ECO401 – INTRODUCTION TO ECONOMICS

Lesson No. Topics Page No.

Lesson 01 Introduction to Economics ……………………………………………. 01
Lesson 02 Introduction to Economics (Continued)………………………………. 04
Exercises 07
Lesson 03 Demand, Supply and Equilibrium Analysis……………...…………….... 10
Lesson 04 Demand, Supply and Equilibrium Analysis (Continued)……………..… 13
Lesson 05 Demand, Supply and Equilibrium Analysis (Continued)……………….. 16
Exercises 19
Lesson 06 Elasticities ……………………………………………………………... 26
Lesson 07 Elasticities (Continued)… ………………………………………............ 32
Lesson 08 Elasticities (Continued)……………………… ………………................. 34
Exercises 37
Lesson 09 Consumer Behavior: Consumption Side Analysis………………………. 40
Lesson 10 Consumer Behavior: Consumption Side Analysis (Continued)…………. 42
Lesson 11 Consumer Behavior: Consumption Side Analysis (Continued)…………. 44
Lesson 12 Consumer Behavior: Consumption Side Analysis (Continued)…………. 46
Exercises 48
Lesson 13 Producer Behavior: Production Side Analysis 53
Lesson 14 Producer Behavior: Production Side Analysis (Continued)……………... 56
Lesson 15 Producer Behavior: Production Side Analysis (Continued)……………... 58
Lesson 16 Producer Behavior: Cost Analysis………………………..……………... 60
Lesson 17 Revenue and Profit Maximization Analysis……………………………... 63
Exercises 66
Lesson 18 Profit Maximization Analysis (Cont) and Market Structures……………. 71
Introduction to Economics –ECO401 VU
Lesson 1
INTRODUCTION TO ECONOMICS

WHAT IS ECONOMICS?
Economics is not a natural science, i.e. it is not concerned with studying the physical world like chemistry,
biology. Social sciences are connected with the study of people in society. It is not possibleto conduct
laboratory experiments, nor is it possible to fully unravel the process of human decision- making.
“Economics is the study of how we the people engage ourselves in production, distribution and
consumption of goods and services in a society.”
The term economics came from the Greek for oikos (house) and nomos (custom or law), hence "rules of
the household.
Another definition is: “The science which studies human behavior as a relationship between ends and
scarce means which have alternative uses.”

BRANCHES OF ECONOMICS
Normative economics:
Normative economics is the branch of economics that incorporates value judgments about what the
economy should be like or what particular policy actions should be recommended to achieve a desirable
goal. Normative economics looks at the desirability of certain aspects of the economy. It underlies
expressions of support for particular economic policies. Normative economics is known as statements of
opinion which cannot be proved or disproved, and suggests what should be done to solve economic
problems, i-e unemployment should be reduced. Normative economics discusses "what ought to be".
Examples:
1-A normative economic theory not only describes how money-supply growth affects inflation, but it
also provides instructions that what policy should be followed.
2- A normative economic theory not only describes how interest rate affects inflation but it also
provides guidance that what policy should be followed.

Positive economics:
Positive economics, by contrast, is the analysis of facts and behavior in an economy or “the way things
are.” Positive statements can be proved or disproved, and which concern how an economy works, i-e
unemployment is increasing in our economy. Positive economics is sometimes defined as the economics
of "what is"
Examples:
1- A positive economic theory might describe how money-supply growth affects inflation, but it does
not provide any instruction on what policy should be followed.
2- A positive economic theory might describe how interest rate affects inflation but it does not provide
any guidance on whether what policy should be followed.
We the people: includes firms, households and the government.
Goods are the things which are produced to be sold.
Services involve doing something for the customers but not producing goods.

FACTORS OF PRODUCTION
Factors of production are inputs into the production process. They are the resources needed to produce
goods and services. The factors of production are:
 Land includes the land used for agriculture or industrial purposes as well as natural resources
taken from above or below the soil.
 Capital consists of durable producer goods (machines, plants etc.) that are in turn used for
production of other goods.
 Labor consists of the manpower used in the process of production.
 Entrepreneurship includes the managerial abilities that a person brings to the organization.
Entrepreneurs can be owners or managers of firms.

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 Introduction to Economics –ECO401 VU
Scarcity does not mean that a good is rare; scarcity exists because economic resources are unable to
supply all the goods demanded. It is a pervasive condition of human existence that exists because society
has unlimited wants and needs, but limited resources used for their satisfaction. In other words, while we
all want a bunch of stuff, we can't have everything that we want.
Rationing is a process by which we limit the supply or amount of some economic factor which is scarcely
available.t It is the distribution or allocation of a limited commodity, usually accomplishedbased on
a standard or criterion. The two primary methods of rationing are markets and governments. Rationing is
needed due to the scarcity problem. Because wants and needs are unlimited, but resources are limited,
available commodities must be rationed out to competing uses.

ECONOMIC SYSTEMS
There are different types of economic systems prevailing in the world.

Dictatorship:
Dictatorship is a system in which economic decisions are taken by the dictator which may be an
individual or a group of selected people.
Command or planned economy:
A command or planned economy is a mode of economic organization in which the key economic functions
– for whom, what, how to produce are principally determined by government directive. In a planned
economy, a planning committee usually government or some group determines the economy’s output of
goods and services. They decide about the optimal mix of resources in the economy. They also decide how
the factor of production needs to be employed to get optimal mix.
Free market/capitalist economy:
A free market/capitalist economy is a system in which the questions about what to produce, how to
produce and for whom to produce are decided primarily by the demand and supply interactions in the
market. In this economy what to produce is thereby determined by the market price of each good and
service in relation to the cost of producing each good and service.
In a free economy the only goods and services produced are those whose price in the market is at least
equal to the producer’s cost of producing output. When a price greater than the cost of producing that
good or service prevails, producers are induced to increase the production. If the product’s price falls
below the cost of production, producers reduce supply.
Islamic economic system:
This system is based on Islamic values and Islamic rules i-e zakat, ushr, etc. Islam forbids both the taking
and giving of interest. Modern economists, too, have slowly begun to realize the futility of interest. The
Islamic economic principles if strictly followed would eliminate the possibility of accumulation of wealth
in the hands of a few and would ensure the greater circulation of money as well as a wider distribution of
wealth. Broadly speaking these principles are (1) Zakat or compulsory alms giving (2) The Islamic law
of inheritance which splits the property of an individualinto a number of shares given to his relations
(3) The forbiddance of interest which checks accumulation of wealth and this strikes at the root of
capitalism.
Pakistan case: A mixed economy
In Pakistan, there is mixed economic system. Resources are governed by both government and
individuals. Some resources are in the hand of government and some are in the hand of public. Optimal
mix of resources is decided by the price mechanism i-e by the market forces of demand and supply.
Pakistan economy thus consists of the characteristics of both planned economy and free market economy.
People are free to make their decisions. They can make their properties. Government controls the Defense.

CIRCULAR FLOW OF GOODS & INCOME

There are two sectors in the circular flow of goods & services. One is household sector and the other is
the business sector which includes firms. Households demands goods & services, Firms supply goods &
services. An exchange takes place in an economy. In monetary economy, firms exchange goods & services
for money. Firms’ demands factors of production and households supply factors of production. Firms pay
the payment in terms of wages, rent, etc. This is circular flow of goods. On the other hand,

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Household gives money to firms to purchase the goods & services from firms, and firms’ gives money to
households in return for factors of production.

DISTINCTION BETWEEN MICRO & MACRO ECONOMICS

Micro Economics:
The branch of economics studies the parts of the economy, especially such topics as
markets, prices, industries, demand, and supply. It can be thought of as the study of economic trees, as
compared to macroeconomics, which is the study of the entire economic forest. Microeconomics is a
branch of economics that studies how individuals, households, and firms make decisions to allocate
limited resources typically in markets where goods or services are being bought and sold. It also examines
how these decisions and behaviors affect the supply and demand for goods and services, which determines
prices, and how prices, in turn, determine the supply and demand of goods and services.

Macro Economics:
The branch of economics that studies– the entire economy, especially such topics as
aggregate production, unemployment, inflation, and business cycles. It can be thought of as the study of
the economic forest, as compared to microeconomics, which is the study of the economic trees.
Macroeconomics, involves the "total of economic activity, dealing with the issues of growth, inflation,
and unemployment and with national economic policies relating to these issues” and the effects of
government actions (e.g., changing taxation levels) on them.

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Lesson 02
INTRODUCTION TO ECONOMICS (CONTINUED)

COST & BENEFIT ANALYSIS

Rational choice is the choice based on pure reason and without succumbing to one’s emotions or whims.
Consumers can decide about the rational decision by using cost and benefit analysis. Rational choice is a
general theory of human behavior that assumes individuals try to make the most efficient decisions
possible in an environment of scarce resources. By "efficient" it is meant that humans are "utility
maximizers" - for any given choice a person seeks the most benefit relative to costs. Consumers can make
about the rational decision by using cost and benefit analysis. Consumers want to maximize their level of
satisfaction relative to their cost. Rational choice is also the optimal choice.
Optimum means producing the best possible results (also optimal).
Equity in economics means a situation in which everything is treated fairly or equally, i.e. according to
its due share. So if the lives of all individuals are deemed to have equal value, equity would demand that
all of them have equal financial net worth.
Nepotism means doing unfair favors for near ones when in power.
Rational choice is the choice based on pure reason and without succumbing to one’s emotions or whims.
Barter trade is a non-monetary system of trade in which “goods” not money is exchanged. This was
the system used in the world before the advent of coins and currency.

HOW CONSUMER DECIDES ABOUT OPTIMAL CHOICE

The consumers decide about the optimal choice by using the cost and benefit analysis which maximizes
the benefit relative to the cost.
Example:
Benefit Cost Net Benefit
(Salary) (Transportation) = Benefit – Cost
Job A (Lahore) 15,000 1,000 14,000

Job B (Gujranwala) 20,000 7,000 13,000

Since net benefit of job A is greater so the rational choice is job A which is in Lahore.

HOW PRODUCERS DECIDE ABOUT OPTIMAL CHOICE

Assume that a firm which is thinking to open a new production line of car manufacturing. Rational
decision involves the cost and benefit of that car’s production.
Costs will be additional labor employed, additional raw material and additional parts & components that
have to be bought.
Benefits will be additional revenue that the firm will get by selling the additional number of cars.
It will be profitable to invest if revenue is greater than the cost.

OPPORTUNITY COST
The opportunity cost of a particular choice is the satisfaction that would have been derived from the
next best alternative foregone; in other words, it is what must be given up or sacrificed in making a certain
choice or decision.
Example:
Let’s take the decision to buy the book or not, if you will not buy the book then you will be involved in
many other activities. In the following table, opportunity Cost of buying the book and not giving charity
= 20 SU, which is the benefit derived from giving charity. You will buy the book if the benefit from
other alternatives is less than the benefit derived from buying of book.

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Benefit Derived in
Cost
Satisfaction Unit
Book 200 10
Clothes 200 5
Charity 200 20

MARGINAL COST AND MARGINAL BENEFIT

Marginal cost is the increment to total costs of producing an additional unit of some good or service.
There are other broader definitions as well.
Marginal benefit is the increment to total benefit derived from consuming an additional unit of good or
service. There are other broader definitions as well.

PRODUCTION POSSIBILITY FRONTIER (PPF)

Production possibility frontier (PPF) is the curve which joins all the points showing the maximum amount
of goods and services which the country can produce in a given time with limited resources, given a
specific state of technology. A production possibilities frontier represents the boundary or frontier of the
economy's production capabilities. That's why it's termed a production possibilitiesfrontier (or PPF).
As a frontier, it is the maximum production possible given existing (fixed) resources and technology.
Table: Choice & Opportunity cost revisited: The law of increasing opportunity cost

Rice Cotton Opportunity Cost

(Bags) (Bushels) of Additional Unit
A 0 10
B 1 9 1
C 2 7 2
D 3 4 3
E 4 0 4

This table represents the alternative combinations of rice and cotton for a hypothetical economy which
is producing only 2 goods. At point A only cotton is produced, rice is not produced. In order to produce
one unit of rice, we have to give up one unit of cotton (10-9=1). So the opportunity cost is 1 at point B.
further in order to produce next unit of rice, we have to give up 2 units of cotton (9-7=2). So the
opportunity cost of next additional unit is 2 and so on. This table shows that opportunity cost is increasing
with each additional unit. It means we have to give up higher and higher units of cotton in order to produce
each additional unit of rice. This is the principle of increasing opportunity cost. If opportunity cost
decreases with each additional unit produced, then it is the principle of decreasing opportunity cost. And
if opportunity cost remains constant with each extra unit produced, it is the principle of constant
opportunity cost.
The law of increasing opportunity cost is what gives the curve its distinctive convex shape. Points on the
PPF show the efficient utilization of resources. Points inside the PPF show inefficient use of resources.
Points outside the PPF show that some of the resources are unemployed or not utilized. PPF curve shifts
upward due to technological advancements. If there is improvement in technology to produce the
output, then total output will increase and PPF will shift outward.

OPPORTUNITY COST & PRODUCTION POSSIBILITIES

The production possibilities analysis, which is the alternative combinations of two goods that aneconomy
can produce with given resources and technology, can be used to illustrate opportunity cost-- the highest
valued alternative foregone in the pursuit of an activity. The PPF showed in the video lecture slide shows
the principle of increasing opportunity cost.

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PPF AND ITS RELATIONSHIP WITH MACROECONOMICS

In the graph of PPF, Points within the PPF are inefficient and it is the rare possibility in the real world.
Inefficient means that it may not be using its available resources. May be some workers are unemployed
creating the macroeconomic problem of unemployment or may be capital is not using properly. Points
outside the PPF are unattainable since the PPF defines the maximum output produced at the given time
period so there is no possibility to produce output outside the PPF. Here in PPF, we are not concerned
with the combinations of goods which is a micro economic issue rather we are concerned with the overall
output produced which is a macroeconomic issue.

Economic growth is an increase in the total output of a country over time. It is the long-run expansion of
the economy's ability to produce output. When GDP of a country is increasing it means that countryis
growing economically. Economic growth is made possible by increasing the quantity or quality of the
economy's resources (labor, capital, land, and entrepreneurship).

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EXERCISES

Could production and consumption take place without money? If you think they could, give
examples.
Yes. People could produce things for their own consumption. For example, people could grow vegetables
in their garden or allotment; they could do their own painting and decorating. Alternatively people could
engage in barter: they could produce things and then swap them for goods that other people had produced.
Must goods be at least temporarily unattainable to be scarce?
Goods need not be unattainable to be scarce. Because people’s incomes are limited, they can not have
everything they want from shops, even though the shops are stocked full. If all items in shops were free,
the shelves would soon be emptied!
If we would all like more money, why does the government not print a lot more? Could it not thereby
solve the problem of scarcity ‘at a stroke’?
The problem of scarcity is one of a lack of production. Simply printing more money without producing
more goods and services will merely lead to inflation. To the extent that firms cannot meet the extra
demand (i.e. the extra consumer expenditure) by extra production, they will respond by putting up their
prices. Without extra production, consumers will be unable to buy any more than previously.
Which of the following are macroeconomic issues, which are microeconomic ones and which could
be either depending on the context?
a) Inflation.
b) Low wages in certain service industries.
c) The rate of exchange between the dollar and the rupee.
d) Why the price of cabbages fluctuates more than that of cars.
e) The rate of economic growth this year compared with last year.
f)The decline of traditional manufacturing industries.
a) Macro. It refers to a general rise in prices across the whole economy.
b) Micro. It refers to specific industries
c) Either. In a world context, it is a micro issue, since it refers to the price of one currency in terms
of one other. In a national context it is more of a macro issue, since it refers to the exchange rate
at which all Pakistanis goods are traded internationally. (This is certainly a less clear–cut division
that in (a) and (b) above.)
d) Micro. It refers to specific products.
e) Macro. It refers to the general growth in output of the economy as a whole.
f) Micro (macro in certain contexts). It is micro because it refers to specific industries. It could,
however, also help to explain the macroeconomic phenomena of high unemployment or balance
of payments problems.
Assume that you are looking for a job and are offered two. One is more unpleasant to do, but pays
more. How would you make a rational choice between the two jobs?
You should weigh up whether the extra pay (benefit) from the better paid job is worth the extra hardship
(cost) involved in doing it.
How would the principle of weighing up marginal costs and benefits apply to a worker deciding how
much overtime to work in a given week?
The worker would consider whether the extra pay (the marginal benefit) is worth the extra effort and loss
of leisure (the marginal cost).
Would it ever be desirable to have total equality in an economy?
The objective of total equality may be regarded as desirable in itself by many people. There are two
problems with this objective, however. The first is in defining equality. If there were total equality of
incomes then households with dependants would have a lower income per head than households where
everyone was working. In other words, equality of incomes would not mean equality in terms of standards
of living.

