Oxfo Business & Technology College

Module for the Course

Micro Economics II
Course Code = ECON-212
Credit Hour = 3

Wisdom at the source of Blue Nile

March, 2017
Shire Tigray
Course introduction

Dear learner, welcome to the course Micro economics II. This course will enable you to
understand the basic knowledge and principle of the course.
The types of courses are listed below. So you are expected to read the notes and practice the
activities carefully. This course is composed of five chapters. These are

Unit 1: the theory of consumer behavior

Unit 2: the theory of production

Unit 3: Equation and Inequality Involving Rational Expression
Unit 4: Equations involving Exponents and Logarithm
Unit 5: Ratio
Unit 6: Proportion
Unit 7: Percentage
Unit 8: Mixture
Unit 9: Application of Percentage
Course objective
After studying and up on combination of these course students should be able to

 Will be able use economic problem solving skills to discuss the opportunities and
challenges of country economy.

Icons and what they indicate

Icon What indicates

Type
 Indicates pre test
 Indicates post test
 Indicates check lists that enables you trace
understanding of unit concept
 Indicates answer to questions
 Indicates activities to be answered by student
 Indicates assignments to be answered
! Indicates important points need emphasis

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Table of Contents
Unit One.................................................................................................................................... 2
THE THEORY OF CONSUMER BEHAVIOR....................................................................... 3
2.1 The Cardinal Utility Approach ................................................................................... 4
2.2 The Ordinal Utility Theory ......................................................................................... 8
Unit Two ................................................................................................................................. 48
THE THEORY OF PRODUCTION....................................................................................... 48
2.1 The Production Function................................................................................................... 48
Unit Three ............................................................................................................................... 70
THEORY OF COST ............................................................................................................... 70
3.1 Short-Run Costs ................................................................................................................ 70
3.2 Long-run costs .................................................................................................................. 77
Unit Four................................................................................................................................. 85
PERFECT COMPETITION ................................................................................................... 85
4.1 Introduction.................................................................................................................. 85
4.2 Short-run Equilibrium of the Firm and the Industry .................................................... 86
4.3 Long Run Equilibrium of the Firm And Industry ........................................................ 89
Unit Five ................................................................................................................................. 90
PURE MONOPOLY............................................................................................................... 90
5.1 Short Run and Long Run Equilibrium ............................................................................. 92
5.2. Discriminating Monopoly................................................................................................ 93
5.3 Multiplan Monopoly ......................................................................................................... 96
5.4 Social Cost of Monopoly .................................................................................................. 97

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 UNITE ONE

THE THEORY OF CONSUMER BEHAVIOR

Contents
 Utility
 Cardinal Utility
 Derivation of Demand curve
 Ordinal Utility
 Marginal rate of Substitution
 Optimum Consumer
 Income Consumption
 Price Consumption Curve
 Elasticity of Demand

Objective
Dear learner! The main objective of this part is to explain for students about the behavior
of consumer in maximizing utility. It tries to explain the rational consumer decision in profit
maximization.
The theory of consumer behavior is the concern of how consumers decide on the basket of
goods and services they consume in order to maximize their satisfaction. The theory of
demand starts with the examination of the behavior of the consumer, since the market
demand is assumed to be the summation of the demand of the individual consumers.
In explaining the consumer behavior, which is the basis for the theory of demand, we assume
that:
i) The consumer is rational: - given his/her income and the market price of the
commodities, he/she plans the spending of his/her income so as to attain the highest
possible satisfaction or utility. This is the axiom of utility maximization.
ii) The consumer has complete knowledge of all the information relevant to his/her
decision, i.e., he/she has:
- complete knowledge of all the available commodities,
- complete knowledge of the price of the commodities,
- complete knowledge of his/her income.

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! Some Basic Concepts
Consumer: - A decision making unit (an individual or a household) who uses or consumes a
commodity or service.
Utility:-The power of a commodity to satisfy human wants. It is the satisfaction or subjective
pleasure that one gets from consuming a good or service.
Relativity of Utility: - The utility of a commodity is subjective to a person’s need. It is not
absolute (objectively determined).
Utility And Moral Values: - Utility is free from moral values. For example, eating a food
item which may be immoral in a society yields utility as long as it satisfies hunger. It is also
the case that utility is “ethically neutral” between good and bad, and harmful and useful. For
example, drug yields utility to the drug-takers.
In order to maximize utility, the consumer must be able to compare the utility of the various
baskets of goods which he/she can buy with his/her income. There are two approaches to the
problem of comparison (measurability) of utility:
i) the cardinal approach
ii) the ordinal approach

2.1 The Cardinal Utility Approach

The cardinal school postulated that utility can be measured in monetary units (i.e., by the
amount of money that the consumer is willing to sacrifice for another unit of a commodity)
or by subjective unit called “utils”.

Assumptions
i) Rationality:- the consumer is assumed to be rational since that he/she aims at the
maximization of his/her utility subject to the constraints imposed by his/her
income.
ii) Cardinal utility: - the utility of each commodity is measurable, with the most
convenient measure being money.
iii) Constant marginal utility of money:- the utility that one derives from each
successive unit of money income remains constant.

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 iv) Diminishing marginal utility (DMU):- the MU of a commodity diminishes as the
consumer acquires more and more of it.
v) Additively of utility: - even though dropped in the latter version of the approach,
utility was assumed to be additive in the earlier version. That is:
U = U1(X1) + U2(X2) + --- + Un (Xn)
vi) The total utility of a basket of goods and services depends on the quantities of
the individual commodities. That is:
U = f(x1, x2… xn)

Equilibrium of the Consumer

Dear learner! Let’s assume that the consumer consumes a single commodity, x. The
consumer can either buy x or retain his money income Y. Under these conditions the
consumer is in equilibrium when the marginal utility of X is equated to its market price (px).
Symbolically,
MUx = Px
Mathematically, we can derive the equilibrium of the consumer as follows:
- The utility function is
U = f (qx), where utility is measured in monetary units and qx is the quantity of x
consumed by the consumer.
If the consumer buys qx, his/her expenditure is pxqx. Presumably the consumer seeks to
maximize the difference between his/her utility and total expenditure. That is:
U – Pxqx
The necessary condition for a maximum is that the partial derivative of a function with
respect to qx be equal to zero. Thus,
d (U – pxqx)
= O
dqx

═> dU d (pxqx)
- = O
dqx dqx
═> dU dqx

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 - px = O
dqx dqx

═> dU = px
dqx

═> MUx = Px

If MUx > Px, the consumer can increase his/her welfare by purchasing more unit of X, and if
the MUx < Px, welfare can be increased by reducing the consumption of X.
In the case there are more commodities, the condition for optimality of the consumer is the
equality of the ratios of MU of the individual commodities to their prices, i.e. the utility
derived from spending an additional unit of money must be the same for all commodities.

MU1 = MU2 = ….. = MUn

P1 P2 Pn

Derivation of the Demand Curve

The derivation of demand is based on the axiom of diminishing marginal utility. The MU of
commodity X is depicted by a line with a negative slope which is the slope of total utility
function, U =f(qx). As successively increasing quantities of X are consumed, the total utility
increases but at a decreasing rate (recall the assumption of DMU), reaches a maximum at
quantity X* and then starts declining. Accordingly, the MUx declines continuously and
becomes negative beyond X*.

MUx = slope of TUx = dTU

dqx

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 Thus it can be shown that the demand curve for commodity X is identical to the positive
segment of the MUx curve. For example, at X1 the MU is MU1 which is equal to P1 at the
optimum point. Hence at P1 the consumer demands X1 quantity. Similarly at X2 the marginal
utility is MU2 which is equal to P2. Hence at P2 the consumer demands X2 and so on. This

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 forms the demand curve for commodity X. As negative price do not make sense in
economics, the negative potion of MUx does not form part of the demand curve.

O X1 X2 X3 X*
Panel A: The MU curve Panel B: The demand curve

The demand curve is simply the graphical representation of the relationship between price
and quantity demanded.

Critiques of the Approach

1) The satisfaction derived from the various commodities can not be measured
objectively. The cardinality of the utility is extremely doubtful.
2) The assumption of constant MU of money is unrealistic because as income changes
the MU of money changes.
3) The additivity assumption of utility is unrealistic.

2.2 The Ordinal Utility Theory

The ordinals school suggests that utility is not measurable, but is an ordinal magnitude. That
is, to make his/her choice, the consumer need not know the utility of various commodities in
specific unit, but be able to rank the various basket of goods(order of preference) according
to the satisfaction that each bundle gives.

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There are two main theories in the ordinal approach:
1) The Indifference Curve Theory, and
2) The revealed preference hypothesis

2.2.1 The indifference curve theory

Indifference curve(IC):- is the locus of points of different combinations of two goods (a
bundle of goods) which yields the consumer the same level of satisfaction (utility) so that he
is indifferent as to the particular combination he/she consumes.

An Indifference Map: - shows a set of all the ICs, which rank the preference of the consumer.
Combination of goods situated on an IC yields the same level of utility. Combination of
goods lying on a higher IC yields higher level of satisfaction and are preferred.

Assumptions
1) Rationality: - the consumer is assumed to be rational.
2) Utility is ordinal: - the consumer can rank his/her preference (order the various
baskets of goods) according to the satisfaction of each basket.

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 3) Diminishing marginal rate of substitution (DMRS):- preferences are ranked in terms
of ICs, which are assumed to be convex to the origin. This implies that the slope of IC
(MRS) decreases in absolute terms.
4) The total utility of the consumer depends on the quantities of the commodities
consumed.
U = f (q1, q2… qn)
5) Consistency and transitivity of choices:-
═> If bundle A>B, then B is not greater than A
═> If bundle A >B and B>C, then A>C.

Properties of Well Behaved Indifference Curves

1) An indifference curve has a negative slope:- which denotes that if the quantity of one
commodity(Y) decreases the quantity of the other (X) must increase, if the consumer
is to stay on the same level of satisfaction.
2) The further away from the origin an IC lies, the higher level of utility it denotes.
3) ICs do not intersect. If they did, the point of their intersection would imply two
different level of satisfaction, which is impossible.
4) ICs are convex to the origin:- this implies that the slope of an IC (MRS) decreases( in
absolute terms) as we move along the curve from the left down wards to the right.

The Marginal Rate of Substitution (MRS)

The marginal rate of substitution of X and Y (MRSx,y) is defined as the number of units of
commodity Y that must be given up in exchange for an extra unit of commodity X so that the
consumer maintains the same level of satisfaction. It is the negative of the slope of an IC at
any one point and is given by the slope of the tangent line at that point:
Slope of IC = -dy
= MRSx,y
dx

The concept of marginal utility is implicit in the definition of MRS since it can be proved
that the MRS (the slope of IC) is equal to the ratio of the marginal utilities of the
commodities in the utility function.

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 MUx OR MUy
MRSx,y = MRSy,x =
MUy MUx
Proof:
The total utility function in the case of two commodities X&Y is
U = f(x, y)
The equation of an IC is
U = f(x, y) = K, where K is constant.
At equilibrium, the total derivative of U is equal to zero.
ӘU ӘU
═> du = dy + dx
Әy Әx
= (MUy) dy + (MUx) dx
Along any particular IC, the total differential is by definition equal to zero.
═> du = (MUy) dy + (MUx) dx = o
═> MUy dy = - MUx dx
═> - dy + MUx = MRSx,y
Dx MUy

The Optimum of the Consumer

To define the optimum of the consumer, we should introduce the concept of the budget line.
The budget line is the set of bundles of goods that cost exactly the consumer’s income. This
implies that income acts as a constraint in the attempt of maximizing utility.

Assuming two goods (x,y), the budget line will have the equation:
Px.X +Py.Y= M
Y = 1/Py.M – Px/Py.X
Where M= is fixed money income
Px = is the price of good X
Py = is the price of good Y

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Assigning successive values to X (given income, M and the commodities price, Px and Py),
we may find the corresponding values of Y. Thus,
If X = O (if the consumer spends all his/her income on Y), the consumer can buy
M/Py units ofY.
If Y = O, the consumer can buy M/Py units of X.
If we join these two points by a line, we obtain the budget line.
Y

M
Py

O M X
Px

M/Py M Px
Slope of the budget line = = .
M/Px Py M

= Px
Py
Mathematically, slope of the budget line is the derivative of the budget equation:
ӘY Ә (1/Px.M – Px/Py.X)
=
ӘX ӘX

ӘY Px
=
ӘX Py

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The consumer is in equilibrium when he/she maximizes his/her utility, given income and the
market prices. Two conditions must be fulfilled for the consumer to be in equilibrium.
1) MRSx,y = MUx/MUy = Px/Py, which is the necessary condition.
2) The IC be convex to the origin (decreasing MRSx,y)
Graphically, the equilibrium of the consumer is at the point of tangency of the budget line
and the highest possible IC (at point e).

At the point of tangency (point e) the slope of the budget line (Px/Py) and of the IC (MRSx,y
= MU x MUy) are equal.

MRSx,y = MUx/MUy = Px/Py, which is the FOC.

