College OF BUSINESS AND ECONMICS

DEPARTMENT OF ECONMICS

MICROECONOMICS
Microeconomics-I

UNIT one
THEORY OF CONSUMER BEHAVIOR AND DEMAND
Introduction
The theory of consumer choice lies on the assumption of the consumer being rational to
maximize his/her level of satisfaction. The consumer makes choices by comparing bundle
of goods.
1.1: Consumer Preferences and Choices
After completing this section, you will be able to:
 Describe the theory of consumer preference an choice
 Explain the assumptions of consumer preference
1.1.1 Consumer Preference
Given any two consumption bundles (groups of goods) available for purchase, how a
consumer compares the goods? Does he prefer one good to another, or does he indifferent
between the two groups.
Given any two consumption bundles, the consumer can either decide that one of
consumption bundles is strictly better than the other, or decide that he is indifferent
between the two bundles.
Strict preference
Given any two consumption bundles(X1,X2) and (Y1,Y2),if (X1,X2)>(Y1,Y2) or if he
chooses (X1,X2) when (Y1,Y2) is available the consumer definitely wants the X-bundle
than Y.
Weak preference
Given any two consumption bundles(X1,X2) and (Y1,Y2),if the consumer is indifferent
between the two commodity bundles or if (X1,X2) ¿ (Y1,Y2,the consumer would be
equally satisfied if he consumes (X1,X2) or (Y1,Y2).

Indifference
If indifferent between the two commodities i.e. (x1, x2) (y1, y2) =>the consumer is
indifferent between two bundles of goods. Indifference means that the consumer would
be equally satisfied with either basket.

PADM year-II semester-I 2013 E.C Page 1

Microeconomics-I

Completeness
For any two commodity bundles X and Y, a consumer will prefer X to Y,Y to X or will
be indifferent between the two.
Transitivity
It means that if a consumer prefers basket A to basket B and basket B to basket C, then
the consumer also prefers A to C.
More is better than less
Consumers always prefer more of any good to less and they are never satisfied or
satiated. However, bad goods are not desirable and consumers will always prefer less of
them.
1.1.2 Utility
The term utility to describe the satisfaction or enjoyment derived from the consumption
of a good or service.
Definition

Utility refers to the satisfaction/pleasure that a consumer derives from consuming of

goods and services or undertaking an activity. Utility can also be defined as the want-
satisfying power of a commodity or service. Consumer makes choice so as to maximize
his/her utility, that is, to make them as happy as possible. Utility is the way to describe
preferences and preferences were defined in terms of utility, to say that ( x 1 , x 2 ) ≻( y 1 , y 2),
means that X-bundle had a higher utility than Y- bundle.

In defining strict preference, we said that given any two consumption bundles(X1,X2)
and (Y1,Y2),the consumer definitely wants the X bundle than the Y bundle if
(X 1 , X 2)>(Y 1, Y 2) .This means, the consumer preferred bundle (X1,X2) to bundle
(Y1,Y2) if and only if the utility (X1,X2) is larger than the utility of (Y1,Y2).

Given his income and the market prices of the various commodities, the consumer plans
to spend his income so as to attain the highest possible satisfaction or utility. This is the
axiom of utility maximization. In order to attain this objective of utility maximization,
the consumer must be able to compare the utilities of the various ‘baskets of goods’,
which he can buy with his income.

The concept of utility is characterized with the following properties:

PADM year-II semester-I 2013 E.C Page 2

Microeconomics-I

 ‘Utility’ and ‘Usefulness” are not synonymous. For example, paintings by Picasso
may be useless functionally but offer great utility to art lovers.
 Utility is subjective. The utility of a product will vary from person to person. That
means, the utility that two individuals derive from consuming the same level of a
product may not be the same. For example, no-smokers do not derive any utility
from cigarettes.
 The utility of a product can be different at different places and time. For example,
the utility that we get from meat during fasting is not the same as any time else.

1.2 Approaches to measure Utility

There are two major approaches of measuring utility. These are Cardinal and ordinal
approaches.

1.2.1. The Cardinal Utility theory

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). They argued that utility is measurable like weight, height, temperature and
they suggested a unit of measurement of satisfaction called utils. A util is a cardinal
number like 1,2,3 etc simply attached to utility. Hence, utility can be quantitatively
measured.

Assumptions of Cardinal Utility theory

The cardinal utility theory is based on the following underlying assumptions:

1. Rationality of Consumers. The consumer is rational i.e. his/her aim is utility

maximization subject to the constraint imposed by his/her given income and
market prices. In other words, he/she measures, calculates, compares and chooses
the utilities of different units of various commodities thereby maximizing utility.
2. Utility is Cardinally Measurable. According to this approach, the utility or
satisfaction of each commodity is measurable. Money is the most convenient
measurement of utility. In other words, the monetary unit that the consumer is
prepared to pay for another unit of commodity measures utility or satisfaction.

PADM year-II semester-I 2013 E.C Page 3

Microeconomics-I

3. Constant Marginal Utility of Money. According to assumption number two,

money is the most convenient measurement of utility. However, if the marginal
utility of money changes with the level of income (wealth) of the consumer, then
money cannot be considered as a measurement of utility.
4. Limited Money Income. The consumer has limited money income to spend on
the goods and services he/she chooses to consume.
5. Diminishing Marginal Utility (DMU).The utility derived from each successive
units of a commodity diminishes. In other words, the marginal utility of a
commodity diminishes as the consumer acquires larger quantities of it.
6. The total utility of a basket of goods depends on the quantities of the individual
commodities.

If there are n commodities in the bundle with quantities,

X 1 , X 2 ,. . . X n the total
utility is given by:
TU =f ()

Total and Marginal Utility

Total Utility (TU) refers to the total amount of satisfaction a consumer gets from
consuming or possessing some specific quantities of a commodity at a particular time. As
the consumer consumes more of a good per time period, his/her total utility increases.
However, there is a saturation point for that commodity in which the consumer will not
be capable of enjoying any greater satisfaction from it.
For example, a person consumes eggs and gains 50 utils of total utility. This total utility
is the sum of utilities from the successive units (30 utils from the first egg, 15 utils from
the second and 5 utils from the third egg).
Marginal Utility (MU): It refers to the additional utility obtained from consuming an
additional unit of a commodity. In other words, marginal utility is the change in total
utility resulting from the consumption of one or more unit of a product per unit of time.
Graphically, it is the slope of total utility.
Mathematically, the formula for marginal utility is:

PADM year-II semester-I 2013 E.C Page 4

Microeconomics-I

ΔTU
MU =
ΔQ Where, TU is the change in Total Utility, and,
Q is change in the amount of product consumed.

Law of diminishing marginal Utility (LDMU)

Dear learner, is the utility you get from consumption of the first orange is the same as the
second orange?
The utility that a consumer gets by consuming a commodity for the first time is not the
same as the consumption of the good for the second, third, fourth, etc.

The Law of Diminishing Marginal Utility States that as the quantity consumed of a
commodity increases per unit of time, the utility derived from each successive unit
decreases, consumption of all other commodities remaining constant.
The LDMU is best explained by the MU curve that is derived from the relationship
between the TU and total quantity consumed.
Table 1.1 Hypothetical table showing TU and MU of consuming Oranges (X)

Quantity(x) consumed in units 0 1 2 3 4 5 6

TUX in utils 0 10 16 20 22 22 20
MUX - 10 6 4 2 0 -2

PADM year-II semester-I 2013 E.C Page 5

Microeconomics-I

The above figure 1.1 indicates as the consumer consumes more of a good per time period,
the total utility increases, at an increasing rate when the marginal utility is increasing and
then increases at a decreasing rate when the marginal utility starts to decrease and reaches
maximum when the marginal utility is Zero.

The total utility curve reaches its pick point (Saturation point) at point A. This Saturation
point indicates that by consuming 5 oranges, the consumer attains its highest satisfaction
of 11 utils. However, Consumption beyond this point results in Dissatisfaction, because
consuming the 6th and more orange brings a lesser additional utility than the previous
orange. Point B where the MU curve reaches its maximum point is called an inflexion
point or the point of Diminishing Marginal utility.

Equilibrium of the Consumer in the cardinal utility approach

A. For a single Commodity

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). The
consumer wants to maximize the difference between the utility of x and the cost of
purchase of x i.e. U (x )− px
Equilibrium then occurs when the marginal utility of x exactly equals the market price i.e.
P x=MU x
Table1.2 Utility schedule for a single commodity (when price=2)

Marginal utility
Quantity of
Total utility Marginal utility per Birr(price=2
Orange
birr)
0 0 - -
1 6 6 3
2 10 4 2
3 12 2 1
4 13 1 0.5
5 13 0 0
6 11 -2 -1
For consumption level lower than three quantities of oranges, since the marginal utility of
orange is higher than the price, the consumer can increase his/her utility by consuming
more quantities of oranges. On the other hand, for quantities higher than three, since the

PADM year-II semester-I 2013 E.C Page 6

Microeconomics-I

marginal utility of orange is lower than the price, the consumer can increase his/her
utility by reducing its consumption of oranges.
Mathematically, the equilibrium condition of a consumer that consumes a single good X
occurs when the marginal utility of X is equal to its market price.
MU X = P X
Proof
The utility function is:

U =f ( X )
If the consumer buys commodity X, then his expenditure will be
Q X P X .Thus, the
consumer wants to maximize the difference between his/her utility and expenditure
Max(U −Q X P X )
The necessary condition for maximization is equating the derivative of a function with
zero. Thus,X
dU d (Q X P X )
− =0
dQ X dQ X

dU
−P X =0 ⇒ MU X =P X
dQ X
If MU x > p x , the consumer can increases his welfare (utility) by purchasing more units of
x.
If MU x < p x , the consumer can increase his total satisfaction by cutting (curtailing) the
quantities of x and keeping more of his income unspent.
Therefore, the consumer attains his/her equilibrium when MU x=¿ px

For more than one commodity

A consumer that maximizes utility reaches his/her equilibrium position when allocation
of his/her expenditure is such that the last birr spent on each commodity yields the same
utility.
For example, if the consumer consumes a bundle of n commodities i.e x1,x2,…,xn,he/she
would be in equilibrium or utility is maximized if and only if:

MU X MU X 2 MU X n
1
= = .. . .. .. . .=
PX P X2 P Xn
1

PADM year-II semester-I 2013 E.C Page 7

Microeconomics-I

Table1.3 Utility schedule for two commodities

Orange, Price=2birr Banana, Price=4birr

Quantity TU MU MU/P Quantity TU MU MU/P
0 0 - - 0 0 - -
1 6 6 3 1 6 6 1.5
2 10 4 2 2 22 16 4
3 12 2 1 3 32 10 2.5
4 13 1 0.5 4 40 8 2
5 13 0 0 5 45 5 1.85
6 11 -2 -1 6 48 3 0.75

As we discussed above, utility is maximized when the condition of marginal utility of one
commodity divided by its market price is equal to the marginal utility of the other
MU 1 MU 2
=
commodity divided by its market price i.e. P1 P2

Thus, the consumer will be at equilibrium when he consumes 2 quantities of Orange and
MU orange MU banana 4 8
= = = =2
4 quantities of banana, because Porange Pbanana 2 4

Derivation of the Cardinalist Demand

The derivation of demand is based on the axiom of diminishing marginal utility. As we
discussed that marginal utility is the slope of the total utility function. The derivation of
demand curve is based on the concept of diminishing marginal utility. If the marginal
utility is measured using monetary units the demand curve for a commodity is the same
as the positive segment of the marginal utility curve.

PADM year-II semester-I 2013 E.C Page 8

Microeconomics-I

Figure 1.2 Derivation of Demand curve

At X1 the marginal utility is MU1, which at equilibrium is equal to P1 and

at X2 marginal utility is MU2, which in turn is equal to P2 at equilibrium.
The negative section of the MU curve does not form part of the
demand curve, since negative quantities and price do not make sense
in economics.

