RIFT VALL UNIVERSITY

COLLEGE OF BUSINESS AND

ECONMICS DEPARTMENT OF
ECONMICS

MICROECONOMICS FOR
BUSINESS MANAGEMENT
(Econ1021)

1
CHAPTER ONE
Theory of Consumer Behavior and Demand
Section 1: Consumer Preferences and Choices
1.1 Consumer Preference

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 (X 1,
X2) or (Y1, Y2).

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 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.

1.2 Utility
Definition

Utility is the level of satisfaction that is obtained by consuming a commodity or undertaking an activity.

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

The concept of utility is characterized with the following properties:

• ‘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.
A Consumer considers the following points to get maximum utility (satisfaction):
• How much satisfaction he gets from buying and then consuming an extra unit of
a good or service.
• The price he pays to get the good.
• The satisfaction he gets from consuming alternative products.
• The prices of alternative goods and services.

Section 2: Approaches to measure Utility

There are two major approaches of measuring utility. These are Cardinal and ordinal approaches. This sub
unit is divided into two Sections. In this Section will be discussed these two approaches.

2.1 : The Cardinal Utility theory

Neo classical economists 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.

2.1.1 Assumptions of Cardinal Utility theory

1. Rationality of Consumers. The main objective of the consumer is to maximize

his/her satisfaction given his/her limited budget or income. Thus, in order to
maximize his/her satisfaction, the consumer has to be rational.
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.
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 can not 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 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.
X 1 , X 2 ,...X n
If there are n commodities in the bundle with quantities, the total utility is given by:
X 1 , X 2........X n
TU=f ( )

2.1.2 Total and Marginal Utility

Total Utility (TU): It 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.

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:

∆ TU
MU = Where,∆ TU is the change in Total Utility, and,∆ Q is change in the amount of product consumed.
ΔQ
2.1.3 The Law of Diminishing Marginal Utility (LDMU)
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.

Table1.1 Hypothetical table showing TU and MU of consuming Oranges (X)

Units of 0 1st 2nd 3rd 4th 5th 6th

Quantity(x) Unit Unit unit unit unit Unit Unit
consumed
TUX 0 util 10 utils 16 utils 20 utils 22 utils 22 utils 20 utils
MUX 0 10 6 4 2 0 -2

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.

20
TUX

15

10
Marginal Utility

Quantity X
10

Quantity X
1 2 3 4 5
Fig.1.1 Derivation of marginal utility fromMU
total
X utility
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.

2.1.4 Equilibrium of a consumer

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 X 1,X2,…,Xn, he/she would be in
equilibrium or utility is maximized if and only if:
MU x 1 MU x 2 MU x 3 MU x m
= = ------------- =
Px1 Px2 Px3 Pxm
Where: MUm –marginal utility of money
Table 1.2 Utility schedule for a single commodity

Quantity of Total utility Marginal Marginal utility Marginal utility of

Orange utility per Birr(price=2 birr) money
0 0 - - 1
1 6 6 3 1
2 10 4 2 1
3 12 2 1 1
4 13 1 0.5 1
5 13 0 0 1
6 11 -2 -1 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 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

MU X = PX
utility of X is equal to its market price.
Proof

The utility function is:

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

dU d (QX PX ) => dU - dQX PX = 0 => Mux = px

= =0
dQX dQX dQX dQX
Table 1.3 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 6
2 10 4 2 2 22 16 4
3 12 2 1 3 32 12 3
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

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 commodity divided by its market price MU i.e.
MU1 = MU 2
P1 P2
Thus, the consumer will be at equilibrium when he consumes 2 quantities of Orange and 4 quantities of banana,
because MUorange MUbanana 4 8
= = = =2
Porange Pbanana 2 4
2.1.5 Derivation of the Cardinalist Demand
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.

P1 a

P b
Price

P2 c

O Quantity

MUX

P1
Price

P
Demand
P2 curve

O
Q1 Q Q2 Quantity

Fig.1.2 Derivation of Cardinalist Demand curve

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.

2.2 The Ordinal Utility Theory

In this approach, utility cannot be measured absolutely but different consumption bundles are ranked
according to 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 possible for the
st nd rd
consumers to rank commodities in the order of their preference as 1 2 3 and so on.
 2.2.1 Assumptions of Ordinal Utility theory
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 (X1, X2, X3, …)
5. Preferences are transitive or consistent:
• It is transitive 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.
2.2.2. 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.
Table 1.4 Indifference Schedule

Bundle (Combination) A B C D
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 total utility. Thus, the individual is
indifferent whether he consumes combination A, B, C or D.
Banana (Y)
Indifference Curves: an indifference curve shows the various combinations of two goods that provide the
10
1
2

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
1

he/she consumes.
24

Fig1.3 indifference curves and indifference map.

C
(IC)
Curve
en ce
Indiffer
7
Good B

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Good A
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I
 IC3
Indifference curve Indifference map

Indifference Map: To describe a person’s preferences for all combinations 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 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.

2.2.3 Properties of Indifference Curves:

1. Indifference curves have negative slope (downward sloping to the right). It is because
the consumption level of one commodity can be increased only by reducing the
consumption level of the other commodity. That means, if the quantity of one
commodity increases with the quantity of the other remaining constant, the total
utility of the consumer increases. On the other hand, if the quantity of one commodity
decreases with the quantity of the other remaining constant, the total utility of the
consumer reduces. 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 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.
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 are convex to the origin. This implies that the slope of an
indifference curve decreases (in absolute terms) as we move along the curve from the
left downwards to the right. This assumption implies that the commodities can

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 Banana

.
substitute one another at any point on substitutesan

A
Orange
 indifference curve, but are not perfect

Figure 1.4 positively sloped and intersected indifference curves

B
Banana

As we discussed earlier, Indifference curves cannot intersect each other. If they did, the consumer would
Orange
be indifferent between C and E, (Right panel of figure 2.6) since both

E
are on indifference curve one (IC1). Similarly, the consumer would be indifferent

C
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
D
prefer D to C because he/she can have more Orange at point D (more Orange by an amount of X).
IC1

IC2

2.2.4 The Marginal rate of substitution (MRS).

Definition: 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.

MRS
X ,Y
 Number of

Number of
units of units of
Y given up 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:
y
i.e., Slope of indifference curve,
 MRSX ,Y
x

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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.

MRSX ,Y
measures the downward vertical distance (the amount of y that the individual is
willing to give up) per unit of horizontal distance (i.e. per additional unit of x required) to

remain on the same indifference curve. That is,

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MRS

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X ,Y

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Y

X because of the reduction

in Y, MRS is negative. However, we multiply by negative one and express positive value.

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MRSX ,Y
as a

The rationale behind the convexity, that is, diminishing MRS, is that a consumer’s subjective willingness to
substitute A for B (or B for A) will depend on the amounts of B and A he/she possesses.
Table1.5 level of consumption of good X and Y
Bundle A B C D
(Combination)
Orange(X) 1 2 4 7
Banana (Y) 10 6 3 1

MRS

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X ,Y

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Y
(between points A and B 
X

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4
 4
1

It means the consumer is willing to forgo 4 units of Banana to obtain 1 more unit of Orange. If the
consumer moves from point B to point C, he is willing to give up only 2 units of Banana(Y) to obtain 1 unit
of Orange (X), so the MRS is 2(∆Y/∆X =4/2). Having still less of Banana and more of Orange at point D,
the consumer is willing to give up only 1 unit of Banana so as to obtain 3 units of Orange. In this case, the
MRS falls to ⅓. In general, as the amount of Y increases, the marginal utility of additional units of Y

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decreases. Similarly, as the quantity of X decreases, its marginal utility increases. In addition, the
MRS decreases as one move downwards to the right.

Marginal Utility and Marginal rate of Substitution

It is also possible to show the derivation of the MRS using MU concepts as follow.

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  MUY dY 0

MU X
MUY

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dY
 MRS dX

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X ,Y

Or,

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MUY
MU X

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dX
 MRS dY

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Y,X

Example

Suppose a consumer’s utility function is given by

MRSX ,Y .

