IBS-GURGAON

2018
 Learning Objectives

At the end of this lecture you will be able to-

 Appreciate the importance of studying Economics

 Understand the concept of Scarcity and Efficiency

 Differentiate between different branches of Economics

 Describe the three important problems of Economy

 Explain different types of Economies.

 WHY TO STUDY
ECONOMICS
 To get a good Job.

 To understand more deeply the reports on Inflation and
Unemployment.

 To understand what kind of policies might slow global

warming or

 What it means to say an IPOd is “made in China”

 DEFINITION OF
ECONOMICS-

 Economics is the study of how societies use scarce resources
to produce valuable goods and services and distribute them
among different individuals.
 SCARCITY AND
EFFICIENCY

 Two Key Ideas in all the definition of economics-

 A. Goods are scarce

 B. Society must use its resources efficiently.

 SCARCITY

 Ours is a world of scarcity

 No society has reached a utopia of limitless

possibilities.

 A situation of scarcity is one in which goods are

limited relative to desires.
 EFFICIENCY

 Given unlimited wants, It is important that an
economy make THE BEST USE OF ITS LIMITED
RESOURCES.

 Efficiency denotes the most effective use of a

society’s resources in satisfying people’s wants and
needs.
 Efficiency

 Economic efficiency requires that an economy
produce the highest combination of quantity and
quality of goods and services given its technology
and scarce resources.

 An economy is producing efficiently when No

individual’s economic welfare can be improved
unless someone else is made Worse off.
 Essence of Economics

 To acknowledge the reality of scarcity.

 To figure out how to organize society in a way

which produces the most efficient use of resources.
 Branches of Economics

 Micro economics :

 Adam Smith – Founder of Microeconomics. Book

written by him- “The Wealth of Nations” (1776)

 Branch of economics concerned with the behavior of

individual entities such as markets, firms, and
households.
 Macro Economics

 Concerned with overall performance of the economy.

 John Maynard Keynes - “General Theory of

Employment, Interest and Money” -1936

 Macroeconomics deals with areas such as How total

investment and consumption are determined, how central
banks manage money and interest rates, What causes
international financial crises, why some nations grow
rapidly while others stagnate.
 Positive Economics Vs.
Normative Economics

 Positive Economics: Issues and questions of Facts

 Deals with questions such as-

 Why do managers earn more than supervisors?

 Do high interest rates slow the economy and lower

inflation?

 These type of issues can be resolved by reference to

analysis and empirical evidence.
 Normative Economics

 Issues involves ethical and norms of fairness.

 Should unemployment be raised to ensure that price

inflation does not become too rapid.

 Should India negotiate further agreements with ASEAN

countries to lower tariffs on imports?

 Has the distribution of income in India become too unequal.

 The answers can be resolved only by discussions and

debates over society’s fundamental values.
 The Three Problems of
Economic Organization

 Three fundamental economic problems-

 1. What commodities should be produced

 2. How to produce such commodities

 3. For Whom they are produced.

 WHAT?

 What commodities are produced and In what quantities?

 Will we produce pizzas or shirts today?

 Few high quality shirts or many cheap shirts?

 Fewer Consumption goods ( like Pizzas) and more

Investment goods (like Pizza-Making machines, which
will boost production and consumption tomorrow?
 HOW?

 How are goods produce?

 Who will do the production, with what resources

and what production techniques they will use?

 Will electricity be generated from Oil, from Coal, or

from the sun?

 Will factories be run by people or robots?

 FOR WHOM?

 For whom goods are produced?

 Who gets to eat the fruit of economic activity?

 Is the distribution of Income and Wealth fair and

equitable?

 How is the National product divided among different

house holds?

 Will society provide minimal consumption to the poor, or

must people work if they are to eat.
Market ,Command, and
Mixed Economies

 Society can answer theses crucial question of What,
How and for Whom through the way society is
organized through Alternative economic system

 Two fundamentally different ways of Organizing an

economy.

Government makes Decisions are

most economic decisions made in Markets
 Market Economy

 Most economic questions and decisions are settled by the
Market Mechanism. Example- USA

 A market economy is the economy in which individuals and

private firms make the major decisions about production and
consumption.

 A system of Prices, of Markets, of Profits and Losses, of

incentives and rewards determines What, How and for Whom.

 The Extreme cases of Market economy is called Laissez-Faire

Economy. Here Government do not interfere in economic
decisions.
 COMMAND
ECONOMY

 Government makes all important decisions about production and
distribution. (Example-Erstwhile Soviet Union during most of the
20th century)
 Government owns most of the means of production (land and
capital)
 Also, owns and directs the operations of enterprises in most of the
industries
 It is the employer of most workers and tells them how to do their
jobs;
 It decides how the output of the society is to be divided among
different goods and services.
 In short, government answers the major economic questions
through its ownership of resources and its power to enforce
decisions
 MIXED ECONOMY

 No contemporary society falls completely into either of these
extreme categories.

 All societies are Mixed Economies, with elements of market

and command.

 Government plays an important role in overseeing the

functioning of the market

 Government pass laws that regulates economic life produce

educational and police services and control pollution.
Every Gun that is made, every warship
launched, every rocket fired signifies, in the
final sense, a theft from those who hunger
and are not fed.

- President Dwight D Eisenhower

 
 Goods are scarce and wants are Many

 An economy must decide the most efficient

allocation of its limited resources like land, technical
knowledge, factories, etc.

 Economy must choose among different bundles of

goods (the What), select from different techniques of
production ( the How), and decide who will
consume the goods (the for Whom).
 INPUTS & OUTPUTS

 INPUTS: Commodities or services that are used to
produce goods and services.

 Another term for Inputs –Factors of Production

 Three broad categories- Land , Labor , Capital

 OUTPUT: Various useful goods or services that

result from the production process for consumption
or employed in further production.
 THE PRODUCTION
POSSIBILITY FRONTIER

 The production possibility frontier ( or PPF) shows the
maximum quantity of goods that can be efficiently
produced by an economy, given its technical knowledge
and the quantity of available inputs.
POSSIBILITIES BUTTER GUNS
(millions of (thousands)
Pounds)
A 0 15
B 1 14
C 2 12
D 3 9
E 4 5
F 5 0
Guns-Butter Tradeoff

 
 Scarce Inputs and technology imply that the
production of guns and butter is limited.

 As we go from B to D …. To C an economy is
transferring resources labor, machines and land from
the gun industry to butter industry and can thereby
increase butter production.
Future Consumption Vs.
Current Consumption

Today’s Choices Future Consequences
Capital Invst. Capital Invst.

Country 3

Country 2
B3

A3 Country 1 B2
A2
A1 B1
Current Consumption
Current Consumption
 
 Three countries start out even. They have the same PPF
but different investment rates.
 Country 1 does not invest for the future and remains at
A1 merely replacing machines.
 Country 2 abstains modestly from consumption and
invest at A2.
 Country 3 sacrifices a great deal of current consumption
and invest heavily.
 In the following years, countries that invest more
heavily forge ahead.
 Countries that invest heavily can have both higher
investment and consumption in future.
Two roads diverged in a wood, and I,
I took the one less traveled by,
And that has made all the difference. -

Robert Frost
 OPPORTUNITY COST

 Related to one of the deepest concepts of economics –
OPPORTUNITY COST.

 When you decide whether to study economics, buy a car,

or go to some university you will give something up.

 There will be a forgone opportunity.

 In a world of scarcity, choosing one things means giving

up something else. The opportunity cost of a decision is
the value of the good or service forgone.
 EFFICIENCY

 Efficiency means that the economy’s resources are being
used as effectively as possible to satisfy people’s desires.

 Efficiency means that the economy is on the PP frontier

rather than inside the PPF.

 Productive efficiency occurs when an economy cannot

produce more of one good without producing less of
another good; this implies that the economy is on its
PPF.
 MARKET

 A market is a mechanism through which buyers and
sellers interact to determine prices and exchange
goods, services, and assets.

 The central role of markets is to determine the price

of goods

 Prices are the balance wheel of the market

mechanism.
 THE MARKET
MECHANISM

 No single individual or organization or government is
responsible for solving the economic problems in a
market economy.

 Instead, millions of businesses and consumers engage

in voluntary trade, intending to improve their own
economic situations, and their actions are invisibly
coordinated by a system of prices and markets.
 Market Equlibrium

 Markets are constantly solving the What, How and
for whom.

 A market equilibrium represents a balance among

all the different buyers and sellers

 The market finds the equilibrium price that

simultaneously meets the desires of buyers and
sellers
 Market and Three
Economic Problems

 What goods and services will be produced is
determined by the dollar votes of consumers in their
daily purchase decisions.

 How things are produced is determined by the

competition among different producers. To
maximize profits they keep costs at a minimum by
adopting the most efficient methods of production.
 
 For Whom things are produced- Who is consuming
and how much depends on the supply and demand
in the markets for factors of production.

 Factor markets , i.e., markets for factor of production

determine wage rates, land rents, interest rates and
profits. Such prices are called factor prices.
THE INVISIBLE HANDS

 Adam Smith- “The Wealth of Nations”-1776 –saw the
harmony between private profit and public interest.

 Doctrine of Invisible Hand - private interest can lead to

public gain when it takes place in a well-functioning
market mechanism.

 According to economic theorists, under limited

conditions a perfectly competitive economy is efficient.
 Failures of Invisible
Hand

 Markets do not always lead to the most efficient outcome.

 Spillovers or External forces outside the market place- e.g.

Scientific Discoveries and Spillovers such as Pollution.

 When the income distribution is politically or ethically

unacceptable.

 Due to any of the above factors, Adam Smith’s Invisible-

hand doctrine breaks down. In such cases Government may
want to step in to correct the Flawed Invisible Hand.
 The Visible Hand-
Government

 Governments have three main economic functions in a
market economy-

 Increases efficiency by promoting competition, curbing

externalities like pollution, and providing public goods.

 Promotes equity by using tax and expenditure programs to

redistribute income toward particular groups.

 Macroeconomic stability and Growth- reducing

unemployment and Inflation while encouraging economic
growth – through fiscal and monetary policy
 Partial Vs. General
Equilibrium

 Partial Equilibrium:-
 Analysis of an equilibrium position for a particular sector
of an economy.
Example- The equilibrium of a single consumer, a single
producer, a single firm and a single Industry .

 Alfred Marshall major proponent of Partial Equilibrium

theory.