Limitation of the Cardinalist approach

The Cardinalist approach involves the following three weaknesses:

1. The assumption of cardinal utility is doubtful because utility may not be

quantified.
2. Utility can not be measured absolutely (objectively). The satisfaction obtained
from different commodities can not be measured objectively.
3. The assumption of constant MU of money is unrealistic because as income
increases, the marginal utility of money changes.

1.2.2 The Ordinal Utility Theory

In the ordinal utility approach, utility cannot be measured absolutely but different
consumption bundles cab be ranked according to consumer’s preferences. The concept is
based on the fact that it may not be possible for consumers to express the utility of
various commodities they consume in absolute terms, like, 1 util, 2 util, or 3 util, but it is
always possible for the consumers to express the utility in relative terms. It is practically

PADM year-II semester-I 2013 E.C Page 9

Microeconomics-I

possible for the consumers to rank commodities in the order of their preference as
1st 2nd 3rd and so on.

Assumptions of Ordinal Utility theory

Basic Assumptions underlying Ordinal Utility Theory are:

1. The Consumers are rational-they aim at maximizing their satisfaction or utility

given their income and market prices.
2. Utility is ordinal, i.e. utility is not absolutely (cardinally) measurable. Consumers
are required only to order or rank their preference for various bundles of
commodities.
3. Diminishing Marginal Rate of Substitution (MRS): The marginal rate of
substitution is the rate at which a consumer is willing to substitute one commodity (x)
for another commodity (y) so that his total satisfaction remains the same. When a
consumer continues to substitute X for Y the rate goes decreasing and it is the slope
of the Indifference curve.
4. The total utility of the consumer depends on the quantities of the commodities

consumed, i.e.U=f ( X 1 , X 2 . .. .. . X n )
5. Preferences are transitive and consistent:
 It is transitive in the senses that if the consumer prefers market basket X to market
basket Y, and prefers Y to Z, and then the consumer also prefers X to Z.
 When we said consistent it means that If market basket X is greater than market
basket Y (X>Y) then Y not greater than X (Y not >Y).
The ordinal utility approach is expressed or explained with the help of indifference
curves. An indifference curve is a concept used to represent an ordinal measure of the
tastes and preferences of the consumer and to show how he/she maximizes utility in
spending income. Since it uses ICs to study the consumer’s behavior, the ordinal utility
theory is also known as the Indifference Curve Analysis.
1.2.2.1 Indifference Set, Curve and Map
Indifference Set/ Schedule: It is a combination of goods for which the consumer is
indifferent, preferring none of any others. It shows the various combinations of goods
from which the consumer derives the same level of utility.

PADM year-II semester-I 2013 E.C Page 10

Microeconomics-I

Table1.4 Indifference Schedule

Bundle A B C D
(Combination)
Orange(X) 1 2 4 7

Banana (Y) 10 6 3 1

Each combination of good X and Y gives the consumer equal level of satisfaction. Thus,
the individual is indifferent whether he consumes combination A, B, C or D.
Indifference Curves: an indifference curve shows the various combinations of two
goods that provide the consumer the same level of utility or satisfaction. It is the locus of
points (particular combinations or bundles of good), which yield the same utility (level of
satisfaction) to the consumer, so that the consumer is indifferent as to the particular
combination he/she consumes.
By transforming the above indifference schedule into graphical representation, we get an
indifference curve.

Indifference map
Indifference curve

10 A
Bana Goo
na Indifferen
B dB
(Y) 6 ce
Curve
C
2 IC3
D IC2
1
IC1

1 2 4 7 Good A
OrangeX
Fig1.3 indifference curves and indifference map.

Indifference Map: To describe a person’s preferences for all combinations of potato and
meat, we can graph a set of indifference curves called an indifference map. In other
words it is the entire set of indifference curves is known as an indifference map, which
reflects the entire set of tastes and preferences of the consumer. A higher indifference

PADM year-II semester-I 2013 E.C Page 11

Microeconomics-I

curve refers to a higher level of satisfaction and a lower indifference curve shows lesser
satisfaction. IC2 reflects higher level of utility than that of IC1.Any consumer has lots of
indifference curves, not just one.
Properties of Indifference Curves:
Indifference curves have certain unique characteristics with which their foundation is
based.
1. Indifference curves have negative slope (downward sloping to the right). Because,
the consumption level of one commodity can be increased only by reducing the
consumption level of the other commodity in order to be on the same IC. Hence, in
order to keep the utility of the consumer constant, as the quantity of one commodity
is increased, the quantity of the other must be decreased.
2. Indifference curves are drawn convex to the origin exhibiting the diminishing
marginal rate of substitution (MRSx,y). This implies that the slope of an
indifference curve decreases (in absolute terms) as we move along the curve from
left to right. This, in turn, means that the number of units of Y the consumer is
willing to sacrifice in order to obtain an additional unit of X decreases as we move
along the indifference curve.
3. A higher Indifference curve is always preferred to a lower one. The further away
from the origin an indifferent curve lies, the higher the level of utility it denotes:
baskets of goods on a higher indifference curve are preferred by the rational
consumer, because they contain more of the two commodities than the lower ones.
4. Indifference curves do not intersect each other. Intersection between two
indifference curves is inconsistent with the reflection of indifference curves. If they
did, the point of their intersection would mean two different levels of satisfaction,
which is impossible.

PADM year-II semester-I 2013 E.C Page 12

Microeconomics-I

Fig.1.4 intersected indifference curves

If they did, the consumer would be indifferent between C and E, (Right panel of figure
2.6) since both are on indifference curve one (IC1). Similarly, the consumer would be
indifferent between points D and E, since they are on the same indifference curve,
IC2.By transitivity, the consumer must also be indifferent between C and D. However, a
rational consumer would prefer D to C because he/she can have more Orange at point D
(more Orange by an amount of X).

The Marginal rate of substitution (MRS)

Marginal rate of substitution of X for Y is defined as the number of units of commodity

Y that must be given up in exchange for an extra unit of commodity of X so that the
consumer maintains the same level of satisfaction.

Number of units of Y given up

MRS X , Y =
Number of units of X gained
It is the negative of the slope of an indifference curve at any point of any two
commodities such as X and Y, and is given by the slope of the tangent at that point:
i.e., Slope of indifference curve
Δy
=MRS X , Y
Δx
In other words, MRS refers to the amount of one commodity that an individual is willing
to give up to get an additional unit of another good while maintaining the same level of
satisfaction or remaining on the same indifference curve. The diminishing slope of the
indifference curve means the willingness to substitute X for Y diminishes as one move
down the curve.

PADM year-II semester-I 2013 E.C Page 13

Microeconomics-I

MRS X , Y ) measures the downward vertical distance (the amount of y that the
Note that (
individual is willing to give up) per unit of horizontal distance (i.e. per additional unit of
ΔY
MRS X , Y =−
x required) to remain on the same indifference curve. That is, ΔX

It is also possible to show the derivation of the MRS using MU concepts. The
MRS X , Y is
related to the MUx and the MUy is:
MU X
MRS X , Y =
MU Y
Proof:
Suppose the utility function for two commodities X and Y is defined as:
U =f ( X ,Y )
Since utility is constant on the same indifference curve:
U =f ( X ,Y )=C
The total differential of the utility function is:
∂U ∂U
dU = dX + dY =0
∂X ∂Y
MU X dX + MU Y dY =0
MU X dY
=− =MRS X ,Y
MU Y dX

MU Y dX
=− =MRS Y , X
Or, MU X dY
Example
X4
U =5
Suppose a consumer’s utility function is given by Y −2 .Compute the MRS X , Y .
MU X
MRS X , Y =
MU Y
dU dU
MU X = and MU Y =
dX dY
4−1 2 3 2 4 2−1 4
Therefore, MU X =4( X Y )=4 ( X Y ) and MU Y =2 ( X Y )=2 X Y
MU X 4 X 3 Y 2 Y
MRS X , Y = = 4
=2
MU Y 2 X Y X

1.2 The Budget Line or the Price line

PADM year-II semester-I 2013 E.C Page 14

Microeconomics-I

Indifference curves only tell us about the consumer’s preferences for any two goods but
they can’t tell us which combinations of the two goods will be chosen or bought..
In reality, the consumer is constrained by his/her money income and prices of the two
commodities. Therefore, in addition to consumer preferences, we need to know the
consumer’s income and prices of the goods. In other words, individual choices are also
affected by budget constraints that limit people’s ability to consume in light of prices they
must pay for various goods and services. Whether or not a particular indifference curve is
attainable depends on the consumer’s money income and on commodity prices. A
consumer while maximizing utility is constrained by the amount of income and prices of
goods that must be paid. This constraint is often presented with the help of the budget
line constructing by alternative purchase possibilities of two goods. Therefore, before we
discuss consumer’s equilibrium, it is better to understand his/ her budget line.
The budget line is a line or graph indicating different combinations of two goods that a
consumer can buy with a given income at a given prices. In other words, the budget line
shows the market basket that the consumer can purchase, given the consumer’s income
and prevailing market prices.
Assumptions for the use of the budget line
In order to draw the budget line facing the consumer, we consider the following assumptions:
1. there are only two goods, X and Y, bought in quantities X and Y;
2. each consumer is confronted with market determined prices, Px and Py, of good X and
good Y respectivley; and
3. the consumer has a known and fixed money income (M).
By assuming that the consumer spends all his/her income on two goods (X and Y), we
can express the budget constraint as:
M=P X X +P Y Y Where, PX=price of good X
PY=price of good Y
X=quantity of good X
Y=quantity of good Y
M=consumer’s money income
This means that the amount of money spent on X plus the amount spent on Y equals the
consumer’s money income.

PADM year-II semester-I 2013 E.C Page 15

Microeconomics-I

Suppose for example a household with 30 Birr per day to spend on banana(X) at 5 Birr

each and Orange(Y) at 2 Birr each. That is, P X =5 , PY =2 , M=30 birr .

Therefore, our budget line equation will be:
5 X +2 Y =30
Table2.6 Alternative purchase possibilities of the two goods

Consumption
A B C D E F
Alternatives
Kgs of banana
0 1 2 3 4 6
(X)
Kgs of
15 12.5 10 7.5 5 0
Orange(Y)
Total
30 30 30 30 30 30
Expenditure

At alternative A, the consumer is using all of his /her income for good Y. Mathematically
it is the y-intercept (0, 15). And at alternative F, the consumer is spending all his income
for good X. mathematically; it is the x-intercept (6, 0). We may present the income
constraint graphically by the budget line whose equation is derived from the budget
equation.
M =P X X +P Y Y
M − XPX =YPY
By rearranging the above equation we can derive the general equation of a budget line,

M P
Y= − X X
PY PY

M
PY = Vertical Intercept (Y-intercept), when X=0.
PX
−
= slope of the budget line (the ratio of the prices of the two goods)
PY

The horizontal intercept (i.e., the maximum amount of X the individual can consume or
purchase given his income) is given by:

M P M/PY
− X X =0
PY PY

M P
= X X
B
PY PY 

A

PADM year-II semester-I 2013 E.C Page 16

M/PX
 Microeconomics-I

M
X=
PX

Fig.1.5 Derivation of the Budget Line

Therefore, the budget line is the locus of combinations or bundle of goods that can be
purchased if the entire money income is spent.

Factors Affecting the Budget Line

1. Effects of changes in income
If the income of the consumer changes (keeping the prices of the commodities
unchanged) the budget line also shifts (changes) parallel to the original line.

