝑃 2
Cross-price elasticity of demand = 𝑒𝑐 =𝜕𝑃 . 𝑄𝑠 = 1. 10 = 0.2
𝑠
 CROSS PRICE ELASTICITY: PROBLEM 11, CH.2

b. Suppose the price of the good, P, goes to $2.00. Now what is the price elasticity of demand? What is the cross-
price elasticity of demand?
SESSION 7: ELASTICITY GAME

Chhavi Tiwari
“ TAPMI Cafe”
Situation 1

You have income of Rs. 50. You

need to spend all the income. Individual Market
Write down the quantities you Quantities Quantities
will buy of the products. You may Can of Coke ( Rs. 10)
buy any quantity (including 0).
Snickers Bar (Rs. 10)

Twinkie (Rs.10)
Milk (Rs. 10)
Situation 2

Due to a peanut production

catastrophe the price of Individual Market
Quantities Quantities
Snickers Bars increases to Rs.
20 and all other prices Can of Coke ( Rs. 10)
remained unchanged. Now
again write down the Snickers Bar (Rs. 20)
quantities you will purchase.
Twinkie (Rs.10)

Milk (Rs. 10)

Situation 3

The peanut production

catastrophe gets all straightened Individual Market
out (i.e., the price of Snickers Bars Quantities Quantities
decreases to its original market
price of Rs. 10). Further, a Can of Coke ( Rs. 10)
university donor has offered more
scholarship support to students, Snickers Bar (Rs. 10)
leading to increased income for
all. Your income increased to Rs. Twinkie (Rs.10)
80
• Write down the quantities. Milk (Rs. 10)
Exercise

• In your working groups, Determine the market quantities for situation 1 and situation 2.
• Develop the demand curve for snickers bar.
• Compute the price elasticity.
• Determine the market quantities for situation 3.
• Compute the income elasticity.
• Compute the cross-price elasticity for other goods.
• Coke, Twinkie, Milk
SESSION 8: THEORY OF
CONSUMPTION

Chhavi Tiwari
 CONSUMER BEHAVIOR

Theory of consumer behavior: description of how

consumers allocate incomes among different goods and
services to maximize their well-being.
• Individual consumption decisions are made with the goal of
maximizing total satisfaction from consuming various goods
and services
• Subject to the constraint that spending on goods exactly
equals the individual’s money income

• Consumers choose the “best” bundle of goods they “can

afford”.

• “Best” : Preferences
• “what consumers can afford”: Budget constraint
 CONSUMER PREFERENCES

Assumptions

1. Completeness: For every pair of consumption bundles, A and B, the consumer can say
one of the following:
• A is preferred to B
• B is preferred to A
• The consumer is indifferent between A and B

2. Transitivity: If A is preferred to B, and B is preferred to C, then A must be preferred to C

3. Nonsatiation: More of a good is always preferred to less

 TOTAL UTILITY AND MARGINAL UTILITY

Utility
• Benefits consumers obtain from goods &
services they consume is utility

• A utility function shows an individual’s perception

of the utility level attained from consuming each
conceivable bundle of goods, 𝑈 = 𝑓(𝑥, 𝑦)

Marginal utility
• Addition to total utility attributable to the
addition of one unit of a good to the current
rate of consumption, holding constant the
amounts of all other goods consumed,
𝜕𝑈
• For Good x, 𝑀𝑈𝑥 =
𝜕𝑥
 LAW OF DIMINISHING MARGINAL UTILITY

• The marginal utility declines as we consume more and more of a commodity.

 PREFERENCES: WHAT THE CONSUMER WANTS

Indifference curve: Quantity One of Sachin’s

shows consumption bundles of Clothes indifference curves
that give the consumer the
same level of satisfaction

B
A, B, and all other bundles on U1
make Sachin equally happy: he is A
indifferent between them.
U1

Quantity
of Food
FOUR PROPERTIES OF INDIFFERENCE CURVES

Quantity One of Sachin’s

1. Indifference curves of Clothes indifference curves
are downward-
sloping.

If the quantity of
food is reduced, B

the quantity of
A
clothes must be
U1
increased to keep
Sachin equally
happy. Quantity
of Food
FOUR PROPERTIES OF INDIFFERENCE CURVES

Quantity A few of Sachin’s

2. Higher indifference of Clothes indifference curves
curves are preferred
to lower ones.

Sachin prefers every

bundle on U2 (like C) C
D
to every bundle on U1
A U2
(like A).
U1
He prefers every
bundle on U1 (like A) U0
to every bundle on U0 Quantity
(like D). of Food
FOUR PROPERTIES OF INDIFFERENCE CURVES

Quantity Sachin’s
3. Indifference curves of Clothes indifference curves
cannot cross.
Suppose they did.
Sachin should prefer
B to C, since B has B
more of both goods.
Yet, Sachin is indifferent C A
between B and C: U1 U4
He likes C as much as A
(both are on U4).
He likes A as much as B Quantity
of Food
(both are on U1).
FOUR PROPERTIES OF INDIFFERENCE CURVES

Quantity
4. Indifference curves of Clothes
are bowed inward.

A
Sachin is willing to
give up more clothes 6
for one unit of Food if
1
he has few food (A)
B
than if he has many 2
(B). 1 U1

Quantity
of Food
 THE MARGINAL RATE OF SUBSTITUTION

Marginal rate of
substitution (MRS): Quantity MRS = slope of
Maximum amount of a good that a consumer is of Clothes indifference curve
willing to give up in order to obtain one additional
unit of another good.
A
Sachin’s MRS is the amount of Clothes he would MRS = 6
substitute for another unit of food.
1
MRS falls as you move down along an indifference
B
curve.
MRS = 2
1 U1
Convexity : The decline in the MRS reflects a
diminishing marginal rate of substitution. When the Quantity
MRS diminishes along an indifference curve, the curve of Food
is convex.
SESSION 9: THEORY OF
CONSUMPTION

Chhavi Tiwari
 THE MARGINAL RATE OF SUBSTITUTION

Marginal rate of
substitution (MRS): Quantity MRS = slope of
Maximum amount of a good that a consumer is of Clothes indifference curve
willing to give up in order to obtain one additional
unit of another good.
A
Sachin’s MRS is the amount of Clothes he would MRS = 6
substitute for another unit of food.
1
MRS falls as you move down along an indifference
B
curve.
MRS = 2
1 U1
Convexity : The decline in the MRS reflects a
diminishing marginal rate of substitution. When the Quantity
MRS diminishes along an indifference curve, the curve of Food
is convex.
 UT I L I TY AND UT I L I TY FUNCT I ONS

Utility: Numerical score representing the satisfaction that a consumer gets from a given market
basket.

