HSS-01: Economics Lesson: 01

Introduction
Preliminaries, Basics of Demand & Supply
1. PRELIMINARIES
 Why (Micro)economics?
• Understand how individuals make decisions
• Understand how corporations and businesses make decisions
• Understand how markets (consumers, producers, quantities, prices) function
• Better insight into public policy decisions
• A gateway to better understand the underlying processes of macroeconomic
phenomena
• We are a part of the financial economy. B. Tech students also! Being aware about
some basics always helps.
 Themes of Microeconomics
• Consumers
• Workers
• Investments & Savings
• Firms
• Prices
• Assumptions; Positive vs. Normative Analysis
 A Market
• A market is a collection of buyers and sellers that, through their actual or
potential interactions, determine the price of a product or set of products
• Arbitrage is the practice of buying at a low price at one location and selling
at a higher price in another
• Market with many buyers and sellers, so that no single buyer or seller has a
significant impact on price is called a perfectly competitive market
 Prices – Real vs. Nominal
• Nominal price is the absolute price of a good, unadjusted for inflation
• Real price of a good is its price relative to an aggregate measure of prices.
Hence real price has been adjusted for inflation
• Consumer Price Index (CPI) is a measure of the aggregate price level
• Producer Price Index (PPI) is a measure of the aggregate price level for
intermediate products and wholesale goods
2. BASICS OF SUPPLY & DEMAND
 Supply Curve
Relationship between the quantity of a good
that producers are willing to sell and the price
of the good.

The supply curve, labeled S in the figure,

shows how the quantity of a good offered for
sale changes as the price of the good changes.
The supply curve is upward sloping: The
higher the price, the more firms are able and
willing to produce and sell.
If production costs fall, firms can produce
the same quantity at a lower price or a larger
quantity at the same price. The supply curve
then shifts to the right (from S to S).
Demand Curve
Relationship between the quantity of a good
that consumers are willing to buy and the
price of the good.
The demand curve, labelled D, is downward
sloping; holding other things equal,
consumers will want to purchase more of a
good as its price goes down.
The quantity demanded may also depend on
other variables, such as income, the weather,
and the prices of other goods. For most
products, the quantity demanded increases
when income rises. A higher income level
shifts the demand curve to the right (from D
to D).
 Types of Goods

SUBSTITUTES COMPLIMENTS
• Two goods for which an increase in the price of one • Two goods for which an increase in the price of one
leads to an increase in the quantity demanded of the leads to a decrease in the quantity demanded of the
other. other.
• e.g. – chicken and mutton • e.g. – hardware and software
 Market
Equilibrium
The market clears at price P_0 and quantity
Q_0.

Tendency in a free market for price to

change until the market clears.

At the higher price P_1, a surplus develops,

so price falls. At the lower price P_2, there is
a shortage, so price is bid up.
Changes in Market Equilibrium
Long Run Market Conditions for Copper
Price Elasticity
 Price Elasticity of Demand

Linear Demand Curve Infinitely Elastic Demand Inelastic Demand

 Other Elasticities

Income Elasticity of Demand Cross-price Elasticity of Demand

 • Year 1981
• Supply curve of wheat: QS = 1800 + 240P
The Market for Wheat • Demand curve: QD = 3550 – 266P
• P and Q represent price and quantity respectively
The price of wheat fluctuates in response to the
weather and changes in export demand.
• Find the market equilibrium of wheat, i.e., the market-clearing
price and quantity of wheat.
• Find the price elasticity of demand at equilibrium.

• Ans: P = 3.46, Q = 2630; EDP = - 0.35

 The Market for Wheat

The price of wheat fluctuates in response to the

weather and changes in export demand.

See Example 2.5 for the calculations of market

equilibrium (price, quantity) and elasticities..
Price elasticities
of Demand
(a) In the short run, an increase in price has
only a small effect on the quantity of
gasoline demanded. In the longer run,
however, because they will shift to smaller
and more fuel-efficient cars, the effect of the
price increase will be larger. Demand,
therefore, is more elastic in the long run. (b)
The opposite is true for automobile
(durable) demand. If price increases,
consumers initially defer buying new cars;
thus annual quantity demanded falls sharply.
In the longer run, however, old cars wear out
and must be replaced; thus annual quantity
demanded picks up. Demand, therefore, is
less elastic in the long run than in the short
run.
 Cyclical
Industries
Because the demands for durable goods
fluctuate so sharply in response to short-run
changes in income, the industries that
produce these goods are quite vulnerable to
changing macroeconomic conditions, and
in particular to the business cycle—recessions
and booms.
Thus, these industries are often called
cyclical industries—their sales patterns tend
to magnify cyclical changes in gross domestic
product (GDP) and national income.
Price elasticities
of Supply
Like that of most goods, the supply of
primary copper, shown in part (a), is more
elastic in the long run. If price increases,
firms would like to produce more but are
limited by capacity constraints in the short
run. In the longer run, they can add to
capacity and produce more. Part (b) shows
supply curves for secondary copper. If the
price increases, there is a greater incentive to
convert scrap copper into new supply.
Initially, therefore, secondary supply (i.e.,
supply from scrap) increases sharply. But
later, as the stock of scrap falls, secondary
supply contracts. Secondary supply is
therefore less elastic in the long run than in
the short run.
 Government
Interventions
Without price controls, the market clears at
the equilibrium price and quantity P_0 and
Q_0.