 Markets are considered to be small enough so that its

inter- dependence with the rest of the economy could be
neglected.
 General Equlibrium

 Leon Walras - Book “ Elements of Pure Economy”
 Created theoretical and Mathematical model of general
equilibrium to integrate both the effects of demand and
supply side forces in the WHOLE ECONOMY.

 General equilibrium gives an understanding of the

whole economy using a bottom –top approach, starting
with individual market and agents.

 It is different from macro economic equilibrium, which

uses top-bottom approach ( which starts with larger
aggregates)
 CASE- AUTOMOBILE EMISSION STANDARD (10 Marks)
 Most of the states in India have imposed strict tailpipe emission
standards on New automobiles. These standards have become
increasingly stringent in metros like Delhi. Currently Bharat-II is in
force. Now, as the number of cars on the roads keeps increasing, the
government must consider how stringent these standards should be
in the coming years.
The design of a program relating to control of pollution
involves a careful analysis of the ecological and health effects of auto
emissions. But it also involves a good deal of economics.

1. Evaluate the impact of the program on consumers. (4 Marks)

2. Why market oriented economy is not able to solve the problems

related to air pollution? (3 Marks)

3. Do Auto emission control program makes sense on a cost-benefit

basis? (3 Marks)
IBS GURGAON, 2018
 Learning Objectives

 At the end of this lecture you will be able to –

 Understand the demand schedule

 Plot the Demand curve

 Define Elasticity of demand

 Calculate different type of elasticities.

 DEMAND SCHEDULE

 Amount of a commodity people buy depends on its
price.

 The higher the price of an article, other things held

constant, the fewer units consumers are willing to
buy.

 The lower its market price, the more units of it are

bought.
 DEMAND SCHEDULE
 between the market
 There exists a definite relationship
price of a good and the quantity demanded of that good,
other things held constant.
 This relationship between price and quantity bought is
called the demand schedule or the demand curve.
 Demand schedule- Price ( $ per box) Q (mn. Of
boxes per year)
A 5 10
Demanded
B 4 18
C 3 26
D 2 38
E 1 54
THE DEMAND CURVE

 The Graphical representation of the demand
schedule is the demand curve.
 For the given example-
 FEATURES OF
DEMAND CURVE

 The demand curve shows the quantity of the good that
the consumers are willing to buy as the price per unit
changes. Mathematically , Q d = Qd (P)

 The demand curve slopes downward from left to right.

 Law of downward sloping demand –

When the price of a commodity is raised, other things held
constant, Consumers tends to buy less of the commodity
and vice-a-versa.
 The income effect

 Quantity demanded tends to fall as price rises for
two reasons-
 The Income Effect and Substitution Effect

 If we assume that money income is fixed, the income

effect suggests that, as the price of a good falls, real
income - that is, what consumers can buy with
their money income - rises and consumers increase
their demand.
Income Effect

 The Substitution effect

 In addition, as the price of one good falls, it
becomes relatively less expensive. Therefore, assuming
other alternative products stay at the same price, at
lower prices the good appears cheaper, and
consumers will switch from the expensive alternative
to the relatively cheaper one.

 SHIFTING OF
DEMAND CURVE

 What will happen if Income levels increases or there is
changes in preferences or tastes of consumers.

 Changes in factors like average income and preferences

can cause an entire demand curve to shift right or left.

 This causes a higher or lower quantity to be demanded

at a given price, ceteris paribus assumption.
 SHIFTING TOWARDS
RIGHT

PRICE ORIGINAL
NEW Qd
(£) Qd
1.10 0 100
1.00 100 200
90 200 300
80 300 400
70 400 500
60 500 600
50 600 700
40 700 800
30 800 900
 
PRICE ORIGINAL
NEW Qd
(£) Qd
1.10 0
1.00 100
90 200 100
80 300 200
70 400 300
60 500 400
50 600 500
40 700 600
30 800 700
 ELASTICITY OF
DEMAND

 Elasticity measures the sensitivity of one variable to
another.

 The percentage change in one variable due to a 1 %

increase in another variable.

 For ex. The price elasticity of demand measures the

sensitivity of quantity demanded to changes in price
 Price elasticity of
Demand

 Let quantity demanded be Q and Price be P,
 Price elasticity of demand
∆𝑄/𝑄
Ep= %∆𝑄/%∆𝑃 = -------- = (P/Q). ∆𝑄/∆𝑃
∆𝑃/𝑃
 The price elasticity of demand is usually a negative number.
We consider the Absolute level.

 If, Ep > 𝟏 ∶ − 𝑫𝒆𝒎𝒂𝒏𝒅 𝒊𝒔 𝑷𝒓𝒊𝒄𝒆 𝑬𝒍𝒂𝒔𝒕𝒊𝒄

Ep < 𝟏 ∶ −𝑫𝒆𝒎𝒂𝒏𝒅 𝒊𝒔 𝒔𝒂𝒊𝒅 𝒕𝒐 𝒃𝒆 𝑷𝒓𝒊𝒄𝒆 𝑰𝒏𝒆𝒍𝒂𝒔𝒕𝒊𝒄
Ep= 1 : - Demand is Unitary Elastic
 
 In general, Price Elasticity of demand for a good
depends on the availability of substitute goods.

 If there are more close substitute for a commodity,

the demand will be highly Price elastic.

 When there are no close substitutes, demand will

tend to be Price Inelastic.
 Income Elasticity of
Demand

 Usually, Demand for most goods usually rises when
aggregate income rises.

 The income elasticity of demand is the percentage

change in the quantity demanded, Q, due to a 1
percent increase in income, I, ∆𝑄/𝑄 I∆𝑄
Ei =--------= ---------
∆𝐼/𝐼 Q ∆𝐼
CROSS PRICE ELASTICITY OF
DEMAND

 Cross Price elasticity of Demand refers to the
percentage change in the quantity demanded for a
good that result from a 1 percent increase in the price
of another. For Ex. Tea and Coffee
∆𝑄𝑡/𝑄𝑡 Pc ∆𝑄𝑡
 EQt,Pc= _________ = _________ ; Qt – quantity of tea
∆𝑃𝑐/𝑃𝑐 Qt∆ 𝑃𝑐 Pc- Price of Coffee

 Here, Cross elasticity will be positive as Goods are

Substitutes.
 Complimentary Goods

 Some goods are compliments because they tend to be
used together.

 An increase in the price of one tends to push down

the consumption of the other. For ex. Petrol and
Motor Oil.
 If the price of petrol goes up, the demand for petrol
goes down- Motorist will drive less. Thus, demand
for motor oil falls. In this case Cross price elasticity of
motor oil with respect to price is negative.
Linear Demand Curve

 Ep at point e = 0

 Ep at point c = -1

 Ep at point a= - ∞
 Price elasticity of demand
depends not only on the
slope of the demand curve
but also on the price and
quantity.
  Completely Inelastic
Infinitely Elastic Demand Demand
Price Price

D
P
D

Quantity
Q Quantity
 
 Que1: If a 3 % increase in the price of corn flakes
causes a 6 percent decline in the quantity demanded,
what is elasticity of Demand?

 Que-2: A consumer spends all his income on two

goods X and Y. If a 50 % increase in the price of good
X does not change the amount consumed of good Y,
what is the price elasticity of demand for good X?
 The Supply Curve

 The quantity of a good that producers are willing to
sell at a given price, Ceteris Paribus (holding
constant any other factors that might affect the
quantity supplied)

 The supply curve is the relationship between the

quantity supplied and the price.

 QS = QS (P)
 
 Supply curve is upward sloping Curve.

 Higher the price , the more firms are able and willing
to produce and sell.

 If the production costs fall, firms can produce the

same quantity at a lower price OR a larger quantity
at the same price.

 The Supply curve shifts to the right. From S1 to S2.

 Other Variables

 Quantity producers are willing to produce or sell
depends on other variables besides price.

 Production costs such as WAGES, Interest Cost, Raw

Material Cost etc.

 Any increase or Decrease in such cost , Given the Price

remains at the same level, will make the quantity
supplied to decrease or Increase accordingly..

 EQUILIBRIUM

 The two curve Demand Curve and Supply Curves
intersect at the Equilibrium.

 Equilibrium is also known as Market Clearing Price and

Quantity.

 At this price (P0),

Quantity Supplied = Quantity Demanded.
 The Market Mechanism

 The Market Mechanism is the tendency in a free market for the price
to change until the Market Clears- i.e.

QUANTITY SUPPLIED = QUANTITY DEMANDED

 If the price were initially above the market clearing prices P0 ,

Producers will try to produce and sell more than consumers are
willing to buy. A situation of SURPLUS will result

 SURPLUS Situation –
Quantity supplied > Quantity demanded.

 To clear this surplus sellers will start lowering their prices.

Eventually Equilibrium will reach.
MARKET EQUILIBRIUM
 
 If Prices were initially below P0- A Shortage situation
will arise.

 Here, Quantity demanded > Quantity Supplied

 Producers will react by increasing prices and expand Output.

 Again, the price would eventually reach P0.

Changes in Market
Equlibrium

 
 When the Supply curve shifts to the right, the market
clears at a lower price P2 and larger quantity Q3.

 When the demand curve shifts to the right, the

market clears at a higher price P and larger quantity
demanded.
Effects of Govt. Intervention
–Price control

 PRICE CONTROL
 PC

is below the equilibrium price of P .E
 At PC, sellers are willing to offer A1 apartments.
 Consumers would like to rent A2 apartments at the
price ceiling of PC.
 Because PC is below the equilibrium price, there is a
shortage of apartments equal to (A2 – A1).
 (Notice that if the price ceiling were set above the
equilibrium price it would have no effect on the
market since the law would not prohibit the price
from settling at an equilibrium price that is lower
than the price ceiling.)
 
 This excess demand sometimes take the form of
QUEUES.

 These queues are the result of Price controls.

 Sometimes, it SPILLS OVER into other markets where

it artificially increases demand.
For Ex.:- Natural gas price controls caused potential
buyers of gas to use Oil instead

 Some people gain and Some loose from price control.


 

Consumer behaviour
 Learning Objectives
will be able to –
At the end of this lecture you

 Understand the Choice & Utility Theory

 Define Marginal Utility & Law of Diminishing

Marginal Utility

 Derive Market Demand and Consumer Surplus and Its

Application.