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If on the other hand, equality were to be defined in terms of standards of living, then should the different
needs of different people be taken into account? Should people with special health or other needs have a
higher income? Also, if equality were to be defined in terms of standards of living, many people would
regard it as unfair that people should receive different incomes (according to the nature of their household)
for doing the same amount of work.
The second major problem concerns incentives. If all jobs were to be paid the same (or people were to be
paid according to the composition of their household), irrespective of people’s efforts or skills, then what
would be the incentive to train or to work harder?
If there are several other things you could have done, is the opportunity cost the sum of all of them?
No. It is the sacrifice involved in the next best alternative.
What is the opportunity cost of spending an evening revising for an economics exam? What would
you need to know in order to make a sensible decision about what to do that evening?
The next best alternative might be revising for another exam, or it might be taking time off to relax or to
go out. To make a sensible decision, you need to consider these alternatives and whether they are better or
worse for you than studying for the economics exam. One major problem here is the lack of information.
You do not know just how much the extra study will improve your performance in the exam, because you
do not know in advance just how much you will learn and you do not know what is going to be on the
exam paper. Similarly you do not know this information for studying for other exams.
Make a list of the benefits of higher education.
The benefits to the individual include: increased future earnings; the direct benefits of being more
educated; the pleasure of the social contacts at university or college.
Is the opportunity cost to the individual of attending higher education different from the
opportunity costs to society as a whole?
Yes. The opportunity cost to society as a whole would include the costs of providing tuition (staffing
costs, materials, capital costs, etc.), which could be greater than any fees the student may have to pay. On
the other hand, the benefits to society would include benefits beyond those received by the individual. For
example, they would include the extra profits employers would make by employing the individual with
those qualifications.
There is a saying in economics, ‘There is no such thing as a free lunch’. What does this mean?
That there is always (or virtually always) an opportunity cost of anything we consume. Even if we do not
incur the cost ourselves (the ‘lunch’ is free to us), someone will incur the cost (e.g. the institution providing
the lunch).
Are any other (desirable) goods or services truly abundant?
Very few! Possibly various social interactions between people, but even here, the time to enjoy them is
not abundant.
Under what circumstances would the production possibility curve be (a) a straight line; (b) bowed in
toward the origin? Are these circumstances ever likely?
a) When there are constant opportunity costs. This will occur when resources are equally suited to
producing either good. This might possibly occur in our highly simplified world of just two goods.
In the real world it is unlikely.
b) When there are decreasing opportunity costs. This will occur when increased specialization in
one good allows the country to become more efficient in its production. It gains ‘economies of
scale’ sufficient to offset having to use less suitable resources.
Will economic growth necessarily involve a parallel outward shift of the production possibility
curve?
No. Technical progress, the discovery of raw materials, improved education and training, etc., may favour
one good rather than the other. In such cases the gap between the old and new curves would be widest
where they meet the axis of the good whose potential output had grown more.
Which of the following are positive statements, which are normative statements and which could be
either depending on the context?
a) Cutting the higher rates of income tax will redistribute incomes from the poor to the rich.

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b) It is wrong that inflation should be reduced if this means that there will be higher
unemployment.
c) It is wrong to state that putting up interest rates will reduce inflation.
d) The government should raise interest rates in order to prevent the exchange rate falling.
e) Current government policies should reduce unemployment.
a) Positive. This is merely a statement about what would happen.
b) Normative. The statement is making the value judgment that reducing inflation is a less desirable
goal than the avoidance of higher unemployment.
c) Positive. Here the word ‘wrong’ means ‘incorrect’ not ‘morally wrong’. The statement is making
a claim that can be tested by looking at the facts. Do higher interest rates reduce inflation, or don’t
they?
d) Both. The positive element is the claim that higher interest rates prevent the exchange rate falling.
This can be tested by an appeal to the facts. The normative element is the value judgment that the
government ought to prevent the exchange rate falling.
e) Either. It depends what is meant. If the statement means that current government policies are
likely to reduce unemployment, the statement is positive. If, however, it means that the
government ought to direct its policies towards reducing unemployment, the statement is
normative.

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Lesson 03
Demand, Supply & Equilibrium Analysis

GOODS MARKET AND FACTORS MARKET

Goods/product/commodity markets:
Markets used to exchange final good or service. Product markets exchange consumer goods purchased by
the household sector, capital investment goods purchased by the business sector, and goods purchased
by government and foreign sectors. A product market, however, does NOT include the exchange of raw
materials, scarce resources, factors of production, or any type of intermediate goods. The total value of
goods exchanged in product markets each year is measured by gross domesticproduct. The demand
side of product markets includes consumption expenditures, investment expenditures, government
purchases, and net exports. The supply side of product markets is production of the business sector.
Factors markets:
Markets used to exchange the services of a factor of production: labor, capital, land, and entrepreneurship.
Factor markets, also termed resource markets, exchange the services of factors, NOT the factors
themselves. For example, the labor services of workers are exchanged through factor markets NOT the
actual workers. Buying and selling the actual workers are not only slavery (which is illegal) it's also the
type of exchange that would take place through product markets, not factor markets. More realistically,
capital and land are two resources and are legally exchanged through product markets. The services of
these resources, however, are exchanged through factor markets. The value of the services exchanged
through factor markets each year is measured as national income.
Assumption is a belief or feeling that something is true or that something will happen, although there is
no proof. Economists make frequent use of assumptions in putting forward their theories.
Perfect competition refers to a situation in which no firm or consumer is big enough to affect the
market price.

DEMAND ANALYSIS
Shortage:
A shortage is a situation in which demand exceeds supply, i.e. producers are unable to meet market
demand for the product. Shortages cause prices to raise prompting producers to produce more and
consumers to demand less.
Surplus:
A surplus is a situation of excess supply, in which market demand falls short of the quantity supplied;
i.e. the producers are unable to sell all the produced goods in the market. Surpluses cause prices to fall
prompting producers to supply less and consumers to demand more.
Price Mechanism:
The price mechanism is a signaling and rationing device which prompts consumers and producers to
adjust their demand and supply, respectively, in response to a shortage or surplus. Shortages cause
prices to rise, prompting producers to produce more and consumers to demand less. Surpluses cause prices
to fall prompting producers to supply less and consumers to demand more. In either case, the price
mechanism attempts to clear the shortage or surplus in the market.
Normal goods are goods whose quantity demanded goes up as consumer income increases.
Inferior goods are goods whose quantity demanded goes down as consumer income increases.
Giffen goods are the sub category of inferior good. It is a rare type of good seldom seen in the real world,
in which a change in price causes quantity demanded to change in the same direction (inviolation
of the law of demand). In other words, an increase in the price of Giffen good results in an increase in the
quantity demanded. The existence of a Giffen good requires the existence of special circumstances. First,
the good must be an inferior good. Second, the income effect is greater than the substitution effect. A
Giffen good is most likely to result when the good is a significant share of the consumer's budget.
Margarine is a Giffen good as compared to butter.
Substitution effect:
It is one of two reasons for law of demand and the negative slope of the market demand curve. The
substitution effect occurs because a change in the price of a good makes it relatively higher or lower

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than the prices of other goods that might act as substitutes. A higher price means that a good is more
expensive relative to other goods, while a lower price means it's less expensive.
Or more simply we can say that if price of any good increases, people reduce its consumption and
substitute any other good whose price is not increased. This is substitution effect.
Income effect:
It is also one of two reasons for the law of demand and the negative slope of the market demand curve.
The income effect results because a change in price gives buyers more real income, or the purchasing
power of the income, even though money or nominal income remains the same. This causes changes in
the quantity demanded of the good.
Or more simply we can say that when price of any good increases, consumer’s real income falls and its
purchasing power also decreases. This is income effect.
Price effect:
Price effect is the addition of income and substitution effect.
Price effect = Income effect + Substitution effect
Substitutes are goods that compete with one another or can be substituted for one another, like butter
and margarine.
Compliments are goods that go hand in hand with each another. Examples are left shoe and right shoe,
or bread and butter
Cash crops are the crops which are not used as food but as a raw material in factories e.g. cotton.
DEMAND
Demand is the quantity of a good that buyers wish to purchase at each conceivable price.
Law of demand:
The law of demand states that holding all other factors constant, if the price of a certain commodity
rises, its quantity demanded will go down, and vice-versa. Other factors are income, population, tastes,
prices of all other goods etc.
Demand schedule:
A demand schedule is a table (sometimes also referred to as a graph) which shows various combinations
of quantity demanded and price.

Price Quantity demanded Quantity demanded

(Individual) (Market)
5 3.5 3500
4 4.5 4500
3 6.0 6000
2 8.0 8000
1 11.0 11000
Demand curve:
A demand curve is a graph that obtains when price (one of the determinants of demand) is plotted
against quantity demanded.

Price (P)
Demand Curve

Quantity Demanded (Q)

Demand function:
A demand function is an equational representation of demand as a function of its many determinants.

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Qd = f ( Pg , T , Psi … Psn , Pci … Pcm , Y , B , Pge t+1 )
Where,
Pg = Price of the good, T = Tastes, Psi … Psn = Prices of substitute goods, Pci … Pcm = Prices of
complimentary goods, Y = Income, B = Income Distribution, Pge t+1 = Future prices
Equation of demand function is Qd= a – b P
Shifts in the demand curve:
Shifts in the demand curve plotted in P-Qd space are caused by changes in any determinant of demand
other than the price of the good itself. Movements along the curve correspond to the changes in the
variable on the vertical axis.

FACTORS SHIFTING DEMAND CURVE:

Factors Changing Effect on Direction of Effect on Effect on

Demand Demand Shift in Demand Equilibrium Equilibrium
Curve Price Quantity
Increase in income Increase Rightward Increase Increase
(normal good)
Decrease in Decrease Leftward Decrease Decrease
income(normal good)
Increase in income Decrease Leftward Decrease Decrease
(inferior good)
Decrease in Increase Rightward Increase Increase
income(inferior good)
Increase in price of Increase Rightward Increase Increase
Substitute
Decrease in price of Decrease Leftward Decrease Decrease
substitute
Increase in price of Decrease Leftward Decrease Decrease
complement
Decrease in price of Increase Rightward Increase Increase
complement
Increase in taste and Increase Rightward Increase Increase
preference for good
Decrease in taste and Decrease Leftward Decrease Decrease
preference for good
Increase in number of Increase Rightward Increase Increase
consumers
Decrease in number of Decrease Leftward Decrease Decrease
consumers

MARKET DEMAND CURVE

Market demand curve is a graphic representation of a market demand which shows the quantities of a
commodity that consumers are willing and able to purchase during a period of time at various alternative
prices, while holding constant everything else that effects demand. The market demand curve for a
commodity is negatively sloped, indicating that more of a commodity is purchased at a lower price.

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Lesson 04
DEMAND, SUPPLY & EQUILIBRIUM ANALYSIS (CONTINUED)

SUPPLY
Supply is the quantity of a good that sellers wish to sell at each conceivable price.
Law of supply:
The law of supply states that the quantity supplied will go up as the price goes up and vice versa. As
output increases, cost will also increase. Higher prices means more profit so firms will produce more of
that product whose price has increased. New producers will also emerge in the market. And total supply
will also increase.
Supply schedule:
A supply schedule is a table (sometimes also referred to as a graph) which shows various combinations
of quantity supplied and price.

Price Quantity supplied Quantity supplied

(Individual) (Market)
5 75 7500
4 70 7000
3 60 6000
2 40 4000
1 10 1000

Supply curve:
A supply schedule is a table that shows various combinations of quantity supplied and price. GA graphical
illustration of this table gives us the supply curve.

Price (P)

Supply Curve

Quantity Supplied (Q)

Supply function:
A supply function is an equational representation of supply as a function of all its determinants.
Quantity Supplied = f (Price)
QS = f ( Pg , Cg , a1 … an , j1 … jm , R , A , Pge t+1 )
Where,
Quantity Supplied = Qs, Price of the goods = Pg, Profitability of alternative goods = a1…..an,
Profitability of the goods jointly supplied = j1….jm, Nature and Other Random Shocks = R, Aims of
Producers = A, Expected Price of good = Pge at some future time = t+1
A supply equation is QS = c + d P

PROBLEMS OF IDENTIFICATION OR DETERMINANTS OF SUPPLY

Problems of identification arise when we cannot determine that the change in the equilibrium quantities
is either caused by a change in demand or by changes in both demand and supply.
Determinants of supply are:
 Costs of production
 Profitability of alternative products (substitutes in supply)
 Profitability of goods in joint supply

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 Nature and other random shocks
 Aims of producers
 Expectations of producers
Determinants in the context of supply of butter:
 A reduction in the cost of producing butter.
 A reduction in the profitability of producing cream or cheese.
 An increase in the profitability of skimmed milk.
 If weather conditions are favorable, grass yields and hence milk yields are likely to be high.
 If butter producers expect the price to rise in near future, they may decide to release less to the
market now.

FACTORS SHIFTING SUPPLY CURVE

Factors Changing Supply Effect on Direction of Effect on Effect on

Supply Shift in Supply Equilibrium Equilibrium
Curve Price Quantity
Increase in resource price Decrease Leftward Increase Decrease
Decrease in resource price Increase Rightward Decrease Increase
Improved technology Increase Rightward Decrease Increase
Decline in technology Decrease Leftward Increase Decrease
Expect a price increase Decrease Leftward Increase Decrease
Expect a price decrease Increase Rightward Decrease Increase
Increase in number of Increase Rightward Decrease Increase
suppliers
Decrease in number of Decrease Leftward Increase Decrease
suppliers

EQUILIBRIUM
Equilibrium is a state in which there are no shortages and surpluses; in other words the quantity
demanded is equal to the quantity supplied.
Equilibrium price is the price prevailing at the point of intersection of the demand and supply curves; in
other words, it is the price at which the quantity demanded is equal to the quantity supplied.
Equilibrium quantity is the quantity that clears the market; in other words, it is it is the quantity at which
the quantity demand is equal to the quantity supplied.

Demand Curve
Price (P) Supply Curve

Qd = Qs

Quantity (Q)

ALGEBRAIC REPRESENTATION OF EQUILIBRIUM

If we have following demand and supply function
Qd = 100 – 10 P
Qs = 40 + 20 P

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In equilibrium,
Qd = Qs
Therefore,
100 - 10P = 40 + 20P
20P + 10P = 100 - 40
30P = 60
P = 60/30
P=2

Putting the value of price in any of demand and supply equation,

Q = 100 – 10x2 (or 40 + 20x2)

Q = 100 – 20
Q = 80

The equilibrium price is 2 and the equilibrium quantity is 80

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Lesson 05
DEMAND, SUPPLY & EQUILIBRIUM ANALYSIS (CONTINUED)

EQUILIBRIUM CAN SHIFT IF

 Demand Curve Shifts.
 Supply Curve Shifts.
 Both Shift.
This gives rise to eight possibilities. These eight possibilities can be summarized as following:
D  , S ~, P Q
D~,S, P Q
D,S, P? Q
D,S~, P Q
D~,S, P Q
D,S, P Q ?
D,S, P Q ?
D,S, P? Q

The symbol “” or “” shows increase and the symbol “” and “” shows a decrease while the
symbol “~” shows that the particular thing remains same.