The SOC is implied by the convex shape of the IC. Thus, the consumer maximizes utility by
buying X* & Y* of the two commodities.
Mathematical derivation of the equilibrium of the consumer is as follows:
- Assume that there are two commodities, X&Y. The consumer is in equilibrium when
he/she maximizes utility given hi/her income and the market price of the
commodities.
- Formally the problem can be stated as:
Maximize U = f(x,y)
Subject to M = Px.X + Py.Y
- By using the lagrangian method, the steps involved are:
a) rewrite the constraint as
Px.X + Py.Y – M = O

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 b) Multiply the constraint by a constant  (lagrangian multiplier)
(Px.X + Py.Y – M) = O
C) Subtract from the objective function to obtain a composite function.
L = U - (Px.X + Py.Y – M)
D) Derivate L with respect to X, Y, & and equate to zero.
L/X = U/X - Px = O
=> U/X = Px
=>MUx = Px
=>  = MUx/ Px………………………………………… (1)
L/y = U/y - Py =O
=> U/y = Py
=>MUy = Py
=>  = MUy/Py………………………………………….. (2)
L/ = Px.X + Py.Y – M = O…………………………... (3)
From (1) and (2), we can infer that
 = MUx/ Px = MUy/Py
 MUx/ Px = MUy/Py
 MUx/MUy = Px/ Py = MRSx,y
We observe that the equilibrium conditions are identical in the cardinal’s approach and in the
Indifference curve approach. In both theories we have:
MUx/ Px = MUy/Py = ---- = MUn/Pn
Example
Let us assume that an individual, whose income is birr 10 consumes two types of goods, X &
Y, whose prices are Px = 2 and Py = 1, spend all his income on these goods. By using the
above information and the MU table for the two goods, determine the following things/
answer the following questions.
(A) Indicate how much of X & Y the individual should purchase to maximize utility.
(B) Show that the condition for constrained utility maximization is achieved.
(C) Determine how much total utility the individual receives when he /she maximizes
utility. How much utility would the individual get if he/she spent all income on X/Y?

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Qx MUx Qy MUy MUx/Px MUy/Py
1 10 4 5 5 5
2 6 5 4 3 4
3 4 6 3 2 3
4 2 7 2 1 2
5 0 8 1 0 1

Solution:
(A) the individual maximizes his/her utility when he/she consumes 2 units of X and 6
units of Y since at this point MUx/Px = MUy/Py, i.e, 6/2 = 3/1.
(B) The condition for utility maximization is that MUx/Px = MUy/Py, give that all the
consumer income is spent.
Thus at the optimum of the consumer,
MUx/Px = MUy/Py i.e. 6/3 = 3/1 => 3 = 3 and
PxX + PyY = I
 2(2) + 1(6) = 10
 10 = 10
(C) TU = ∑MUs = ∑MUx + ∑Muy
 TU = (10 + 6)x + (5 + 4 + 3)y
 TU = (16)x + ( 12 )y
 TU = 28
 If the individual spends all his/her income, he/she will get the total utility of:
Tux = ∑MUx
Tux = 10 + 6 + 4 + 2 + 0
Tux = 22
This is because the consumer can consume 5 units of X given that his/her income is 10 birr
and Px is 2 birr.

 if the consumer spends all his/her income on Y:

Tux = ∑MUx
Tux = 5 + 4 + 3 + 1
Tux = 13

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 Corner Solutions
If ICs are every where either flatter or steeper than the budget line, or if they are concave
rather than convex to the origin, then the consumer maximizes utility by spending all income
on either good Y or X. These are called the corner solutions.
Y Y Y
U1 U2 U3 J
Y* J U3 J Y*

U2

B U1 L B

O OX U1 U2 U3
K X O
K X* X

In the left panel, ICs are every where flatter than the BL, and U2 is the highest IC that the
consumer can reach by purchasing Y* of Y (point J). The middle panel shows ICs every where
steeper than the BL, and U2 is the highest IC that the consumer can reach by spending all
income to purchase X* of X (point K). In the right panel, concave IC U2 is tangent to the
budget line at point B, but this is not the optimum point because the consumer can reach higher
IC U2 by consuming only good Y (point J).

Income Consumption Curve (ICC)

Increase in income shifts the budget line outward in a parallel manner (if commodities prices
are kept constant). If we go on increasing income (i.e., shifting the budget line outward), we
will have a set of optimum points corresponding to each budget line. The curve which connects
these optimum points is called the Income Consumption Curve (ICC). It is the locus consumer
optimum points resulting only when the consumer income changes. The ICC is also known as

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the Income Offer Curve or the Income Expansion Path. From the ICC we can then derive the
consumer Engle Curve. The Engle curve shows the amount of a good (X) that the consumer

would purchase per unit of time at various income levels. To derive the Engle curve we keep
the same horizontal scale as in the top panel but measure money income on the vertical axis.
Y A’’

A’

A ICC
E2 E3
E1
U2 U3
U1

O X1 X2 X3 B B’ B’’ X
M

At income level M1, the consumer is in equilibrium at point E1 by consuming X1 units of X

and this is shown by point E1’ on the M-X plane. When income of the consumer increases to
M2, the budget line shifts to A’B’ and the consumer will a higher IC U2 at point E2 by
purchasing X2 units of X. this is shown by point E2’ on the second panel. Similarly, when
income increase to M3, the consumer is in equilibrium at point E3 by purchasing X3 of X and
this is shown by point E3’ on the second panel.
If we connect equilibrium points of the consumer in the first panel we obtain the Income
Consumption Curve. Similarly, if we connect the points on the second panel, we obtain the
Engle Curve.

Normal and Inferior Goods

A normal good is one of which the consumer purchases more with an increase in income.

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An inferior good is one of which the consumer purchases less with an increase in income.
Good X in the above figure is a normal good because the consumer purchases more of it with
an increase in income. This is shown by a positively sloping income consumption curve and
the Engle curve. However, for an inferior good, the income consumption curve and the Engle
curve are negatively sloping because as income increases, the consumer purchases less of these
commodities. This can be shown by the following graph.

Y
A’
ICC
E2
A
U2

E1

U1

O X
X2 X1 B B’
M

M2 E2

E1
M1

X2 X1 O X

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 The classification of goods as normal or inferior depends only on how a specific
consumer views the particular good.
Thus, the same good X can be regarded as a normal good by another consumer.
 Furthermore, a good can be regarded as a normal good by a consumer at a particular level
of income and as an inferior good by the same consumer at a higher level of income.
 A normal good can be further classified as a necessity or a luxury depending on whether
the quantity purchased increases proportionately more or less than the increase in income.

Price Consumption (Offer) Curve

When the price of a good (say X) decreases the budget line becomes flatter (rotates to the
right) from its initial position (AB) to a new position (AB’) due to the increase in the
purchasing of the given income of the consumer. The new budget line is tangent to a higher
IC at point E2 showing that as price of X falls, more of commodity X will be bought. If we
allow price of X to fall continuously and we join the points of tangencies of successive
budget lines and the higher ICs, We form the so called price consumption curve from which
we derive the demand curve for commodity X. at point E1 the consumer buys quantity X1 at
price P1. At point E2 the price P2 is lower than P1 and the quantity demanded has increased
to X2 and so on.

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 Y

PCC
E3
E2
E1 I3
I2
I1
O
X1 X2 B X3 B’ B’’ X
P

P1
P2

P3
DD-Curve
O X
X1 X2 X3
Thus, we derive the demand curve by plotting the price quantity pairs defined by the points of
equilibrium (on the price consumption curve) on the price quantity space.
The demand curve for normal goods (goods whose demand increases with increase in income)
will always have a negative slope denoting the law of demand which states that the quantity
demanded increases as price increases and vice versa. In the case of giffen goods the demand
for a good decreases when its price decreases.
Mathematical derivation of the demand curve:
Derive the demand function for good X and Y given

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 U(x, y) = 1/4QxQy, Px, Py, &M.
Solution
=> M = QxPx + QyPy
At the optimum choice, the slope of IC (MRSx,y = MUx/MUy) is equal to the slope of the
budget line(Px/Py). That is,
MUx/ MUy = Px/ Py
But MUx = U/ X = ¼ Qy and
MUy = U/ Y = ¼ Qx
 ¼ Qy/ ¼ Qx = Px/ Py
 QyPy = QxPx----------------------------------------(1)
The budget constraint is
M = QxPx + QyPy
=> Qy = M/ Py – Px/ Py Qx------------------------------ (2)
Substitute (2) in to (1)
 Py ( M/ Py – Px/ Py Qx) = Qx Px
 M – PxQx = QxPx
 2PxQx = M
 Qx = 1 M
2Px
To obtain the demand function for Y:
M = PxQx + PyQy
=> PxQx = M – PyQy
Qx = 1/ PxM – (Py/Px)Qy--------------------------------(3)
Substitute (3) into (1)
 PxQx = PyQy
 Px(1/PxM – Py/PxQy) = PyQy
 M – PyQy = PyQy
 2PyQy = M
 Qy = 1 x M  is the demand function for Y.
2Py

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Example: given utility U(x, y) = X1/3Y2/3 , Px = 2, Py = 5 and M = 400, find:
(1) The demand equation for X and Y.
(2) The utility maximizing levels of X and Y.
(3) The maximum utility
(4) The MRSx,y at the optimum level.
Solution:1
U(x, y) = X1/3Y2/3
At equilibrium, MUx/MUy= Px/Py
But, MUx = U/ /X = 1/3 X-2/3Y2/3

MUy = U/ /Y = 2/3X1/3 Y-1/3

=> 1/3 X-2/3Y2/3 Px
=

2/3X1/3 Y-1/3 Py

=> X-2/3Y2/3 . 3 Px
=
3 2X1/3 Y-1/3 Py

=> X-2/3Y2/3 Px
2X1/3 Y-1/3 =
Py

=> X-1Y Px
=
2 Py
=> Y Px
=
2X Py
=> Py Y = 2 Px X-------------------------------------------------(1)
But, M = Py Y + PxX  Is the budget constraint.
=> PyY = M – PxX

=> Y = M/ Py – Px/ Py X-----------------------------------------(2)

And PxX = M – PyY

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 => X = M/Px –(Py/Px)Y-------------------------------------------(3)
Substitute equation (2) into (1)
 PyY = 2 PxX
 Py(M/Py – Px/Py X) = 2PxX
 M – Px X = 2PxX
 3PxX = M
 X=M
 Is the demand equation for X.
3Px
Similarly, substitute equation (3) into (1).
PyY = 2PxX
 2Px(M/Px – Py/PxY) = PyY
 2M – 2PyY =PyY
 3PyY = 2M
 Y = 2M
 Is the demand function for commodity Y.
2Py
(2) The above functions of X & Y are derived from the equilibrium position of the consumer.
Thus, substitute the value of M, Px and Py in the demand equations to find the optimum
value of X and Y.
X = M/ 3Px = 400/ 3(2) = 400/6 = 200/3=66.7
Y = 2M/3Py = 2(400)/3(5) = 160/3 = 53.3
(3) U = X1/3Y2/3
= (66.7)1/3(53.3)2/3 = 57.5 is the maximum utility.
(4) At the equilibrium or at the optimum point,
MRSx,y = MUx/MUy = Px/Py
=>MRSx,y = 2/5 = 0.4
OR MRSx,y = MUx/MUy =1/3 X-2/3Y2/3 Y 160/3
= =
2/3X1/3 Y-1/3 2X 2(200/3)

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 = 160/3 80 40
= = = 0.4
400/3 200 100

Decomposition of Income and Substitution Effects

A fall in the price of a good has two effects:
(1) The consumer will tend to buy more of a good that has become cheaper and less of
those goods that are now relatively expensive. The consumer will tend to substitute
cheaper commodity for relatively expensive one. This response to the change in
relative prices of goods is called the substitution effect.
(2) Because one of the goods is now cheaper, the consumer enjoys an increase in real
purchasing power. The consumer is better of because he/she can buy the same amount
of the good for less money and thus money left over for additional purchases. The
change in demand resulting from this change in real purchasing power is called the
income effect.
The substitution effect is the increase in the quantity bought as the price of the
commodity falls after adjusting income so as to keep the real purchasing power of the
consumer the same as before. This adjustment in income is called compensating
variation and is shown graphically by a parallel shift of the new budget line until it
becomes tangent to the initial IC. The purpose of the compensating variation is to allow
the consumer to remain on the same level of satisfaction as before the price change.
In the following graph, the consumer was initially at point E1 on the budget line AB.
When the price of X falls, the budget line has rotated from AB to AB’ resulting in anew
equilibrium point E2. The increase in the consumption of X from X1 to X3 is the total
effect of a fall in the price of X which can be split into substitution effect and income
effect. In order to split these two effects we draw a parallel budget line (compensating
budget line) which is tangent to the new budget line.
This allows the real purchasing power of the consumer to remain as before and thus to
reject the income effect so the consumer will be on the same level of satisfaction as
before. Accordingly, the movement from point E1 to E1’ shows the substitution effect of
the price change (the consumer buys more of X now that it cheaper, substituting X
for Y).

24
 Y

A’
E1
E2

E1’ U1

U2
O X
X1 X2 B X3 A’ B’

The substitution effect is negative for all goods since the consumer substitutes the cheaper for
more expensive one. This implies a decrease in price leads to an increase in quantity
demanded.

The movement from E1’ to E2 is the income effect of the fall in the price of X. to isolate the
income effect, we assume that the relative price of the goods has not changed (shown by the
parallel line AB’ and A’A’). The income effect in this case can be thought of as being
negative (comparing the direction of the change in price and quantity demanded of a good) or
a positive (comparing the direction of the change in the purchasing power of the consumer
and the quantity demanded).

25
 => For normal good, income effect of a price change is negative, i.e. Px =>PP=> Qx.
Ultimately, Px => Qx.
=> For inferior good, income effect of a price change is positive, i.e. Px =>PP=> Qx.
Ultimately, Px => Qx.