 Analyze Indifference Curve and Forecasting Demand.

 
 https://www.youtube.com/watch?v=wFrGhooQhe
U

 https://www.youtube.com/watch?v=DD128Y0P9Y
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 https://www.youtube.com/watch?v=huI0k5mFVto

 https://www.youtube.com/watch?v=LOjyVoGTGj8
 Choice and Utility
Theory

 Fundamental issue in microeconomics

 How consumer with a limited income decides which

goods and services to buy?

 How Consumers allocate their incomes across goods

and how this allocation decision determines the
demands for various goods and services.
 Three Basic steps

 Consumer Preferences – to find the reasons people
might prefer one good to another.

 Budget Constraints- Consumers have limited incomes

restricting the quantities of goods they can buy.

 Consumer Choices- Given their preferences and limited

incomes, consumers choose to buy combination of
goods that maximizes their satisfaction
 Market Basket
 of one or more goods.
 A list with specific quantities
For Ex. - Various food items in a grocery cart,
quantities of food, clothing and housing that a
consumer buys each month etc.
MARKET UNITS OF UNITS OF
BASKET FOOD CLOTHING
A 20 30
B 10 50
C 40 20
D 30 40
E 10 20
F 10 40
 
 Theory of Consumer behavior asks whether
consumers prefer one market basket to another.

 Consumer usually select market basket that make

them as well off as possible.
 Basic Assumptions

 Three Basic Assumptions about consumer ‘s preferences-
1. COMPLETENESS: -
 Preferences are assumed to be complete. In other words,
consumers can compare and rank all possible baskets.
 Thus for any two market baskets A and B, a consumer will
prefer either A to B or will prefer B to A or will be indifferent
between the two.

 By indifferent means that person will be equally satisfied

with either basket.
 
2. Transitivity- Preferences are Transitive.
If A>B and B>C then A>C

Transitivity is regarded as necessary for consumer

consistency.

3. More is Better than Less:- Goods are assumed to be

desirable. Consequently , consumers always prefer
more of any good to less. Consumers are never satisfied
or Satiated (assumption of Non Satiation)
 CARDINAL & ORDINAL
MEASUREMENT

 Exact amount of measurement in absolute numbers
For Ex.- Bill gates - $ 56 Billion
Warren Buffet- $ 45 Billion
Steve Jobs - $ 14.5 billion
Oprah Winfrey- $ 2.7 billion

ORDINAL MEASUREMENT –
 Here number denotes ranking
For Ex. Bill Gates – 1, Warren Buffet -2, Steve Jobs-3
and so on.
 UTILITY

 UTILITY denotes satisfaction.

 A subjective pleasure that a person derives from

consuming a good or service.

 It is want satisfying power of a commodity.

For example- Chocolates have want satisfying power for
having something sweet.

 More precisely, it refers to how consumers rank different

goods and services.

 If basket A has higher Utility than basket B for Mr. X, then

Mr. X will prefer A over B.
 UTILITY

 Utility is a scientific construct that economists use to
understand how rational consumers make decision.

 In the theory of demand, we assume that people

maximizes their utility.

 It means that they choose the bundle of consumption

goods that they prefer most.
 MARGINAL UTILITY

 The expression ‘Marginal’ is a key term in
economics and always means ‘Additional’ or ‘Extra’.

 When you consume an additional unit of a

commodity you will get some additional satisfaction
or Utility. The increment to your utility is called
Marginal Utility.

 “Marginal utility denotes the additional utility you

get from the consumption of an additional unit of
a commodity.”
 Law of Diminishing
Marginal Utility

 One of the fundamental idea behind demand theory
is ‘Law of diminishing Marginal utility.’

 This law states that the amount of extra or marginal

utility declines as a person consumes more and more
of a good.

 The Law of diminishing Marginal utility states that,

as the amount of a good consumed increases, the
marginal utility of that good tends to decline.
 Marginal Utility
Quantity of

Total Utility Marginal
a good (U) Utility (MU)
consumed
(Q)
0 0
1 4 4
2 7 3
3 9 2
4 10 1
5 10 0

 
 From graph we see that-
 1. Total utility rises with consumption, but it rises at
a decreasing rate, showing diminishing marginal
utility.

 The Law of Diminishing Marginal utility implies that

the Marginal Utility curve must slope downwards.
 The EQUI MARGINAL
Principle

 The fundamental condition of maximum satisfaction
or utility is the equimarginal principle.

 A consumer will achieve maximum satisfaction or

utility when the marginal utility of the last dollar
spent on a good is exactly the same as the marginal
utility of the last dollar spent on any other good.

 The common marginal utility per dollar of all

commodities in consumer equilibrium is called the
marginal utility of income.
 Equimarginal Principle

 It measures the additional utility that would be
gained if the consumer could enjoy an extra dollar’s
worth of consumption.

 If Marginal utilities are MUs and Prices Ps of the

different goods then fundamental condition of
consumer equilibrium is
 MU Good 1/P1=MU Good 2/P2=MU Good 3/P3=….= MU per $
of Income
Consumer’s Equilibrium

 If Consumer distributes his expenditure rationally
among commodities, X, Y, Z, etc., the following
relationship will hold good in equilibrium.

 MU of X/ Price of X = MU of Y/Price of Y = MU of
Z/Price of Z = MUM

 where MUM is the common marginal utility of

money (i.e., marginal utility of a rupee).
 Consumer’s Surplus

 Consumer’s surplus = What a consumer is willing to pay minus
what he actually pays.

 CS = ∑ Marginal utility – (Price x Number of units of a

commodity purchased)

Marshall’s Measure of Consumer Surplus:

 measures extra utility or satisfaction which a consumer obtains

from the consumption of a certain amount of a commodity over
and above the utility of its market value.

 Thus the total utility obtained from consuming water is

immense while its market value is negligible.

 Marginal Utility
and Consumer Surplus
 Total utility derived by the consumer

from OM units of the commodity will be
equal to the area under the demand or
marginal utility curve up to point M.
That is, the total utility of OM units in
Fig. 14.2 is equal to ODSM.

 In other words, for OM units of the good

the consumer will be prepared to pay the
sum equal to Rs. ODSM. But given the
price equal to OP, the consumer will
actually pay the sum equal to Rs. OPSM
for OM units of the good.

 It is thus clear that the consumer derives

extra utility equal to ODSM minus
OPSM = DPS, the shaded area.
 Indifference Curve

 Consumer preferences can be graphically expressed
by Indifference Curve.

 An Indifference Curve represents all combinations of

Market Basket that provide a consumer with the
same level of satisfaction.

 This consumer is Indifferent among the Market

basket represented by the points graphed on the
curve.
Indifference Curve

Indifference Map- Set of
Indifference curves

 The shape of
Indifference Curves

 Indifference curves are Downward Sloping curves

 This is due to our assumption that more of a good is

better than less.

 If an IC sloped upward, this means a consumer would be

indifferent between two market baskets even though one
of them had more of both food and clothing.

 Downward shape describes how a consumer is willing to

substitute one good for another.
Marginal Rate of
Substitution

 Marginal Rate of
substitution

 The amount of one good that a consumer will give
up to obtain more of another.

 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.

 For Ex.:- MRS 3, means that the consumer will give

up 3 units of clothing to obtain 1 additional unit of
food.
 The shape of
Indifference Curves

 Indifference curves are Downward Sloping curves

 This is due to our assumption that more of a good is

better than less.

 If an IC sloped upward, this means a consumer

would be indifferent between two market baskets
even though one of them had more of both food and
clothing.

 Downward shape describes how a consumer is

willing to substitute one good for another.
 Convexity of
Indifference curve
inward) due to the
 IC are convex ( or bowed
Diminishing Marginal Rate of substitution.

 Convex means that the slope of the indifference

curve increases (i.e., becomes less negative) as we
move down along the curve.

 That is, Indifference curves is convex if the MRS

diminishes along the curve

 BUDGET
CONSTRAINTS

 Budget constraints means Limited Income.

 Budget constraints restricts consumer behavior by forcing the consumer to

select a bundle of goods that is affordable.

 Mathematically, Px.X+ Py.Y≤M

Where Px and Py – prices of good x and y and X and Y are quantities of
goods x and y purchased. M represents total income of consumer.

The Budget sets defines the combinations of goods X and Y that

are affordable for the consumer
 BUDGET LINE

 If the consumer spends all his income on the two goods, this
equation becomes equality. This relation is called Budget line.

Px.X + Py.Y= M

 In other words, the budget line defines all the combinations of

goods X and Y that exactly exhaust the consumer’s income.

 Dividing both sides of above equation by Y and solving for Y

we get - Y= M/Py –Px/PyX
 That is , Y is a linear function of X with vertical intercept of M/Py and a slope of –Px/Py.
Budget Line

 Consumer’s Equilibrium:
Interplay of budget line and
indifference curves

 In the given diagram, IC1,
IC2 and IC3 are three
different indifference
curves and AB is a budget
line.
 A consumer can only
consume such
combinations of goods
which lie upon the budget
line at a given income
level and constant price of
goods X and Y.
 Conditions of
Consumer’s Equilibrium

 The following are the conditions of consumer’s
equilibrium-

 Budget line should be tangent to the indifference curve

 At the point of equilibrium, slope of the budget line =

slope of the indifference curve

 Indifference curve should be convex to the point of origin.

Changes in Income and
Price

 Substitution Effect and
Income Effect

 If good 1 becomes cheaper, it means that you have to give up less
of good 2 to purchase good 1. The change in the price of good 1 has
changed the rate at which the market allows you to "substitute"
good 2 for good 1. The trade-off between the two goods that the
market presents the consumer has changed.

 At the same time, if good 1 becomes cheaper it means that your

money income will buy more of good 1. The purchasing power of
your money has gone up; although the number of dollars you have
is the same, the amount that they will buy has increased.

 The first part—the change in demand due to the change in the rate
of exchange between the two goods—is called the substitution
effect. The second effect—the change in demand due to having
more purchasing power—is called the income effect.
Substitution & Income
effect.

 Substitution effect and
income effect

 The pivot gives the

substitution effect, and
the shift gives the
income effect.
Deriving The Demand
curve

 The price of pizza is $4, the
quantity demanded of pizza is
two.
 If the price of pizza decreases, the
budget constraint becomes flatter
and the consumer can purchase
more pizza, say the price of pizza
drops to $2 and consumer
purchases 4 units.

