Handout, micro economics , Econ By Fetiya N.

Chapter one.

Theory of Consumer Behavior and Demand

Introduction: - As a consumer, we take numerous decisions in our daily life: should we take tea or
coffee in the morning? Should we carry lunch packet or take lunch in the cafeteria?

The way consumers take decisions on such problem is called consumer’s decision - making behavior. By
consumer behavior is meant how consumers decide on the basket of goods and services they consume.
People demand goods and services because they satisfy the wants of the people and the economists
assume that consumer is a utility maximizing entity.

Utility means a want satisfying power of a commodity. It is also defined as property of the commodity,
which satisfies the wants of the consumers. Utility is a subjective entity and resides in the minds of
people. Being subjective it varies with different persons, that is different persons derive different amounts
of utility from a given good. The desire for a commodity by a person depends on the utility he expects to
obtain from it. The greater the utility he expect from a commodity, the greater his desire for that
commodity. In studying the behavior of consumers, economists assume the following about consumers of
economic goods and services:

a. Objective of the consumer is maximization of utility- its assumed that consumers are utility
maximizes. As an economic agent consumer is assumed to have only the objective of optimizing
utility that can be derived from the consumption of goods and services.
b. Consumers are subject to constraint – as an economic agents and optimizer of utility
consumers constrained by the size of their income and prices of goods & services.
c. Rationality of consumers - consumers are assumed to be rational beings. He/she can reason out
as to what is good and what is bad for him and he prefers more of good to less of it further more
he aims at the maximization of his utility subject to the constraint imposed by his income .

Approaches to the analysis of consumer Behavior

There are two main approaches to the analysis of consumer behavior:

i) Cardinal utility approach and ii) Ordinary utility approach

2.1 Cardinal Utility Theory (CUT )

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Handout, micro economics , Econ By Fetiya N.

Cardinal utility theory is based up on certain important assumptions.

i. Utility is measurable: - The utility of each commodity can be measured in absolute terms. For instance
a person can say that from consumption of commodity X, he derives 10 utils of utility and from
commodity Y, he drives 5 utils of utility & so on…. According to Marshall, money is a measuring rod of
utility. Marshall argues that the amount of money that a person is prepared to pay for a unit of good rather
than go without it is a measure of the utility he derives from that good.

ii. The marginal utility of money is constant: - This assumption is necessary if monetary unit is used as
the measure of utility. Marginal utility of commodities diminish as more of them are purchased or
consumed, but the marginal utility of money remains constant throughout when the individual is spending
money on a good and due to which the amount of money with him varies.

iii. The Law diminishing marginal utility: - the utility gained from successive units of a commodity goes
on diminishing as the consumer consumes more of it. That is, the additional benefit or marginal utility a
person derives from a given increase of quantity consumed of a commodity diminishes with every
increase in quantity.

iv. Utility is additive - total utility from consumption of different baskets of goods obtained by adding
utility from each basket of good.

Total and marginal utility Concepts

The concept of cardinal utility makes it possible to define the total and marginal utility in quantitative
terms.

Total utility (TU):- may be defined as the sum of the utility derived from all the units consumed of the
commodity. if there ‘n’ number of commodities ; such as X 1 , X 2 , … , X n , total utility is the sum of utility
obtained from each commodity.

TU =U 1+U 2+U 3+ … …+U n , if the consumes n unites.

Marginal utility(MU) – is the addition to the total utility deriving from the consumption or acquisition of
one additional unit; or it is the change in the total utility resulting from the change in quantity
consumption of a commodity/ good. That is,

MU =ΔTU / ΔQ

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Where ∆TU = change in total utility, ∆Q = change in quantity consumed of a good or service. Marginal
utility indicates how TU changes in response to change in quantity consumed.

Numerical Example:-Table 2.1 presents a numerical illustration of the law of diminishing marginal utility.
As the table shows total utility increases with increase in consumption of sandwiches, but at a decreasing
rate. It means that MU decreases with increase in quantity consumed. This is shown in the last column of
the table.

Table 2.1 total and marginal utility

Q- quantity TU MU
In the table, the total utility reaches maximum at 67 at
0 0 consumed;
the 5th unit 0 Here, MU = 1. Consumption of
th
1 the 6 unit30yields30negative utility and the total utility
starts declining.
2 50 20
3 60 10
4 66 6
5 67 1
6 66 -1

Graphical illustration: - the law of diminishing marginal utility is graphically illustrated in Fig 2.1 (a) and
(b). By plotting the data given in table 2.1 total utility curves goes on raising still the 5 th unit consumed.
Beyond the 5th unit the TU curve start fall and it shows decrease in the MU

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Handout, micro economics , Econ By Fetiya N.

. TU
Maximum TU
67
TU
60

50

30

0 1 2 3 4 5 6 Quantity consumed

Fig 2.1A. Total Utility

MU

30 MU curve
Fig 2.1B. Marginal Utility
20

10

0 1 2 3 4 5 6 Qx

Fig 2.1 Total Utility Marginal Utility

 Theoretically, TU reached maximum when MU is approximately becomes zero.

 MU curve is downward sloping, or has a negative slope indicating the inverse relation between MU
derived and quantity consumed of a good.
 Up to the fifth unit MU is decreases with successive consumption but still positive; and TU utility is
increasing. This decrease in MU with the successive consumption indicates the Law of DMU.
 Starting from the 6th unit MU is negative, and TU starts to fall.

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The Law of Diminishing Marginal Utility (LDMU) - The axiom or law of diminishing marginal utility
is central to the cardinal utility analysis of the consumer behavior. The axiom or law postulates
decline/diminishing marginal rate of substitution among goods.

This law states that as the quantity consumed of a commodity increase over a unit of time, the utility
derived by the consumer from successive units goes on decreasing provided the consumption of all other
goods remain constant. In other words, as a consumer takes more units of a good the extra utility or
satisfaction that he derives from an extra unit of the good goes on falling.

Law of diminishing marginal utility holds only under certain given conditions. These conditions are

I. The good in consumption has to be standard, i.e., has to same quality, size or in any other
dimensions otherwise the law may not hold.
II. Consumer’s taste or preference must remain unchanged during the period of consumption.
III. There must be continuity in consumption and where break in continuity necessary, it must be
appropriately short.
IV. The mental condition of the consumer must remain normal during the period of consumption
of a commodity.

Consumers Equilibrium: - Cardinal Utility Theory/ Approach (CUT)

As mentioned earlier, a consumer is assumed to be a utility maximize. A consumer reaches equilibrium

position, when he maximizes his total utility given his income and prices of commodities he consumers.
Analyzing consumer’s equilibrium requires answering the question as to how a consumer allocates his
money income among the various goods and services he consumes.

Consumer equilibrium:- one commodity case - We being with the simple model of a single
commodity X. the consumer can either buy some quantity of good X or retain his money income, M.
under these conditions the consumer is in equilibrium when the marginal utility of X ( MU x ¿ is equated
to its market price ( P x). Symbolically we have:

Given the budget constraint is satisfied; M = X P x .

If MU x > Px , the consumer can increase his well fare by purchasing more units of X. Similarly if MU x <
P x the consumer reduces quantity of good X to increase total utility and keeping more of his income
unspent. Therefore, he attains the maximization of his utility. When MU x = P x. When only a single or
type of commodity is consumed

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Equilibrium when more than one commodity is consumed (CUT) - If there are more commodities,
the condition for the equilibrium of the consumer is the equality of the ratio of the marginal utilities of the
individual commodities to their respective prices. Suppose we have two commodities X and Y to be
consumed by a consumer with prices and marginal utilities: P x, MU x ;∧P y ∧MU y respectively. The
consumer equilibrium conditions would be stated as:

MU x MU y
A. ¿
Px Py

B. The budget constraint is: ¿ X P x +Y P y ; M – total income

The utility derived from spending on additional unit of money must be the same for all commodities. If
the consumer derives grater utility from any one commodity, he can increase his welfare by spending
more on that commodity and less on the others, until the above equilibrium condition is fulfilled.