PANEL A PANEL B
Y Y

A
A
E2

A’
A’ E2
E1
E1 U2

U2 E1’
E1’
U1 U1
O B XO X
X1 X3 X2 A’ B’ X3 X1 X2 B A’ B’

SE SE

IE IE

TE TE

TE = SE + IE TE = SE + IE
X1X3 = X1X2 +X2X3 X1X3 = X1X2 +X2X3

26
For an inferior good whose negative substitution effect more than offsets the positive income
effect (panel A above), the total effect will be negative (Px  => Qx) and thus the law of
demand holds. If, however, the IE is positive and very strong that it more than offsets the
negative SE, the demand curve will have a positive slope (Px => Qx)  the GIFFEN
PARADOX. A Giffen good is a good whose demand curve slopes down ward because the
positive IE is larger than the negative SE (panel B).

Good IE SE TPE
Normal Negative Negative Negative
inferior Positive Negative Ambiguous

The Revealed Preference Hypothesis

The revealed preference hypothesis is considered as a major break through in the theory of
demand because it has made possible the establishment of the law of demand directly on the
basis of the revealed preference axiom without the use of indifference curves and all their
restrictive assumptions.

Assumptions:
(1) Rationality: the consumer is assumed to behave rationally, in that he prefers bundles
of goods that include more quantities of the commodities.
(2) Consistency: if A > B, then B is not greater than A.
(3) Transitivity: if in any particular situation A > B and B > C, then A > C.
(4) The revealed preference axiom: the consumer, by choosing a collection of goods in
any one situation, reveals his/her preference for that particular collection. The chosen
basket of goods maximizes the utility of the consumer.
Derivation of the Demand Curve
Assume that the consumer has the budget line AB in the figure below and chooses the
collection of goods denoted by point Z, thus revealing hi/her preference for this basket. This
bundle of goods defines the equilibrium of the consumer which maximizes his/her utility.
Suppose that the price of X falls so that the new budget line facing the consumer is AC. We
will show (proof) that the new bundle of goods includes more of X.

27
 Y

A’

Z W N
X
O X1 X2 B B’ X3 C

In order to split the SE & IE , we make a compensating variation shown by a parallel budget
line to the new budget line, which passes through the point Z. in this case the consumer has
enough income to buy Z combinations if he/she so wishes. Since the collection Z is available
to the consumer, he/she will not choose any bundle to the left of Z on the segment A’Z
because they contain less quantity of X & Y than bundles on the segment AZ. Hence the
consumers will either continuo to buy Z (in which case the substitution effect is zero) or
he/she will choose a bundle on ZB’, such as W, which includes a larger quantity of X
(namely X2). Secondly, if we allow the income effect and hence the consumer to move on
the new budget line AC, he/she will choose a bundle to the right of W (such as N) if the
commodity X is normal with the positive income effect. The new revealed equilibrium
position (N) includes a larger quantity of X (i.e. X3) resulting from a fall in price. Thus we
derive the demand curve directly from the revealed preference axiom (i.e. as a price X falls
the demand for X increases).

Derivation of the Market Demand

In our previous discussion we have derived the individual demand curve from the utility
maximization behavior of consumers. Now we will derive the market demand from this
individual demand curves. As it has been proved, the individual demand is negatively related

28
 to the price commodity in the sense that when price decrease, the individual consumer
purchases more of the commodity in order to maximize his/her utility. The market demand
curve for the commodity is simply the horizontal summation of the demand curve of all the
consumers in the market. In other words the quantity demanded in the market at each price is
the sum of the individual demands of all consumers at that price.

Example:
Assume that there are two consumers in the market for a particular commodity X ( say
hamburger) and their demand at each price is given as follow:
Price ($) Qx dded by A Qx dded by B Market demand
2 2 2 4
1 6 4 10
0.5 10 6 16

Graphically the market demand can be derived as follows:

Px Px Px
Individual A Individual B Market demand

2------ --------------------------- ------------------------------------- -------------

1--------------------------------- ------------------------------------ ---------------------

0.5-------------------------------- ------------------------------------ --------------------

d1 d2 MD

O 2 6 10 O 2 4 6 O 4 10 16

29
 Thus, the market demand fort a commodity shows the various quantities of the commodity
demanded in the market per unit of time at various alternative price of the commodity while
holding every thin else constant. The market demand for a commodity is negatively sloped
(just as an individual demand curve), indicating that price and quantity are inversely related.
That is, the quantity demanded of the commodity increases when its price falls and decreases
when its price rises.

Determinants of Demand
Determinants of demand are factors that cause the consumer to increase or decrease its
demand for a particular commodity. Demand is a multi-variety function in a sense that it’s
determined by many factors/variables. The most important determinants of market demand
are considered to be the price of the commodity in question, the price of other related
commodities, the consumer income and testes. The result of change in the price of the
commodity is shown by a movement from one point to another on the same demand curve,
while the effect of changes in other determinants is shown by a shift of demand curve and
these factors are called shift factors.
Px

P2----------- B

P ------------------------------

P1--------------------------- A D D’ D’’
D
Qx Qx
O X2 X1 O X1 X2 X3

Movement along the demand curve Shifts of the demand curve as, for exam-
as the price of X changes. ple income increases

30
Apart from the above determinants, demand is affected by numerous other factors, such as
the distribution of income, total population and its consumption, wealth, credit availability,
change in expectation about the future price of the commodity, etc.

Elasticity of Demand
The concept of elasticity is used to measure the amount by which the quantity demanded
changes when its determinants change. There are as many elasticities of demand as there are
its determinants. The most important of these elasticities are:
(A) The price elasticity of demand
(B) The income elasticity of demand
(C) The cross-elasticity of demanded.
The Price Elasticity of Demand
The price elasticity is a measure of the responsiveness of demand to changes in the
commodity’s own price. If the changes in price are very small we use as a measure of the
responsiveness of demand the point elasticity of demand. If the changes in price are not small
we use the arc elasticity of demand as a relevant measure.
The point elasticity of demand is defined as the proportionate change in the quantity
demanded resulting from a very small proportionate change in price. Symbolically, we may
write as:
ep = dQ/Q dQ P
OR ep = x
dP/P dP Q
If the demand is linear
Q = bo – b1P, its slope is dQ/dP = -b1. Substituting in the formula we obtain, ep = -b1.P/Q.
Graphically, the point elasticity of a linear demand curve is shown by the ratio of the
segments of the line to the right and to the left of the particular point. For example, in the
figure below the elasticity at point F is the ratio:
ep = FD’/FD
P

31
 P1---------------- F

P2------------------------ F’
E

Q
O Q1 Q2 D’

Proof:
From the above figure we see that:
P = P1P2 = EF
Q = Q1Q2 = EF’
P = OP1
Q = OQ1
If we consider very small change in P and Q, then P = dP and Q. Thus, substituting in the
formula for the point elasticity, we obtain:

Ep = (dQ/dP) P/Q = Q1Q2 OP1 EF’ OP1

x = x
P1P2 OQ1 EF OQ1

From the figure we can also see that the triangles FEF’ and FQ1D’ are similar (because each
corresponding angles are equal).
Hence, EF’ Q1D’ Q1D’
= =
EF FQ1 OP1

Q1D’ OP1 Q1D’

Thus, ep = x =
OP1 OQ1 OQ1

32
Furthermore the triangles DP1F and FQ1D’ are similar, so that
Q1D’ P1F OQ1
= =
FD’ FD FD
Rearranging we obtain:
Q1D’ FD’
=
OQ1 FD

Thus, the price elasticity at point F is

Q1D’ FD’
Ep = =
OQ1 FD
Given this graphical measurement of point elasticity it is obvious that at the mid-point of a
linear demand curve ep = 1 (point M). At any point to the right of M the point elasticity is
less than unity (ep < 1); finally at any point to the left of M, ep > 1. At point D, the ep 
, while at point D’ the ep = O. The price elasticity is always negative because of the inverse
relationship between Q and P implied by the law of demand. However, the negative sign is
omitted when writing the formula of the elasticity.
The range of values of the elasticity is O  ep  .
(1) If ep = O, then the demand is perfectly inelastic
(2) If ep = 1, then the demand is unitary elastic
(3) If ep = , then the demand is perfectly elastic
(4) If O< ep < 1, then the demand is inelastic
(5) If 1 < ep < , then the demand is elastic.

Px
D ep

ep>1
M ep = 1
ep<1

33
 o ep = O
P P P

P D
D
Q o Q Q
ep = o ep = 1 ep = 
The above formula for the price elasticity is applicable only for infinitesimal changes in the
price. If the price changes appreciably we use the following formula, which measures the arc
elasticity of demand:
Q P 1 + P2 Q P1 + P2
ep = x 2 x
P = P Q1 + Q2
Q1 + Q2

2
The arc elasticity is a measure of the average elasticity, i.e. the elasticity at the mid-point of
the two points A and B on the demand curve defined by the initial and the new price levels.
P

P1---------- A

P2--------------------------------B
D
Q
O Q1 Q2

34
Determinants of Price Elasticity Of Demand
The basic determinants of the elasticity of demand of a commodity with respect to its own
price are the:
(1) The availability of substitute; the demand for a commodity is more elastic if there are
close substitute for it.
(2) nature of the need that the commodity satisfies. In general, luxury good are price
elastic, while the necessity is price inelastic.
(3) time period; demand is more elastic in the long run.
(4) number of uses to which a commodity can be put. The more the possible uses of a
commodity, the greater its price elasticity will be.
(5) proportion of income spent on the particular commodity.

Income Elasticity of Demand

The income elasticity is defined as the proportionate change in the quantity demanded
resulting from a proportionate change in income.
ey = dQ/Q dQ Y
= x
dY/Y dY Q

If ey > o, then the commodity is normal.

If ey < o, “ “ “ inferior.
If ey > 1, “ “ “ luxury.
If o < ey < 1, “ “ necessity.

The main determinants of income elasticity are

(1) The nature of the need that the commodity covers: the percentage of income spent on
food declines as income increases.
(2) The initial level of income of a country. For example, a TV set is a luxury in
underdeveloped countries while it is a necessity in a country with high per capital
income.
(3) The time period, because consumption patterns adjust with a time lag to changes in
income.

35
The Cross- Elasticity Of Demand
The cross elasticity of demand is defined as the proportionate change in quantity demand of
X resulting from a proportionate change in the price of Y.
dQx/Qx dQx Py
exy = = x
dPy/Py dPy Qx
If exy < o, then X & Y are complementary goods.
If exy > o, “ “ substitute goods.

The main determinants of the cross elasticity is the nature of the commodities relative to their
use. If two commodities can satisfy equally well the same need, cross elasticity is high and
vice versa.

Price Elasticity and Total Expenditure

An important relationship exists between the price elasticity of demand and the total
expenditure of consumers on the commodity (total revenue of producers). It postulates that a
decline in the commodity price results in an increase in total expenditures if demand is elastic
leaves total expenditure unchanged if demand is unitary elastic, and results in a decline in
total expenditure if demand is inelastic.

Specifically when the price of the commodity falls, total expenditure (price times quantity)
increase if demand is elastic because the percentage increase in quantity (which by itself
tends to increase total expenditure) exceeds the percentage decline in price (which by itself
tends to decline total expenditure). Total expenditures are maximum when /ep/ = 1and
decline thereafter. That is, when /ep/ < 1, a reduction in the commodity price leads to a
percentage increase in the quantity demanded of the commodity that is smaller than the
percentage reduction in price, and so total expenditure on the commodity decline. This can be
shown by the following table.

36
point Price of X (Px) Quantity (Qx) Total Absolute value
expenditure(TE) of ep /ep/
A 2.00 0 0 
C 1.50 3 4.50 3
E 1.00 6 6.00 1
F 0.50 9 4.50 1/3
H 0 12 0 0

From the above table we see that between points A and E, /ep/>1 and total expenditure on the
commodity increases as the commodity price declines. The opposite is true between points E
and F over which /ep/<1. Total expenditures are maximum at point E (the geometric mid-
point of the demand curve). The general rule summarizing the relationship among total
expenditures, price and the price elasticity of demand is that total expenditures and price
move in opposite directions if demand is elastic and in the same direction if demand is
inelastic.

Market Demand, TR and MR

From the market demand curve we can derive the total expenditure of the consumer, which
forms the total revenue of firms selling the particular product. The total revenue is the
product of the quantity sold and the price.
TR = P.Q
If the market demand is linear the TR curve will be a curve which initially slopes upwards,
reaches a maximum and then starts declining. We can proof this from our previous
discussion of the relationship between elasticity and TR/TE.
P TR
D

Rmax
P1 A
B
P* ep = 1
C
P2
D’ TR
O Q1 Q* Q2 Q O Q* Q

37
Another important point in the theory of firm is the MR. the marginal revenue is the change
in total revenue resulting from selling an additional unit of the commodity. Graphically, MR
is the slope of total revenue curve at any one point. If the demand curve is linear, the MR
curve is twice as steep as the demand curve.
P
D

D’
O Q
MR
This can be proved mathematically as follows:
MR is the derivative of TR function:
MR = d(TR)
dQ
= d(PQ)
dQ
= P + Q.dP
dQ
if the demand curve is linear its equation in terms of price is:
P = ao – a1Q
Substituting P in the TR function we find
TR = PQ = aoQ – a1Q2
The MR is then MR = d(TR)
dQ
= ao – 2a1Q
This proves that the MR curve starts from the same point (ao) as the demand curve, and that
the MR is a straight line with a negative slope twice as steep as the slope of the demand
curve.

