Micro-Economics

Nishita Raje
 Price Theory
• Price theory examines how the prices of various products are
determined.
• The product pricing explains how the relative prices of house, car,
rice, sugar & thousands of other commodities are determined.
• Price of the commodity depends upon the forces of demand &
supply.
• Demand side covers the HOUSEHOLDS or consumer behaviour
• Supply side covers the FIRMs or producers behaviour.
• Microeconomics also deals with the factor pricing that is rent, wages,
interest & profits for the LAND, LABOR, CAPITAL & ENTERPRISE.
 Micro-Economics
• Microeconomics is the study of how individual agents (i.e. consumers
and firms) in the economy make decisions given scarce
resources(times, money, etc).
• In order to make these decisions, certain weights must be assigned
to different "goods" based on how much the agent values that good.
• These weights are the prices of different goods. They may be relative
to other goods (for example, I might value one banana the same as
two apples and assuming all do so this will reflect in the price) in a
more standardized form (for example: a banana costs 2 rupees and
an apple costs 4 rupees each).
Learning Outcomes

• Modern market economy uses price signals to solve the

complex problems involved in using resources to
produce goods and services that people want.
• The choice between competing demands for scarce
resources.
Learning Outcomes

• Interaction between production, employment, and

consumption decisions.
• Market economy generally delivers outcomes desired
by consumers.
• Governments step in when markets fail to produce
results that are regarded as successful.
 ECONOMIC ISSUES AND CONCEPTS

The Complexity of the Modern Economy

• A market economy is self-organizing in the sense that when
individuals act independently to pursue their own self-interest,
responding to prices set on open markets, they produce co-
ordinated and relatively efficient economic activity.
 ECONOMIC ISSUES AND CONCEPTS

Resources and Scarcity

• Scarcity is a fundamental problem faced by all economies
because not enough resources - land, labour, capital, and
entrepreneurship - are available to produce all the goods and
services that people would like to consume.
• Scarcity makes it necessary to choose among alternative
possibilities: what products will be produced and in what
quantities.
 ECONOMIC ISSUES AND CONCEPTS

• The concept of opportunity cost emphasises scarcity and choice

by measuring the cost of obtaining a unit of one product in
terms of the number of units of other products that could have
been obtained instead.
• A production-possibility boundary shows all of the combinations
of goods that can be produced by an economy whose resources
are fully employed.
• Movement from one point to another on the boundary shows a
shift in the amounts of goods being produced, which requires a
reallocation of resources.
 ECONOMIC ISSUES AND CONCEPTS

Who Makes the Choices and How

• Modern economies are based on the specialization and division of
labour, which necessitate the exchange of goods and services.
• Exchange takes place in markets and is facilitated by the use of
money.
• Much of economics is devoted to a study of how markets work to co-
ordinate millions of individual, decentralized decisions.
• Three pure types of economy can be distinguished: traditional,
command, and free market.
• In practice, all economies are mixed economies in that their
economic behaviour responds to mixes of tradition, government
command, and price incentives.
 ECONOMIC ISSUES AND CONCEPTS

• Governments play an important part in modern mixed

economies.
• They create and enforce important background institutions
such as private property.
• They intervene to increase economic efficiency by
correcting situations where markets do not effectively
perform their co-ordinating functions.
• They also redistribute income and wealth in the interests of
equity.
 A Production-Possibility Boundary

Unattainable combinations

Production possibility
boundary
Attainable
combinations

0
Quantity of public sector goods
 A Production-Possibility Boundary

Unattainable combinations
c0 a

Production possibility
boundary
Attainable
combinations

0 g0

Quantity of public sector goods

 A Production-Possibility Boundary

Unattainable combinations
c0 a
•d

Production possibility
boundary
Attainable
combinations

c1 b
c

0 g0 g1

Quantity of public sector goods

 A Production-Possibility Boundary

Unattainable combinations
c0 a
•d

Production possibility
C boundary
Attainable
combinations

c1 b
c
G

0 g0 g1

Quantity of public sector goods

 A production-possibility boundary

• The quantity of public sector goods produced is measured along the

horizontal axis.
• The quantity of private sector goods is measured along the vertical axis.
• Any point on the diagram indicates some amount of each kind of good
produced.
• The production-possibility boundary separates the attainable
combinations, such as a, b, and c, from unattainable combinations, such
as d.
• Points a and b represent efficient uses of society’s resources.
• Point c represents either an inefficient use of resources or a failure to use
all the resources that are available.
A production-possibility boundary

• The boundary is negatively sloped because in a fully employed economy

more of one good can be produced only if resources are freed by
producing less of other goods.
• Moving from point a (with coordinates c0 and g0) to point b (with
coordinates c1 and g1) implies producing an additional amount of public
sector goods, indicated by G in the figure
• The opportunity cost of this increase in G is a reduction in private sector
goods by the amount indicated by C.
The effect of economic growth on the
production possibility boundary

• Economic growth shifts the boundary outwards.

• Some combinations of goods that were previously
unattainable become attainable.
 The Effect of Economic Growth on the Production-Possibility Boundary

Production possibility
boundary before growth

Quantity of public sector goods

0
 The Effect of Economic Growth on the
Production-Possibility Boundary

a
d Production possibility
boundary after growth

Production possibility b
boundary before growth

0
Quantity of public sector goods
 Determinants of Demand
• LAW OF DEMAND
• If Price increases, then Quantity
Demanded decreases. If Price
decreases, then Quantity Demanded
increases. (movement along the Curve)
• DETERMINANTS OF DEMAND
• Consumer Income ,
• Consumer Tastes and Preference
• Price of Substitute Good
• Price of Complementary Good
• Number of Buyers
• Consumer Future Expectations
• Changes in demand determinants will
shift the Demand Curve.
EXAMPLE: If Consumer Income increases, then Demand will
increase.
The Ceteris Paribus Assumption

A demand curve or a supply curve is a relationship between

two, and only two, variables: quantity on the horizontal axis
and price on the vertical axis. The assumption behind a
demand curve or a supply curve is that no relevant economic
factors, other than the product’s price, are changing.
Economists call this assumption ceteris paribus, a Latin
phrase meaning “other things being equal.” Any given demand
or supply curve is based on the ceteris paribusassumption that
all else is held equal.
 DEMAND Schedule
Alisha’s Demand Schedule Demand Curve

Point on DD Price [Rs per dozen] Quantity demanded

[dozen per month]
3.00 f
a 0.50 7.0 e
b 1.00 5.0 2.50
c 1.50 3.5 d
d 2.00 2.5 2.00
e 2.50 1.5 c
f 3.00 1.0 1.50
b
1.00
a
0.50

1 2 3 4 5 6 7
Quantity of Bananas [dozen per month]
DETERMINANTS OF DEMAND
• Consumer Income --> rightward shift in DD curve
Price

Quantity Demanded per unit of Time

Rightward Shift(RWS)
Changes in demand determinants will shift the Demand Curve:
• Rise in Income
• Consumer Tastes and Preference shift towards this commodity
• Price of Substitute Good Rises
• Price of Complementary Good Falls
Market Demand Curve RWS
• A redistribution of income towards those who favour the commodity
• Number of Buyers
• Consumer Future Expectations.
Leftward Shifts in the demand curve

• When the demand curve shifts from D0 to D2, less is

demanded at each price.
• Such a decrease in demand can be caused by:

• a fall in the price of a substitute

• a rise in the price of a complement,
• a fall in income
• a redistribution of income away from groups that
favour the commodity
• a change in tastes that dis-favours the commodity.
Note
• A rise in the price of a product’s substitute shifts the demand curve
for the product to the right. More will be purchased at each price.