Numerical Example;- suppose the utility function for two goods X and y is given below;

 U ( x , y)=4 Xy− y 2 ; MUX = 4y and MUy = 4x - 2y

 Subject to budget constraint: 2 x+5 y =110 (note; P X=birr 2∧Py=birr 5 ¿ .
MU x MU Y
Soln: equilibrium condition: =
Px Py

4 Y 4 X−2 Y
=
2 5
8X - 4Y = 20Y

8X = 24Y and X =3 Y

Substituting this into budget equation; we have:2(3 Y )+ 5Y =110;

Hence,11 Y =110 ,∧Y =10 units. Since X =3 Y ∧X =3∗10=30 units ;

Therefore, the optional choice of the consumer is x=30 units ,∧ y=10 units

Derivation of demand of the consumer under CUT - the demand curve is derived from the MU curve
based on the axiom of diminishing marginal utility. The LDMU states that as quantity consumed
increases, marginal utility derived from consumption of a commodity will decreases. The downward
sloping of MU curve shows the LDMU.

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MU

MUx

0 D Good X

Fig 2.2 MU curve

Accordingly the marginal utility declines continuously and become negative beyond point D. If the
marginal utility is measured in monetary units; the demand curve for the commodity is identical to the
positive segment of the marginal utility curve (segment between points R and D).

 Thus, under CUT the demand curve for a commodity is derived from the positive segment of the MU
curve (segment RD in the fig above).
 The LDMU and MU curve are the basis for the derivation of the law of demand.
Consumers always pay a price for each good based the MU per unit of a good. For a higher MU,
consumers pay high prices; similar a low MU pay low price unit of good.

In fig 2.3 below;

 At X1 units the marginal utility is MU1, and the price paid is p1. From the perspectives of consumers
MU1 = P1. By implication, at P1 the consumer demands X1 units of the product.
 Similarly at X2 the marginal utility is MU2 and is equal to the price P2. Hence at P2 the consumer will
buy X2 units, and soon.
 At X3, marginal utility is MU3 and consumers willing to pay a price, P3.

MU
R A where MU1 = P1
MU1

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MU2 B where MU2 = P2

MU3 C where MU 3 = P3

D QX

0 X1 X2 X3 MUx

Critiques of cardinal approach

The following are some basic weaknesses of the cardinal utility theory.

I. The assumption of cardinal approach that utility is cardinally or objectively measurable is. Utility is
a subjective concept, which cannot be measured objectively.
II. The assumption of constant marginal utility of money is used because money serves as a measure
of utility. However, this assumption is unrealistic b/c marginal utility of money, like that of all other
goods is subject to change and therefore it cannot serve as a measure of utility derived from goods
and services.
III. The psychological law of diminishing marginal utility has been established from introspection. The
law is accepted as an axiom without empirical verification.
Ordinal Utility Theory/Approach (OUT)
Unlike the cardinal utility theory, the ordinal utility theory stated that utility is not measurable. It asserted
consumer can only rank or order the utility he/she derives from different goods. The theory uses
indifference curve (IC) in analyzing the consumer behavior, hence referred as Indifference curve
theory/approach.

This theory provides another method of studying the consumer’s behavior, since it uses indifference
curves [IC] to study the consumer’s behavior, the ordinal utility theory is also known as the indifference
curve approach.

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The OUT rejects the view that utility is measurable objectively because utility is a subjective concept it
can’t be measured objectively or cannot be expressed numerically. The theory argued utility is an
ordinal magnitude – that is – consumers can only rank or order utility derived from the consumption of
different goods.

Good Y good Y

IC 1

good X good X

Indifference curve, IC Indifference map

Ordinal utility is not quantity or a numerical value. It is only an expression of ranking or ordering
consumer’s preference for one commodity over another.

The concept of ordinal utility is based on the following axioms (Rule of principle)

a. It is not possible for a consumer to express his/her utility in quantitative terms. But it is always possible
for him/her to tell which of any two goods he prefers.

b. In view of this the consumer can order all the commodities he consumes in the order of their
preference.

In the opinion of the ordinals, this is sufficient to analyses consumer behavior, and absolute measurement
of utility is nether neither feasible nor necessary for analyzing consumer behavior.

Assumption of ordinal utility theory - the theory makes the following assumptions;

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1- Rationality:- the consumer is assumed to be rational, he aims at the maximization of his utility given
his income and market prices. It is assumed he has full knowledge of all relevant information.
2- Utility is ordinal: - utility is ordinal magnitude; it can’t be measured or expressed numerically.
Consumers can rank or order their preferences from consumption of different baskets of goods according
to the satisfaction of each basket. It is difficult to numerically /objective measure utility for consumers.
They need not know precisely the amount of satisfaction, it is enough somehow the compare and rank
utility from different goods.
3- Consistency and transitivity of choice:- it is assumed that consumers are consistent in their choice,
that is, if in one period he chooses bundle A over B he will not choose B over A at another period if both
bundles are available to him. The consistency assumption may be symbolically written as follows:
If A> B , then B < A .
Similarly, it is assumed that consumer’s choice is characterized by transitivity: if bundle A is preferred to
B, and B is preferred to C, then bundle A, is preferred to C, symbolically we may write the transitivity
assumption as follow; If A> B ,∧B>C then A >C .

4. Law of Diminishing Marginal Rate of Substitution (Law of DMRS).

The marginal rate of substation (MRS) is the rate at which a consumer is willing to substitute one
commodity (X) for another (Y) without changing or affecting total utility. The Rate is given by ∆Y/∆X.
the assumption of DMRS/ diminishing marginal rate of substitution, is that, ∆Y/∆X goes on decreasing,
when a consumer continue substitute X for Y. in other words, DMRS refers to the increasingly difficulty
one face in substituting one commodity for another without affecting TU.

The law of DMRS states that the rate at which one commodity is substitute to another decreases as one
keep on increasing consumption of one commodity while at the same time reducing quantity consumed of
the other commodity.

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Nature of Indifference curve (IC)

An Indifference curve is the locus of points, each representing a different combination of two goods,
which yield the same utility or level of utility. IC is a curve that shows the different combinations of two
goods (say goods X and Y) that give the same level of utility. On IC consumers can choose between any
combinations of goods without affecting total utility.

 An IC contains infinite no. of points or combinations of goods X

and Y. such as combinations A, B, C and D.
good Y  Since all points (A, B, C, D , ETC) are on the same IC , represent
the same amount of utility.
100 .A (X= 5, y= 100)  At points A and D we different combinations of X and Y, but level of
utility is same for both.

.B

.C

0 5 50 good X

Indifference curve, IC (convex in shape)

Indifference curves are also called iso- utility curves [equal utility curves]. For example: let us suppose
that commodity X and Y are substitute to each other and combinations; A, B, C, D, of the two
commodities, as presented in table 2.2. Since all combinations on an IC yield the same level of
satisfaction, consumer is indifference between any of the possible combinations. Table 2.2 Indifference
schedules of commodities X and Y.

Combination commodity Y commodity X

utility

A 20 5 U

B 15 12 U

C 10 20 U

D 5 30 U

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It shows various combination two goods yielding the same degree of satisfaction or utility.