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U 5

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X4

2
Y . Compute the
MU X dU dU
MRS 

X ,Y MU X  and MUY 
MU
Y dX dY
4 1 2 3 2 4 2 1 4
MU X 4( X Y ) 4( X Y ) and MUY 2( X Y ) 2X Y

MRS

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X ,Y

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MU X

MUY

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3 2
4X Y Y

 2
2 X 4Y X

2.2.5 Special Indifference Curves

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I. Perfect substitutes: If two commodities are perfect substitutes (if they are essentially

IC2
the same), the indifference curve becomes a straight line with a negative slope. MRS for

IC3
perfect substitutes is constant. (Panel a)
Fig.1.5 Special cases of indifference curves

Right shoe

IC1
IC3
Panel a Panel b Panel c
Out dated books
II. Perfect complements: If two comm odities are perfect complements the indifference
curve takes the shape of a right angle. S uppose that an individual prefers to consume left

IC1
shoes (on the horizontal axis) and right shoes on the vertical axis in pairs. For example, if
an individual has two pairs of shoes, additional right or left shoes provide no more utility
Food

for him/her. MRS for perfect complements is zero (both i.e. zero).
IC3

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MRSXY

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and MRSXY

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is the same,
III. A useless good: Panel C in the above figure shows an individual’s indifference
curve for food (on the horizontal axis) and an out-dated book, a useless good, (on the
vertical axis). Since they are totally useless, increasing purchases of out-dated books does
not increase utility. This person enjoys a higher level of utility only by getting additional
food
IC2
consumption. For example, the vertical indifference curve shows that utility will be
IC2
as long as this person has some units of food no matter how many out dated books
he/she has.

2.3 The Budget Line or the Price line

An indifference curves only tell us about the consumer’s preferences for any two goods but they can not tell
us which combinations of the two goods will be chosen or bought. In

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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.

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.

2.3.1 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 PX X  PY Y

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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.

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Suppose for example a household with 30 Birr per day to spend on banana(X) at 5 Birr
PX 5, PY 2, M 30birr
each and Orange(Y) at 2 Birr each. That is, .
Therefore, our budget line equation will be: 5X  2Y 30

Table 1.6 Alternative purchase possibilities of the two goods

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

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 PX X  PY Y
M  XPX YPY
By rearranging the above equation we can derive the general equation of a budget line,
M PX
Y  X
PY PY
M
PY
PX PY


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= Vertical Intercept (Y-intercept), when X=0.

= slope of the budget line (the ratio of the prices of the two goods)

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

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X 0
M PX

X PY PY

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M
X 
PX

M/PY

Fig.1.6 Derivation of the BMu/dPXget 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.

2.3.2 Factors Affecting the Budget Line

2.3.2.1 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).

M2/Py

Where M2>M>M1

M/Py
B B2

B1

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M1/PX M/PX M2/PX

Fig.1.7 Effects of change in income
Increase in income causes an upward shift of the budget line that allows the consumer to buy more goods
and services and decreases in income causes a downward shift of the budget line that leads the consumer to
buy less quantity of the two goods. It is important to note that the slope of the budget line (the ratio of the
two prices) does not change when income rises or falls. The budget line shifts from B to B1 when income
decreases and to B2 when income rises.

2.3.2.2 Effects of Changes in Price of the commodities

Disproportional 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.
A. Price of x falls, while price of good Y & money incme remaining constant

M/py A

Here Px ’ < Px, hence M/Px <M/Px1

B B’
M/Px M/Px ' X
Fig. 1.8 Effect of a decrease in price of x on the budget line
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 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’.
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B. Price of x rises, while price of good Y & 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’.

A
M/Py

B
B’

M/Px1 M/Px2
Fig. 1.9 Effect of an increase in price of x on the budget line

C. Price of Y rises, while price of good X & 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.

Y
A
M/py
A’
M/py'

B
M/Px X
Fig.1.10 Effect of a raise in price of Y on the budget line

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D. Price of Y falls, while price of good Y & money incme remaining constant
Y
M/py'
A’
M/py
A

M/Px B X

Fig.1.11 Effect of a fall in price of Y on the budget line

The above figure shows what happens to the budget line when the price of Y decreases while the price of good X
and money income held constant. Since Py decreases, M/Py increases thereby the budget line shifts outward.

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?
P X  PY Y M
The budget line for two commodities expressed as: X

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3X  5Y 100
5Y 100  3X
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:

A
Y
A’

B’ B
33.33 X
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 solved as:
3X  5Y 75
5Y 75  3X
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  5Y 100 and
if the price of good Y falls to 4, the equation for the new budget line will be
6X  4Y 100 .

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2.4 Optimum of the Consumer

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. This occurs
where an indifference curve is tangent to the
MRSXY
budget line so that the slope of the indifference curve ( ) is equal to the slope of the budget line
(PX / PY ).

Thus, the condition for utility maximization, consumer optimization, or consumer equilibrium occurs
where the consumer spends all income (i.e. he/she is on the budget line) and the slope of the
indifference curve equals to the slope of the budget line
MRSXY PX / PY .

The preferences of the consumer (what he/she wishes) are indicated by the indifference curve and the
budget line specifies the different combinations of X and Y the consumer can purchase with the limited
income. Therefore, the consumer tries to obtain the highest possible satisfaction with in his budget line.
However, the consumer cannot purchase any bundle lying above and to the right of the budget line.
Because Indifference curves above the region of the budget line are beyond the reach of the consumer and
are irrelevant for equilibrium consideration. The question then arises as to which combinations of X and Y
the rational consumer will purchase.
Graphically, the consumer optimum or equilibrium is depicted as follows:

Y
A

B
E
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C
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IC3
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IC4
IC 2
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IC1
 X

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Figure1.12 Consumer equilibrium

At point ‘A’ on the budget line, the consumer gets IC 1 level of satisfaction. When he/she moves down to
point ‘B’ by reallocating his total income in favor of X he/she derives greater level of satisfaction that is
indicated by IC2. Thus, point ‘B’ is preferred to point ‘A’. Moving further down to point ‘E’, the consumer
obtains the greatest level of satisfaction (IC3) relative to other indifference curves.

Therefore, 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 within his/her reach 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. Put differently, equilibrium is
established at the point where the slope of the budget line is equal to the slope of the indifference curve.
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 PX X  PY Y M
We can rewrite the constraint as follows:

M  PX X  PY Y 0 or

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PX X  PY Y 

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M 0

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Multiplying the constraint by Lagrange multiplier 

(M  PX X  PY Y ) 0

Forming a composite function gives as the Lagrange function:

 U ( X ,Y )  (M  PX X  PY Y )

Or,

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 Micro Economics I
 U ( X ,Y )  (PX 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.
 U

X X

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  PX

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 U
0 ; 
Y Y

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 PY

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0 and

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 (PX X  PY Y  


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M ) 0
From the above equations we obtain:
U
 P X
X
U
MU X
X

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U
and
Y
U
and
Y

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 P Y

MUY
Therefore, substituting and solving for  we get the equilibrium condition:
MU X

PX
By rearranging we get:

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MUY

PY
MU X
MUY

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PX

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.

2
X 2

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2
U
 0
X 2

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and

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2

Y 2

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2
U
 0
Y 2

Example

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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
Solution

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MRSX ,Y

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 Micro Economics I

at optimum.
The Lagrange equation will be written as follows:
  XY  2 X  (60  4 X  2Y )

Y  2   4 0
X

 X   2 0
Y

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……………………….. (1)

…………………………… (2)

60 


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4 X  2Y 0

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…………………… (3)

From equation (1) we get Y  2 4

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and from equation (2) we get

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X 2 .Thus, we can

Y2
X 

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1
 X
get that 2
X

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and equation (2) gives as 2 .
Y2

2 Y 14 and X 8.
in to equation (2) we get
By substituting

MU X Y2
MRS 
X ,Y 
MU
B. Y X
After inserting the optimum value of Y=14 and X=8 we get 2 which equals to the price

ratio of the two goods

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PX
(
PY

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4
 2)
2
.
2.4 Optimum of the Consumer
2.4.1 Effects of Changes in Income and Prices on Consumer

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2.4.1.1 Changes in Income: Income Consumption Curve and the Engel Curve
In our previous discussion, we noted that an increase in the consumer’s income (all other things held
constant) results in an upward parallel shift of the budget line. This allows the consumer to buy more of the
two goods. And when the consumer’s income falls, ceteris paribus, the budget line shifts downward,
remaining parallel to the original one.