38
The Relationship between MR And Price Elasticity
The MR is related to the price elasticity of demand with the formula
MR = P(1 – 1/e)
Proof:
Assume that the demand function is P = f(Q)
The total revenue is TR = PQ = [f(Q)]Q

The MR is
MR = d(PQ)
dQ
= P.dQ + Q.dP
dQ dQ
= P + Q.dP
dQ
The price elasticity of demand is defined as
e = - dQ .P
dP Q
Rearranging we obtain
-eQ = dQ
P dP
-P = dP
eQ dQ
Substituting dP/dQ in the expression of the MR we find
MR = P + QdP
dQ
= P – Q.P
eQ
=P–P
e
MR = P(1 – 1/e)

39
Total revenue, marginal revenue and price elasticity
We said that if the demand curve is falling the TR curve initially increases, reaches a
maximum, and then starts declining. We can use the earlier derived relationship between
MR, P and e to establish the shape of the total revenue curve.
The total revenue curve reaches its maximum at the point where e = 1, because at this point
its slope, the MR, is equal to zero:
MR = P(1 – 1/1) = 0
If e>1 the TR curve has a positive slope, that is, it is still increasing and hence has not
reached its maximum point given that
P > 0 and (1 – 1/e) >0; hence MR > 0
If e<1 the TR curve has a negative slope, that is, it is falling given
P > 0 and (1 – 1/e) < 0; hence MR < 0
We may summarize these results as follows:
- If the demand is inelastic (e<1), an increase in price leads to an increase in TR, and a
decrease in price leads to a fall in TR.
- If the demand is elastic (e>1), an increase in price will result in a decrease of TR,
while a decrease in price will result in an increase in TR.
- If the demand is unitary elastic, TR is not affected by change in price since e=1 and
MR=0.

Choice under Uncertainty

Traditional demand theory, as examined until now, implicitly assumed a risk less world. It
assumed that consumers face complete certainty as to the results of the choices they make.
Clearly, this is not the case in most instances. In contrary to our assumptions of price income
and other variables to be known with certainty, many of the choices that people make involve
considerable uncertainty.

Although risk and uncertainty are usually used interchangeably, some people distinguish
between the two.
(I) Uncertainty: refer to a situation when there are more than possible outcomes to a
decision and where the probability of each specific outcome is not known. This

40
 may be due to insufficient past information or instability in the structure of the
variables.
(II) Risk: refers to a situation where there are more than one possible outcome to a
decision and the probability of each specific outcome is known or can be
estimated.
(III) Certainty: refers to a situation where there is only one possible outcome to a
decision and this outcome is known precisely. For example, investing on treasury
bills leads to only one outcome (i.e. the amount of the yield), and this is known
with certainty.
We need two measures to describe and compare risk choices. These measures are:
(I) Expected value: is the weighted average of all possible payoffs/outcomes that can result
from a decision under the various state of nature, with the probability of those payoffs used
as weights. It measures the value that we would expect on average. If we multiply each
possible outcome or payoff by its probability of occurrence and add these products, we get
the expected value. If, for instance, there are two possible outcomes having payoffs X1 and
X2 and if the probabilities of each outcome are given by P1 and P2, then the expected value
is:
E(X) = P1X1 + P2X2
Example: If the probability that an oil exploration project is successful is ¼ and the
probability that it is unsuccessful is ¾ and if success yields a payoff of 40 birr per share
while failure a payoff of 20 birr per share, the expected value is:
EV = p(success)(40 birr/share) + p(failure)(20birr/share)
= ¼ (40) + ¾ (20)
= 25 birr/share
(II) Variability: is the extent to which possible outcomes of an uncertain event may differ.
We measure variability by recognizing that large differences between actual and expected
value imply greater risk. Standard deviation is the often used measure of variability. Standard
deviation measures the dispersion of possible outcomes from the expected value. The smaller
the value of sd, the tighter or less dispersed the distribution is and the lower the risk attached
to it and vise versa.

Standard deviation (sd) -  =  P1(X1-E(X))2 + P2(X2-E(X))2

41
If two alternatives to choose from have the same expected value, the one with the
lower/smaller standard deviation is less risky and hence is preferred. If, however, one
alternative offers a higher expected value but is much riskier than the other one and vise
versa, the preference depends on the individual – whether he/she is a risk averse, risk neutral
or a risk loving person.
Different Preference Towards Risk
A Risk Averse Person: is a person preferring a certain income to a risky income with the
same expected value. For a risk averse person losses are more important (in terms of the
change in utility) than gains. Losses hurt him/her more seriously than gains benefit him/her.
Thus, the MU of income diminishes as income rises.
Assume that the person can either have a certain income of birr 20, or an alternative decision
yielding an income of 30 birr with probability of 0.5 and an income of 10 birr with
probability 0.5. The expected income of this alternative is, EV = 0.5(30) + 0.5(10) = 20 birr.
This is the same as the income earned without risk. He/she prefers to consume the risk less
20 birr to trying the alternative in which he/she could have consumed 30 birr if successful or
10 birr if unsuccessful. Utility at B > utility at C (16>14). The risk averse person achieves the
expected utility of 14 at a lower but risk less income of 16 birr. Thus, he/she is willing to pay
birr 4 (20-16) to avoid taking risk. The maximum amount of money (4 in our case) that a risk
averse person will pay to avoid taking a risk is called a risk premium.
Utility of this risk averse person is 14 = 0.5(10) + 0.5(18). Consider the following graph for
the above explanation.
Utility

18 E
16 B
14 D C

A
10

Income
O 10 16 20 30
A RISK NEUTRAL PERSON: is a person indifferent between a certain income and an
uncertain income with the same expected value. For this person, the MU of income is
constant.

42
 E(U) = 0.5U(10) + 0.5U(30)
= 0.5(6) + 0.5(18)
= 12
=> E(U) = U(20) = 12
Utility

18 E

12 C

6 A
O Income
10 20 30

A Risk Loving Person: - is a person preferring a risky income to a certain income with the
same expected value. This person prefers an uncertain income to a certain one, even if the
expected value of the uncertain income is less than that of the certain income.
E(U) = 0.5U(10) +0.5U(30)
= 0.5(3) + 0.5(18)
= 10.5
 E(U) > U(20)
 10.5 > 8
The expected utility of the uncertain income is greater than the utility of a certain income for
a risk loving person and thus their utility of income curve is upward bending.
Utility
E
18

10.5

8 ------------------ C
3 A
Income
O 10 20 30

43
 - Risk loving people are few, at least with respect to major purchases or large amounts
of income or wealth.
- Risk loving people prefer alternatives with high expected value and high standard
deviation (risk) to a lower paying but less risky alternative (unlike the risk averse
people).
NB: Expected utility E(U) is the sum of the utilities associated with all possible
outcomes, weighted by the probability that each outcome will occur.

Risk Aversion and Indifference Curves

We also describe the extent of a person’s risk aversion in terms of indifference curves that
relate the expected income to the variability of income, the latter being measured by the
standard deviation. An IC shows the combination of expected income and standard deviation
of income that give the individual the same amount of utility. ICs are upward sloping. This is
because risk is undesirable so that the greater the amount of risk, the greater the amount of
income needed to make the individual equally well-off. An increase in the standard deviation
(a higher variability of income) must be compensated by a higher expected income so as to a
very leave a risk averse person on the same level of utility. In the case of a slightly risk
averse person, a large increase in the standard deviation of income requires only a small
increase in expected income.
E(I) U3 E(I)
U2
U3
U2
U1
U1

O O
Standard deviation of income () Standard deviation of income ()
(A) A high risk averse person (B) A slightly risk averse person

44
The Trade Off Between Risk and Return
Suppose a consumer or an investor wants to allocate his income between two assets- one
risky and the other risk free. He might allocate his entire income only to the risk free, only to
the risky, or to some combinations of the two.

Let the expected return from the risky asset be Rr and the actual return be rr. Let also the risk
free return from the risk free asset be Rf. In order for the consumer to have the combination
of the two assets or goods and to construct the budget line, assume that Rr > Rf. The expected
return on the total expenditure, Rp, is a weighted average of the expected return on the two
assets.
Rp = R(brr + (1-b)Rf) = E(brr) + E((1-b)Rf)
Rp = bRr + (1-b)Rf ------------------------------------------- (1)

The standard deviation of the total allocation, p (with one risky and one risk free asset), is
the fraction of the fund allocated to the risky asset times the standard deviation of the asset.
p = br ------------------------------------------------------ (2)
Equation (1) above can be rewritten as:
Rp = Rf + b(Rr – Rf) --------------------------------------- (3)
Substituting the value of b(from equation 2) into equation 3.
Rp = Rf + (Rr – Rf) p
r
This equation is a budget line because it describes the trade-off between risk (p) and
expected return (Rp). Because Rf, Rr and r are constant, this equation is an equation for a
straight line (the slope (Rr-Rf)/ r is a constant). This slope tells us how much extra risk the
consumer (investor) must incur to enjoy a higher expected return Rp. Thus it is the price of
risk.

If all income is allocated to the risk free asset (b=0), an expected return of Rf would be
received but with risk as high as r. A higher expected income and a reduced (minimi
zed) risk are achieved at the point of tangency of the budget line and the indifference curve.

45
A less risk averse (risk lover) person is at the optimum at a higher level of return (allocating
more income to the risky asset) but incurring more risk.
E(I) U3 U2 Ub
U1

Budget line
Rr Eb

R* E

Rf O  * r

As we have discussed earlier a risk averse person has an indifference curve which is steeper
and thus the equilibrium point for this person is at point E with R* return and * variability.
For the risk loving person the equilibrium point is at Eb where the flatter indifference curve
is tangent to the budget line. At this point the person gets Rr return with r variability which
greater than that of the risk averse person.

Reducing Risk
In the face of a broad variety of risky situations, people are generally risk averse. Consumers
and managers commonly reduce risk in various ways. The major ones are diversification,
insurance and obtaining more information.

Diversification: - reducing risk by allocating resources to a variety of activities whose

outcomes are not closely related –“Don’t put all your eggs in one basket.”

Insurance: - If the cost of insurance is equal to the expected loss, risk averse people will
buy enough insurance to recover fully from any losses they might suffer. For a risk averse
consumer, the guarantee of the same income regardless of the outcome generates more utility
than would be the case if that person had a high income when there was no loss and a low
income when a loss occurred.

46
The value of information: - people often make decisions based on limited information. If
more information were available, one could make better predictions and reduce risk. Even
though forecasting is inevitably imperfect, it may be worth investing in a marketing study
that provides a reasonable forecast for the future.

47
 UNIT TWO

THE THEORY OF PRODUCTION

Contents
 Production Function
 Isoquants
 Short Run Production
 Factor Intensity
 Law of Production
 Product Line
 Equilibrium of The Firm

Objective
Dear learner! The main objective of this chapter tries to explain about the decision of
rational producer on production activities.

3.1 The Production Function

Dear Student! In the production process/ activity, firms turn inputs into output. This
transformation of inputs (factor of productions) into output at a particular time period and at
a given technology (state of knowledge about the various methods that might be used to
transform inputs into outputs) is described by a production function.

The production function is a function that shows the highest output that a firm can produce
for every specified combination of inputs. It is a purely technical relation which connects
factor inputs to outputs. Assuming labor (L) and capital (K) as the only inputs, the production
function can be written as: Q = f(L,K).

The production function allows inputs to be combined in varying proportions so that output
can be produced in many ways (using either more capital or less labor or vise versa). For
example, a unit of commodity X may be produced by the following processes:

48
 Process P1 Process P2 Process P3
Labor units 2 3 1
Capital units 3 2 4

Activities or these methods of productions can be shown by a line from the origin to the point
determined by the labor and capital inputs combination.
K

3 p1
2 p2

1 p3

0 2 3 4 L

The production function (a purely technical relationship which connects factor inputs and
outputs) includes all the technically efficient methods of production. The technically
inefficient methods are not included in the production functions. A method of production A
is technically efficient than any other method B if A uses less of at least one input and no
more of the other factors as compared with B. For example, commodity Y can be produced
by two methods, A and B as follows:
A B
Labor 2 3
Capital 3 3
Method A is considered as technically efficient method as compared with B. The basic
theory of production concentrates only on efficient methods and thus inefficient methods will
not be used by rational producer.
If a process A uses less of some factor(s) and more of some other(s) as compared with B,
then A and B cannot be directly compared on the criterion of technical efficiency. For
example, the activities
A B
Labor 2 1
Capital 3 4

49
are not directly compared. Both processes are considered as technically efficient and are
included in the production function. Which one of them will be chosen at any particular time
depends on the price of factors (inputs).The choice of any particular technique among the set
of technically efficient processes is an economic one, which is based on the price of factors
of production. Note that a technically efficient method is not necessarily economically
efficient.