If price is regulated (by government for

e.g.) to be no higher than Pmax, the quantity
supplied falls to Q_1, the quantity demanded
increases to Q_2, and a shortage develops.
HSS-01: Economics Lesson: 02

Consumer Behavior
Consumer Preferences, Budget Constraints, Consumer Choice,
Revealed Preference, Marginal Utility
 • Price of cloth is $2 per unit.
• Price of food is $1 per unit.

Shopping Time

You are at a supermarket to buy some food and • You’ve got $80 in your wallet.
clothes.
• You want to spend this amount for food and clothes
only.

• How many units of cloth and food will YOU buy?

 • Did you choose quantities C and F such that
$2 x C + $1 x F = $80
Shopping Time

You are at a supermarket to buy some food and

clothes.
• Why are your choices different?

• What is the best or the most ideal basket (C, F) to

choose?
 Theory of Consumer Behavior

Description of how consumers allocate incomes among different goods

and services to maximize their wellbeing.

Rational models
More realistic models – behavioral economics
3.1. CONSUMER PREFERENCES
Preferences for Baskets of Goods
Assumptions of
Consumer Theory
• Completeness
• Transitivity
• More is better than less
 Indifference
Curve
All combinations of market baskets
that provide a consumer with the
same level of satisfaction.

The indifference curve U1 that passes

through market basket A shows all baskets
that give the consumer the same level of
satisfaction as does market basket A; these
include baskets B and D.
Our consumer prefers basket E, which lies
above U1, to A, but prefers A to H or G,
which lie below U1.
 Indifference
Maps
A set of indifference curves
showing the market baskets among
which a consumer is indifferent.

Indifference curves can

not intersect.
Shape of Indifference Curves
The MRS of food F for clothing C is the
maximum amount of clothing that a
person is willing to give up to obtain one
additional unit of food.

• −∆C/∆F
• Diminishing marginal rate of
substitution (MRS)
• an indifference curve is convex if
the MRS diminishes along the curve
Shape of Indifference Curves
 Comparing
Indifference Curves -
Utility
Utility is a numerical score
representing the satisfaction
that a consumer gets from a
given market basket.
Utility function assigns a level
of utility to each market basket.
• Ordinal vs. Cardinal
function
Indifference curve is an
isoutility curve.
3.2. BUDGET CONSTRAINTS
 Budget Line

A budget line describes the

combinations of goods that can be
purchased given the consumer’s
income and the prices of the goods.
Line AG (which passes through points
B, D, and E) shows the budget
associated with an income of $80, a
price of food of PF = $1 per unit, and a
price of clothing of PC = $2 per unit.
The slope of the budget line (measured
between points B and D) is –PF/PC = -
10/20 = -1/2.
Effects of Changes in Income and Price
on the Budget Line
3.3. CONSUMER CHOICE
 How do (rational) consumers choose
a market basket?

Consumers see goods in the market, and have money in the pocket.

A particular consumer therefore chooses a basket

 located on the budget line
 with the highest preference (highest utility)
MRS = − ∆C/∆F = PF/PC = 1/2 Maximize
Utility
A consumer maximizes satisfaction by
choosing market basket A.
At this point, the budget line and
indifference curve U2 are tangent, and no
higher level of satisfaction (e.g., market
basket D) can be attained.
At A, the point of maximization, the MRS
between the two goods equals the price ratio.
At B, however, because the MRS [-(-10/10)
= 1] is greater than the price ratio (1/2),
satisfaction is not maximized.
MRS = − ∆C/∆F = PF/PC = 1/2 Maximize
Utility
Satisfaction is maximized when the marginal
rate of substitution (of F for C) is equal to the
ratio of the prices (of F to C).

Satisfaction is maximized when the

marginal benefit—the benefit associated
with the consumption of one additional
unit of food—is equal to the marginal
cost—the cost of the additional unit of
food. The marginal benefit is measured by
the MRS.
Corner Solution! Maximize
Utility
Satisfaction is maximized when the marginal
rate of substitution (of F for C) is equal to the
ratio of the prices (of F to C). But not always!