Combinations: A, B, C, D given in table 2.2 plotted

and joined by a smooth curve, the resulting curve
Commodity Y

known as indifference curve(IC).

20 A *The IC is convex in shape – because of LDMRS.
The MRS between X&Y is different for every point

15 B

10 C D IC

0 5 12 20 30 Commodity X

Indifference curve (convex in shape)

The MRS (marginal rate of substitution) is the rate at which one commodity can be substituted for
another, the level of satisfaction remaining the same.

The MRS between two commodities, X and Y may also be defined as the ratio of quantities of X and Y
required replacing one for another under the conditions that total utility remains the same. It implies that
the utility of units of X given up is equal to the utility of additional units of Y. Suppose moving from
point A to B, MRS between X and Y is computed as

MRS x, y = |−∆∆ XY | |−57|

= = 5/7 = 0.714

− ΔY MUX
=
MRSYX = ΔX MUY

The MRS of X for Y represent amount of Y the consumer has given up so as getting additional quantity
of X.

 Slope of indifference curve is negative implying possibility of substitution between commodities in

consumption (X and Y). However, substitution is carried out in a way that keeps total utility constant or
leaves total utility unaffected.

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 The shape of IC is convex to origin – as we move along the X - axis by increasing X and decreasing Y
– the curve become flatter, its slope fall in absolute term. This particular convex shape of IC (or fall in
slope) indicates the postulate or Law of DMRS.
 The Postulate of diminishing Marginal Rate of substitution is one of the basic postulates of OUT or in
indifference curve analysis, which asserts marginal rate of substitution between commodities will
eventually tend to diminishes. This axiomatic assumption of ordinal utility theory is analogous to the
assumption of ‘Diminishing Marginal utility’ in cardinal utility theory.
ΔY change in good Y
MRS X,Y = ΔX change in good X

Indifference curves Map

Qy

- Indifference Map contain a set of ICs

- In the map, each IC represents different level

of utility IC 1

- The used to rank/order preferences or

0 Qx

Indifference curves map

Indifference curves map - is a map containing a set or group of ICs (indifference curves) that denote or
show different levels of utility. On indifference map the level of utility varies as we move from one IC to
the other. For-example, moving from IC 1 to IC3, on the indifference map, the level of Utility increases.
Utility denoted by IC3 is higher than utility represented by IC 1 because IC 3 is farther away from the origin
than IC1; and IC3 denoted larger quantities of both goods relative to IC1.

U ( IC 1 )>U (IC 2)>U ¿

Single Indifference curve represent a constant level of utility even if combinations of the two goods varies
along IC, utility don’t change. Map of Indifference curves contains more than two ICs representing
different level of utility.

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Map of ICs used to rank or order level of utility. The far away an IC from the origin it represents a
higher level of utility.

Properties of indifference curves

1) An indifference curve has a negative slope, which denotes that if the quantity of one commodity(Y)
decreases, the quantity of the other (X) must increase. That is, it shows the two goods are substitute to
each other.
2) The indifference curve is convex to the origin. This implies that the slope of an indifference curve
decrease as we more along the curve. It is due to the Law of diminishing MRS X, Y. In addition to
LDMRS, the convexity of IC indicates the rate substitution between goods is different for each point
on the curve.
3) Indifference curves do not intersect. If they did, the point of their intersection would imply two
different levels of satisfaction on one point, which is impossible. If intersect, it violet the assumption
of transitivity and consistency of choice, that is, ranking/order of utility will become inconsistent.
4. The farther away from the origin an indifference curve lies, the higher the level of utility it denotes ;
bundles of goods on a higher indifference curve are preferred by the rational consumer. Because as IC is
far away from the origin, it represent large amount of quantity consumed. This property is special relevant
to indifference map which used to rank /order utility from different bundles of goods consumed.

The budget constraint of the consumer

The consumer has a given income, which sets limits to his maximizing behavior. Income acts as a
constraint in the attempt for maximizing utility. The income constraint, in the case of two commodities,
may be written;

M = Px Qx + Py Qy

QY

A M/PY

Budget Line

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The consumer in his attempt to maximize his satisfaction will try to reach the highest possible
indifference curve. But buying more and more goods and obtaining more and more satisfaction he/she has
to work under two constraints;

I. Has limited money income ii. Prices for goods and services.

2.2.2 Equilibrium of the consumer under ordinal / IC approach

Consumer attains her/his equilibrium when she/he eventually maximizes total satisfaction (utility) given
his income and market prices of goods and services.

There are almost 3 conditions for consumer equilibrium

1. MRS must be equal to the ratio of commodity prices. Considering the earlier two commodity model,
we have;
MRSXY = MUX/MUY = PX / PY

(Slope of IC) = (Slope of the budget line)

2. The first condition (I) fulfilled when the highest possible IC is tangent to the budget line.

3. At this point the budget constraint has to be maintained, ie, the consumer has to exhaust its budget;
M = X P x +Y P y

The equilibrium conditions depicted graphically below

Qy
*AB is budget line which is tangent to IC 2 at point E
A PX
* At point E, MRSX,Y = PY = MUX / MUY
equilibrium is at the point of tangency of IC 2 with
budget line.
Y1 E IC3

IC2

IC1

X1 B Qx

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Exercise – suppose the following are given:

Total utility function: U = 2XY 2

∆U ∆U
Marginal utility functions: MU X ¿ = 2Y 2 & MU Y ¿ = 4XY
∆x ∆Y

PX = Birr 6, Py = 4 birr, M = Birr 180

A. writes the budget constraint equation (180 = 6X +4Y)

B. Determine the equilibrium quantity of X and Y in consumption and show on graph

Solutions

Soln B: - equilibrium condition: MUx /MUy=Px / Py

2Y
2
6
= Px /Py =
4 XY 4

Y 6
= ⤇ 4 Y =12 X ; hence, Y =3 X
2X 4

180 = 6X + 4Y ⤇ 180 = 6X + 4(3X)

180 =18X ⤇ X = 180/18 = 10 Units

Since Y = 2X, Y = 3* 10 = 30Units

Thus; the equilibrium quantities are X = 10 & y = 30units

45

IC

30 E

0 10 18 X

Graphical presentation of the consumer equilibrium

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Chapter 2 - Theory of Production

3.1 Concepts of production

What is Production? – it is the process of using the inputs or economic resources to produce
goods and services available. Inputs are anything that can be used in the production of goods and
services. Inputs /factors of productions includes: capital, labor, land, raw materials etc. All
inputs can be divided in to two categories:

Fixed inputs: - are factor inputs whose supply cannot be varied (changed) over the time period
under consideration. In other words, the quantity of fixed inputs does not change with output or it
takes long time to change their quantity. Buildings, machinery and managerial personal are some
example of fixed inputs. Once, their physical quantity /size are determined; these inputs don’t
change frequently during the production process. The size of fixed inputs determined before
production began.

Variable inputs: - is one whose quantity changes with output. Labor and most raw materials are
included in this category. Variable inputs could be increased or increased during the production
process.

In line with this classification of inputs, economists use two production periods; that is: short run
and long run production period.

Short-run period of production - refers to a production period in which the supply of certain
inputs is fixed and some others are variable. In the short run we have both variable and fixed
inputs. Firms or producers can increases or decreases their amount of variable inputs in the short
run; but can’t change the size their fixed inputs. A firm can only increase or decrease its output
in short run by increasing or decreasing the amount of the variable inputs.