Utility function: Formula that assigns a level of utility to individual market baskets. 𝑈 = 𝑓(𝑥, 𝑦) ; [x= Food, y=
Clothes]

Marginal Utility : Additional utility from

consuming one extra unit
𝜕𝑈
𝑀𝑈𝑋 = Marginal utility of Food =
𝜕𝑋
Similarly,
𝜕𝑈
𝑀𝑈𝑌 = Marginal utility of Cloth =
𝜕𝑌
 SLOPE OF AN INDIFFERENCE CURVE

• 𝑈 = 𝑓(𝑥, 𝑦)
• Taking total differential,
𝜕𝑈 𝜕𝑈
𝑑𝑈 = 𝑑𝑥 + 𝑑𝑦
𝜕𝑥 𝜕𝑦
• On a given indifference curve, 𝑑𝑈 = 0
Marginal rate of
𝜕𝑈/𝜕𝑋 𝑀𝑈𝑥 substitution (MRS)
𝑑𝑦/𝑑𝑥 = − =−
𝜕𝑈/𝜕𝑌 𝑀𝑈𝑦
 SPECIAL CASES

Perfect Substitutes and Perfect Complements

● perfect substitutes Two goods for which the marginal rate

of substitution of one for the other is a constant.

● perfect complements Two goods for which the MRS is

zero or infinite; the indifference curves are shaped as right
angles.
Bads
● bad Good for which less is preferred rather than more.
 SPECIAL CASES

Perfect Substitutes and Perfect Complements

In (a), Bob views orange juice and In (b), Jane views left shoes and
apple juice as perfect substitutes: right shoes as perfect complements:
He is always indifferent between a An additional left shoe gives her no
glass of one and a glass of the extra satisfaction unless she also
other. obtains the matching right shoe.
 SPECIAL CASES

• Y is bad, X is normal • Y good is normal X is neutral

 CH. 3, REVIEW QUESTION 4

Jon is always willing to trade one can of Coke for one can of Sprite, or one can of Sprite for one
can of Coke.
a. What can you say about Jon’s marginal rate of substitution?
Solution:
Jon’s marginal rate of substitution can be defined as the number of cans of Coke he would be
willing to give up in exchange for a can of Sprite. Since he is always willing to trade one for one, his
MRS is equal to 1.

b. Draw a set of indifference curves for Jon.

Solution : Linear with a slope of -1.
 CH 3. EXERCISE 2

a. Joe has convex preferences and dislikes both hamburgers and soft drinks.
b. Jane loves hamburgers and dislikes soft drinks. If she is served a soft drink, she will pour it
down the drain rather than drink it.
c. Bob loves hamburgers and dislikes soft drinks. If he is served a soft drink, he will drink it to be
polite.
d. Molly loves hamburgers and soft drinks, but insists on consuming exactly one soft drink for
every two hamburgers that she eats.
e. Bill likes hamburgers, but neither likes nor dislikes soft drinks.
f. Mary always gets twice as much satisfaction from an extra hamburger as she does from an
extra soft drink.
SESSION 10: BUDGET CONSTRAINT

Chhavi Tiwari
 THE BUDGET CONSTRAINT:
WHAT THE CONSUMER CAN AFFORD

Sachin divides his income (M) between two goods (X and Y):
food (Good X) and clothes (Good Y).
• A “consumption bundle” is a particular combination of the goods, e.g., 40
food & 300 clothes.
• Budget constraint: the limit on the consumption bundles that a consumer
can afford
• Budget line: All combinations of goods for which the total amount of
money spent is equal to income

𝑃𝑋 𝑋 + 𝑃𝑌 𝑌 = 𝑀
 BUDGET CONSTRAINT

Sachin’s income (M): ₹1200

Prices: PX = ₹ 4 per unit of food, PY = ₹ 1 per unit of cloth
A. If Sachin spends all his income on food,
how much food that he can buy?
B. If Sachin spends all his income on clothes
how many clothes does he buy?
C. If Sachin buys 100 unit of food, how many clothes can he buy?
D. Plot each of the bundles from parts A – C on a graph that measures food on the horizontal
axis and clothes on the vertical, connect the dots.
 BUDGET CONSTRAINT

Quantity D. Sachin’s budget

of clothes constraint shows
M/ 𝑃𝑌 the bundles he can
B
A. ₹1200/ ₹4 afford.
= 300 food
B. ₹1200/ ₹1 C
= 1200 clothes
C. 100 food cost
₹400,
₹ 800 left buys
800 clothes
A
M/ 𝑃𝑋 Quantity
of Food
 THE SLOPE OF THE BUDGET CONSTRAINT

Quantity of
From C to D, Clothes The slope of the
“rise” = M/ 𝑃𝑌 budget constraint
–200 clothes equals the relative
“run” = price of the good
+50 food on the X axis.
Slope = – 4 C
Sachin must
give up D
4 units of cloth
to get one unit of food.
The slope of the budget line:
𝑃𝑋
=−
𝑃𝑌

M/ 𝑃𝑋
Quantity
of Food
 FACTORS THAT CAN IMPACT BUDGET LINES

Show what happens to Sachin’s budget constraint if:

A. His income falls to ₹800.
B. The price of clothes rises to
PY = ₹ 2 per unit of cloth
 A. FALL IN INCOME

Quantity A fall in income

Now, of Clothes shifts the budget
Sachin constraint down.
can buy
₹ 800/ ₹4
= 200 food
or
₹800/ ₹1
= 800 clothes
or any
combination in
between. Quantity
of Food
 B. INCREASE IN THE PRICE OF CLOTH

Sachin Quantity An increase in the

of Clothes price of one good
can still buy
300 food. pivots the budget
constraint inward.
But now he
can only buy
₹1200/ ₹ 2 =
600 clothes.
Notice:
slope is smaller,
relative price of
food is now only
Quantity
2 clothes. of Food
 EXERCISE 10, CH. 3

Antonio buys five new college textbooks during his first year at school at a cost of $80 each. Used books cost
only $50 each. When the bookstore announces that there will be a 10% increase in the price of new books
and a 5% increase in the price of used books, Antonio’s father offers him $40 extra.
a. What happens to Antonio’s budget line? Illustrate the change with new books on the vertical axis.