 If the price drops to $1.33, the

quantity demanded increases to
5. Plotting each of the price and
quantity demanded points creates
the demand curve for p

 QUIZ

 http://global.oup.com/us/companion.websites/978
0199397129/student/chapt1/multiplechoice/
 The Production
Function

 Production process utilizes two inputs Capital (K) and
Labor (L).

 Production function summarizes the technology available

for converting capital and labor into output.

 The production function is an engineering relationship

that defines the maximum amount of output that can be
produced with a given set of inputs.

 Mathematically, the production function Q=F(K,L)

Short Term versus Long
Term

 Managers job is to use the available production
function efficiently

 i.e., to determine how much of each input to use to

produce output

 In the short term, some factors of production are

fixed and this limits the choices of managerial
decision
 
 The short term is defined as the time frame in which there are
fixed factors of production.

 Suppose Capital and Labor are the only two inputs in

production and Capital is fixed in the short term.

 Therefore, In short run Production function is function of Labor

only, as Capital is fixed.

 Q=f(L)= F(K*,L)

 The Long Run is defined as the horizon over which the

manager can adjust all factors of production. (usually >3
years)
 
 Three most important measures of productivity are-
Total Product, Average Product, Marginal Product.

1. Total Product:- Maximum level of output that can

be produced with a given amount of Inputs.
This is the amount that would be produced if the
optimum units of Labor put forth maximum effort.

2. Average Product- Total product divided by the

quantity used of the input.
 
 In particular, the average product of Labor (APL)
APL=Q/L
 And the average product of Capital (APK)
APK = Q/K

Marginal Product – MP of an input is the change in total

output due to last unit of an input.
∆𝑄
Therefore, The marginal product of capital MPk=
∆𝐾

AND, Marginal product of Labor MPL= ∆𝑄/∆𝐿

The Law of diminishing
marginal returns
amounts of the variable input,
 Law states that - as successive
i.e., labor, are added to a fixed amount of other resources,
i.e., capital, in the production process the marginal
contribution of the additional variable resource will
eventually decline.
 As the marginal product begins to fall but remains positive,
total product continues to increase but at a decreasing rate.

 As long as the marginal product of a worker is greater than

the average product the average product will rise.

 Thus the marginal product will always intersect the average

product at the maximum average product.
 THREE STAGES OF
PRODUCTION

 STAGE-I:- Marginal product rises, reaches maximum and
then falls due to law of diminishing returns while average
product rises and reaches maximum.

 STAGE-II:- Marginal product falls till it becomes Zero

while average product keeps on falling but is positive

 Stage III:- Marginal Product is Negative, i.e., Contribution

of the additional labor to the total output is Negaitve.
3 stages of Production

 
 A Rational producer
should not produce in
Stage I and Stage II.
 It should produce in
Stage-II. Why?
 Technological Changes

 As knowledge of new and more efficient methods of
production become available, technology changes.

 Furthermore new inventions may result in the

increase of the efficiency of all methods of
production. At the same time some techniques may
become inefficient and drop out from the production
function.

 These changes in technology constitute technological

progress.
Technological Progress

 
 Graphically the effect of innovation in processes is
shown with an upward shift of the production
function , or a downward movement of the
production isoquant.

 This shift shows that the same output may be

produced by less factor inputs, or more output may
be obtained with the same inputs.
 Economies of Scale

As plant capacity increases, firms are able to specialize their labor and
capital to a greater degree.

Workers can specialize on doing a limited number of tasks extremely well.

Another factor contributing to economies of scale is the spreading out of
the design and start up costs over a greater output amount.

For many products, significant costs are in design and development. For
example in the movie industry, the marginal cost of making a second copy
of a movie is nearly zero and as copies of the movie are produced, the
average cost declines significantly. Some film makers will film the movie
and its sequel at the same time to lower the per unit costs.
 RETURNS TO SCALE

 In the long run all factors of production are variable.
No factor is fixed.

 Accordingly, the scale of production can be changed

by changing the quantity of all factors of production.

 “The term returns to scale refers to the changes in

output as all factors change by the same
proportion.”- Koutsoyiannis
 
 Returns to scale are of the following three types:
1. Increasing Returns to scale.
2. Constant Returns to Scale
3. Diminishing Returns to Scale

 Suppose, initially production function is as follows:

P = f (L, K)
 Now, if both the factors of production i.e., labour and
capital are increased in same proportion i.e., x, product
function will be rewritten as.
 Increasing Return to
Scale

 Increasing returns to scale or diminishing cost refers
to a situation when all factors of production are
increased, output increases at a higher rate.

 It means if all inputs are doubled, output will also

increase at the faster rate than double. Hence, it is
said to be increasing returns to scale.

 This increase is due to many reasons like division

external economies of scale. Increasing returns to
scale can be illustrated with the help of a diagram
IRS

 Diminishing returns

 Diminishing returns or increasing costs refer to that
production situation, where if all the factors of production
are increased in a given proportion, output increases in a
smaller proportion.

 It means, if inputs are doubled, output will be less than

doubled. If 20 percent increase in labour and capital is
followed by 10 percent increase in output, then it is an
instance of diminishing returns to scale.

 The main cause of the operation of diminishing returns to

scale is that internal and external economies are less than
internal and external diseconomies.
DRS

Constant Return to Scale

 Constant returns to scale or constant cost refers to the production
situation in which output increases exactly in the same proportion
in which factors of production are increased.

 In simple terms, if factors of production are doubled output will

also be doubled.

 In this case internal and external economies are exactly equal to

internal and external diseconomies. This situation arises when after
reaching a certain level of production, economies of scale are
balanced by diseconomies of scale. This is known as homogeneous
production function. Cobb-Douglas linear homogenous production
function is a good example of this kind.
CRS

 Expansion Path

 The point where the iso-cost line is tangent to an isoquant
represents the least cost combination of the two factors for
producing a given output.

 If all points of tangency like LMN are joined by a line, it is

known as an output- factor curve or least-outlay curve or the
expansion path of a firm.

 Salvatore defines expansion path as “the locus of points of

producer’s equilibrium resulting from changes in total
outlays while keeping factor prices constant.”

 It shows how the proportions of the two factors used might be

changed as the firm expands.

 Economies of Scope

While economies of scale lowers the per unit cost as more of the
same output is produced, economies of scope lowers the per unit
cost as the range of products produced increases. For example, if a
restaurant that provides lunch and dinner began to offer breakfast,
the fixed costs of the kitchen equipment and the seating area could
be spread out over a larger number of meals served decreasing the
overall cost per meal. Likewise a gas station that already must
have a service attendant and building can lower the per unit cost by
providing convenience store items such as drinks and snacks.
Since the cost of producing or providing these products are
interdependent, providing both lowers the cost per unit.
 Production with two
variable Inputs

 In Long run, both the Inputs Labor and Capital is
variable.
 Firm can produce its outputs by combining different
amounts of Labor and Capital
 ISOQUANTS
 The word 'iso' is of Greek
origin and means equal or
same and 'quant' means quantity. An isoquant may be
defined as:

 "A curve showing all the various combinations of two

factors that can produce a given level of output. The
isoquant shows the whole range of alternative ways of
producing the same level of output".

 The modern economists are using isoquant, or "ISO"

product curves for determining the optimum factor
combination to produce certain units of a commodity at
the least cost.
Combinations Factor X
 Factor Y Total Output

A 1 14 100 METERS

B 2 10 100 METERS

C 3 7 100 METERS

D 4 5 100 METERS
100 METERS
E 5 4

 
 The five factor combinations of X and Y are plotted and are
shown by points a, b, c, d and e. if we join these points, it forms
an 'isoquant'.

 An isoquant therefore, is the graphic representation of an iso-

product schedule.

 It may here be noted that all the factor combinations of X and Y

on an iso-product curve are technically efficient combinations.

 The producer is indifferent as to which combination he uses for

producing the same level of output. It is in this way that an iso
product curve is also called 'production indifference curve'.
Isoquant Map

 An isoquant
map shows a set of iso-
product curves.
 Each isoquant
represents a different
level of output.
 A higher isoquant
shows a higher level of
output and a lower
isoquant represents a
lower level of output.
Marginal Rate of Technical
Substitution (MRTS)
we use concept of marginal
 In producers equilibrium
rate of technical substitution (MRTS) which is similar
to Marginal rate of substitution of theory of demand.

 Marginal rate of technical substitution (MRTS) is: "The

rate at which one factor can be substituted for another
while holding the level of output constant".

 The slope of an isoquant shows the ability of a firm to

replace one factor with another while holding the
output constant.
 
 MRTS= -Change in capital input/change in Labor input

 For example, if 2 units of factor capital (K) can be

replaced by 1 unit of labor (L), marginal rate of technical
∆𝑲
substitution will be : MRS = =2/1= 2:1
∆𝑳

Also,along an Isoquant

 
 The decline in MRTS along an Isoquant for
producing the same level of output is named as
diminishing marginal rates of technical education.

 The decline in MRTS along an isoquant as the firm

increases labor for capital is called Diminishing
Marginal Rate of Technical Substitution.
 Iso Cost Line

 A firm can produce a given level of output using
efficiently different combinations of two inputs.

 For choosing efficient combination of the inputs, the

producer selects that combination of factors which
has the lower cost of production.

 The information about the cost can be obtained from

the isocost lines
 
 An isocost line is also called outlay line or price line or
factor cost line.

 An isocost line shows all the combinations of labor and

capital that are available for a given total cost to-the
producer.

 Just as there are infinite number of isoquants, there are

infinite number of isocost lines, one for every possible
level of a given total cost.

 The greater the total cost, the further from origin is the
isocost line.
Isocost Line

 
 The isocost line plays a similar role in the firm's decision
making as the budget line does in consumer's decision
making.

 The only difference between the two is that the consumer

has a single budget line which is determined by the
income of the consumer. Whereas the firm faces many
isocost lines depending upon the different level of
expenditure the firm might make.

 A firm may incur low cost by producing relatively lesser

output or it may incur relatively high cost by producing a
relatively large quantity.
 Law of Variable
Proportions

 Keeping other factors fixed, the law explains the
production function with one factor as variable.