If we connect all of the points representing equilibrium market baskets corresponding to all possible levels
of money income, the resulting curve is called the Income consumption curve (ICC) or Income expansion
curve (IEC). The Income Consumption Curve is a curve joining the points of consumer optimum
(equilibrium) as income changes (ceteris paribus). Or, it is the locus of consumer equilibrium points
resulting when only the consumer’s income varies.

ICC
Commodity Y

E
3
E
2
E
1
Commodity X

Engle Curve
I3
I2
Income

I1

X1 X2 X3 Commodity X

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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; (celeries 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.

For example, in the figure below good Y is a normal good while good X is a normal good until the person’s
level of income reaches M2 .Thus, when income increases beyond M 2, the person will buy less of good X as
his income increases. Therefore, good X is a normal good Up to point A and becomes an inferior good as
the income consumption curve bends backward.

M3/Py
M3/Py
M2/Py

ICC
M2/Py
M1/Py

M1/Px M2/Px M3/Px M1/Px M2/Px M3/Px

Figure 1.14 income consumption curves
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2.4.1.2 Changes in Price: Price Consumption Curve and Individual Demand Curve

We now look at the second factor that affects the equilibrium of the consumer that is price of the goods.
The effect of price on the consumption of good is even more important to economists than the effect of
changes in income. Here, we hold money income constant and let price change to analyze the effect on
consumer behavior.

In our earlier previous discussion, we have seen that an increase in the price of good X, for example,
increases the absolute value of the slope of the budget line, but it does not affect the vertical (Y) intercept
of the line. Thus, the change in the price of x will result in out ward shift of the budget line that makes the
consumer to buy more of good x.If we connect all the points representing equilibrium market baskets
corresponding to each price of good X we get a curve called price-consumption curve.

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.
Commodity Y

PCC

Commodity X

Px1
Px
Price of X

2
Px Individual
3 Demand curve
X1 X2 X3 Commodity X
Figure1.15 the PPC and derivation of the demand curve

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2.4.2 Decomposition of Income and Substitution

Effects (Normal, inferior and giffen goods)
We have noted that there are two effects of a price change. If price falls (rises), the good becomes cheaper
(more expensive) relative to other goods; and consumers substitute toward (away from) the good. This is
the substitution effect. Also, as price falls (rises), the consumer’s purchasing power increases (decreases).
Since the set of consumption opportunities increases (decreases) as price changes, the consumer changes
the mix of his or her consumption bundle. This effect is called the income effect. Let us analyze each effect
in turn, and then combine the two in order to see why demand is assumed to be downward sloping.

A. Let us Consider the case of a price-decline:

First a decrease in price increases the consumer’s real income (purchasing power), thus enhancing the
ability to buy more goods and services to some extent. Second, a decrease in the price of a commodity
induces some consumers (the consumer) to substitute it for others, which are now relatively expensive
(higher price) commodities.The 1st effect is known as the income effect, and the 2 nd effect is known as the
substitution effect. The combined effect of the two is known as the total effect (net effect).

A. Case of Normal Good

Suppose initially the income of the consumer is
 Micro Economics I

I1
, price of goodY is
I
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Py1
, and Price of
I
good X is
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Px1
, we have the budget line with y-intercept
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Py1
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and X-intercept
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Px1
. The
consumer’s equilibrium is point A that indicates the point of tangency between the budget
line and indifference curve
 Micro Economics I
IC1 .

I/py1
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Note that:

X1 X 3
=NE= Total (net) effect

X1 X 2
= SE=Substitution effect
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A B
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IC2
X X

C IC 1
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x1
SE

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x2 IE

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x3 I’/px1

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 I/px2
Micro Economics I NE

Figure1.16 Income and Substitution effect for a normal good

Px1 Px2
As a result of a decrease in the price of X from to the budget line shifts outward

I I
Py1 Px2
with Y-intercept & X-Intercept . The consumer’s new equilibrium will be on point B.

The total change in the quantity purchased of commodity X from the 1st equilibrium point at A to the
second equilibrium point at B shows the Net effect or total effect of the price decline (change).

The total effect of the price change can be conceptually decomposed into the substitution effect and income
effect.

The Substitution Effect

The substitution effect refers to the change in the quantity demanded of a Commodity resulting exclusively
from a change in its price when the consumer’s real income is held constant; thereby restricting the
consumer’s reaction to the price change to a movement along the original indifference curve. The decline
in the price of X results in an increase in the consumer’s real income, as evidenced by the movement to a
higher indifference curve even though money income remains fixed.

Now, imagine that we decrease the consumer’s income by an amount just sufficient to return to the same
level of satisfaction enjoyed before the price decline. Graphically, this is accomplished by drawing a
fictitious (imaginary) line of attainable combinations with a

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Px2

Py1
slope corresponding to new ratio of the product price so that it is just tangent to the

original indifference curve

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IC1 .

The point of tangency is the imaginary point C (imaginary equilibrium). The movement from point A to the
imaginary intermediate equilibrium at point C, which shows increase in consumption of X from X1 to X2 is
the substitution effect.In other words, the effect of a decrease in price encourages the consumer to increase
consumption of X than Y.

The Income Effect

The income effect may be defined as the change in the quantity demanded of a commodity exclusively
associated with a change in real income. The income effect is determined by observing the change in the
quantity demanded of a commodity that is associated solely with the change in the consumer’s real income.

In figure 1.16, letting the consumer’s real income rise from its imaginary level (defined by the line of
attainable combinations tangent to point C) back to its true level (defined by the line of attainable
combinations tangent to point B) gives the income effect. Thus, the income effect is indicated by the
movement from the imaginary equilibrium at point C to the actual new equilibrium at point B, the increase
in the quantity of X purchased from X2 to X3 is the income effect.

The income effect of a change in the price of good shows the change in quantity demanded via change in
real income, while the relative price ratio remains constant. This movement does not involve any change in
prices; the price ratio is the same in budget line 1 as in budget line 2. It is due to a change in total
satisfaction and such a change is a movement from one indifference curve to another.

When we look at both the substitution and income effects, the magnitude of the substitution effect is
greater than that of the income effect. The reason is that:

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• Most goods have suitable substitutes and when the price of good falls, the
quantity of the good purchased is likely to increase very much as consumers
substitute the now cheaper good for others.
• Spending only a small fraction of his /her income, i.e. with the consumers
purchasing many goods and spending only a small fraction of their income on
any one good, the income effect of a price change of any one good is likely to
be small.

Usually, the income and substitution effects reinforce one another i.e. they operate in the same direction.
The substitution effect is always negative. i.e. if the price of a good X increases and real income is held
constant, there will always be a decrease in the consumption of good X, and vise versa. This result follows
from the fact that indifference curves have negative slopes. However, the income effect is not predictable
from the theory alone. In most cases, one would expect that increases in real income would result in
increases in consumption of a good. This is the case for so called Normal goods.

In short in the case of normal goods, the income effect and the substitution effect operate in the same
direction –they reinforce each other. But not all goods are normal. Some goods are called inferior goods
because the income effect is the opposite (of that of a normal good) for them-they operate in opposite
direction.

B. Case of Inferior Goods

Y KEY:
X1X3= NE=Net effect
X1X2= SE=Substitution
IC
effect X 22 X3=
E3

E1
IC1
E2

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SE

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Figure 1.17 Income, Substitution, and Net effect for an inferior commodity

For an inferior good, a decrease in the price of the commodity causes the consumer to buy more of it (the
substitution effect), but at the same time the higher real income of the consumer tends to cause him to
reduce consumption of the commodity (the income effect). We usually observe that the substitution effect
still is the more powerful of the two; even though the income effect works counter to the substitution effect,
it does not override it. Hence, the demand curve for inferior goods is still negatively sloped. The above
diagram that shows the income, substitution and net effect for an inferior commodity in the case of a
decline in the price of good X.