If the MRS of ice cream for frozen yogurt is

substantially greater than the price ratio, as in the
Figure on left, then a small decrease in the price of
frozen yogurt will not alter the consumer’s choice;
he will still choose to consume only ice cream. But
if the price of frozen yogurt falls far enough,
the consumer could quickly choose to
consume a lot of frozen yogurt.
3.4. REVEALED PREFERENCE
Infer Preferences
post Choices
If an individual facing budget line I1
chose market basket A rather than
market basket B, A is revealed to be
preferred to B.
Likewise, the individual facing budget
line I2 chooses market basket B, which is
then revealed to be preferred to market
basket D.
Whereas A is preferred to all market
baskets in the green-shaded area, all
baskets in the pink-shaded area are
preferred to A.
 Inferring Preferences
– An Example

When facing budget line I1, an

individual chooses to use a health club
for 10 hours per week at point A.

When the fees are altered, she faces

budget line I2. She is then made better
off because market basket A can still be
purchased, as can market basket B,
which lies on a higher indifference
curve.
3.5. MARGINAL UTILITY
 Diminishing Marginal Utility

MARGINAL UTILITY (MU)

• Additional satisfaction obtained from
consuming one additional unit of a good.

DIMINISHING MU
• Principle that as more of a good is
consumed, the consumption of additional
amounts will yield smaller additions to
utility.
Marginal Utility & Consumer Choice

MUF ∆F + MUC(∆C) = 0
 MUF
= −
∆C
MUC ∆F
MRS = − ∆ C / ∆ F 
= PF / PC
MUF MUC
=
PF PC

Equal Marginal Principle

 Rationing &
The Poor Lady
When a good is rationed, less is available
than consumers would like to buy.
Consumers may be worse off.
Without gasoline rationing, up to 20,000
gallons of gasoline are available for
consumption (at point B).
The consumer, a lady, chooses point C on
indifference curve U2, consuming 5000
gallons of gasoline.
However, with a limit of 2000 gallons of
gasoline under rationing (at point E), the
consumer moves to D on the lower
indifference curve U1.
 Rationing &
The Free Market
Some consumers will be worse off, but others
may be better off with rationing.
With rationing and a gasoline price of $1.00
she buys the maximum allowable 2000
gallons per year, putting her on indifference
curve U1.
Had the competitive market price been $2.00
per gallon with no rationing, she would have
chosen point F, which lies below indifference
curve U1.
However, had the price of gasoline been only
$1.33 per gallon, she would have chosen
point G, which lies above indifference curve
U1.
HSS-01: Economics Lesson: 03

Individual & Market Demand

Individual Demand, Income Effect, Substitution Effect, Market
Demand, Consumer Surplus
 • Domestic demand for wheat: QDD = 1430 - 55P
The Demand for Wheat
• International demand for wheat: QDI = 1470 - 70P
The demand for wheat produced in U.S. varies • P and Q represent price and quantity respectively
with changes in price of wheat.

• What is the price elasticity of demand for wheat?

• What is the income elasticity of demand for wheat? (Any guess?)
4.1. INDIVIDUAL DEMAND
 Individual Demand Curve
Curve relating the quantity of a good that a single (or a particular) consumer will buy to its price.

• Assume a basket of clothes and food.

 The level of utility that can be attained changes as we move along the demand curve.
 At every point on the demand curve, the consumer is maximizing utility by satisfying
the condition that the marginal rate of substitution (MRS) of food for clothing equals
the ratio of the prices of food and clothing.
 “NORMAL”
GOOD

Effect of
Price Changes
A reduction in the price of food, with
income and the price of clothing
fixed, causes this consumer to choose
a different market basket. In (a), the
baskets that maximize utility for
various prices of food (point A, $2;
B, $1; D, $0.50) trace out the price-
consumption curve. Part (b) gives the
demand curve, which relates the price
of food to the quantity demanded. Note that changes
(Points E, G, and H correspond to happen along the
demand curve
points A, B, and D, respectively).
 “NORMAL”
GOOD

Effect of
Income Changes
An increase in income, with the
prices of all goods fixed, causes
consumers to alter their choice of
market baskets. In part (a), the
baskets that maximize consumer
satisfaction for various incomes
(point A, $10; B, $20; D, $30) trace
out the income-consumption curve.
The shift to the right of the demand
curve in response to the increases in Note that the
income is shown in part (b). (Points demand curve
shifts
E, G, and H correspond to points A,
B, and D, respectively.)
 INFERIOR
GOOD

Effect of
Income Changes
for
Inferior Goods
quantity demanded falls as
income increases (~ price fall)

An increase in a person’s income can

lead to less consumption of one of
the two goods being purchased. Here,
hamburger, though a normal good
between A and B, becomes an
inferior good when the income-
consumption curve bends backward
between B and C.
 Engel Curves
Curve relating the quantity of a good consumed to income
4.2. INCOME &
SUBSTITUTION EFFECTS
Decomposition of individual demand into two underlying components
 Income and Substitution Effects
Effect of a price change can be seen as having two underlying mechanisms.

• A fall in the price of a good has two (simultaneous) effects:

• SUBSTITUTION EFFECT: Holding utility level fixed, consumers will tend to buy more of the
good that has become cheaper and less of those goods that are now relatively more expensive.