• A fall in the price of one product that is complementary to a second

product will shift the second product’s demand curve to the right.
More will be purchased at each price.
Note
• A rise in the price of a product’s substitute shifts the demand curve
for the product to the right. More will be purchased at each price.

• A fall in the price of one product that is complementary to a second

product will shift the second product’s demand curve to the right.
More will be purchased at each price.
 What is a Demand Function?

• “The functional relationship between the quantity of a

commodity that a consumer is willing to buy and the factors that
influence the demand of (or willingness to buy) that commodity”

• D = Function of (Own Price, Price of Substitutes, Price of

Complements, Income of the Household, Taste, Fashion)
Characteristics of Demand
1. Dynamic in nature: Demand is dynamic in nature. It means that demand for a commodity does not
remain the same all the time. Different factors affect the demand for a commodity, and hence, an
organization has to consider every factor to fulfill the present demand of the consumers.
2. Expressed with respect to time period: Demand for a commodity is expressed with reference to time.
Even though the price of a commodity is the same, the demand may change in an hour, day, month, or
year.
3. Depends on price: Demand for a commodity is price sensitive. It means that if the price of a commodity
change, its demand will also change. Generally, there is an inverse relationship between the price and
demand of a commodity. If the price of a commodity increases, its demand will fall, and vice-versa.
4. Sensitive to the competition: Demand for a commodity is affected by competition in the market. If a
manufacturer has a monopoly on a product in the market, its demand will be at its peak, and the
company can sell the product at any price they want. However, if there are numerous manufacturers in
the market, there will be high competition, and the value of the product will decrease in the market.
 Individual and Market Demand
• Individual Demand
• Individual demand for a commodity is the quantity demanded by a
consumer and his willingness and ability to purchase at every possible
price at a given time period. For example, Ram has a demand of 20 units
per month of a commodity X at the rate of ₹50.
• Market Demand
• Market demand for a commodity is the quantity demanded by all
consumers of the market, along with their willingness and ability to pay for
the commodity at each possible price during the given time period. For
example, there are six consumers of commodity X, and their consumption
in a month is 10, 20, 25, 30, 40, and 50, respectively. Hence, the market
demand for X will be 175 .
Determinants of Market 1) Price of the Product
Demand
2) Price of the Related Goods
3) Consumer's Income
The market demand for a 4) Consumer's taste and preference
commodity depends on various
factors. These factors are as 5) Advertisement Expenditure
follows:
6 Consumers' Expectations
7) Consumer-Credit Facility
8) Population of the Country
9) Distribution of National Income
Convincing Vs Taxation of cigarettes
Supply
• We now look at the supply side of markets. The suppliers are firms,
which are in business to make the goods and services that consumers
want to buy.
• The amount of a product that firms are able and willing to offer for
sale is called the quantity supplied.
• Supply is a desired flow: how much firms are willing to sell per period
of time, not how much they actually sell.
Firms Level motives
• Economic theory gives firms several attributes.

• Firstly, each firm is assumed to make consistent decisions, as though it was run by a
single individual decision-maker.

• Secondly, firms hire workers and invest capital and entrepreneurial talent in order to
produce goods and services that consumers wish to buy.

• Thirdly, firms are assumed to make their decisions with a single goal in mind: to make as
much profit as possible.
• DETERMINANTS OF SUPPLY
• LAW OF SUPPLY
• If Price increases, then Quantity
Supplied increases.
If Price decreases, then Quantity Supplied
decreases.
• SHIFTS in Supply Curve
• Input Costs
Technology and Productivity Taxes and
Subsidies Producer Future Expectations
Number of Suppliers
• Changes in supply determinants will shift
the Supply Curve.

• EXAMPLE: If Input Costs increase (it

costs more to make a product), then
Supply will decrease (producers have to
spend more to make a product and have
to cut back on production).
Market
Supply
Curve
 Equilibrium

• The market supply curve SS shows how

much of the commodity firms would wish S
to supply at different prices, and the D
demand curve DD tells us how much of
the commodity, the consumers would be
willing to purchase at different prices.
• Graphically, an equilibrium is a point
where the market supply curve
intersects the market demand curve
because this is where the market
demand equals market supply.
Questions
1. Distinguish between quantity demanded and
demand and explain what determines demand.
2. Distinguish between quantity supplied and
supply and explain what determines supply.
3. Explain how demand and supply determine
price and quantity in a market and explain the
effects of changes in demand and supply.
 Shift in Demand

The demand for a product changes due to an alteration in any of the

following factors:
• Price of complementary goods
• Price of substitute goods
• Income
• Tastes and preferences
• An expectation of change in the price in future
• Population
 Shift in Supply

The supply of product changes due to an alteration in any of the

following factors:
• Prices of factors of production
• Prices of other goods
• State of technology
• Taxation policy
• An expectation of change in price in future
• Goals of the firm Profit maximisation to Sales maximisation
• Number of firms
Shifts in the supply curve
• A shift in the supply curve from S0 to S1 indicates more is supplied at
each price.
• Such an increase in supply can be caused by:
• Improvements in the technology of producing the commodity
• A fall in the price of inputs that are important in producing the
commodity
• A shift in the supply curve from S0 to S2 indicates less is supplied at each
price.
• Such a decrease in supply can be caused by:
• A rise in the price of inputs that are important in producing the
commodity.
• Changes in technology that increase the costs of producing the
commodity (rare).
 The ‘Laws’ of Demand and Supply and Shifts

S0
D1
S D S1
D0

E1
E0
p1
E0 p0 E1
p0
p1

q1 Quantity q0 q1 Quantity
q0
[i]. The effects of shifts in the demand curve [ii]. The effects of shifts in the supply curve
Elasticity

Nishita Raje
 Introduction to Elasticity
• The demand and supply analysis helps us to understand the direction
in which price and quantity would change in response to shifts in
demand or supply.
• What economists would like to know is ‘what will happen to
demand/supply when price changes?’
• What will happen to the amount spent on the good or the revenue
received by the seller
Elasticity of Demand
A measure of the
What is price elasticity responsiveness of What is price §more money is made
of demand? quantity demanded to elasticity of Supply per unit
a price change

You measure the

How do I measure a
How do I measure percent change in
§fewer units are sold percent change in
responsiveness? quantity demanded
quantity?
when price changes

You take the difference

between the two
quantities and divide
by the original number
 Price elasticity of demand = % change in quantity

