CHAPTER TWO: DEMAND AND SUPPLY

I. THEORY OF THE DEMAND

Demand :is willingness and ability of a consumer to purchase
the commodity at a given time at various prices

refers to various quantities of a commodity or

service that a consumer would purchase at a given time
in a market at various prices, given other things
unchanged (ceteris paribus). It Is the willingness of
consumer that is backed by the ability to buy the product.

Law of demand :his is the principle of demand, which

states that , price of a commodity and its quantity
demanded are inversely related i.e., as price of a
commodity increases (decreases) quantity demanded for
that commodity decreases (increases), ceteris paribus.
1
Quantity demanded is the amount of a good that buyers are
willing and able to purchase at various prices in a given period
of time, oher things remaining unchanged (Ceteris Paribus).

A demand schedule is a tabular listing that shows how

much of a given product a household would be willing
to buy at d/t prices in a given period of time .

A demand schedule states the relationship between price and

quantity demanded in a table form.

Table 2.1 Individual household demand for orange per week

Combinations A B C D E

Price per kg 5 4 3 2 1

Quantity demand/week 5 7 9 11 13

2
 Demand Curve
• Demand curve is a graphical representation of the relationship
between different quantities of a commodity demanded by an
individual at different prices per time period

3
 Demand function
is a mathematical relationship between price and quantity
demanded, all other things remaining the same. A typical
demand function is given by

4
 Individual and market Demand
• Demand for a good or service can be defined for an
individual household, or for a group of households
that make up a market;

• Market demand is the sum of all the quantities of a

good or service demanded per period by all the
households buying in the market for that good or
service.

5
 Market demand

Quantity Demanded/week Market

Price Mr.A Mr.B Mr.C Demand/week

6 2 0.5 1.5 4
5 3 1.5 2.5 7
4 4 2 4 10
3 5 3 5 13
2 6 4.5 5.5 16
1 7 6 7 20

6
 Market demand graphically:

P P P P

3 3 3 3

5 Q 3 Q 5 Q 13 Q

Mr.A’s Mr.B’s Mr.C’s Market

demand demand demand Demand

7
 Determinants of Demand
The demand for a product is influenced by many factors.
Some of these factors are:
Own determinants of the demand . Brings movement along the
same demand curve ..change in quantity demanded
I.Price of the product.

Non- Own determinants of the demand…demand curve

shifters / brings changes in the demand
II. Taste or preference of consumers…

III. Income of the consumers

IV. Price of related goods

V. Consumers expectation of income and price

VI. Number of buyers in the market

8
 Cont’d
I. Taste or preference
When the taste of a consumer changes in favor of a good, her/his demand
will increase and the opposite is true.
II. Income of the consumer

• Goods are classified into two categories depending on how a change in

income affects their demand. These are normal goods and inferior
goods.
• Normal Goods are goods whose demand increases as income increase,
while inferior goods are those whose demand is inversely related with
income.
• In general, inferior goods are poor quality goods with relatively lower
price and buyers of such goods are expected to shift to better quality
goods as their income increases.
• However, the classification of goods into normal and inferior is
subjective and it is usually dependent on the socio-economic
development of the nation

9
 III. Price of related goods
• Two goods are said to be related if a change in the price of one
good affects the demand for another good
There are two types of related goods. These are substitute and
complimentary goods.
Substitute goods are goods which satisfy the same desire of the
consumer. For example, tea and coffee or Pepsi and Coca-Cola are
substitute goods. If two goods are substitutes, then price of one
and the demand for the other are directly related.
Complimentary goods, on the other hand, are those goods which
are jointly consumed. For example, car and fuel or tea and sugar
are considered as compliments. If two goods are complements,
then price of one and the demand for the other are inversely
related.

10
 Cont’d
• IV Consumer expectation of income and price
• Higher price expectation will increase demand while a
lower future price expectation will
• decrease the demand for the good.
• V Number of buyer in the market
• Since market demand is the horizontal sum of
individual demand, an increase in the number of
• buyers will increase demand while a decrease in the
number of buyers will decrease demand

11
A change in Demand Vs a change in Quantity
Demanded

• A change in demand is not the same as a

change in quantity demanded;

• A higher price causes lower quantity demanded

and a move along the demand curve;

• Changes in the determinants of demand, other

than price, cause a change in demand, or a shift
of the entire demand curve.

12
Graphically: A Change in Demand Versus a
Change in Quantity Demanded

Change in price of a good or service

leads to Change in quantity demanded
(Movement along the curve).