M2/Py

M/Py Where M2>M>M1

M1/Py
B B2

B1

M1/PX M/PX M2/PX

Fig.1.6 Effects of change in income

2. Effects of Changes in Price of the commodities

Changes in the prices of X and Y is reflected in the shift of the budget lines. Changes in
the prices of the commodities change the position and the slope of the budget line. But,
proportional increases or decreases in the price of the two commodities (keeping income
unchanged) do not change the slope of the budget line if it is in the same direction.
 What would happen if price of x falls, while the price of good Y and money incme
remaining constant?
Since the Y-intercept (M/Py) is constant, the consumer can purchase the same amount of Y by
spending the entire money income on Y regardless of the price of X. We can see from the above

PADM year-II semester-I 2013 E.C Page 17

 Microeconomics-I

figure that a decrease in the price of X, money income and price of Y held constant, pivots the
budget line out-ward, as from AB to AB’.
 What would happen if price of x rises, while the price of good Y and money incme
remaining constant?
Since the Y-intercept (M/Py) is constant, the consumer can purchase the same amount of
Y by spending the entire money income on Y regardless of the price of X. We can see
from the figure below that an increase in the price of X, money income and price of Y
held constant, pivots the budget line in-ward, as from AB to AB’.

Figure 1.10 the Effects of change in price of X while keeping other things constant
 What would happen if price of Y rises, while the price of good X and money incme
remaining constant?
Since the X-intercept (M/Py) is constant, the consumer can purchase the same amount of
X by spending the entire money income on X regardless of the price of Y. We can see
from the above figure that an increase in the price of Y, money income and price of X
held constant, pivots the budget line in-ward, as from AB to A’B.
 What would happen if price of Y falls, while the price of good X and money incme
remaining constant?
The above figure shows what happens to the budget line when the price of Y increases while the
price of good X and money income held constant. Since P y decreases, M/Py increases thereby the
budget line shifts outward.

PADM year-II semester-I 2013 E.C Page 18

Microeconomics-I

Figure 1.11 the Effects of change in price of Y while keeping other things constant

Numerical Example
A person has $ 100 to spend on two goods(X,Y) whose respective prices are $3 and $5.
a) Draw the budget line.
b) What happens to the original budget line if the budget falls by 25%?
c) What happens to the original budget line if the price of X doubles?
d) What happens to the original budget line if the price of Y falls to 4?
Dear learner from our previous discussion the budget line for two commodities was
expressed as:
P X X + PY Y =M
3 X +5 Y =100
5 Y =100−3 X
100 3
Y= − X
5 5
3
Y =20− X
5
When the person spends all of his income only on the consumption of good Y, we can get
the Y intercept that is (0,20).However, when the consumer spends all of his income on
the consumption of only good X,then we get the X intercept that is (33.33,0). Using these
two points we can draw the budget line. Thus, the budget line will be:

PADM year-II semester-I 2013 E.C Page 19

Microeconomics-I

Y 20
A

A’

B’ B
33.33 X
Figure 1.11 the Effects of increase in income while keeping other things constant

If the budget decreases by 25%, then the budget will be reduced to 75.As a result the
budget line will be shifted in-ward that is indicated by (A’B’).This forces the person to
buy less quantity of the two goods. The equation for the new budget line can be solved as
follows:
3 X +5 Y =75
5 Y =75−3 X
75 3
Y= − X
5 5
3
Y =15− X
5
Therefore, the Y-intercept is 15 while the X-intercept is 25.However, since the ratio of
the prices does not change the slope of the budget line remains constant.
If the price of good X doubles the equation of the budget line will be 6 X +5 Y =100 and
if the price of good Y falls to 4, the equation for the new budget line will be
6 X + 4 Y =100 .

1.3 Optimum of the Consumer

A rational consumer seeks to maximize his utility or satisfaction by spending his or her
income. It maximizes the utility by trying to attain the highest possible indifference
curve, given the budget line. A consumer attains his equilibrium position when he
maximizes his total utility given is income and price of the commodities.
Technically, the conditions that make the consumer in equilibrium are:
i) First order condition (Necessary condition)
MRSxy should be equal with price ratio. i.e. MRSxy= Px /Py

PADM year-II semester-I 2013 E.C Page 20

Microeconomics-I

ii) Second order condition ( Sufficient condition)

MRSxy= Px /Py should be at higher IC
Graphical presentation: Given the indifference map of the consumer and his budget
line, the equilibrium is defined by the point of tangency of the budget line with the
highest possible indifference curve.

Figure 1.12 Consumer equilibrium

px
At the point of tangency the slope of the budget line ( ) and of the indifference curve
py
M Ux
(MR S x , y = )are equal to:
M Uy

At point ‘a’ on the budget line, the consumer gets IC 1 level of satisfaction. When he/she
moves down to point ‘e’ by reallocating his total income in favor of X he/she derives
greater level of satisfaction that is indicated by IC2.
Point ‘e’ (which represents combination X and Y) is the most preferred position by the
consumer since he/she attains the highest level of satisfaction given his/her budget line
and point ’e’ is known as the point of consumer equilibrium (or consumer optimum).
This equilibrium occurs at the point of tangency between the highest possible
indifference curve and the budget line.

PADM year-II semester-I 2013 E.C Page 21

Microeconomics-I

Mathematical derivation of equilibrium

Suppose that the consumer consumes two commodities X and Y given their prices by
spending level of money income M. Thus, the objective of the consumer is maximizing
his utility function subject to his limited income and market prices. In utility
maximization, the function that represents the objective that the consumer tries too
achieve is called the objective function and the constraint that the consumer faces is
represented by the constraint function.

The maximization problem will be formulated as follows:

MaximizeU =f ( X ,Y )

Subject to P X X+P Y Y =M

We can rewrite the constraint as follows:

M −P X X + P Y Y =0 or P X X + PY Y −M =0

Multiplying the constraint by Lagrange multiplier λ

λ (M −P X X + PY Y )=0

Forming a composite function gives as the Lagrange function:

ℓ=U ( X ,Y )+ λ( M−P X X + PY Y )

Or, ℓ=U ( X ,Y )−λ ( P X X +PY Y −M )

The first order condition requires that the partial derivatives of the Lagrange function
with respect to the two goods and the langrage multiplier be zero.

∂ ℓ ∂U ∂ ℓ ∂U ∂ℓ
= −λP X =0 ; = −λPY =0 and =−(P X X +PY Y −M )=0
∂X ∂X ∂Y ∂Y ∂λ
From the above equations we obtain:

PADM year-II semester-I 2013 E.C Page 22

Microeconomics-I

∂U ∂U
=λP X and = λPY
∂X ∂Y
∂U ∂U
=MU X and =MU Y
∂X ∂Y
Therefore, substituting and solving for λ we get the equilibrium condition:
MU X MU Y
λ= =
PX PY
By rearranging we get:
MU X P X
=
MU Y PY
The second order condition for maximum requires that the second order partial
derivatives of the Lagrange function with respect to the two goods must be negative.
∂ ℓ2 ∂U 2 ∂ ℓ2 ∂ U2
= < 0 and = <0
∂ X 2 ∂ X2 ∂Y 2 ∂ Y 2
Interpretation of λ
λ is interpreted as the marginal utility of income (MUI), because
∂U ∂U ∂ X ∂U ∂ Y ∂X ∂Y
= . + . MUx . +MUy .
MUI = ∂ I ∂ X ∂ I ∂Y ∂ I ⇒ ∂I ∂I
∂X ∂Y
λ Px . +λ Py .
= ∂I ∂I
λ( Px . ∂ X+Py ∂Y )
= ∂I , here Px . ∂ X +Py .∂ Y =∂ I
λ(∂ I )
= ∂I
∴ MUI = λ
Thus, MUI is interpreted as the extra satisfaction derived from having one more birr
and it is amounted to λ .
Example
A consumer consuming two commodities X and Y has the following utility function
U =XY +2 X .If the price of the two commodities are 4 and 2 respectively and his/her
budget is birr 60.
a) Find the quantities of good X and Y which will maximize utility.

b) Find the
MRS X , Y at optimum.
Solution

PADM year-II semester-I 2013 E.C Page 23

Microeconomics-I

The Lagrange equation will be written as follows:

ℓ= XY +2 X + λ(60−4 X−2 Y )
∂ℓ
=Y + 2−λ 4=0
∂X ……………………….. (1)
∂ℓ
=X −λ 2=0
∂Y …………………………… (2)
∂ℓ
=60−4 X −2Y =0
∂λ …………………… (3)
From equation (1) we get Y +2=4 λ and from equation (2) we get X =2 λ .Thus, we can
Y +2 1
X= λ= X
get that 2 and equation (2) gives as 2 .
Y +2
X=
By substituting 2 in to equation (2) we get Y =14 and X=8 .
MU X
MRS X , Y =
MU Y
Y +2
=
X
After inserting the optimum value of Y=14 and X=8 we get 2 which equals to the price
P 4
( X = =2 )
ratio of the two goods PY 2 .
Exercise
Assume the consumer having a given income of 200 birr consumes only two
1
commodities X and Y and his utility function is given as U (X,Y)= 4 XY
Assuming further that prices of X and Y are 5 birr and 10 birr respectively.
Determine:
a) the consumer’s optimal bundles
b) his marginal utility of income and its interpretation

1.4 Effects of Changes in Income and Prices on Consumer

How people change their choices when conditions change? In particular, how changes in
income or change in price of a good affect the amount that people choice to consume? In
this section we discuses about these issues. We will compare the new choice with those

PADM year-II semester-I 2013 E.C Page 24

Microeconomics-I

that were made before conditions change. This approach leads to construct curves that
show how an individual respond to different levels of income and prices for a good.

A. Changes In Income: Income Consumption Curve and the Engel Curve

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 of consumer optimum points resulting only when the consumer
income changes. The ICC is also known as 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 good 1 say X on the
horizontal axis but measure money income on the vertical axis.

PADM year-II semester-I 2013 E.C Page 25

Microeconomics-I

Figure 1.13 the income –consumption and the Engle curves

From the Income Consumption Curve we can derive the Engle Curve. The Engle curve is
named after Ernest Engel, the German Statistician who pioneered studies of family
budgets and expenditure positions
The Engle Curve is the relationship between the equilibrium quantity purchased of a
good and the level of income. It shows the equilibrium (utility maximizing) quantities of
a commodity, which a consumer will purchase at various levels of income; (coteries
paribus) per unit of time.
In relation to the shape of the income-consumption and Engle curves goods can be
categorized as normal (superior) and inferior goods. Thus, commodities are said to be
normal, when the income consumption curve and its Engle curve are positively sloped;
meaning that more of the goods are purchased at higher levels of income. On the other
hand, commodities are said to be inferior when the income consumption curve and Engle
curve is negatively sloped, i.e. their purchase decreases when income increases.

PADM year-II semester-I 2013 E.C Page 26

Microeconomics-I

B. Changes in Price: Price Consumption Curve (PCC) and Individual

Demand Curve

Here, we hold money income constant and let price change to analyze the effect on
consumer behavior.
Suppose that we let the price of good1 change while we hold p2 and income fixed.
Geometrically this involves pivoting the budget line. If we connect the optimal points we
get the price offer curve. This curve represents the bundles that would be demanded at
different prices for good1. 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.

PADM year-II semester-I 2013 E.C Page 27

Microeconomics-I

The price-consumption curve is the locus of the utility-maximizing combinations of

products that result from variations in the price of one commodity when other product
prices, the money income and other factors are held constant.
We can derive the demand curve of an individual for a commodity from the price
consumption curve. Below is an illustration of deriving the demand curve when price of

commodity X decreases from

Px 1 to Px 2 to Px 3 .

1.5. 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 elasticity of demand as there
are its determinants. The most important of these elasticity’s 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:
dQ/Q
e p= dQ P
dp Or ep=
dp Q
p

Suppose for linear demand function

Q=b o – b 1 P , its slope is dQ /dP=−b 1. Substituting in the formula we obtain,
ep=−b 1. P/Q .
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

PADM year-II semester-I 2013 E.C Page 28

Microeconomics-I

(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.

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:
P 1+ P 2
∆Q 2 ∆ Q (P1+ P 2)
ep= =
∆ P Q 1+Q 2 ∆ P (Q1+Q 2)
2
The arc elasticity is a measure of the average elasticity, i.e. the elasticity at the mid-point
of the two points on the demand curve defined by the initial and the new price levels.