Price Elasticity % change in price

of Demand
Point elasticity
Elasticity of Demand

Inelastic demand or price inelastic < 1 is

when change in price results in only a
Price elastic Demand when price small change in quantity demanded. I
increases and there is a net loss in Examples of this are necessities like food
revenue, the demand curve is price and fuel. Consumers will not reduce
elastic > 1 their food purchases if food prices rise,
although there may be shifts in the types
of food they purchase.
In this Chapter
• We extend our understanding of supply and demand and consider the
following:
• How the sensitivity of quantity demanded to a change in price is measured by the
elasticity of demand and what factors influence it.
• How elasticity is measured at a point or over a range.
• How income elasticity is measured and how it varies with different types of goods.
• How elasticity of supply is measured and what it tells us about conditions of production.
• Some of the difficulties that arise in trying to estimate various elasticities from sales
data.
 Price Elasticity of Demand

Price elasticity of demand = % change in quantity

% change in price

Point elasticity
 Arch Elasticity
• The formula used here for computing elasticity of demand is:
(Q1 – Q2) / (Q1 + Q2)
(P1 – P2) / (P1 + P2)
• If the formula creates an absolute value greater than 1, the
demand is elastic. In other words, quantity changes faster
than price. If the value is less than 1, demand is inelastic. In
other words, quantity changes slower than price.
 Unit Elasticity
• If the number for Price Elasticity of Demand is equal to 1, elasticity of
demand is unitary.
• In other words, quantity changes at the same rate as the price

• Price elasticity of demand = % change in quantity =1

• % change in price
 Elasticity of Demand
What is price elasticity of demand?
A measure of the responsiveness of quantity demanded to a price change

What is price elasticity of Supply

▪more money is made per unit
▪fewer units are sold

How do I measure responsiveness?

You measure the percent change in quantity demanded when price changes

How do I measure a percent change in quantity?

You take the difference between the two quantities and divide by the original
number
 Elasticity of Demand
Price elastic Demand when price increases and there
is a net loss in revenue, the demand curve is price
elastic > 1
Inelastic demand or price inelastic < 1 is when change in
price results in only a small change in quantity demanded. I
Examples of this are necessities like food and fuel.
Consumers will not reduce their food purchases if food
prices rise, although there may be shifts in the types of food
they purchase.
 Unit Elasticity
• If the number for Price Elasticity of Demand is equal to 1, elasticity of
demand is unitary.
• In other words, quantity changes at the same rate as the price

• Price elasticity of demand = % change in quantity =1

• % change in price
 If the percentage change in
quantity demanded divided by
It is known as: Which means:
the percentage change in price
equals:

Types of Price Infinity Perfectly elastic

Changes in price result in
demand declining to zero

Elasticity of Greater than 1 Elastic

Changes in price yield a
significant change in demand
Demand Changes in price yield
1 Unitary equivalent (percentage)
changes in demand
Changes in price yield an
Less than 1 Inelastic insignificant change in
demand
Changes in price yield no
0 Perfectly inelastic
change in demand
Elastic Part of the Demand Curve
Understanding price elasticity
• The value of price elasticity of demand ranges from zero to minus
infinity.
• In this section, however, we concentrate on absolute values, and so
ask by how much the absolute value exceeds zero.
• Elasticity is zero if quantity demanded is unchanged when price
changes, namely when quantity demanded does not respond to a
price change.
Nature of Product and elasticity

• What makes a product elastic? If a price change for a product causes a substantial
change in either its supply or its demand, it is considered elastic. Generally, it means that
there are acceptable substitutes for the product. Examples would be cookies, luxury
automobiles, and coffee.

• What makes a product inelastic? If a price change for a product doesn’t lead to much, if
any, change in its supply or demand, it is considered inelastic. Generally, it means that
the product is considered to be a necessity or a luxury item for addictive constituents.
Examples would be gasoline, milk, and iPhones.

• What is the importance of price elasticity of demand? Knowing the price elasticity of
demand for goods allows someone selling that good to make informed decisions about
pricing strategies. This metric provides sellers with information about consumer pricing
sensitivity. It is also key for makers of goods to determine manufacturing plans, as well as
for governments to assess how to impose taxes on goods.
Note!
• 1. When elasticity of demand exceeds unity (demand is elastic), a fall in price
increases total spending on the good and a rise in price reduces it.
• 2. When elasticity is less than unity (demand is inelastic), a fall in price
reduces total spending on the good and a rise in price increases it.
• 3. When elasticity of demand is unity, a rise or a fall in price leaves total
spending on the good unaffected.
 Price inelasticity implies that Demand remains relatively
changes in price result in stable despite price
proportionally smaller fluctuations, indicating
changes in quantity consumers are less
demanded. responsive to price changes.

Price increases may lead to a

Factors like substitutes,
Inelastic moderate decrease in total
revenue, while price
consumer behavior shifts,
and market saturation can
decreases might lead to a
demand limited increase in total
revenue.
influence the impact of price
inelasticity on demand.

It's important for companies

to properly assess their
product's characteristics, as
price elasticity often works
opposite of price inelasticity.
Summary
Elasticity
& Tax
Supply Curve
Elasticity of Supply
Elasticity of
Supply
 Change in Technology
Traditional business analytics has undergone technological changes thanks to the internet
revolution, cloud computing and the shift to self-service analytics, contributing to the
recent rise of embedded analytics in business operations. Embedded analytics involves
embedding and integrating visualizations, dashboards, reports or predictive analytics in
everyday business applications.
Digital age has ushered in a new era where consumers crave additional information and
hold higher expectations. Management seeks quick responses and analysts demand
immediate access to data without any delays.
Companies depend on different software and capabilities to perform business analytics.
To create a dashboard manually, professionals may need to open individual HR, CRM, BI
and data visualization software separately.
When these dashboards are all integrated into a single surface, business leaders are
finding that analysis becomes more accessible and fluid for users, increasing efficiency in
scores of workflows along the way.
Effect on Employment Decrease in DD for analysts and rise in DD for AI experts
Market Equilibrium and Shifts
Impact of Elasticity of the Supply Curve on
the Impact of a Shift in the Demand Curve
Impact of Elasticity of the Supply Curve on
the Impact of a Shift in the Demand Curve
Some Concepts Revised
Interventions
in the
market
 The ‘Laws’ of Demand and Supply and Shifts