Long run period:- is a production period/ time in which all inputs are variable. There is no fixed
factor. Producers or firms have enough time to change all forms inputs in the long run. Long run
production period related with change in entire level or scale operation of a firm; such as, change
from small scale to large scale operation. Hence, in the long run a firm can change its entire
scale of operation or capacity of production by changing all forms of inputs; and could attain a

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much larger production capacity.(To understand long run production think in terms of plan ,
future expansion).

Production Function - The term production function describes the technological relationship
between inputs and outputs. Mathematically, it can be represented as:

Q=f ( X 1 , X 2 , X 3 ,−−−−−−−−−, X n).

Q represents the maximum quantity of output.

X 1 , X 2 , X 3 ,−−−, Xn are quantities of different types of inputs used in production.

The production function tells us how different inputs combined in the production process to give
a certain quantity of output. It refers to: quantity of inputs – how much each inputs have to be
used, Methods/technology - in what proportion inputs have to be combined, and how much
output to produce. As such production function shows the best possible ways of combining inputs
to produce a certain level of output.

Production function could also be short run or long run production functions on the bases of our
assumptions about the variability of different inputs used in the production process. In other
words, the terms “short run” and” long run “refers to firms’ adjustment period to a changing
economic environment; such as to changes in demand, prices , etc.

In the short run, producers have limited capacity respond to changing circumstances. Say for
example, the demand for the product of a firm increased for some reason. In the short run in
response to this change a firm could increase its output by increasing employment of certain
variable inputs.

In the long run , a firm could came with a new plan that could change every aspects of
production – install new machines , equipment’s buildings , etc. ; thus, change its scale or level
of operation, and could significantly increases its output.

4.2 Short run production with One Variable Input (say labor, L)

Short run production is a production where we have both fixed and variable inputs. In the short
run, producers can change level of output only by changing the quantity of variable inputs, given
a constant quantity of fixed inputs. Usually production involves the uses of more than one type
of variable inputs, in this case for the sake simplicity of analysis we consider a single variable
input – Labor, L.

3.2.1Total, marginal and average products of variable Inputs

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i. Total physical product (TP) – is the total output produced using inputs over a given period of
time. TP of a firm depends on the quantity of inputs used, in the short TP can be increased or
decreased by increasing or decreasing the quantity of variable inputs used.

ii. Average product (AP) – is the total product per unit of the variable input/variable factor (VF).
It is obtained by dividing total output (Q) by the total variable inputs. AP shows the average
productivity of variable inputs used.
AP=Q/VF , Where Q – total output, VF - variable factor
For example Labor (L) is the only variable input, the Average product of labor (APL) is
computed by dividing total output to total labor used in production process:
AP L=Q /L ; L - labor total variable input used.

iii. Marginal product (MP) – is change in total output due to one unit change in a variable input.
MP=Q/VF ,

A firm employs a variable input as far as it contributes to its output. A variable input that doesn’t
add to the total output is not employed. As such, the MP of a variable input help firms to decide
whether to employ /or not / an extra unit of the variable input. As far as MP of a factor is
positive, its employment will increase total output.

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Graphical presentation: we can show the above table by using the production function curves.
Roughly drawn the production curves have the shape depicted on fig below.
TP
112 C

TPL
80 A

60 B

30

10

0 3 4 8 9 L
4.1 Total Product Curve
APL and MPL

20 A

10 B

MPL APL

0 3 4 8 L

Fig 4.2 AP and MP curves

Relationship between TP, AP and MP - Note the following points:

i. TPL first increases at an increasing rate , then increases at decreasing rate reaches its
maximum at point C with L = 8 units. Beyond this point it starts fall/ declines.

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ii. The patterns of average product and marginal product curves are similar. Both APL and MPL
curves initially increase, reach their respective maximum and then decline. Moreover, MPL
eventually becomes negative beyond the 8th unit of labor.

iii. When total product is maximum (at point C with employment of L = 8 units of labor),
marginal product becomes of labor zero.

iv. When MPL is above APL: APL increases until it becomes equal to MPL at point B (with L =
3).

V. when MPL curve crosses or intersect with APL curve at point B; then APL reaches its
maximum and becomes equal with MPL. Beyond this point MPL is less than APL and APL start
to fall.

Vi. A factor that doesn’t contribute to output can’t be employed. Rational producer employ labor
(or any variable input) as far as its MPL is positive. In the figure beyond the 8th unit of labor
contribution of labor to TP is negative, it decreases TP, and hence, Labor has no productive on to
output.

3.2.2 Stages of Production and laws of Diminishing Returns to Variable Input

The Law of Diminishing Returns a variable input (LDR): It is short run production law
which states that the marginal return from a successively increased employment of a variable
input will ultimately decreases. The MP of a variable first increases as employment of the
variable factor (input) increases, then reaches its maximum and beyond this the maximum MP
additional employment of the variable input reduces MP. LDR to variable factor implies that
Marginal productivity of a variable factor decreases with a successive increase of employment of
the input.

Hence, total output can’t be increased indefinitely only by increasing uses of variable input,
because there will come a time where the capacity fixed input will be exhausted (wear out) and
could no longer bear additional employment of variable input in productive way.

If more and more of a variable input is applied to a fixed input, the total output may initially
increase at an increasing rate, but beyond a certain level of output it increases at a decreasing
rate; and ultimately the contribution of the variable input to total output will become zero and
even goes to negative. In other words, if some factors are held constant and more and more units
of a variable factor are combined with these fixed factors, the marginal product of the variable
factor eventually declines - goes to zero and below.

The three stages of production - Economists use the relationships among average and marginal
products to define three stages of production associated with uses of a variable input. The

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behavior of output when varying quantity of one factor is combined with a fixed quantity of
another factor can be divided in to three distinct stages.

TP,AP, MP C

Stage I II III

TPL
A
B

MPL APL

0 D L

I II III

Fig 3.3 the three stages of production

The shape of the MP curve is as show in the fig above is determined by the Law of diminishing
return to variable input. Which asserted that the return from an increased uses of a variable input
will initially rises however will ultimately diminishes with the increase of the variable input.
Hence, the shape the MP curve shows the law of diminishing returns at work.

Numerical Example – Suppose we have short run production function with labor (L) as the only variable
input;
2 3
Q=90 L – 2 L

dQ ∆ Q 2 Q 2
Hence; MPL= = =180 L – 6 L and APL= =90 L – 2 L
dL ∆ L L

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Then answer the following:

A. determine the L the gives the maximum output

B. determine the labor employment where APL is maximum
C. compute L for which MPL is maximum (at L= 15 units)

Solution (A). Output maximum when MPL=0

2
MPL=dQ /dL=180 L – 6 L =0

180 L=6 L2 ⤇ L=180 L/6 L=180 /6=30 Units

At L = 30 units MPL is zero and TP is maximum.

The maximum TP is obtained by inserting L = 30 into the production function

2 3
Q=90× 30 – 2 ×30 =90× 900 – 2 ×27000=81,000 – 54,000=27,000

Q = 27, 000 units is the maximum output which could be obtained at L = 30 units.

Solution B ;- APL maximum when it is equal to MPL; APL=MPL

180 L – 6 L2=90 L – 2 L2 ⤇ 180 L−90 L=6 L2 – 2 L2

90 L=4 L
2
⤇ 90 /4=LThen L=22.5 units

L = 22.5 units - is labor employment where APL is maximum or where MPL = APL.