Isoquants
Assuming that labor and capital are the only two inputs used to produce an item, the output
achievable for various combinations of inputs can be shown by using isoquants. An isoquant
is the locus of all the technically efficient methods (or all the combinations of factors of
production) for producing a given level of output. It is a curve showing all possible
combinations of inputs that yield the same output. The production isoquant may assume
different shapes depending on the degree of substitutability of factors. These are:
(1) Linear isoquant: this type assumes perfect substitutability of factors: a given output
may be produced by only labor, or only capital, or by an infinite combinations of K
and L. See figure A below.
(2) Input-output isoquant: this assumes strict complementarily (i.e. zero substitutability)
of the factors of production. There is only one method of production for any one
commodity. The isoquant takes the shape of right angle triangle. This type of isoquant
is called “Liontief isoquant” after the name Leontief who invented the input output
analysis. See figure B below.
(3) Kinked isoquant: this assumes limited substitutability of K and L. there are only few
processes for producing a particular commodity. Substitutability of the factors is
possible only at the kinks. See figure C below.
(4) Smooth or convex isoquant: this form assumes continuous substitutability of K and L
only over a certain range, beyond which factors can not substitute each other. The
isoquant is a smooth curve which is convex to the origin. Consider figure D below.

50
 K K

O L O L
A. Linear isoquant B. Input-output isoquant
K K
P1
P2
X
P3

P4 X

O L O L
C. Kinked isoquant D. Convex isoquant
Even though the kinked isoquant is more realistic, most of the time the smooth or convex
isoquant is used in the tradition economic theory because it is mathematically simpler to
handle by the simple rules of calculus.
Isoquant map: is a graph combining several or a set of isoquants. An isoquant map is
another way of describing a production function, just as an indifference map is a way of
describing a utility function. The level of output increases as we move upward to the right
where as it remains constant along an isoquant (see points A, B & C in the figure below).
K

*A
*C

Q=100 *B
O Q=50 L

51
Short Run Production Function and Stages Of Production
The production function in the traditional theory assumes the form:
X = f(L, K, r, y)
Where L is labor, K is capital, r is returns to scale which refers to the long run analysis of the
laws of production since it assumes change in the plant, and y is the efficiency parameter
related to the organizational and entrepreneurial aspect of the production.
Graphically, the production function can be shown as follows:
X Panel A X Panel B

X=f(L)k3,r3,y3 X=f(K)L3,r3,y3

X=f(L)k1,r1,y1
X=f(K)L1,r1,y1
O L O K
In panel A, as labor increases, ceteris paribus, output increases: we move along the curve
depicting the production function. If K and/or r, and/or y increase, the production function
shifts upwards. The same is true for panel B.
The slope of the production function is the marginal products of the factors of production.
The MP of a factor is defined as the change in output resulting from the change in the factor,
keeping all other factors constant. That is
MPL = X and MPK = X
L K
Graphically, the MPL is shown by the slope of the production function X=f(L) and the MPK is
shown by the slope of the production function X=f(K). The slope of a curve at any one point
is the slope of a tangent line at that point.

X MPL=X = 0 MPK=X = 0

L K
X=f(L) X=f(K)

52
 O A’ B’ L O C’ D’ K
MPL MPK

Stage I Stage II Stage III Stage I Stage II Stage III

APL APK
O A B L O C D
MPL MPK

From the above graph we can understand that as the labor units used in the production
processes goes on increasing, the output initially increases at an increasing rate, then starts
rising at a decreasing rate, reaches a maximum and then starts falling. As a result the MP
initially increases, reaches a maximum, and then starts declining since it is the slope of the
TP curve. The MP is even negative when the TP declines. On the other hand, the AP is given
by the slope of the line drawn from the origin to the corresponding point on the TP curve.
Thus, the AP initially increases, reaches a maximum at A’ level of input and then starts
declining. AP and MP are equal at the maximum of the AP. Accordingly we can divide this
production function into three stages as stage I (from zero TP, MP, & AP up to the maximum
of AP), stage II (from the maximum of AP to zero MP), and stage III (from zero MP
onwards).

At stage I, MP>AP and both of them are rising initially and MP falls latter on. Since each
additional unit of labor (on panel A) is coming up with contribution larger than the average,
it is rational to hire more labor and produce more. Thus, it is not reasonable to produce at this
stage.

53
At the third stage where both APL and MPL are declining and MPL<APL, it is not rational
to produce at all because each additional unit of labor added makes the total product to
decline (i.e. its contribution is negative).

Thus, it is in the second stage that a rational firm operates. Here each additional labor
contributes positively to the production but less than the average. At this stage as the use of a
variable input (labor) increases with other inputs (capital) being fixed, the resulting additions
to output (MPL) will eventually decrease. This principle is known as the law of variable
proportion or the law of diminishing marginal returns.

In summary, the production theories concentrate only on the efficient part of the production
function, that is, on the ranges of output over which the MP’s are positive. No rational firm
would employ labor beyond OB or capital beyond OD since an increase in the factors beyond
these levels would result in the reduction of the TP of the firm. Thus, the basic theory of
production concentrates on the range of output over which the MPs are although positive,
decreases (i.e. A’B’ and C’D’). This means over the range where
MPL > 0 but (MPL) < 0 and MPK > 0 but (MPK) < 0
L K
This condition implies that the tradition theory of production concentrates on the range of the
isoquants over which their slope is negative and convex to the origin. In the figure below, the
production function is depicted by a set of isoquants. Similar to the case of indifference
curves, the further away from the origin an isoquant lies, the higher the level of output it
represents and isoquants do not intersect.

The locus of points of isoquants where the marginal products of the factors are zero forms the
ridge line. At points A, B, &C the MPK is zero and hence forms the upper ridge line. The
lower ridge line shows that the MPL is zero. Thus, production techniques are only efficient
inside the ridge lines. Outside the ridge lines the marginal product of the factors is negative
and the methods of productions are inefficient, since they require more quantities of both
factors for producing a given level of output.

54
inside the ridge lines. Outside the ridge lines the marginal product of the factors is negative
and the methods of productions are inefficient, since they require more quantities of both
factors for producing a given level of output.

K
Upper ridge line (MPK = 0)
A B C Lower ridge line (MPL = 0)
F X3
X2
E

O D L

The slope of the isoquant (dK/dL) defines the degree of substitutability of the factors of
production. This slope decreases (in absolute terms) as we move downwards along the
isoquant, showing the increasing difficulty in substituting L for K. The slope of the isoquant
is called the rate of technical substitution, or the marginal rate of technical substitution
(MRTS) of factors:
MRTSL,K = -K = slope of an isoquant.
L
MRTSL,K is defined as the amount of K that the firm must sacrifice in order to obtain one
more unit of L so that it produces the same level of output. It is the slope of an isoquant.
It can be proved that the MRTS is equal to the ratio of the marginal products of the factors.
That is,
MRSL,K = -K = X/L = MPL
L X/K MPK
Proof:
The production function can be written as X = f(K,L)= C. It is equal to C because along an
isoquant the TP is constant.
The slope of a curve is the slope of a tangent line at that point. The slope of a tangent line is
defined by the total differential. The total differential (dX) is zero along an isoquant since the
TP is constant. Thus,
dX = (X/K)K + (X/L)L = 0
 (MPK)K + (MPL)L = 0

55
  -(MPK)K = (MPL)L
 -K/L = MPL/MPK
Along the upper ridge line we have
MRTSL,K = MPL/MPK = ∞ => MPK = 0
And along the lower ridge line
MRTSL,K = MPL/MPK = 0 => MPL = 0
The MRTS as a measure of the degree of substitutability of factors has a serious defect since
it depends on the units of measurement of the factors. A better measure of factor
substitutability is provided by the elasticity of substitution. It is given by:
 = percentage change in K/L
Percentage change in MRS
 = d(K/L)/(K/L)
d(MRTS)/(MRTS)
The elasticity of substitution is a pure number independent of the unit of measurement of K
and L since both the numerator and the denominator are measured in the same units.

Factor Intensity
Factor intensity refers to a measure of the intensity of a method of production in the sense
that a measure of whether a given method of production is labor intensive (uses more labor
than capital) or capital intensive (uses more capital than labor). It can be measured by the
slope of the line from the origin to a particular point on the isoquant representing a particular
process. Factor intensity can also be measured by the capital labor ratio. In the figure below
process P1 is more capital intensive than process P2 because the slope of the line OP1 is
higher than the slope of OP2 or the ratio K1/L1 is greater than K2/L2. This implies that the
upper part of the isoquant includes more capital intensive techniques where as the lower part
includes more labor intensive techniques.

56
 K

K1 P1

P2
K2 X

O L
L1 L2

 EXAMPLE:
Let us illustrate the above concepts with a specific form of production function, namely the
Cobb-Douglas production function. This form is the most popular in applied research,
because it is easier to handle mathematically. It is of the form:
X = bo.Lb1.Kb2
1. The marginal product of factors
MPL = X/L = b1.bo.Lb1-1.Kb2
= b1(boLb1Kb2)L-1
= b1.X/L = b1(APL) since X = bo.Lb1.Kb2
and APL = X/L
MPK = b2.X/K = b2(APK)
2. The marginal rate of substitution
MRSL,K = X/L = b1(X/L) = b1 . K
X/k b2(X/K) b2 L`
3. The elasticity of substitution
 = d(K/L)/(K/L) = 1
d(MRS)/(MRS)
Proof:
Substitute the MRS in to the elasticity formula and obtain
 =d(K/L)

57
 (K/L)
d(b1/b2.K/L)
(b1/b2.K/L)

= d(K/L) . (b1/b2)(K/L)
(K/L) d(K/L)(b1/b2)

= d(K/L)(b1/b2) = 1
d(K/L)(b1/b2)

4. Factor intensity. In a Cobb-Douglas function factor intensity is measured by the ratio

b1/b2. The higher the ratio the more labor intensive the technique is and vise versa.
5. The efficiency of production. The efficiency in the organization of factors of production
is measured by the coefficient bo. It is clear that if two firms have the same K, L, b1, and
b2 and still produce different quantities of output, the difference can be due to the
superior organization and entrepreneurship of one firm which resulted in production
difference. The more efficient firms will have a higher bo than the less efficient one.
6. The returns to scale. In the Cobb-Douglas production function, the returns to scale are
measured by the sum of the coefficients b1+b2. It will be discussed latter on.

Laws of Production
The laws of production describe the technically possible ways of increasing the level of
production. This can be in various ways. Output can be increased by changing all factors of
production which is possible in the long run. This is called the law of returns to scale. On the
other hand output can be increased by changing only the variable input while keeping the
fixed inputs constant, which is possible in the short run. The MP of the variable factor will
decline eventually as more and more quantities of this factor are combined with the other
constant factors. This is known as the law of variable proportion. Let us see these laws one
by one.

1. The Law of Variable Proportion

This is a law for the case of short run where there is at least one fixed inputs. In our earlier
discussion of the short run production function and stages of production, we have assumed

58
labor as a variable input and capital as a fixed input. From that graph, what we can
understand is that as the use of a variable input (labor) increases with other inputs (capital)
fixed, the resulting addition to output will eventually decreases. This is shown by a
downward sloping MPL curve after its maximum point. This principle is known as the law of
variable proportion or the law of Diminishing returns.

2. Laws of Returns to Scale

The law of returns to scale refers to the long run analysis of production. In the long run,
where all inputs are variable output can be increased by changing all factors by the same
proportion. The rate at which output increases as inputs are increased by the same proportion
is called returns to scale. We have three cases of returns to scale: increasing, constant and
decreasing returns to scale.
I) Increase returns to scale: this is the case where increasing all factors by the same
proportion, m, leads to an increase in output by more than m scale.
II) Constant returns to scale: if we increase input by some factor, m and output is
increased by the same proportion as inputs, m, then it is called constant returns to
scale. In this case the size of the firm’s operation doesn’t affect the productivity of
its factors.
III) Decreasing returns to scale: if scaling up all inputs by m scales output up by less
than m, it is called decreasing returns to scale. This is because, may be difficulties
in organizing and running a large scale operation may lead to decreased
production of both labor and capital.
Examples
1. If Q = 2K + 3L. We will increase both K and L by m and create a new production function
Q*. Then we will compare Q* to Q.
Q* = 2(Km) + 3(Lm) = 2Km + 3Lm = m(2K + 3L) = mQ

After factoring, we can replace (2K + 3L) with Q, as we were given that from the start. Since
Q* = mQ, we note that by increasing all of our inputs by the multiplier m we have increased
production by exactly m. So we have constant returns to scale.

2. Q=.5KL Again we put in our multipliers and create our new production function.

Q* = .5(Km)(Lm) = .5KLm2 = Qm2. Since m > 1, then m2 > m. this implies our new
production has increased by more than m.. so we have increasing returns to scale.

59
3. Q=K0.3L0.2 Again we put in our multipliers and create our new production function. Q* =
(Km)0.3(Lm)0.2 = K0.3L0.2m0.5 = Q m0.5. Since m > 1, then m0.5 < m. Our new production
has increased by less than m. so we have decreasing returns to scale.

Returns to Scale And Homogeneity of the Production Function

Suppose we increase both factors of production function X=f(L, K) by the same proportion
m, and we observe the resulting new level of output X* as X* = f(mK, mL). If m can be
factored out (that is, can be taken out of the bracket as a common factor), then the new level
of output can be expressed as a function of m (to the power n) and the initial level of output
as follows: X* = mnf(L, K) or X* = mnX. If so, the function is called homogeneous. If m
cannot be factored out, the production function is called non- homogeneous. The above three
examples are a homogeneous functions since m can be factored out. Thus, a homogeneous
function a function such that if each of the inputs is multiplied by m, the m can be completely
factored out of the function. The power n of m is called the degree of homogeneity and is a
measure of the returns to scale.
If n=1, we have a CRS.
If n <1, “ DRS.
If n >1, “ IRS.