Change in income, preferences, or

prices of other goods or services
leads to Change in demand
(Shift of the curve).

13
 Shifts of the Demand Curve
Price of
Bread

Decrease
in demand
Demand
curve, D2
Demand
curve, D1
Demand curve, D3
O
Qty of bread
14
 2.3 Elasticity of demand
Elasticity is a measure of responsiveness of a dependent
variable to changes in an independent variable. is very
crucial and is used to analyze the quantitative
relationship between price and quantity purchased or
sold
Elasticity of demand refers to the degree of
responsiveness of quantity demanded of a good to a
change in its price, or change in income, or change in
prices of related goods. Commonly,
there are three kinds of demand elasticity: price
elasticity, income elasticity, and cross
elasticity. 15
 1. Price Elasticity of Demand
• Price elasticity of demand means degree of responsiveness
of demand to change in price. It indicates how consumers
react to changes in price. computed as the percentage
change in quantity demanded divided by the percentage
change in price.
Price elasticity demand can be measured in two
ways. These are point and arc elasticity .
1. Point Price Elasticity of Demand
• This is calculated to find elasticity at a given point. The
price elasticity of demand can be determined by the
following formula

16
Cont..d

17
Cont’d

18
 b. Arc price elasticity of demand
• In arc price elasticity of demand, the midpoints of
the old and the new values of both price and
quantity demanded are used. It measures a
portion or a segment of the demand curve
between the two points.

19
• Here, Qo = Original quantity demanded
• Q1 = New quantity demanded
• Po = Original price
• P1 = New price

For example : Suppose that the price of a commodity is

Br. 5 and the quantity demanded at that price is 100
units of a commodity. Now assume that the price of
the commodity falls to Br. 4 and the quantity
demanded rises to 110 units. In terms of the above
formula, the value of the arc elasticity will be

20
• Note that:
Cont’d
 Elasticity of demand is unit free because it is a ratio of percentage change.
 Elasticity of demand is usually a negative number because of the law of
demand. If the price . elasticity of demand is positive the product is inferior.

21
 Determinants of price Elasticity of Demand
The following factors make price elasticity of demand elastic or inelastic
other than changes in the price of the product.
•i) The availability of substitutes: the more substitutes available for a product,
the more elastic will be the price elasticity of demand.

II. Time: In the long- run, price elasticity of demand tends to be

elastic. Because:
· More substitute goods could be produced.
· People tend to adjust their consumption pattern.
iii) The proportion of income consumers spend for a product:-
the smaller the proportion of income spent for a good, the less
price elastic will be.
iv) The importance of the commodity in the consumers’ budget :
· Luxury goods  tend to be more elastic, example: gold.
· Necessity goods  tend to be less elastic example: Salt.
22
ii. Income Elasticity of Demand

23
Cont’d

24
 II. THEORY OF SUPPLY
• Supply indicates the various quantities of a product
that sellers (producers) are willing and able to
provide at each of a series of possible prices in a
given period of time, other things remain unchanged;

• A supply schedule is a table showing how much of a

given product a firm would be willing to sell at
different prices in a given period of time.

25
 Supply… cont’d

• The supply curve is a graph illustrating how much of

a given product a firm would be willing to sell at
different prices in a given period of time;

• Supply curve can also be expressed in the form of

mathematical equation, which is called supply
function.

26
 Mr.X’s supply schedule and supply curve

Price of
Bread Supply curve
Price of Quantity of
Bread Bread supplied $3.00

2.50 1. An increase
$0.00 0 cones
in price
0.50 0 2.00
1.00 1
1.50
1.50 2 2. increases quantity
2.00 3 1.00 of bread supplied.
2.50 4
0.50
3.00 5

0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of Bread

Hypothetical SS schedule: Quantity of SS increase as Price rises

27
 Law of Supply

• The law of supply states that, the quantity supplied of

a good rises when the price of the good rises, as long
as all other factors that affect suppliers’ decisions are
unchanged.

28
 Individual Supply and Market Supply
• The supply of a good or service can be defined for an
individual firm, or for a group of firms that make up a
market or an industry;

• Market supply is the sum of all the quantities of a

good or service supplied per period by all the firms
selling in the market for that good or service;

• Market supply is the horizontal summation of

individual firms’ supply curves.