• INCOME EFFECT: Relative prices held constant, because one of the goods is now cheaper,
consumers enjoy an increase in real purchasing power. So they will buy more of all goods.
Note that the demand curve (P-Q) Income and
for food is downward sloping.
Substitution Effects
NORMAL GOOD

A decrease in the price of food has both an

income effect and a substitution effect. The
consumer is initially at A, on budget line RS.
When the price of food falls, consumption
increases by F1F2 as the consumer moves to
B. The substitution effect F1E (associated
with a move from A to D) changes the
relative prices of food and clothing but keeps
real income (satisfaction) constant. The
income effect EF2 (associated with a move
from D to B) keeps relative prices constant
but increases purchasing power. Food is a
normal good because the income effect EF2
is positive.
Note that the demand curve (P-Q) Income and
for food is downward sloping,
still… Substitution Effects
INFERIOR GOOD

The consumer is initially at A on budget line

RS. With a decrease in the price of food, the
consumer moves to B. The resulting change
in food purchased can be broken down into a
substitution effect, F1E (associated with a
move from A to D), and an income effect,
EF2 (associated with a move from D to B). In
this case, food is an inferior good because the
income effect is negative.
However, because the substitution effect
exceeds the income effect, the decrease in the
price of food leads to an increase in the
quantity of food demanded.
 … but not anymore. Income and
In this case, the demand curve for
food (P-Q) is upward sloping. Substitution Effects
GIFFEN GOOD

When food is an inferior good, and when

the income effect is large enough to
dominate the substitution effect, the
demand curve will be upward-sloping.
The consumer is initially at point A, but, after
the price of food falls, moves to B and
consumes less food.
Because the income effect EF2 is larger than
the substitution effect F1E, the decrease in
the price of food leads to a lower quantity of
food demanded.
4.3. MARKET DEMAND
From Individual to
Market Demand
The market demand curve is obtained
by summing our three consumers’
demand curves DA, DB, and DC.
At each price, the quantity of coffee
demanded by the market is the sum of
the quantities demanded by each
consumer.
At a price of $4, for example, the
quantity demanded by the market (11
units) is the sum of the quantity
demanded by A (no units), B (4 units),
and C (7 units).
 Notes on Market Demand

• The market demand curve will shift to the right as more consumers enter the market.

• Factors that influence the demands of many consumers will also affect market demand.
Isoelastic Demand
Curve
Demand curve with a constant
price elasticity

The figure shows a unit-elastic

demand curve.
When the price elasticity of
demand is -1.0 at every price, the
total expenditure is constant along
the demand curve D.
Price Elasticity and Consumer Expenditures
4.4. CONSUMER SURPLUS
 Note that this is a case shown for
an individual demand curve (P-Q). Consumer Surplus

Difference between what a

consumer is willing to pay for a
good and the amount actually
paid (market price)

Here, the consumer surplus

associated with six concert tickets
(purchased at $14 per ticket) is
given by the yellow-shaded area.
Note that this is the total surplus
for all consumers in the market.
Consumer Surplus
Generalized

For the market as a whole,

consumer surplus is measured by
the area under the demand curve
and above the line representing the
purchase price of the good.
Here, the consumer surplus is given
by the yellow-shaded triangle and is
equal to 1/2 * ($20 - $14) * 6500 =
$19,500.
HSS-01: Economics Lesson: 04

Production
Production Decisions, Variable Inputs, Returns to Scale, Costs
in Short & Long Run, Economies of Scope
6.1. PRODUCTION DECISIONS
 The Real Role of a Firm
You and me, if we have enough time, can also build a house, isn’t it? At least a very small one…
We can convert inputs into output, isn’t it? Why do we need a firm/company?

• Benefits of a firm

 Organizational efficiency – machines, workers, managers

 Large scale process automation – factories (More than sum of the parts.)

A natural extension of you and me working together… As we grow, we become a small scale firm, then a
medium scale firm, and finally a large enterprise.
 Factors of production • Land
• Capital
Production (in a firm) is done in a way to minimize
the costs of production.
• Labour
• Inputs (e.g., natural resources)

• Technology – efficiency of transforming inputs to output

Since a firm wants to minimize the costs of production,
why do you think they would pay you more for your job?

You would ideally expect that, isn’t it?

 Production Function of a Firm
The highest output q that a firm can produce for every specified combination of inputs.

q = F (K, L)

 K = capital
 L = labour

Imagine that the function F() is applied on a given set of inputs/materials to produce output.
In above equation, technology is assumed to be a constant.
 Short Run vs. Long Run
You take time to learn how to write an essay. A firm takes time to learn to minimize costs.

• Short run: Period of time in which quantities of one or more production factors cannot be
changed. At least one factor (fixed input) that cannot be varied.
• Long run: Amount of time needed to make all production inputs variable.