Solution : Antonio’s Budget = 5*80 = $400

New price of new books = 80*1.10 = 88
New price of old books = 50*1.05= 52.5
Increase in income =40 , total new budget= 440

b. Is Antonio worse or better off after the price change? Explain.

Solution : Not worse off. He will be better off if he switches to some used books.
OPTIMIZATION: CONSUMER’S EQUILIBRIUM

A is the optimum: Quantity

The optimum
the point on the of Clothes
is the bundle
budget constraint
Sachin most
that touches the
1200 prefers out of
highest possible
all the bundles
indifference curve.
he can afford.
Sachin prefers B to A, B
but he cannot afford B. 600
A

Sachin can afford C

C and D, D
but A is on a higher
indifference curve. 150 300 Quantity
of Food
 OPTIMIZATION: CONSUMER’S EQUILIBRIUM
At the optimum, Quantity
Slope of Indifference of Clothes
curve= Slope of Budget
Line
1200

Equilibrium condition

MRS = MUX/MUY = PX/PY A

600

marginal
price of
value of
food (in
food(in
terms of
terms of 150 300 Quantity
clothes)
clothes) of Food
 CH 3. EXERCISE 12

Ben allocates his lunch budget between two goods, pizza and burritos.
a. Illustrate Ben’s optimal bundle on a graph with pizza on the horizontal axis.
b. Suppose now that pizza is taxed, causing the price to increase by 20%. Illustrate Ben’s new
optimal bundle.
c. Suppose instead that pizza is rationed at a quantity less than Ben’s desired quantity. Illustrate
Ben’s new optimal bundle.
 CH 3. EXERCISE 16

Julio receives utility from consuming food (F) and clothing (C) as given by the utility function U(F, C) =
FC. In addition, the price of food is $2 per unit, the price of clothing is $10 per unit, and Julio’s weekly
income is $50.
a. What is Julio’s marginal rate of substitution of food for clothing when utility is maximized? Explain.
Find the optimal bundle.
Solution:
Julio’s utility is maximized when his MRS (of food for clothing) equals PF/PC, the price ratio. The price
ratio is 2/10 = 0.2, so Julio’s MRS will equal 0.2 when his utility is maximized.

b. Suppose instead that Julio is consuming a bundle with more food and less clothing than his utility-
maximizing bundle. Would his marginal rate of substitution of food for clothing be greater than or less
than your answer in part a? Explain.
In absolute value terms, the slope of his indifference curve at this non-optimal bundle is less than the
slope of his budget line, because the indifference curve is flatter than the budget line. Therefore, his MRS
is less than the answer in part a.
 CH 3. EXERCISE 16

Find the optimal bundle.

Solution:
Max U(F,C) = FC
Budget Constraint = 2F+10C= 50
𝑀𝑈𝐹 𝑃𝐹
Julio will be at eqm where =
𝑀𝑈𝐶 𝑃𝐶
𝜕𝑈
𝑀𝑈𝐹 = =𝐶
𝜕𝐹
𝜕𝑈
𝑀𝑈𝐶 = =𝐹
𝜕𝐶
𝐶 2 2𝐹
At eqm, = ,𝐶 = = 0.2𝐹,
𝐹 10 10
Putting the value of C into budget equation,
2𝐹 + 10 0.2𝐹 = 50
4𝐹 = 50, 𝐹 = 12.5
And C = 0.2(12.5) = 2.5
Julio will buy 12.5 units of food and 2.5 units of cloth at his utility maximization level.
SESSION 11: CONSUMER’S
EQUILIBRIUM

Chhavi Tiwari
 CH 3. EXERCISE 16

Julio receives utility from consuming food (F) and clothing (C) as given by the utility function U(F, C) =
FC. In addition, the price of food is $2 per unit, the price of clothing is $10 per unit, and Julio’s weekly
income is $50.
a. What is Julio’s marginal rate of substitution of food for clothing when utility is maximized? Explain.
Find the optimal bundle.
Solution:
Julio’s utility is maximized when his MRS (of food for clothing) equals PF/PC, the price ratio. The price
ratio is 2/10 = 0.2, so Julio’s MRS will equal 0.2 when his utility is maximized.

b. Suppose instead that Julio is consuming a bundle with more food and less clothing than his utility-
maximizing bundle. Would his marginal rate of substitution of food for clothing be greater than or less
than your answer in part a? Explain.
In absolute value terms, the slope of his indifference curve at this non-optimal bundle is less than the
slope of his budget line, because the indifference curve is flatter than the budget line. Therefore, his MRS
is less than the answer in part a.
 CH 3. EXERCISE 16

Find the optimal bundle.

Solution:
Max U(F,C) = FC
Budget Constraint = 2F+10C= 50
𝑀𝑈𝐹 𝑃𝐹
Julio will be at eqm where =
𝑀𝑈𝐶 𝑃𝐶
𝜕𝑈
𝑀𝑈𝐹 = =𝐶
𝜕𝐹
𝜕𝑈
𝑀𝑈𝐶 = =𝐹
𝜕𝐶
𝐶 2 2𝐹
At eqm, = ,𝐶 = = 0.2𝐹,
𝐹 10 10
Putting the value of C into budget equation,
2𝐹 + 10 0.2𝐹 = 50
4𝐹 = 50, 𝐹 = 12.5
And C = 0.2(12.5) = 2.5
Julio will buy 12.5 units of food and 2.5 units of cloth at his utility maximization level.
 OPTIMIZATION: CONSUMER’S EQUILIBRIUM

Corner solution: Situation in which the marginal rate of substitution of one good for another in a chosen market
basket is not equal to the slope of the budget line.