Given a Cobb-Douglas production function Q=boLb1Kb2, returns to scale is measured by the

sum of the powers of the factors. That is,
If b1 + b2 =1, then there is a CRS
If b1 + b2 >1, “ “ IRS
If b1 + b2 <1, “ “ DRS
Proof
Let L and K increases by m. The new level of output is
X*=bo(mL)b1(mK)b2
= bomb1Lb1mb2Kb2
X* =mb1+b2(boLb1Kb2)
X*= mb1+b2X
This implies the function is homogeneous of degree b1+b2 and the returns to scale depend on
the sum.

60
Product Line: It shows a physical movement from one isoquant to another as we change
either both factors or a single factor. It describes the technically possible alternative paths of
expanding output. What path will actually chosen by the firm will depend on the prices of
factors. The product curve passes through the origin if both factors are variable. But if only
one factor variable (the other being kept constant), the product line is a straight line parallel
to the axis of the variable factor.
K K K

PL (Isoclines) PL
(Points with constant PL
MRTSL,K are joined)
PL
K PL

O L O L O L
Product line for homogen Non-homogeneous function Product line where K is fixed.
eous function. (Here, the K/L ratio diminishes)

A special type of product line which is the locus of points of different isoquants at which the
MRS of factors is constant is called an isocline. For homogeneous production functions the
isoclines are straight lines through the origin. In such case, the K/L ratio is constant along
any isocline (refer to the first graph).
Graphical Presentation of Returns to Scale for Homogeneous Production Function
Constant returns to scale: Along any isocline, the distance between successive isoquants is
constant. Doubling the factor inputs double the level of output, tripling inputs results in triple
output, and so on.

61
Decreasing returns to scale: the distance between consecutive isoquant increases. By
doubling inputs, output increases by less than twice its original level.
K
In this case, there is a decreasing
PL returns to scale because doubling
Inputs will bring an output which is l
3K C 3Q1 less than double.

2K B <3Q1
2Q1
K A
Q1 <2Q1
O L
L 2L 3L
increasing returns to scale: the distance between consecutive isoquant decreases. By
doubling inputs, output is more than doubled.
K
PL In this case there is an increasing return
To scale because doubling inputs results
3K in an output which is more than double.

C >3Q1
2K
B >2Q1 3Q1
K A 2Q1 Q1
O L 2L 3L L

Technical Progress and the Production Function

As knowledge of new and more efficient methods of production become available,
technology changes. Furthermore new inventions may result in increase of the efficiency of
all methods of production. These changes in technology constitute technical progress.

62
Graphically, the effect of technical progress is shown with an upward shift of the production
function or a downward movement of the isoquant. This shift shows that the same output
may be produced by less factor inputs, or more output may be produced with the same inputs.

X K

X’ X’=f(L)
X=f(L)
X

Xo
O L* L O Xo L

Technical progress may also change the shape (as well as produce a shift) of the isquant.
Hicks has distinguished three types of technical progress, depending on its effect on the rate
of substitution of the factors of production.

Capital deepening technical progress: a technical progress which increases the MPK by
more than the MPL. For this kind of technical progress, along a line on which the K/L ratio is
constant, the MRTSL,K decreases in absolute terms (the slope of an isoquant declines). The
slope of the shifting isoquants becomes less steep along any given radius. This type of
technical progress is also called capital saving or labor using technical progress.
K
Isocline

A’
A’’

O L

63
Labor deepening technical progress: a technical progress which increases the MPL by more
than the MPK. Along a line on which the K/L ratio is constant, the MRTSL,K increases(the
slope of an isoquant increases in absolute value). It is also called labor saving or capital using
technical progress.
K
Isocline A

A’

A’’

Neutral technical progress: a technical progress that increases the MPL and MPK by the
same percentage, so that the MRTSL, K (along any radius) remains constant. The isoquant
shifts downwards parallel to itself.
K
Isoline
A
A’
A’’
O L

Equilibrium of the Firm: Choice of Optimal Combination of Factors of Production

A firm is said to be in equilibrium when it employs those levels of inputs that will maximize
its profit. This means the goal of the firm is profit maximization (maximizing the difference
between revenue and cost). Thus the problem facing the firm is that of constrained profit
maximization, which may take one of the following forms:
a) Maximizing profit subject to a cost constraint. In this case total cost and prices are given
and the problem may be stated as follows
Max П = R – C
П = PxX – C

64
Clearly maximization of П is achieved in this case if X is maximized, since C and Px are
constants.
b) Maximize profit for a given level of output.
Max П = R- C
П = PxX –C
Clearly in this case maximization of profit is achieved by minimizing cost, since X and Px
are given.

To derive graphically the equilibrium point of the firm, we will use the isoquant map and the
isocost line. An isoquant is a curve that shows the various combinations of K and L that will
give the same level of output. It is convex to the origin whose slope is defined as:
- ∂K/∂L = MRSL,K = MPL/MPK = ∂X/∂L
∂X/∂K
The isocost line is defined by the cost equation
C = rK + wL
Where w=wage rate, and r=price of capital services.
The isocost line is the locus of all combinations of factors that the firm can purchase with a
given monetary cost outlay.

The slope of the isocost line is equal to the ratio of the prices of the factors of production,
w/r.
K the isocost equation is given by C=wL + rK
C/r => rK = C - wL
=> K = C/r – w/r L
From this the slope is –w/r or it is the vertical
change over the horizontal change.
=> Slope = C/r
O L C/w
=> Slope = C/r.w/C
=> Slope = w/r.

65
Case 1: Maximization of output subject to a cost constraint.
Given the level of cost and the price of the factors and output, the firm will be in equilibrium
when it maximizes its output. This is at the point of tangency of the isocost line to the highest
possible isoquant curve. In the following graph, it is at point e where the firm produces X2
with K1 and L1 units of the two inputs. Higher levels of output to the right of e are desirable
but not attainable due to the cost constraint. Other points below the isocost line lie on a lower
isoquant than X2. Hence X2 is the maximum output that can be achieved given the above
assumptions (C, w, r, & Px being constant).
K
A

K1 e X3

X2
X1
B L L1
At the point of tangency:
a. slope of isoquant = slope of isocost
w/r = MPL/MPK = MRSL,K. this is a necessary condition.
b. the isoquant is convex to the origin. This is the sufficient condition.
NOTE: If the isoquant is concave to the origin, the point of tangency does not define the
equilibrium position.
K

e1
e
X2
O e2 L

Output X2 depicted by the concave isoquant can be produced with lower cost at e2 which lies
on a lower isocost curve than e (corner solution).

66
Mathematical derivation of the equilibrium of the firm
A rational producer seeks the maximization of its output, given total cost outlay and the
prices of factors. That means:
Maximize X = f (K, L)
Subject to C = wL + rK

This is a constrained optimization which can be solved by using the lagrangean method. The
steps are:
a. rewrite the constraint in the form
wL + rK – C = 0
b. multiply the constraint by a constant which is the lagrangian multiplier
(wL + rK – C) = 0
c. form the composite function
Z = X - (wL + rK – C)
d. partially derivate the function and then equate to zero
∂Z = ∂X - w = 0
∂L ∂L
 MPL = w
  = MPL-----------------------------------------------------------------------(1)
w
∂Z = ∂X - r = 0
∂K ∂K
 MPK = r
  = MPK----------------------------------------------(2)
r
∂Z = rL + rK – C = 0------------------------------------------- (3)
∂
From equation (1) and (2) we understand that
MPL = MPK
w r
=> MPL = w

67
 MPK r
This shows that the firm is in equilibrium when it equates the ratio of the marginal
productivities of factors to the ratio of their prices. It can be shown that the second order
conditions for the equilibrium of the firm require that the marginal product curves of the two
factors have a negative slope.
Slope of MPL = ∂2X
∂L2
Slope of MPK = ∂2X
∂K2
=> ∂2X < 0 and ∂2X < 0
∂L2 ∂K2
2
2 2 2
And ∂ X.∂ X> ∂ X
∂L2 ∂K2 ∂L∂K
Case 2: minimization of cost for a given level of output
The condition for the equilibrium of the firm is formally the same as in case 1. That is, there
must be tangency of the given isoquant and the lowest possible isocost line, and the isoquant
must be convex. However, in this case we have a single isoquant which denotes the desired
level of output, but we have a set of isocost lines. Curves closer to the origin show a lower
total cost outlay. Since isocosts are drawn on the assumption of constant prices of factors,
they are parallel to each other and their slopes (w/r) are equal. Thus the firm minimizes its
cost by employing the combination of K and L determined by the point of tangency of X
isoquant with the lowest possible isocost line. Points below e are desirable because they
show lower cost but are unattainable for output X. points above e show higher costs. Hence
point e is the least cost point.

K
e
K1

X
O L
L1

68
In this case also the lagrangian method can be followed to derive the equilibrium point
mathematically. But the problem is different. That is,
Minimize C = wL + rK
Subject to X = f(K,L)
The lagrangian function will be:
Z = (wL + rK) + [X-f(K,L)]
Partially derivate Z w.r.t L, K, &  and equate to zero.
∂Z = w -  ∂f(K,L) = 0
∂L ∂L
=> w -  ∂X = 0
∂L
=> w =  MPL
=>  = MPL ----------------------------------------- (1)
w
∂Z = r -  ∂f(K,L) = 0
∂K ∂K
=> r -  ∂X = 0
∂K
=> r =  MPK
=>  = MPK --------------------------------------- (2)
r
∂Z = X – f(K,L) = 0 ------------------------------------(3)
∂
From equation (1) and (2):
MPL = MPK
w r
=> w = MPL = MRSL,K
r MPK
This is the same as the condition in case one. In a similar way, the second condition will be:

=> ∂2X < 0 and ∂2X < 0

∂L2 ∂K2
2
2 2 2
And ∂ X.∂ X> ∂ X
∂L2 ∂K2 ∂L∂K

69
 CHAPTER THREE

THEORY OF COST
Contents
 Short run costs
 Long run costs
 Derivation of costs
 Dynamic changes in costs

Objectives
Dear learner! The main objective of this chapter is to explain for learners about the costs
in production. Both short run and long run.

Cost functions are derived functions (derived from production function).Economic theory
distinguishes between short-run and long-run costs. Both in the short-run and in the long-run,
total cost is a multi variable function, i.e. total cost is determined by many factors such as
output, technology, prices of factors and fixed factors. To simplify the analysis we consider
cost as a function of output [c= f(x)] on a ceteris paribus assumption. Thus, determinants of
costs, other than output, are called shift factors.

4.1 Short-Run Costs

Short-run costs are costs over a period during which some factors of production 9usually
capital equipment and management) are fixed. Short-run total costs are split into two groups:
total fixed costs and total variable costs: TC = TFC+TVC.Total variable cost is a cost that
varies as output varies whereas total fixed cost is a cost that does not vary with the level of
output. The fixed costs include:
 salaries of administrative staff
 expenses for building depreciation and repairs
 expenses for land maintenances
 depreciation of machinery.

70
 The variable costs include:-
 the raw materials cost
 the cost of direct labor
 the running expenses of fixed capital, such as fuel, ordinary repairs and routine
maintenance.
As the total fixed cost (TFC) does not depend on the level of output, it is represented by a
horizontal line.
TC
Cost

TVC

TFC

O
Output (X)
The total variable cost has usually an inverse-S shape which reflects the law of variable
proportions. According to this law, at the initial stage of production with a given plant, as
more of the variable factors is employed, its productivity increases and thus total variable
cost(TVC) increases at a decreasing rate = AVC declines. When the productivity of the
variable input falls, larger and larger units of the variable input will be needed to increase
output by the same unit and thus TVC and TC increase at increasing rates. By adding the
TFC and TVC we obtain the TC of the firm.
From the total-cost curves we obtain average cost curves.
 AFC is the total fixed cost divided by the amount of output, i.e., AFC= TFC.
X

71
 Since TFC is constant, increase in X reduces the ratio and thus the AFC approaches the
quantity (output) axis as output rises.
 AVC= TVC.
X
Graphically the AVC at each level of output is derived from the slope of a line drawn from
the origin to the point on the TVC curve corresponding to the particular level of output. For
example in the figure below, the AVC at X1 is the slope of the ray oa, the AVC at X2 is the
slope of a ray ob, and so on. It is clear from the figure that the slope of a ray through the
origin declines continuously until the ray becomes tangent to the TVC curve at c. to the right
of this point the slope of rays through the origin starts increasing. Thus the AVC curve falls
initially as the productivity of the variable factor increases, reaches a maximum when the
plant is operated optimally and rises beyond that point.

C C AVC

TVC

d a

c b d
B
a c

o x1 x2 x3 x 4 X o x1 x 2 x3 x4 X

 ATC or AC = TC = TFC+TVC = AFC + AVC.

X X

Graphically the ATC curve is derived in the same way as the AVC. The ATC at any one
point is the slope of a line from the origin to the point on the TC curve.

72
 C C ATC

TC

d a

c b d
b
a c

o x1 x2 x3 x 4 X o x1 x 2 x3 x4 X

 MC = ∆TC = ∆ (TFC+TVC) = ∆TVC.

∆X ∆X ∆X
Graphically the marginal cost is the slope of the TC curve (which of course is the same at any
point as the slope of the TVC). The slope of the TC curve at any one point is the slope of a
tangent line at that point. As we can see from the following graph, the tangent line is initially
becoming flatter up to X4 level of output and then become steeper as the output goes on
increasing. This implies the slope of the TC curve (MC) is initially decreasing, reaches a
minimum and then starts increasing.