S0
D1
S D S1
D0

E1
E0
p1
E0 p0 E1
p0
p1

q1 Quantity q0 q1 Quantity
q0
[i]. The effects of shifts in the demand curve [ii]. The effects of shifts in the supply curve
Shifts in the supply curve
• A shift in the supply curve from S0 to S1 indicates more is supplied at
each price.
• Such an increase in supply can be caused by:
• Improvements in the technology of producing the commodity
• A fall in the price of inputs that are important in producing the
commodity
• A shift in the supply curve from S0 to S2 indicates less is supplied at each
price.
• Such a decrease in supply can be caused by:
• A rise in the price of inputs that are important in producing the
commodity.
• Changes in technology that increase the costs of producing the
commodity (rare).
The laws of demand and supply (i)
shifts in demand
• The original curves are D0 and S, which intersect to produce
equilibrium at E0.
• Price is p0, and quantity q0.
• An increase in demand shifts the demand curve to D1.
• Price rises to p1 and quantity rises to q1 taking the new equilibrium to
E1.
• A decrease in demand now shifts the demand curve to D0.
• Price falls to p0 and quantity falls to q0 taking the new equilibrium to
E0.
• Thus, an increase in demand raises both price and quantity while a
decrease in demand lowers both price and quantity.
The laws of demand and supply (ii)
shifts in supply
• The original demand and supply curves are D and S0, which intersect
to produce an equilibrium at E0, price p0 and quantity q0.
• An increase in supply shifts the supply curve to S1. Price falls to p1
and quantity rises to q1, taking the new equilibrium to E1.
• A decrease in supply shifts the supply curve back to S0. Price rises to
p0 and quantity falls to q0 taking the new equilibrium to E0.
• Thus an increase in supply raises quantity but lowers prices while a
decrease in supply lowers quantity but raises price.
Note!
• 1. When elasticity of demand exceeds unity (demand is elastic), a fall in price
increases total spending on the good and a rise in price reduces it.
• 2. When elasticity is less than unity (demand is inelastic), a fall in price
reduces total spending on the good and a rise in price increases it.
• 3. When elasticity of demand is unity, a rise or a fall in price leaves total
spending on the good unaffected.
What determines elasticity of demand?

• The main determinant of elasticity is the availability of substitutes.

• Closeness of substitutes—and thus measured elasticity —depends
both on how the product is defined and on the time period under
consideration.
 Elasticity on a Linear Demand Curve

• Starting at point A and moving to point B, the ratio p/q is the

slope of the line.
• Its reciprocal q/p is the first term in the percentage definition of
elasticity.
• The second term in the definition is p/q, which is the ratio of the
coordinates of point A.
• Since the slope p/q is constant, it is clear that the elasticity along
the curve varies with the ratio p/q.
• This ratio is zero where the curve intersects the quantity axis and
‘infinity’ where it intersects the price axis.
Three Constant-elasticity Demand Curves

D0 D1

D2

Quantity
Note!

A product with close substitutes tends to have an elastic demand; one

with no close substitutes tends to have an inelastic demand.
 Total and Marginal Utility Schedules

Number of films Total utility Marginal utility

attended per month
0 0.00

1 15.00 15.00

2 25.00 10.00

3 31.00 6.00

4 35.00 4.00

5 37.50 2.50

6 39.00 1.5

7 40.25 1.25

8 41.30 1.05

9 42.20 0.90

10 43.00 0.80
 Total and Marginal Utility Schedules

• As consumption increases, total utility rises but marginal

utility falls.
• The marginal utilities are the changes in utility when
consumption is altered by one unit.
• For example, the marginal utility of 10m, shown in the
entry in the last column, arises because with attendances
at the second film total utility increase from 15 to 25 a
difference of 10.
• The data in this table are plotted in the following figure.
 Total and Marginal Utility Curves

50

20
40

30 15

20 10

10 5

0 2 4 6 8 10 0 2 4 6 8 10
Quantity of films [attendance per month]

[i]. Increasing total utility [ii]. Diminishing marginal utility

 Consumer’s Surplus for an Individual

3.00

2.00

1.00 Market price

0.30

1 2 3 4 5 6 7 8 9 10
Glasses of milk consumed per week
 Consumer’s Surplus for an Individual

• Consumer’s surplus is the sum of the extra valuations placed on

each unit above the market price paid for each.
• This figure is based on the data in the table.Ms.
• Green pays the red area for the 8 glasses of milk she consumes per
week when the market price is £0.30 a glass.
• The total value she places on these 8 glasses of milk is the entire
shaded area (red and green).
• Hence her consumer’s surplus is the green area.
 Consumers’ Surplus for the Market

0 Quantity
 Consumers’ Surplus for the Market

Market price

p0

0 Quantity q0
 Consumers’ Surplus for the Market

• The area under the demand curve shows the total valuation that
consumers place on all units consumed.
• For example, the total value that consumers place on q0 units is the
entire area shaded red and green under the demand curve up to
q0.
• At a market price of p0 the amount paid for q0 units is the red area.
• Hence consumers surplus is the green area under the demand
curve and above p0.
MARGINAL UTILITY

The Utility Theory of Demand

• Marginal utility theory distinguishes between the total utility
that each consumer gets from the consumption of all units of
some product and the marginal utility each consumer obtains
from the consumption of one more unit of the product.
• The basic assumption in utility theory is that the utility the consumer
derives from the consumption of successive units of a product diminishes
as the consumption of that product increases.
• Each consumer reaches a utility-maximizing equilibrium when the utility
he or she derives from the last £1 spent on each product is equal.
 MARGINAL UTILITY

• Another way of putting this is that the marginal utilities

derived from the last unit of each product consumed will be
proportional to their prices.
• Demand curves have negative slopes because when the
price of product X falls, each consumer restores equilibrium
by increasing his or her purchases of X.
• The increase must be enough to lower the marginal utility
of X until its ratio to the new lower price of X is the same as
it was before the price fell.
• This restores the equality of the ratio to what it is for all
other products.
 MARGINAL UTILITY

Consumers’ Surplus
• Consumers’ surplus is the difference between [1] the value
consumers place on their total consumption of some
product and [2] the actual amount paid for it.
• The first value is measured by the maximum they would
pay for the amount consumed rather than go without it
completely.
• The second is measured by market price times quantity.
 MARGINAL UTILITY

• It is important to distinguish between total and marginal

values because choices concerning a bit more and a bit less
can not be predicted from knowledge of total values.
• The paradox of value involves confusion between total and
marginal values.
• Elasticity of demand is related to the marginal value that
consumers place on having a bit more or a bit less of some
product; it bears no necessary relationship to the total value
that consumers place on all of the units consumed of that
product.
 Bundles Conferring Equal Satisfaction

Bundle Clothing Food

A 30 5

B 18 10

C 13 15

D 10 20

E 8 25

F 7 30
Bundles Conferring Equal Satisfaction

35
a
30

25
g
20 b

15
c
d
10 e f
h T
5

5 10 15 20 25 30 35
Quantity of food
 Bundles Conferring Equal Satisfaction

• None of the bundles in the table are obviously superior to any of the
others in the sense of having more of both commodities.
• Since each of the bundles shown in the table give the consumer equal
satisfaction, he is indifferent between them.
• The data in this table are plotted in the corresponding figure.
 An Indifference Map

I5
I4
I3
I1 I2

0 Quantity of food per week

 An Income-consumption Line

Income-consumption line

Quantity of clothing per week

E3

E2

E1

I3

I2

I1

0 Quantity of food per week

 An Income-consumption Line

• This line shows how a consumer’s purchases react to changes in

income with relative prices held constant.
• Increases in income shift the budget line out parallel to itself, moving
the equilibrium from E1 to E2 to E3.
• The blue income-consumption line joins all these points of
equilibrium.
Derivation of an Individual’s Demand Curve

Price-consumption line
E2
E1
E0
I2
I0 I1

0 60 120 220 267 400 800

[i] Petrol [litres per month]

0.75 x

y
0.50 Demand curve

0.25 z

0 60 120 220
Consumer Surplus
 Utility Function
U(y): total
utility of
Mangoes1.75 U(y) = y.5

1.5 C
B
1.0
A

1 2 3
y, weekly consumption of Mangoes
Slopes on A and C give marginal utility – each additional unit makes person happy
but by less than the previous unit 114
Additional unit of Consumption
• All units of the same product are identical but the satisfaction that a
consumer gets from each unit of a product in not the same.
• This suggests that the satisfaction that people get from consuming a
unit of any product varies according to how many of this product they
have already.
Marginal Utility
Marginal Utility: Rate at which total utility changes as
the level of consumption rises.
▪ Each new mango makes you happier, but makes you
happier by smaller and smaller amount.