In the short run, firms vary the intensity with which they utilize a given plant and machinery; in the long run, they vary
the size of the plant.
All fixed inputs in the short run represent the outcomes of previous long-run decisions based on estimates of what a
firm could profitably produce and sell.
6.2. PRODUCTION WITH ONE
VARIABLE INPUT (LABOR)
 One Variable
Input -- Labor
Average output = q/L
Marginal output = Δq/ΔL

Once the labor input exceeds 9

units (point C), the marginal
product becomes negative, so that
total output falls as more labor is
added.

But why?
 Law of Diminishing
Marginal Returns

As the use of an input increases

with other inputs fixed, the
resulting additions to output
will eventually decrease.

This holds irrespective of the

quality/productivity of labor.
 Labor Productivity
Average product of labor for an entire industry or for the economy as a whole.

• Determines the real standard of living in an economy (e.g., a country).

• Income as a producer is spent to purchase items, as a consumer.
• Consumers, in aggregate economy, can increase consumption by increasing production.
• Sources of growth in labor productivity
• Stock of capital – amount of capital available for use in production.
• Technological change -- development of new technologies that allow labor (and other factors of
production) to be used more effectively
What about AI?
6.3. PRODUCTION WITH TWO
VARIABLE INPUTS (LABOR)
 Production
Isoquants
Diminishing
Marginal Returns
Production isoquants show the
various combinations of inputs
necessary for the firm to produce a
given output. A set of isoquants, or
isoquant map, describes the firm’s
production function. Output
increases as we move from
isoquant q1 (at which 55 units per
year are produced at points such as
A and D), to isoquant q2 (75 units
per year at points such as B), and to
isoquant q3 (90 units per year).
 Marginal Rate of
- ΔK /ΔL
Technical Substitution

Isoquants are downward sloping

and convex.
The slope of the isoquant at any
point measures the marginal rate of
technical substitution (MTRS)—the
ability of the firm to replace capital
with labor while keeping the same
level of output.
On isoquant q2, the MRTS falls
from 2 to 1 to 2/3 to 1/3.
 Substitution among Inputs
The marginal rate of technical substitution between two inputs is equal to the ratio of the marginal
products of the inputs.

• Along an isoquant, we have:

(MPL)(ΔL) + (MPK)(ΔK) = 0

• and on rearranging, we get:

MRTS = MPL / MPK
Special Cases of Production Functions
PERFECT FIXED
SUBSTITUTES PROPORTIONS
6.4. RETURNS TO SCALE
 Returns to Scale –
Increasing/Decreasing/Constant
Rate at which output increases as inputs are increased proportionately.

CONSTANT INCREASING
7.1. MEASURING COST
 Various Types of Costs
• Accounting cost = just note down the transactions of assets and liabilities (upto now)
• Economic cost = overall costs (upto now + future)
• Opportunity cost = cost of best alternative opportunity
• Sunk cost = cost/expenditure that can not be recovered in future (no alternative use)
• Fixed cost FC = cost that does not vary with the level of production output
• Variable cost VC = cost that varies with level of output
• Total cost TC = fixed cost + variable cost
 Cost Calculations
• Marginal cost MC =
• Increase in cost resulting from the production of one extra unit of output
• ΔTC / Δq = ΔVC / Δq
• Average total cost ATC = TC / q
• Average fixed cost AFC = FC / q
• Average variable cost AVC = VC / q
7.2. COST IN THE SHORT RUN
 Nature of Marginal Cost
• When there are diminishing marginal returns, marginal cost will increase as output increases.

• If the marginal product of labor decreases only slightly as the amount of labor is increased,
costs will not rise so quickly when the rate of output is increased.

• Suppose labor is hired at a fixed wage w (in a competitive market). Then

MC = w ΔL / Δq = w / MPL
 Cost Curves
for a Firm
In (a) total cost TC is the vertical
sum of fixed cost FC and variable
cost VC.

In (b) average total cost ATC is the

sum of average variable cost AVC
and average fixed cost AFC.

Marginal cost MC crosses the

average variable cost and average
total cost curves at their minimum
points.
7.3. COST IN THE LONG RUN
 Cost Minimizing Input Choice

 Price of Capital
• Capital expenditure per year (a flow measure), also called user cost of capital
r = Depreciation rate + Interest rate.