When the consumer’s marginal rate of substitution is

not equal to the price ratio for all levels of
consumption, a corner solution arises. The
consumer maximizes satisfaction by consuming only
one of the two goods.
Given budget line AB, the highest level of satisfaction
is achieved at B on indifference curve U1, where the
MRS (of ice cream for frozen yogurt) is greater than
the ratio of the price of ice cream to the price of
frozen yogurt.
 PROBLEM: CH. 3 PROB. 14

Connie has a monthly income of $200 that she allocates among two goods: meat and potatoes.
a. Suppose meat costs $4 per pound and potatoes $2 per pound. Draw her budget constraint.
Solution:
Let M = meat and P = potatoes. Connie’s budget constraint is 4M + 2P = 200, or M = 50 − 0.5P.
Slope of the budget line : if meat is plotted on the x axis; 𝑃𝑀 Τ𝑃𝑃 = 4/2 = 2

b. Suppose also that her utility function is given by the equation U(M, P) = 2M + P. What combination of meat and potatoes
should she buy to maximize her utility?
Solution:
𝑴𝑼𝑴 = 𝟐, 𝑴𝑼𝑷 = 𝟏
Slope of the indifference curve= 2
Slope of the IC= Slope of the Budget line
The indifference curve coincides with her budget constraint. Any combination of meat and potatoes along this line will
provide her with maximum utility.
 PROBLEM: CH. 3 PROB. 14

c. Connie’s supermarket has a special promotion. If she buys 20 pounds of potatoes (at $2 per pound), she gets the
next 10 pounds for free. This offer applies only to the first 20 pounds she buys. All potatoes in excess of the first 20
pounds (excluding bonus potatoes) are still $2 per pound. Draw her budget constraint.
Solution: Connie’s budget constraint has a slope of -1/2 until Connie has purchased 20 pounds of potatoes. Then her
budget line is flat from 20 to 30 pounds of potatoes, because the next 10 pounds of potatoes are free, and she does
not have to give up any meat to get these extra potatoes. After 30 pounds of potatoes, the slope of her budget line
becomes -1/2 again until it intercepts the potato axis at 110.
 PROBLEM: CH. 3 PROB. 14

d. An outbreak of potato rot raises the price of potatoes to $4 per pound. The supermarket ends its promotion.
What does her budget constraint look like now? What combination of meat and potatoes maximizes her utility?
Solution: New Budget Constraint
4M + 4P = 200
𝑃𝑀 Τ𝑃𝑃 = 1
Connie may buy either 50 pounds of meat or 50 pounds of potatoes, or any combination in between.
Slope of the indifference curve= 2
Slope of the Budget Line = 1
Corner solution at 50 pounds of meat.
Session 12: Production
Chhavi Tiwari
 Production Theory

• Production: Art of converting inputs to outputs

• Production theory is much simpler than consumption theory because the

outputs of the production process is generally observable whereas the
outputs of the consumption (utility) is not directly observable.

Inputs and Outputs

• Inputs to production are called factors of production.
• Factors of production are; land, labour, capital, raw materials
Basic concepts of Production Theory
• Production function
• It expresses a quantitative relationship between inputs
and outputs given technology or method of production.
• Production function is defined for a given technology:

𝑄 = 𝑓(𝐿, 𝐾)

Where 𝑄 = 𝑂𝑢𝑡𝑝𝑢𝑡, 𝐿 = 𝐿𝑎𝑏𝑜𝑢𝑟 𝑎𝑛𝑑 𝐾 = 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

 Basic concepts of Production Theory

• Inputs are considered variable or fixed depending on how readily

their usage can be changed

• Variable input
• An input for which the level of usage may be changed quite readily

• Fixed input
• An input for which the level of usage cannot readily be changed,
and which must be paid even if no output is produced
 Basic concepts of Production Theory

• Short run
• At least one input is fixed
• All changes in output achieved by changing usage of variable
inputs

• Long run
• All inputs are variable
• Output changed by varying usage of all inputs
Short Run Production with one variable input

• In the short run, Capital (K) is fixed

• Only changes in the variable labor input can change the level of
output

• Short run production function;

Q = f ( L, K ) = f ( L )

• Total Product of Labour (𝑇𝑃𝐿 ) = 𝑓 𝐿, 𝐾 , 𝐾 = 𝐶𝑜𝑛𝑠𝑡𝑎𝑛𝑡

𝑄 𝑓(𝐿,𝐾)
• Average Product of Labour (𝐴𝑃𝐿 ) = =
𝐿 𝐿
𝜕𝑄
• Marginal Product of Labour (𝑀𝑃𝐿 ) =
𝜕𝐿
 Total, Average, & Marginal Products of Labour, K = 2
A company is deciding how many interns to hire for the summer of
2021:
Number of Total product (Q) Average product Marginal product
workers (L) (AP=Q/L) (MP=Q/L)
0 0 -- --
1 52 52 52
2 112 56 60
3 170 56.7 58
4 220 55 50
5 258 51.6 38
6 286 47.7 28
7 304 43.4 18
8 314 39.3 10
9 318 35.3 4
10 314 31.4 -4
Total, Average, & Marginal Products of Labour, K = 2
 Average & Marginal Products
• Average product of labor
• AP = Q/L
• Marginal product of labor
• MP = Q/L
• When AP is rising, MP is greater than AP
• When AP is falling, MP is less than AP
• When AP reaches it maximum, AP = MP
• Law of diminishing marginal product
• As usage of a variable input increases, a point is reached beyond which
its marginal product decreases
 Why 𝑀𝑃𝐿 is Important?
• When the Company hires an extra intern,
• the costs rise by the wage it pays to the intern
• the output rises by 𝑀𝑃𝐿

• Comparing them helps the Company to decide whether it should hire

the intern or not.
 Why 𝑀𝑃𝐿 diminishes?

• Company’s output rises by a smaller and smaller amount for each

additional intern. Why?

• As the company adds workers, the average worker has less capital to
work with and will be less productive.

• In general, 𝑀𝑃𝐿 diminishes as L rises whether the fixed input is land or

capital (equipment, machines, etc.).

• Diminishing marginal product:

The marginal product of an input declines as the quantity of the input
increases (other things equal).
 Stages of Production
Panel A

Stage I (𝑶𝑳𝟏 ): Abundance of Q2

fixed factor. Stage of Increasing
returns. Q1 Total
product

Stage I Stage II Stage III

Stage II(𝑳𝟏 𝑳𝟐 ): Stage of
decreasing returns. Beyond 𝑳𝟐 ,
the fixed factors become L1 L2

limiting. Panel B

A rational firm will

Stage II𝐈(𝑳𝟐 𝒐𝒏𝒘𝒂𝒓𝒅𝒔): Stage of
operate in stage two.
negative returns. Abundance of
variable factors Average
product

L1 L2
Marginal
product
 Exercise 1, Chapter 6
The menu at Joe’s coffee shop consists of a variety of coffee drinks,
pastries, and sandwiches. The marginal product of an additional worker
can be defined as the number of customers who can be served by that
worker in a given time period. Joe has been employing one worker, but
is considering hiring a second and a third. Explain why the marginal
product of the second and third workers might be higher than the first.
Why might you expect the marginal product of additional workers to
diminish eventually?
Session 13: Long run
Production
Chhavi Tiwari
 Long run Production Function
• In the long run, all inputs are variable & isoquants are used to
study production decisions

• An isoquant is a curve showing all possible input combinations

capable of producing a given level of output

• Isoquants are downward sloping; if greater amounts of labor are

used, less capital is required to produce a given output
Typical Isoquants
TABLE 6.4 Production with Two Variable Inputs
LABOR INPUT
Capital Input 1 2 3 4 5
1 20 40 55 65 75
2 40 60 75 85 90
3 55 75 90 100 105
4 65 85 100 110 115
5 75 90 105 115 120

● isoquant Curve showing

all possible combinations
of inputs that yield the
same output.
 Marginal Rate of Technical Substitution
Marginal rate of technical substitution (MRTS) Amount by which the quantity of one input can be reduced when
one extra unit of another input is used, so that output remains constant.