29
 Market supply

Quantity supplied/week Market

Price Seller A Seller B Seller C supply/week

6 9 7 8 24
5 7.5 6 6 19.5
4 6 5 5 16
3 4.5 4 4.5 13
2 3 3 3 9
1 1.5 2 2.5 6

30
 Market supply graphically:

P P P
P

3 3 3 3

Q
4.5 Q 4 Q 4.5 Q 13
Seller A Seller B Market
Seller C
supply

31
 Determinants of Supply
The supply of a product is determined/influenced by:
Price of the product;
Input prices(cost of inputs);
Technology;
Sellers expectation of price of the product;
Number of sellers (short run);
Taxes and subsidies; and
Weather
32
Change in quantity supplied and change in
supply

• A higher price causes higher

quantity supplied, and a
move along the SS curve.

• A change in determinants of SS
other than price causes an
increase in SS, or a shift of the
entire supply curve, from SA to SB.

33
 Shift of supply Versus movement along a
supply curve

Change in price of a good or service

leads to Change in quantity supplied
(Movement along the curve).

Change in costs, input prices,

technology,
or prices of related goods and services
leads to Change in supply
(Shift of curve).

34
 Shifts in the Supply Curve: What causes them?
Price of
Bread Supply curve, S3
Supply
curve, S1 Supply
curve, S2
Decrease
in supply

Increase
in supply

Quantity of Bread
0
35
 2.2.3 Elasticity of supply
• It is the degree of responsiveness of the supply
to change in price. It may be defined as the
percentage change in quantity supplied divided
by the percentage change in price.
As the case
• with price elasticity of demand, we can measure
the price elasticity of supply using point and arc
elasticity methods. However, a simple and most
commonly used method is point method.
36
Cont’d

37
 III. MARKET EQUILIBRIUM
• An equilibrium is the condition that exists when quantity
supplied and quantity demanded are equal. We assume
that the price will automatically reach a level at which
the quantity demanded equals the quantity supplied

• At equilibrium, there is no tendency for the market price

to change.
• Given market demand: Qd= 100-2P, and market supply: P
=( Qs /2) + 10= 2p-20
• a) Calculate the market equilibrium price and quantity b)
Determine, whether there is surplus or shortage at P= 25
and P= 35.
38
• Calculate the market equilibrium price and
quantity b) Determine, whether there is
surplus or shortage at P= 25 and P= 35.

39
 Mkt Equilibrium … cont’d
Price of
Ice-Cream
Cones Supply
$3.00

2.50 Equilibrium
price Equilibrium
2.00

1.50
1.00
Equilibrium Demand
0.50 quantity

0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of Ice-Cream Cones

40
 Markets Not in Equilibrium

Price of
(a) Excess Supply
Ice-Cream
cone Supply
Surplus
$2.50

2.00

Demand

0 4 7 10 Quantity of Ice-Cream
Quantity Quantity cones
demanded supplied
41
 Mkts not in Equilibrium … cont’d

• Surplus
– When price exceeds equilibrium price, then
quantity supplied is greater than quantity
demanded:
• There is excess supply or a surplus;
• Suppliers will lower the price to increase sales, thereby
moving toward equilibrium;
• Excess supply, or surplus, is the condition that exists
when quantity supplied exceeds quantity demanded at
the current price.

42
 Mkts not in Equilibrium … cont’d

(b) Excess Demand

Price of
Ice-Cream
Supply
cone

$2.00

1.50
Shortage

Demand

0 4 7 10 Quantity of Ice-Cream
Quantity Quantity cones
supplied demanded
43
 Mkts not in Equilibrium … cont’d

• Shortage
– When price is less than equilibrium price, then
quantity demanded exceeds the quantity supplied:
• There is excess demand or a shortage;
• Suppliers will raise the price due to too many buyers
chasing too few goods, thereby moving toward
equilibrium;
• Excess demand, or shortage, is the condition that exists
when quantity demanded exceeds quantity supplied at
the current price.

44
How an increase in demand affects the equilibrium
Price of
Ice-Cream 1. Hot weather increases the
Cone demand for ice cream . . .