NOTE: (Graphical illustration of all these possibilities is given in the video lecture)
Points to note in these 8 possibilities:
1. Whenever the demand curve shifts the new equilibrium is obtained by moving along the supply
curve.
2. Whenever supply curve shifts, the new equilibrium is obtained by moving along the demand
curve.
3. Whenever both demand and supply curves shifts, we will move first on the demand curve and
then along the supply curve.

THE MARKET FOR BUTTER

Question: What will happen to the equilibrium price and quantity of butter in each of the following
cases?
a. A rise in the price of the margarine. D  , S 
b. A rise in the demand for milk. S ; D  ( if milk is a substitute )
c. A rise in the price of bread. D 
d. A rise in the demand of bread. D 
e. An expected rise in the price of butter in near future. S  D 
f. A Tax on butter production. S 
g. An invention of a new, but expensive, process of removing all cholesterol from butter , plus the
passing of law which states that all producers must use this process. D  S 


GOVERNMENT’S ROLE IN PRICE-DETERMINATION & EQUILIBRIUM ANALYSIS

Identification problem is the problem of how to identify demand & supply curve. This problem arises
when both price and quantity.
Government can impact on equilibrium by two fundamental ways. The government may intervene in the
market and mandate a maximum price (price ceiling) or minimum price (price floor) for a good or service.

PRICE CEILING:
A price ceiling is the maximum price limit that the government sets to ensure that prices don’t rise above
that limit (medicines for e.g.).

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If a price ceiling is placed below the market-clearing price, as Pc, the market-clearing or equilibrium price
of Pe becomes illegal. At the ceiling price, buyers want to buy more than sellers will make available. In
the graph, buyers would like to buy amount Q4 at price Pc, but sellers will sell only Q1. Because they
cannot buy as much as they would like at the legal price, buyers will be out of equilibrium. The normal
adjustment that this disequilibrium would set into motion in a free market, an increase in price, is illegal;
and buyers or sellers or both will be penalized if transactions take place above Pc. Buyers are faced with
the problem that they want to buy more than is available. This is a rationing problem.

PRICE FLOOR:
A price floor is the minimum price that a Government sets to support a desired commodity or service in
a society (wages for e.g.).

Price ceilings are not the only sort of price controls governments have imposed. There have also been
many laws that establish minimum prices, or price floors. The graph illustrates a price floor with price Pf.
At this price, buyers are in equilibrium, but sellers are not. They would like to sell quantity Q2, but buyers
are only willing to take Q3. To prevent the adjustment process from causing price to fall, government may
buy the surplus, If it does not buy the surplus, government must penalize either buyers or sellers or both
who transact below the price floor, or else price will fall. Because there is no one else to absorb the surplus,
sellers will.

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RATIONING & SUPPLY SHOCKS (ALTERATION OF EQUILIBRIUM PRICE BY THE
GOVT)
There are two ways for this:
1. Through Tax :
Tax (to be paid by the producer) will increase the Supply Price, Supply Curve shifts left ward, Price
increases & quantity decreases.
2. Through Subsidy :
Subsidy (given to the producer) will decrease the Supply Price, Supply Curve shifts rightward, Price
decreases & quantity increases.

SOCIAL COST
Social cost is the cost of an economic decision, whether private or public, borne by the society as a
whole.
MARGINAL SOCIAL COST
Marginal social cost is the change in social costs caused by a unit change in output.

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EXERCISES

Asif and Aasia’s “monthly” demand schedules for potatoes are given. Roughly draw these demand
schedules on the same graph. Assume that there are 200 consumers in the market. Of these, 100
have schedules like Asif’s and 100 have schedules like Aasia’s. Complete the Total market demand
(“monthly”) column in the table below?
Price Asif Aasia Total
market
demand
(pence (Qd in (Qd in (kg)
per kg) kg) kg)
20 28 16 4400
40 15 11 2600
60 5 9 1400
80 1 7 800
100 0 6 600

100

90

80

70

60
Price in Rs/kg

50

40
Asif’s
30 demand
Aasia’s
20 demand
10

0
0 5 10 15 20 25 30
Quantity demanded (kg per month)

Assuming that demand does not change from month to month, how would you plot the annual
market demand for potatoes?
The amount demanded would be 12 times higher at each price. If the scale of the horizontal axis were
unaltered, the curve would shift way out to the right. A simple way of showing the new curve, therefore,
would be to compress the scale of the horizontal axis. (If each of the numbers on the axis were multiplied
by 12, the curve would remain in physically the same position.)
At what price is their demand the same?
The two curves cross at a price of Rs50 per kg and at a demand of 10 kg per month.
What explanations could there be for the quite different shapes of their two demand curves?
One explanation could be that Asif is quite happy to eat rice, pasta or bread instead of potatoes. Thus
when the price of potatoes goes up she switches to these other foods, and switches to potatoes when the
price of potatoes comes down. Aasia, by contrast, may not see these other foods as close substitutes and
thus her demand for potatoes will be less price sensitive.

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Do all these the determinants of demand affect both an individual’s demand and the market
demand for a product?
All except the distribution of income in the economy.
You are given a market demand curve for apples. Assume that the price of apples increases by 20
per cent at each price – due, say, to substantial increases in the prices of other substitute fruits. Plot
the new demand curve for apples. Is the new curve parallel to the old one?
See below. As you can see, the curves are not parallel. A constant percentage increase in quantity
demanded gives a bigger and bigger absolute increase as quantity increases.

100

90

80

70
Price (Rs per kg

60

50

40

30 demand
20
demand
10

0
0 100 200 300 400 500 600 700 800 900
Quantity demanded (kg per month)

The price of lamb meat rises and yet it is observed that the sales of lamb meat increase. Does this
mean that the demand curve for lamb meat is upward sloping? Explain.
No not necessarily. For example, the price of substitutes such as beef or chicken may have risen by a
larger amount. In such cases the demand curve for lamb meat will have shifted to the right. Thus although
a rise in the price of lamb meat will cause a movement up along this new demand curve, more lamb meat
will nevertheless be demanded because lamb meat is now relatively cheaper than thealternatives.
A demand function is given by Qd = 10000 – 200P. Draw this in P-Qd space. What is it about the
demand function equation that makes the demand curve in P- Qd space (a) downward sloping; (b) a
straight line?
a) The fact is that the 200P term has a negative sign attached to it. This means that as P rises, Qd
falls.
b) The fact is that there is no P to a power term. The demand curve thus has a constant slope of –
1/200.
A demand function is given by Qd = a + bY, where Y is total income. If the term “a” has a value of –
50 000 and the term “b” a value of 0.001, construct a demand schedule with respect to Y. Do this
for incomes between Rs100 million and Rs300 million at Rs50 million intervals.

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Y (in Rs Qd (in 000s)

millions)

100 50
150 100
200 150
250 200
300 250

Now use this schedule to plot a demand curve with respect to income. Comment on its shape.
The curve will be an upward-sloping straight line, crossing the horizontal axis at –50 000. It would rise by
100 000 units for each Rs100 million rise in income.
300

250
Income (Rs millions

200

150

100

50

0
0 50 100 150 200 250 300
Quantity demanded
Market demand (with respect to income)

What are the reasons which cause the market supply of potatoes to fall?
Examples include:
 The cost of producing potatoes rises.
 The profitability of alternative crops (e.g. carrots) rises.
 A poor potato harvest.
 Farmers expect the price of potatoes to rise (short-run supply falls).
For what reasons might the supply of leather rise?
Examples include:
 The cost of producing leather falls.
 The profitability of producing mutton and chicken decreases.
 The price of beef rises (goods in joint supply).
 A long-running industrial dispute involving leather workers is resolved.
 Producers expect the price of leather to fall (short-run supply increases).
This question is concerned with the supply of gas for home and office heating in winters. In each
case consider whether there is a movement along the supply curve (and in which direction) or a shift
in it (left or right). (a) New gas fields start up in production. (b) The demand for home heating rises.
(c) The price of electric heating falls. (d) The demand for CNG for cars (produced in joint supply)
rises. (e) New technology decreases the costs of gas production.
(a) Shift right. (b) Movement up along (as a result of a rise in price). (c) Movement down along (as a result
of a fall in price resulting from a fall in demand as people switch to electric heating). (d) Shift right (more
of a good in joint supply is produced). (e) Shift right.

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A supply function is given as Qs = c + dP, where “c” is 500 and “d” is 1000. Draw the schedule
(table) and graph for equation for prices from Rs1 to Rs10. What is it in the equation that
determines the slope of the supply ‘curve’?

10
9
Supply
8
7
6
Price 5
4
3
2
1
0
0 2000 4000 6000 8000 10000
Quantity supplied

P (in Qs
Rs) (units)

1 1500
2 2500
3 3500
4 4500
5 5500
6 6500
7 7500
8 8500
9 9500
10 10500

The graph is an upward sloping straight line crossing the horizontal axis at 500 units. The slope is given
by the value of the d term: i.e. the slope is 1/1000 (for every Re1 increase in price, quantity supplied
increases by 1000 units).
Explain the process by which the price of houses would rise if there were a shortage.
People with houses to sell would ask a higher price than previous sellers of similar houses (probably with
the advice of an estate agent). Potential purchasers would be prepared to pay a higher price than previously
in order to obtain the type of house they wanted.
With a typical upward sloping market supply curve and downward sloping market demand curve,
what would happen to equilibrium price and quantity if the demand curve shifted to the left?
Both price and quantity will fall. You should be able to label two demand curves (e.g. D1 and D2), two
equilibrium points (e.g. e1 and e2) corresponding prices Pe2 and Pe1 (Pe2 < Pe1), and quantities Qe2 and Qe1
(Qe2 > Qe1).
What will happen to the equilibrium price and quantity of butter in each of the following cases?
You should state whether demand or supply (or both) have shifted and in which direction. (In each
case assume ceteris paribus.)
(a) A rise in the price of margarine; (b) A rise in the demand for yoghurt; (c) A rise in the price of
bread; (d) A rise in the demand for bread; (e) An expected rise in the price of butter in the near
future; (f) A tax on butter production; (g) The invention of a new, but expensive, process for

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removing all cholesterol from butter plus the passing of a law which states that all butter producers
must use this process.
a) Price rises, quantity rises (demand shifts to the right: butter and margarine are substitutes).
b) Price falls, quantity rises (supply shifts to the right: butter and yoghurt are in joint supply).
c) Price falls, quantity falls (demand shifts to the left: bread and butter are complementary goods).
d) Price rises, quantity rises (demand shifts to the right: bread and butter are complementary goods).
e) Price rises, quantity rises or falls depending on relative sizes of the shifts in demand and supply
(demand shifts to the right as people buy now before the price rises; supply shifts to the left as
producers hold back stocks until the price does rise).
f) Price rises, quantity falls (supply shifts to the left).
g) Price rises, quantity rises or falls depending on the relative size of the shifts in demand and supply
(demand shifts to the right as more health-conscious people start buying butter; supply shifts to the
left as a result of the increased cost of production).
Are there any factors on the supply side that influence house prices?
Yes. Although they are usually less important than demand-side factors, they are, nevertheless important
in determining changes in house prices. The two most important are the expectations of the construction
industry. If house building firms (contractors) are confident that demand will continue to rise, and with it
house prices, they are likely to start building more houses. The resulting increase in the supply of houses
(after the time taken to build them) will help to dampen the rise in prices.
The other major supply-side factor is the expectations of house owners. If people think that prices will rise
in the near future and are thinking of selling their house, they are likely to delay selling and wait until
prices have risen. This (temporary) reduction in supply will help to push up prices even further.
Draw a supply and demand diagram with the price of labour (the wage rate) on the vertical axis and
the quantity of labour (the number of workers) on the horizontal axis. What will happen to
employment if the government raises wages from the equilibrium to some minimum wage above the
equilibrium?
Firms’ demand for labour will shrink at the new higher wage rate. The supply of workers will rise as more
workers would be willing to work (and work more hours) at the higher wage rate. There will thus be
unemployment (a surplus of workers) at the minimum wage set.
All economies have black markets in goods; whether this poses a serious problem is another matter.
What would be the effect on black-market prices of a rise in the official price?
Other things being equal, there would probably be a fall in the black-market price. A rise in the official
price would cause an increase in the quantity supplied and a reduction in the quantity demanded and hence
less of a shortage. There would therefore be less demand for black-market products.
Will a system of low official prices plus a black market be more equitable or less equitable than a
system of free markets?
More equitable if the supplies at official prices were distributed fairly (e.g. by some form of rationing). If,
however, supplies were allocated on a first-come, first-served basis, then on official markets there would
still be inequity between those who are lucky enough or queue long enough to get the product and those
who do not get it. Also, the rich will still be able to get the product on the black market!
Think of some examples where the price of a good or service is kept below the equilibrium (e.g. rent
controls). In each case consider the advantages and disadvantages of the policy.
Two examples are:
 Rent controls.
Advantages: makes cheap housing available to those who would otherwise have difficulty in
affording reasonable accommodation. Disadvantages: causes a reduction in the supply of private
rented accommodation; causes demand to exceed supply and thus some people will be unable to find
accommodation.
 Tickets for a concert.

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Advantages: allows the price to be advertised in advance and guarantees a full house; makes seats
available to those who could not afford the free-market price. Disadvantages: causes queuing or seats
are being only available to those booking well in advance.
Primary and secondary schooling is free in state schools in most countries. If parents are given a
choice of schools for their children, there will be a shortage of places at popular schools. What
methods could be used for dealing with this shortage? What are their relative merits?
Some form of rationing (selection) will have to be applied. This could be done on the basis of ability. If
the objective is to have schools that cater for the full range of abilities, then this objective will not be met.
If the objective is to recruit the most able children, then selection by ability is consistent with this goal. An
alternative is to select by geographical location, with the students living nearer to the school being given
preference over those living further away. This is the system used by most state schools. It could well
disadvantage children with particular needs, however, for whom the school would be particularly suitable.
Other methods include the ‘sibling’ rule, whereby children who have older brothers or sisters already at
the school are given preference. This, however, could lead to children living nearer the school being
deprived of a place.
Under what circumstances would making a product illegal (a) cause a fall in its price; (b) cause the
quantity sold to fall to zero.
a) Where the shift in demand was greater than the shift in supply (perhaps because of very ‘law
abiding’ consumers, or where consumers faced harsher penalties than suppliers.
b) Where the penalties were very harsh and the law was strictly enforced, and/or where people were
very law abiding.
Can you think of any examples where prices and wages do not adjust very rapidly to a shortage or
surplus? For what reasons might they not do so?
 Many prices set by companies are adjusted relatively infrequently: it would be administratively too
costly to change them every time there was a change in demand. For example a mail order company,
where all the items in its catalogue have a printed price, would find it costly to adjust prices very
frequently, since that would involve printing a new catalogue, or at least a new price list.
 Many wages are set annually by a process of collective bargaining. They are not adjusted in the
interim.
Why do the prices of fresh vegetables fall when they are in season? Could an individual farmer
prevent the price falling?
Because supply is at a high level. The increased supply creates a surplus which pushes down the price.
Individual farmers could not prevent the price falling. If they continued to charge the higher price,
consumers would simply buy from those farmers charging the lower price.
If you were the owner of a clothes shop, how would you set about deciding what prices to charge for
each garment at the end of season sale?
You would try to reduce the price of each item as little as was necessary to get rid of the remaining stock.
The problem for shop owners is that they do not have enough information about consumer demand to
make precise calculations here. Many shops try a fairly cautious approach first, and then, if that is not
enough to sell all the stock, they make further ‘end of sale’ reductions later.
The number of owners of CD players has grown rapidly and hence the demand for CDs has also
grown rapidly. Yet the prices of CDs have fallen. How could this come about?
 The costs of manufacturing CDs may have fallen with improvements in technology and mass-
production economies.
 Competition from increased numbers of manufacturers may have increased supply of CDs and
driven prices down.
 The advent of copying tracks from the internet reduces the demand for CDs. This change in demand
has further compounded the fall in price.
Explain in words what is happening in the following diagram.