In very rare occasions, a good may be so strongly inferior that the income effect actually overrides the
substitute effect. Such an occurrence means that a decline in the price of a good would lead to a decline in
the quantity demanded and that a rise in price will induce an increase in quantity demanded. In other words,
price and quantity move in the same direction. The name given to such a unique situation is Giffen
paradox; and it constitutes an exception to the Law of demand. That is for Giffen goods the income effect
(which decreases the quantity demanded) is so strong that it offsets the substitution effect (which increases
the quantity demanded), with the result that the quantity demanded is directly related to the price, at least
over some range of variation of price.

C. Case of Giggen Goods

KEY:
X3

E3

X1X3= NE=Net effect

NE

E1
IE

X1

X1X2= SE=Substitution effect

X2 X3= IE=Income effect
SE

E2
X2

IC2
IC1

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X

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.
Figure 1.18 Income, Substitution and net effects for a Giffen
good, When there is a price decline.

2.4.3 Derivation of market demand

The market demand curves can be derived as the sum of the individual demand curves of all consumers in
a particular market.

To keep things simple, let's assume that only three consumers (A, B, and C) are in the market for coffee.
The following table tabulates several points on each of these consumers' demand curves.
(1)price per (2) individual A (3) individual B (4) individual C (5) Market
kg Birr (utils) (utils) (utils) (utils)
10 6 10 16 32
20 4 8 13 25
30 2 6 10 18
40 0 4 7 11
50 0 2 4 6

The market demand column (5), is found by adding columns (2), (3), and (4) to determine the total quantity
demanded at every price. For example, when the price is $3, the total quantity demanded is 2 + 6 + 10, or
18.

We sum horizontally to find the total amount that the three consumers will demand at any given price. For
example, when the price is $40, the quantity demanded by the market (11 units) is the sum of the quantity
demanded by A (no units), by B (4 units), and by C (7 units). Because all the individual demand curves
slope downward, the market demand curve will also slope downward. However, the market demand curve
need not be a straight line, even though each of the individual demand curves is so.

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The aggregation of individual demands into market demands is not just a theoretical exercise. It becomes
important in practice when market demands are built up from the demands of different demographic groups
or from consumers located in different areas.

For example, we might obtain information about the demand for home computers by adding independently
obtained information about the demands of (i) households with children, (ii) households without children,
and (iii) single individuals. Or we might determine the Ethiopia demand for natural gas by aggregating -the
demands for natural gas of the major regions (Oromiya, Amara, SNNP, Tigray, and West, for example).

2.5 Elasticity of demand

Law of demand indicates only the direction of change in quantity demanded in response to a change in
price. This does not tell us by how much or to what extent the quantity demanded of a good will change in
response to change in its price. This information as to how much or to what extent the quantity demanded
of a good will change as a result of a change in its price is provided by the concept of elasticity of demand.
The concept of elasticity of demand refers to the degree of responsiveness of quantity demanded of a good
to a change in its price, consumer’s income and prices of related goods. Accordingly, there are three
concepts of demand elasticity:
 Price elasticity
 Income elasticity
 Cross elasticity
I. Price elasticity of Demand
It indicates the degree of responsiveness of quantity demanded of a good to the change in its price, other
factors such as income, price of related commodities that determine demand are held constant. And
mathematically can be calculated as:
Price elasticity of demand (ep) =

Ep = %∆Qd/%∆P

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%Qd

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(Q1 Qo) / Qo*100


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where, Ep = price elasticity of demand
%P

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(P1 Po) / Po *100
(Q1 Qo)* Po


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Qd = change in quantity demanded
(P1  Po)* Qo

(Q1 Qo) Po
 *

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P = change in price
(P1 Po) Qo

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NB :  Ep Ed

Ep = ∆Qd/∆P * Po/Qo It is known as point price elasticity of demand

We also use another formula to determine price elasticity of demand if the change in price is substantially
large. This is called Arc price elasticity of demand or mid-point elasticity of demand. And measures the
average responsiveness of quantity demanded between two points on the demand curve to change
in price other things remaining constant. Mathematically,
Ep=
= )*100%
= ( )* =)*(
Ep =)*(

NB: - when the change in price is quite large, say more than 5 percent, and also when we want to measure
elasticity between two points then accurate measure of price elasticity of demand can be obtained by taking
the average of original price and subsequent price as well as average of the original quantity and
subsequent quantity as the basis of measurement of percentage changes in price and quantity. Moreover
 Ep is unit free because it is a ratio of percentage change
 Ep is usually a negative number because of the law of demand i.e. negative relationship between
price and quantity demand. So we can take the absolute value of /Ep/.
The main reason for differences in elasticity of demand is the possibility of substitution
i.e. the presence or absence of competing substitutes. The greater the ease with which

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substitutes can be found for a commodity or with which it can be substituted for other commodities, the
greater will be the price elasticity of demand of that commodity. The demand for salt is inelastic since it
satisfies a basic human want and no substitutes for it are available. People would consume almost the
quantity of salt whether it become slightly cheaper or dearer than before.

Perfectly elastic and perfectly inelastic: in perfectly inelastic whatever the price, quantity demanded of the
commodity remains unchanged. An approximate example of perfectly inelastic demand is the demand of
acute diabetic patient for insulin. Because he/she has to get the prescribed doze of insulin per week
whatever its price. In perfectly elastic demand the horizontal demand curve for a product implies that a
small reduction in price would cause the buyers to increase the quantity demanded from zero to all they
could obtain. On the other hand, a small rise in price of the product will cause the buyers to switch
completely away from the product so that its quantity demanded falls to zero. The perfectly elastic demand
curve found for the product of an individual firm working under perfect competition. Products of different
firms working under perfect competition are completely identical. If any perfectly competitive firm raises
the price of its product, it would lose all its customers who would switch over to other firms and if it
reduces its price somewhat it would get all the customers to buy the product from it.

p p dd

ep = 0
Q
a)

ep = 
dd
Q
Perfectly elastic dd c

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urve

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b) Perfectly Inelastic dd curve

II. Cross elasticity of demand

Degree of responsiveness of demand for one good in response to the change in prices of another good
represents the cross elasticity of demand of one good for the other.

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We can measure the responsiveness or sensitivity in the quantity purchased of commodity X as a result
of a change in the price of commodity Y by the cross elasticity of demand (Exy). This is given by:
Coefficient of cross elasticity =

Exy =

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Qx

PY

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P
Y
0 .
Qx0-------------------------------------------------------
point formula
Qx  Py1  Py2 
. 
P Qx  Q
Exy =

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Y  1 2 ---------------------------
Arc Formula
 Substitute goods, Exy >0.
 Complement goods, Exy < 0
 Unrelated goods ,Exy = 0,

III. Income Elasticity (E1)

Income elasticity of demand shows the degree of responsiveness of quantity demanded of a good to a small
change in the income of consumers. And this is measured by:
Income elasticity =

%Qd

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 Q1  Q0    0 

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Qd I0
E 
%I

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 
 1

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 0

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 
  Q0  I

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
Q0.........................
Point income elasticity of demand
 Q1  Q0   1   0 
E 
 

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 
Q Q
 1 0  1

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0  ……Arc income elasticity of demand formula
The result for income elasticity can be:
a) Positive (EI> 0): if it is Normal Goods that Consumption of the goods varies
directly (positively) with income i.e. when income increases consumption of these
goods also increases& vice Versa.
 A good having income elasticity more than one and which therefore bulks larger in
consumer’s budget as he becomes richer is called a luxury.
 A good with an income elasticity less than one and which claims declining proportion of
consumer’s income as he becomes richer is called a necessity.

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 When income elasticity of demand for a good is equal to one, then proportion of income
spent on the good remains the same as consumer’s income increases.
b) Negative (EI < 0): if it is inferior goods in such increase in income will lead to the
fall in quantity demanded of the goods.
c) EI= 0, means consumption of the good does not vary with income, e.g. salt

CHAPTER TWO
CHOICE –INVOLVING RISK AND UNCERTAINTY
2.1. Introduction
So far we have assumed that prices, incomes, and other variables are known with certainty. However, many
of the choices that people make involve considerable uncertainty. For example, most people borrow to
finance large purchases, such as a house or a college education, and plan to pay for the purchase out of
future income. But for most of us, future incomes are uncertain. Our earnings can go up or down; we can
be promoted, demoted, or even lose our jobs. Or if we delay buying a house or investing in a college
education, we risk having its price rise in real terms, making it less affordable. How should we take these
uncertainties into account when making major consumption or investment decisions?