Income Elasticity of Demand

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

The Cross- Elasticity Of Demand

PADM year-II semester-I 2013 E.C Page 29

Microeconomics-I

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
e XY = =
dPy /Py dPy Qx
If e xy < o, then X & Y are complementary goods.
If e xy > o, “ “ substitute goods.

PADM year-II semester-I 2013 E.C Page 30

Microeconomics-I

Chapter two
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 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

PADM year-II semester-I 2013 E.C Page 31

Microeconomics-I

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 )−¿ √ P 1( X 1−E( X))2+ P 2( X 2−E( X))2
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 vice
versa, the preference depends on the individual – whether he/she is a risk adverse, risk
neutral or a risk loving person.

Different Preference towards Risk

A Risk Averse Person: is a person who 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 >is greater than utility at C (16>14). The
risk adverse person achieves the expected utility of 14 at a lower but risk less income of

PADM year-II semester-I 2013 E.C Page 32

Microeconomics-I

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 adverse person will pay to avoid taking a risk
is called a risk premium.6
Utility of this risk averse person is 14 = 0.5(10) + 0.5(18).
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.
E(U) = 0.5U(10) + 0.5U(30)
= 0.5(6) + 0.5(18)
= 12
=> E(U) = U(20) = 12
A Risk Loving Person: - is a person who 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 )=0.5 U (10)+0.5 U (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.
- 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.
Reducing Risk

PADM year-II semester-I 2013 E.C Page 33

Microeconomics-I

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 adverse people
will buy enough insurance to recover fully from any losses they might suffer. For a risk
adverse 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.
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.
Risk spreading
Suppose that each consumer decides to diversify the risk that he/she faces. They do this
by selling some of their risk to other individuals. Suppose that 1000 individuals decided
to insure one another. If anybody incurs $10,000 loss, each of the 1000 consumers will
contribute $10 to that person. In this way the consumer is compensated for his loss, and
the others have peace of mind that they will be compensated if the same condition happen
to them. This is an example of risk spreading. Each consumer spreads his risk over all of
the other consumers and there by reduces the amount of risk he bears.

PADM year-II semester-I 2013 E.C Page 34

Microeconomics-I

UNIT THREE
THE THEORY OF PRODUCTION AND COST
3.1 Production Function
Production can be defined it as any activity that creates present or future utility. In the
production process/ activity, firms turn inputs into outputs. This transformation of inputs
(factor of productions) into outputs 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.
Thus, no production (transforming raw material into output) can take place without the
use of inputs.

The production function depicts the relationship between inputs and outputs. It indicates
what outputs can be obtained from various amounts and combinations of factors of
production. In particular, it shows the maximum possible amount of output that can be
produced per unit of time with all combinations of factor inputs, given current factor
endowments and state of available technology.

A production function can also be defined as the specification of the minimum input
requirements needed to produce a given amount of output, given the available
technology. The relationship between input and output is nonmonetary i.e. the production
function relates physical inputs with physical output not their money value. Assume that
labor (L) and capital (K) are the only inputs, the production function can be written as:
Q=f (L , K).
Fixed Vs variable inputs
In economics, inputs can be classified as fixed & variable.

 Fixed inputs: - are factor inputs whose supply can not be varied (changed) over
the time period under consideration. In other words, the quantities of fixed inputs
do not change with output. Buildings, machinery and managerial personnel are
some example of fixed inputs.

 Variable input: - is one whose quantity changes with output. Many types of labor
services and most raw materials fall into this category

PADM year-II semester-I 2013 E.C Page 35

Microeconomics-I

In line with this classification of inputs, economists use two production periods.

 Short-run period: - refers to that period of time in which the quantity of at least
one input is fixed. Short run is that time period which is not sufficient to change
the quantities of all inputs, so that at least one input remains fixed.

 Long run period: - is a period of time in which all inputs are variable. On the
other hand, it is that time period (planning horizon) which is sufficient to change
the quantities of all inputs. Thus there is no fixed input in the long -run.

Note that! Short-run doesn’t refer to relatively short period of time like a year or less, and
long-run doesn’t refer to a period of time greater than a year. These periods rather refer to
the nature of economic adjustment in the form to changing economic environment.
3.2 Short run production
3.2.1 Total product, marginal product and average product
Total Product (TP): refers to the total output produced by a given amount of a

variable input, keeping the quantity of other (fixed) inputs constant.

Average Product (AP) of an input is the total product divided by the number of

units of that input used. That is:

(
total product TP
APL = number of wor ker s = L
) ( )
Average product measures the output per worker, which is an indication of
the productivity of the input.
Marginal Product (MP) is the extra or additional output obtained, with

one extra unit of the variable input while other factors remain fixed.

(
change intotal product Δ TP
MPL = change in number of wor ker s = ΔL
) ( )
MP is nothing but it is the slope of the TP.

PADM year-II semester-I 2013 E.C Page 36

 Microeconomics-I

Graphing the short run production curves

The following figures shows how the TP, MP and AP of the variable (labor) input vary
with the number of the variable input.

Fig 3.1 Total product, average product and marginal product curves:

The Relationship between TP, AP and MP

By Referring to the above figure 3.1, the relationship between TPL, MPL and APL can
be stated as follows:

I. TP first increases at an increasing rate (convex shape), then increases at decreasing rate
(concave shape) reaches maximum and finally declines.

II. The patterns of average product and marginal product curves are similar both AP and
MP curves initially increase, reach their respective maximum and then decline.
Moreover, MP eventually becomes negative

III. MPL increases when TP increases at an increasing rate and It starts to fall but positive
when TP increases at a decreasing rate. MPL reaches zero when TP is maximum
and MPL is negative when TP is falling.

PADM year-II semester-I 2013 E.C Page 37

 Microeconomics-I

IV. The relationship between APL and MPL can be expressed as follows:
 when MPL > APL, Slope of APL is positive (APL rises)
 When MPL = APL, Slope of APL is zero (APL is at its maximum).
 When MPL < APL, Slope of APL is negative (APL falls)
Region of Production in the short-run
We can divide this production function into three stages
 Stage I – ranges from the origin to the point of equality of the APL and MPL.
 Stage II – starts from the point of equality of MPL and APL and ends at a point
where MP is equal to zero.
 Stage III – covers the range of labor over which the MPL is negative.
Now, which stage of production is efficient and preferable?
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.

At the third stage where both APL and MPL are declining and MPL<0, 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.
3.3 The law 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

PADM year-II semester-I 2013 E.C Page 38

Microeconomics-I

combined with the other constant factors. This is known as the law of variable proportion.
Let us see these laws one by one.

3.3.1 Law of variable proportion or Law of Diminishing Returns

This law states that, if more and more of a variable input is applied to a fixed input, the
total output may initially increase at an increasing rate, but beyond a certain level of
output it increases at a diminishing rate. In other words, if some factors are held constant
and more and more units of a variable factor are combined with the fixed factor, the
marginal product of the variable factor eventually declines. From figure 3.1, 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 (at L1). This principle is
known as the law of variable proportion or the law of Diminishing returns.

3.3.2 Laws of Returns to Scale: Long run analysis of Production

The law of returns to scale refers to the long run analysis of production. In the long run,
where all inputs are variable and 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. Suppose initially the production function is
Q0=f (L , K)
If we increase all factors by the same proportion t (t>1), we clearly obtain a new level of
output Q* where,
¿ m
Q =f ( tL , tK )=t f ( L , K )
We have three cases of returns to scale: increasing, constant and decreasing returns to
scale.
I) Increase returns to scale (if m>1): this is the case where increasing all factors
by the same proportion, t, leads to an increase in output by more than t scale.
II) Constant returns to scale (if m=1): if we increase input by some factor, m and
output is increased by the same proportion as inputs, m, and 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.

PADM year-II semester-I 2013 E.C Page 39

Microeconomics-I

III) Decreasing returns to scale (if m<1): 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=2 K +3 L. 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)=2 Km+ 3 Lm=m(2 K +3 L)=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.

2 n 2
Q∗¿ .5( Km)( Lm)=.5 KL m =m Q . Since m>1 ,then m > m. this implies our new
production has increased by more than m.. so we have increasing returns to scale.

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.

Isoquants
In the long run the firm can produce its output in a variety of ways by combining
different amounts of labor and capital. With both variable factors, a firm can usually
produce a given level of output by using a great deal of labor and very little capital or a
great deal of capital and very little labor or moderate amount of both. These situations
will be analyzed by using isoquant.

An isoquant is a curve that shows all possible efficient combinations of inputs that can
yield equal level of output. If both labor and capital are variable inputs, the production
function will have the following form.

PADM year-II semester-I 2013 E.C Page 40

Microeconomics-I

Q = f (L, K)
Given this production function, the equation of an isoquant, where output is held constant
at q is
q = f (L, K)
Thus, isoquants show the flexibility that firms have when making production decision:
they can usually obtain a particular output (q) by substituting one input for the other.
Isoquant maps: when a number of isoquants are combined in a single graph, we call the
graph an isoquant map. An isoquant map is another way of describing a production
function. Each isoquant represents a different level of output and the level of out puts
increases as we move up and to the right. The following figure shows isoquants and
isoquant map.

Fig 3.2 Isoquant and isoquant map.

Isoquants show the fact that long run production process is very flexible. A firm can
produce q1 level of output by using either 3 capital and 1 labor or 2 capital and 3 labor
or 1 capital and 6 labor or any other combination of labor and capital on the curve. The
set of isoquant curves q1 q2 & q3 are called isoquant map.

Properties of isoquants
Isoquants have most of the same properties as indifference curves. The biggest difference
between them is that output is constant along an isoquant where as indifference curves
hold utility constant. Most of the properties of isoquants, results from the word ‘efficient’
in its definition.

PADM year-II semester-I 2013 E.C Page 41

 Microeconomics-I

1. Isoquants slope down ward. Because isoquants denote efficient combination of inputs
that yield the same output, isoquants always have negative slope. Thus, efficiently requires
that isoquants must be negatively sloped. As employment of one factor increases, the
employment of the other factor must decrease to produce the same quantity efficiently.
2. Isoquants are convex to the origin: convexity of isoquants implies not only the negative
shape but also a diminishing rate of MRTS
3. The further an isoquant lays away from the origin, the greater the level of output it
denotes. Higher isoquants (isoquants further from the origin) denote higher combination
of inputs. The more inputs used, more outputs should be obtained if the firm is producing
efficiently. Thus efficiency requires that higher isoquants must denote higher level of
output.
4. 3. Isoquants do not cross each other. This is because such intersections are inconsistent
with the definition of isoquants.

Consider the following figure.

Capital Fig 3.4 Efficiency requires that

isoquants do not cross each other,
Q=20 q=50
because the point of their intersection
implies that there is inefficiency at
this point.

K*

L*

This figure shows that the firm can produce at either output level (20 or 50) with the
same combination of labor and capital (L* and K*). The firm must be producing
inefficiently if it produces q = 20, because it could produce q = 50 by the same
combination of labor and capital (L* and K*). Thus, efficiency requires that isoquants do
not cross each other.

PADM year-II semester-I 2013 E.C Page 42

Microeconomics-I

The slope of an isoquant: marginal rate of technical substitution (MRTS)

The slope of an isoquant (-K/L) indicates how the quantity of one input can be traded
off against the quantity of the other, while output is held constant. The absolute value of
the slope of an isoquant is called marginal rate of technical substitution (MRTS).
ΔK MPL
MRTS L, K =− =
ΔL MPK

This can be shown analytically and algebraically respectively as follows:

Analytically: since an isoquant measures the combination of two inputs (say K, L) that
yields the same (equal) output, along the same isoquant increase in one factors of
production needs the reduction on the other factor, provided that the change in output is
zero.
Let the production function is given as:
q= f (L, K) Where q- is output
L- is unit of labor employed
K-is the amount of capital employed.