Supply

$2.50 New equilibrium

2.00
2. . . .
Resulting in a Initial
higher equilibrium
price . . . D

0 7 10 Quantity of
Ice-Cream Cones
3 . . . and a higher
quantity sold 45
 How an increase in demand affects the equilibrium
Price of
Ice-Cream 1. An increase in the price of
Cone sugar reduces the supply of
ice-cream. . .
S2
S1

$2.50 New equilibrium

2.00 Initial equilibrium

2. . . . resulting
in a higher
price of ice
cream . . . Demand

0 4 7 Quantity of
3. . . . and a lower Ice-Cream Cones
quantity sold. 46
47
 Home work

• Suppose the demand functions of two markets, A and B

are given as: QdA = 100-2P and QdB = 130-2P. If the two
markets have the same supply condition and the supply
functions shift from Qs = 10+4P to Qs = 40+P, compare
the resulting effects on the equilibrium price and
quantity demanded in the two markets.

48
When both Supply and Demand Shift

49
CHAPTRE four : Theory of Production &
Costs
• Firms are buyers of factors of production (or resources) and
sellers of goods & services.

• Production is the process of transforming inputs into

outputs

• It can also be defined as an act of creating value or

utility.
• The end products of the production process are outputs
which could be tangible (goods) or intangible (service

50
 The Production Function
• Production function refers to the physical relationship b/n
the inputs or resources of a firm and their output of goods
and services at a given period of time, ceteris paribus.
• It defines the technical relationship b/n inputs and the
output that can be produced within a given time period
and technology.
• Thus, it shows the best technology available for a given level
of output in the production process (inferior combinations of
factors, involving more of all inputs, are ignored).
• Mathematically, the production function can be expressed as:
Q = f(K, L), where
Q = is the level of output, K = units of capital, L = units of
labour, and f( ) represents the production technology
51
Diagrammatic: The Production
Function

52
• Inputs are commonly classified as fixed or variable.
• Fixed inputs are those inputs whose quantity cannot
readily be changed when market conditions indicate that
an immediate adjustment in output is required.
• In fact, no input is ever absolutely fixed but may be fixed
during an immediate requirement.
• e.g., if the demand for Beer rises suddenly in a week, the
brewery factories cannot plant additional machinery
overnight and respond to the increased demand.
• Buildings, land and machineries are examples of fixed
inputs since their quantity cannot be manipulated easily
in a short period of time.
53
• Variable inputs are those inputs whose quantity can be
altered almost instantaneously in response to desired
changes in output.
• i.e., their quantities can easily be diminished when the
market demand for the product decreases and vice versa.
The best example of variable input is unskilled labour.
• In economics, short run refers to a period of time in which
the quantity of at least one input is fixed.
• In other words, short run is a time period which is not
sufficient to change the quantities of all inputs so that at
least one input remains fixed.
54
 Definition of Terms: Inputs & production period
• Inputs are any thing that can be used in the production of
goods and services. E.g. labor, land, capital & entrepreneurship.

• Two time horizons: Short run and long run:

• The short-run (SR) production function describes the
maximum quantity of good or service that can be produced
by a set of inputs, assuming that at least one of the inputs is
fixed at some level.

• The long-run (LR) production function describes the

maximum quantity of good or service that can be produced
by a set of inputs, assuming that the firm is free to adjust the
level of all inputs
55
 Production function with One Variable Input
• Total product (TP): is the total amount of output produced
in physical units (where units refer to: kilograms of sugar,
sacks of rice produced, etc)
 It is total amount of output produced at different levels
of the variable input (take the variable input, labor).
• Average product(AP): is the total product per unit of
variable input, AP = TP/L.
• The marginal product (MP): refers to the rate of change in
output as an input is changed by one unit, holding all other
inputs constant. E.g. TP for a unit change in labor emp’t is
TPL
MPL 
L
56
 Production Function of a Rice Farmer
Units of Total Average Product Marginal Product
Labor(L) Product of labor (APL) of labor (MPL)
of labor(TPL)
0 0 - -
1 2 2 2
2 6 3 4
3 12 4 6
4 20 5 8
5 26 5.2 6
6 30 5 4
7 32 4.6 2
8 32 4 0
9 30 3.3 -2
10 26 2.6 -4
57
58
• The relationship b/n MPL and APL can be stated as follows.
• When APL is increasing, MPL > APL.
• When APL is at its maximum, MPL = APL.
• When APL is decreasing, MPL < APL.
Example: Suppose that the short-run production function of a
certain cut-flower firm is given by:
Q = 4KL− 0.6K2 − 0.1L2, where Q is quantity of cut-flower produced,
L is labour input and K is fixed capital input (K = 5).
a) Determine the average product of labour (AP L) function.
b) At what level of labour does the total output of cut-flower
reach the maximum?
c) What will be the maximum achievable amount of cut-flower
production?
59
60
 Law of Diminishing Marginal Returns
• As more and more of an input is added (combined with a
fixed amount of other inputs), total output initially largely
increase but eventually smaller increments; and then the
additions to total output will tend to diminish;

• This phenomenon is referred as the Principle of

Diminishing Marginal Returns (also called the law of
Variable Proportion). It is SR phenomenon b/c it is
defined with at least one fixed factor.