 In the short run when output of a commodity is to be

increased, the law of variable proportions comes into
operation.
 Definitions

 “As the proportion of the factor in a combination of
factors is increased after a point, first the marginal
and then the average product of that factor will
diminish.” Benham
 “An increase in some inputs relative to other fixed
inputs will in a given state of technology cause
output to increase, but after a point the extra output
resulting from the same additions of extra inputs
will become less and less.” Samuelson
 Assumptions

Law of variable proportions is based on following
assumptions-
i) Constant Technology:
The state of technology is assumed to be given and
constant. If there is an improvement in technology the
production function will move upward.
ii) Factor Proportions are Variable:
The law assumes that factor proportions are variable. If
factors of production are to be combined in a fixed
proportion, the law has no validity.
 
iii) Homogeneous Factor Units:
The units of variable factor are homogeneous. Each unit
is identical in quality and amount with every other
unit.
iv) Short-Run:
The law operates in the short-run when it is not
possible to vary all factor inputs.
 Explanation of the Law

 In order to understand the law of variable
proportions we take the example of agriculture.
Suppose land and labour are the only two factors of
production.

 By keeping land as a fixed factor, the production of

variable factor i.e., labour can be shown with the
help of the following table:



 Postponement of the
Law

 The postponement of the law of variable proportions is
possible under following conditions:

(i) Improvement in Technique of Production:

 The operation of the law can be postponed in case
variable factors techniques of production are improved.
(ii) Perfect Substitute:
 The law of variable proportion can also be postponed in
case factors of production are made perfect substitutes
i.e., when one factor can be substituted for the other.
ANALYSIS OF COST
 Accounting Cost

 An accountant is concerned with the financial
statements.

 Accountants tend to take a retrospective look at a

firm’s finances as they have to keep track of assets
and liabilities and evaluate past performance.

 Accounting costs include actual expenses and

depreciation expenses for capital equipment, which
are determine for tax purposes.
 ECONOMIC COST

 Economist thinks of cost differently from an accountant.

 Economists take a forward-looking view of the firm.

 They are concerned with what costs are expected to be in

the future, and

 How the firm would be able to rearrange its resources to

lower its costs and improve its profitability.

 They are concerned with opportunity costs.

 EXAMPLE
a building, and, therefore,
 Consider a firm that owns
pays no rent for office space. Does this mean that the
cost of office space is zero for the firm? Though an
accountant might treat this cost as zero, an economist
would consider the rent that the firm could have
earned by leasing the office space to another company.

 This foregone rent is an opportunity cost of utilizing

the office space and should be included as part of the
economic cost of doing business.
 SUNK COST

 A sunk cost is a Cost that an entity has incurred, and which it can no
longer recover by any means.

 Sunk costs should not be considered when making the decision to

continue investing in an ongoing project, since these costs cannot be
recovered.

 Instead, only relevant costs should be considered. However, many

managers continue investing in projects because of the sheer size of
the amounts already invested in the past. They do not want to "lose
the investment" by curtailing a project that is proving to not be
profitable, so they continue pouring more cash into it.

 Rationally, they should consider earlier investments to be sunk costs,

and therefore exclude them from consideration when deciding
whether to continue with further investments.
 Examples

 Marketing study. A company spends $50,000 on a
marketing study to see if its new product will succeed in
the marketplace. The study concludes that the it will not
be profitable. At this point, the $50,000 is a sunk cost. The
company should not continue with further investments in
this project, despite the size of the earlier investment.

 Research and development. A company invests $ 200,000

over several years to develop a new mobile phone model.
Once developed the market is indifferent, and buys no
units. The $200,000 development cost is a sunk cost, and
so should not be considered in any decision to continue or
terminate the product.
 
 Training. A company spends $20,000 to train its sales
staff in the use of new tablet computers, which they
will use to take customer orders. The computers
prove to be unreliable, and the sales manager wants
to discontinue their use. The training is a sunk cost,
and so should not be considered in any decision
regarding the computers.

 A sunk cost is also known as a stranded cost.

 Fixed Cost and Variable
Cost

 Fixed cost – A cost that does not vary with the level of
output.
 This cost can be eliminated only by going out of business.
 Example- Expenditures on Factory/office Building, Plant
& Machineries, Maintenance, Insurance, Electricity,
Salaries of few Key executives etc.

 Variable Cost- A cost that varies as output varies

 Example- Expenditure on Wages and Salaries, raw

materials used increases as output increases.
 
 Variable costs refer to those costs which change with
the change in the volume of output. These costs are
unavoidable or contractual costs. Marshall called
these costs as “Prime Costs”, “Direct Costs” or
“Special Costs”.

 Variable costs include expenditure on transport,

wages of labour, price of raw material etc. Thus,
according to Dooley, “Variable costs are one which
varies as the level of output varies.”
Total Cost &Variable
Cost

 Theory of cost

 Generally theories of costs can be divided into two
parts:

 Traditional Theory of Costs/Short Run

Cost Curves:
 In traditional theory, costs are generalized in two
parts on the basis of time period i.e. costs in short
run and costs in long run period.
 
 Costs are mainly of the following types:
1. Total cost
2. Average cost
3. Marginal Cost
 Total Cost
 According to Dooley-

 “Total cost of production is the sum of all
expenditure incurred in producing a given volume
of output.”

 In other words, the amount of money spent on the

production of different levels of a good is called total
cost.
 Marginal and Average
Cost

 Marginal Cost (MC):- Also called as Incremental
cost.
 The increase in cost that results from producing one
extra unit of output.
 Fixed cost does not change as the firm’s level of
output changes, therefore , Marginal cost is equal to
increase in Variable cost or the increase in Total cost
that results from an extra unit of output.
Total/Average/Marginal
Cost Cost

 
 Total Fixed Cost (TFC) – costs independent of output,
e.g. paying for factory
 Marginal cost (MC) – the cost of producing an extra unit
of output.
 Total variable cost (TVC) = cost involved in producing
more units, which in this case is the cost of employing
workers.
 Average Variable Cost AVC = Total variable cost /
quantity produced
 Total cost TC = Total variable cost (VC) + total fixed cost
(FC)
 Average Total Cost ATC = Total cost / quantity


 Costs in the short run

 Short run cost curves tend to be U shaped because
of Diminishing returns.

 In the short run, capital is fixed.

 After a certain point, increasing extra workers leads

to declining productivity. Therefore, as you employ
more workers the marginal cost increases.

 
 Because the short run marginal cost curve is sloped
like this, mathematically the average cost curve will
be U shaped.

 Initially, average costs fall. But, when marginal cost

is above the average cost, then average cost starts to
rise.

 Marginal cost always passes through the lowest

point of the average cost curve.
Average Cost Curves

 ATC (Average Total
Cost) = Total Cost /
quantity

 AVC (Average Variable

Cost) = Variable cost /
Quantity

 AFC (Average Fixed

Cost) = Fixed cost /
Quantity
 
 The lowest point of the AVC curve is called the shut
(close)- down point and that of the ATC curve the
break-even point.

 Finally, we see that MC lies below both AVC and

ATC over the range in which these curves decline

 MC lies above them when they are rising.

 Long Run Total Cost

 Definition:
The time period during which all the factors (except
factor prices and the state of technology or art of
production) is variable is called the long run and the
associated curve that shows the minimum cost of
producing each level of output is called the long- run
total cost curve.
 Long Run Cost Curves

 The long-run cost curves are ‘U’ shaped for different
reasons.

 It is due to Economies of Scale and Diseconomies of Scale.

 If a firm has high fixed costs, increasing output will lead

to lower average costs.

 However, after a certain output, a firm may experience

diseconomies of scale. This occurs where increased output
leads to higher average costs. For example, in a big firm, it
is more difficult to communicate and coordinate workers.


 The Shape of the LAC

 Shape of LAC is due to Economies and Diseconomies of
Scale.

 The shape of the long-run average cost depends on

certain advantages and disadvantages associated with
large scale production. These are known as economies
and diseconomies of scale.

 Economies of Scale:

 Various factors may give rise to economies of scale, that

is, to decreasing long-run average costs of production.
 Factors for Economies
of Scale

 Greater Specialization of Resources

 More Efficient Utilization of Equipment

 Reduced Unit Costs of Inputs

 Utilization of by-products

 Growth of Auxiliary Facilities

 Diseconomies of Scale

 This is attributable to the following two main rea-
sons:

 Decision-Making Role of Management

 Competition for Resources


 
 Where economies of scale are negligible, diseconomies
may soon assume paramount significance causing LAC to
turn up at a relatively small volume of output. (Panel A)

 In other cases, economies of scale assume strategic

significance.

 Even after the efficiency of management starts declining,

technological economies of scale may offset the
diseconomies over a wide range of output. Thus, the LAC
curve may not slope upward until a very large volume of
output is produced (Panel B)
 
 In many actual situations, however, neither of these
extremes describes the behaviour of LAC.

 A very modest scale of operation may not set in until

a very large volume of output is produced.

 In such a situation, LAC would have a long

horizontal section as shown in Panel C
 
 However, not all firms will experience diseconomies
of scale.

 It is possible the LRAC could just be downward

sloping.
 PLANT SIZE and Cost

 In the long run, the firm can change the size of the
plant.

 Starting from zero output level, successively larger

plants typically have lower and lower ATC up to
some output level and then successively higher ATC
curves beyond.

 The three representative ATC curves associated with

the three successively larger plants are shown in Fig.

 
 Plant I is the best plant for output levels less than 900
units because its AC curve is the lowest to the left of point
a.

 Plant II is the best plant size for output levels between 900
to 2,000 units, because its AC curve is the lowest between
point a and b.

 Plant III is the best plant size for output levels greater
than 2,000 units, since its AC curve is the lowest beyond
point b.
 
 If these are only three possible plant sizes, the long run
ATC curve will consist of -
 the segments of Plant I’s AC curve up to point a,
 the segment of plant II’s AC curve between points a and
b, and
 the segment of Plant Ill’s AC curve from point of b and so
on.

 The thick LAC is composed of the three lowest branches

of SACs. This is why the LAC is called the envelope
curve.
 
 We get the smooth envelope Long run cost curbe.

 Samuelson: “In the long run, a firm can choose its

best plant sizes and its lower envelope curve.”

 Since there is an infinite number of choices, we get

LAC as a smooth envelope. And, as in the short-run,
we can derive LMC from LAC, and LMC emerges
from the minimum point of LAC with a smoother
slope than the SMC curve.

Cost Elasticity

 On the basis of the
relation between MC and
AC we can develop a new
concept, viz., the concept
of cost elasticity.