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T h e p r i ce m e c h a n is m : th e e f f e c t o f th e d i s c o v e r y o f ra w m a te r i a l s

F ac to r M a rk e t
S i 
S i  s u rp lu s P i  u n t il D i = S i
( S i > D i) D i 

G o o d s M a rket
S g 
Pi  S g  s u r p lu s P g  until D g = S g
( S g > D g)
D g 

The new discovery of raw material i means an increase in the supply i. This causes a surplus (excess
supply) in the market for i, causing the price of i to fall until the same is removed (lower Pi causes demand
to increase and supply to fall). The reduction in Pi also reduces the cost of producing good g (we can
assume good g uses the factor i intensively), causing the supply of good g to increase beyond demand. The
surplus in the market for good g drives the price of g down until the excess is cleared. The diagram
illustrates interdependence between goods and factor markets.
Can different factor markets be interdependent also? Give examples.
Yes. A rise in the price of one factor (e.g. oil) will encourage producers to switch to alternatives (e.g.
coal). This will create a shortage of coal and drive up its price. This will encourage increased production
of coal. Similarly an increase in the population (and consequently size of the labour force) of a country
will depress the price of labour (wages). This will cause producers to shift to more labour intensive
production and reduce production methods which are capital (or machine) intensive. As a result the
demand for capital will fall reducing its rental price.

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Lesson 06
ELASTICITIES

IMPORTANCE OF ELASTICITY IN OUR TODAY’S LIFE

There is much more importance of the concept of elasticity in our life.
 The firm which uses advertising to change prices uses the concept of elasticity of demand of its
product.
 Mostly firms set the prices of their product by viewing at the elasticity of demand of their
product.
 The government collects revenues by imposing taxes. The good tax imposed by the government
on the products is one for which either demand is inelastic or the supply is inelastic.
 So if the government wants to put tax burden on the consumers then it will choose the productto
tax with low price elasticity of demand.
 And if government wants to panelize the producers then it must choose the product with low
price elasticity of supply.

ELASTICITY
Elasticity is a term widely used in economics to denote the “responsiveness of one variable to changes
in another.” In proper words, it is the relative response of one variable to changes in another variable. The
phrase "relative response" is best interpreted as the percentage change.

TYPES OF ELASTICITY
There are four major types of elasticity:
 Price Elasticity of Demand
 Price Elasticity of Supply
 Income Elasticity of Demand
 Cross-Price Elasticity of Demand
Price Elasticity of Demand:
Price elasticity of demand is the percentage change in quantity demanded with respect to the percentage
change in price.
Price elasticity of demand can be illustrated by the following formula:

PЄd = Percentage change in Quantity Demanded

Percentage change in Price

Where Є = Epsilon; universal notation for elasticity.

If, for example, a 20% increase in the price of a product causes a 10% fall in the Quantity demanded,
the price elasticity of demand will be:
PЄd = - 10% = - 0.5
20%
Price Elasticity of Supply:
Price elasticity of supply is the percentage change in quantity supplied with respect to the percentage
change in price.
Price elasticity of supply can be illustrated by the following formula:

PЄs = Percentage change in Quantity Supplied

Percentage change in Price

If a 15% rise in the price of a product causes a 15% rise in the quantity supplied, the price elasticity of
supply will be:
PЄs = 15 % = 1
15 %

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Income Elasticity of Demand:
Income elasticity of demand is the percentage change in quantity demanded with respect to the
percentage change in income of the consumer.
Income elasticity of demand can be illustrated by the following formula:

YЄd = Percentage change in Quantity Demanded

Percentage change in Income

If a 2% rise in the consumer’s incomes causes an 8% rise in product’s demand, then the income
elasticity of demand for the product will be:
YЄd = 8% =4
2%
Cross-Price Elasticity of Demand:
Cross price elasticity of demand is the percentage change in quantity demanded of a specific good, with
respect to the percentage change in the price of another related good.

PbЄda = Percentage change in Demand for good a

Percentage change in Price of good b

If, for example, the demand for butter rose by 2% when the price of margarine rose by 8%, then the
cross price elasticity of demand of butter with respect to the price of margarine will be.
PbЄda = 2% = 0.25
8%

If, on the other hand, the price of bread (a compliment) rose, the demand for butter would fall. If a 4%
rise in the price of bread led to a 3% fall in the demand for butter, the cross-price elasticity of demand
for butter with respect to bread would be:
PbЄda = - 3% = - 0.75
4%

WHY WE USE PERCENTAGE CHANGE RATHER THAN ABSOLUTE CHANGE IN

ELASTICITY?

1. By using percentage changes and proportions we can avoid the problem of comparison in two
different quantitative variables i-e Qd is measured in units and Price is measured in rupees. So by
calculating percentages we can avoid the problem of unit conversion into rupees.
2. It helps us avoid that of what size of units to be changed i-e A jump from Rs.2 to Rs.4 could be
described as a 100% increase or as an increase of Rs.2. but by using percentages we can avoid
this problem because both gives the same answer.
3. It also helps how to define big or small changes. By looking at Rs.2 or Rs.4, we can’t say that it
is a big change or a small change. But if we translate it in the form of percentages then it becomes
100% which is a big change.

ELASTIC AND INELASTIC DEMAND

Slope and elasticity of demand have an inverse relationship. When slope is high elasticity of demand is
low and vice versa.
When the slope of a demand curve is infinity, elasticity is zero (perfectly inelastic demand); and when the
slope of a demand curve is zero, elasticity is infinite (perfectly elastic demand).
Unit elasticity means that a 1% change in price will result in an exact 1% change in quantity demanded.
Thus elasticity will be equal to one. A unit elastic demand curve plots as a rectangular hyperbola. Note
that a straight line demand curve cannot have unit elasticity as the value of elasticity changes along the
straight line demand curve.

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Elastic demand curve

Inelastic demand curve

TOTAL REVENUE AND ELASTICITY

Total revenue (TR) = Price x Quantity (P x Q)
Elastic demand means when price of any product increases, its demand decreases more than the increase
in price. As price increases total revenue decreases in case of elastic demand.
Inelastic demand of any product means that if price of that product increases there is very small effect
on its quantity demanded. As price increases, total revenue also increases in case of inelastic demand.
For example, flour is the basic necessity of life for all people. Its demand is inelastic. As the price of
flour increases, its quantity demanded does not decrease much because people have to use flour in all
situations whether its price is high or low.

EXAMPLE OF 2 FIRMS
Firm 1: (Inelastic demand curve)

For inelastic demand curve, firm increases its prices but quantity demanded does not change as much.
Increase in price is greater while the decrease in quantity is smaller. So firm will earn more revenues by
increasing prices. So TR increases as the price increases.

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Price

10 F

Inelastic demand
curve

0 90 100 Quantity
Demanded

Є = percentage change in Qd
Percentage change in P
= 90 – 100 ÷ 10 – 6
100 6
= - 0.15
In the above figure, Elasticity for firm 1 is equal to -0.15; it is less than 1 (ignoring minus sign) which
shows that the demand curve is inelastic.

Firm 2: (Elastic demand curve)

For elastic demand curve, firm does not increase its prices. Because as prices increases, quantity
demanded decreases much larger. Decrease in quantity demanded is greater than the increase in prices.
So firm will earn less revenue. So TR decreases as price increases.

Price

10

Elastic demand curve

7 U

0 40 100 Quantity
Demanded

Є = percentage change in Qd
Percentage change in P
= 40 – 100 ÷ 7 – 6
100 6
= - 3. 6

In the above figure elasticity for firm 2 is -3.6; it is greater than 1 (ignoring minus sign) which shows
that the demand curve is elastic.

ELASTICITY BETWEEN TWO POINTS

Elasticity can also be calculated between two points.
Figure:

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Price

10

Elastic demand curve

8 K

0 8 16 Quantity
Demanded

In this figure, elasticity from point K to L is -4.

ЄKL = percentage change in Qd
Percentage change in P
= 16– 8 ÷ 6 – 8
8 8
= -4
Since absolute value is greater than 1 so it is elastic.
Similarly we can also calculate for inelastic demand curve.
Arc Elasticity
Arc elasticity measures the “average” elasticity between two points on the demand curve. The formula
is simply (change in quantity/change in price)*(average price/average quantity).

To measure arc elasticity we take average values for Q and P respectively.

Point Elasticity
Point elasticity is used when the change in price is very small, i.e. the two points between which elasticity
is being measured essentially collapse on each other. Differential calculus is used to calculate the
instantaneous rate of change of quantity with respect to changes in price (dQ/dP) and then this is multiplied
by P/Q, where P and Q are the price and quantity obtaining at the point of interest. The formula for point
elasticity can be illustrated as:
Є=∆Q x P
∆P Q
Or this formula can also be written as:
Є= dQ x P
dP Q
Where d = infinitely small change in price.

If elasticity = zero then demand curve will be vertical.

If elasticity is infinity then the demand curve will be horizontal.

POINT ELASTICITY FOR QUADRATIC DEMAND FUNCTION

The quadratic demand function is
Qd = 60 – 15P + P2
Assume different values of price e-g from 0 to 10. Put these values in this equation and find out the
quantity demand. Here we take price from 0 to 3.

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P 60 -15P P2 Qd = 60 – 15P + P2
0 60 0 0 60
1 60 -15 1 46
2 60 -30 4 34
3 60 -45 9 24

Then draw a figure, plot prices on vertical axis and quantity on horizontal axis. The resulting curve will
be downward sloping curve.
7
6
5
4
3
2
1
0
0 20 40 60 80

To find the point elasticity of demand from this quadratic equation, differentiate it with respect to price,

Qd = 60 – 15P + P2

dQ/dP = -15 + 2P

IF P=3 then

dQ/dP = -15 + 2(3)

= -15 + 6
= -9
And

Qd = 60- 15(3) + (3)2

= 24

The formula of elasticity = (dQ / dP) (P/Q)

= -9 (3/24)
= -1.125
Its absolute value (ignoring minus sign) is greater than one so it is point elastic.

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Lesson 07
ELASTICITIES (CONTINUED)

INELASTIC DEMAND 0< Є < 1

• Price rises:
As P increases, Q decreases
Percentage change in P > percentage change in Q
Now TR = P x Q TR will also increase
• Price falls:
As P decreases, Q increases
Percentage change in P > percentage change in Q
Now TR = P x Q TR will also decrease

ELASTIC DEMAND Є > 1

• Price rises:
As P increases, Q decreases
Percentage change in P < percentage change in Q
Now TR = P x Q TR will also decrease
• Price falls:
As P decreases, Q increases
Percentage change in P < percentage change in Q
Now TR = P x Q TR will also increase

UNIT ELASTIC DEMAND Є = 1

• Price rises:
As P increases, Q decreases
Percentage change in P = percentage change in Q.
Now TR = P x Q TR will remain unchanged.
• Price falls:
As P decreases, Q increases
Percentage change in P = percentage change in Q.
Now TR = P x Q TR will remain unchanged.

TABLE OF UNITARY ELASTICITY

P Q TR
2.5 400 1,000
5 200 1,000
10 100 1,000
20 50 1,000
40 25 1,000

The curve of unitary elastic demand will be a hyperbola.

DETERMINANTS OF PRICE ELASTICITY OF DEMAND
1. Number of close substitutes within the market - The more (and closer) substitutes available in the
market the more elastic demand will be in response to a change in price. In this case, the substitution
effect will be quite strong.
2. Percentage of income spent on a good - It may be the case that the smaller the proportion of income
spent taken up with purchasing the good or service the more inelastic demand will be.
3. Time period under consideration - Demand tends to be more elastic in the long run rather than in the
short run. For example, after the two world oil price shocks of the 1970s - the "response" to higher oil
prices was modest in the immediate period after price increases, but as time passed, people found ways
to consume less petroleum and other oil products. This included measures to get better mileage

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from their cars; higher spending on insulation in homes and carpooling for commuters. The demand for
oil became more elastic in the long-run.

EFFECTS OF ADVERTISING ON DEMAND CURVE

Advertising aims to:
 Change the slope of the demand curve – make it more inelastic. This is done by generating
brand loyalty;
 Shift the demand curve to the right by tempting the people’s want for that specific product.

PRICE ELASTICITY OF SUPPLY

The relative response of a change in quantity supplied to a relative change in price. More specifically
the price elasticity of supply can be defined as the percentage change in quantity supplied due to a
percentage change in supply price.

Inelastic Supply Curve

Price (P)
Unitary elastic Supply Curve

Elastic Supply Curve

Quantity Supplied (Q)

 Calculating elasticity’s between two points at the same curve involves arc elasticity method.
 While calculating elasticity at a certain point involves point elasticity method.

DETERMINANTS OF PRICE ELASTICITY OF SUPPLY

 If costs increases, lower will be the supply. Lower the costs the more will be the supply.
 Amount of time given to quantity respond to a price increase or decrease. There may be
immediate time period, short term and long term time period.

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Lesson 08
ELASTICITIES (CONTINUED)

INCOME ELASTICITY OF DEMAND

The relative response of a change in demand to a relative change in income. More specifically the income
elasticity of demand can be defined as the percentage change in demand due to a percentage change in
buyers' income. The income elasticity of demand quantitatively identifies the theoretical relationship
between income and demand.
Єdy = ∆ Q ÷ ∆ Y
Q Y
Less income elastic Єdy < 1
Income (Y)

More income elastic Єdy > 1

Quantity demanded (Q)

If the sign of income elasticity of demand is positive, the good is normal and if sign is negative, the
good is inferior.
Table:
Quantity Demanded
Income (Rs)
(units)
10000 100
12000 105

YЄd = ∆ Q ÷ ∆ Y
Q Y
= 5 ÷ 2000
100 10000
= 0.25
The Good is normal (the sign is positive). But its demand is income inelastic o< | Є | < 1.

DETERMINANTS OF INCOME ELASTICITY OF DEMAND

The determinants of income elasticity of demand are:
 Degree of necessity of good.
 The rate at which the desire for good is satisfied as consumption increases
 The level of income of consumer.
Short Run and Long Run
Short run is a period in which not all factors can adjust fully and therefore adjustment to shocks can
only be partial.
Long run is a period over which all factors can be changed and full adjustment to shocks can take place.

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MINISTRY OF AGRICULTURE REPORT
Food Stuff YЄd
Milk -0.40
Eggs -0.41
Mutton -0.21
Bread -0.25
Butter -0.04
MargarIne -0.44
Sugar -0.54
Fresh Potatoes -0.48
Tea -0.56
Cheese 0.19
Beef 0.08
Cakes&Buiscuits 0.02
Fresh Green Vegetables 0.13
Fresh Fruit 0.48
Fresh Juices 0.94
Coffee 0.23
ElasticIty For All Food -0.01

CROSS-PRICE ELASTICITY OF DEMAND

Cross price elasticity of demand is the percentage change in quantity demanded of a specific good, with
respect to the percentage change in the price of another related good.

PbЄda = ∆ Qa ÷ ∆ Pb
Qa Pb

Table
Demand for A Price of B
100 10
140 12

PbЄda = ∆ Qa ÷ ∆ Pb
Qa Pb
= 40 ÷ 2
100 10
= 2
Goods are substitutes (sign is positive). Demand is cross price elastic | є | > 1.

DETERMINANTS OF CROSS PRICE ELASTICITY OF DEMAND

 Time period
The longer the time period, the more will be the elasticity,
 Tastes and preferences
Taste and preferences can change.

INCIDENCE OF TAXATION
A tax results in a vertical shift of the supply curve as it increases the cost of producing the taxed
product.

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The incidence of taxation relates to how much of the tax’s burden is being borne by consumers and
producers. The more inelastic the demand, the more of the tax’s burden will fall on consumers. The
more inelastic the supply, the more of the tax’s burden will fall on producers.
Terms of trade means the ‘real’ terms at which a nation sells its exports and buys its import.
OPEC: Organization of Petroleum Exporting Countries.