 Rental Rate of Capital

• Cost per year of renting one unit of capital
• Capital that is purchased can be treated as though it were rented at a rental rate equal to the user
cost of capital
 Isocost Line
Graph showing all possible combinations of labor and capital that can be purchased for a given total cost

• C = w L + r K => K = C/r - (w/r) L

Δ K / Δ L = - (w / r )

• If the firm gave up a unit of labor (and recovered w dollars in cost) to buy w/r units of capital at a cost
of r dollars per unit, its total cost of production would remain the same.
 Isocost Line & Production

• Since MRTS = - ΔK / ΔL = MPL / MPK we have :

MPL / w = MPK / r

• For a a cost-minimizing firm, additional output that results from spending an additional dollar for
labor is the same as that of spending for capital.
 Producing Output
at Minimum Cost
Isocost curve C1 is tangent to
isoquant q1 at A and shows that
output q1 can be produced at
minimum cost with labor input L1 and
capital input K1.
Other input combinations—L2, K2
and L3, K3 — yield the same output
but at higher cost.
Input Substitution as
Input Price Changes
Facing an isocost curve C1, the firm
produces output q1 at point A using
L1 units of labor and K1 units of
capital.
When the price of labor increases, the
isocost curves become steeper.
Output q1 is now produced at point B
on isocost curve C2 by using L2 units
of labor and K2 units of capital.
 Expansion Path
Combinations of labor and capital that the firm will choose to minimize costs at each output level.

 The curve passing through the points of tangency between

 the firm’s isocost lines, and
 its isoquants.

 As long as the use of both labor and capital increases with output, the curve will be upward sloping.
.
 passes through points
of tangency between a
Cost Minimization firm’s isocost lines and
its isoquants

with Varying Output

In (a), the expansion path (from
the origin through points A, B, and
C ) illustrates the lowest-cost
combinations of labor and capital
that can be used to produce each
level of output in the long run—
i.e., when both inputs to
production can be varied.

In (b), the corresponding long-run

total cost curve (from the origin
through points D, E, and F)
measures the least cost of
producing each level of output.
7.4. LONG RUN vs. SHORT RUN
 Inflexibility in
Short Run
When a firm operates in the short run, its
cost of production may not be minimized
because of inflexibility in the use of capital
inputs.
Output is initially at level q1. In the short
run, output q2 can be produced only by
increasing labor from L1 to L3 because
capital is fixed at K1.
In the long run, the same output can be
produced more cheaply by increasing labor
from L1 to L2 and capital from K1 to K2.
 Long Run Costs –
Average, Marginal
When a firm is producing at an output
at which the long-run average cost
LAC is falling, the long-run marginal
cost LMC is less than LAC.
Conversely, when LAC is increasing,
LMC is greater than LAC.
The two curves intersect at A, where
the LAC curve achieves its minimum.
 Economies of Scale
Situation in which output can be doubled for less than a doubling of cost.

 Some cases in which costs decreases:

• If the firm operates on a larger scale, workers can specialize in the activities at which they are most productive.
• The firm may be able to acquire some production inputs at lower cost because it is buying them in large quantities and
can therefore negotiate better prices.

 Some cases in which costs increases:

• At least in the short run, factory space and machinery may make it more difficult for workers to do their jobs
effectively.
• Managing a larger firm may become more complex and inefficient as the number of tasks increases.
 Economies of Scale
Situation in which output can be doubled for less than a doubling of cost.

 vs. Returns to Scale

• Increasing returns to scale => Output more than doubles when the quantities of all inputs are doubled
• Economies of Scale => Output more than doubles even with less than a doubling of cost

• Basically, additional inputs obtained during doubling the total output comes at less cost.
• For e.g., technology can be used only when the input size is large (machines to milk cows).
 Economies of Scale
Measured using cost-output elasticity
EC = (ΔC/C) / (Δq/q) = MC / AC

EC = 1 => Neither economies nor diseconomies of scale

• Costs increase proportionately with output
• Constant returns to scale would apply if input proportions were fixed
EC < 1 => Economies of scale
• Costs increase less than proportionately with output
• Marginal cost is less than average cost (both are declining)
 Relationship btw.
Long & Short Run
Costs

Long-run Cost with Economies

and Diseconomies of Scale

The long-run average cost curve LAC is

the envelope of the short-run average
cost curves SAC1, SAC2, and SAC3.

With economies and diseconomies of

scale, the minimum points of the short-
run average cost curves do not lie on
the long-run average cost curve.
7.5. PRODUCTION WITH TWO
OUTPUTS
 Product Trans-
formation Curves
The product transformation curve
describes the different combinations
of two outputs that can be produced
with a fixed amount of production
inputs.
The product transformation curves
O1 and O2 are bowed out (or
concave) because there are
economies of scope in production.
 Economies of Scope
Situation in which joint output of a single firm is greater than output that could be achieved by two
different firms when each produces a single product.

 Degree of economies of scope

• Percentage of cost savings resulting when two or more products are produced jointly rather than individually.
COBB-DOUGLAS COST AND
PRODUCTION FUNCTIONS
 We have already seen
this. Please recall.