MRTS = − Change in capital input/change in labor input

Like indifference curves, isoquants are downward = − ΔK/ΔL (for a fixed level of q)
sloping and convex. The slope of the isoquant at any
point measures the marginal rate of technical
substitution—the ability of the firm to replace capital
with labor while maintaining the same level of output.
On isoquant q2, the MRTS falls from 2 to 1 to 2/3 to
1/3.

(MP ) / (MP ) = −(K / L) = MRTS

L K
 Marginal Rate of Technical Substitution

• The MRTS is the slope of an isoquant & measures the rate at which the
two inputs can be substituted for one another while maintaining a
constant level of output

K
MRTS = −
L
• The MRTS can also be expressed as the ratio of two marginal products:

MPL
MRTS =
MPK
 Slope of the Isoquant

𝑄 = 𝑓(𝐿, 𝐾)
Taking total differential,
𝜕𝑄 𝜕𝑄
𝑑𝑄 = . 𝑑𝐿 + . 𝑑𝐾
𝜕𝐿 𝜕𝐾

On a given isoquant, 𝑑𝑄 = 0,
𝜕𝑄ൗ
𝑑𝐾 𝜕𝐿 = − 𝑀𝑃𝐿
=−
𝑑𝐿 𝜕𝑄ൗ 𝑀𝑃𝐾
𝜕𝐾

𝑀𝑃𝐿
𝑀𝑅𝑇𝑆𝐿𝐾 =−
𝑀𝑃𝐾
 Two special cases of Isoquants
Perfect complements or fixed proportion Inputs are perfect substitute. 𝑄 = 𝑎𝐿 + 𝑏𝐾, 𝑎 >
𝐿 𝐾
production function. 𝑄 = min ,
𝑎 𝑏
, 𝑎 > 0, 𝑏 > 0, 𝑏 > 0.
0
 Problem: Chapter 6, Exercise 7

The marginal product of labor in the production of computer chips is 50 chips

per hour. The marginal rate of technical substitution of hours of labor for
hours of machine capital is 1/4. What is the marginal product of capital?
Solution:
𝑀𝑃𝐿
= 𝑀𝑅𝑇𝑆𝐿𝐾
𝑀𝑃𝐾

50 1
=
𝑀𝑃𝐾 4

Therefore, 𝑀𝑃𝐾 = 200 computer chips per hour.

 Isocost Line
• Show various combinations of inputs that may be purchased for given level of expenditure (C) at
given input prices 𝑤, 𝑟 , w = price of labour, r = price of capital
𝐶 = 𝑤𝐿 + 𝑟𝐾

We can rewrite it as in a straight-line equation form as;

𝐶 𝑤
𝐾= − 𝐿
𝑟 𝑟

𝐶
• Intercept represents amount of capital that may be purchased if zero labor is purchased.
𝑟

𝑤
• Slope of an Isocost curve is the negative of the input price −( 𝑟 ), which is the ratio of the wage

rate to the rental cost of capital.

Isocost Curves
 Equilibrium
• Objective: Minimize total cost of producing a given level of output Q,
choosing the input combination

• Equilibrium condition
• Two slopes are equal in equilibrium
• Implies marginal product per rupee spent on last unit of each input is
the same.

𝑀𝑃𝐿 𝑤 𝑀𝑃𝐿 𝑀𝑃𝐾

= 𝑜𝑟 =
𝑀𝑃𝐾 𝑟 𝑤 𝑟
𝑤
𝑀𝑅𝑇𝑆𝐿𝐾 =
𝑟
Optimal input combination to minimize cost for given output
 Expansion path
• Expansion path gives the efficient (least-cost) input combinations for
every level of output

• Derived for a specific set of input prices

• Along expansion path, input-price ratio is constant & equal to the

marginal rate of technical substitution
Expansion path
Derivation of long-run cost curve from the expansion path
 The Inflexibility of Short-Run Production

• In short-run, cost of
production may not
be minimized.
 Problem 16. Ch.7
Suppose that a paving company produces paved parking spaces (q) using a fixed quantity of land (T) and
variable quantities of cement C and labor (L). The firm is currently paving 1000 parking spaces. The
firm’s cost of cement is $4,000 per acre covered and its cost of labor is $12/hour. For the quantities of C
and L that the firm has chosen MPC = 50 and MPL = 4.
a. Is this firm minimizing its cost of producing parking spaces? How do you know?

Solution: To minimize its cost of production, the firm should produce where 𝑀𝑃𝐶 /𝑃𝐶 = 𝑀𝑃𝐿 /𝑃𝐿 . For this
firm, 𝑀𝑃𝐶 /𝑃𝐶 = 50/4000 = 0.0125 and 𝑀𝑃𝐿 /𝑃𝐿 = 4/12 = 0.333. Since 𝑀𝑃𝐶 /𝑃𝐶 is not equal to 𝑀𝑃𝐿 /𝑃𝐿 , the
firm is not minimizing its cost of producing parking spaces.

b. If the firm is not cost-minimizing, how must it alter its choices of C and L in order to decrease cost?