 It measures the
responsiveness of total
cost to a small change in
the level of output.
 Economies of scope

 Economies of scope occur when a firm can gain
efficiencies from producing a wider variety of products.
 These efficiencies can involve lower average costs. It can
also involve increased revenue from being able to increase
sales in new, related markets.
 It is similar to concept of Economies of scale – where
higher output leads to lower average costs. But, there is a
difference. Economies of scope is not about producing the
same good at lower average cost, but using its size and
resources to produce similar or related goods.
Starbucks instant coffee

 Starbucks has a strong brand name for coffee retail
on the high street. It took the decision to produce an
instant coffee – making use of its own financial
resources and brand name.

 This is an economy of scope, as it is greater variety of

coffee. Interestingly some asked whether it was a
good idea because instant coffee is an anathema for
serious coffee connoisseurs, and it could harm its
brand image for high quality coffee.
 
 Using brand name to enter different markets

 tesco-finance

 A large supermarket like Tesco or Sainsbury’s can use its

powerful brand name to enter a completely different
market to groceries – selling financial services, credit
cards, insurance and banking. The firm makes use of its
brand name, customer data and regular contact with
potential customers to diversify into becoming a much
more encompassing firm.
 Break Even Analysis

 Break Even Analysis in economics, business, and cost
accounting refers to the point at which total cost and
total revenue are equal.

 A break even point analysis is used to determine the

number of units or revenue needed to cover total
costs (fixed and variable costs).


 Break Even Analysis
costs / (Sales price per
 Break even quantity = Fixed
unit – Variable cost per unit)

 Fixed costs are costs that do not change with varying

output (i.e. salary, rent, building machinery).
 Sales price per unit is the selling price (unit selling price)
per unit.
 Variable cost per unit is the variable costs incurred to
create a unit.

 Sales price per unit minus variable cost per unit is the
contribution margin per unit. For example, if a book’s
selling price is $100 and its variable costs are $5 to make
the book, $95 is the contribution margin per unit and
contributes to offsetting the fixed costs.
Break Even Point-Graph

 
 The Break Even Analysis is important to business owners
and managers in determining how many units (or
revenues) are needed to cover fixed and variable expenses
of the business.
 Therefore, the concept of break even point is as follows:
 Profit when Revenue > Total Variable cost + Total Fixed
cost
 Break-even point when Revenue = Total Variable cost +
Total Fixed cost
 Loss when Revenue < Total Variable cost + Total Fixed
cost
 Example
accountant in charge of
 Mr. Raghav is the managerial
Company A, which sells water bottles. He previously
determined that the fixed costs of Company A consist
of property Tax, a lease, and executive salaries, which add
up to $100,000. The variable costs associated with
producing one water bottle is $2 per unit. The water bottle
is sold at a premium price of $12. To determine the break
even point of Company A’s premium water bottle:

 Break even quantity = $100,000 / ($12 – $2) = 10,000

 Therefore, given the fixed costs, variable costs, and selling

price of the water bottles, Company A would need to sell
10,000 units of water bottles to break even.

MARKET STRUCTURE
ANALYSIS AND
ESTIMATION
 PERFECT
COMPETITION
 CHARACTERISTICS

 Perfect Competition or Competitive markets -also
referred to as pure, or free competition

 Combination of a wide range of firms,

 Free entry or Exit, i.e., No entry or exit barriers.

 Characteristics

 Considers prices as information, since each bidder
only provides a relative small share of the Good to
the market and thus do not exert a noticeable
influence on it.

 Therefore, perfect competitors cannot influence the

levels of market clearing prices.

 Also, buyers are numerous and disperse, which also

means that they cannot influence pric
 Assumptions

 This market model is based on a set of assumptions, each
of them representing a necessary but insufficient
condition to ensure Perfect Competition. These
assumptions are:

1-Homogeneous product: all firms offer the same goods,

with the same characteristics and quality as the others.

2 -Large number of agents: there should be a sufficient

quantity of buyers and sellers, so that no action from a single
agent will affect the market structure or its prices.
 
3-No entry or exit barriers: there has to be free entry and exit
of agents in the market. This assumption is of special interest
for firms, which must be able to enter or leave the market
freely.

4-Price flexibility: price adjustments to changes happen as

fast as possible. Usually, price changes are assumed
instantaneous.

5 -Free and perfect information: all agents have perfect

knowledge of products and their prices, and everything else
related to them, as well as free access to this information.
 
6 -Perfect factor mobility: all factors should be able to change
so adjustments processes can be carried out with the greatest
efficiency.

7 -No government intervention: markets should be left alone

as government intervention would only lead to imbalances
in perfectly competitive markets

8. Perfect Competition among Buyers and Sellers:

In this purchasers and sellers have got complete freedom for
bargaining, no restrictions in charging more or demanding
less, competition feeling must be present there
 
9. Absence of Transport Cost:
There must be absence of transport cost. In having less or
negligible transport cost will help complete market in
maintaining uniformity in price.

10. One Price of the Commodity:

There is always one price of the commodity available in the
market.

11. Independent Relationship between Buyers and Sellers

 
 There are assumed to be no externalities, that is no
external costs or benefits to third parties not
involved in the transaction.

 Firms can only make normal profits in the long run,

although they can make abnormal (super-normal)
profits in the short run.
 
 There should not be any attachment between sellers and
purchasers in the market.

 Here, the seller should not show pick and choose method in
accepting the price of the commodity.

 “Perfect Competition is a pure myth.” - Perfect competition

markets are almost impossible to find in the real word as all
markets have some type of imperfection.

 This is the reason they are mostly considered only theoretically.

However, its study helps understand real world markets and
their phenomena.
 Firms are price taker

 The single firm takes its price from the industry, and
is, consequently, referred to as a price taker.

 The industry is composed of all firms in the industry

and the market price is where market demand is
equal to market supply.

 Each single firm must charge this price and cannot

diverge from it.
Supply and Demand in
Perfect Competition

 Let’s say there is a single individual,
Joan.

 Joan’s demand for, let’s say, books, is

such as shown in the adjacent graph.

 If the price of a book is $35 or more,

Joan won’t demand any (point a),
given her preferences (basically, she
would rather spend her money on
something else).

 However, if the price of books goes

down to $30, she will want to buy one
(point b). If it decreases to $20, Joan
will buy two books (point c), and so
on.

 By joining all the points (a-h), we’ll

get Joan’s demand curve.
 
 From a macroeconomic point of view, the demand
curve is just the aggregation of all demand curves
from all buyers in a particular market.

 Let’s say the market for books has only two buyers:
Joan and her classmate Edward.

 The horizontal sum of Joan and Edward’s demand

curves will give us the market demand.

 SUPPLY

 starting with an individual’s offer, let’s say his name is Robert.

 Robert is willing to supply books for $10 or more, i.e, Robert

won’t supply any books for $5 (point a).

 However, if the price of books goes up to $10, he will be willing

to sell one book (point b).

 If it increases to $15, Robert will sell two books (point c), and so
on.

 By joining all the points (a-g), we’ll get Robert’s supply curve.
Notice that the supply curve goes up and seems not to have
limits, an assumption made for simplicity’s sake.

 Market Supply Curve

 The market’s supply
curve is just the
aggregation of all supply
curves from all sellers in
a particular market.

 Let’s say the market for

books has only two
sellers: Robert and the
librarian next door,
Gregory.
 Equilibrium and
market clearing

 The demand and supply curves define the market clearing, that
is, where the demand of the products meets its supply.

 An equilibrium point, with its corresponding price and

quantity of equilibrium.

 Disequilibrium occur when the amount demanded does not

equal the amount supplied. In situations in which the quantity
demanded is higher than the quantity supplied, the market is
suffering from an excess demand. When the opposite occurs
results in an excess supply.

 Prices will have to gradually adjust through different market

mechanisms until the equilibrium

Price Maker Vs. Price
Taker

Possible situations in Short Run
Situation-I

  Here, the given price is P1.

 The firm wants to maximise

profits, so it produces at the level
of output where MC = MR. This
occurs at point A.

 Drop a vertical line to find the

firm's output (Q1). At Q1, AR >
AC and the difference between
average revenue and average cost
is the distance AB.

 This is the profit per unit. To find

the total super normal profit, we
must multiply the profit per unit
per the number of units. In the
diagram, this is the area ABCP1
SITUATION-II
 In this case, the given price is P2.

 The firm will not be making a profit.

The AC curve is above the AR curve
at all levels of output.

 The firm will still want to minimise

its losses. This can be done
where MC = MR. This occurs at
point D giving output Q2.

 At Q2, AR < AC and the difference

between average revenue and
average cost is the distance DE. This
is the loss per unit. To find the total
losses, we must multiply the loss
per unit per the number of units. In
the diagram, this is the area DEFP2
SITUATION-III
 Here, the given price is P . 3

 Again the firm will

produce the level of
output for which MC =
MR. This occurs at point
G, giving a level of output
of Q3.

 At this point, AR = AC, so

the firm is making normal
profit.
 
 So, in the short run, a perfectly competitive firm
could be making super normal profit, or a
loss, or just normal profit, depending on the given
market price.

 Note that if the firm's losses get too big in the short
run (i.e. AR < AVC) then it will have to shut down
LONG RUN EQUILIBRIUM


 Long run equilibrium

 The two sets of diagrams show that in the long
run, all firms in a perfectly competitive market
earn only normal profit.

 Here the initial price is P1, due to the fact that the initial
demand and supply curves, D1 and S1, cross at point C.

 This given price means that each firm's demand curve is

D1. MC = MR occurs at point A. AR > AC, so each firm is
making super normal profits.

 In the long run there are no barriers to entry or exit in a

perfectly competitive market.
 
 New firms will be attracted, in quite large numbers, into the
market.

 This will increase market supply, shifting the supply curve to

the right. This will keep happening until the given price is such
that all firms in the market earn only normal profit.

 All of the super normal profit will have been competed away.
Once the supply curve has shifted all the way to S2, with a
given price of P2, then every firm in the industry will be earning
normal profit and there will be no incentive for any firm to
enter or leave the industry.

 This is, therefore, the long run equilibrium.


 
 Each firm is making a loss at the initial price P1.

 MC = MR occurs at point F, where AR < AC.

 Firms can take a reasonable sized loss in the short run, but this is
not sustainable as we move into the long run.

 Again, there are no barriers to exit, so some firms will leave the
industry, causing the market supply curve to shift to the left. This
will keep happening until the given price is such that all firms in
the market earn only normal profit.