U U
MUy = = = Slope of the utility curve
y y

116
Marginal and total utility
• The satisfaction a consumer receives from consuming that product is
called utility.
• Total utility refers to the total satisfaction derived from all the units
of that product consumed.
• Marginal utility refers to the change in satisfaction resulting from
consuming one unit more or one unit less of that product.
Maximising utility
• Consumers will maximize their overall satisfaction when the marginal utility per pound
spent is equal for all products purchased.
• A theory of demand can be built by focusing on bundles of goods between which the
consumer is indifferent.
• Indifference curves show combinations of goods that give the same level of satisfaction.
• A budget constraint shows what the consumer could buy with a given income.
• A consumer optimizes by moving to the highest indifference curve that is available with a
given budget constraint.
Marginal Utility (more than one good)
• The marginal utility: of a good, x, is the additional utility that the
consumer gets from consuming a little more of x when the
consumption of all the other goods in the consumer’s basket remain
constant.
U/x (y held constant) = MUx=∂ U/∂ x
U/y (x held constant) = MUy =∂ U/∂ y
• …or…the marginal utility of x is the slope of the utility function with
respect to x.
• The principle of diminishing marginal utility: states that the
marginal utility falls as the consumer consumes more of a good

119
Marginal Utility
MU(y): -If more is always better: marginal utility must
marginal always be positive.
utility of -Diminishing marginal utility
mangoes1.00
-A positive marginal utility means you like the good.

.50
.25

1 2 3
y, weekly consumption of muffins
120
Diminishing marginal utility
• A basic assumption of utility theory, which is sometimes called the
law of diminishing marginal utility, is as follows:

The marginal utility generated by additional units of any product

diminishes as an individual consumes more of it, holding constant
the consumption of all other products.
 Total and Marginal Utility Schedules

Number of films Total utility Marginal utility

attended per month
0 0.00

1 15.00 15.00

2 25.00 10.00

3 31.00 6.00

4 35.00 4.00

5 37.50 2.50

6 39.00 1.5

7 40.25 1.25

8 41.30 1.05

9 42.20 0.90

10 43.00 0.80
Maximizing utility
• We can now ask: what does diminishing marginal utility imply for the
way a consumer who has a given income will allocate spending in
order to maximize total utility?
• How should a consumer allocate his or her income in order to get the
greatest possible satisfaction, or total utility, from that spending?
• If all products had the same price, the answer would be easy.
• A consumer should simply allocate spending so that the marginal
utility of all products was the same.
• If the marginal utility of all products were not equal then total utility
could be increased by a different spending pattern.
For example!
• If one product had a higher marginal utility than the others, then
expenditure should be reallocated so as to buy more of this product,
and less of all others that have lower marginal utilities.
• By buying more, its marginal utility would fall. This continues until the
consumer's utility equates to his/her expenditure and utility is
maximized.
• How does this work if products have different prices?
• Again, the same principles apply but now the best a consumer can do
is to rearrange spending until the last unit of satisfaction per pound
spent on each product is the same.
Note!

To maximize utility consumers allocate spending between products so

that equal utility is derived from the last unit of money spent on
each.
Conditions for maximising utility
• The conditions for maximizing utility can be stated more generally.
• Denote the marginal utility of the last unit of product X by MUX and
its price by pX.
• Let MUY and pY refer, respectively, to the marginal utility of a second
product, Y, and its price.
• The marginal utility per pound spent on X will be MUX/pX.
Equi-Marginal Utility of the last Rupee spent
• The condition required for any consumer to maximize utility is that
the following relationship should hold, for all pairs of products:
Note!
• This is the fundamental equation of utility theory.
• Each consumer demands each good up to the point at which the
marginal utility per pound spent on it is the same as the marginal
utility of a pound spent on each other good.
• When this condition is met, the consumer cannot shift a pound of
spending from one product to another and increase total utility.
 Consumers choose quantities not
prices
• If we rearrange the terms in previous equation we can gain additional
insight into consumer behaviour:
• The right-hand side of this equation states the relative price of the
two goods.
• It is determined by the market and is beyond the control of individual
consumers, who react to these market prices but are powerless to
change them.
• The left-hand side of the equation states the relative contribution of
the two goods to add to satisfaction if a little more or a little less of
either of them were consumed, a choice that is available.
Income Elasticity of Demand
 The Relation Between Quantity Demanded and Income

Quantity

0
Income
 The Relation Between Quantity Demanded and Income

qm

Positive income elasticity

Quantity

Zero income
elasticity
Negative income elasticity
[inferior good]

y1 y2 Income
0
The Relation Between Quantity Demanded and Income

• Normal goods have positive income elasticities.

• Inferior goods have negative elasticities.
• Nothing is demanded at income less than y1, so for incomes below y1
income elasticity is zero.
• Between incomes of y1 and y2 quantity demanded rises as income rises,
making income elasticity positive.
• As income rises above y2, quantity demanded falls from its peak at qm,
making income elasticity negative.
Income Elasticity
 Three Constant-elasticity Supply Curves