Solution: Since 𝑀𝑃𝐿 /𝑃𝐿 is much greater than 𝑀𝑃𝐶 /𝑃𝐶 , the additional output per dollar is much greater for
labor than for cement, so the firm should use relatively more L and less C in its production process.
Session 14: Theory of
costs
Chhavi Tiwari
A recap of theory of production
 Costs: Explicit vs. Implicit
• Explicit costs require an outlay of money,
e.g., paying wages to workers.
• Implicit costs do not require a cash outlay,
e.g., the opportunity cost of the owner’s time.
• This is true whether the costs are implicit or explicit. Both matter for
firms’ decisions.
Opportunity Cost
Cost of best alternative. Whatever
must be given to obtain something
Examples:
The opportunity cost of…
…going to college for a year is
not just the tuition, books,
and fees, but also the
foregone wages.
…seeing a movie is not just the
price of the ticket,
but the value of the time you
spend in the theater.
 Economic cost vs. Accounting cost

• Accounting costs ignores

implicit costs, so it’s lower
than economic costs.
 Problem

Consider Farhan decision to go to college. If he goes to

college, he will spend ₹ 21,000 on tuition, ₹ 11,000 on room
and board, and ₹ 1,800 on books. If he does not go to
college, he will earn ₹ 16,000 working in a store and spend ₹
7,200 on room and board. Farhan’s cost of going to college
is:
Answer :
21000+11000+1800 +16000 –7200
= ₹ 42,600
 Exercise 1, Ch. 7
Joe quits his computer programming job, where he was earning a salary of $50,000
per year, to start his own computer software business in a building that he owns and
was previously renting out for $24,000 per year. In his first year of business he has
the following expenses: salary paid to himself, $40,000; rent, $0; other expenses,
$25,000. Find the accounting cost and the economic cost associated with Joe’s
computer software business.
Solution:
Accounting cost : $40,000+25,000= $65,000
Economic cost: $40,000+25,000+24,000+10,000= $99,000.
Short run Production costs : Fixed and Variable
Costs

• Fixed costs (FC) do not vary with the quantity of output produced.
• For our example, FC = 1000 for renting plants
• Other examples:
cost of equipment, loan payments, rent
• Fixed cost versus Sunk Cost?
• Sunk cost: Expenditure that has been made and cannot be recovered.
• Variable costs (VC) vary with the quantity produced.
• For our example, VC = cost of material
• Short run total cost = Total fixed cost +Total variable cost

𝑆𝑇𝐶(𝑄) = 𝑇𝐹𝐶 + 𝑇𝑉𝐶(𝑄)

EXAMPLE : Costs
$ 800 FC
Q FC VC TC $ 700 VC
TC
0 $100 $ 0 $100 $ 600
1 100 70 170 $ 500

Costs
2 100 120 220
$ 400
3 100 160 260
$ 300
4 100 210 310
$ 200
5 100 280 380
$ 100
6 100 380 480
$0
7 100 520 620 0 1 2 3 4 5 6 7
Q
 Average Costs

• Average fixed cost (AFC)

𝑇𝐹𝐶 AFC will be a rectangular
𝐴𝐹𝐶 =
𝑄 hyperbola

• Average variable cost (AVC)

𝑇𝑉𝐶
𝐴𝑉𝐶 =
𝑄

• Average total cost (ATC)

𝑇𝐶
𝐴𝑇𝐶 = = 𝐴𝑉𝐶 + 𝐴𝐹𝐶
𝑄
EXAMPLE : Average Costs
Q TC ATC AFC AVC Average total cost
(ATC) equals total
0 $100 n/a n/a n/a
cost divided by the
1 170 170 100 70 quantity of output:
2 220 110 50 60 ATC = TC/Q
3 260 86.67 33.33 53.33
Also,
4 310 77.50 25 52.50
ATC = AFC + AVC
5 380 76 20 56.00
6 480 80 16.67 63.33
7 620 88.57 14.29 74.29
Marginal Cost

• Marginal Cost (MC) is the increase in Total Cost from producing one more unit:

Δ𝑇𝐶
𝑀𝐶 =
Δ𝑄
EXAMPLE : Marginal Cost

Q TC MC Recall,
$200 Marginal Cost (MC)
is the
$175change in total cost from
0 $100
$70 producing one more unit:
$150
1 170
50 $125
∆TC
MC =

Costs
2 220 ∆Q
40 $100
3 260 Usually, MC rises as Q rises, due
50 $75
to diminishing marginal product.
4 310 $50
70 Sometimes (as here), MC falls
5 380 $25
100 before rising.
6 480 $0
140 (In other0examples,
1 2 3 MC 4 may
5 be
6 7
7 620 constant.) Q
Why MC is important?

• Producers are rational and wants to maximize their profit.

• If the cost of additional output (MC) is less than the revenue the firm would get from
selling it, then the profits rise if you produce more.
Average and Marginal cost curves together
$200
$175
$150
ATC
$125

Costs
AVC
$100
AFC
MC $75
$50
$25
$0
0 1 2 3 4 5 6 7
Q
Why ATC Is Usually U-Shaped
As Q rises: $200

Initially, $175
falling AFC $150
pulls ATC down. $125

Costs
Eventually, $100
rising AVC $75
pulls ATC up.
$50
Efficient scale: $25
The quantity that
$0
minimizes ATC. 0 1 2 3 4 5 6 7
Q
ATC and MC
When MC < ATC, $200 ATC
ATC is falling. MC
$175
When MC > ATC, $150
ATC is rising. $125

Costs
The MC curve $100
crosses the $75
ATC curve at $50
the ATC curve’s
$25
minimum.
$0
0 1 2 3 4 5 6 7
Q
Session 15: Long run
costs
Chhavi Tiwari
 True or False
• If the owner of a business pays himself no salary, then the accounting
cost is zero, but the economic cost is positive.
• A firm that has positive accounting profit does not necessarily have
positive economic profit.
• If a firm hires a currently unemployed worker, the opportunity cost of
utilizing the worker’s services is zero.
Short Run Average & Marginal Cost Curves

Lowest point of ATC is

always to the right of
the lowest point of AVC
(By vertical summation
of AFC and AVC, we get
ATC).
 Exercise 4, Ch.7
Suppose a firm must pay an annual tax, which is a fixed sum, independent of whether it
produces any output.
a. How does this tax affect the firm’s fixed, marginal, and average costs?
Solution: The tax does not affect marginal or variable cost because it does not vary with output. The tax increases
both average fixed cost and average total cost by T/q.
b. Now suppose the firm is charged a tax that is proportional to the number of items it
produces. Again, how does this tax affect the firm’s fixed, marginal, and average cost
Solution:When a tax is imposed on each unit produced, total variable cost
increases by tq and fixed cost does not change.
 Exercise 9, Ch.7
The short-run cost function of a company is given by the equation TC = 200 + 55q, where TC is the total cost
and q is the total quantity of output, both measured in thousands.
a. What is the company’s fixed cost?
Solution: When q = 0, TC = 200, so fixed cost is equal to 200 (or $200,000).
b. If the company produced 100,000 units of goods, what would be its average variable cost?
Solution: Variable cost is 55q (55*100). Average variable cost (AVC) = VC/q = 5500/100 = 55(or $55,000)
c. What would be its marginal cost of production?
Solution: With constant average variable cost, marginal cost is equal to AVC, 55.
d. What would be its average fixed cost?
Solution: AFC = FC/q = 200/100 = 2.
e. Suppose the company borrows money and expands its factory. Its fixed cost rises by $50,000, but its
variable cost falls to $45,000 per 1000 units. The cost of interest (i) also enters into the equation. Each 1-point
increase in the interest rate raises costs by $3000. Write the new cost equation.
Solution: Fixed cost changes from 200 to 250, measured in thousands. Variable cost decreases from 55
to 45, also measured in thousands. Fixed cost also includes interest charges of 3i. The cost equation is TC
= 250 + 45q + 3i
 Costs in the long run