Sometimes we must choose how much risk to bear. What, for example, should you do with your savings?
Should you invest your money in something safe such as a savings account or something riskier but
potentially more lucrative such as the stock market? Another example is the choice of a job or even a
career. Is it better to work for a large,

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stable company where job security is good but the chances for advancement are limited, or to join (or form)
a new venture, which offers less job security but more opportunity for advancement?

To answer questions such as these, we must be able to quantify risk so we can compare the riskiness of
alternative choices. We therefore begin this chapter by discussing measures of risk. Afterwards, we will
examine people's preferences toward risk. (Most people find risk undesirable, but some people find it more
undesirable than others.) Next, we will see how people can deal with risk. Sometimes risk can be reduced-
by diversification, by buying insurance or by investing in additional information. In other situations (e.g.,
when investing in stocks or bonds), people must choose the amount of risk they wish to bear.

To describe risk quantitatively, we need to know all the possible outcomes of a particular action and the
likelihood that each outcome will occur.' Suppose, for example, that you are considering investing in a
company that is exploring for offshore oil. If the exploration effort is successful, the company's stock will
increase from $30 to $40 a share; if not, it will fall to $20 a share. Thus, there are two possible future
outcomes, a
$40 per share price and a $20 per share price.

Probability refers to the likelihood that an outcome will occur. In our example, the probability that the oil
exploration project is successful might be 1/4, and the probability that it is unsuccessful 3/4. Probability is a
difficult concept to formalize because its interpretation can depend on the nature of the uncertain events and
on the beliefs of the people involved. One objective interpretation of probability relies on the frequency
with which certain events tend to occur. Suppose we know that of the last 100 offshore oil explorations 25
have succeeded and 75 have failed. Then the probability of success of1/4 is objective because it is based
directly on the frequency of similar experiences. But what if there are no similar past experiences to help
measure probability? In these cases objective measures of probability cannot be deduced, and a more
subjective measure is needed.

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Subjective probability is the perception that an outcome will occur. This perception may be based on a
person's judgment or experience, but not necessarily on the frequency with which a particular outcome has
actually occurred in the past. When probabilities are subjectively determined, different people may attach
different probabilities to different outcomes and thereby-make different choices. For example, if the search
for oil were to take place in an area where no previous searches had ever occurred, I might attach a higher
subjective probability than you to the chance that the project will succeed because I know more about the
project, or because I have a better understanding of the oil business and can therefore make better use of
our common information. Either different information or different abilities to process the same information
can explain why subjective probabilities vary among individuals.

Whatever the interpretation of probability, it is used in calculating two important measures that help us
describe and compare risky choices. One measure tells us the expected value and the other the
variability of the possible outcomes.

2.2. Expected utility

To simplify things, we'll consider the consumption of a single commodity-the
consumer's income, or more appropriately, the market basket that the income can buy.
We assume that consumers know all probabilities, and (for much of this section) that
payoffs are now measured in terms of utility.

Table 2.1a shows how we can describe a woman's preferences toward risk. The level
of utility increases from 10 to 16 to 18, as income increases from $10,000 to $20,000
to $30,000. But marginal utility is diminishing, falling from 10 when income
increases from 0 to $10,000, to 6 when income increases from $10,000 to $20,000,
and "to 2 when income increases from $20,000 to $30,000.

Now suppose she has an income of $15,000 and is considering a new but risky sales
job that will either double her income to $30,000 or cause it to fall to $10,000. Each

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possibility has a probability of .5. As table 2.1a shows, the utility level associated
with an income of $10,000 is 10 (at point A), and the utility associated with a level of
income of $30,000 is 18 (at E). The risky job must be compared with the current job,
for which the utility is 13 (at B).

To evaluate the new job, she can calculate the expected value of the resulting income.
Because we are measuring value in terms of the woman's utility, we must calculate
the expected utility E(u) she can obtain. The expected utility is the sum of the utilities
associated with all possible outcomes, weighted by the probability that each outcome
will occur. In this case, expected utility is
E(u) = (1/2)u($10,000) + (1/2)u($30,000=) 0.5(10) +0.5(18) = 14
The new risky job is thus preferred to the original job because the expected utility of 14 is greater than the
original utility of 13. The old job involved no risk-it guaranteed an- income of $15,000 and a utility level of
13. The new job is risky, but it offers both a higher expected income ($20,000) and, more important, a
higher expected utility. If the woman wished to increase her expected utility, she would take the risky job.
Table 2.1 Differ in preferences toward risk

combination A B C D E
Income 10000 15000 16000 20000 30000
Utility 10 13 14 16 18
(a)

Combination A C E
Income 10000 20000 30000
Utility 3 8 16
(b)

Combination A C E
Income 10000 20000 30000
Utility 6 12 16
(c)
In (a) consumer's marginal utility diminishes as income increases. The consumer is risk averse because she
would prefer a certain income of $30000 (with a utility of 16) to a gamble with a .5 probability of
$10,00O'and a 5 probability of $301000 (and expected utility of 14). In (b) the consumer is risk loving,
because she would prefer the same gamble (with expected utility of 105) to the certain income (with a

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utility of 8). Finally, in (c) the consumer is risk neutral and is indifferent between certain events and
uncertain events with the same expected income.
2.3. Risk Choice
People differ in their willingness to bear risk. Some are risk averse, some risk loving, and some risk neutral.
A person who prefers a certain given income to a risky job with the same expected income is described as
being risk averse.(Such a person has a diminishing marginal utility of income.) Risk aversion is the most
common attitude toward risk. To see that most people are risk averse most of the time, note the vast
number of risks that people insure against. Most people not only buy life insurance, health insurance, and
car insurance, but also seek occupations with relatively stable wages.

Table 2.1a applies to a woman who is risk averse. Suppose she can have a certain income of $20,000, or a
job yielding an income of $30,000 with probability .5 and an income of
$10,000 with probability .5 (so that the expected income is $20,000). As we saw, the expected utility of the
uncertain income is 14, an average of the utility at point A (10) and the utility at E (18), and is shown by C.
Now we can compare the expected utility associated with the risky job to the utility generated if $20,000
were earned without risk. This utility level, 16, is given by D in table 2.1a. It is clearly greater than the
expected utility associated with the risky job.

A person who is risk neutral is indifferent between a certain income and an uncertain income with the same
expected value. In table 2.1c the utility associated with a job generating an income of either $10,000 or
$30,000 wit$ equal probability is 12, as is the utility of receiving a certain income of $20,000.

Table 2.1b shows the third possibility-risk loving. In this case the expected utility of an uncertain income
that will be either $10,000 with probability .5 or $30,000 with probability .5 is higher than the utility
associated with a certain income of $20,000. Numerically,
E(u) = .5u($10,000) + .5u($30,000) = .5(3) + .5(18) = 10.5 > u($20,000) = 8
The primary evidence for risk loving is that many people enjoy gambling.

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Some criminologists might describe criminals as risk lovers, especially when a robbery is committed that
has a high prospect of apprehension and punishment. These special cases aside, few people are risk loving,
at least with respect to major purchases or large amounts of income or wealth.'

2.4. Risk Diversification

Suppose that you plan to take a part-time job selling appliances on a commission basis. You can decide to
sell only air conditioners or only heaters, or you can spend half your time selling each. Of course, you can't
be sure how hot or cold the weather will be next year. How should you apportion your time to minimize
the risk involved in the sales job? The answer is that risk can be minimized by diversification-by
allocating your time toward selling two or more products (whose sales are not closely related), rather than
a single product. Suppose that there is a fifty-fifty chance that it will be a relatively hot year, and a
fifty-fifty chance that it will be cold.

Table 2.2 Income from Sales of Equipment

Hot weather Cool weather

Air conditioner sales 30000 12000
Heater sales 12000 30000

The above table gives the earnings that you can make selling air conditioners and heaters. If you sell only
air conditioners or only heaters, your actual income will be either $12,000 or $30,000 but your expected
income will be $21,000 [.5($30,000) +. .5($12000)]. But suppose you diversify by dividing your time
evenly between the two products. Then your income will certainly be $21,000, whatever the weather. If the
weather is hot, you will earn $15,000 from air conditioner sales and $6000 from heater sales; if it is cold,
you will earn $6000 from air conditioner sales and $151000 from heater sales. Hence, by diversifying you
eliminate all risk.