Given this production function, the equation of a specific isoquant can be obtained by

equating the production function with a given level of output, say q .

q = f (L, K) = q
Total differential of q measures the total change in q that happens as a result of a
simultaneous change in L and K. i.e,
∂q ∂f
dq= . dL+ . dk=d q
∂L ∂k

But since q is constant, dq is zero (dq =0)

∂q ∂q
. dL+ dk =0
So, ∂ L ∂k
∂q ∂q
=MPl =MPk
(But, ∂ L and ∂ k )
Thus, the above equation can be written as:
MPL. dL + MPK.dk = 0
MPL −dK
=
 MPk dL

PADM year-II semester-I 2013 E.C Page 43

Microeconomics-I

Therefore, the slope of an isoquant can be given as the ratio of marginal products of
inputs.

3.4 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.
To determine the economically efficient input combination, the following simplifying
assumptions hold true:
Assumptions

1. The goal of the firm is maximization of profit (∏ ¿¿) where ∏ ¿ R−C

Where ∏ ¿¿-Profit, R-revenue and C-is cost outlay.

2. The price of the product is given and it is equal to

PX .

3. The prices of inputs are given (constant).Price of a unit of labor is w and that of

capital isr .
Isocost line
An isocost line is the locus points denoting all combination of factors that a firm can
purchase with a given monetary outlay, given prices of factors.
Suppose the firm has C amount of cost out lay (budget) and prices of labor and capital
are w and r respectively. The equation of the firm’s isocost line is given as:
C=rK +wL , where K and L are quantities of capital and laborrespectively.
Given the cost outlayC , the maximum amounts of capital and labor that the firm can
C C
purchase are equal to r and w respectively. The straight line that connects these points
is the iso-cost line.
PL w
The slope of iso−cost line= =
PK r
See the following figure:

PADM year-II semester-I 2013 E.C Page 44

Microeconomics-I

Fig: 3.5 the iso cost line: shows different combinations of labor and capital that the firm
can buy given the cost out lay and prices of the inputs.

Maximization of output subject to cost constraint

Suppose a firm having a fixed cost out lay (money budget) which is shown by its iso-cost
line. Here, the firm is in equilibrium when it produces the maximum possible output,
given the cost outlay and prices of input. The equilibrium point (economically efficient
combination) is graphically defined by the tangency of the firm’s iso-cost line (showing
the budget constraint) with the highest possible isoquant. At this point, the slope of the

w MP L
iso cost line ( r ) is equal to the slope of the isoquant ( MP K ).
At the point of tangency:
a. slope of isoquant = slope of isocost
w MP L MP L MP K
= or =
r MP K w r . this is a necessary condition.
b. the iso-quant is convex to the origin. This is the sufficient condition.
See the following figure:

Capital

Q3
K1 E

Q2
Q1

L1 B Labor

PADM year-II semester-I 2013 E.C Page 45

Microeconomics-I

Fig: 3.6 the optimal combination of inputs ( L1 and K 1 ) is defined by the tangency of the
iso-cost line (AB) and the highest possible isoquant (Q 2 ), at point E.

Mathematical derivation of the equilibrium condition

A rational producer seeks the maximization of its output, given total cost outlay and the
prices of factors. The problem can be stated as:

Maximize X =f (L , K ).. . .. .. . .. .. . .. .. . .. .. . .. .Objective function

Subject to C=wL+rK ..........................Constraint function
This is a constrained optimization which can be solved by using the lagrangian method.
The steps are:

The lagrangian equation can be written as:

Z=X −(wL+rK – C) (i)

partially differentiate eq.(i) w.r.t L,K, and  and then equate to zero

∂Z ∂X MP L
= −wL=0 ⇒ MP L=wλ ⇒ λ=
∂L ∂L w
(ii)
∂Z ∂X MP K
= −rλ=0 ⇒ MP K =rλ ⇒ λ=
∂K ∂K r
(iii)
∂Z
=−wL−rK +C=0
∂λ
(iv)
From equation (ii) and (iii) we have the equilibrium condition:
MP L MP K w MP L
= or =
w r r MP K
The second order condition (the convexity of isoquant) would be insured when:

( )( ) ( )
2
∂2 X ∂2 X ∂2 X ∂2 X ∂2 X
<0 , < 0 and <
∂ L2 ∂ K2 ∂ L2 ∂ K2 ∂L∂K
Numerical Example
1/2 1/2
Suppose the production function of a firm is given as X =0 .5 L K prices of labor and
capital are given as $ 5 and $ 10 respectively, and the firm has a constant cost out lay of
$600.Find the combination of labor and capital that maximizes the firm’s output and the
maximum output.

Solution

PADM year-II semester-I 2013 E.C Page 46

Microeconomics-I

MP L MP K MP L w
= or =
The condition of equilibrium is w r MP K r
∂X
MP L= =0 . 25 L−1 /2 K 1 /2
∂L
∂X
MP K = =0 .25 L1/2 K −1/2
∂K
Thus, the equilibrium exists when,
0 .25 L−1/2 K −1/2 $ 5
=
0 .25 L−1/2 K −1/2 $ 10

K 1
= ⇒ L=2 K ...................................(1)
L 2
The constraint equation is:
wL+rK=C
5 L+10K =600......................................(2)
Solving equation (1) and (2) would give us the optimal combination of L and K.
L=2 K
5 L+10 K =600
⇒ L=60 units and K=30 units.
Thus, the firm should use 60 units of labor and 30 units of capital to maximize its
production (output). (Check the second order condition).
The maximum output can be found by substituting 60 and 30 for L and K in the
production process.

3.4 COSTS OF PRODUCTION

3.4.1 Types of cost
Cost is the value of inputs or factors of production that are utilized in the production
process. Therefore, cost is the payment made for inputs like land, labor and capital, raw
materials, etc. We can identify two types of cost of production: social cost and private
cost.
Social cost: is the cost of producing an item to the society. This cost is realized due to the
fact that most resources used for production purpose are scarce and some production
process, by their nature, emit dangerous chemicals, bad smell, etc to surrounding society.
For example, when a certain beer factory wants to produce beer in Ethiopia, the society
as a whole also incurs a cost.
Private cost: This refers to the cost of producing an item to the individual producer. It is
the cost that the beer factory incurs to produce the beer, in our example:

PADM year-II semester-I 2013 E.C Page 47

 Microeconomics-I

Private cost of production can be measured in two ways:

i) Economic cost
In economics the cost of production to the individual producer includes the cost of all
inputs used for the production of an item.

The producer may buy part of the inputs from the market. For example, he/ she hire
workers, buy raw materials, the necessary machines, etc. the actual or out- of- pocket
expenditures that the firm incurs to purchase these inputs from the market are called
explicit costs.
But, the producer can also use his/ her own inputs which are not purchased from the
market for the production purpose. For example, the producer may use his/ her own
building as a production place, he/she may also manage his firm by himself instead of
hiring another manager, etc. since these inputs are used for the purpose of production,
their value has to be estimated and included in the total cost of production. As to how to
estimate the cost of these non- purchased inputs is concerned, we usually estimate their
cost from what these inputs could earn in their best alternative use. For instance, if the
firm uses his own building for production purpose, the cost of using this building for
production is estimated by the rent income foregone. The estimated cost of there non-
purchased inputs are called implicit costs.
Thus, Economic cost is the summation of Explicit and Implicit costs
ii. Accounting (explicit) Cost: refers to the actual expenditure (monetary payment) by the
firm to outsiders for those who supply factors of production. In other words, cost of
production only includes the cost of purchased inputs.
iii. Implicit cost: refers to the value of inputs owned by the firm and used by the firm in
its own production process. For example, the costs involved in using the firms’ own
building and self-managing represent implicit costs. Implicit costs can be determined by
the monetary payment, which these resources could have earned in their best alternative
employment i.e. the opportunity cost of the input.

To clarify the difference between accounting cost and economic cost on this regard,
consider the following example.
Suppose Bedele Brewery factory purchases 1000 quintals of barely for 200 birr per
quintal in 1998 to use this barley for production purpose in the year 1999. However,

PADM year-II semester-I 2013 E.C Page 48

Microeconomics-I

suppose that the price of the barely has been increased to 300 birr per quintal in the year
1999.
-Now shall we use the actual price with which the barely was bought in 1998 or the
current price (1999 price) to estimate the cost of barely in 1999?
In economics, the 1999 price should be taken because, though the barley was bought for
200 birr per quintal in 1998, the cost of using this barely for the production purpose in
1999 is the 300 birr per quintal, the amount of income that could be obtained if the barely
were sold in the market.
But accountants use the 1998 price to estimate the cost of production in the year 1999.
Economics theory also distinguishes between long run and short run costs. Long-run
costs are costs incurred over a long period where all inputs are variable but short-run
costs are costs incurred over a short period during which some inputs are fixed while
others are variable.

Cost functions
Cost function shows the algebraically relation between the cost of production and various
factors which determine it. Among others, the cost of production depends on the level of
output produced, technology of production, prices of factors, etc. hence; cost function is a
multivariable function. Symbolically,
C = f (Q, t, pi)
Where c- is total cost of production
Q - is the amount of output
T – is the available technology of production.
Pi – is the price of input

3.4.1 – Short-Run Cost Functions

In the short-run we have two types of inputs: fixed & variable inputs. So our costs can
also be classified as fixed and variable costs.
Total Fixed Cost (TFC) refers to the sum total of the value of all fixed factors of
production used in the production process. It is independent of the level of output
produced.

PADM year-II semester-I 2013 E.C Page 49

Microeconomics-I

Total Variable Cost (TVC) refers to the sum total of the value of all Variable inputs
used in the production process. It represents those costs that vary with the level of output.
Total Cost (TC) represents the lowest total (dollar) expense needed to produce each
level of output i.e. the summation of TVC and TFC.

TC=TFC+TVC
Graphically,

Fig 3.8 the total cost curves

Average and Marginal Costs in the Short Run

TFC
i. Average Fixed Cost (AFC) equals total fixed cost dived by output, i.e. AFC = Q
( )
ii. Average Variable Cost (AVC) equals total Variable cost divided by output, i.e.

AVC =
( TVC
Q )
iii. Average Total Cost or Average cost (ATC or AC) equals total cost divided by output,

i.e.
( TC
ATC or AC = Q ,
) but TC =TVC+TFC

PADM year-II semester-I 2013 E.C Page 50

Microeconomics-I

=
( TFC+TVC
Q ) (= TFC
Q + Q )
) ( TVC
AC = AVC + AFC

iv. Marginal Cost (MC) refers to the addition to total cost as a result of the
production of one more unit of output. Or, MC equals the change in total cost per unit

change in output, i.e.

( ΔTC
MC = ΔQ =
) ( Δ ( TFC +TVC )
ΔQ ) =
ΔTFC+ ΔTVC
ΔQ ( ΔTVC
= ΔQ
)
dTC
or MC =
dQ
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.

Fig 3.9 per unit and marginal cost curves

3.4.2 The relationship between AVC, ATC and MC

PADM year-II semester-I 2013 E.C Page 51

Microeconomics-I

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 AC

Finally, the MC curve passes through the minimum point of both ATC and AVC curves.
This can be shown by using calculus.
Suppose the TC = f (Q), recall

d ( f (Q))
MC=
dQ
TC f (Q)
AC= =
Q Q

Slope of AC function can be calculated as:

d ( AC ) d (TC ) 1
= +d ¿ ¿
dQ dQ Q

1 f (Q)
( MC− AC ) , where = AC
Slope of AC = Q Q

Given that Q and ATC are Positive,

 If MC<ATC, slope of ATC is negative .i.e. ATC is declining
 If MC=ATC, slope of ATC=0, (ATC reaches its minimum).
 If MC>ATC, slope of ATC>0.i.e ATC is increasing

The relationship between AVC and MC can be shown in a similar fashion.

PADM year-II semester-I 2013 E.C Page 52

Microeconomics-I

3.4.3 Long-run costs

In the long run all factors and all costs are assumed to be variable. The long-run cost
curve is a planning curve in the sense that it can serve as guides to entrepreneurs in their
decisions to plan the future expansion of their output. In other words, the time period
corresponding to the long run will be such that the producer can make necessary
adjustments as to the size of his plant.
Long run costs differ from short run costs in the fact that in the long run we assume all
costs are variable and there will be no fixed costs. This is because the firm will have a
sufficiently long time to change the level of capital and machinery.