61
 Relationship between Average, Marginal
and Total Product Curves: Rule of Thumb
• The principle of diminishing returns yields interesting
r/ships b/n AP and MP;

• AP at a particular level of labor employment is given by

the slope of a line from the origin to a point on the TP
corresponding to the given level of employment;

• Thus as we move along TP from left to right up to point

b, the ray from the origin becomes flatter and flatter;

• Thus, the steepest possible ray from the origin to any

point on the TP curve is ob (i.e. b is the point where AP
reaches maximum) .
62
 Relationship b/n TP, AP & MP … Cont’d
• When the marginal product is less than the average, the
average product decreases.

• When the marginal is equal to the average, the average

does not change (it is at maximum)

• When the marginal is greater than the average, the

average increases (fig. below):
If MP > AP then AP is rising(increases).
If MP < AP then AP is falling(decreases).
If MP = AP when AP is maximized.
If TP is maximum then MP is zero.
63
 Highest slope of line
Q
from origin
Max APL

TPL

0 L
L1 L2 L3

64
 Exclusive: Numerical Example of TP, AP & MP
AP, MP

At Max AP, MP = AP

Max MPL
Max APL

APL

0 L
L1 L2
L3
MPL

65
 Stages of Production
There are three stages of production (fig. below)
• Stage I:
– Starts from the origin up to the point where AP is
maximum;
– APL is increasing so MP > AP;
– More or less, all the product curves are increasing;
– Stage I stops where APL reaches its maximum;
– MP peaks and then declines and the law of
diminishing returns begins to manifest at this stage.
66
 TP

TPL

0 L1 L2 L3 L
Stage I Stage II Stage III
AP,MP MP > AP MP < AP MP < 0
AP increasing AP decreasing AP decreasing
MP still positive

APL

0 L1 L2 L3 L
MPL 67
 Stage of production … cont’d
• Stage II:
– starts from where APL = MPL up to MPL is zero;
– MP is zero when TP is maximum;
– Marginal product is continuously declining and
reaches zero as additional labor inputs are employed.

• Stage III:
– starts where the MPL has turned negative;
– all product curves are decreasing; and
– total output starts falling even as the input is
increased.
68
 Theory of COSTS
• Cost: is the monetary value of inputs used in the production
 Two types of cost of a product
 Social cost: is the cost of producing an item to the society
 Private cost: is the cost of producing an item to the
individual producer.

 Private cost of production can be measured in two ways

 Economic cost and accounting cost

A. Economic cost: the cost of all inputs used to produce the item.
Economic cost = Explicit costs + opp. cost + other Implicit cost

69
 Implicit Vs Explicit Costs
 Explicit costs – costs paid in cash (payment to
outsiders);
 Implicit cost – imputed cost of self-owned or self employed
resources based on their opportunity costs;
 Opportunity Cost - the economic cost of an input used in a
production process is the value of output sacrificed
elsewhere. The (principle of) opportunity cost of an input is
the value of foregone income in best alternative
employment.

B. Accounting cost: refers to the cost of purchased inputs

only. It is the explicit cost or outlay of production only.
70
Cost Concepts (Short-run cost of production)
1. Total Fixed Cost (TFC)

2. Total Variable Cost (TVC)

3. Total Cost (TC = TVC + TFC)

4. Average Fixed Cost (AFC = TFC/Q)

5. Average Variable Cost (AVC = TVC/Q)

6. Average Total Cost (AC = AFC + AVC)

7. Marginal Cost (MC = ∆TVC/∆Q

71
 Cost Concepts
• Two time horizons in cost consideration: SR and LR
costs;

• Total fixed cost (TFC) or fixed cost (FC) is those costs

that do not vary as the firm change its output level
– Examples: include the payment or rent for land, buildings
and machinery, Depreciation, Interest, Property Taxes,
Insurance
– The fixed cost is independent of the level of output
produced.
– Graphically, depicted as a horizontal line.

72
… Concepts … cont’d

• Total variable cost (TVC) or Variable cost (VC) refers

to the cost that changes as the amount of output
produced is changed.
– Examples - purchases of raw materials, payments to
workers, electricity bills, fuel and power costs.