Soln (C):- MPL is maximum when the slope of MPL curve is zero, dMPL /dL = 0

dMPL/dL=180−12 L=0 ⤇ L=180 /12=15Units

3.2.3 Short run Production with Two Variable Inputs: Isoquants

When there are two variable inputs in the production process, the production function is describe
through curve commonly referred as an Isoquant curve. it is a curve that shows how inputs can
be combined in different ways to get the same level of output. An isoquant is a firm’s counter
part of the consumer’s indifference curve.

An isoquant is a curve that shows all the combinations of inputs that yield the same level of
output. In this context, “iso” means equal and “quant” means quantity so an iso-quant represents
a constant quantity of output. If we assume that two variable inputs: capital (K) and Labor (L)
where output (Q) is a function of K and L, the production function given as Q = f(K, L). For a
given level of output the isoquant curve could draw graphically as follows.

Capital, K

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∆K
Slope of Isoquant Curve =
∆L

IQ

0 labor, L

Fig 4.3 Convex Isoquant curve

The isoquant curve (similar to indifference curve) has negative slope and called marginal rate of
technical substitution (MRTS) between the two variable inputs. It indicates how inputs (L and K
in this case) could be substituted one another in production. The concept of iso-quant schedule
can be easily explained with the help of the table given below.

Combinations A, B, C and D show the possibility of producing100 Units of Q by applying

various combinations of labor and capital. An iso-product curve- is the graphic representation of
an iso- product schedule. The above combinations on an isoquant curve as follows.

9 A

6 B An iso-quant curve

4 C

3 D IQ =100

0 5 10 15 20 L

Iso-quant map – is a set of iso-quants that show the maximum attainable output from any given
combination of inputs.
Capital, K

IQ3 = 300
IQ2 = 200

IQ1 = 300

0 L
An isoquant map

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On an Isoquant map, each Isoquant curve represents different level of output than that
represented by any other curve.

Properties of iso-quants

i. Iso-quant slope down ward (has negative slope). As the employment of one variable input
increases, the quantity employed of the other variable factor should decreases so as to produce
the same level of total product. This implies are inputs substitute to each on the isoquant curve.

ii. Iso-quants are convex to the origin in shape: convexity of is-quants implies not only the
negative slope but also a diminishing rate of MRTS between inputs (The LDMRTS). That is,
MRTS between inputs on an isoquant curve is not constant but it decreases as one continuously
substitutes one factor for another. Convex isoquant shows that variable Inputs are not perfect
substitute to each other.

iii. Isoquants cannot intersect or be tangent to each other- intersection or tangency of two
Isoquants implies that a certain combination of L and K can produce two different quantities.

iv. Upper Isoquants represent higher output. An upper isoquant is an isoquant that lies far away
(to the right) from the origin. The farther away the isoquant curve from the origin the higher the
level of output it denotes. This is because upper isoquant represents high utilization of both
variable inputs (larger quantities of both inputs are used) than at lower isoquant.

Marginal rate of technical substitution (MRTS)

MRTS is the rate at which one input can be substituted for another in production process without
changing or affecting the level of output. In other words the MRTS of labor for capital may be
defined as the number of capital, which can be replaced by one unit of labor, keeping the level of
output constant. In mathematical terms;

MRTS L, K =−K /L = slope of Isoquant

The concept of MRTS LK can be easily understood from the table below

Table 2.3 Marginal Rate of Technical Substitution

Combination of L& Labor capital (K) Output, Q MRTS L, K =−K /L
K (L)
A 5 9 100 -

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B 10 6 100 3:5
C 15 4 100 2:5
D 20 3 100 1:5

In the above table all the four factor combinations A, B, C and D produce the same level of out
put.i.e, 100 meters of cloth. They are all iso –product combinations. As we move from
combination A to combination B, it is clear that 3 units of capital can be replaced by 5 units of
labor; hence MRTSLK is 3:5. Similarly, when we more from combination B to C, 2 units of
capital is replaced by 5 units of labour, and C to D 1 K is substituted by 5 units of L.

MRTS and Marginal Products of inputs;

MRTS L, K =MP L/ MP K - The Marginal rate of substitution between two inputs equals the ratio
of their marginal products.

Law of Diminishing MRTS – along an iso-quant curve, MRTS continuously declines, hence
making the curve convex to the origin. The reason is that along the iso-quant, as the quantity of
labor is increased and the quantity of capital is reduced, the marginal productivity of labor
diminishes and the marginal productivity of capital increases. Therefore, less and less of capital
is required to be substituted by an additional unit of labor to maintain the same level of output
and hence a diminishing marginal rate of technical substitution.

3.3 Laws of Returns to Scale (Long Run Production Law)

Here we will discuss the long run production (input – output relationship) under the condition
that all inputs vary or change proportionally and simultaneously. When all inputs are variable the
scale of production or size of the firm will also change.

If we simultaneously increase all inputs the scale of operation / size of the firm also change from
small scale to large scale operation. Note that the term “returns to scale “usually refers to the
relationship between changes in size of the firm or scale of operation and level of output. How
change in size/scale affect total output?

In the discussion, it is assumed that all factors or inputs are broadly categorized into Capital (K)
and Labor (L); and change in scale is thus a function of simultaneous change of employment of
labor and capital factors. Based on the impact of change in scale of operation (or proportionate
change in all factors) on output, three cases of returns to scale are identified.

1. The law of increasing returns to scale (LIRS) - Occurs when increase in output is more than
proportional to the increase in inputs. Here increase in scale will further increases the

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Here, output increase by a proportion greater than the proportional increase in all inputs.

Q1=F (1 K , 1 L)=10units Q2=F (2 K ,2 L)=25units, Q3=F ( 4 K , 4 L)=60units

Handout, micro economics , Econ By Fetiya N.

productivity of all inputs. This situation might arise from; advanced technology, indivisibility
(unused capacity), specialization, etc.

2. The Law of Constant Returns to Scales (LCRS)

LCRS occurs when increase in output is proportional to increase in input. As a firm expands, it
gradually exhausts the economies, both capital internal and external both capital internal and
external both capital internal and external diseconomies of scale are exactly in balance over a
particular range of output.

Here, output increase the same proportion that all inputs increased.

Q1=F (1 K , 1 L )=10 units, Q2=F (2 K ,2 L)=20units, Q3=F (4 K , 4 L)=40 units

The productivity of inputs remains constant as size changes.

100% increase in all inputs will increase output by the same proportion; output also increases
by 100%.

3. The Law of Decreasing Returns to Scale, LDRS

Under the LDRS total output increases is less than the proportional increase of in inputs. Here
increase in size /scale of operation will reduce productivity of factors of production, increase in
scale negatively affects the productivity of inputs. As the size of the firm expands, managerial
efficiency decreases.

Here, output increase by less than the proportional increase of all inputs.

Q1=F (1 K , 1 L)=10 Units; Q2=F (2 K ,2 L)=18units; Q3=F ( 4 K , 4 L ) =20Units

100% increase in all inputs will lead to a less than 100% increase in output. This is due to
decrease in factors productivities.

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Chapter 3. Theory of Cost

4.1 Introduction

Definition: The cost of production of a commodity is the aggregate prices paid for the factors of
production used in producing that commodity. In other words cost of production explains the
money value of inputs.

Actual Cost versus Opportunity Cost

Actual Costs - are costs that are actually incurred by firms as payments for factors of
production: labor, machineries, building equipment’s, etc. The total money expenses recorded by
accountants (accounting costs) are actual costs. Hence this comes under accounting concept of
cost.

Opportunity cost – is the value of the best alternative surrendered when a choice is made. In
addition to the actual cost incurred economists also consider opportunist costs of production. It is
the opportunity lost for example when a medical doctor deciding to open his own private clinic
will forgo his wage that could be obtained from being hired in a hospital.