THREE CORE RULES OF ELASTICTY

RULE # 01

Less than greater than

Price elasticity Inelastic 1 Elastic

RULE # 02

Normal good

Income elasticity
Inferior good

RULE # 03

+ Substitutes

Cross elasticity

- Complements

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EXERCISES

Why will the price elasticity of demand for a particular brand of a product (e.g. Shell) be greater
than that for the product in general (e.g. petrol)? Is this difference the result of a difference in the
size of the income effect or the substitution effect?
The price elasticity of demand for a particular brand is more elastic than that for a product in general
because people can switch to an alternative brand if the price of one brand goes up. No such switching
will take place if the price of the product in general (i.e. all brands) goes up. Thus the difference in
elasticity is the result of a difference in the size of the substitution effect.
Will a general item of expenditure like food (or clothing) have a price-elastic or inelastic demand?
Discuss in the context of income and substitution effects.
The income effect will be relatively large (making demand relatively elastic). The substitution effect will
be relatively small (making demand relatively inelastic). The actual elasticity will depend on the relative
size of these two effects.
Demand for oil might be relatively elastic over the longer term, and yet it could still be observed that
over time people consume more oil (or only very slightly less) despite rising oil prices. How can this
apparent contradiction be explained?
Because, there has been a rightward shift in the demand curve for oil. This is likely to be the result of
rising incomes. Car ownership and use increase as incomes increase. Also tastes may have changed so
that people want to drive more. There may also have been a decline in substitute modes of transport such
as rail transport and buses. Finally, people may travel longer distances to work as a result of a general
move to the suburbs.
Assume that demand for a product is inelastic. Will consumer expenditure go on increasing as price
rises? Would there be any limit?
So long as demand remains inelastic with respect to price, then consumer expenditure will go on rising as
price rises. However, if the price is raised high enough, demand always will become elastic.
Can you think of any examples of goods which have a totally inelastic demand (a) at all prices; (b)
over a particular price range?
a) No goods fit into this category, otherwise price could rise to infinity with no fall in demand – but
people do not have infinite incomes!
b) Over very small price ranges, the demand for goods with no close substitutes, oil, water (where it
is scarce) may be totally inelastic.
What will the demand curve corresponding to the following table look like?
If the curve had an elasticity of –1 throughout its length, what would be the quantity demanded (a)
at a price of £1; (b) at a price of 10p; (c) if the good were free?

P (£) Q Total
Expenditure
(£)
2.5 400 1000
5 200 1000
10 100 1000
20 50 1000
40 25 1000

The curve will be a ‘rectangular hyperbola’: it will be a smooth curve, concave to the origin which
never crosses either axis (Qd = 1000/P).
a. 1000 units.
b. 10 000 units.
c. There would be infinite demand!
Referring to the following table, use the mid-point (arc) formula to calculate the price elasticity of
demand between (a) P = 6 and P = 4; (b) P = 4 and P = 2. What do you conclude about the elasticity

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of a straight-line demand curve as you move down it?

Price Quantity Demanded

6 20
5 25
4 30
3 35
2 40
Using the formula: (Q/mid Q)  (P/mid P) gives the following answers:
(a) 10/25  –2/5
= 10/25  5/–2
= 50/–50
= –1 (which is unit elastic)
(b) 10/35  –2/3
= 10/35  3/–2
= 30/–70
= –0.43 (which is inelastic)
The elasticity decreases as you move down a straight-line demand curve.
Given Qd = 60 – 15P + P², calculate the (point) price elasticity of demand at a price of:
a. 5
b. 2
c. 0.
Given that:
Qd = 60 – 15P + P²
Then,
dQ/dP = –15 + 2P.
Thus using the formula, Pd = dQ/dP  P/Q, the elasticity at the each of the above price points
Equals:
(a) (–15 + (2  5))  (5/ (60 – (15  5) + 5²))
= –5  5/10 = –2.5
(b) (–15 + (2  2))  (2/ (60 – (15  2) + 2²))
= –11  2/34 = –0.65
(c) (–15 + (2  0))  (0/ (60 – (15  0) + 0²))
= –15  0/60 = 0
As you move down a straight-line demand curve, what happens to elasticity? Why?
It decreases. P/Q gets less and less, but dQ/dP remains constant.
Given the following supply schedule:
2 4 6 8 10
P
Q 0 10 20 30 40
a. Draw the supply curve.
b. Using the arc method calculate price elasticity of supply:
i. Between P = 2 and P = 4;
ii.Between P = 8 and P = 10
c. Using the point method calculate price elasticity of supply at P = 6.
d. Does the elasticity of the supply curve increase or decrease as P and Q increase? Why?
e. What would be the answer to (d) if the supply curve had been a straight line butintersecting
the horizontal axis to the right of the origin?
a. The supply curve will be an upward sloping straight line crossing the vertical axis where P = 2.
b. Using the formula Q/average Q  P/average P, gives:
10/5  2/3= 3
10/35  2/9= 1.29

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c. Using the formula dQ/dP  P/Q, and given that dQ/dP = 5 (= 10/2), gives:
5  6/20= 1.5
d. The elasticity of supply decreases as P and Q increase. It starts at infinity where the supply curve
crosses the vertical axis (Q = 0 and thus P/Q =).
e. No. At the point where it crossed the horizontal axis, the elasticity of supply would be zero (P =
0 and thus P/Q = 0). Thereafter, as P and Q increased, so would the elasticity of supply.
Which are likely to have the highest cross elasticity of demand: two brands of tea, or tea and coffee?
Two brands of tea, because they are closer substitutes than tea and coffee.
Supply tends to be more elastic in the long run than in the short run. Assume that a tax is imposed
on a good that was previously untaxed. How will the incidence of this tax change as time passes?
How will the incidence be affected if demand too becomes more elastic over time?
As supply becomes more elastic, so output will fall and hence tax revenue will fall. At the same time price
will tend to rise and hence the incidence will shift from the producer to the consumer.
As demand becomes more elastic, so this too will lead to a fall in sales. This, however, will have the
opposite effect on the incidence of the tax: the burden will tend to shift from the consumer to the producer.
If raising the tax rate on cigarettes raise more revenue and reduce smoking, are there any conflict
between the health and revenue objectives of the government?
There may still be a dilemma in terms of the amount by which the tax rate should be raised. To raise the
maximum amount of revenue may require only a relatively modest increase in the tax rate. To obtain a
large reduction in smoking, however, may require a very large increase in the tax rate. Ultimately, if the
tax rate were to be so high as to stop people smoking altogether, there would be no tax revenue at all for
the government!
You are a government minister; what arguments might you put forward in favour of maximising
the revenue from cigarette taxation?
That it is better than putting the taxes on more socially desirable activities. That there is the beneficial
spin-off from reducing a harmful activity. (You would conveniently ignore the option of putting up taxes
beyond the point that maximizes revenue and thus cutting down even more on smoking.)
You are a doctor; why might you suggest that smoking should be severely restricted? What methods
would you advocate?
That the medical arguments concerning damage to health should take precedence over questions of raising
revenue. You would probably advocate using whatever method was most effective in reducing smoking.
This would probably include a series of measures from large increases in taxes, to banning advertising, to
education campaigns against smoking. You might even go so far as to advocate making smoking tobacco
illegal. The problem here, of course, would be in policing the law.
Why is the supply curve for food often drawn as a vertical straight line?
It is because; the supply of food is virtually fixed in the short run. Once a crop is grown and harvested,
then it is of a fixed amount. (In practice, the timing of releasing crops on to the market can vary, given
that many crops can be stored. This does allow some variation of supply with price.)
The income elasticity of demand for potatoes is negative (an ‘inferior’ good). What is the implication
of this for potato producers?
Potato producers would expect to earn less as time goes past, given that national income rises over time.
Thus if the incomes of individual potato producers are to be protected, production should be reduced (with
some potato dairy farmers switching to other foodstuffs or away from food production altogether).

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Lesson 09
CONSUMER BEHAVIOR: CONSUMPTION SIDE ANALYSIS

SCARCITY AND RATIONAL CHOICE

Although scarcity, as defined in Lectures 1-2 was of a different nature, the most common form of scarcity
is the scarcity of income, i.e., the money resources are limited and consumers are faced with the decision
on how to spend those scarce resources on different goods and services.
Rational choice consists in evaluating the costs and benefits of different decisions and then choosing the
decision that gives the highest benefit relative to cost.
While taking decisions, economics stress the importance of weighing the marginal costs against marginal
benefits rather than total costs and benefits.
Ignorance and Irrationality:
There is a difference between “ignorance” and “irrationality.” A person operating under uncertainty and
thus at least partial ignorance can still make rational decisions by taking into account all the information
she has at her disposal. Rationality is an ex-ante concept. Economists do not judge rational behavior on
the basis of actual outcomes, rather on the basis of choices made.

CARDINAL VS. ORDINAL APPROACH

There are two approaches to analyzing consumer behavior;
 Marginal utility analysis (Cardinal approach)
 Indifference curve approach (Ordinal approach)

MARGINAL UTILITY ANALYSIS OR CARDINAL APPROACH

Marginal utility approach involves cardinal measurement of utility, i.e., you assign exact values or you
measure utility in exact units, while the indifference curve approach is an ordinal approach, i.e., you
rank possibilities or outcomes in an order of preferences, without assigning them exact utility values.
Utility is the usefulness, benefit or satisfaction derived from the consumption of goods and services.
Total utility (TU) is the entire satisfaction one derives from consuming a good or service.
Marginal utility (MU) is the additional utility derived from the consumption of one or more unit of the
good.

THE LAW OF DIMINISHING MARGINAL UTILITY

The law of diminishing marginal utility states that as you consume more and more of a particular good,
the satisfaction or utility that you derive from each additional unit falls.
Example:
Bottle of coke TU MU
0 0 -------
1 7 7-0=7
2 11 11-7=4
3 13 2
4 14 1
5 14 0
6 13 -1

As we consume more & more bottles of cokes, total utility increases & marginal utility remains positive
till units 4, after that total utility starts decreasing & marginal utility becomes negative. Total utility is
maximum at unit 5 & marginal utility is zero at this point.
Total & Marginal utility curves:
The marginal utility curve slopes downwards in a MU-Q graph showing the principle of diminishing
marginal utility. The MU curve is exactly equal to the demand curve.
The total utility curve starts at the origin and reaches the peak when marginal utility is zero. Marginal
utility can be derived from total utility. It is the slope of the lines joining two adjacent points on the TU
curve.

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A At point A, TU
Utility is at maximum
& MU is zero

TU

Bottle of
coke MU

Marginal utility functions can also be derived using calculus:

TU = 60Q – 4Q2
This is quadratic utility function. To find out marginal utility, we take derivative of TU function:
MU = dTU/ dQ = 60-8Q
For calculating MU, we take different values of Q.

DECIDING ON THE OPTIMAL LEVEL OF CONSUMPTION

Consumer Surplus:
Consumer surplus is the difference between willingness to pay and what the consumer actually has to pay:
i.e. CS= MU-P. Total consumer surplus is the area between the MU curve and the horizontal market
price line. Thus as price increases, consumer surplus shrinks, and vice versa.
The optimal point of consumption is that point where consumer surplus becomes zero. If marginal utility
is greater than price, consumption will increase causing MU to fall until it equals price, and vice versa.
There are 3 points regarding marginal utility and price:
1- Consumer will consume additional units of the commodity until marginal utility becomes equal to the
price (MU = P)
2- If MU > P then consumer will increase consumption, increasing consumption causes MU to fall and
MU will become equal to the P.
3- If MU < P then consumer will decrease consumption, decreasing consumption causes MU to rise and
MU will become equal to the P.

THE EQUI-MARGINAL PRINCIPLE

In the case of more than two goods, optimum consumption point can be arrived at by using the equi-
marginal principle. This states that a person will derive a maximum level of TU from consuming a
particular bundle of goods when the utility derived from the last dollar spent on each good is the same:
MUa = MUb = MUc …………….
Pa Pb PC

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Lesson 10
CONSUMER BEHAVIOR: CONSUMPTION SIDE ANALYSIS (CONTINUED)

SUPPLY SIDE AND DEMAND SIDE VIEWS ON THE VALUE OF GOOD

According to the supply side view on the value of a good, the value of a good was determined by the labor
content that had gone into producing well, either directly or indirectly.
According to the demand side view on the value of a good, the value of a good was determined by its
marginal utility. This helped solve the diamond-water paradox, i.e. why diamonds have such a high
price while water (much more essential for life) sells so cheaply.

SUPPLY SIDE AND DEMAND SIDE: DIAMOND WATER PARADOX

Economists like record and Karl Marx focused on the supply side of the economics. In their opinion any
good produced, its value is equal to the labor content used in its production. For example, if workersare
working 8 hours a day to produce bicycles then their time multiplied is the value of that bicycle. This is
labor content. On the other hand, economists like Adam smith focused on the demand side of the
economics.
They face a paradox of diamond and water. They found that water and diamond are very different in value.
Water is extremely used thing while diamonds are not much used. The price of diamond is very high while
the price of water is very low. Since water is used widely so it’s marginal utility is very low. And diamonds
are used very rarely so its marginal utility is very high.
On supply side, water is abundant so has low value and diamond is scarce so has very high value.
The “law” of diminishing marginal utility is said to explain the “paradox of water and diamonds”, most
commonly associated with Adam Smith. Human beings cannot even survive without water, whereas
diamonds were in Smith's day mere ornamentation or engraving bits. Yet water had a very small price,
and diamonds a very large price, by any normal measure. Margin lists explained that it is the marginal
usefulness of any given quantity that matters, rather than the usefulness of a class or of a totality. For most
people, water was sufficiently abundant that the loss or gain of a gallon would withdraw or add only some
very minor use if any; whereas diamonds were in much more restricted supply, so that thelost or gained
use were much greater.
That is not to say that the price of any good or service is simply a function of the marginal utility that it
has for any one individual nor for some typical individual. Rather, individuals are willing to trade based
upon the respective marginal utilities of the goods that they have or desire (with these marginal utilities
being distinct for each potential trader), and prices thus develop constrained by these marginal utilities.
The “law” is not about geology or cosmology, so does not tell us such things as why diamonds are
naturally less abundant on the earth than is water, but helps us to understand how relative abundance
affects the value imputed to a given diamond and the price of diamonds in a market.

UNCERTAINTY IN THE CONSUMPTION DECISION ANALYSIS

Uncertainty is the possibility that any number of things could happen in the future. In other words, the
future is not known.

The problem of uncertainty is integral to consumption decisions especially in the matter of purchasing
durable goods. Uncertainty means assigning probabilities to the outcomes.
A consumer’s response to uncertainty depends upon her attitude to risk: whether she is:
a. Risk averse
b. Risk-loving
c. Risk neutral

RISK
Risk means to take a chance after the probabilities have been assigned. Risk is the possibility of gain or
loss. Risk the calculated probability of different events happening, is usually contrasted with uncertainty
the possibility that any number of things could happen. For example, uncertainty is the possibility that
you could win or lose $100 on the flip of a coin. You don't know which will happen, it could go either
way. Risk, in contrast, is the 50 percent chance of winning $100 and the 50 percent chance of losing

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$100 on the flip of the coin. You know that your probability of winning or losing is 50 percent because
the coin has a 50 percent chance of coming up either heads or tails.
The odds ratio (OR) is the ratio of the probability of success to the probability of failure. It can be
equal to 1, less than 1 or greater than 1. If it is equal to 1 we call it fair odds, if less than 1 unfavorable
odds, and if greater 1 then favorable odds.
A risk neutral person is one who buys a good when OR > 1. He is indifferent when OR = 1 and will
not buy when OR < 1.
A risk averse person will not buy if OR < 1. He will also not buy if OR = 1. He might also not decide
to buy if OR > 1.
A risk loving person will buy if OR > 1 or = 1, but he might also buy when OR is < 1.
The degree of risk aversion increases as your income level falls, due to diminishing marginal utility of
income.
Risk aversion is a common feature of rational utility maximizing behavior by the average consumer.
Example:
If chances of winning = 50%
Chances of losing = 50%
You toss a coin, if head comes, you are given Rs. 100 & if tail comes, you have to pay Rs. 100. Will you
play this game or not?
The answer is if you are a risk averse person then you will not play this game because you consider much
the loss of Rs. 100 than the gain of Rs. 100. On the other hand, if you are risk loving person then you will
play this game.
The total utility curve for a risk neutral person will be a straight line while it will be convex for risk
averse person. The greater the convexity (curvature) the more risk averse the person will be.