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Diversification is not always this easy. In our example heater and air conditioner sales were inversely
related-whenever the sales of one were strong, the sales of the other were weak. But the principle of
diversification is a general one. As long as you can allocate your effort or your investment funds toward a
variety of activities whose outcomes are not closely related, you can eliminate some risk

2.5. Risk spreading

Consider the situation of an individual who had $35,000 and faced a .01 probability of a
$10,000 loss. Suppose that there were 1000 such individuals. Then, on average, there would be 10 losses
incurred, and thus $100,000 lost each year. Each of the 1000 people would face an expected loss of .01
times $10,000, or $100 a year. Let us suppose that the probability that any person incurs a loss doesn’t
affect the probability that any of the others incur losses. That is, let us suppose that the risks are
independent.

Then each individual will have an expected wealth of .99 × $35, 000 +.01×$25, 000 =
$34, 900. But each individual also bears a large amount of risk: each person has a 1 percent probability of
losing $10,000. Suppose that each consumer decides to diversify the risk that he or she faces. How can they
do this? Answer: by selling some of their risk to other individuals. Suppose that the 1000 consumers decide
to insure one another. If anybody incurs the $10,000 loss, each of the 1000 consumers will contribute $10
to that person. This way, the poor person whose house burns down is compensated for his loss, and the
other consumers have the peace of mind that they will be compensated if that poor soul happens to be
themselves! This is an example of risk spreading: each consumer spreads his risk over all of the other
consumers and thereby reduces the amount of risk he bears.

Now on the average, 10 houses will burn down a year, so on the average, each of the 1000 individuals will
be paying out $100 a year. But this is just on the average. Some years there might be 12 losses, and other
years there might be 8 losses. The probability is

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very small that an individual would actually have to pay out more than $200, say, in any one year, but even
so, the risk is there.

But there is even a way to diversify this risk. Suppose that the homeowners agree to pay
$100 a year for certain, whether or not there are any losses. Then they can build up a cash reserve fund that
can be used in those years when there are multiple fires. They are paying $100 a year for certain, and on
average that money will be sufficient to compensate homeowners for fires.
Chapter Three
Theory of
Production
3.1 Production Function
To an economist production means creation of utility for sales. Alternatively, production may be defined as
the act of creating those goods/services which have exchange value for sale (not for personal
consumption).Raw materials yield less satisfaction to the consumer by themselves. In order to get utility
from raw materials, first they must be transformed into output. However, transforming raw materials into
final products require factor inputs such as land, labor, and capital and entrepreneurial ability. Thus, no
production (transforming raw material into output) can take place without the use of inputs.

Fixed Vs variable inputs

In economics, inputs can be classified as fixed & variable. Fixed inputs are those inputs whose quantity
cannot readily be changed when market conditions indicate that an immediate change in output is required.
In fact no input is ever absolutely fixed, but may be fixed during an immediate requirement. For example, if
the demand for Beer shoots up suddenly in a week, the brewery factories cannot plant additional machinery
over a night to respond to the increased demand. It takes long time to buy new machineries, to plant them
and use for production. Thus, the quantity of machinery is fixed for some times such as a weak. Buildings,
machineries and managerial personnel are examples of fixed inputs because their quantity cannot be
manipulated easily in short time periods.

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Variable inputs, on the other hand, are those inputs whose quantity can be changed almost instantaneously
in response to desired changes in output. That is, their quantity can easily be diminished when the market
demand for the product decreases and vise versa. The best example of variable input is unskilled labor.
In our previous example, if the brewery factory had idle machinery before the market demand shot up, the
factory can easily and immediately respond to the market condition by hiring laborers.

Short run Vs. long run

In economics, short run refers to that period of time in which the quantity of at least one input is fixed. For
example, if it requires a firm one year to change the quantities of all the inputs, those time periods below
one year are considered as short run. Thus, 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. One thing to be noted here is that short
run periods of different firms have different duration. Some firms can change the quantity of all their inputs
with in a month while it takes more than a year to change the quantity of all inputs for another type of
firms. For example, the time required to change the quantities of inputs in an automobile factory is not
equal with that of flour factory. The later takes relatively shorter time. Long run 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.

3.2 Production in the short run: Production with one variable input
Production with one variable input (while the others are fixed) is obviously a short run
phenomenon because there is no fixed input in the long run.

Assumption of short run production analysis

1. Perfect divisibility of inputs and outputs

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This assumption implies that factor inputs and outputs are so divisible that one can hire, for example a
fraction of labor, a fraction of manager and we can produce a fraction of output, such as a fraction of
automobile.
2. Limited substitution between inputs
Factor inputs can substitute each other up to a certain point, beyond which they can not substitute each
other

3. Constant technology
They assumed that level of technology of production is constant in the short run.
Suppose a firm that uses two inputs: Capital (which is a fixed input) and labor (which is variable input).
Given the assumptions of short run production, the firm can increase output only by increasing the amount
of labor it uses.
Hence, its production function is given as: Q = f (L)K Where Q
is the quantity of production (Output)
L is the quantity of labor used, which is variable, and K is the
quantity of capital (which is fixed)

The production function shows different levels of output that the firm can obtain by efficiently utilizing
different units of labor and the fixed capital. In the above short run production function, the quantity of
capital is fixed. Thus output can change only when the amount of labor used for production changes.
Hence, Q is a function of L only in the short run.

Total product, marginal product and average product

Total product: is the total amount of output that can be produced by efficiently utilizing a specific
combination of labor and capital. The total product curve, thus, represents various levels of output that can
be obtained from efficient utilization of various combinations of the variable input, and the fixed input. It
shows the output produced for different amounts of the variable input, labor.

An increasing the variable input (while some other inputs are fixed) can increase the total product only up
to a certain point. Initially, as we combine more and more units of the

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variable input with the fixed input output continues to increase. But eventually, increasing the unit of the
variable input may not help output increase. Even as we employ more and more unit of the variable input
beyond the carrying capacity of a fixed input, out put may tends to decline. Thus increasing the variable
input can increase the level of output only up to a certain point, beyond which the total product tends to fall
as more and more of the variable input is utilized. This tells us what shape a total product curve assumes.
The shape of the total variable curve is nearly S-shape (see fig 2.1 Panel A)

Marginal Product (MP)

The marginal product of variable input is the addition to the total product attributable to the addition of one
unit of the variable input to the production process, other inputs being constant (fixed). Before deciding
whether to hire one more worker, a manager wants to determine how much this extra worker (L =1) will
increase output, q. The change in total output resulting from using this additional worker (holding other
inputs constant) is the marginal product of the worker. If output changes by q when the number of
workers (variable input) changes by ∆L, the change in out put per worker or marginal product of the
variable input, denoted as MPL is found as
Q dTP
orMPL 
L dL
MPL =
Thus, MPL measures the slope of the total product curve at a given point. In the short run, the MP of the
variable input first increases reaches its maximum and then tends to decrease to the extent of being
negative. That is, as we continue to combine more and more of the variable inputs with the fixed input, the
marginal product of the variable input increases initially and then declines.

Average Product (AP)

The AP of an input is the ratio of total output to the number of variable inputs.
totalproduct TP
APlabour  
numberofL L

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The average product of labor first increases with the number of labor (i.e. TP increases faster than the
increase in labor), and eventually it declines.