Inputs optimizing condition

MPL / w = MPK / r
 Cobb-Douglas Production Function

• q is the rate of output

q = F(K, L) = A Kα Lβ
• K is the quantity of capital
• L is the quantity of labor

• A, α, β are positive constants

• Assume α < 1, β < 1 so that MPL and MPK are decreasing
• α+β=1 => Firm has constant returns to scale
 Cobb-Douglas Production Function

• MPL = β A Kα Lβ-1
<= q = F(K, L) = A Kα Lβ
• MPK = α A Kα-1 Lβ

β 𝑟𝑟
• MPL / w = MPK / r => L = K
α 𝑤𝑤
 Cobb-Douglas Production Function

β 1
M
K = ( ) ( )
α 𝑤𝑤
β 𝑟𝑟
α+ β 𝑞𝑞
𝐴𝐴
α+ β
q = F(K, L) = A Kα Lβ

and similarly,
MPL / w = MPK / r α 1 L = β 𝑟𝑟 K
L =
α 𝑤𝑤 ( ) ( )
β 𝑟𝑟 α + β 𝑞𝑞
𝐴𝐴
α+ β
α 𝑤𝑤
Cobb-Douglas Production Function

β 1

K = ( ) ( )
α 𝑤𝑤
β 𝑟𝑟
α+ β 𝑞𝑞
𝐴𝐴
α+ β
What do these equations say?

Factor demands, given output!

How do K and L change when:

α 1

( ) ( )
β 𝑟𝑟 α+ β 𝑞𝑞 α+ β w increases?
L = r increases?
α 𝑤𝑤 𝐴𝐴
A increases?
Cobb-Douglas Production Function

β 1

K = ( ) ( )
α 𝑤𝑤
β 𝑟𝑟
α+ β 𝑞𝑞
𝐴𝐴
α+ β
C ( q, w, r) = w L + r K

The cost function.

Can you see that when α + β = 1,

α 1
the firm has has constant returns to scale?

L = ( ) ( )
β 𝑟𝑟
α 𝑤𝑤
α+ β 𝑞𝑞
𝐴𝐴
α+ β
What happens when α + β < 1?
HSS-01: Economics Lesson: 05

Output, Prices & Markets

Maximizing Profit, Choosing Output,
Supply Curve, Market Structure
 Till now, we studied how consumers make buying decisions. Whether one consumer buys a
certain product or not will hardly make a difference in the market. (In exceptional cases, it
could, but we can ignore it now.)

 However, decisions made by each supplier (of a given product) in the market usually
matters because suppliers are not “too many” like the consumers.

 Let’s see supplier’s decisions on price and output level, and how it depends on
market structure (supply-side).
8.1. PERFECTLY COMPETITIVE
MARKETS
Characteristics

 Price Taking

 Product Homogeneity

 Free Entry & Exit

 When Is a Market Highly Competitive?

 In real world, there is no way to judge absolutely whether a market is perfectly competitive or not.

• A market with many suppliers may be not competitive, while a market with a handful of
suppliers might be competitive. How?
8.2. PROFIT MAXIMIZATION
 Do Firms Maximize Profit?

 The assumption of profit-maximizing behavior of firms, used in microeconomics, is an

assumption.
 It makes models easy to be analyzed.

 How true is it in real scenarios?

 Small firms, vs. corporations, vs. cooperatives
 Alternative Forms of Organization

 Non-profit organizations
 Cooperatives: Association of businesses or people jointly owned and operated by members for
mutual benefit

For this course, we shall assume that profit maximization is a

reasonable assumption.
8.3. MARGINAL REVENUE & COST,
AND PROFIT MAXIMIZATION
 Profit Maximization in General
• Output: q
• Cost: C(q)
• Revenue: R(q) = p(q) x D(q)
• Profit: π(q) = R(q) – C(q)
• Marginal revenue and cost: partial derivatives of R and C w.r.t. q
• Profit-maximizing output level: MR(q) = MC(q)
Profit Maximization
in Short Run

A firm chooses output q*, so that

profit, the difference AB between
revenue R and cost C, is
maximized.
At that output, marginal revenue
(the slope of the revenue curve) is
equal to marginal cost (the slope of
the cost curve).
Demand Curve Faced by a Competitive Firm
Profit Maximization by a Competitive Firm
• Profit-maximizing output level: MR(q) = MC(q)
• MR(q) is independent of q for a firm in a competitive market
• MR(q) = MR = p

• So, choose q such that MC(q) = p

• Its a rule for setting output. Price is taken from the existing market.
• A very simple rule for the level of output.
8.4. CHOOSING OUTPUT IN THE
SHORT RUN
SHORT RUN

At least one of the factors of production is fixed.

Usually, a firm operates with a fixed amount of capital and

chooses the levels of its variable inputs (labor and materials).
 A Competitive
Firm making a
Positive Profit
In the short run, the competitive
firm maximizes its profit by
choosing an output q* at which its
marginal cost MC is equal to the
price P (or marginal revenue MR)
of its product.

The profit of the firm is measured

by the rectangle ABCD.

Any change in output, whether

lower at q1 or higher at q2, will lead
to lower profit.
 A Competitive
Firm making a
Negative Profit
A competitive firm should shut
down if price is below AVC.

The firm may produce in the

short run if price is greater than
average variable cost AVC.