RISK HEDGING can be used to reduce the extent to which concerns about uncertainty affect our daily
lives.
Example: Insurance companies operate under the principle of law of large numbers. An insurance
company collects the premium from the people. They also diversify the risk.
In the presence of asymmetric information, an insurance company has to contend with the problems of
adverse selection (people who want to buy insurance are also the most risky customers; an ex-ante
problem) and moral hazard (once a person is insured his behavior might become more rash; an ex-post
problem).

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Lesson 11
CONSUMER BEHAVIOR: CONSUMPTION SIDE ANALYSIS (CONTINUED)

THE INDIFFERENCE CURVE APPROACH OR ORDINAL APPROACH

This ordinal approach to utility consists in asking the question as to whether the consumer prefers one
combination or bundle of goods to another combination or bundle of goods. Ordinal approaches do not
require a “measurement” of the utility a person gains, rather, only a ranking of the various bundles in
order of preference.
An indifference curve is a line which charts out all the different points on which the consumer is
indifferent with respect to the utility he derives (in other words it is a combination of all equi-utility
points). It is drawn in goods space, i.e. a good Y on the vertical axis and a good X on the horizontal
axis.
Indifference curves are bowed in towards the origin. In other words its slope decreases (in absolute terms)
as we move down along the curve from left to right.
Good
Y

Indifference
curve

Good X

MARGINAL RATE OF SUBSTITUTION

The average slope of the indifference curve between any two points is given by the change in the quantity
of good Y divided by change in the quantity of good X. This is called the marginal rate of substitution
(MRS). MRS states how much unit of a good you have to give up in order get an additional unit of another
good.
A diminishing marginal rate of substitution (MRS) is related to the principle of diminishing marginal
utility. MRS is equal to the ratio of the marginal utility of X to the marginal utility of Y.

dY = MUX = MRS
dX MUY
The indifference curve for perfect substitutes is a straight line, while it is L-shaped for perfect
compliments.
Good
Y Indifference
Curve for
perfect
substitutes

Good X
cc

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Good
Indifference
Y
Curve for perfect
compliments

Good X

An indifference map shows a number of indifference curves corresponding to different levels of utility.
A higher indifference curve corresponds to a higher level of utility. Indifference curves never intersect.
The Budget Line and Indifference curves:
The budget line shows various combinations of 2 goods X & Y that can be purchased. Its slope –Px/PY
is called input price ratio.

Good
Y

Budget Line

Good X
EQUATION OF THE BUDGET LINE
Budget line in terms of Y = a + bX
kX + lY = M
lY = – kX + M
Y= –kX + M
l l
Where,
M = total amount of money
k & l = Prices of two goods
M = intercept
l
- K = Px = slope
l Py

The budget line can shift due to changes in total budget and the relative price ratio –Px/PY. If money
income rises, the budget line will shift outwards (parallel to the initial budget line). If the relative price
ratio changes, the slope of the budget line changes.

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Lesson 12
CONSUMER BEHAVIOR: CONSUMPTION SIDE ANALYSIS (CONTINUED)

THE OPTIMUM CONSUMPTION POINT FOR THE CONSUMER is where the budget line is
tangent to the highest possible indifference curve. At such a point, the slopes of the indifference curve
and the budget line are equal. In other words: vMRS = Px/Py = Y/X = MUx/MUy.
Just as we can use indifference analysis to show the combination of goods that maximizes utility for a
given budget, so too we can show the least-cost combination of goods that yields a given level of utility.
Good At point t,
Y Indifference curve is
tangent to the budget
line. This is the
optimal point of
consumption
t

Good X

LEAST COST COMBINATION can be derived also from the indifference curve & budget line.
Good Point t, is the least
Y cost combination
point.

Good X

This figure shows how consumer minimizes his cost.

Normal Goods and Giffen Good
A normal good is one whose consumption increases when income increases, while inferior good is one
whose consumption decreases with increase in income.
A Giffen good is a sub-category of inferior goods; its consumption increases when it’s price increases.
This is because of its very strong income effect.
Both normal and inferior goods have downward sloping demand curves.

THE INCOME CONSUMPTION CURVE (ICC)

The income consumption curve (ICC) can be used to derive the Engel Curve, which shows the
relationship between income and quantity demanded.

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Income
Engel curve

Good X
Engel curve shows the positive relationship between income & quantity demanded of normal good. As
income increases, quantity demanded for normal goods also increases.

PRICE CONSUMPTION CURVE (PCC)

The price consumption curve (PCC) traces out the optimal choice of consumption at different prices.
The PCC can be used to derive the demand curve, which shows the relationship between price & quantity
demanded.
When the price of one good change, two things happen:
 One the purchasing power of consumer changes i.e., the budget line shifts (leads to income effect).
 Secondly, the slope of budget line changes due to a change in the relative price ratio (leads to
substitution effect).
The substitution effect of a price rise is always negative, while the income effect of a price rise on the
consumption of a normal good is negative. The income effect for an inferior good is positive. The income
effect of a Giffen good is so positive that it offsets the negative substitution effect, therefore.

LIMITATION OF INDIFFERENCE APPROACH

The indifference curves approach has the following limitations:
a. Indifference curve analysis is only possible for 2 or at best for 3 goods.
b. It is almost impossible to practically derive indifference curves.
c. The consumer may not always behave rationally.
d. The consumer may not always realize the level of utility (ex-post) from consumption, that she
originally expected (ex-ante).
e. Indifference curve analysis can not help when one of the goods (X or Y) is a durable good.

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EXERCISES

Do you ever purchase things irrationally? If so, what are they and why is your behaviour
irrational?
A good example is things you purchase impulsively, when in fact you do have time to reflect on
whether you really want them. It is not a question of ignorance but a lack of care. Your behavior is
irrational because the marginal benefit of a bit of extra care would exceed the marginal effort involved.
Imagine that you are going out for the evening with a group of friends. How would you decide
where to go? Would this decision-making process be described as ‘rational’ behavior?
You would probably discuss it and try to reach a consensus view. The benefits to you (and to other group
members) would probably be maximized in this way. Whether these benefits would be seen as purely
‘selfish’ on the part of the members of the group, or whether people have more genuinely unselfish
approach, will depend on the individuals involved.
If you buy something in the shop on the corner when you know that the same item could have been
bought more cheaply two miles up the road from the wholesale market, is your behavior irrational?
Explain.
Not necessarily. If you could not have anticipated wanting the item and if it would cost you time, effort,
and maybe money (e.g. petrol) to go to the wholesale market, then your behavior is rational. Your behavior
a few days previously would have be irrational, however, if, when making out your weekly shopping list
for the wholesale market, a moment’s thought could have saved you having to make the subsequent trip
to the shop on the corner.
Are there any goods or services where consumers do not experience diminishing marginal utility?
Virtually none, if the time period is short enough. If, however, we are referring to a long time period,
such as a year, then initially as more of an item is consumed people may start ‘getting more of a taste for
it’ and thus experience increasing marginal utility. But even with such items, eventually, as
consumption increases, diminishing marginal utility will be experienced.
If Ammaar were to consume more and more crisps, would his total utility ever (a) fall to zero; (b)
become negative? Explain.
Yes, both. If he went on eating more and more, eventually he would feel more dissatisfied than if he
had never eaten any in the first place. He might actually be physically sick!
Complete this table to the level of consumption at which total utility (TU) is at a maximum, given
the utility function TU = Q + 60Q – 4Q2.

Q 60Q –4Q2 = TU
1 60 –4 = 56
2 120 –16 = 104
3 180 –36 = 144
4 240 –64 = 176
5 300 –100 = 200
6 360 –144 = 216
7 420 –196 = 224
8 480 –256 = 224

Derive the MU function from the following TU function:

TU = 200Q – 25Q² + Qt
From this MU function, draw up a table (like the one above) up to the level of Q where MU becomes
negative. Graph these figures.
MU = dTU/dQ = 200 – 50Q + 3Q²

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Q 200 –50Q + 3Q2 = MU

1 200 –50 + 3 = 153
2 200 –100 + 12 = 112
3 200 –150 + 27 = 77
4 200 –200 + 48 = 48
5 200 –250 + 75 = 25
6 200 –300 + 108 = 8
7 200 –350 + 147 = –3

180

160

140

120

100

80

60

40

20
MU
0

-2 0

If a good were free, why would total consumer surplus equal total utility? What would be the level
of marginal utility?
Because there would be no expenditure. At the point of maximum consumer surplus, marginal utility
would be equal to zero, since if P = 0, and MU = P, then MU = 0.
Why do we get less consumer surplus from goods where our demand is relatively elastic?
Because we would not be prepared to pay such a high price for them. If price went up, we would more
readily switch to alternative products.
How would marginal utility and market demand be affected by a rise in the price of a
complementary good?
Marginal utility and market demand would fall (shift to the left). The rise in the price of the complement
would cause less of it to be consumed. This would therefore reduce the marginal utility of the other good.
For example, if the price of lettuce goes up and as a result we consume less lettuce, the marginal utility of
mayonnaise will fall.
The diagram illustrates a person’s MU curves of water and diamonds. Assume that diamonds are
more expensive than water. Show how the MU of diamonds will be greater than the MU of water.
Show also how the TU of diamonds will be less than the TU of water.

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MU, P

Pd

Pw MU water
MU diamonds
Qd Qw

Define ‘risk’ and ‘uncertainty’.

Risk: when an outcome may or may not occur, but its probability of occurring is known.
Uncertainty: when an outcome may or may not occur and its probability of occurring is not known.
Give some examples of gambling (or risk taking in general) where the odds are (a) unfavorable; (b)
fair; (c) favorable.
a. Betting on the horses; firms launching a new product in a market that is already virtually saturated
and where the firm does not bother to advertise.
b. Gambling on a private game of cards which is a game of pure chance; deciding which of two
alternative brands to buy when they both cost the same and you have no idea which you will like
the best.
c. The buying and selling of shares on the stock exchange by dealers who are skilled in predicting
share price movements; not taking an umbrella when the forecast is that it will not rain (weather
forecasts are right more often than they are wrong!); an employer taking on a new manager who
has excellent references from previous employers.
(Note that in the cases of (a) and (c) the actual odds may not be known, only that they are unfavorable or
favorable.)
Which game would you be more willing to play, a 60:40 chance of gaining or losing Rs10 000, or a
40:60 chance of gaining or losing Re1? Explain why.
Most people would probably prefer the 40:60 chance of gaining or losing Re1. The reason is that, given
the diminishing marginal utility of income, the benefit of gaining Rs10 000 may be considerably less than
the costs of losing Rs10 000, and this may be more than enough to deter people, despite the fact that the
chances of winning are 60:40.
Do you think that this provides a moral argument for redistributing income from the rich to the
poor? Does it prove that income should be so redistributed?
Arguments like this are frequently used to justify redistributing income and form part of people’s moral
code. Most people would argue that the rich ought to pay more in taxes than the poor and that the poor
ought to receive more state benefits than the rich. The argument is frequently expressed in terms of a
pound being worth more to a poor person than a rich person. It does not prove that income should be so
redistributed, however, unless you argue (a) that the government ought to increase total utility in society
and (b) that it is possible to compare the utility gained by poor people with that lost by rich people –
something that is virtually impossible to do.
What details does an insurance company require to know before it will insure a person to drive a
car?
Age; sex; occupation; accident record; number of years that a license has been held; traffic law violations
and convictions; model and value of the car; age of the car; details of other drivers of the car.

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How will the following reduce moral hazard?
a. A no-claims bonus.
b. The driver having to pay the first so many rupees of any claim (called “excess”).
c. Offering lower premiums to those less likely to claim (e.g. if a house has a burglar alarm, it is less
likely to be burgled and therefore the insurance premiums for its contents – TV, VCR, etc. can be
reduced by the insurance company).
In the case of (a) and (b) people will be more careful as they would incur a financial loss if the event they
were insured against occurred (loss of no-claims bonus; paying the first so much of the claim). In the case
of (c) it distinguishes people more accurately according to risk. It encourages people to move into the
category of those less likely to claim (but it does not make people more careful within a category: e.g.
those with burglar alarms may be less inclined to turn them on if they are well insured!).
If people are generally risk averse, why do so many people around the world take part in national
lotteries?
Because the cost of taking part is so little, that they do not regard it as a sacrifice. They also are likely to
take a ‘hopeful’ view (i.e. not based on the true odds) on their chances of winning. What is more, the act
of taking part itself gives pleasure. Thus the behaviour can still be classed as ‘rational’: i.e. one where the
perceived marginal benefit of the gamble exceeds the marginal cost.
Why are insurance companies unwilling to provide insurance against losses arising from war or
‘civil disorder’?
Because the risks are not independent. If family A has its house bombed, it is more likely that family B
will too.
Name some other events where it would be impossible to obtain insurance.
Against losses on the stock market; against crop losses resulting from drought.
Although indifference curves will normally be bowed in toward the origin, on odd occasions they
might not be. What would indifference curves look like in each of the following cases?
a. X and Y are left shoes and right shoes.
b. X and Y are two brands of the same product, and the consumer cannot tell them apart.
c. X is a good but Y is a ‘bad’ – like household refuse.
a. L-shaped. An additional left shoe will give no extra utility without an additional right shoe to go
with it!
b. Straight lines. The consumer is prepared to go on giving up one unit of one brand provided that it
is replaced by one unit of the other brand.
c. Upward sloping. If consumers are to be persuaded to put up with more of the ‘bad’, they must
have more of the good to compensate.
What will happen to the budget line if the consumer’s income doubles and the price of both X and Y
double?
It will not move. Exactly the same quantities can be purchased as before. Money income has risen, but
real income has remained the same.
The income–consumption curve is often drawn as positively sloped at low levels of income. Why?
Because for those on a low level of income the good is not yet in the category of an inferior good. Take
the case of inexpensive margarine. Those on very low incomes may economise on their use of it (along
with all other products), but as they earn a little more, so they can afford to spread it a little thicker or use it
more frequently (the income–consumption curve is positive). Only when their income rises more
substantially do they substitute better quality margarines or butter.
Illustrate on an indifference diagram the effects of the following: A ceteris paribus (a) rise in the
price of good Y (b) fall in the price of good X.
a. The budget line will pivot inwards from B1 to B2.
b. The budget line would pivot outward on the point where the budget line crosses the vertical axis.
It is likely that the new tangency point with an indifference curve will represent an increase in the
consumption of both goods. The diagram above can be used to illustrate this. Assume the budget
line pivots outwards from B1 to B2. The optimum consumption point will move from point a to
c.
Illustrate the income and substitution effects in the above question.

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See the diagram above. In each case the substitution effect is shown by a movement from point a to point
b and the substitution effect is shown by a movement from point b to point c.
Are there any Giffen goods that you consume? If not, could you conceive of any circumstances in
which one or more items of your expenditure would become Giffen goods?

Substitution
B1a
a c
Income

1a

It is unlikely that any of the goods you consume are Giffen goods. One possible exception may
be goods where you have a specific budget for two or more items, where one item is much
cheaper: e.g. fruit bought from a greengrocer (or rehri waala on the street). If, say, apples are
initially much cheaper than bananas, you may be able to afford some of each. Then you find
that apples have gone up in price, but are still cheaper than bananas. What do you do? By
continuing to buy some of each fruit you may feel that you are not eating enough pieces of fruit
to keep you healthy and so you substitute apples for bananas, thereby purchasing more apples
than before (but probably less pieces of fruit than originally).

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Lesson 13
PRODUCER BEHAVIOR: PRODUCTION SIDE ANALYSIS
FIRM

A firm is any organized form of production, in which someone or collections of individuals are involved
in the production of goods and services. An organization that combines resources for the production and
supply of goods and services. The firm is used by entrepreneurs to bring together otherwise unproductive
resources. The key role played by a firm is the production of output using the economy's scarce resources.
Firm's are the means through which society transforms less satisfying resources into more satisfying goods
and services. If firms did not do this deed, then something else would. And we would probably call those
something else’s firms.
A firm faced with three basic questions:
a. What should it produce?
b. How should it produce it and
c. How much profit/net benefit will the firm make?