Private, External and Social Costs

Private costs: are those costs which are actually incurred by firms for the purchase of inputs or
factors of production.

External cost – are those costs not borne by the firm (or not covered by the firm who cause it),
but is incurred by others in the society. A firm /producer can transfer such costs to others who
are not responsible for causing it. This includes cots associated environmental damage,
pollutions of air and water due to economic activities.

Social cost – sum of all costs which a society bears on account of production of goods and
services. As a result a true cost to the society must include all costs, regardless of the persons on
whom its impact falls and its incidence as to who bear them.

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Social Cost = private Cost + External Cost

Implicit Cost and Explicit Cost

Explicit costs - are those costs which are actually paid by the firm in production of goods and
services; they are visible costs one would incur. Such costs include wages and salaries, price of
raw materials; amounts paid on fuel, advertisement, taxes etc. These costs are actual or out-of-
pocket expenditures that the firm incurs to purchase in puts and other utilities (supplies).

Implicit costs – are implied value of the entrepreneur’s own resources that is not paid for it. In
other words, implicit costs are costs of self owned and self – employed resources which could
have earned income in their best alternative uses.

5.2 Relation between output and Costs of production

A. Short Run Cost of Production:- in the short run, input are divided in to two: fixed and
variable inputs. Likewise, short run costs are divided into Fixed Cost (FC) and Variable Costs
(VC). FC are costs incurred on fixed factors while VC are costs incurred for the acquisition of
variable factors of production. Thus, in the short run total cost (TC) of production is the sum of
VC and FC.

i) Total Cost (TC):-represents the value of the total resources used in the production of goods and
services, it includes both fixed and variable costs.

ii) Average Cost (AC) – is the cost per unit of output. And is calculated as: AC =TC/Q

iii) Marginal Cost (MC) – is the addition to the total cost on account of producing one additional
unit of a product.

dTC ∆TC
MC= =
dQ ∆Q

iv)Total Variable Cost (VC) – are costs which are incurred on the employment of variable factors
of production.

V) Total Fixed Cost (FC) – costs which do not change over a certain level of output. Here note
the following algebraic relationships between the above measurements of costs.

TC =VC + FC

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i)Total cost curves

AC, TC, FC
As you can see from figure FC remains constant
irrespective of output level.

VC shows an increasing trend first at a decreasing

TC VC
rate and then increase by an increasing rate the
pattern

FC FC

Fig 3.1 The total cost curves

ii) Average and Marginal cost curves ( ‘U’ shaped)

All average costs and marginal cost curves in traditional theory of cost assumed to have “U”
shape. AFC continuously declines but never becomes zero having a geometric hyperbola shape,
while AVC; AC & MC first decline, reach their respective minimum and then start to rise having
‘U’ shaped curves.

AC, MC , AVC , AFC

AC
MC

C AVC

A
AFC

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0 Q1 Q2 Q3 Q

Fig 3.2, the average and marginal cost curves

 MC curve first falls (its slope is negative) and reach its minimum at point A, beyond this
minimum point it starts to rise (its slope becomes positive).
 AVC first falls and reaches its minimum at point B. Beyond its mimum point it starts to rise
and its slope becomes positive. At the minimum of AVC, MC is equal to AVC.
 The AC (or ATC) curve first fall until it reaches its mimum at point C. Beyond its minimum
point it rises (its slope become positive). AC is also equal to MC at its minimum.
 AC is always above AVC and the two can’t be equal.
Whenever MC is below AVC & AC, both curves decline and MC is equal to AVC & AC both
curves reach their respective minimum, and when MC is above the average curves, they start to
increase.

When we see the relation between AC and AVC, since AC is sum of AVC and AFC the trend of
AC is determined by these two costs. When both decline AC declines if the decrease in AFC is
greater than the increase in AVC, AC declines; on the other hand if the decrease in AFC is less
than an increase in AVC, AC increases. Furthermore the distance between AC and AVC curves
narrow down. Since AFC continuously declines,

4.2.3 Long run cost analysis

In the previous chapter we have discussed that in long run production period all inputs are
variable, hence, output is increased by increasing all inputs. To analyze the long run, we use a
serious of short run periods of production.

Long run average cost (LAC)

The LAC curve is derived from short run cost curves of alternative scales / firm sizes. Each point
on LAC curve represents different scale of operation or different firm size. Firm size at point A
on fig below represent a firm whose AC is falling and could further reduce AC through
increasing its size. In this region a firm enjoys Economies of Scale (fall in AC of production as
size increases).At point B a firm has minimum AC of production, and AC can’t fall beyond this
point. The firm operating at point B has the most optimum size (Most Efficient Scale, MES).

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LAC

LAC Curve

LAC

A C

Region of Economies of scale B Region of Diseconomies of scale

O Q
QE
Expansion of size beyond point B such to point C is not optimum, and AC of production will
increases to increase size to the left of B. A firm that operates beyond point B such as at point C
will encounter Diseconomies of Scale (a rise in AC of production as size increased). This is due
to over expansion of the firm that lead to inefficiency and increased per unit of cost (AC) of
production.

LAC is also called as “planning curve’ as it serves as a guide to the entrepreneur in his planning
to future expansion of its scale/ size of operation.

 The most optimum or efficient firm size is that which corresponds to the Minimum LAC
(point B on the figure above); where the firm exhaustively used all possible advantages of
expansion; or all Economies of Scale associated with size are used up.
 Operation to the left of point B or firm size such at point A indicate under- expansion where
all possible gains from economies of scale or size are not exhaustively used. So, such firm
should expend or increase size/ scale of operations until they reach point B.
 Scale of operation beyond point B (to the right of B) indicates over expansion. Firm size
such as at point C are inefficient and high AC. Such firm should reduce their size or scale of
operation until they reach point B (to the minimum LAC of production).
Long run marginal cost (LMC)
The LMC curve is derived from short run marginal cost curves of firms’ with different sizes. As
such each point on the LMC shows marginal cost associated with a particular size of a firm or

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certain level of scale of operation. As firm size changes the LMC curve first fall, reaches its
minimum at point M then starts to rise as size increases.

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Causes of Economies and Diseconomies of Scale

Why Does the Long Run Average Cost (LAC) has a ’U’ shaped? – it is due to economies and
diseconomies of scale operating in the long run.

The LAC first declines, reaches minimum and then rises due to economies and diseconomies of
scale which also determines the returns to scale.

LMC & LAC

A
LAC

LMC

Region of Economies of scale Region of Diseconomies of scale

0 QE Q

Fig 3.5 Regions of Economies and diseconomies of scales on LAC

When the size of a firm expands, there emerge certain economies of scale. Economies of scales
reduce average cost of production. on the fig above moving from 0 to Q E, as output increase
average cost fall, the curve shows a negative slope and is minimum at point B. Beyond point B,
as output increased average cost will also increases, the curve will have a positive slope – this is
region of diseconomies of scale. In this region, the LMC is above LAC curve (LMC > LAC).

Economies scale – refers to a situation where the average cost of production (AC) tends to fall as
total output increases. Increase in firm size/scale of operation enables the firm to produce more at
a lower per unit cost (Average Cost). This is shown by the falling portion of the LAC curve (to
the left of point B on the graph above). Note that when a firm enjoys economies of scale, its
LMC curve is below LAC, this is for output level to the left of point B ( LMC < LAC).