S1 [ii]. Infinite Elasticity

[i]. Zero Elasticity

S2
p1

Quantity

q1 Quantity S3

p [iii]. Unit Elasticity

q p

Quantity
 Three Constant-elasticity Supply Curves

• Curve S1, has a zero elasticity, since the same quantity q1, is supplied
whatever the price.
• Curve S2 has an infinite elasticity at price p1; nothing at all will be
supplied at any price below p1, while an indefinitely large quantity
will be supplied at the price of p1.
• Curve S3, as well as all other straight lines through the origin, has a
unit elasticity, indicating that the percentage change in quantity
equals the percentage change in price between any two points on the
curve.
Other demand elasticities
• The concept of demand elasticity can be broadened to measure the
response to changes in any of the variables that influence demand.
• Income elasticity of demand
• Cross elasticity of demand
Cross-elasticity
• The responsiveness of quantity demanded of one product to changes
in the prices of other products is often of considerable interest.
Learning Outcomes
• In particular, you will learn that:
• Consumers will maximize their overall satisfaction when the marginal utility per pound
spent is equal for all products purchased.
• A theory of demand can be built by focusing on bundles of goods between which the
consumer is indifferent.
• Indifference curves show combinations of goods that give the same level of satisfaction.
• A budget constraint shows what the consumer could buy with a given income.
• A consumer optimizes by moving to the highest indifference curve that is available with a
given budget constraint.
Production, Costs and Profits
• The production function relates inputs of factor services to outputs.
• In addition to what firms count as their costs, economists include the
imputed opportunity costs of owners’ capital.
• This includes the pure return, what could be earned on a riskless
investment, and a risk premium, what could be earned over the pure
return on an equally risky investment.
• Pure or economic profits are the difference between revenues and all
these costs.
• Pure profits play a key role in resource allocation.
• Positive pure profits attract resources into an industry; negative pure
profits induce resources to move elsewhere.
Costs in the Short Run
• Short run variations in output are subject to the law of diminishing
returns:
• Equal increments of the variable input sooner or later produce
smaller and smaller additions to total output and, eventually, a
reduction in average output per unit of variable input.
• Short-run average and marginal cost curves are U-shaped, the rising
portion reflecting diminishing average and marginal returns.
• The marginal cost curve intersects the average cost curve at the
latter’s minimum point, which is called the firm’s capacity output.
• There is a family of short-run average and marginal cost curves, one
for each amount of the fixed factor.
Introduction
• Economics seeks to understand many important issues in the world
around us and ask the following questions, amongst others:
• What makes some countries grow richer when others seem to get poorer?
• Why do we sometimes have recessions?
• When should the government try to influence markets? What are the costs and benefits
of globalization?
• Will some new technology eliminate many jobs?
• In order to get a handle on such big issues, economists have
developed ways of setting out and testing their theories
• They also seek to use what they have learned in order to provide
advice on how things could be improved.
Learning outcomes
• By the end of the lecture you should have a good understanding of:
• The difference between positive and normative statements
• How economists set out their theories
• How economic data are handled and graphed
• How economic relationships are represented in diagrams.
Positive and normative statements
• Economists give advice on a wide variety of topics. Advice comes in
two broad types:
• Normative
• Positive
Normative advice
• Normative advice depends upon a value judgement and it tells others
what they ought to do.
Positive advice
• Positive advice is where the adviser is saying, ‘If this is what you want
to do, then here are ways of doing it.’
Positive and Normative statements
• It is difficult to have a rational discussion of issues if positive and
normative issues are confused.
• Much of the success of modern science depends on the ability of
scientists to separate their views on what does, or might, happen in
the world, from their views on what they would like to happen.
Note!

Distinguishing what is true from what we would like to be, or what

we feel ought to be, depends to a great extent on being able to
distinguish between positive and normative statements.
To clarify
• Normative statements depend on value judgments. They involve
issues of personal opinion, which cannot be settled by recourse to
facts.
• In contrast, positive statements do not involve value judgments.
They are statements about what is, was, or will be; that is, statements
that are about matters of fact.
Economic theorizing
• In order to address the problems that we face economists have
developed an approach that involves developing theories and
building models.
• These help the economist to understand problems and find realistic
and practical solutions where possible!
Theories
• Theories are constructed to explain things!
• These theories are built around definitions, assumptions, and
predictions.
• They simplify the problem in hand and allow the economist to
observe the problem first hand.
Definitions
• The basic elements of any theory are its variables.
• A variable is a magnitude that can take on different possible values.
 Endogenous and exogenous
variables
• An endogenous variable is a variable that is explained within a
theory.
• An exogenous variable influences endogenous variables but is itself
determined by forces outside the theory.
Assumptions
• A theory’s assumptions concern motives, physical relationships, lines
of causation, and the conditions under which the theory is meant to
apply, as well as the direction of causation!
• The variable that does the causing is called the independent variable
and the variable that is caused is called the dependent variable.
Predictions
• A theory’s predictions are the propositions that can be deduced from
it.
• These propositions are then taken as predictions about real-world
events.
Models
• Economists often proceed by constructing what they call economic
models.
• More often, a model means a specific quantitative formulation of a
theory.
• The term ‘model’ is often used to refer to an application of a general
theory in a specific context.
Evidence
• Economists make much use of evidence, or, as they usually call it,
empirical observation.
• Such observations can be used to test a specific prediction of some
theory and to provide observations to be explained by theories.
Testing the evidence
• A theory is tested by confronting its predictions with evidence.
• Are events of the type contained in the theory followed by the
consequences predicted by the theory?
Note!

Generally, theories tend to be abandoned when they are no longer

useful. A theory ceases to be useful when it cannot predict better than
an alternative theory. When a theory consistently fails to predict
better than an available alternative, it is either modified or replaced.
Theories about human behaviour
• So far we have talked about theories in general.
• But what about theories that purport to explain and predict human
behaviour?
• A scientific study of human behaviour is only possible if humans
respond in predictable ways to things that affect them.
• Is it reasonable to expect such stability?
Think about this!
• We humans have free will and can behave in capricious ways if the
spirit moves us.
• This thus implies human behaviour really is unpredictable!
• How is it that human behaviour can show stable responses even
though we can never be quite sure what one individual will do?
• Successful predictions about the behaviour of large groups are made
possible by the statistical ‘law’ of large numbers.
• Very roughly, this ‘law’ asserts that (under a carefully specified set of
conditions) random movements of a large number of items tend to
offset one another.
Note!
• Individuals may do peculiar things that, as far as we can see, are
inexplicable. But the group’s behaviour will nonetheless be
predictable, precisely because the odd things that one individual does
will tend to cancel out the odd things that some other individual
does.
Why do economists often disagree?
• When all their theories have been constructed and all their evidence
has been collected, economists still disagree with each other on many
issues.
Sources of disagreement?
• There are five possible sources that results in economists disagreeing:
• Different benchmarking.
• Different time frames being used.
• Lack of knowledge.
• Different values held by economists.
• Both sides of the problem are justified.
Economic data
• Economists seek to explain observations made of the real world.
• Real-world observations are also needed to test the predictions of
economic theories.
Collecting data
• Political scientists, sociologists, anthropologists, and psychologists all
tend to collect much of the data they use to formulate and test their
theories.
• Economists are unusual among social scientists in mainly using data
collected by others, often government statisticians.
• In economics there is a division of labour between collecting data and
using it to generate and test theories.
• The advantage is that economists do not need to spend much of their scarce
research time collecting the data they use.
• The disadvantage is that they are often not as well informed about the
limitations of the data collected by others, as they would be if they collected
the data themselves.
Index Numbers
• Once data are collected they can be displayed in various ways.
• Where we are interested in relative movements rather than absolute
ones, the data can be expressed in index numbers.
• Comparisons of relative changes can be made by expressing each
price series as a set of index numbers.
• To do this we take the price at some point of time as the base to
which prices in other periods will be compared.
• We call this the base period.
• The formula of any index number is:

Value of index in period t = (value in period t/value in base period) ×

100
Index numbers – An example
Price of cocoa and coffee
(average price in each quarter; US cents per kg)

Period Cocoa Coffee

2001 (Q1) 100.4 146.7

2001 (Q2) 104.5 146.4

2001 (Q3 100.8 129.7

2001 (Q4) 121.8 126.4

2002 (Q4) 149.0 136.6

Calculation of an index of coffee
prices
Period Coffee Coffee Index

2001 (Q1) (146.7/146.7)x100 100

2001 (Q2) (146.4/146.7)x100 99.8
2001 (Q3 (129.7/146.7)x100 88.4
2001 (Q4) (126.4/146.7)x100 86.2
2002 (Q4) (136.6/146.7)x100 93.1
Index of cocoa and coffee prices

Period Cocoa Index Coffee Index

2001 (Q1) 100 100

2001 (Q2) 104.1 99.8
2001 (Q3 100.4 88.4
2001 (Q4) 121.3 86.2
2002 (Q4) 148.4 93.1
Index numbers as averages
• Index numbers are particularly useful if we wish to combine several
different series into some average. This can be done by:
• An un-weighted index
• An output-weighted index
Note!