TRADITIONAL THEORY OF THE FIRM

The traditional theory of the firm says that the firm’s basic goal is to maximize profits. Profit is the
difference between the total revenue & total cost.
π = TR – TC
TR should be greater than the TC in order to maximize the profit. Some economists say that firm do not
want to maximize profit rather it wants to maximize its sales growth, its product likeliness etc. some
theories says that firms basic objective is to drive its competitor out of the market. All these are rival
theories. However, the traditional theory says that firm’s objective is to maximize the profit.
Types of firms:
A firm can be sole proprietorship (one-person ownership), partnership (a limited number of owners) or a
limited company (a large number of changing shareholders).

ENTREPRENEURSHIP
Entrepreneurship refers to the management skills, or the personal initiative used to combine resources in
productive ways. It involves taking risks. It is the managerial function that combines land, labor, and
capital in a cost-effective way and uncovers new opportunities to earn profit; includes willingness to
take the risks associated with a business venture.

PRODUCTION FUNCTION
A mathematical relation between the production of a good or service and the inputs used. A production
function is usually expressed in this general form: Q = f(L, K), where Q = quantity of production output,
L = quantity of labor input, and K = quantity of capital input. A production function is simply the
relationship between inputs & outputs.
Mathematically it can be written as:
Q = f (K, L, N, E, T, P…)
Where,
Q = Output = Total product produced
K = Capital
L = Labor
N = Natural resources
E = Entrepreneurship
T = Technology
P = Power

COBB DOUGLAS PRODUCTION FUNCTION

In economics, the Cobb-Douglas functional form of production functions is widely used to represent the
relationship of an output to inputs. It was proposed by Knut Wicksell, and tested against statistical
evidence by Paul Douglas and Charles Cobb in 1928.
Cobb Douglas production function can be represented by the following equation,
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Q = A Kα L1 – α
Where:
Q = output
L = labor input
K = capital input
A, α and 1 – α are constants determined by technology.
Short run:
In terms of the macroeconomic analysis of the aggregate market, a period of time in which some prices,
especially wages, are rigid, inflexible, or otherwise in the process of adjusting. Short-run wage and price
rigidity prevents some markets, especially resources markets and most notably labor markets, from
achieving equilibrium. In terms of the microeconomic analysis of production and supply, a period of time
in which at least one input in the production process is variable and one is fixed. In the microeconomic
analysis, the short run is primarily used to analyze production decisions for a firm.
Long run:
In terms of the macroeconomic analysis of the aggregate market, a period of time in which all prices,
especially wages, are flexible, and have achieved their equilibrium levels. In terms of the microeconomic
analysis of production and supply, a period of time in which all inputs in the production process is variable.
The actual length of the short run and long run can vary considerably from industry to industry.

THE LAW OF DIMINISHING MARGINAL RETURNS

The law of diminishing marginal returns states that as you increase the quantity of a variable factor
together with a fixed factor, the returns (in terms of output) become less and less. Thus if we are using
labor in the production of wheat given a fixed amount of land, after a certain point the increase in the
output of wheat will become less and less until it starts reducing the total output of wheat.

Wheat production per year from a particular

farm
Quantity of variable
Total physical product:
factor: number of
output of wheat in tones
workers employed
( Lb ) per year ( TPP)

0 0
1 3
2 10

3 24

4 36
5 40

6 42
7 42

8 40

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Graphical illustration

45
TP P
40

35

30

25

20

15

10

8 10

No of farm workers

The total physical product (TPP) of a factor (F) is the latter’s total contribution to output measured in
units of output produced.
Average physical product (APP) is TPP per unit of the variable factor. APP can be represented by the
following formula,
APP = TPPF/QF
Marginal physical product (MPP) is the addition to TPP brought by employing an extra unit of the
variable factor. More generally,
MPPF = ∆TPPF/∆QF

RELATIONSHIP BETWEEN APP AND MPP

• If the marginal physical product equals the average physical product, the average physical
product will not change.

• If the marginal physical product is above the average physical product, the average physical
product will rise.

• If the marginal physical product is below the average physical product, the average physical
product will fall.

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Lesson 14
PRODUCER BEHAVIOR: PRODUCTION SIDE ANALYSIS (CONTINUED)

THERE ARE TWO THEORIES OF PRODUCTION

1. Short run productivity theory or the law of diminishing marginal returns. This theory states that
as we increase the amount of a variable factor with the fixed factor, initially the output will
increase but afterwards there will come a point when each extra unit of the variable factor
produces less extra output than the previous unit. In this theory, we take one factor as fixed
therefore; it applies only in the short run.
2. Long run productivity theory or returns to scale theory. In long run, all factors are variable.
This theory includes constant, increasing & decreasing returns to scale.
If population is increasing and output remains constant, then diminishing returns set in and therefore
average per capita production/consumption can be expected to fall ceteris paribus.
A firm confronted with three more decisions;
a. Scale of production,
b. Location, size of industry
c. Optimum combination of inputs

THE SCALE OF PRODUCTION

Returns to scale refers to a technical property of production that examines changes in output subsequent
to a proportional change in all inputs (where all inputs increase by a constant). If output increases by that
same proportional change then there are constant returns to scale (CRTS), sometimes referred to simply
as returns to scale.
The scale of production (returns to scale) can be increasing, decreasing or constant. Increasing
(decreasing) returns to scale arise when a 1% increase in the amount of all the factors employed causes a
>1% (<1%) increase in output. Constant returns arise when a 1% increase in all the factors causes a 1%
increase in output.
Returns to scale and returns to factor are two different concepts, the latter related to the short-term, the
former to the long-term.
Increasing returns to scale or (economies of scale) arise if, as firms become bigger and bigger, their costs
per unit of output fall. This could be because of larger more efficient plants, financial economies, more
efficient specialized labour, bulk discounts on purchases etc.

THE LOCATION, SIZE OF DECISION

The location decision depends upon both the location of raw material suppliers and the location of the
market. The nature of the product, transportation costs, availability of suitable land for production,
stable power supply and good communications network, availability of qualified and skilled workers,
level of wages, the cost of local services and availability of banking and financial facilities are among
some other important factors. The size of an industry can lead to external economies and diseconomies of
scale.
Economies of scale:
The increase in efficiency of production as the number of goods being produced increases. Typically, a
company that achieves economies of scale lowers the average cost per unit through increased production
since fixed costs are shared over an increased number of goods.
There are two types of economies of scale:
External economies - the cost per unit depends on the size of the industry, not the firm.
Internal economies - the cost per unit depends on size of the individual firm.

EXTERNAL ECONOMIES AND DISECONOMIES OF SCALE

External economies are benefits accruing to any one firm due to actions or the presence of other firms.
For example, advertising by a rival industry, setting up of credit information bureaus by banks.
An example of external diseconomies of scale arising is when, as an industry grows larger, a shortage of
specific raw materials or skilled labor occurs, adversely affecting the costs and prospects of all firms in
the industry.

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Diseconomies of scale
Diseconomies of scale are the forces that cause larger firms to produce goods and services at increased
per-unit costs. They are less well known than what economists have long understood as "economies of
scale", the forces which enable larger firms to produce goods and services at reduced per-unit costs.

THE OPTIMUM COMBINATION OF FACTORS

The optimum combination of factors will obtain at the point where the marginal physical product of the
last dollar spent on all inputs is equal, i.e.:
MPPK = MPPL
PK PL
If MPPK ≠ MPPL
PK PL

It would be possible to reduce cost per unit of output by using a different combination of labor and capital
If MPPL> MPPK
PL PK
More labor should be used relative to capital, since the firm is getting a greater physical return for its
money from using extra workers than it is getting from using extra capital. However as more and more
labor is used, diminishing returns to labor set in. Thus MPPL will fall. Likewise, as less capital is used,
MPPK will rise. Until
MPPK = MPPL
PK PL
(Technical or productive
Efficiency point)

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Lesson 15
PRODUCER BEHAVIOR: PRODUCTION SIDE ANALYSIS (CONTINUED)

ISOQUANT
An isoquant represents different combinations of factors of production that a firm can employ to produce
the same level of output. Isoquant can be used to illustrate the concepts of returns to scale and returns to
factor.
Capital

Isoquant
curve

Labor
Isoquant Map:
Like an indifference map, an isoquant map consists of parallel isoquants that do not intersect. Thehigher
the output level the further to the right an isoquant will be.

MARGINAL RATE OF TECHNICAL SUBSTITUTION (MRTS)

The slope of an isoquant is called marginal rate of technical substitution (MRTS). It is analogous to the
term marginal rate of substitution (MRS) in consumer analysis. MRTS is the amount of one factor, e.g.
capital, that can be replaced by a one unit increase in the other factor e.g. labor, if output is to be held
constant.
The principle of diminishing MRTS is related to the law of diminishing returns. As one moves down
along an isoquant drawn in K-L space, increasing amounts of labor are used relative to capital. Now,
given diminishing returns, the MPP of labor will fall relative to the MPP of capital.
MRTS = ∆ K
∆L

∆ K. MPPK = ∆L. MPPL

Rearranging

∆ K = MPPL
∆ L MPPK

Also MRTS = ∆ K = MRTS

∆L

MRTS = MPPL
MPPK
Isoquant can be used to illustrate the concepts of returns to scale and returns to factor.
a. Constant returns to scale: equally spaced isoquants;
b. Increasing returns to scale: isoquants become closer and closer to each other;
c. Decreasing returns to scale: isoquants become further and further apart from each other.
d. Diminishing returns to factors can be illustrated by keeping one of the inputs constant (say
capital). Here if there are constant returns to scale, ever-increasing increments of labor will be
required to produce equal increments to output.

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ISOCOST OR BUDGET LINE
The concept of isocost is similar to the budget line developed in indifference curve analysis. It is a line,
which captures all the different combinations of inputs that the firm can afford to hire.
a. If price of both inputs increases, the isocost line shifts inwards.
b. If price of one input increases, it pivots out.
c. The slope of isocost is PL/PK.
The isoquant-isocost combination can help answer:
a. What is the least cost way of producing a particular level of output?
b. What the highest level of output the firm can produce given a certain budget.

OPTIMAL COMBINATION OF FACTORS

In either case, the optimal factor combination obtains at the point of tangency between the relevant iso-
cost and isoquant. At this point
MRTS = MPPL = PL
MPPK PK
Capital
At point R, Isoquant
curve is tangent to the
budget line (Isocost).
This is the optimal
combination of factors
R of production.

Labor
SUNK COST
In economics and in business decision-making, sunk costs are costs that have already been incurred and
which cannot be recovered to any significant degree. Sunk costs are sometimes contrasted with variable
costs, which are the costs that will change due to the proposed course of action. In microeconomic theory,
only variable costs are relevant to a decision. Economics proposes that a rational actor does not let sunk
costs influence one's decisions, because doing so would not be assessing a decision exclusively on its own
merits. It is important to note that the decision-maker may make rational decisions according to their own
incentives; these incentives may dictate different decisions than would be dictated by efficiency or
profitability, and this is considered an incentive problem and distinct from a sunk cost problem.

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Lesson 16
PRODUCER BEHAVIOR: COST ANALYSIS

Economists argue that sunk cost should not be included in a rational person’s decision-making process
while opportunity cost should be included.

VARIABLE COST (VC)

Costs, which vary with the level of activity (or output), are called variable costs. Variable cost is a cost of
labor, material or overhead that changes according to the change in the volume of production units.
Combined with fixed costs, variable costs make up the total cost of production. While the total variable
cost changes with increased production, the total fixed cost stays the same.
Fixed Cost (FC)
Costs, which do not vary with the level of activity or output, are called fixed costs. In long run, there are
no fixed costs. Fixed cost does not vary depending on production or sales levels, such as rent, property
tax, insurance, or interest expense.
Total Cost (TC)
Total cost (TC) is the sum of all fixed and variable costs. It plot as a vertical summation of the
horizontal line total fixed cost (TFC) curve and the upward sloping total variable cost (TVC) curve.
TC = FC + VC
Average Cost or Average total cost (AC or ATC)
Total cost per unit of output, found by dividing total cost by the quantity of output. Average total cost,
usually abbreviated ATC, can be found in two ways. Because average total cost is total cost per unit of
output, it can be found by dividing total cost by the quantity of output. Alternatively, because total cost
is the sum of total variable cost and total fixed cost, average total cost can be derived by summing average
variable cost and average fixed cost. Average cost (AC) is the vertical summation of the AFC & AVC.
Average variable cost plus average fixed cost equals average total cost.
AVC + AFC = ATC or AC
Average variable cost (AVC)
AVC is an economics term to describe the total cost a firm can vary (labor, etc.) divided by the total
units of output.
AVC = TVC/Q
Average fixed cost (AFC)
AFC is total; fixed cost divided by the total units of output.
AFC = TFC/Q
AC = AFC + AVC, where average fixed cost (AFC) is a downward sloping line as you are dividing a
fixed number by an increasing number of output units. By contrast, average variable cost (AVC) first falls
as output increases and then rises.
Study of AC is necessary for firms to be able to set the price or (average revenue) at which they will
sell. Also they will be interested in knowing how AC is broken down into AFC & AVC.

MARGINAL COST (MC)

The change in total cost (or total variable cost) resulting from a change in the quantity of output produced
by a firm in the short run. Marginal cost indicates how much total cost changes for a given change in the
quantity of output. Because changes in total cost are matched by changes in total variable cost in the short
run (remember total fixed cost is fixed), marginal cost is the change in either total cost or total variable
cost. Marginal cost, usually abbreviated MC, is found by dividing the change in total cost (or total variable
cost) by the change in output.
Marginal cost is the addition to TC caused by a unit increase in output. More generally:
MC = TC/Q
The secret of the shape of the MC curve lies in the law of diminishing marginal returns. The relationship
between MC and AC is a reflection of the relationship between MPP & APP. That is: both MC and AC
fall in the beginning, then MC starts to rise, cutting AC from below at the latter’s turning point
(minima).

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In the long run, the law of diminishing marginal returns does not apply to the extent that it does in short
run.

TC = TVC + TFC
Output ( Q ) TFC TVC TC
0 12 0 12
1 12 10 22
2 12 16 28
3 12 21 33
4 12 28 40
5 12 40 52
6 12 60 72
7 12 91 103

120 TC
100
TVC
80
Cost

60
40
TFC
20
0
0 2 4 6 8
Output
RELATIONSHIP BETWEEN AC AND AVC
Initially, AC falls more rapidly than AVC because AC is a summation of AFC & AVC and since both are
falling the effect of two falling curves is greater than the effect of one falling curve. After the turning point
in AVC, both AC and AVC rise but the gap between them narrows because of same reasoning as given
above.
There is an inverse relationship between costs and productivity, i.e. as productivity rises, costs fall and
vice versa.
The equivalent of constant, increasing and decreasing returns to scale in terms of costs are economies of
scale, diseconomies of scale and constant costs (or constant returns to scale).
i. In the case of economies of scale, long run total cost (LRTC) is an upward sloping curve
but with falling slope. Note that the slope can never become zero or negative, though.
ii. In diseconomies of scale, LRTC is an upward sloping curve with an increasing slope.
iii. In constant costs, LRTC is a positively sloped straight line.

THE LONG-RUN AVERAGE COST CURVE (LRAC)

The long-run average cost (LRAC) curve for a typical firm is U shaped.
i. As a firm expands, it initially experiences economies of scale (due to productive efficiency,
better utilization of resources etc.); in other words, it faces a downwardsloping LRAC
curve.
ii. After the scale of operation is increased further, however, the firm achieve constant costs
i.e., LRAC become flat.
iii. If the firm further increases its scale of operation, diseconomies of scale set in (due to
problems with managing a very large organization etc.) and the LRAC assumes a positive
slope.