 Once the supply curve has shifted all the way to S3, with a given
price of P3, then every firm in the industry will be earning normal
profit and there will be no incentive for any firm to enter or leave
the industry. This is, therefore, the long run equilibrium.
 Efficiency in
Competitive Markt

 In the long run, all firms in a perfectly competitive market are
both allocatively efficient (because price = MC)
and productively efficient (because at the equilibrium output,
MC = AC).

 Allocative efficiency:

 In both the short and long run we find that price is equal to
marginal cost (P=MC) and thus allocative efficiency is achieved.

 At the ruling price, consumer and producer surplus are

maximised.

 No one can be made better off without making some other

agent at least as worse off – i.e. we achieve a Pareto optimum
allocation of resources.
 Productive efficiency:

 Productive efficiency occurs when the equilibrium
output is supplied at minimum average cost.

 This is attained in the long run for a competitive

market.

 Firms with high unit costs may not be able to justify

remaining in the industry as the market price is
driven down by the forces of competition.
 Dynamic efficiency

 We assume that a perfectly competitive market
produces homogeneous products.

 In other words, there is little scope for innovation

designed purely to make products differentiated
from each other and allow a supplier to develop and
then exploit a competitive advantage in the market
to establish some monopoly power.
 PRODUCR’S SURPLUS

 The producer’s surplus of a firm is the sum over all
units of production of the difference between the
market price and the MC of production.

 Just as the consumer’s surplus measures the area

below the demand curve of an individual and above
the market price, producer’s surplus measures the
area above a producer’s supply curve and below the
market price.

 Producer’s Surplus and
Profit

• Producer’s surplus is related to profit, but is not
equal to it.

• Producer’s surplus subtracts only variable costs from

revenues,

• While profit subtracts both variable and fixed costs.

PS = TR – TVC and
Profit – π =TR- TVC – TFC.
• Thus, producer’s surplus is always greater than profit
 
 The extent to which firms enjoy PS depends on their costs
of production.

 Higher-cost firms have less PS than low-cost firms.

 By adding up all the individual firm’s producer’s

surplus, we can find the PS for a market.

 In Fig. the market PS is obtained by the area below the

market price and above the market supply curve, between
O and output Q*.

 
 https://www.tutor2u.net/economics/reference/per
fect-competition-economic-efficiency
 Effects of TAXES

 Firm responds to a tax on output.
 We assume that the firm uses a fixed-proportion production
technology.

 Suppose for the moment that the output tax is imposed only on
a particular firm in the industry, and, thus, does not affect the
market price of the product.

 Fig. shows the relevant Short-run cost curves for a firm

enjoying positive economic profit by producing an output
q1 and selling its product at the market price P1.

 Because the tax is a unit tax, it raises the firm’s MC curve from
MC1 to MC2 = MC1 + t, where t is the tax per unit of the firm’s
output. The tax also raises the AVC curve by the amount t.

 Two possible effects

 If the tax is less than the firm’s profit margin, the
firm maximises its profit by choosing an output at
which its MC + t = P. The firm’s output falls from
q1 to q2, and the impact of the tax is to shift the
firm’s short run supply curve upward,

 If the tax is greater than the firm’s profit margin,

then the AVC will rise, and if the minimum AVC is
greater than the market price, the firm will choose
not to produce.
 Now suppose an output

tax is placed on all firms
in a competitive market
which will shift the short-
run supply curve for the
industry upward by the
amount of the tax.

 This raises the market

price of the product and
lowers the total output of
the industry as shown in
fig.
 
 https://www.youtube.com/watch?v=5c_dBgYMzC
Q

 https://www.youtube.com/watch?v=V81gQroEszI
MONOPOLY
 MEANING

 A monopoly is a specific type of economic market structure.

 Irving Fisher described monopolies as market structures where

there is no competition.

 Neoclassical economists considers a monopoly as the exact

opposite to perfect competition.

 A simpler definition would be that a monopoly is just a market

where there is only one seller.

 Monopoly exists when a specific person or enterprise is the only

supplier of a particular good.

 As a result, monopolies are characterized by a lack of competition

within the market producing a good or service
 Monopoly vs. Competitive
Market
 SIMILARITIES- 
 Monopolies and competitive markets mark the extremes in
regards to market structure. However, there are few
similarities

 the cost functions are the same

 both minimize cost and maximize profit

 the shutdown decisions are the same,

 both are assumed to have perfectly competitive market

factors.
 Monopoly vs.
Competitive Market
 DIFFERENCES
 marginal revenue and price

 product differentiation

 number of competitors

 barriers to entry

 elasticity of demand

 excess profits, profit maximization, and

 the supply curve.

 Monopoly vs.
Competitive Market

 The most significant distinction is that-

 a monopoly has a downward sloping demand

instead of the “perceived” perfectly elastic curve of
the perfectly competitive market.
 CHARCTERISTICS

 A monopoly can be recognized by certain characteristics
that set it aside from the other market structures:
 Profit Maximizer: a monopoly firm maximizes it’s
profits. Due to the lack of competition a firm can charge a
set price above what would be charged in a competitive
market, thereby maximizing its revenue.
 Price maker: Monopoly firm decides the price of the
good or product being sold. The price is set by
determining the quantity in order to demand the price
desired by the firm (maximizes revenue).
 High barriers to entry: other sellers are unable to enter
the market of the monopoly.
 CHARCTERISTICS

 Single seller: in a monopoly one seller produces all
of the output for a good or service. The entire market
is served by a single firm. For practical purposes the
firm is the same as the industry.

 Price discrimination: in a monopoly the firm can

change the price and quantity of the good or service.

 In an elastic market the firm will sell a high quantity

of the good if the price is less. If the price is high, the
firm will sell a reduced quantity in an elastic market.
 SOURCES OF
MONOPOLY POWER

 In a monopoly, specific sources generate the
individual control of the market. Sources of power
include:
 Economies of scale
 Capital requirements
 Technological superiority
 No substitute goods
 Control of natural resources
 Network externalities
 Legal barriers
 Deliberate actions
 EXAMPLE

 A classic example of a monopoly based on resource control is De
Beers. De Beers Consolidated Mines were founded in 1888 in South
Africa as an amalgamation of a number of individual diamond
mining operations. De Beers had a monopoly over the production
of diamonds for most of the 20th century, and it used its dominant
position to manipulate the international diamond market. It
convinced independent producers to join its single channel
monopoly. In instances when producers refused to join, De Beers
flooded the market with diamonds similar to the ones they were
producing. De Beers also purchased and stockpiled diamonds
produced by other manufacturers in order to control prices
through supply. The De Beers model changed at the turn of the
21st century, when diamond producers from Russia, Canada, and
Australia started to distribute diamonds outside of the De Beers
channel. The sale of diamonds also suffered from rising awareness
about blood diamonds. De Beers’ market share fell from as high as
90 percent in the 1980s to less than 40 percent in 2012.
 EXAMPLE

 Around the world government monopolies on

 public utilities

 telecommunications systems

 railroads
Monopoly and Market
Demand

 
 Contrast the situation in Panel (b) with Panel a.

 Because it is the only supplier in the industry, the monopolist faces the
downward-sloping market demand curve alone. It may choose to
produce any quantity. But, unlike the perfectly competitive firm,
which can sell all it wants at the going market price, a monopolist can
sell a greater quantity only by cutting its price.

 Suppose, for example, that a monopoly firm can sell quantity Q1 units
at a price P1 in Panel (b). If it wants to increase its output to Q2 units—
and sell that quantity—it must reduce its price to P2. To sell
quantity Q3 it would have to reduce the price to P3. The monopoly firm
may choose its price and output, but it is restricted to a combination of
price and output that lies on the demand curve. It could not, for
example, charge price P1 and sell quantity Q3.
 To be a price setter, a firm must face a downward-sloping demand
curve.
 Demand ,
Elasticity,Total Revenue

 
 Total revenue for each quantity equals the quantity times
the price at which that quantity is demanded.

 The monopoly firm’s total revenue curve is given in Panel

(b).

 Because a monopolist must cut the price of every unit in

order to increase sales, total revenue does not always
increase as output rises.

 In this case, total revenue reaches a maximum of $25

when 5 units are sold. Beyond 5 units, total revenue
begins to decline.
Demand & Marginal
Revenue

 Monopoly Equilibrium: Applying the
Marginal Decision Rule

 Graph shows a demand


curve and an associated
marginal revenue curve
facing a monopoly firm.

 The marginal cost curve

is falls over the range of
output in which the firm
experiences increasing
marginal returns, then
rises as the firm
experiences diminishing
marginal returns.
 
 Thus we can determine a monopoly firm’s profit-
maximizing price and output by following three steps:

 Determine the demand, marginal revenue, and marginal

cost curves.

 Select the output level at which the marginal revenue and

marginal cost curves intersect.

 Determine from the demand curve the price at which that

output can be sold.
 NATURAL
MONOPOLIES

 Natural monopolies occur when a single firm can serve the entire
market at a lower cost than a combination of two or more firms.

 A natural monopoly ‘s cost structure is very different from that

of most industries. For a natural monopoly, the average total cost
continues to shrink as output increases.

 Natural monopolies tend to form in industries where there are

high fixed costs. A firm with high fixed costs requires a large
number of customers in order to have a meaningful return on
investment.
 Other firms are discouraged from entering the market because of
the high initial costs and the difficulty of obtaining a large
enough market share to achieve the same low costs as the
monopolist.
 
 Imagine there are two firms in a natural monopoly’s
market and each of them produces half of the quantity
that the monopoly produces.

 The total cost of the natural monopoly is lower than the

sum of the total costs of two firms producing the same
quantity.

 Examples of natural monopolies are water and electricity

services. For both of these, fixed costs of building the
necessary infrastructure are high. The cost of constructing
a competing transmission network and delivering service
will be so high that it effectively bars potential
competitors from entering the monopolist’s market.
 NATURAL
MONOPOLIES

 Short Run & Long Run
EQUILIBRIUM
 Profit Maximization

 In perfectly competitive markets, in which marginal
revenue is the same as price.

 Monopoly production, however, is complicated by

the fact that monopolies have demand curves and
MR curves that are distinct, causing price to differ
from marginal revenue.
 Calculating
Monopolist’s Profit
  The average total cost (ATC)
at an output of Qm units
is ATCm.