An index that averages changes in several series is the weighted

average of the indexes for the separate series, the weights reflecting
the relative importance of each series.
Price indexes
• Economists make frequent use of indexes of the price level that cover
a broad group of prices across the whole economy.
• One of the most important of these is the retail price index, RPI,
which covers goods and services that individuals buy.
• All price indexes are calculated using the same procedure.
• First, the relevant prices are collected. Then a base year is chosen.
Then each price series is converted into index numbers.
• Finally, the index numbers are combined to create a weighted average
index series where the weights indicate the relative importance of
each price series.
Index of cocoa and coffee prices

Period Equal weights Coffee = 0.9;

Cocoa = 0.1
2001 (Q1) 100 100
2001 (Q2) 101.9 100.2
2001 (Q3 94.2 89.6
2001 (Q4) 103.7 89.7
2002 (Q4) 120.7 98.6
Graphing economic data
• A single economic variable such as unemployment or GDP can come
in two basic forms:
• Cross-section
• Time-series
Scatter diagrams
• Another way in which data can be presented is in a scatter diagram.
• This type of chart is more analytical than those shown previously.
• It is designed to show the relationship between two different
variables.
• To plot a scatter diagram, values of one variable are measured on the
horizontal axis and values of the second variable are measured on the
vertical axis.
• Any point on the diagram relates a specific value of one variable to a
corresponding specific value of the other.
Households Annual income (£) Annual savings
1 70,000 10,000
2 30,000 2,500
3 100,000 12,000
4 60,000 3,000
5 80,000 8,000
6 10,000 500
7 20,000 2,000
8 50,000 2,000
9 40,000 4,200
10 90,000 8,000
Graphing economic relationships
• Theories are built on assumptions about relationships between
variables.
• How can such relationships be expressed?
• When one variable is related to another in such a way that to every
value of one variable there is only one possible value of the second
variable, we say that the second variable is a function of the first.
• When we write this relationship down, we are expressing a functional
relationship between the two variables.
Note!
• A functional relationship can be expressed in words, in a numerical
schedule, in an equation, or in a graph.
Annual Income Consumption Reference letter
0 800 p
2,500 2,800 q
5,000 4,800 r
7,500 6,800 s
10,000 8,800 t
Functions
• Let us look in a little more detail at the algebraic expression of this
relationship between income and consumption spending.
• To state the expression in general form, detached from the specific
numerical example shown previously, we use a symbol to express the
dependence of one variable on another.
• Using ‘f’ for this purpose, we write C = f(Y).
• This is read ‘C is a function of Y’. Spelling this out more fully, it reads
‘The amount of consumption spending depends upon the
household’s income.’
• The variable on the left-hand side is the dependent variable, since its
value depends on the value of the variable on the right-hand side.
• The variable on the right-hand side is the independent variable, since
it can take on any value.
Graphing relationships
• Different functional forms have different graphs - When income goes
up consumption goes up.
• In such a relationship the two variables are positively related to each
other.
The slope of a straight line
• Slopes are important in economics.
• They show you how fast one variable is changing as the other
changes.
• The slope is defined as the amount of change in the variable
measured on the vertical or y-axis per unit change in the variable
measured on the horizontal or x-axis.
Maxima and minima
• So far, all the graphs we have shown have had either a positive or
negative slope over their entire range.
• But many relationships change direction as the independent variable
increases.
Theory of the Firm
The Cost Structure
of Firms
Chapter 6
LIPSEY & CHRYSTAL
ECONOMICS 12e
Introduction
• The firm is the most important agent in the economy that makes
decisions about production of the specific goods or services in which
it specializes.
• The firms’ options are affected by the market structure in which they
operate.
• They also have to make supply decisions in the light of their costs of
production.
Learning Outcomes

• Real-world firms can adopt one of several different legal

structures, but for most of the analysis in the book firms
are assumed to have a very simple structure.
• There is a difference between economists’ measure of
profit and accountants’ measure of profit.
• For economists, profit is the difference between total cost
and total revenue, where total cost includes the cost of
capital.
• The production function relates physical quantities of inputs to the
quantity of output.
• Cost curves show the money cost of producing various levels of
output.
• The short-run cost curve is U-shaped because some inputs are being
held constant and the law of diminishing returns applies to these that
are allowed to vary.
• The long-run cost curve can take on various shapes depending on the
scale effects when all inputs are allowed to vary at once.
• Costs in the very long run are altered by technical change.
Firms in Practice and Theory
• Production is organised either by private sector firms, which may take
the following forms:
• Sole traders
• Ordinary partnerships
• Limited partnerships
• Joint-stock companies
• Public corporations
• Non-profit units
• Modern firms finance themselves by selling shares, reinvesting their
profits, or borrowing from lenders such as banks.
• Firms are in business to make profits, which they define as the
difference between what they earn by selling their output and what it
costs them to produce that output.
• This is the return to owner’s capital.
Production, Costs and Profits
• The production function relates inputs of factor services to outputs.
• In addition to what firms count as their costs, economists include the
imputed opportunity costs of owners’ capital.
• This includes the pure return, what could be earned on a riskless
investment, and a risk premium, what could be earned over the pure
return on an equally risky investment.
• Pure or economic profits are the difference between revenues and all
these costs.
• Pure profits play a key role in resource allocation.
• Positive pure profits attract resources into an industry; negative pure
profits induce resources to move elsewhere.
Costs in the Short Run
• Short run variations in output are subject to the law of diminishing
returns:
• Equal increments of the variable input sooner or later produce
smaller and smaller additions to total output and, eventually, a
reduction in average output per unit of variable input.
• Short-run average and marginal cost curves are U-shaped, the rising
portion reflecting diminishing average and marginal returns.
• The marginal cost curve intersects the average cost curve at the
latter’s minimum point, which is called the firm’s capacity output.
• There is a family of short-run average and marginal cost curves, one
for each amount of the fixed factor.
Costs in the Long Run
• In the long run, the firm can adjust all inputs to minimize the cost of
producing any given level of output.
• Cost minimization requires that the ration of an input’s marginal
product to its price be the same for all inputs.
• The principle of substitution states that, when relative input prices
change, firms will substitute relatively cheaper inputs for relatively
more expensive ones.
• Long-run cost curves are often assumed to be U-shaped, indicating
decreasing average costs (increasing returns to scale) followed by
increasing average costs (decreasing returns to scale).
• The long-run cost curve may be thought of as the envelope of the
family of short-run curves, all of which shift when factor prices shift.
The Very Long Run
• In the very long run, innovations introduce new methods of
production that alter the production function.
• These innovations occur as response to changes in economic
incentives such as variations in the prices of inputs and outputs.
• These cause cost curves to shift downwards.
Profit and Loss Account for XYZ Company For the Year
Ending 31 Dec. 20XX
Variable costs (VC) Revenue from sales £1,000,000