To derive long run cost curves, it would be imperative to imagine that the long run is
composed of a series of short-run production decisions. Stated differently, long run
average cost (LAC) curve is derived from short-run average cost curves. It is crucial to
make a note here that the short-run average cost curve (SAC) cannot be below the
long-run average cost curve (LAC). This is because there are more constraints
(capacity constraint and constraints imposed by other fixed factors) in the short-run
than in the long run and the producer has an opportunity of minimizing the costs of
the chosen output with respect to all factors.

Similar to the SAC curve, the LAC curve of a firm is also U-shaped, but the reason for
the U-shapedness of LAC curve is different from that of the SAC curve.
The LAC curve is U-shaped due to the laws of returns to scale(i.e increasing and
decreasing returns to scale).that is, as output expands from a very low levels increasing
returns to scale prevails (i.e., output rises proportionally more than inputs), and so the
cost per-unit of output falls(assuming that input prices remain constant).As output
continues expand, the forces of decreasing returns to scale eventually begin to overtake
the forces of increasing returns to scale and the LAC begins to rise.
In other words, the per unit costs of production decreases initially as the plant size
increases, due to the economies of scale which larger plant size makes possible.

The long-run marginal cost curve.

PADM year-II semester-I 2013 E.C Page 53
Microeconomics-I

The long-run marginal cost curve (LMC) is derived from the short run MC curve but
does not envelope them. The LMC is formed from points of intersection of the SMC
curves with the vertical lines (to the x-axis) drawn from the points of tangency of
corresponding SAC curves and the LAC curve.

SAC1
SMC1 SAC3

LMC LAC
SAC2

SMC2 SMC3

Q1 Q2 Q3 Q

Fig4.3.10: Long run cost curves;

Note that, the LMC curve passes through the minimum of the LAC curve.

3.5 Derivation of Cost Function from the Production Function

Cost curves 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
C = f(X)

PADM year-II semester-I 2013 E.C Page 54

Microeconomics-I

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)
∂λ
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.
M PL w −1/ 3 1 /3
2/3 L K 2
1. = =¿ −2 /3 2 /3
=
MP K r 1/3 K L 4
2K 1
=> =
L 2
=> L = 4K
2. Q = L2/3K1/3
Q = (4K)2/3K1/3
Q = 42/3K
Q
=> K= 2 /3
4
Q
=> L=4 K=4 2/ 3
4
=> L = 41/3Q
3. C = 2L + 4K
C = 2(41/3Q) + 4(Q/41/3)
C = 25/3Q + 41/3Q

PADM year-II semester-I 2013 E.C Page 55

Microeconomics-I

C = (25/3 + 41/3)Q

3.6 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.

Fig4.3.11: Learning Curve: shows that at the firm’s cumulative output increases(as the
firm gets experienced),the amount of inputs(such as labor)required to produce one unit of
output decreases.

PADM year-II semester-I 2013 E.C Page 56

Microeconomics-I

In the above graph, the per unit production costs decreases along with the amount of
labor required to produce a unit of the commodity. This happens because labor input Per
unit of output directly affects the production costs. The fewer the hours of labor needed to
produce a unit of the commodity, the lower the marginal and average costs of production.

PADM year-II semester-I 2013 E.C Page 57

Microeconomics-I

Chapter Four
Introduction to market structure
4.1 Introduction

The objectives of firms are producing goods and service and sell it to consumers in order
to maximize their profit. Consumer demand for goods and services determines the
revenue side of a business operation. Production theory has been used to derive the cost
conditions faced by firms. Bring together, revenue and cost determines the behavior of a
profit maximizing business firm.

The most important factor that determines firm’s choice of price and output is the market
structure. The term market structure refers to the organizational features of an industry
that influence the firm’s behavior in its choice of price and output. Economists classify
markets in to four general categories:
 perfect competition
 monopoly
 monopolistic competition and
 oligopoly

These classifications are based largely on the numbers of firms in the industry, the nature
of products and the nature of entrance of new firms and nature of competition. In this
unit, we investigate how price and output are determined in perfectly competitive markets
in the short as well as long run periods.

4.2 Perfect Competitive Market

Perfect competition is a market structure characterized by a complete absence of rivalry

among the individual firms, because, there are so many firms in the industry so that no
personal recognition among individual firms in a market. Perfect competition is
characterized by the following assumptions.

PADM year-II semester-I 2013 E.C Page 58

Microeconomics-I

1. Large number of sellers and buyers.

The perfect competitive market includes a large number of buyers and sellers. How
large should the number of buyers and sellers is large to the extent that the market
share of each firm (and buyer) is too small to have a perceptible effect on the price of
the commodity. That is the action of a single seller or buyer can not influence the
market price of the commodity, since the firm or (the buyer) is too small in relation to
the market.
2. Products of the firms are homogeneous.
This means the products supplied by all the firms in the market have uniform physical
characteristics (are uniform in terms of quantity, quality etc) and the services
associated with sales and delivery are identical. Thus buyers can not differentiate the
product of one firm from the product of the other firm.

The assumptions of large number of sellers and of product homogeneity imply that
the individual firm in pure competition is a price taker: its demand curve is infinitely
elastic, indicating that the firm can sell any amount of output at the prevailing market
price. Since the share of the firm from the market supply is too small to affect the
market price, the only thing that the firm can do is to sell any quantity demand at the
ongoing market price. Thus, the demand curve that an individual firm faces is a
horizontal line.

Fig 4.1 Market equilibrium and the firm’s demand curve

PADM year-II semester-I 2013 E.C Page 59

Microeconomics-I

3. Free entry and exit of firms: There is no restriction or market barrier on entry of
new firms to the industry, and no restriction on exit of firms from the industry. A firm
may enter the industry or quit it on its accord.
4. The goal of all firms is profit maximization. it is assumed that the goal of a firm is
profit maximization.
5. No government regulation
The Government does not interfere in any way with the functioning of the market.
There are no discriminator taxes or subsidies, no licensing, no allocation of inputs by
the procurement, or any kind of direct or indirect control. That is, the government
follows the free enterprise policy. Where there is intervention by the government it is
intended to correct the market imperfection.
6. Perfect mobility of factors of production
Factors of production (including workers) are free to move from one firm to another
throughout the economy. Alternatively, there is also perfect competition in the market
of factors of production.
7. Perfect knowledge
It is assumed that all sellers and buyers have a complete knowledge of the conditions
of the prevailing and future market. That is all buyers and sellers have complete
information about price, quality, etc
4.2.2Demand and revenue functions under perfect competition
Due to the existence of large number of sellers selling homogenous products, each seller
is a price taker in perfectly competitive market. That is, a single seller cannot influence
the market by supplying more or less of a commodity. Single buyer also can not influence
the market price .Thus firms operating in a perfectly competitive market are price takers
and sell any quantity demanded at the ongoing market price. They take the price
determined by the forces of market demand and market supply. Hence, the demand
function that an individual seller faces is perfectly elastic (or horizontal line). In this case
The marginal revenue (MR) and average revenue (AR) of a firm operating under perfect
competition are equal to the market price. i.e.
MR= AR=P

PADM year-II semester-I 2013 E.C Page 60

Microeconomics-I

4.2.3 Short run equilibrium of the firm

A firm is said to be in equilibrium when it maximizes its profit (Õ). Profit is defined
as the difference between total cost and total revenue of the firm:
Õ= TR-TC
Under perfect competition, the firm is said to be in equilibrium when it produces that
level of output which maximizes its profit, given the market price. Thus,
determination of equilibrium of the firm operating in a perfectly competitive market
means determination of the profit maximizing level of output since the firm is a price
taker.

And short – run equilibrium is based on the following assumptions

1. Capital is fixed and labor is variable

2. Price of inputs are given

3. Price of the commodity is fixed, and

4. The firm is faced with short run cost curves.

The level of output which maximizes the profit of the firm can be obtained by
MR=MC ⟹ P=MC Necessary condition
MC is increasing-Sufficient condition

The firm’s equilibrium in the short run is illustrated in the following figure. It can be seen
in the figure below that SMC curve intersect the P= MR line at point E, from below,
where SMC= P a perpendicular drawn from point E to the output axis determines the
equilibrium output at OQe. It can be seen in the figure that output OQe meets both the
first and the second order condition of profit maximization. At output OQe, therefore
profit is maximized. The output OQe is thus the equilibrium output. Firm’s maximum
pure profit is shown by the shaded area (PEE’p’). If the ATC is below the market price
at equilibrium, the firm earns a positive profit equal to the area between the ATC curve
and the price line up to the profit maximizing output(fig 4.3)

Price (P) Abnormal profit SMC SAC

PADM year-II semester-I 2013 E.C Page 61

Microeconomics-I

SAVC
P E P= MR
P’ E’

0 Qe output (Q)
Fig 4.3: the profit maximizing output

In short run, a firm may not always earn abnormal profit; it may earn just a normal profit
or even make losses, depending on its cost and revenue conditions. if its SAC is tangent
to P = MR line at equilibrium, the firm makes only normal profit. This point is known as
breakeven point. If the AVC is tangent to price line at equilibrium, the firm’s lose is
equal with its fixed cost. This point is known as shutdown point.
In case a firm is making loss it must cover its short run average variable cost (SAVC).
And a firm unable to recover its minimum SAVC will have to close down. The SMC
intersects SAVC at its minimum level. In this point the firm covers all of its variable cost
but all fixed costs are uncovered. In this case the firm should close (shut down) its factory
in order to minimize loses.
Mathematical derivation of the equilibrium condition
Profit (Õ) = TR-TC
TC is a function of output, TC=f (Q)
TR is also a function of output, TR=f (Q)
Thus, profit is a function of output, Õ=f (Q)
Õ= TR-TC
To determine the profit maximizing output we find the first derivative of the Õ function
and equate the result to zero.

d ∏ dTR dTC
= − =0
dQ dQ dQ
= MR – MC = 0
= MR = MC --------------------------------- (First order condition necessary condition)

PADM year-II semester-I 2013 E.C Page 62

 Microeconomics-I

The equality of MC and MR is a necessary, but not sufficient condition. The sufficient
condition for maximization of II is that the second derivative of the II function should be
less than zero (or negative) i.e.

d2 ∏ d 2 TR d 2 TC
<0 − <0 ⇒ dMR < dMC
dQ 2 Ú dQ
2
dQ 2
dQ dQ
d 2 TR d2 TC
2
< 2
⇒Slope of MR < Slope of MC
Thus, dQ dQ
Or Mc is increasing………………. Sufficient condition
Thus, the condition for profit maximization under perfect competition is
MR= MC………………….necessary condition and
MC is increasing…………. sufficient condition
Example:
2. Suppose that the firm operates in a perfectly competitive market. The market price of his
product is$10. The firm estimates its cost of production with the following cost function:
TC=10q-4q2+q3, then,
A) What level of output should the firm produce to maximize its profit?
B) Determine the level of profit at equilibrium.
C) What minimum price is required by the firm to stay in the market?
Solution
Given: p=$10
TC= 10q - 4q2+q3
A) The profit maximizing output is that level of output which satisfies the following
condition
MC=MR &
MC is rising
Thus, we have to find MC& MR first
 MR in a perfectly competitive market is equal to the market price. Hence, MR=P=10

dTC d (10 q−dq 2 +q 3 )

= =10−8 q+3 q2
MC= dq dq
 To determine equilibrium output just equate MC& MR

PADM year-II semester-I 2013 E.C Page 63

 Microeconomics-I

10 – 8q + 3q2 = 10 and solve for q we have

q = 0 or q = 8/3
Now we have obtained two different output levels which satisfy the first order
(necessary) condition of profit maximization
 To determine which level of output maximizes profit we have to use the second order test
dMC
 To see this first we determine the slope of MC: Slope of MC = dq = -8 + 6q
 At q = 0, slope of MC is -8 + 6 (0) = -8 which implies that marginal cost is decreasing at q
= 0. Thus, q = 0 is not equilibrium output because it doesn’t satisfy the second order
condition.
 At q = 8/3, slope of MC is -8 + 6 (8/3) = 8, which is positive, implying that MC is
increasing at q = 8/3