As the number of the labor hired increases (capital being fixed), the TP curve first rises, reaches its
maximum when L3 amount of labor is employed, beyond which it tends to decline. Assuming that this
short run production curve represents a certain car manufacturing industry, it implies that L3 numbers of
workers are required to efficiently run the machineries. If the numbers of workers fall below L3, the
machine is not fully operating, resulting in a fall in TP below TP3. On the other hand, increasing the
number of workers above L3 will do nothing for the production process because only L3 number of
workers can efficiently run the machine. Increasing the number of workers above L3, rather results in lower
total product because it results in overcrowded and unfavorable working environment.
Ray a

TP1
TP2 TPL

TP1

Labour
L1 L2 L3

APL
MPL

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L1 L L
2 3

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MPL

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

Marginal product curve increases until L1 number of labor reaches its maximum at L1, and then it tends to
fall. The MPL is zero at L3 (when the TP is maximal); beyond which its value assumes zero indicating that
each additional worker above L3 tends to create over crowded working condition and reduces the total
product. Thus, in the short run (where some inputs are fixed), the marginal product of successive units of
labor hired increases initially, but not continuously, resulting in the limit to the total production.
Geometrically, the MP curve measures the slope of the TP. The slope of the TP curve increases (MP
increases) up to L1, it decreases from L1 to L3 and it becomes negative beyond L3.

The average product curve increases up to L2, beyond which it continuously declines. The AP curve can be
measured by the slope of rays originating from the origin to a point on the TP curve. For example, the APL
at L2 is the ratio of TP2 to L2. This is identical to the slope of ray a.

The relationship between AP and MP of the variable input

The relationship between MPL and APL can be stated as follows:
• For all number of workers (Labor) below L2, MPL lies above APL.
• At L2, MPL and APL are equal.
• Beyond L2, MPL lies below the APL
Thus, the MPL curve passes through the maximum of the APL curve from above. This relationship
between APL and MPL can be shown algebraically as follows:

Suppose the production function is given as TP = f

(L), K -being constant

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Given the total product function,

dTP df (L)
MPL  

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TP
APL 

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f (L)

dL dL

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 Micro Economics I
and L = L

To determine the relationship between APL and MPL, consider the slope of the APL function.

dAPL

Slope of APL = dL

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f (L)
d( )
L
= dL =

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df (L)
.L 
dL
L2

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dL
. f (L)
dL

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(quotient rule)
df (L)
.L
dL

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f (L)

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ab a b
2
= L
df (L)

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- L2

f (L)

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----------------------------- (note that c

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 
c c)

dL L
= L - L
MPL  APL df (L) f (L)

= L , because dL = MPL and L = APL

• 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)

The law of production diminishing marginal returns

(LDMR): Short –run law of production (law of variable
proportion)
The LDMR states that as the use of an input increases in equal increments (with other inputs being fixed), a
point will eventually be reached at which the resulting additions to output decreases. When the labor input
is small (and capital is fixed), extra labor adds considerably to output, often because workers get the chance
to specialize in one or few tasks. Eventually, however, the LDMR operates: when the number of workers
increases further, some workers will inevitably become ineffective and the MPL falls (this happens when
the number of workers exceeds L1 in fig 3.1)

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Note that the LDMR operates (MP of successive units of labor decreases) not because highly qualified
laborers are hired first and the least qualified last. Diminishing marginal returns results from limitations on
the use of other fixed inputs (e.g. machinery), not from decline in worker quality.

The LDMR applies to a given production technology (when the level of technology is fixed). Over time,
however, technological improvements in the production process may allow the entire total product curve
shift upward, so that more output can be produced with the same input.

3.3 Long run Production: Production with two variable inputs

For the sake of simplicity, assume that the firm uses two inputs (labor and capital) and both are variable.
The firm can now produce its output in a variety of ways by combining different amounts of labor and
capital. With both factors variable, 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. In
this section, we will see how a firm can choose among combinations of labor and capital that generate the
same output. To do so, we make the use of isoquant. So it is necessary to first see what is meant by
isoquants and their properties.

Isoquants
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.
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.

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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.

X3

a
MUX
TP3 Outp
T
T a
P
TP1

Units L3 L2

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 labor on the curve. The
set of isoquant curves q1 q2 & q3 are called isoquant map.

Properties of isoquants
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. Isoquants can never be horizontal, vertical or upward sloping

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2. 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.

3. Isoquants do not cross each other. This is because such intersections are inconsistent
with the definition of isoquants.
Consider the following figure.

Q=20 q=50

K*

L
L*
Fig 3.3Isoquant do not cross each other .

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.

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 out put is held constant. The absolute value of
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the slope of an isoquant is called marginal rate of technical substitution (MRTS). The MRTS shows the
amount by which the quantity of one input can be reduced when one extra unit of another input is used, so
that output remains constant. MRTS of labor for capital, denoted as MRTS L, K shows the amount by which
the input of capital can be reduced when one extra unit of labor is used, so that output remains constant.

This is analogues to the marginal rate of substitution (MRS) in consumer theory.

MRTS L,K decreases as the firm continues to substitute labor for capital (or as more of labor is used). In
fig.2.9 to increase the amount of labor from 1 to 2, the firm reduces 4 units of capital (K=4), to increase
labor from 2 to 3, the firm reduce 2 unit of capital (K=2), and so on. Hence, the firm reduces lower and
lower number of capital for the successive one unit of labor.

The reason is that when the number of capital is large and that of labor is low, the productivity of capital is
relatively lower and that of labor is higher (due to the low of diminishing marginal returns). Thus, at this
point relatively large amount of capital is required to replace one unit of labor (or one unit of labor can
replace relatively large amount of capital). As the employment of labor increases and that of capital
decreases (as we move down ward along the isoquant), quite the reverse will happen. That is, productivity
of capital increases and that of labor decreases. Hence, the amount of capital that needs to be reduced
increase when one extra labor is used decreases. The fact that the slope of an isoquant is decreasing makes
an isoquant convex to the origin.

MRTS L, K (the slope of isoquant) can also be given by the ratio of marginal products of factors. That is,
MRTS

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L,K

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K MPL
 
L MPK

The long run law of production: The law of returns to scale

The laws of production describe the technically possible ways of increasing the level of production. Output
may increase in various ways. In the long run output can be increased

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by changing all factors of production. This long run analysis of production is called Law of returns to
scale.

In the short run output may be increased by using more of the variable factor, while
capital (and possibly other factors as well) are kept constant. The expansion of output
with one factor (at least) constant is described by the law of variable proportion or the
law of (eventually) diminishing returns of the variable factor.

In the long run all inputs are variable. Expansion of output may be achieved by varying all factors of
production by the same proportion or by different proportions.

The traditional theory of production concentrates on the first case, i.e. the study of output as all inputs
change by the same proportion. The term returns to scale refers to the change in output as all factors change
by the same proportion. Suppose initially the production function is X0 = f (L, K)

If we increase all factors by the same proportion t, we clearly obtain a new level of output X* where, X* = f
(tL, tK)
• If X* increases by the same proportion t or if X* = tX0, we say that there is
constant returns to scale.
• If X* increases less than proportionally with the increase in the factors (or if
X* increases by a proportion less than t), we have decreasing returns to scale.
• If X* increases more than proportionally with the increase in the factors (by a
more than t proportion), we have increasing returns to scale.
Returns to scale and homogeneity of production function
Suppose we increase both factors of the function X 0=f (L, K) by the same proportion‘t’, and we get the new
level of output X = f (tL, tK)

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If t can be factored out (that is, may be taken out of the brackets as a common factors), then the new level
of output X* can be expressed as a function of t (to any power V) and the initial level of output, and the
production function is said to be homogeneous.
v V
X* = t f (LK) or X* = t X 0

If t cannot be factored out, the production function is non-homogeneous. Thus, a homogeneous function is
a function such that if each of the input is multiplied by t, then t can be completely factored out of the
function. The power V of t is called degree of homogeneity of the function and is measure of returns to
scale.

If V=1, we have constant returns to scale. This is also called linear homogeneous If V<1,
decreasing return to scale prevails
If V>1, increasing return to scale prevails For a
Cobb-Douglas production function
X = b0Lb1 Kb2, V = b1 +b2 and it is a measure of returns to scale.
Proof: Let L and K increase by t. The new level of output is X* = b0 (tL)
b1
(tk) b2
X* = b0 tb1 lb1 tb2kb2 X*

= b0Lb1Kb2 tb1+b2 X* =
X (t b1+b2) Thus V =
b1+b2

Causes of increasing returns to scale

Technical and /or managerial indivisibility. Mostly, processes of production can be doubled but it may not
be possible to half them. When the production system expands, workers will specialize in one extreme and
their productivity increases.