– Total variable cost increases as the amount of output

increases.
 If no output is produced, then total variable cost is
zero;
 the larger the output, the greater the total variable
cost.
73
… Concepts … cont’d
• Total cost (TC) is the sum of total fixed cost and total
variable cost
TC = TFC + TVC

– As the level of output increases, total cost of the

firm also increases.

• Marginal Cost (MC) is: the additional cost incurred

from producing an additional unit of output:
MC = TC/Q, Q = output
= TVC/Q
74
Costs of Production
Total Total
Fixed Variable Total Marginal Average
Q Cost Cost Cost Cost Cost
0 100 0 100 - -
1 100 30 130 30 130
2 100 50 150 20 75
3 100 60 160 10 53.3
4 100 65 165 5 41.25
5 100 75 175 10 35
6 100 95 195 20 32.5
7 100 125 225 30 32.14
8 100 165 265 40 33.12
9 100 215 315 50 35
10 100 275 375 60 37.5

75
TC
TVC
TFC
TC
(Total Cost)

TVC
(Total Variable
Cost)

TFC
(Total Fixed
Cost)

0 Q

Fig. COST CURVES

76
AFC

AFC = TFC/Q.
As more output is produced, the
Average Fixed Cost decreases.

AFC
(Average Fixed
Cost)

0 Q

77
TVC The Average Variable
Cost at a point on the TVC
AVC
curve is measured by the
slope of the line from the
origin to that point.
AVC=TVC/Q
TVC
(Total Variable Cost)

Minimum AVC

0 q1 Q

78
Selected attributes
• MC is generally increasing.

• MC crosses ATC and AVC at their minimum point.

• If MC is below the average value:

– Average value will be decreasing.

• If MC is above the average value:

– Average value will be increasing.

79
TVC
TVC
(Total Variable Cost)

Inflection
point

0 q1 Q
MC
AV
C

80
q1
AVC

The Average Variable Cost

is U shaped. First it
decreases, reaches a
minimum and then
increases.
AVC
(Average Variable
Cost)

Minimum AVC

0 q1 Q

81
MC The Marginal Cost curve
passes through the
AVC
minimum point of the
AVC curve. MC (Marginal
Cost)

It is also U-shaped. First AVC

it decreases, reaches a (Average Variable
Cost)
minimum and then
increases.

Minimum AVC

0 q1 Q

82
MC
MC
AC
AVC
AC
AFC

AV
C

AF
C
0 q1 Q

The “PER UNIT” COST 83

Table 5.4 Average Cost of Production

(Q) (TC) (AC)

0 100 -
1 130 130.00
2 150 75.00
3 160 53.33
4 165 41.25
5 175 35.00
6 195 32.50
7 225 32.14
8 265 33.13
9 315 35.00
10 375 37.50
84
Table 5.5 Average Variable Costs of Production

Output Total Variable Average Variable

(Q) Cost (TVC) Cost (AVC)
0 0 0
1 30 30.0
2 50 25.0
3 60 20.0
4 65 16.3
5 75 15.0
6 95 15.8
7 125 17.9
8 165 20.6
9 215 23.9
10 275 27.5

85
 The Link between Production and Cost
maximum MP

Unit product maximum AP

AP

Labor

MP
Unit cost

MC

AVC

minimum MC minimum AVC

Quantity

86
 Summary of production and cost
There is an inverse relationship between AP and AVC

There is an inverse relationship between MP and MC

Whenever MP is above AP, the MC is below AVC

Whenever MP is below AP, the MC is above AVC

Whenever MP is equal to AP, the MC is equal to AVC

i.e. MP = AP when AP is minimum, MC = AVC,

when AVC is minimum

87
 Cost Curves in the Long Run
• In the long run, the amount of all factors of production
can be varied so that there are no fixed costs.

• The time period corresponding to the long run will be

such a condition that the producers can make all the
necessary changes in the size of the plant.

• Fixed cost will be variable in the long run decision of

production. When we say that fixed costs vary with
the size of the plant, we mean that all costs behave in
the same way as all other components of the variable
costs.
88
 The Long run average cost curves
• The long- run average cost curve is an ‘envelope’ of
all the short run ATC curves corresponding to all the
different levels of factors of production that are fixed
in the short- run.

• The long run average cost curve is given by the point

of tangency to all the short-run curves representing
all the alternative plant sizes that a firm could be
able to build in the long-run.