Materials Wages £200,000

Materials £300,000
Other Others £1000,00
Total VC
Total VC 600,000
Fixed Costs
Fixed costs (FC)
Rent
Rent 50,000
Managerial salaries 60,000
Interest on loans 90,000
Depreciation allowance 50,000

Total FC 250,000

Total FC Total Costs (FC+VC) 850,000

Profit (revenue less total costs) £150,000

A simplified profit and loss account

• Costs are divided between variable and fixed.

• Total revenue minus total costs as measured by the
firm give profits in the sense used by firms.
• To the firm, profits include the opportunity cost of its
capital - what it must earn to induce it to keep its
capital in its present use.
 Calculation of Pure Profits

Profits as reported by the firm £150,000

Opportunity cost of capital

Pure return on the firm’s capital -£100,000
Risk Premium -£40,000

Pure or economic rent £10,000

Calculation of pure profits

• The economist’s definition of profits does not

include the opportunity cost of capital.
• To arrive at this figure the opportunity cost of capital
must be deducted from what the firm regards as its
capital.
Total, Average and Marginal Products in the Short Run

Quantity of Total Product Average Product Marginal Product

Labour (L) (TP) (AP) (MP)

(1) (2) (3) (4)

1 43 43 43
2 160 80 117
3 351 117 191
4 600 150 249
5 875 175 275
6 1152 192 277
7 1375 196 220
8 1536 192 164
9 1656 184 120
10 1750 175 94
11 1815 165 65
12 1860 155 45
 Total, average and marginal product curves

2100
300 Point of diminishing
TP marginal returns
1800
250
Total product [T/P]

1500
200
1200 AP
150
900 Point of diminishing
average returns
100
600 MP

50
300

0 2 4 6 8 10 12 2 4 6 8 10 12
Quantity of Labour
[i] Total Product Quantity of labour [ii] Average and Marginal Product
 Total, average and marginal product curves

(i): Total product curve

• The TP curve shows the total product steadily
rising, first at an increasing rate, then at a
decreasing rate.

(ii): Average and marginal product curves

• The marginal product curves rise at first and then
decline.
• Where AP reaches its maximum. MP = AP.
 Variation of Costs With Capital Fixed and Labour Variable

Inputs Total Cost Average Cost

Capital Labour Output Fixed Variable Total Fixed Variable Total Marginal
[L] [q] [TFC] [TVC] [TC] [AFC] [AVC] [ATC] Product [MP]

[1] [2] [3] [4] [5] [6] [7] [8] [9] [10]

10 1 43 £100 £20 £120 £2,326 £0.465 £2,791 £0.465

10 2 160 100 40 140 0.625 0.250 0.875 0.171

10 3 351 100 60 160 0.285 0.171 0.456 0.105

 Total, Average and Marginal Cost Curves

280 TC

240 TVC 0.70

0.60
200
Cost [£]

0.50
160 MC
0.40
120
TFC 0.30
AVC
80 0.20 ATC

40 0.10
AFC

300 600 900 1200 1500 1800 2100 300 600 900 1200 1500 1800 2100
[i] Total cost curves Output [ii] Marginal and Output
average cost curves
 Total, Average and Marginal Cost Curves

• Total fixed cost does not vary with output.

• Total variable cost and the total of all costs, TC, (= TVC + TFC) rise with
output, first at a decreasing rate, then at an increasing rate.
• The total cost curves in the figure give rise to the average and marginal
curves in this figure.
• Average fixed cost (AFC) declines as output increases.
• Average variable cost (AVC) and average total cost (ATC) decline and then
rise as output increases.
• Marginal cost (MC) does the same, intersecting the AVC and ATC curves at
their minimum points.
• Capacity output is defined as the minimum point of the ATC curve, which is
an output of 1,500 in this example.
 A Long-run Average Cost-curve

c2

c0 E0 LRAC

c1 E1
Attainable levels of cost

Unattainable levels of cost

q0 q1 qm
0 Output per period
 A Long-run Average Cost-curve

• The long-run average cost (LRAC) curve is the boundary between

attainable and unattainable levels of cost.
• Since the lowest attainable cost of producing q0 is c0 per unit, the point
E0 is on the LRAC curve.
• Suppose a firm producing at E0 desires to increase output to q1.
• In the short run, it will not be able to vary all factors, and thus unit
costs above c1, say c2, must be accepted.
• In the long run a plant that is the optimal size for producing output q1
can be built and costs of c1 can be attained.
• At output qm the firm attains its lowest possible per-unit cost of
production for the given technology and factor prices.
 Long-run Average Cost and Short-run Average Cost Curves

SRATC
LRAC
c0

q0 qm

Output per period

 Long-run Average Cost and Short-run Average Cost
Curves

• The short-run average total cost (SRATC) curve is tangent to the

long-run average cost (LRAC) curve at the output for which the
quantity of the fixed factors is optimal.
• The curves SRATC and LRAC coincide at output q0 where the
fixed plant is optimal for that level of output.
• For all other outputs, there is too little or too much plant and
equipment, and SRATC lies above LRAC.
 Long-run Average Cost and Short-
run Average Cost Curves
• If some output other than q0 is to be sustained, costs can be reduced to the level
of the long-run curve when sufficient time has elapsed to adjust the size of the
firm’s fixed capital.
• The output qm is the lowest point on the firms long-run average cost curve.
• It is called the firm’s minimum efficient scale (MES), and it is the output at which
long-run costs are minimized.
The Envelope Long-run Average Cost Curve

LRAC

Output per period

 The Envelope Long-run Average Cost Curve

SRATC

LRAC

c0

q0

Output per period

 The Envelope Long-run Average Cost Curve

SRATC

LRAC

c0

q0

Output per period

 The Envelope Long-run Average Cost Curve

SRATC
SRATC
LRAC

c0

q0

Output per period

 The Envelope Long-run Average Cost Curve

SRATC
SRATC
LRAC

c0

q0

Output per period

 The Envelope Long-run Average Cost Curve

SRATC
SRATC
LRAC

c0

q0 qm

Output per period

 The Envelope Long-run Average Cost Curve

• Each short-run curve shows how costs vary if output varies, with
the fixed factor held constant at the level that is optimal for the
output at the point of tangency with LRAC.
• As a result, each SRATC curve touches the LRAC curve at one point
and lies above it at all other points.
• This makes the LRAC curve the envelope of the SRATC curves.