Thus, the equilibrium output level is q = 8/3

B) At equilibrium output:
TR = P*q= $ 10 * 8/3= $ 80/3
TC = 10 (8/3) – 4 (8/3)2 + (8/3)3 » 23.12
Thus the equilibrium (maximum) profit is
Õ = TR – TC = 26.67 – 23.12 = $ 3.55
c) To stay in operation the firm needs the price which equals at least the minimum AVC.
Thus to determine the minimum price required to stay in business, we have to determine
the minimum AVC.
AVC is minimal when derivative of AVC is equal to zero
dAVC
That is: dQ = 0
Given the TC function: TC = 10q – 4q 2 +q3, there is no fixed cost i.e. TC is equal to the
TVC.
Hence, TVC = 10q – 4q2 + q3

TVC 10 q−4 q2 +q3

AVC = q = q = 10 – 4q2 + q2

PADM year-II semester-I 2013 E.C Page 64

 Microeconomics-I

dAVC d (10−4 q+q2 )

=0 =0
dq – dq
= -4 + 2q = 0
– q = 2 i.e. AVC is minimum when output is equal to 2 units.
The minimum AVC is obtained by substituting 2 for q in the AVC function i.e., Min
AVC = 10 – 4 (2) + 22 = 6
Thus, to stay in the market the firm should get a minimum price of $ 6.
Exercise:
1. Suppose that the total cost (TC) function of a perfectly competitive firm is given by

TC = Q3 – 2Q2 + 5Q + 10 and market price is $16, Then,

b) Calculate the profit maximizing level of output.
c) Determine the maximum profit or the minimum loss whichever is the case.
d) Calculate the AVC and AFC at the profit maximizing level of output.
e) Calculate the level of output that corresponds to the shout down point.

4.2.4 The short run supply curve of the firm and the industry
The Derivation of supply curve of the firm
The supply curve of an individual firm is derived on the basis of its equilibrium output.
The equilibrium output is determined by the intersection of MR and MC curves. The
derivation of supply curve of a firm is shown in the following figure, a and b.
As the figure shows, the firm’s SMC passes through point M, on its SAVC
(a) (b)
Cost S MC SS SS
P3
SAC
R

P2 SAVC
m

P1

0 Q1 Q2 Q3 0 Q1 Q2 Q3

PADM year-II semester-I 2013 E.C Page 65

Microeconomics-I

Fig,4.6 The short run supply curve of a perfectly competitive firm

According to the figure, at price OP1, OQ1 is the minimum supply of the firm. In the short
run the equilibrium level of output at this point is OQ 1. When price increases to OP2; the
equilibrium point shifts from m to R and output increases to OQ 2. Let the price increases
further to OP3 so that equilibrium output rises to OQ 3 by plotting this information, we get
a supply curve. Thus, the short run supply curve of a perfectly competitive firm is that
part of MC curve which lies above the minimum average variable cost (Shut down point)

Short run supply curve of the industry

The industry supply curve or what is also called a market supply curve is the horizontal
summation of the supply curves of the individual firms.
4.2.5 Short run equilibrium of the industry

An industry is in equilibrium in the short run when market is cleared at a given price i.e.
when the total supply of the industry equals the total demand for its product, the prices at
which market is cleared is equilibrium price. When an industry reaches at its equilibrium,
there is no tendency to expand or to contract the output . The equilibrium of the industry
has shown at point E in the following figure.

Fig4.8 :- short run equilibrium of the industry

4.2.6 The long-run Equilibrium

If the firms earn abnormal profit in the short run which may bring about two major
changes in the industry.

PADM year-II semester-I 2013 E.C Page 66

Microeconomics-I

One – existing firms get incentive to increase the scale of their production other average
and marginal cost go down caused by the economics of scale.

Two – attracted by the abnormal profit, new firms enter the industry, for these reasons
the industry supply increase. The shift in supply curve brings down the market price.
Firms attain their equilibrium in the long run where AR= MR= LMC = LAC = SMC=
SAC. That is, the firms of an industry reach their equilibrium position in the long run
where both short run and long run equilibrium condition coincide. In the long run all
firms earn normal profit.
*Equilibrium of the industry
An important condition for the industry to be in equilibrium is that it produces the level
of output at which the quantity demanded and the quantity supplied of its product are
equal. This is achieved at which all firms are in equilibrium producing at the minimum
point of their LAC curve and making just normal profits. Under these condition there is
no further entry or exit of firms in the industry, given the technology and factor prices.

4.3 Imperfect markets

4.3.1 MONOPOLY market
Definition:-Monopoly is a market structure in which one firm makes up the entire
market whose product is unique or no close substitute. It is a polar opposite to perfect
competition. In other words, it is a market structure in which the firm faces no
competitive pressure from other firms. Hence, pure monopolist is price maker/setter,
remember that a perfect competitive firm is a price taker, and the consumers’ option in
this market is “Take it or Leave it price”.

4.3.1.1 Basic assumptions of pure monopoly

1. There is only one seller and many buyers in the market.
2. The product of the monopolist is unique. This implies the product doesn’t have any
close-substitute.
3. Because of the above mentioned assumptions a monopolist firm is a price maker.

PADM year-II semester-I 2013 E.C Page 67

 Microeconomics-I

4. Entry into and exit from the market is difficult. This is because fixed cost/initial
investment is large but the additional cost/marginal cost of producing a unit of output
is small for the monopolist. That is to say that once a huge investment is made to
acquire the best technology with many plants and high capacity, the marginal cost of
producing an additional unit of output is negligible. Such situation is referred to
natural monopoly. Example, EEPCO.
4.3.1.2 Causes for the emergence of monopoly

The emergence and survival of monopoly is attributed to the factors which prevent the
entry of other firms in to the industry. The barriers to entry are therefore the sources of
monopoly power.

The major sources of barriers to entry are

i. legal restrictions
ii. sole control over the supply of key raw materials
iii. efficiency and
iv. patent and copyright right,

i. legal restriction: Some monopolies are created by law in public interest such monopoly
may be created in both public and private sectors. Most of the state monopolies in the
public utility sector, including postal service, telegraph, telephone services, radio and TV
services, generation and distribution of electricity, rail ways, airlines etc… are public
monopolies.
ii. Control over key raw materials: Some firms acquire monopoly power from their
traditional control over certain scarce and key raw materials that are essential for the
production of certain other goods. E.g. Bauxite, graphite, diamond, etc…..for example
Aluminum Company of America had monopolized the aluminum industry because it had
acquired control over almost all sources of bauxite supply; such monopolies are often
called raw material monopolies.
iii.Efficiency: a primary and technical reason for growth of monopolies is economies of
scale, the most efficient plant (probably large size firm, which can produce at minimum
cost, could eliminate the produce at minimum cost, could eliminate the competitors by

PADM year-II semester-I 2013 E.C Page 68

 Microeconomics-I

curbing down its price for a short period and can acquire monopoly power. Monopolies
created through efficiency are known as natural monopolies.
iv.Patent and copyright rights: another source of monopoly is the patent right if a firm for
a product or for a production process. Patent rights are granted by the government to a
firm to produce commodity of specified quality and character or to use a specified rights
to produce the specified commodity or to use the specified technique of production, such
monopolies are called to patent monopolies.

4.3.1.3 The demand and revenue curves of the monopoly firm

The demand curve of monopolist product is downward slopping. Since a monopolist
constitutes a one-firm market; the market demand curve is the monopolist demand curve.
Unlike the case of perfectly competitive firms demand curve, the monopolist demand
curve is different from its marginal revenues. When demand is negatively slopped,
marginal revenue is negatively slopped as well. Furthermore, in pure monopoly market,
marginal revenue is less than price at all relevant points of output. The difference
between marginal revenue and price depends up on the price elasticity of demand.
Graphically
Ep>1

Ep=1

Ep<1

DD

MR

Fig 4.9 demand and MR curves of monopoly firm

Under pure monopolist firm the slope of the marginal revenue is twice steeper than that
of the slope of the demand curve.
Mathematically, given for simplicity a linear demand function of the monopolist by
Q=a-bP where Q= output level, P is price level and b>0.
First let’s derive the inverse demand function
P=a/b -Q/b, -1/b is the slope of the inverse demand function................................ [1]

PADM year-II semester-I 2013 E.C Page 69

Microeconomics-I

MR= a/b -2Q/b, -2/b is the slope of the MR……………………………………........ [2]

From this we can conclude that the slope of the Marginal revenue is twice steeper than
the slope of the demand curve under pure monopoly.
Note! Always a monopolist will set its price in a region where demand is elastic . From
the profit maximization
∏=TR- TC Where TC=F (Q)
TR=P.Q Deriving the marginal revenue from the total revenue
TR QP
MR= =P+
Q Q
Factoring out P we obtain

MR=P 1+
[ ] Q P
.
p Q
Q P
, but we know that . =1 /e
p Q

MR=P 1+
[ ] 1
e
,by definition we know that elasticity of demand is always negative.

MR=P 1−
[ | |] 1
e
........................................................................................................ [1]

Since the monopolist produces in the positive segment of MR (MR>0), elasticity of

demand is always greater than one (|e|>1)

4.3.1.4 Profit maximization in the short run

Under monopoly, the firm is a price maker and has a power to alter the level of output.
Thus, profit maximization under monopoly involves determination of the price and
output combination that yields the firm the maximum possible profit. That is, price-
output combination that yields the monopolist the maximum profit can be determined
equating marginal cost and marginal revenue curves. In other words MC curve cuts the
marginal revenue curve from below. The equilibrium price is the price corresponding to
the equilibrium output from the demand curve. Consider the following figure:

a
P1

P2 SMC
d
P3

b E

PADM year-II semester-I 2013 E.C Page 70

Microeconomics-I

c
DD or AR

Q1 Q2 Q3
MR
Fig. 4.11 Short- run equilibrium of the monopolist: marginal approach.