• To know it more look at the following graph.

89
 LONG-RUN AVERAGE COST CURVE

COST
LA
C
SAC1

SAC2

SAC3 SAC6
SAC4 SAC
5

0 Q

90
CHAPTER VI: MARKET STRUCTURE
Classifying Markets by the Degree of
Competition
• We Classify markets Based on:
– number of firms
– freedom of entry to industry
– nature of product
– nature of demand curve
• The four market structures
– perfect competition
– Monopoly
– monopolistic competition
– oligopoly
91
 Profit Maximization: General Frame
• Disregarding the level of competition, firms are supposed
to be rational and optimize their profit;

• Two methods to identify the optimum level of profit. NB:

when profit has negative value, we say the firm is
minimizing its loss.

1) Total Approach: - this method tries to look at the

maximum positive difference or the minimum negative
difference (if the firm is running at loss) between total
revenue & total cost.

On the other hand, graphically we seek for the point at

which the vertical distance b/n the total revenue curve &
the TC curve is maximum (minimum when it is a loss).
92
• E.g. for the cost table that you have taken, assume that
price of the product is Br. 100.

Q TR=P.Q TC Profit (∏) =TR-TC

0 0 100 -100 loss
1 100 190 -90 loss
2 200 270 -70 loss
3 300 340 -40 loss
4 400 400 0 breakeven output
5 500 470 30 profit
6 600 550 50 profit
7 700 640 60 profit
8 800 750 50 profit
9 900 880 20 profit
10 1000 1030 -30 loss
93
This can be shown graphically as follows: -
TR, TC
TC Loss
900 TR

Max. Profit

400

Loss

0 4 7 9.5 Output

94
2) Marginal Approach: - We use the marginal revenue (MR)
and marginal cost (MC) curves to determine the
optimum output level, where MR= MC.
e.g. If the total cost function of a firm under perfectly
competitive market is given by TC = 2Q 2 – 28Q + 100.
Find the optimum level of output & the corresponding
profit when price of the product is Br. 20.
Solution: MC = 4Q - 28
P= MR = 20 Br.
At equilibrium: MC = MR = P => 4Q-28 = 20
Q* = 12 units
π= 188 (profit maximization)
95
 6.1 Perfect Competition
Perfect competition : Mkt characterized by complete
absence of rivalry among individual firms
• Assumptions
– firms are price takers
– freedom of entry
– Identical/homogenous products
– perfect knowledge

• Short-run equilibrium of the firm

– price, output and profit

• The short-run supply curve of the firm

96
 Output decision of competitive firm

at q1 : MR  MC

MC at q 2 : MC  MR
Revenue
Price at qo : MR MC but MC is failling

at q * : MR MC and MC cuts from below

MC
Loss  for q1  q *
Loss  for q 2  q *
P = MR = AR

qo q1 q * q 2 Output/Sales

97
 Profit Maxn: A competitive firm making positive profit
*
At q : MR  MC and P  ATC

 ( P  AC ) q*
MC
Revenue
Price area of ABCD

MC
ATC
A
D AR = MR = P
B
C AVC

o
qo q* Output/Sales

98
 A competitive firm incurring losses
*
At q : MR  MC and P  ATC

Loss ( P  AC ) q*

MC
Revenue
area of ABCD
Price
ATC
MC
A
D
C AR = MR = P
B
AVC
F E

o
qo q* Output/Sales

99
 A competitive firm at zero profits
*
At q : MR  MC and P  ATC

Zero 
MC
Revenue
Price

ATC
MC

AR = MR = P
AVC

o
q* Output/Sales

100
 A competitive firm incurring losses
*
At q : MR  MC and P  ATC

Loss  ABCD  fixed cos ts  AEFD

Lossless money at zero output

MC var iable cos t not cov ered

Revenue
Price MC
ATC

A
D AVC
F E
C AR = MR = P
B

o
qo q* Output/Sales

101
 Choosing output In the short run
Summary of production decisions

1.  is max when MR  MC

2. If P  ATC the firm making positive 

3. If AVC  P  ATC the firm produces at loss

4. If P  AVC  ATC the firm should shut down

102
 Firm’s Profit maximization
• The firm's problem is to maximise profit

π = TR – TC = P0.Q - TC

– First-order condition:
d dTC
P0 
dQ dQ

 P0 MC

– Second-order condition:
d 2 d 2TC dMC
2
 0   2
 0
dQ dQ dQ
dMC
 0
dQ
103
 Benefits of perfect competition:
• Output produced at minimum feasible cost;

• optimal allocation of resources;

• consumer pay minimum possible price:

P = MC, P = MU thus MU = MC

• Plants are used at full capacity in long run:

- No waste of resource.
- Firms only earn normal profit.