Possible sources of Economies of scale

1. Increase in productivity of factors: - The region of economies of scale is associated with the
law of increasing returns to scale where increases employment all recourses or factors, will lead
to a higher return in output than the rate of increase in cost. Productivity increases as more and

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more factors are employed in the production process; this lower LAC as the firm expands in size.
The LAC curve is downward sloping or falling when there are economies of scale to be gained.

2. Technical Efficiency/economies. Technical efficiency that arises as a result of the adoption

/uses of newly developed equipment’s and technologies which allows firms to produce more
output at lower per unit cost (Average cost). Expansion or increase in scale of operation allows a
firm to employ advanced technologies that increase productivities.

3. Specialization. Increase in the scale operation / size allows a higher degree of specialization.
This will increases productivity; thus, will minimize/reduce per unit costs (AC) of production.

4. Managerial economies – the unit cost of administration falls as production expands.

 Therefore; operation of the law of increasing returns helps to reduce the average cost of
production. However, there are limit to expansion of size a falling AC, because after a
level of expansion there will arises certain diseconomies / inefficiencies that will increase
AC of production.
Diseconomies of scale - a situation where AC of production increases as output increases. That
is, it is a region of the LAC curve where total output can’t be increased without increasing
average or per unit costs of production. Diseconomies of Scale associated with fall in factors’
productivity, and expansion a firm size will increase average costs than it increases output. Thus,
the Average cost curve is rising (upward sloping) in the region of Diseconomies of Scale. Note
when there are diseconomies of scale LMC curve is above LAC curve (LMC >LAC).

The causes for diseconomies are:-

 Over employments and/or utilizations factors of production. Overcrowding of work place
causes loss of control of labor productivity.
 Managerial inefficiency – due to over expansion of plant size, management becomes difficult.
This causes difficult to manage and supervise operational activities leading to inefficiencies that
increase costs.

Chapter 4 Theory of the Firm:

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The Price and Output Determination under perfectly competitive market.

5.1 The Firm, its Objective and Market Structure

By assumption, the objective of a consumer is maximization of utility; likewise the firms also
has objective to achieve. The objective of business firms is to maximize profit from the
production and sell of goods and services.

In Production and Cost theories we have discussed about production and cost functions and
curves faced by firms. Brought together, revenue and cost determines the behavior of a profit
maximizing business firm. The most important factor that determines firm’s choice of price and
output is the market structure in which it operates.

The term market structures refers to the organizational features and characteristics of an industry
or market that influence firm’s behavior in its choice of price and output. Economists broadly
classified market structures into two:

a) perfectly competitive market structure

b) Imperfect Market structures; there are three forms of imperfect markets:

 pure monopoly market structure
 monopolistic competition market
 oligopoly market structure

This Classification of markets into perfect and imperfect depends on number factors or
characteristics that distinguish one market from another. These include: the numbers of firms
available in the industry, the nature of products supplied, condition entrance into a market by of
new firms, resources ownership and mobility, degree of access to information and technology,
etc.

In this unit, we investigate how price and output are determined in perfectly competitive markets
in the short as well as long run periods. Perfect competition is a market structure characterized
by a complete absence of rivalry among the individual firms, because there are so many firms in
the industry so that no personal recognition among individual firms in a market.

5.2 Perfectly Competitive Market Structure

A perfectly competitive firm has the following characteristics:

1. Large number of sellers of the same product: under perfect competition there is large
number of sellers of a product. The number of firms is too large that the share of individual firm
in the total supply of a product is very small. Therefore, no single seller can influence the market
price by changing the quantity supply. (Similarly, the number of buyers is so large that the share

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of each buyer in the total demand is very small). Therefore, in such a market structure, sellers
and buyers are not price makers. Under perfect market individual firm is a price taker (not price
maker). A firm has no power to determine or change the price of its product. Price of a product is
determined by the market through the interaction of market supply and demand forces.

Price Price
DD SS

Pe Pe Demand Curve
P = AR = DD

0 Qe Quantity 0 Q

a) The market Equilibrium b) Demand curve of a firm

Fig 4.1: Market equilibrium; and demand curve of a firm in perfect market

Qd =Q s

2. Homogeneous product: - the product supplies by firms in the market supply a homogenous or
identical product. Homogeneity of product implies the product of one firm can’t be
distinguished from products of other firms in the market. For buyers products supplied by the
various firms of an industry are identical; they can’t make distinction between products supplied
different firms in the market or in the given industry.

Product of each firm is regarded as a perfect substitute for the products of other firms in the
industry/market. Therefore, no firm can gain any competitive advantage over the other firm.

3. Perfect mobility of factors of production: - there is no restriction in flows of factors or

inputs from place to place or from one industry to another. Factors of production are free to
move from one firm to another throughout the economy. This means that labor can move from
one job to another and from one region to another. Capital, raw materials, and other factors are
not monopolized.

4. Free entry and exit; there are no restrictions or market barriers on entry of new firms to a
given industry or for exit/leaving from an industry. A firm may enter the industry or quit/leave it
on its accord. There are no costs to be incurred for leaving from or entering into an industry.

5. Existence of Perfect knowledge/ information:- there is perfect information and knowledge

about the market conditions such as: supply , demand , prices , technology, etc. All the buyers
and sellers have full information regarding the prevailing and future prices and other relevant
market conditions. These information are freely available to all economic agents in the given

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markets, and at no cost – information is free! There are no costs of information to be incurred by
individual agent.

There are no advertisement/promotion cots because no need for advertising a product under
perfect market by individual firm; no marketing research, no cost for research and development
(costs advanced for technological), no licensing costs, etc.

6. No government interference: a perfectly competitive market is free from any form of

government interventions and manipulations. Government does not interfere in any way with the
functioning of the market. There are no discriminator taxes or subsidies, no licensing, no
allocation of inputs by the procurement, or any kind of direct or indirect control. That is, the
government follows the free enterprise policy.

5.1.1 Demand curve, Price, Average revenue (AR) and Marginal revenue (MR) of an
individual firm

We have seen that a perfectly competitive firm faces a horizontal demand curve for its product.
This has a number of implications;

 A perfectly competitive firm can’t affect the market price by changing its output. A firm is
simply a price - taker not price – maker, it simply accept the market price.

 A firm has no market power, all firms have equal market power, ie, is zero.

 Price, AR and MR of a firm are always equal under prefect market; P=MR= AR .

R P ×Q
AR= = =P ,
Q Q

dR d ( P ×Q ) dQ
MR = = = P× =P ; then, P = AR =MR
dQ dQ dQ

 From this we can conclude that the demand curve of individual firm under perfect is also the
AR and the MR curves. Given P is a market price

Price

Pe Pe = AR =MR = DD curve

0 Q
4.1 Demand, AR and MR curve of a perfectly competitive firm

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 A horizontal demand curve also shows, the price elasticity of demand for a competitive firm is
perfectly elastic; Ed = ∞.
 The response is so high that for slight change in price, TR of the firm will become zero.( its
total sale becomes zero).

5.2.1 Short Run Equilibrium of a Firm under perfect market

A) Equilibrium of a firm - A profit maximizing firm is in equilibrium at the level of MC equal

to MR (the marginal approach). And short – run equilibrium is based on the following
assumptions

 there are both fixed and variable inputs

 Prices are constant ( of inputs and output)
 There are two approaches of profit maximization; Total cost and total revenue approach
or marginal cost and Marginal revenue Approach.

i) Total Cost and Revenue Approach: according to this approach profit is maximized when
the vertical difference between total revenue (TR) and total cost (TC) is the largest:

π = TR - TC ;
Where, π = profit, TR = P x Q;, TC = Total cost, P = price of output, Q = quantity of output. It
can be shown graphically by assuming linear total revenue function as follows;
In the figure, at points A & C ,TR = TC and π = 0.
TR, TC, TC

C In between points A & C , TR >TC , and π >0 .