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The following assumptions are made while deriving LRAC curves:
Price of factors are constant, technology is fixed, firms choose that combination of factors at which the
MPP of the last dollar spent on each input is equal.
Long-run marginal cost (LRMC):
In case a firm is enjoying economies of scale, each incremental unit will cost less than the preceding one
i.e., LRMC will be falling. The opposite will be true for diseconomies of scale. In case of constant costs,
each incremental unit will cost the same, i.e., the LRMC will be constant.
Relation between SRAC and LRAC curves:
The LRAC curve for a firm is actually derived from its SRAC curves. The exact shape of the LRAC is a
wave connecting the least cost parts of the SRAC curves. In practice however, LRAC is shown as a smooth
U-shaped curve drawn tangent to the SRAC. This is also called an envelope curve.

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Lesson 17
REVENUE & PROFIT MAXIMIZATION ANALYSIS
REVENUES

Revenues are the sale proceeds that accrue to a firm when it sells the goods it produces; in other words,
they are the cash inflows that the firm received by way of selling its products.
Total Revenue (TR), Average Revenue (AR) and Marginal Revenue (MR):
Total revenue (TR), average revenue (AR) and marginal revenue (MR) concepts apply in the same way
as they did to TC, AC and MC.
i. TR = P x Q.
ii. AR = TR/Q; AR is usually equal to price unless the firm is engaged in price
discrimination.
iii. MR = TR/Q.

PRICE-TAKING FIRM
A firm that does not have the ability to influence market price is a price-taker. In perfect competition, the
firm is price taker. There are large number of buyers and sellers and firm can not influence on the market
price. Price is set by the forces of demand and supply.

PRICE-MAKING FIRM
A firm that influences the market price by how much it produces can be called a price-maker or price-
setter. In Monopoly, firm is price maker. A monopoly or a firm within monopolistic competition has the
power to influence the price it charges as the good it produces does not have perfect substitutes. A
monopoly is a price maker as it holds a large amount of power over the price it charges.

DERIVING A FIRM’S AR & MR CURVES FOR PRICE TAKING FIRM

For a price taker, AR=MR=P. In this case, the demand (or AR) curve the firm faces is a horizontal line.
TR for a price-taking firm is a straight line from the origin.

Price

AR=MR=P

Quantity

TR TR

Quantity

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DERIVING A FIRM’S AR & MR CURVES FOR PRICE MAKING FIRM

Q P = AR TR= P×Q MR
(ships) Rs. Crores Rs. Crores
1 8 8
2 7 14 6
3 6 18 4
4 5 20 2
5 4 20 0
6 3 18 -2
7 2 14 -4

A price maker faces a downward sloping demand (or AR) curve i.e., it cannot sell more without reducing
price. But this means lowering the price for all units, not just the extra units it hopes to sell. The demand
faced by a price maker is elastic, when MR is positive and therefore TR increases due to a decrease in
price. Demand is inelastic when MR is negative, and therefore TR falls due to a decrease in price.
Price

AR

Quantity
MR

TR

TR

Quantity

PROFIT MAXIMIZATION
Firms are interested in profit maximization. Profit is the difference between total revenue & total cost.
Higher the difference, higher is the level of profit. Economists say that when firms earn zero accounting
profits, they actually earn normal economic profits because TC already includes the normal profits that
owners of the firms need for themselves to stay in the business. Positive profits are, for this reason, called
supernormal profits as they are over and above what the owners normally require as a return for their
entrepreneurship.
Profit = TR – TC

APPROACHES OF PROFIT MAXIMIZATION

Profit maximization can be studied using the TR-TC approach and the MR-MC approach.

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i. In the TR-TC approach, it is assumed that firm is price maker and firm is operating in short
run. Total profit is the vertical distance between TR and TC.
ii. In the MR-MC approach, two steps are followed to identify maximum profit. First: the
profit-maximizing output is identified – this is the point where MR cuts MC. Second: the
size of maximum profit is calculated using AC and AR curves.
Assumptions:
1. Demand curve is downward sloping
2. Firm is operating in the short run

TR & TC APPROACH
According to this approach, profit is maximized at that point where the difference between total revenue
& total cost is maximum. In this table, profit is maximized at quantity of 3, where profit is at its maximum
of 4.
Q(units) TR TC Tπ
0 0 6 -6
1 8 10 -2
2 14 12 2
3 18 14 4
4 20 18 2
5 20 25 -5
6 18 36 -18
7 14 56 -42

MR & MC APPROACH
According to this approach, profit is maximized at the point where MC=MR. In this table, profit is
maximized at quantity of 4 where MR=MC=2

Q P=AR TR MR TC AC MC Tπ Aπ
0 9 0 ----- 6 ---- ---- -6 ----
1 8 8 8 10 10 4 -2 -2
2 7 14 6 12 6 2 2 1
3 6 18 4 14 4 2/3 2 4 1 1/3
4 5 20 2 18 4 1/2 4 2 1/2
5 4 20 0 25 5 7 -5 -1
6 3 18 -2 36 ? 11 -18 -3
7 2 14 -4 56 8 20 -42 -6

If MR & AR remain same over the long run, then the profit maximizing output will be obtained where
MR intersects LRMC.
If AC is always above AR, then firms will never be able to make a profit. In this case, the point where
MR=MC, represents the loss-minimizing point.
When MC and MR intersect at two points, not one, then Firms should produce at that point of
intersection of MR and MC beyond which, MC exceeds MR.
If a firm’s AR is below its AVC, it will shut down since it is not covering any part of its fixed costs.

Note: Graphical illustration of these two approaches is discussed in detail in the video lectures.

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EXERCISES

How will the length of the short run for a shipping company depend on the state of the shipbuilding
industry?
If the shipbuilding industry is in recession, the short run (and the long run) may be shorter. It will take
less time to acquire a new ship if there is no waiting list, or if there are already ships available to purchase
(with perhaps only minimal modifications necessary).
Up to roughly how long is the short run in the following cases?
(a) A mobile ice-cream firm. (b) A small grocery. (c) Electricity power generation.
a) 2-3 days: the time necessary to acquire new bicycles, equipment and workers.
b) Several weeks: the time taken to acquire additional premises.
c) 3-5 years: the time taken to plan and build a new power station.
How would you advise the naanwaala (bread-maker) next door as to whether he should (a)
employ an extra assistant on a Sunday (which is a high demand day); (b) extend his shop, thereby
allowing more customers to be served on a Sunday?
a) If maximizing profit is the sole aim, then he should employ an additional assistant if the extra
revenue from the extra customers that the assistant can serve is greater than the costs of employing
the assistant.
b) Only if the extra revenue from the extra customers will more than cover the costs of the extension
plus the extra staffing.
Given that there is a fixed supply of land in the world, what implications can you draw from
about the effects of an increase in world population for food output per head?
Other things being equal, diminishing returns would cause food output per head to decline (a declining
MPP and APP of labour). This, however, would be offset (partly, completely or more than completely)
by improvements in agricultural technology and by increased amounts of capital devoted to agriculture:
this would have the effect of shifting the APP curve upwards.
The following are some costs incurred by a shoe manufacturer. Decide whether each one is a fixed
cost or a variable cost or has some element of both.
(a) The cost of leather. (b) The fee paid to an advertising agency. (c) Wear and tear on machinery.
(d) Business rates on the factory. (e) Electricity for heating and lighting. (f) Electricity for running
the machines. (g) Basic minimum wages agreed with the union. (h) Overtime pay. (i) Depreciation
of machines as a result purely of their age (irrespective of their condition).
(a) Variable. (b) Fixed (unless the fee negotiated depends on the success of the campaign). (c) Variable
(the more that is produced, the more the wear and tear). (d) Fixed. (e) Fixed if the factory will be heated
and lit to the same extent irrespective of output, but variable if the amount of heating and lighting depends
on the amount of the factory in operation, which in turn depends on output. (f) Variable. (g) Variable
(although the basic wage is fixed per worker, the cost will still be variable because the total cost will
increase with output if the number of workers is increased). (h) Variable. (i) Fixed (because it does not
depend on output).
Assume that a firm has 5 identical machines, each operating independently. Assume that with all
5 machines operating normally, 100 units of output are produced each day. Below what level of
output will AVC and MC rise?
20 units. Below this level, the one remaining machine left in operation will begin to operate at a level
below its optimum. (Note that with 5 machines producing 100 units of output, minimum AVC could be
achieved at 100, 80, 60, 40 and 20 units of output, but between these levels some machines may be
working at less than their optimum and some at more than their optimum. Thus if the optimum level for
a machine is critical, then the AVC curve may look ‘wavy’ rather than a smooth line.
Why is the minimum point of the AVC curve (y) at a lower level of output than the minimum point
of the AC curve (z)?
Because between points y and z marginal cost is above AVC (and thus AVC must be past the minimum
point) but below AC (and thus AC cannot yet have reached the minimum point). Even though AVC is
rising beyond point y, the fall in AFC initially more than offsets the rise in AVC and thus AC still falls.
What economies of scale is a large department store likely to experience?

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Specialized staff for each department (saving on training costs and providing a more efficient service for
customers); being able to reallocate space as demand shifts from one product to another and thereby
reducing the overall amount of space required; full use of large delivery lorries which would be able to
carry a range of different products; bulk purchasing discounts; reduced administrative overheads as a
proportion of total costs.
Why are firms likely to experience economies of scale up to a certain size and then diseconomies
of scale after some point beyond that?
Because economies of scale, given that most arise from increasing returns to scale, will be fully realized
after a certain level of output, whereas diseconomies of scale, given that they largely arise from the
managerial problems of running large organizations, are only likely to set in beyond a certain level of
output.
How is the opening up of trade and investment between, say eastern and western Europe, likely to
affect the location of industries within Europe that have (a) substantial economies of scale; (b)
little or no economies of scale?
a) Given that production will take place in only one or two plants, new plants will tend to be located
near to the centre of the new enlarged European market.
b) Plants will still tend to be scattered round Europe, given that the customers are scattered.
These effects will be the result of attempts to minimize transport costs and thus will be more significant
the higher are transport costs per kilometer.
Name some industries where external economies of scale are gained. What are the specific
external economies in each case?
Two examples are:
 Financial services: pool of qualified and experienced labour, access to specialist software, one
firm providing specialist services to another.
 Various parts of the engineering industry: pool of qualified and experienced labour, access to
specialist suppliers, possible joint research, specialized banking services.
Would you expect external economies to be associated with the concentration of an industry in a
particular region?
Yes. There may be a common transport and communications infrastructure that can be used; there is likely
to be a pool of trained and experienced labour in the area; joint demand may be high enough to allow
economies of scale to be experienced in the supply of some locally extracted raw material.
If factor X costs twice as much as factor Y (Px/Py = 2), what can be said about the relationship
between the MPPs of the two factors if the optimum combination of factors is used?
MPPx/MPPy = 2. The reason is that if MPPx/Px = MPPy/Py, then, by rearranging the terms of the
equation, MPPx/MPPy must equal Px/Py (= 2).
Could isoquants ever cross?
Not for a given state of technology, otherwise it would mean that at one side of the intersection the higher
output isoquant would be ‘south-west’ of the lower output isoquant. This would mean that a higher output
could be achieved by using less of both factors of production!
Could they ever slope upward to the right?
Yes. It would mean that one of the two factors had a negative marginal productivity that was greater
than the positive marginal productivity of the other: i.e. that MPPa/MPPb (or MPPb/MPPa) wasnegative
(a negative marginal rate of factor substitution).
This situation will occur when so much is used of one factor that diminishing returns have become so
great as to produce substantial negative marginal productivity: isoquants will bend back on themselves
beyond the points where they become vertical or horizontal. The firm, however, will not produce along
this portion of an isoquant, because the price ratio (Pa/Pb) will (virtually) never be negative.
What will happen to an isocost if the prices of both factors rise by the same percentage?
It will shift inwards parallel to the old isocost.
Why do the prices of cattle and sheep prices fall so drastically “on”, or just “after” the first day of
Eid-ul-Azha?
The supply curve for cattle and sheep is fixed in the short-run, i.e. a vertical supply curve, therefore
price will be determined by demand. Since demand for “cattle for sacrifice” falls drastically after or on
the first day of Eid-ul-Azha, the price has to come down drastically as well for the market to clear.

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Explain the shape of the LRMC curve for a firm with a typical U-shaped LRAC curve.
At first economies of scale cause the LRMC to fall. Then because of (marginal) diseconomies of scale,
additional units of production begin to cost more to produce than previous units: the LRMC begins to
slope upwards. But the LRAC is still falling because the LRMC is below it pulling it down. It is not until
the LRMC crosses the LRAC that the firm will experience a rising LRAC and hence average diseconomies
of scale.
Will the “envelope curve” be tangential to the bottom of each of the short-run average cost curves?
Explain why it should or should not be.
No. At the tangency points the two curves must have the same slope. Thus the slope at the tangency point
is not zero (the slope at the turning point or minima of the SRAC curves).
What would the isoquant map look like if there were (a) continuously increasing returns to scale;
(b) continuously decreasing returns to scale?
a) The isoquants would get progressively closer and closer together.
b) The isoquants would get progressively further and further apart.
What can we say about the slope of the TR and TC curves at the maximum profit point? What
does this tell us about marginal revenue and marginal cost?
The slopes are the same. But given that the slope of the total curve gives the respective marginal, this
means that marginal revenue will be equal to marginal cost.
Fill in the missing figures in the table below.
Q P = AR TR MR TC AC MC Tπ Aπ
0 9 6

1 8 10

2 7 12

3 6 14

4 5 18

5 4 25

6 3 36

7 2 56

Q P = AR TR MR TC AC MC Tπ Aπ

0 9 0 6 – –6 –
8 4
1 8 8 10 10 –2 –2
6 2
2 7 14 12 6 2 1
4 2
3 6 18 14 4.3 4 1.3
2 4

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4 5 20 18 4.5 2 0.5
0 6
5 4 20 25 5 –5 –1
–2 9
6 3 18 36 6 –18 –3
–4 16
7 2 14 56 8 –42 –6

Why should the figures for MR and MC be entered in the spaces between the lines?
Because marginal revenue (or cost) is the extra revenue (or cost) from moving from one quantity
to another.
You are given the following information for a firm.
Q 0 1 2 3 4 5 6 7
P 12 11 10 9 8 7 6 5
TC 2 6 9 12 16 21 28 38
Construct a detailed table like the one you constructed in the earlier question with TR, AC, MR, TC,
AC, MC, T and A. Use your table to draw “two” diagrams (one with the marginal revenue and cost
curves, and one with the total (or average) revenue and cost curves) and use them to show the “profit-
maximizing output” and the “level of maximum profit”, respectively. Confirm your findings byreference
to the table you construct.
Q P = AR TR MR TC AC MC Tπ Aπ
0 12 0 2 – –2 –
11 4
1 11 11 6 6 5 5
9 3
2 10 20 9 4.5 11 5.5
7 3
3 9 27 12 4 15 5
5 4
4 8 32 16 4 16 4
3 5
5 7 35 21 4.2 14 2.8
1 7
6 6 36 28 4.7 8 1.3
–1 10
7 5 35 38 5.4 –3 –0.4
The curves will be a similar shape to those discussed in the lecture, and included in the slides handout. The
peak of the T curve will be at Q = 4. This will be the output where MR and MC intersect.
Will the size of normal ‘profit’ vary with the general state of the economy?
Yes. Normal profit is the rate of profit that can be earned elsewhere (in industries involving similar level
of risk). When the economy is booming, profits will normally be higher than when the economy is in
recession. Thus the ‘normal’ profit that must be earned in any one industry must be higher to prevent
capital being attracted to other industries.
Given the following equations:
TR = 72Q – 2Q²; TC = 10 + 12Q + 4Q²
Calculate the maximum profit output and the amount of profit at that output using both methods.
(a) T = 72Q – 2Q² – 10 – 12Q – 4Q

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= –10 + 60Q – 6Q² (1)
 dT /dQ = 60 – 12Q
Setting this equal to zero gives:
60 – 12Q = 0
 12Q = 60
 Q=5
(b) MR = dTR/dQ = 72 – 4Q
MC = dTC/dQ = 12 + 8Q
Setting MR equal to MC gives:
72 – 4Q = 12 + 8Q
 12Q = 60
 Q=5
To find the level of maximum profit, we must substitute Q = 5 into equation (1). This gives:
T = –10 + (60  5) – (6  5²)
= –10 + 300 – 150
= Rs. 140

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