At the profit-maximizing output q*,

the price P is less than average cost.
Line AB measures the average loss
from production. Likewise, the
rectangle ABCD now measures the
firm’s total loss.
 When should a firm shut down?

Suppose a firm is losing money. Should it shut down and leave the industry?

 Depends in part on the firm’s expectations about its future revenue.

 Conditions during market entry. Example: Reliance Jio (what if Jio was a startup?)
 Conditions for a well established firm. Example: A large bank
8.5. COMPETITIVE FIRM’S
SHORT-RUN SUPPLY CURVE
 A simple rule

 We saw that competitive firms will:

• increase output to the point at which price is equal to marginal cost, and
• shut down if price is below average variable cost

 So, firm’s supply curve is the portion of the marginal cost curve for which
MC > AVC

Remember that for a given price p, the firm chooses q such that MC(q) = p.
So given p, the level of q is fully determined.
price taking

A Competitive Firm’s
Short-run Supply Curve

In the short run, the firm chooses

its output so that marginal cost MC
is equal to price as long as the firm
covers its average variable cost.
The short-run supply curve is given
by the crosshatched portion of the
marginal cost curve.
Firm’s Response to a
Change in Input Price

When the marginal cost of

production for a firm increases
(from MC1 to MC2), the level of
output that maximizes profit falls
(from q1 to q2).
8.6. SHORT-RUN MARKET SUPPLY
CURVE
 Industry Supply
in the Short Run
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.
 Producer Surplus
for a Firm

The producer surplus for a firm is

measured by the yellow area below
ABCD the market price and above the
marginal cost curve, between
outputs 0 and q*, the profit-
maximizing output.
Alternatively, it is equal to rectangle
ABCD because the sum of all
marginal costs up to q* is equal to
the variable costs of producing q*.
 Producer Surplus
for a Market

The producer surplus for a market

is the area below the market price
and above the market supply curve,
between 0 and output Q*.
8.7. CHOOSING OUTPUT IN THE
LONG RUN
Output Choice in
the Long Run
The firm maximizes its profit by
choosing the output at which price
equals long-run marginal cost
LMC.

The firm increases its profit from

ABCD to EFGD by increasing its
output in the long run.

π(q) = R(q) – C(q)

R(q) = p(q) x q

Economies of scale upto q2 >> >> Diseconomies of scale

Output Choice in
the Long Run
The firm maximizes its profit by
choosing the output at which price
equals long-run (LR) marginal cost
LMC.

The firm increases its profit from

ABCD to EFGD by increasing its
output in the long run.
Optimal LR
Output when
P = $40
π(q) = R(q) – C(q)
R(q) = p(q) x q

Optimal LR Output if P = $30. Profit = 0 at this point. Below $30, the firm should shut down.
Long-run Competitive Equilibrium
(i) no incentive to enter/exit market, (ii) zero profit
supply = consumer demand

1 2

profit-maximizing level
 Economic Rent

 Amount that firms are willing to pay for an input less

the minimum amount necessary to obtain it.

 In competitive markets, in both the short and the long

run, economic rent is often positive even though profit
is zero.
For example, transportation cost worth $10000 is
 An opportunity cost to owning any factor of saved in land used for production is close to the
production whose supply is restricted river/sea. (However, this economic rent would have
been paid as extra fixed cost during purchase of the
land.)
Zero Profit for Firm in Long-run Equilibrium

 In the long run, in a competitive market, the producer surplus that a firm earns on the
output that it sells consists of the economic rent from all its scarce inputs.

• e.g., The firm with land close to river enjoys $10000 benefit because it doesn’t have to spend this
transportation costs.

 However, after accounting for the opportunity cost associated with owning such
scarce inputs, the firm earns zero economic profit.

 The firm is likely to have purchased the land close to river at a higher price (equal to $10000 in the scenario
of common information across all parties involved).
8.8. INDUSTRY’S LONG-RUN
SUPPLY CURVE
Long-run Supply in a Constant-cost Industry
Long-run Supply in an Increasing-cost Industry
Effect of Output Tax
on Firm’s Output

An output tax raises the firm’s

marginal cost curve by the amount
of the tax.
The firm will reduce its output to
the point at which the marginal
cost plus the tax is equal to the
price of the product.
Effect of Output Tax
on Industry Output

An output tax placed on all firms in

a competitive market shifts the
supply curve for the industry
upward by the amount of the tax.
This shift raises the market price of
the product and lowers the total
output of the industry.
10-12 NON-COMPETITIVE /
IMPERFECT MARKET STRUCTURE
 Market Power
market structures that reflect real-world scenarios

 Output determination in perfect • Output determination in imperfect

market conditions market conditions
 Competitive markets • Monopoly, Monopolistic Competition,
Oligopoly

 Price Takers – Can’t decide price • Firm in the market can decide both
price and quantity (to different extents,
depending on exact structure)