TR
At point B the firm maximizes its profit at the output Qe,
R where the vertical distance between TR and TC curves is the

A B widest. At output levels below Qa and greater than Qb, π < 0

and the firm incurs loss.
Profit curve
0 Qa Qe Qb Q

Simply taking points A, B and C, the profit curve drawn as follows

profit
Point B denotes the maximum total
B profit curve profit that corresponds with Qe units
of output.

Qa Qe Qb Q

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Handout, micro economics , Econ By Fetiya N.

Fig 4.3: The total approach of profit maximization

ii) The marginal Approach: Marginal Cost (MC) and Marginal Revenue (MR).

According to this approach, the profit maximizing level of output / equilibrium output of a firm
is determined based on its marginal revenue and marginal cost functions, given other things
being constant, such as prices. That is , any rational firm a produces an output level where at
least its MR is equal to its MC.

At equilibrium, a firm could maximize profit or minimizes its loss or earn zero profit by
producing that level of output where the following conditions are fulfilled;

 The first order condition (F.O.C); MR = MC. It is basic equilibrium condition where the
firm determines profit maximizing level of output for a given market price.

MR=MC ; But, MR=dTR /dQ and MC=dTC /dQ

Hence, dTR /dQ=dTC /dQ

Price Price of a commodity is fixed by the market forces in a

perfectly competitive market, individual firm has horizontal
demand curve as shown.
MC
As shown by the line Pe = MR and also Pe =MR= AR - all
Pe E are equal in perfect market.

At point E the equilibrium condition is satisfied; MR =MC; it

also implies that; Pe=MR=MC =AR , at point E .
0 Qe Q
Qe - is the equilibrium level of output – it is a best or most
preferred level output a firm can produce given its MC
4.4 Short run Equilibrium of a firm

It can be seen in the figure below that MC curve intersect the P = MR line at point E, from
below, where MC = MR a perpendicular drawn from point E to the output axis determines the
equilibrium output at Qe. It can be seen in the figure that output Qe meets both the first and the
second order condition of profit maximization.

5.1.3 The Level Total Profit (π), Equilibrium of a Firm, Price and AC

In the short run, equilibrium of a firm doesn’t necessarily tell us the level of profit the firm is
earning. The equilibrium condition, MR = MC, only tell us how much a firm has to produce or it
is the determination of the best possible level of output given the circumstances – of prices and
cost conditions - a firm faced. MC OF a firm doesn’t help to know the total profit.

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In the short run, total profit of a firm depends on AC of production relative to market price of
the product. Accordingly, the total profit (π) of the firm could be positive, zero or negative at
equilibrium based on the AC of the firm relative to price. Observe the following relationship
between P & AC of a competitive firm

π=TR – TC =( AR)×Q−Q× AC

[Because:TR=Q×(TR /Q)=Q × AR , and TC =Q ×(TC / Q)=Q× AC ]

Since under perfect market P= AR , then π=( P ×Q ) −(Q × AC)=Q ×( P – AC )

Thus;
 if market price is greater than average cost, P > AC , then profit is positive π > 0 ,

 if P = AC , then π = 0 , it said the firm is at break- even ( TR = TC)

 if P < AC , then profit is negative or the firm is at loss , π < 0

 if P = AVC , then TR = TC , profit is negative or the of the firm equal to its FC amount. In other
words, the firm can only its variable costs. The firm is said to be at shut- down point. For a price
below its AVC a firm can’t produce, it will leave the market.

These cases are shown graphically below.

Case 1 – when market price greater than AC ( P > AC , π > 0)

As shown in the fig below, the firm is in equilibrium at point E, where the condition is satisfied
(MR = MC) with P> AC ; thus, π >0; the firm will earn positive profit.

π=TR – TC =( AR)×Q−Q× AC , since under perfect market P = AR, then

π=P ×Q – Q × AC =Q( P – AC), thus, π > 0 if P > AC

Output level Qe is, therefore, profit maximizer, or called equilibrium output level. At this output,
the firm is at equilibrium and is making positive profit. Firm’s maximum total profit is shown by
the area of a rectangle, PeERA.

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Price (P) SMC At point E , the equilibrium condition is

SAC satisfied; MC=MR=P e ; Since Pe > AC ,
the earn abnormal or positive profit , shaded
Pe E P = MR region.

0 Qe output (Q)
Fig 4.5: Super normal profit in the short run Equilibrium

Case 2 – when P = AC ; π = 0 ( break –even point)

In the short run, a firm may not always earn abnormal/positive profit. if the firm at equilibrium
with if its short run average cost (SAC) is equal to price. The equilibrium condition is MR = MC
which satisfied at point E with output, Qe. The SAC curve is also tangent to P = MR line, at this
point, where P = SAC. Thus, the firm makes normal profit/zero profit. Note that at point E :
P=MR=SMC=SAC =AR∧π =0

Price SAC

SMC Note that at point E; TR = TC and π = 0

Pe E Pe = MR = AR and called break - even point.

The firm operates at minimum AC, at

point E, produce Qe units of output.

0 Qe output, Q
Fig 4.6: A firm earning normal/ zero profit in the short run

Case 3 - when P < AC and π < 0 ; When market price is less than average cost

If AC is above the price or if a firm at equilibrium where P < AC, the firm incurs losses in the
short run (π < 0). It is shown graphically as follows.
Given Pe is market price; at point E, equilibrium
condition is satisfied ; Pe =MC=MR ; But AC > Pe

Thus, the firm is at equilibrium with negative profit, π <

0.

The total loss the firm is shown by the shaded area of the

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Price
MC AC
B E’
Loss
Pe E

0. Qe output

Fig 4.7: A firm at equilibrium with negative profit (or incurring loss)

Shut –down or close – down point: where market price is equal AVC of the firm

In case a firm is making loss it must cover its short run average variable cost (SAVC). A firm
unable to cover its minimum AVC will have to close down. The MC/MR intersects AVC at its
minimum level as shown in the figure below.
In the fig below, Point E denotes the “shut –down point” because at any price below Pe, better
if firms to close down as it minimizes its loss. But production at point E, the firm at least covers
its VC; and its total loss equal to FC amount.
Price
Given Market price is Pe ; at point E:
MC=MR=Pe - Equilibrium condition
MC
AC Pe = AVC, Hence, the firm is at shut- down.
AC AVC Note that at point E, TR=VC ¿ Loss=FC .
loss = FC
Pe E P=MR Loss=TR – ( FC +VC )=TR – FC – VC ;

Since TR = VC, Then; Loss = FC amount

0 Qe
Fig 4.8: the shut down point

Take Numerical examples. ?

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ii. Equilibrium of an industry/ the market

An industry is in equilibrium in the short-run when market is cleared at a given price i.e. when
the total supply of the industry equals the total demand for its product, the prices at which market
is cleared is the equilibrium price. The equilibrium purely determined by the interaction of the
market demand and supply.

Price
Point E is equilibrium point where the
market demand, DD and the market,
DD SS
SS are equal;

Pe E DD = SS = Qe
Pe is the market equilibrium price
determined by interaction of market

Qe Q
Fig 4.10: the market equilibrium

The industry demand curve and supply curve intersect at point E determining equilibrium price,
Pe and output Qe. In short run equilibrium of the industry, some individual firms may make pure
profit, some normal profits and some may make even losses depending on their cost and revenue
conditions, as we will discuss in the next sub-topic, this situation will however not continue in
the long-run.

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