 The firm’s profit per unit is

thus Pm – ATCm. Total profit
is found by multiplying the
firm’s output, Qm, by profit
per unit,

 Total profit equals Qm(Pm –

ATCm)—the area of the
shaded rectangle
 Welfare loss to society

 In a competitive market, the output will be at Pc and Qc.
(point C)

 In a monopoly, the output will be QM and PM – causing a

fall in consumer surplus.

 Monopoly also causes a fall in producer surplus (less is

sold). But, some of the consumer surplus is captured by
firms (from setting higher price).

 The blue triangle shows the net loss of consumer and

producer surplus to society.

 
 The diagram for a monopoly is generally considered to be
the same in the short run as well as the long run.

 Profit maximisation occurs where MR=MC. Therefore the

equilibrium is at Qm, Pm. (point M)

 This diagram shows how a monopoly is able to make

supernormal profits because the price (AR) is greater than
AC.

 Usually, supernormal profit attracts new firms to enter

the market, but there are barriers to entry in monopoly,
and this enables the monopoly to keep supernormal
profits.
 Efficiency and
monopoly

 Monopolies set a price greater than MC -
Allocatively Inefficient.

 By producing at Qm, the monopoly is productively

inefficient (not lowest point on AC curve)

 With less competition, a monopoly has fewer

incentives to cut costs and therefore will be x-
inefficient.
 
 Three steps can determine a monopoly firm’s profit-
maximizing price and output:

1. Calculate and graph the firm’s marginal revenue,

marginal cost, and demand curves

2. Identify the point at which the marginal revenue and

marginal cost curves intersect and determine the level of
output at that point.

3. Use the demand curve to find the price that can be

charged at that level of output
 Myths

 Three common misconceptions about monopoly are:

1. Because there are no rivals selling the products of

monopoly firms, they can charge whatever they want.

 If it tries to sell Qm units of output for more than Pm, some

of its output will go unsold. The monopoly firm can set its
price, but is restricted to price and output combinations
that lie on its demand curve. It cannot just “charge
whatever it wants.” And if it charges “all the market will
bear,” it will sell either 0 or, at most, 1 unit of outpu
 MYTHS

2. Because monopoly firms have the market to
themselves, they are guaranteed huge profits.

 Suppose the average total cost curve, instead of lying

below the demand curve for some output levels as
shown, were instead everywhere above the demand
curve.

 In that case, the monopoly will incur losses no

matter what price it chooses, since average total cost
will always be greater than any price it might charge
 RECAP

 If a firm faces a downward-sloping demand curve, marginal revenue
is less than price.

 Marginal revenue is positive in the elastic range of a demand curve,

negative in the inelastic range, and zero where demand is unit price
elastic.

 If a monopoly firm faces a linear demand curve, its marginal revenue

curve is also linear, lies below the demand curve, and bisects any
horizontal line drawn from the vertical axis to the demand curve.

 To maximize profit or minimize losses, a monopoly firm produces the

quantity at which marginal cost equals marginal revenue. Its price is
given by the point on the demand curve that corresponds to this
quantity.
 PRICE
DISCRIMINATION

 We have assumed that firms sold all units of output at the
same price.

 In some cases, however, firms can charge different prices

to different consumers. If such an opportunity exists, the
firm can increase profits further.

 When a firm charges different prices for the same good or

service to different consumers, even though there is no
difference in the cost to the firm of supplying these
consumers, the firm is engaging in price discrimination.
 
 The potential for price discrimination exists in all
market structures except perfect competition.

 As long as a firm faces a downward-sloping demand

curve and thus has some degree of monopoly power,
it may be able to engage in price discrimination.

 But monopoly power alone is not enough to allow a

firm to price discriminate. Monopoly power is one of
three conditions that must be met:
 
 A Price-Setting Firm The firm must have some
degree of monopoly power—it must be a price setter.
A price-taking firm can only take the market price as
given—it is not in a position to make price choices of
any kind. Thus, firms in perfectly competitive
markets will not engage in price discrimination.
Firms in monopoly, monopolistically competitive, or
oligopolistic markets may engage in price
discrimination.

 Distinguishable Customers The market must be

capable of being fairly easily segmented—separated
so that customers with different elasticities of
demand can be identified and treated differently.
 
 Prevention of Resale The various market segments
must be isolated in some way from one another to
prevent customers who are offered a lower price
from selling to customers who are charged a higher
price.

 If consumers can easily resell a product, then

discrimination is unlikely to be successful. Resale
may be particularly difficult for certain services, such
as dental checkups.
 EXAMPLES

 Senior citizens and students are often offered discount fares on
city buses.
 Children receive discount prices for movie theater tickets and
entrance fees at zoos and theme parks.

 Faculty and staff at colleges and universities might receive

discounts at the campus bookstore.

 Airlines give discount prices to customers who are willing to

stay over a Saturday night.

 Physicians might charge wealthy patients more than poor ones.

People who save coupons are able to get discounts on many
items.
 
 Monopolies are usually considered to be inefficient, but if
allowed to price discriminate they can (in a perfect world)
be very efficient.

 Of course, unregulated monopolies are illegal and

regulated monopolies generally are not allowed to price
discriminate.

 For this reason, price discrimination is really a practice of

imperfectly competitive firms (oligopolies and
monopolistically competitive firms).
 TYPES OF PRICE
DISCRIMINATION
1. 
First Degree Price Discrimination-

This involves charging consumers the maximum price that they are
willing to pay.

There will be no consumer surplus.

2. Second Degree Price Discrimination

 This involves charging different prices depending upon the

quantity consumed. For example:
 After 10 minutes phone calls become cheaper.
 Electricity is more expensive for the first number of units. For a
higher quantity of electricity consumed the marginal cost is lower.
 Loyalty cards reward frequent buyers with discounts on future
products.
 Third Degree Price
Discrimination

 Third Degree Price Discrimination – ‘Group price
discrimination’

 This involves charging different prices to different groups of

people. For example:
 Student discounts,

 Senior citizen rail card

 Peak travel/ off-peak travel

 Cheaper prices by the time of the day (e.g. happy hour’s in

pubs – usually earlier on in evening where demand is lower.
 Product versioning

 One way firms practise price discrimination is to offer
slightly different products as a way to discriminate
between consumers ability to pay. For example:
 Priority boarding tickets. Same flight but for a premium,
you get a shorter queue.
 Organic coffee / fair trade coffee
 Extra leg room on airplanes
 First class/second class
 This is a form of indirect segmentation. By offering
slightly different choices, the firm is able to separate
consumers who are willing to pay higher prices.
Necessary conditions for
price discrimination
must operate in imperfect
 Firm a price maker. The firm
competition; it must be a price maker with a downwardly
sloping demand curve.
 Separate markets. The firm must be able to separate
markets and prevent resale. E.g. stopping an adults using
a child’s ticket. Prevent business travellers buying
discount tickets.
 Different elasticities of demand. Different consumer
groups must have elasticities of demand. E.g. students
with low income will be more price elastic and sensitive
to price. Business travellers will have more inelastic
demand.
 Low admin costs. It must be relatively cheap to separate
markets and implement price discrimination.
Simple diagram for
Price Discrimination

 
 Without price discrimination, the firm charges one
price £7 * 100 = £700 revenue

 WIth price discrimination, the firm can charge two

different prices:
 £10 * 35 = £350
 £4 * 120 = £480

 Total revenue = £830. Therefore, the firm makes

more revenue under price discrimination.
Profit maximisation under Price
Discrimination

 To maximise profits a firm sets output and price where
MR=MC. If there are two sub markets with different
elasticities of demand.

 The firm will increase profits by setting different prices

depending upon the slope of the demand curve.

 Therefore for a group, such as adults, PED is inelastic – the

price will be higher

 For groups like students, prices will be lower because their

demand is elastic
Diagram of Price
Discrimination

 
 Profit is maximised where MR=MC. Without price
discrimination, there would just be one price set for the
whole market (A+B). There would be a price of P3.

 However, price discrimination allows the firm to set

different prices for segment A (inelastic demand) and
segment B (elastic demand)

 Because demand is price inelastic, segment (A) will have a

higher profit maximising price (P1)

 In segment (B) demand is price elastic, so the profit

maximising price is lower.
 Advantages of price
discrimination

 Firms will be able to increase revenue.

 Increased investment. These increased revenues can be used

for research and development which benefit consumers

 Lower prices for some. Some consumers will benefit from

lower fares. For example, old people benefit from lower train
companies; old people are more likely to be poor.

 Manages demand. Airlines can use price discrimination to

encourage people to travel at unpopular times (early in
morning) This helps avoid over-crowding and helps to spread
out demand.
 Disadvantages of Price
Discrimination

 Higher prices for some. These higher prices are likely to be allocatively
inefficient because P > MC.

 Decline in consumer surplus. Price discrimination enables a transfer

of money from consumers to firms – contributing to increased
inequality.

 Potentially unfair. Those who pay higher prices may not be the
poorest. For example, adults paying full price could be unemployed,
senior citizens can be very well off.

 Administration costs. There will be administration costs in separating

the markets, which could lead to higher prices.

 Predatory pricing. Profits from price discrimination could be used to

finance predatory pricing.
 Importance of marginal cost
in price discrimination

 In markets where the marginal cost of an extra
passenger is very low, the firm has an incentive to
use price discrimination to sell all the tickets.

 This is why sometimes prices for airlines can be very

low just before their date.

 Once the company is due to fly the MC of an extra

passenger will be very low. Therefore this justifies
selling the remaining tickets at a low price.
 
 https://www.tutor2u.net/economics/reference/mo
nopoly-price-and-output-for-a-monopolist
 KEY POINTS

 A monopoly market is characterized by the profit maximizer, price maker, high
barriers to entry, single seller, and price discrimination.

 Monopoly characteristics include profit maximizer, price maker, high barriers

to entry, single seller, and price discrimination.

 Sources of monopoly power include economies of scale, capital requirements,

technological superiority, no substitute goods, control of natural resources,
legal barriers, and deliberate actions.

 There are a few similarities between a monopoly and competitive market: the
cost functions are the same, both minimize cost and maximize profit, the
shutdown decisions are the same, and both are assumed to have perfectly
competitive market factors.

 Differences between the two market structures including: marginal revenue

and price, product differentiation, number of competitors, barriers to entry,
elasticity of demand, excess profits, profit maximization, and the supply curve.