Equilibrium output is Q2, where MC and MR curves intersect each other and MC curve
is up ward sloping. Equilibrium price is the price corresponding to the equilibrium
quantity, Q2 (i.e. p2).
Mathematically, the profit maximizing condition of MR = MC and MC is increasing can
be shown as follows.
∏ = TR – TC
∏ is maximized when dπ
=0
dQ
Dπ dTR dTC
That is, = − =0
dQ dQ dQ
 MR – MC = 0
 MR = MC ………………………….. first order condition
The second order condition of profit maximization is
That:
d2 π
≺0
dQ 2
That is, d 2 π d 2 TR d 2 TC
= − ≺0

dMR dMC
dQ2 dQ 2 dQ 2
d 2 TR
=
d ( )
dTR
dQ
=
dMR
− ≺0 (Because dQ 2 dQ dQ and the same for
dQ dQ
MC)
Slope of MR- slope of MC<0
Slope of MC > slope of MR ------- the second order condition
Numerical example
Suppose the monopolist faces a market demand function given by P=40-Q. The firm has
a fixed cost of $ 50 and its variable cost is given as TVC=Q2 determine:

PADM year-II semester-I 2013 E.C Page 71

Microeconomics-I

a) the profit maximizing unit of output and price

b) the maximum profit
Solution
Given: p=40-Q
TFC=50
TVC= Q2
a) equilibrium condition is MR=MC, and slope of MC>slope of MR.
TR=P.Q = (40-Q) Q =40Q- Q2
TC=TFC+TVC =50 + Q2

dTR d (400−Q2 )
Now, MR= = =40−2Q
dQ dQ

dTC d(50+ Q 2 )
MC= = =2 Q
dQ dQ

MR=MC 40-2Q=2Q⟹ 40=4Q⟹ Q=10

Second order condition (sufficient): slope of MR is less than slope of MC (-2<2). The
second order condition is met. Thus, the profit maximizing level of output is10 and
the profit maximizing price is obtained by substituting the profit maximizing quantity
(10) in the demand function.
Thus, P = 40 – Q
P = 40 – 10 = 30
b) The maximum profit is the level of profit obtained from selling 10 units at $ 30 each.
∏ = TR – TC
But TR = P.Q = $ 30 * 10 = $ 300
TC = 50 + Q2 = 50 + 102 = $ 150
The maximum ∏ is thus $ 300 - $ 150 = $ 150.
Exercise:
144
Q=
Suppose the monopolist faces the market demand function given by P2 .The AVC
of the firm is given as AVC = Q ½ and the firm has a fixed cost of $ 5
a) determine equilibrium P&Q

PADM year-II semester-I 2013 E.C Page 72

Microeconomics-I

b) determine the maximum profit

4.3.1.5 Long -Run Equilibrium under Monopoly

In a pure monopoly, entrance into the market by potential competitors is not possible.
Thus, whether or not a monopolist earns a pure profit in short run; no other producer can
enter the market in the hope of sharing whatever pure profit exists. Therefore, pure
economic profit is not eliminated in the long run, as it is in the case of perfect
competition.
4.3.1.6 Monopoly Power
Pure monopoly is rare. It is common to see market in which several firms compete with
one another. Although many firms compete with one another some firms may have
greater monopoly power than the others. Hence they can affect the market price more
than other firms. You may think that firms which share the larger part of the market
supply have greater monopoly power. But this cannot be necessarily true. What matters is
the consumers’ preference for the firm’s product. If most consumers prefer the product of
the firm to other substitutes, the firm has greater monopoly power than other firms in the
market and the firm can slightly increase the price of his commodity being confident that
he will not lose its customers.

4.3.1.7 The multi- plant monopolist

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 than at plant 2.

PADM year-II semester-I 2013 E.C Page 73

Microeconomics-I

Fig. 4.12 Equilibrium of multi plant monopoly

Profit is maximized when MR = MC at each plant. If MR > MC, the firm would do better
by producing more at both plants. Let divide the output of the monopolist in to two
plants. Q1 and C1 be the output and production cost of plant1 and C1 = C1(Q1) and
Q2 and C2 be the output and production cost of plant-2 and C 2 = C2(Q2). All output,
whether they are produced in plant 1 or in plant2 will be sold at uniform market price,
Say P then the total profit of the monopolist is
∏=PQ – C 1 (Q1) – C 2 (Q2 ), where, Q=Q 1+Q2
d ∏ d (PQ ) d C 1
 = − =0 and
dQ 1 d Q1 d Q1
d ∏ d (PQ ) d C 2
 = − =0
dQ 2 d Q2 d Q2
The equilibrium condition is:
 MR1 = MC1, and MR2 = MC2
But MR1 = MR2 because all outputs whether they are produced in plant1 or plant 2 are
sold at the same market price, thus MR1 = MR2 = MR
Then the above equilibrium condition can be written as:
MR = MC1 and
MR = MC2
Equivalently, it can be written as MR = MC1 = MC2

Numerical example

PADM year-II semester-I 2013 E.C Page 74

Microeconomics-I

Suppose Ethiopian Electric Light and Power Corporation (EELPC) is a multi plant
monopolist having two plants, Tekeze plant (plant1) and Fincha plant (Plant2). The
operating costs of the two plants are given as follows:
Tekeze Plant: TC1=10Q12, where Q1-Amount of electric power produced in Tekeze
Fincha plant: TC2 = 20Q22, where Q2 – amount of electric power produced in Fincha and
EELPC estimates the demand for electric power by the following function
P=700–5Q where P- Is price (total in million birr) per Giga watt and
Q– Is the total amount of Giga watt sold (Q = Q1 + Q2)
Note that a Giga watt of electric power, whether it comes from Fincha or Tekeze plant
worth equal price
a) What level of output (electric power) should EELPC produce and what price per Giga
watt should it charge to maximize its profit? How much of the total output should be
produced in each plant?

Solution
a) The equilibrium condition is:
TR = P.Q
= (700 – 5Q) Q = 700Q-5Q2
dTR
MR = dQ = 700- 10Q, where Q = Q1+Q2
Thus, MR = 700 – 10 Q1 – 10 Q2
dTC 1 dTC 2
=20 Q 1
MC1 = dQ 2 MC2 = dQ 2 = 40 Q2
Now the equilibrium occurs when:
700 – 10Q1- 10Q2 = 20Q1 and
700 – 10Q1 – 10Q2 = 40Q2
Re-arranging the above equations and solving for Q1, Q2 and P.
Q1 = 20 giga watts, Q2 = 10 giga watts, thus, Q=Q1+Q2 = 30 giga watt and P=550m birr

4.3.1.8 Price Discrimination

PADM year-II semester-I 2013 E.C Page 75

Microeconomics-I

So far we have considered monopolist that charge the same price to all consumers. Now
let’s consider what would happen if our monopolist suddenly gained the ability to
discriminate price -to charge different prices to different individuals or group of
individuals. If a monopolist can identify group of customers who have different elasticity
of demand, separate them in some way, and limit their ability to resell its product
between groups, it can charge each group a different price. Specifically, it could charge
consumers with less elastic demand [price insensitive group] a higher price and
individuals with more elastic demand [price sensitive group] a lower price level. By
doing so, it will increase total revenue and there by its profit.

In other words, a firm that discriminates price will set a lower price for price sensitive
group and a higher price for the group that is relatively price insensitive.

For example:-
1. Movie theatres give discount to senior citizens and children →movie theatres charge
senior citizens and children at lower price because they have a more elastic demand
for movies [price sensitive].

2. Entrance fee for National Museum of Ethiopia is quite different for students, senior
citizens and foreigner

Economists usually consider three types of price discrimination.

1. First-degree [perfect] price discrimination:-in this case the monopolist sells different
unit of output for different prices and these prices differ from person to person. In
first degree price discrimination pricing depends up on who you are. Under perfect
price discrimination, the seller leaves no consumer surplus to any buyer.

2. Second-degree [non-linear] price discrimination: - this refers to the case when a

monopolist sells different unit of output for different price but, every individual who
buys the same amount will pay the same price. That is, price differs across amount of
output, not across people.

3. Third-degree price discrimination: - It occurs when a monopolist divides his buyers in

to two or more than two sub markets or groups depending on the price elasticity of

PADM year-II semester-I 2013 E.C Page 76

Microeconomics-I

demand and charges a different price in each sub segment. But every unit of output
sold to a given group of people [e.g. students, households] is sold at the same price.

Assumptions [necessary condition for price discrimination]

 The monopolist is assumed to identify at least two groups of people with different
elasticity of demand.
 The consumers in each market are not able to resell in the other market.
 The market should be imperfectly competitive. In other words, the seller of the
product should have some monopoly power to practice price discrimination.
Now the question arises here if a monopolist discriminates price, charging different
prices to different individuals or group of individuals or setting different prices for
different units of output then how does a monopolist determine the optimal price in each
market?

Given
Max. P1 (Q1 ). Q1+ P2 (Q2). Q2−TC(Q1+Q2 ) ....................................... .......... [1]

The equilibrium conditions are given by:-

MR1=MC......in market one and
MR2=MC......in market two ...................................................................................... [2]
Numerical example
Suppose a monopolist sells its commodity in U.S.A and Ethiopian markets. The demand
function for the monopolist’s product in U.S.A market is given as Pu=100-Qu and in
Ethiopian market the demand function is Pe=80-2Qe, where Pu and Qu denote price and
quantity demanded in U.S A and Pe and Qe denote price and quantity demanded in
Ethiopia.
The monopolist has 55 units of the commodity.
a) How many units should be sold in Ethiopia and U.S.A?
b) In which country should the firm charge larger price? Why?
Solutions
a) the monopolist allocates its product in such a why that MRu= MRe
∂TRu ∂T Re
, and , M Re=
MRu = ∂ Qu ∂ Qe
But, TRu = Pu.Qu =(100-Qu) Qu = 100 Qu- Qu2 and

PADM year-II semester-I 2013 E.C Page 77

 Microeconomics-I

TRe = Pe. Qe =(80-2Qe)Qe =80Qe-2Qe2

d ( 100 Qu−Qu 2 )
MRu=
dQu =100-2Qu and

d ( 100 Qe−Qe 2 )
M Re=
dQe )= 80 - 4Qe
The Firm maximizes its revenue when the condition MRu=MRe is fulfilled. That is, it
maximizes its revenue when:
100 -2 Qu =80-4Qe or
2Qu – 4 Qe =20--------------------------- (1
Moreover, we know that Qu + Qe = 55------------------ (2)
Solving equations (1) and (2) simultaneously, we obtain Qu= 40 units and Qe =15 units.
Thus, the monopolist should sell 40 units in U.S.A and 15 units in Ethiopia to maximize
its TR, price in each country. Pu=100–Qu=100-40=$60 and Pe =80-2Qe=80-2(15)=$ 50
a. Hence, the firm should charge higher price in U.S.A. the reason is that the price elasticity
of demand for the firm’s commodity is lower in U.S.A than Ethiopia. That is,
Price elasticity of demand in U.S.A (Eu) is
dQu Pu
Eu= .
dPu Qu = -1* 60/40 = /-3/2/ = 1.5
and price elasticity of demand in Ethiopia is
dQe Pe
Ee= .
dPe Qe = -1 . 50/2 = / -50/2/ =1. 67
Eu < Ee which implies U.S.A. citizens are less sensitive to a price change than Ethiopians
so that the firm can charge higher price in U.S.A. In fact the firm should charge a higher
price in the market having lower price elasticity of demand.

Exercise
Suppose a profit maximizing monopolist produces its out put with total cost [in dollars]
function given by TC=5Q +20 and sells its product in two market segments which are
completely separated from each other and resell is also impossible. The demand curves
for the product in each segment are given by:

q1=55-p1 – The DD function in market 1

PADM year-II semester-I 2013 E.C Page 78

Microeconomics-I

q2=70-2p2 – The DD function in market 2

Then determine,
A. q1, q2, p1, and p2 that maximizes profit
B. Find the elasticity of DD in the two markets
C. Calculate the total profit the monopolist will obtains from its sell in the two markets
[with price discrimination]
D. Find the output and price levels which optimize profit without price discrimination
E. Is the monopolist better off with or without price discrimination

4.3.1.9 Social costs of monopoly: the dead weight loss

In a competitive market, price equals marginal cost of production. 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. But suppose we value the welfare of consumers the
same as that of producers. In aggregate, does monopoly power make consumers and
producers better off or worse off?

Suppose an industry operating under perfectly competitive situation is suddenly

monopolized. We can answer the questions by comparing the consumer and producer
surplus. Graphically, suppose DD represents the market demand curve, MR represents
the corresponding marginal revenue.
p

F
Dead
D weight
pm
MC
A B Ec
Em
pc
C
G Em
MR DD

0 Qm Qc Q

PADM year-II semester-I 2013 E.C Page 79

Microeconomics-I

Fig. 4.13 Welfare loss under Monopoly

The competitive industry should be in equilibrium when P=MC, This condition is

satisfied at prices opc and the equilibrium output is OQc, if the industry were to be
monopolized, the monopoly firm will reach its equilibrium and maximizes its total profit
at the level of output where MR= MC, thus the equilibrium output under monopoly
would be OQm, and the equilibrium price will be OPm.
Here, we use consumers’ and producers’ surplus as a measure of welfare of each.
Thus monopoly results in a welfare loss which is given by the area ( C+B)
This area is called dead weight loss. It is gained neither by producers nor by
consumers.
The other disadvantage (Social cost) of monopoly is that is discourages innovations.
Monopolist may feel secure and have no incentive to innovate new product (technology)
since there are no competitors.

PADM year-II semester-I 2013 E.C Page 80