Because many decisions are fixed in the short run but variable in the long run, a firm’s long-run cost
curves differ from its short-run cost curves.
 Costs in the long run
• Long-run total cost (LTC) for a given level of output is given by:
• 𝑳𝑻𝑪 = 𝒘𝑳 + 𝒓𝑲

• Where w & r are prices of labor & capital, respectively, & (L*, K*) is the input combination on the
expansion path that minimizes the total cost of producing that output

• Long-run average cost (LAC) measures the cost per unit of output when production can be adjusted so that
the optimal amount of each input is employed
• LAC is U-shaped
• Falling LAC indicates economies of scale
• Rising LAC indicates diseconomies of scale

𝐿𝑇𝐶
𝐿𝐴𝐶 =
𝑄
 Long-Run Marginal Cost
• Long-run marginal cost (LMC) measures the rate of change in long-run total cost
as output changes along expansion path
• LMC is U-shaped
• LMC lies below LAC when LAC is falling
• LMC lies above LAC when LAC is rising
• LMC = LAC at the minimum value of LAC

∆𝐿𝑇𝐶
𝐿𝑀𝐶 =
∆𝑄
Derivation of a Long-Run Cost Schedule

Least-cost
combination of

Output Labor Capital Total cost LAC LMC

LMC
(units) (units) (w = $5, r = $10)

100 10 7 $120 $1.20 $1.20

200 12 8 140 0.70 0.20
300 20 10 200 0.67 0.60
400 30 15 300 0.75 1.00
500 40 22 420 0.84 1.20
600 52 30 560 0.93 1.40
700 60 42 720 1.03 1.60
Long-Run Average & Marginal Cost Curves
 Demand Market Supply

Perfect Competition (No

Firms with Market Power
Market Power)

Short-run
Long-run
Shut-down (if not covering Oligopoly Monopoly
VC) Entry (Profit) versus Exit
(Losses)
versus continue

Pricing Decisions

Uniform Pricing (MC=MR) Price Discrimination

First Degree Second Degree Third Degree

Session 16 :Theory of
Firm

Chhavi Tiwari
Scenario
• Three years after graduating, you run your own business.
• You have forecasted your costs. Fixed and variable costs for the
next five years.
• Now you are wondering how much output you should produce in
the first year. How much price to charge?
• What factors should affect these decisions?

 Your costs?
 How much competition you face?
Type of Competition
Perfectly competitive markets
1. Many buyers and many sellers.

2. The goods offered for sale are largely the same. (Homogeneous products)

3. Firms can freely enter or exit the market.

▪ Because of 1 & 2, each buyer and seller is a

“price taker” – takes the price as given.
The revenue of a competitive firm
• Total revenue (TR) TR = P x Q

TR
• Average revenue (AR) AR = =P
Q

• Marginal revenue (MR): ∆TR

The change in TR from MR =
selling one more unit. ∆Q
 Fill in the empty spaces of the table.
TR ∆TR
Q P TR = P x Q AR = MR =
Q ∆Q
0 $10 $0 n/a
$10
1 $10 $10 $10
Notice that $10
2 $10 $20 $10
MR = P $10
3 $10 $30 $10
$10
4 $10 $40 $10
$10
5 $10 $50 $10
MR = P for a Competitive Firm
• A competitive firm can keep increasing its output without affecting the
market price.

• So, each one-unit increase in Q causes revenue to rise by P, i.e., MR = P.

MR = P is only true for

firms in competitive markets.
 Demand for a competitive firm
Demand curve is horizontal at price determined by intersection of market demand & supply
Perfectly elastic
Marginal revenue equals price
Demand curve is also marginal revenue curve (D = MR)

Price (Rupees)
Price (Rupees)

P0 P0
D = MR

0 Q0 0

Quantity Quantity

Panel A – Market Panel B – Demand curve facing

a price-taker
 Profit Maximization
• What Q maximizes the firm’s
profit?
• To find the answer, “Marginal
analysis.”
If Q increases by one unit,
revenue rises by MR,
cost rises by MC.
• If MR > MC, then increase Q to
raise profit.
• If MR < MC, then reduce Q to raise
profit.
Derivation of Profit maximizing conditions
Objective of a firm: Maximum profit

𝑃𝑟𝑜𝑓𝑖𝑡 π = 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑇𝑅 − 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡𝑠 𝑇𝐶

𝜋=𝑅 𝑄 −𝐶 𝑄
At profit maximization
For maximum, first order necessary condition, output, MR should be
𝜕𝜋 𝜕(𝑇𝑅) 𝜕 𝑇𝐶 equal to MC
= − = 𝑅′ 𝑄 − 𝐶 ′ 𝑄 = 0
𝜕𝑄 𝜕𝑄 𝜕𝑄
Which is, 𝑀𝑅 − 𝑀𝐶 = 0
𝑀𝑅 = 𝑀𝐶

• Second order sufficient condition,

𝜕2𝜋
2 = 𝑅 ′′ 𝑄
− 𝐶 ′′ 𝑄 < 0
𝜕𝑄 MC curve should cut
MR curve from below
Change in MR < Change in MC
Profit maximization in the short-run
In the short run, managers must make two decisions:
1. Produce or shut down?
 If shut down, produce no output and hires no variable inputs
 If shut down, firm loses amount equal to TFC
2. If produce, what is the optimal output level?
 If firm does produce, then how much?
 Produce amount that maximizes economic profit
Firm’s output decision in short-run
Case I: Profits
Profit
Maximizing
output = 600