C C
TC

MC

O X4 O X4 X

73
 In summary the traditional theory of cost postulates that in the short run the cost curves
(AVC, ATC and MC) are U-shaped, reflecting the law of variable proportions. In the
short run with a fixed plant there is a phase of increasing productivity (falling unit costs)
and a phase of decreasing productivity (increasing unit costs) of variable factor. Between
these two phases of plant operation there is a single point at which unit costs are at a
minimum. In general, the short run cost curves can be shown as follows.
Costs MC
ATC

AVC

AFC
O output (X)
The relationship between ATC and AVC
The AVC is a part of the ATC, given ATC = AFC + AVC. Both AVC and ATC are U-
shaped, reflecting the law of variable proportions. However, the minimum point of the ATC
occurs to the right of the minimum point of the AVC. This is due to the fact that ATC
includes AFC which falls continuously with increase in output. Initially the fall in the AFC
offsets the rise in the AVC and thus the ATC declines. But later on the rise in the AVC more
than offsets the fall in the AFC and thus the ATC will start rising continuously. The AVC
approaches the ATC asymptotically as X increases since the AFC declines continuously.

The Relationship between MC and ATC

The MC cuts the ATC and the AVC at their minimum points. We said that MC is the change
in the TC for producing an extra unit of output. Assume that we start from a level of n units
of output. If we increase the output by one unit the MC is the change in TC resulting from the
production of the (n+1)th unit.
The AC at each level of output is found by dividing TC by X. Thus the ATC at the level of
Xn is

74
 ATCn = TCn
Xn
And at the level of n+1
ATCn+1 = TCn+1
Xn+1
Clearly TCn+1 = TCn + MC
Thus,
a) if the MC of the (n+1)th unit is less than ATCn ( the ATC of the previous n units) the
ATCn+1will be smaller than the ATCn.
b) If the MC of the (n+1)th unit is higher than ATCn (the ATC of the previous units) the
ATCn+1 will be higher than the ATCn.
As far as the MC is below the ATC, it pulls the ATC downwards and if the MC is above the
ATC, it pulls the latter upwards. From this it follows that the MC curve intersects the ATC at
the minimum point of the ATC. This can also be proofed by using a simple calculus.
From ATC = TC => TC= (ATC).X
X
MC = d(TC) by definition.
dX

=> MC = d(ATC.X)
dX
=> MC = ATC.dX + X.d(ATC)
dX dX
=> MC = ATC + (X)(slope of the ATC)

Given that X and ATC are Positive,

 MC<ATC if slope of ATC is negative.
 MC=ATC if slope of ATC=0, (at the minimum of the ATC).
 MC>ATC if slope of ATC>0.

75
The relationship between MC and AVC
From AVC = TVC , => TVC = (AVC).X
X
MC = d(TC) = d(TFC+TVC) = d(TFC) + d(TVC)
dX dX dX dX
=> MC = d(TVC) , since there is no change in the TFC.
dX
=> MC = d(AVC.X) = AVC.dX + X.d(AVC)
dX dX dX
=> MC = AVC + (X) (slope of AVC)

Given that AVC and X are Positive,

 MC<AVC if slope of AVC<0
 MC =AVC if slope of AVC=0 (at the minimum point of the AVC).
 MC >AVC if slope of AVC>0.
Relationship between Product Curves and Cost Curves
Unit products and unit cost curves are mirror images of each other, i.e.
o when AP(MP) is ring AC(MC) is falling;
o when AP(MP) is falling AC(MC) is rising; and
o when AP(MP) is maximum AC(MC) is minimum
See below for illustration of these relations.
Let TVC =wL, where w= given wage rate &L =labor input
Thus, AVC= TV = (wL) /Q = w (L /Q) = w
Q (Q/L)
But Q/L=APL, so AVC= w/ APL

Similarly, MC=TVC/Q, since TVC=wL

MC = wL = w (L) = w
Q (Q) (Q/L)
but Q/L =MPL
Thus, MC=w/MPL

76
Graphically:
AP/MP

APL

AC/MC MPL
MC

AVC

4.2 Long-run costs

The long-run is a period of time of such length that all inputs are variable. It is a planning
horizon in the sense that economic agents can plan ahead and choose many aspects of the
“short-run” in which they will operate in the future. Thus, the long-run consists of all
possible short-run situations among which an economic agent may choose.

If a production technology is characterized by constant return to scale (CRS), doubling

output requires doubling of input, which implies doubling of total output (cost) for given
factor prices. Hence, the long-run total cost curve in this case is a straight line through the
origin. This implies that the long-run average and marginal costs are horizontal lines and
equal (LAC = LMC).

77
TC LAC
LMC
TC(Q)

LAC=LMC

O Q O Q

If we consider the case where total cost first increase at a deceasing rate due to increasing
returns to scale (which implies economies of scale). And then at an increasing rate
attributed to decreasing returns to scale after the optimum size, the long-run total cost
curve will look like the following. The LAC and LMC curves will be U-shaped.
LAC
TC TC(Q) LMC LMC
LAC

O Q O Q
The range from the minimum point of LAC to the left is called the economies of scale
range, which means output can be doubled for less than doubling of cost. The range from
the minimum of LAC to the right is called diseconomies of scale, because a doubling of
output requires more than a doubling of cost. The traditional theory of the firm assumes
that economies of scale exist only up to a certain plant, which is known as the optimum
plant size. With this plant all possible economies of scale are fully exploited. If the firm
increases further than this optimum size there are diseconomies of scale arising from

78
managerial inefficiencies. It is argued that management becomes highly complex,
managers are overworked and the decision making process become less efficient.
When a firm is producing at an output at which the LAC is falling, the LMC is less than
LAC. Conversely, when LAC is rising (increasing), LMC is greater than LAC. The two
curves intersect at a point where the LAC curve achieves its minimum. Like the short run
average cost (SAC) and SMC curves, the LAC and LMC curves are U-shaped, but for
different reasons. In the long-run, the source of the U-shape is increasing and decreasing
returns to scale, rather than diminishing returns to a factor of production.

The Relationship between Short-run and long-run Average and Marginal costs
Assume that a firm is uncertain about the future demand for its product and is considering
three alternatives plant sizes: Small, Medium and Large. The short-run average cost
curves are SAC1, SAC2 and SAC3 in the figure below.
Cost

SAC1
SAC3
C1 SAC2
C3
C2
C4

O Q1 Q1* Q2 Q2*
If the firm expects that the demand will expand further than Q1, it will install the medium
plant, because with this plant outputs larger than Q1 are produced with a lower cost (for
instance C2<C1 for output equal to Q*1). Similar considerations hold for the decision of
the firm when it reaches the level Q2.
If we relax the assumption of the existence of only three plants and assume that there is a
very large number (infinite number) of plants, we obtain a continuous curve, which is the

79
 planning LAC curve of the firm. LAC curve is the locus of points denoting the least cost
of producing the corresponding output. It is a planning curve because on the basis of this
curve the firm decides what plant to set up in order to produce optimally (at minimum
cost) the expected level of output. The LAC curve is U-shaped and it is often called the
envelop curve because it envelopes the short run curves.

C
LAC
SAC1 SAC6
SAC2
SAC3 SAC5
SAC4

O Q
M
Because there are economies of scale and diseconomies of scale in the long-run, the points of
minimum average cost of the smaller and larger plant (plants 1 up to 4 and 5 up to 7) do not
lie on the long-run average cost curve. For example, a plant size 2 operating at minimum
average cost is not efficient because a larger plant can take advantage of increasing returns to
scale to produce at a lower average cost.

Each point of the LAC curve is a point of tangency with the corresponding SAC curve. The
point of tangency occurs to the falling part of the SAC curves for points lying to the left of
M. since the slope of the LAC is negative up to M, the slope of the SAC cures must also be
negative, because at the point of tangency the two curves have the same slope. By the same
logic, the point of tangency for outputs larger than Q occurs to the rising part of the SAC
curves.

Only at the minimum point M of the LAC is the corresponding SAC also at a minimum. At
the falling part of the Lac curve the plants are not worked to full capacity. To the rising part
of the LAC curve the plants are overworked. Only at the minimum point M is the plant
optimally employed.

80
The LMC is derived from the SMC curves but does not envelop them. The LMC is formed
from points of intersections of the SMC curves with vertical lines drawn from the points of
tangency of the corresponding SAC and the LAC curve.

C LMC
SMC1 SMC3 SAC3
LAC
a

SMC2

To the left of a, SAC1 is greater than LAC so that SAC1 declines at a faster rate than the
LAC. So they are equal at a. this implies LMC >SMC1 to the left of a. At a, LMC=SMC1
(the same additional costs accrue to both the short-run and the long-run costs so that
SAC1=LAC). To the right of a, LMC<SMC1 (more incremental cost is added to the short-
run cost than to the log-run cost). At the minimum point of the LAC, the LMC intersects the
LAC. At this point, SAC=SMC=LAC=LMC.

Derivation of Cost Function from the Production Function

Cost curves are derived functions in that they are derived from the production function.
Graphically the total cost curve is determined by the locus of points of tangency of
successive isocost lines with highest isoquants.

Mathematically, the cost function can be derived as follows by using the Cobb-Douglus
production function.
X = aLbKc
Given this production function and the cost function
C = wL + rK
We want to derive the cost function, that is, the cost as function of output

81
 C = f(X)
We begin by solving the constrained output maximization problem:
Maximize X = aLbKc
Subject to C = wL + rK
We form the composite function
Z = X - ( wL + rK – C)
Partially derivate Z w.r.t L, K,  and equate to zero.
∂Z = ∂X - w = 0
∂L ∂L

∂Z = ∂X – r  = 0
∂K ∂K

∂Z = wL + rK – C = 0 (complete it by your hand)

∂
Example:
Given Q=L2/3K1/3 , w=2 and r=4, derive the cost function.

Solution:
The steps that are involved to derive the cost function are:
1. Solve for L in terms of K or K in terms of L from the optimality condition.
2. Substitute the result under (1) into the production function.
3. Solve for L and K in terms of Q from the production function.
4. Substitute the results under (3) into the cost constraint.
1. MPL = w
MPK r
=> 2/3 L-1/3 K1/3 = 2
1/3 K-2/3 L2/3 4
=> 2K = 1
L 2
=> L = 4K
2. Q = L2/3K1/3

82
 Q = (4K)2/3K1/3
Q = 42/3K
=> K = Q
42/3
=> L = 4K = 4 Q
42/3
=> L = 41/3Q
3. C = 2L + 4K
C = 2(41/3Q) + 4(Q/41/3)
C = 25/3Q + 41/3Q
C = (25/3 + 41/3)Q

Dynamic changes in costs – the learning curve

A large firm may have a lower LAC than a smaller firm because of increasing returns to
scale in production, which implies that growing firms with increasing returns to scale enjoy
lower average cost over time. But this may not be necessarily the case. In some firms, long-
run average cost may decline overtime because workers and managers absorb new
technological information as they become more experienced at their jobs. As management
and labor gain experience with production, the firm’s MC and AC of producing a given level
of output fall for 4 reasons:
1. As workers become more adapted to a given task, their speed increases.
2. Managers learn to schedule the production process more effectively.
3. Engineers who are initially cautious in their product designs may gain enough experience
to be able to allow for tolerances in design that save cost without increasing defects. Better
and more specialized tools and plant organization may also lower cost.
4. suppliers of materials may learn how to process materials required more effectively and
may pass on some of this advantage in the form of lower materials cost.

As a consequence of this, a firm “learns” overtime as cumulative output increases. The graph
(curve) that describes the relationship between a firm’s cumulative output and the amount of
inputs needed to produce each unit of output is known as the learning curve.
Amount of inputs

83
A firm’s average cost of production can decline overtime because of:
a) Growth of sales when increasing returns are present (movement from A to B in the figure
below), or
b) The existence of learning curve/effect (movement from A to C).

AC

C AC1
AC2
Q

84
 CHAPTER FOUR

PERFECT COMPETITION
Contents
 Assumptions of the market
 Short run equilibrium of t he firm and industry
 Long run equilibrium of firm and the industry

Objectives:
Dear learner! The main objective of this chapter is to explain about perfect competition
market. The structure of the market and profit maximization condition.

4.1 Introduction
Perfect, unlike everyday usage of the word, is characterized by a complete absence of rivalry
(competition) among firms.

Assumptions
- Large number of buyers and sellers: because of the very large number of buyers and
sellers an individual buyer or seller is too small to affect the market price.
- Identical commodities are produced by all firms in an industry in terms of its
technical characteristics and services associated with its sale and delivery ruling out
non-price competition.
- There is free entry to and exit from the industry.
These assumptions will imply that the firms are price takers so they are faced with perfectly
elastic demand curve.
Px

DDx
O Qx

85
 - Profit maximization is the sole objective of firms in the industry (no other objectives
like welfare, etc.)
- No government intervention
- Perfect mobility of productive resources between or among firms.(Skills can be
learned and no factor monopolization and labor unionization.)
- Perfect (complete) knowledge of market condition in the part of sellers and buyers
both of the present and the future, and information is free and costless.
These assumptions rule out any uncertainty.