104
 6.2 Monopolistic Competition

Monopolistic competition (MpC) is a market with

the following characteristics:
 A large number of firms.
 Each firm produces a differentiated product.
 Down ward slopping dd curve
 Firms compete on product quality, price, and
marketing.
 Firms are free to enter and exit the industry.

105
 What Is Monopolistic Competition?
Characteristics of the Firm
1. Large Number of Firms - The presence of a large
number of firms in the market implies:
 Each firm has only a small market share and
therefore has limited market power to influence
the price of its product.
 Each firm is sensitive to the average market price, but
no firm pays attention to the actions of the other, and
no one firm’s actions directly affect the actions of
other firms.
 Collusion, or conspiring to fix prices, is impossible.

106
 Characteristics … cont’d

2. Product Differentiation
– Firms in monopolistic competition practice
product differentiation, which means that each
firm makes a product that is slightly different from
the products of competing firms.
– producing firms exercise a “mini-monopoly” over
their product.
– Product differentiation gives monopolistic
competition its monopolistic aspect.
107
 Characteristic …. Cont’d

 Product differentiation enables firms to compete in

three areas: quality, Advertisement, and Patent and
trade mark.
• Quality includes design, reliability, size ,shape and
service;
• Differentiated products must be marketed using
advertising, design, location and packaging;
• Differentiation exists so long as advertising convinces
buyers that it exists − By patent right and trade mark.

108
 6.3 Pure Monopoly
• Defining monopoly
-one seller
- no substitute products
- barrier to entry
• Bases of monopoly/barrier to entry
– economies of scale
– economies of scope
– product differentiation and brand loyalty
– lower costs for an established firm
– ownership/control of key factors
– ownership/control over outlets
– legal protection/patent/trademark/licence
– mergers and takeovers
– aggressive tactics
– intimidation
109
 Profit maximising under monopoly
£ MC

Total profit
AC

A
AR

B
AC

AR

MR

O Qm Q
110
 Monopoly ... Cont’d
• Disadvantages of monopoly
– high prices / low output: short run
– high prices / low output: long run
– lack of incentive to innovate
– Rent seeking
– X-inefficiency

• Advantages of monopoly
– economies of scale
– profits can be used for investment
– high profits encourage risk taking
111
Comparing Monopolistic Competition with Monopoly
• The difference between a monopolist and a monopolistic
competitor is in the position of the average total cost
curve in long-run equilibrium.

• For a monopolist, the average total cost curve can be, but
need not be, at a position below price so that the
monopolist makes a long-run economic profit.

• For a monopolistic competitor, the average total cost

curve must be tangent to the demand curve at the price
and output chose by the monopolistic competitor.

• No long-run economic profit for monopolistically

competitive firms.
112
 6.4 Oligopolistic Market
Definition:
 Oligopoly is a mkt structure where there are a few
sellers of a particular product or service;
 Firms recognize their rivalry & interdependence;

 Aware that any action on their part is likely to

induce counter-actions by the rivals (strategies &
Counter-Strategies b/n mkt participants);
 It is one of mkt in b/n the two extreme cases: in b/n
PC & PM like the MpC mkt structure.
113
 Oligopoly … Cont’d

 Characteristics of the market:

1. Few sellers but large producers in the mkt;
2. Entry is difficult (obstacles to entry);
3. Products may be either homogeneous or d/ted
(standardized sometimes);
4. Mutual interdependence of firms (b/c firms have
substantial power over price);
5. Sticky or rigid price: – prices tend to be sticky while it is
flexible in the other mkt structures such as MpC.
 Based on this chtx, there are 2 types of oligopoly: Non-
collusive and Collusive oligopoly
114
Summary: Features of the four market structures

115
 Exercise
1. The demand and cost equations of a firm are given by: Q = 50-0.5P
and TC = 50 + 40Q
a. Find the level of output that maximizes profit
b. Find the maximum profit
c. Justify the magnitude you got in b is maximum?
2. Suppose the monopolist faces a market demand function given by
P = 40 - Q. The firm has a fixed cost of $ 50 and its variable cost is
given as TVC = Q2 determine:
a. the profit maximizing unit of output and price
b. the maximum profit

116