TotalProfit
revenue =$36 -x $11,400
= $21,600 600
==$21,600
$10,200

Total cost = $19 x 600

= $11,400
Firm’s output decision in short-run
Case II: Losses

Profit cost
Total = $.3,150
= $17-x$5,100
300
= -1,950
= $5,100

Total revenue = $10.50 x 300

= $3,150
Session 17
Chhavi Tiwari
Firm’s output decision in short-run
Case I: Profits
Profit
Maximizing
output = 600

TotalProfit
revenue =$36 -x $11,400
= $21,600 600
==$21,600
$10,200

Total cost = $19 x 600

= $11,400
Firm’s output decision in short-run
Case II: Losses

Profit cost
Total = $.3,150
= $17-x$5,100
300
= -1,950
= $5,100

Total revenue = $10.50 x 300

= $3,150
A Firm’s Short-run Decision to Shut Down

• Shut-Down Rule: The firm should shut down if the price of the product is
less than the average variable cost of production at the profit-maximizing
output.
• Cost of shutting down: revenue loss = TR
• Benefit of shutting down: cost savings = VC
(firm must still pay FC, FC becomes sunk cost in short-run)
• So, shut down if TR < VC
• Divide both sides by Q: TR/Q < VC/Q
• So, firm’s decision rule is:

Shut down if P < AVC

 Summary of short-run decisions

• AVC tells whether to produce

 Shut down if price falls below minimum AVC

• SMC tells how much to produce

 If P  minimum AVC, produce output at which P = SMC

• ATC tells how much profit/loss if produce

•  = ( P − ATC )Q
 A Competitive Firm’s Short-run Supply Curve

The firm’s supply curve is the portion of the marginal cost curve for which marginal cost
is greater than average variable cost.

If P > AVC, then firm

produces Q where P
= MC.
If P < AVC, then firm
shuts down
(produces Q = 0).
 The short-run market supply curve
The short-run industry supply curve is the
summation of the supply curves of the
individual firms.
Because the third firm has a lower
average variable cost curve than the first
two firms, the market supply curve S
begins at price P1 and follows the
marginal cost curve of the third firm MC3
until price equals P2, when there is a kink.
For P2 and all prices above it, the industry
quantity supplied is the sum of the
quantities supplied by each of the three
firms.
Exercise 4, Ch. 8
Suppose you are the manager of a watchmaking firm operating in a competitive
market. Your cost of production is given by C = 200 + 2q2, where q is the level of
output and C is total cost. (The marginal cost of production is 4q; the fixed cost is
$200.)
a. If the price of watches is $100, how many watches should you produce to maximize
profit?
Solution : Profits are maximized where price equals marginal cost. Therefore,
100 = 4q, or q = 25
b. What will the profit level be?
Solution: Profit is equal to total revenue minus total cost:  = Pq - (200 + 2q2). Thus,
 = (100)(25) - (200 + 2(25)2) = $1050.
c. At what minimum price will the firm produce a positive output?
Solution: The firm’s short run supply curve is its MC above AVC. AVC= 2q2/q= 2q. Also, MC=
4q. So, MC is greater than AVC for any quantity greater than 0. This means that the firm
produces in the short run as long as price is positive.
Session 18: Long run in perfectly
competitive markets
 Entry & Exit in the Long Run
• In the LR, the number of firms can change due to entry & exit.
• If existing firms earn positive economic profit,
 New firms enter, SR market supply shifts right.
 P falls, reducing profits and slowing entry.
• If existing firms incur losses,
 some firms exit, SR market supply shifts left.
 P rises, reducing remaining firms’ losses.
 Long run Equilibrium: Normal or zero profit
A firm begins in …but then an increase …leading to SR profits
long-run eq’m… in demand raises P,… for the firm.

P One firm P Market

MC S1

S2
Profit ATC B
P2 P2
A C
P1 P1

D2
D1
Q Q
Over time, profits induce entry, (firm) Q1 Q2 Q3 (market)
shifting S to the right, reducing P… …driving profits to zero
and restoring long-run eq’m.
The Zero-Profit Condition
• Long-run equilibrium:
The process of entry or exit is complete—
remaining firms earn zero economic profit.
• Zero economic profit occurs when P = ATC.
• Since firms produce where P = MR = MC,
the zero-profit condition is P = MC = ATC.
• Recall that MC intersects ATC at minimum ATC.
• Hence, in the long run, P = minimum ATC.
 Why Do Firms Stay in Business
if Profit = 0?
• Recall, economic profit is revenue minus all costs, including implicit costs like
the opportunity cost of the owner’s time and money.

• In the zero-profit equilibrium,

 firms earn enough revenue to cover these costs
 accounting profit is positive
Exercise 10, Ch.8
Suppose you are given the following information about a particular industry:
Q D = 6500 − 100 P Market demand
Q = 1200 P
S
Market supply
q
2
C (q) = 722 + Firm total cost function
200
2q
MC (q ) = Firm marginal cost function.
200

Assume that all firms are identical, and that the market is characterized by perfect
competition.
a. Find the equilibrium price, the equilibrium quantity, the output supplied by the
firm, and the profit of each firm.
Solution: Solve for equilibrium Price and quantity, P = $5, Q= 6000.
Individual firm output, P=MC, 5= 2q/200 so q= 500.
 q2   5002 
Profit is Total Revenue- Total Cost =  = Pq −  722 + = 5(500) −  722 +  = $528
 200   200 

since the total output in the market is 6000, and each firm’s output is 500, there must
be 6000/500 = 12 firms in the industry.
Exercise 10, Ch.8
b. Would you expect to see entry into or exit from the industry in the long run? Explain. What
effect will entry or exit have on market equilibrium?
c. What is the lowest price at which each firm would sell its output in the long run? Is profit
positive, negative, or zero at this price? Explain.
Solution: In the long run profit falls to zero, which means price falls to the minimum value of AC.
To find the minimum average cost, set marginal cost equal to average cost and solve for q:

2q 722 q
= +
200 q 200
q 722
=
200 q
q 2 = 722(200)
q = 380
AC (q = 380) = 3.8.
Therefore, the firm will not sell for any price less than $3.80 in the long run. The long-run
equilibrium price is therefore $3.80, and at a price of $3.80, each firm sells 380 units and earns
an economic profit of zero because P = AC.
Exercise 10, Ch.8
d. What is the lowest price at which each firm would sell its output in the
short run? Is profit positive, negative, or zero at this price? Explain.

• The firm will sell its output at any price above zero in the short run, because
marginal cost is above average variable cost (MC = q/100 > AVC = q/200) for all
positive prices. Profit is negative if price is just above zero.