4.2 Short-run Equilibrium of the Firm and the Industry

The equilibrium output of the firm is the output that maximizes its total profit. Total profits
equal the difference between total revenues and total costs, i.e.
∏= TR – TC
∏= PQ – ATC (Q)
∏= Q (P –ATC)
In a perfectly competitive market structure, price is given (firms are price takers). Thus firms
decide on the level of output (Q) they produce to attain their equilibrium points. Two
approaches are used in determining a firm’s equilibrium.
1. The total approach: total profits are maximized when the positive difference between
total revenues and costs is largest.
TR/TC STC TR

Qe Q

86
To the left of point B and to the right of C, STC>TR so that the firm is in a loss (negative ∏).
Between B and C, however, the firm is enjoying a positive profit and it is maximized at the
point where the vertical difference between the TR and STC is largest (at Qe). Point B is the
break-even point where the firm just covers its cost of production and operates at zero
economic profit.
2. The marginal approach: the perfectly competitive firm is a price taker and faces a
perfectly elastic demand curve. Since marginal revenue (MR) is dTR/dQ and price(P) is
constant, then P = MR.
MR = dTR = d(PQ) = p dQ = P
dQ dQ dQ
Total profit is maximum when the slope of the TR and total cost curves are equal. That is,
when MR (P) = MC
The firm is at equilibrium at quantity level Qe (where MR = P = MC at point E). To the
left of E, MR > MC (i.e., benefits > costs) and it should increase production. To the right
of E, MC>MR and the firm should cut back its production. This particular figure
represents the case where the firm operates at a loss (= area of rectangle EFGH).
∏ = Q(P – ATC)
∏ = Qe ( - EF)
∏ = - (EH) (EF)
= - area of EFGH
P/MR MC
MC ATC
AC

AVC

F
G M

H I E P=MR

O Qe Q

87
 It can be the case that competitive firms may operate at losses, at positive profits, or at a
normal (zero) profit. For instance, a firm operates at a positive profit if the demand
curves (MR) lies above point M. On the other hand, a firm gets only a normal (zero)
profit if the demand curve passes through M. In general,
If Then
P > AC Positive ( economic) profit
P = AC Normal ( zero ) profit, i.e., break-even point
AVC < P < AC Loss, but the firm continues to produce
P = AVC Shut-down point
P < AVC Loss or no operation

N.B.: In the figure above, P(MR) = MC at two points, E and I. But the profit maximizing
level of output is that level of output which corresponds to E. Condition for profit
maximization is
1. MR = MC this implies d∏ = 0
dQ
2. MC is rising => d2∏ < 0 or dM∏ < 0
dQ2 dQ
The firm operates at different points at the marginal cost curve depending on the level of
price it faces. Thus, its supply curve is its MC curve but above the shut-down point. The
industry supply curve is the simple horizontal summation of the supply curves of the
individual firms. Thus, the industry is at equilibrium when the industry demand curve
intersects the industry supply curve.
S
$ $
S

Pe P = MR
D
E Pe E*

O Qe Q O Qe Q

Panel A – short-run equilibrium Panel B – Equilibrium of the

the firm. Industry.

88
4.3 Long Run Equilibrium of the Firm And Industry
When long-run equilibrium is achieved, product prices will be exactly equal to, and
production will occur at each firm’s point of minimum ATC. This is illustrated below for a
constant cost industry (the case where the expansion of the industry through entry of new
firms will have no effect up on resource prices and, therefore, up on production costs) and a
respective firm.

S0
LM
C ATC
$ S1

P1
P1 = P1
MR1
P Po=
o MRo
Po D1
Q
D0
Firm
Industry

Suppose that a change in consumer tastes increase and thus product demand from D0 to D1.
This favorable shift in demand obviously makes production profitable; the new price (P1)
exceeds ATC. This economic profit will lure new firms into the industry. As the firms enter,
the industry supply of the product will increase causing product price to gravitate downward
towards the original level. The economic profits caused by the boost in demand have been
completed away to zero and as a result the previous incentive for more firms to enter the
industry has disappeared.
Therefore, in the long-run, all firms operate at a point where
(1) P = MR = LMC = LAC = SMC = SAC for the firm and
(2) Supply curve crosses demand for the industry.
In the long-run, all firms in a perfectly competitive industry (market) enjoy only normal
profit (zero profit) or at the break-even where TR = TC.

89
 CHAPTER FIVE

PURE MONOPOLY
Contents
 Assumption
 Short run equilibrium
 Long run equilibrium
 Discrimination monopoly
 Multi plant monopoly

Objective
Dear learner! The main objective of this chapter is to explain the monopoly market
structure. It tries to explain about price setting, profit of monopolist, social exploitation in
case of monopoly.

Introduction
Dear Student! Pure monopoly is the form of a market in which a single firm sells a
commodity for which there are no close substitutes. Thus the monopolist represents and faces
the industry's negatively sloped demand curve for the commodity.
Monopoly can arise from several causes (barriers to entry). Some are:
1. A firm may own or control the entire supply of essential raw material(s).
2. A firm may own a patent for the exclusive right to produce a commodity or to use a
particular production process.
3. Economies of scale may operate over a sufficiently large range of outputs so as to leave
a single firm supplying the entire market. Such a firm is called Natural monopoly.
4. Licenses protect present license holders from new competition. i.e., confer monopoly
power to them as a group.

The crucial difference between a pure monopolist and a pure competitive seller lies on the
demand side of the market. A pure monopoly can increase its sales only by charging a lower
unit price for its product. But each additional unit sold will add to total revenue its price less:
the sum of the price cuts which must be taken on all prior units of output. Price cuts will

90
apply not only to the extra output sold but also to all other units of output which otherwise
could have been sold at a higher price. Hence, marginal revenue is less than price (average
revenue) for every level of output except the first.

TR PQ
TR  PQ Or AR    P => AR  P
Q Q
d (TR ) d ( PQ ) dQ dP
MR    P.  Q.
dQ dQ dQ dQ
dP
 MR  P  Q .
dQ

dP
Since  0, MR equals P + some negative numbers, => MR  P
dQ

P dP
MR  pd  1 MR  P  Q.
dQ
 pd  1  Q dP 
MR  P1  . 
 P dQ 
 pd  1
 1 
MR  P1  d 
  
 p 
 1 
Q

MR  P 1  d
  p 
MR Demand 

From the above relation it can be shown that:

a) MR is positive (but less than P), when demand is elastic
b) MR is zero when demand is unitary elastic,

c) MR<0 when  p <1, and

d

d) MR=P when  p = 
d

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6.1 Short Run and Long Run Equilibrium
In the short-run, a monopolist maximizes total profits by producing the level of output at
which marginal revenue equals marginal cost or where the distance between the total revenue
and total cost curves is the largest).
  TR  TC
  PQ  Q( ATC )
  Q.( P  ATC )

P
MC

A
Pe
ATC
C

D
B

Q
Qe MR

In this particular case P (=Pe)> ATC and hence the monopolist enjoys a positive profit equal
to the area PeABC.
If P is smaller than ATC at the point where MR = MC, the monopolist will incur a loss in the
short-run. However, if P > AVC, it pays for the monopolist to continue to produce because
production covers part of the fixed costs.
In the long-run, the best or profit maximizing level of output is given by the point where the
monopolist's LMC = MR (and LMC curve intersects MR curve from below).
>graph
Even though profits attract additional firms in to the perfectly competitive industry until just
all firms break-even in the long-run, the monopolist can continue to earn profits in the long-
run because of blocked entry.
The monopolist, as opposed to a perfectly competitive firm, doesn't produce at the lowest
point on its LAC curve. Only if the monopolist's MR curve happened to go through the
lowest point on its LAC would this be the case.

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6.2. Discriminating Monopoly
To this point it has been assumed that the monopolist charges a uniform price to all buyers.
Under certain conditions the monopolist might be able to exploit its market position fully and
thus increase profits by charging different prices to different buyers. By doing so the seller is
engaging in price discrimination. Price discrimination refers to charging different prices (for
different quantities of a commodity or in different markets) that are not justified by cost
differences. In general, price discrimination is workable when three conditions are realized.

1. The seller must possess some degree of monopoly power,

2. The seller must be able to segregate buyers into separate classes where in each group has a
different ability and willingness to pay for the product.
3. The original purchaser cannot resell the product.

Price discrimination (the practice of charging different prices to different customers for
similar goods) can take three broad forms which we call first, second and third degree price
discrimination.

If the monopolist could sell each unit of the commodity separately and charge the highest
price each customer would be willing to pay for the commodity - reservation price - the
monopolist would be able to extract the entire customer's surplus. This is called first degree
or perfect price discrimination.

P
A

Pe R
MC

D
Q
Qe
O
MR

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Without price discrimination, the monopolist charges Pe, sells quantity Qe and thus total
revenue equals the area of PeRQeO. With perfect price discrimination, the monopolist
captures the entire consumer surplus ARPe by selling its product at a maximum price that
consumers are willing to pay for the commodity (shown by point A). this method is also
known as “take-it-or-leave-it” price discrimination, because the monopolist charges the
maximum price consumers are willing to pay.

Knowing the exact shape of each consumer's demand curve (and be able to charge
reservation prices) and be able to prevent arbitrage is impossible or prohibitively expensive
to carry out. Thus, first degree price discrimination is not very common in the real world.
More practical and common is second-degree or multipart price discrimination. This refers to
the charging of a uniform price per unit for a specific quantity of the commodity, a lower
price for an additional batch or block of the commodity, and so on. Quantity discounts are an
example of second degree price discrimination. Here the monopolist extracts part, but not all,
of the consumer's surplus.
Third degree price discrimination is the practice of dividing consumers in to two or more
groups with separate demand curves and charging different prices to each group. Some
characteristic is used to divide customers in to distinct group. For many goods, for example,
students are usually willing to pay less on average than the rest of the population.
Pc

MC

P2

P1

MC=MR E
E1 E2
DT

D2
O D1

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The total quantity produced, X is determined by the intersection of the MRT and MC curves.
This quantity is then divided between the two groups of customers (assuming only two
groups for simplicity) so that marginal revenues for each group are equal. Otherwise, the firm
would not be maximizing profit. For example, if MR1 > MR2, the firm could clearly do by
shifting output from the second group to the first. Not only should the two marginal revenues
equal, but also the marginal cost should be equal to the marginal revenues. If this were not
the case the firm could increase its profitability by raising or lowering total output (and
lowering or raising its prices to both groups).

Total profit of the firm is given by π = P1Q1 + P2Q2 - C(QT)

Where P1 = the price charged to group one
P2 the price charged to group two
C (QT) = total cost of producing output QT = Q1 + Q2

The firm should increase its sells to each group until the incremental profit from the last unit
sold is zero.

d d
 0, and 0
dQ1 dQ2
d ( PQ11 ) dC d ( P Q)2
  0, and 0
dQ dQ1 dQ
MR1  MC  0, andMR 2  MC  0
MR1  MC , andMR 2  MC
Prices and output must be set so that MR1 = MR2 = MC
- Recall that
Rearranging gives

 
1  1 
P1  e p 2 

p2  
1  1 
 e 
 p1  At the maximum profit

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If the demand in market segment 2 is relatively elastic,( i.e. if ep 2  ep1 , then

   
1  1  1  1   1  1   P1  P2
ep2 e p1  e p2   e p2 

The higher price will be charged to consumers with the lowest demand elasticity.

6.3 Multiplan Monopoly

A monopolist maximizes profit by setting output at a level where MR =MC. For many
monopolists, production takes place in two or more different plants whose operating costs
can differ. However, the logic used in choosing output levels is very much similar to that for
the single-plant firm. Suppose a firm has two plants. Whatever the total output, it should be
divided between the two plants so that MC is the same in each plant. Otherwise, the firm
could reduce its costs and increase its profit by reallocating production. For example, if MC1
> MC2, the firm could produce the same output at a lower total cost by producing less at
plant 1 and at plant 2.

P MC1
MC2
MR
MC
MCT

P*

O Q1 Q2 Q3 Q
D

Profit is maximized when MR = MC at each plant. If MR > MC, the firm would do better by
producing more at both plants.

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 ∏ = PQt – C1(Q1) – C2(Q2)
 d∏ = d(PQt) – dC1 = 0, and d∏ = d(PQt) – dC2 = 0
dQ1 dQ1 dQ1 dQ2 dQ2 dQ2

 MR = MC1, and MR = MC2

 MR = MC1 = MC2

6.4 Social Cost of Monopoly

In a competitive market, price equals marginal cost. Monopoly power on the other hand,
implies that price exceeds marginal cost. Because monopoly power results in higher prices
and lower quantities produced, we would expect it to make consumers worse off and the firm
better off. Suppose we value welfare of consumers the same as that of producers. In the
aggregate, does monopoly power make consumers
and producers better or worse off?
P
MC
MC

Pm
E
Pc G
MR D

Pc, the competitive firm’s price, equals MC and thus Qc quantity is produced.
If this firm is replaced by a monopolist, Pm price will be charged and Qm
quantity will be produced. Consumer’s surplus declines from PcEY to PmeY (by the amount
equal to PmEPc). But, only PmeFPc is extracted by the monopolist. Similarly, GEF is the
proportion of the producers’ surplus lost. In sum, while PmeFPc represents transfer from
consumers’ surplus to producers, eEF + EFG represents the dead-weight loss due to
monopoly – the social cost of monopoly.

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 EXERCISE
1. A drug company has a monopoly on a new patented medicine. The product can be made in
either of two plants. The costs of production for the two plants are MC 1 = 10 + 2Q1 and
MC2 = 25 + 5Q2. The firm’s estimate of demand for the product is P = 2000 – 3(Q1+Q2).
How much should the firm plan to produce in each plant? At what price should it plan to
sell the product?

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