Causes of decreasing returns to scale

The most common causes are ‘diminishing returns to management’. If we expand the out put beyond
optimum, the top management personnel will be over burdened and the

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productivity of additional unit of the variable inputs decline eventually. E.g., doubling fishing fleet may not
double fish catch.

Technological process and production function

Technological improvement (progress) makes factors of production more productive or it makes production
system more efficient; so that the firm will get higher output from the same combinations of labor and
capital than before.

Graphically, this can be shown by upward movement of the total product curve (indicating higher output
level can be achieved from the same input) and down ward movement of isoquant denoting lower
combinations of factors of production can produce equal level of output. See the figures
TP

2.5X 2K1

B’
3X

a c
3.75

b L 3K1 c

Fig 3.4 technological progress shifts the TP curve up ward &the isoquant down ward

3.3 Choice of optimal combination of factors of production

In our previous discussion we have said that an isoquant denotes efficient combination of labor and capital
required to produce a given level of output. But, this does not mean that the monetary cost of producing a
given level of output is constant along an isoquant. That

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is, though different combinations of labor and capital on a given isoquant yield the same level of output,
the cost of these different combinations of labor and capital could differ because the prices of the inputs
can differ. Thus, isoquant shows only technically efficient combinations of inputs, not economically
efficient combinations.

Technical efficiency takes in to account the physical quantity of inputs whereas economic efficiency goes
beyond technical efficiency and seeks to find the least cost (in monetary terms) combination of inputs
among the various technically efficient combinations. Hence, technical efficiency is a necessary condition,
but not a sufficient condition for economic efficiency. To determine the economically efficient input
combinations we need to have the prices of inputs.

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

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 R  C

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 is r .
Now before we go to the discussion of optimal input combination (or economically efficient combination),
we need to know the isocost line, because optimal input is defined by the tangency of the isoquant and
isocost line.

Isocost line
Isocost lines have most of the same properties as that of budget lines, 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.

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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 Kand L are quantities of capital and labor
respectively.
Given the cost outlay C , 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. See the following figure:

K1

2X

L
O
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.

Now we are in a position to determine the firm’s optimal in put combination. However, the problem of
determining optimal input combination (economic efficiency) takes two forms. Sometimes, situations may
happen when a firm has a constant cost outlay and seek to maximize its output, given this constant and cost
out lay and prices of inputs. Still, there are also situations when the goal of the firm is to produce a
predetermined
(given) level of output with the least possible cost. Under we will discuss the two situations separately.

Case1: Maximization of output subject to cost constraint

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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

iso cost line ( r

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MPL

MPK
) is equal to the slope of the isoquant ( ).
w MPL MPL MPK
 or 
r MPK w r
The condition of equilibrium under this case is, thus:

This is the first order (necessary) condition. The second order (sufficient) condition is that isoquant
must be convex to the origin. See the following figure:
K

K1 X3
E

X2
X1
L
L1 B
L1 and K1
Fig: 3.6 the optimal combination of inputs ( )

The optimal point is defined by the tangency of the iso-cost line (AB) and the highest
w
X2
possible isoquant ( ), at point E. At this point the slope of iso-cost line ( r ) is equal to
MPL

X2 MPK
the slope of isoquant ( ).The second order condition is also satisfied by the
convexity of the isoquant.

Mathematical derivation of the equilibrium condition

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The problem can be stated as:

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

Subject to CwL  rK..........................Constra int function

or C wL  rK  C 0
We use the lagrangian method to solve the problem. The
lagrangian equation is written as:

  X  (C)
 
, ,

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
and
Then we find

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L K

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 Micro Economics I
 and set all of them equal to zero to solve for
L and K.

That is,

  X  (wL  rK  C)

And,

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

L

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X

L

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wL 0 

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MPL

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w 

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MPL

w


K

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X
 r 0 
K

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MPK

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r 

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MPK

r

 wL 


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rK  w 0 

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wL  rK C

Solving these equations simultaneously, we obtain the equilibrium condition

MPL MPK w MPL

 or 
w r r

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MPK

The second order condition (the convexity of isoquant) would be insured when:

2 X

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2
 X

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  X   2 X 
2

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 X 
2

0
L2

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, 0
2
K

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and 

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2
L

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 Micro Economics I
   2
K 2 LK
    

Numerical Example

1/ 2 1/ 2
Suppose the production function of a firm is given as X 0.5L K prices of labor and
capital are given as $ 5 and $ 10 respectively, and the firm has a constant cost out lay of $

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600.Find the combination of labor and capital that maximizes the firm’s output and the maximum output.
Solution

The condition of equilibrium is

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MPL
w

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MPK

r

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MPL w
or  MPK r

MPL MPK

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X
 0.25L 1/ 2 K 1/ 2
L
X
 0.25L1/ 2 K  1/ 2
K
Thus, the equilibrium exists when,

0.25L 1 / 2 K  1/ 2
0.25L 1 / 2 K  1 / 2

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$5

$10

K 1
  L 2K....................................(1)
L 2
The constraint equation is:
wL  rK C
5L 10K 600..................................................(2)

Solving equation (1) and (2) would give us the optimal combination of L and K.

L 2K
5L 10K 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.

Case -2: Minimization of cost for a given level of output

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In this case, consider an entrepreneur (a firm) who wants to produce a given output (for
example a bridge or a building or x tones of a commodity) with minimum cost outlay.
That is, we have a single isoquant which denotes the desired level of output, but there are
a set of isocost lines which denotes the different cost outlays. Higher isocost lines denote
higher production costs. The production costs of a desired level of output will therefore
be minimized when the isoquant line is tangent to the lowest possible isocost line (see
fig) At the point of tangency, the slope of the isoquant and isocost lines are

identical. That is

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w MPL

r MPK

Capital

a
E
K1
Isoquant

L1 b d

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 Micro Economics I
Q2
f

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Labor

Fig: 3.7 the equilibrium combination of factors is K1 and L1 amounts of capital and labor
respectively. Lower isocost lines such as ‘ab’ are economically desirable but un
attainable given the desired level of output. So point E shows the least cost combination
of labor and capital to produce X amount of output.

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Now let us see the mathematical derivation of the equilibrium condition. As mentioned earlier, we
minimize the cost of producing a given level of output.
Thus, the problem can be stated as:
Minimize C = f (q) = WL + rK--------------------------------------------------------(Objective function)
Subject to q = f (L, K)----------------------------------------------------------------(Constraint function)
Or f (L, K) – q = 0
We use the LaGrange an method to obtain the equilibrium condition. Accordingly, the LaGrange an
function will be:
 C  ( f (L, K )  q)
 WL  rK  ( f (L, K )  q)

  
, and
The condition of equilibrium will be obtained by finding solving them simultaneous after equating each to zero.
That is

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L K

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 and then
 f (L, K )
w   0
L L

w  MPL 0 

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w
 MPL
 f (L, K )
r   0
K K

r  MPK 0 

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r
  MPK

 f (L, K ) 


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 Micro Economics I

q 0

w r

Thus, the equilibrium condition is

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MPL

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MPK
MPL w

Rearranging the above condition, we obtain MPK r
 MPL W


MPK
This condition 

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
r
is only a necessary condition.

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The sufficient condition is that the isoquant must be convex to the origin. That is

2q 2

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2
q

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  q   q 
2 2
 2 X 
L2

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 0,
k

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 0and  2  2    
L k LK
2
    
Numerical example:
Suppose a certain contractor wants to maximize  from building one bridge. The contractor uses
both labor and capital, and efficient combinations of Labor and capital
1 1

that are sufficient to make a bridge is by the function 0.25 L 2 K 2 . If the prices of labor
(w) and capital (r) are $ 5 and $ 10 respectively, then find the least cost combination of L and K, and the
minimum cost.

Solution:
The contractor wants to build one bridge. Thus, the constraint equation can be written as

1 1

0.25 L 2 k =1
2

1 1

2
MPL = 0.125 L K2
1 1

MPK = 0.125 L 2 K 2

The equilibrium condition is

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MPL W

MPK r
1 1

0.125L 2 K 2 $5
1 1

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
$10
0.125L2 K 2
K 1
  L 2K
L 2
Substituting L = 2K in the constraint equation we obtain
1 1
2 2
0.125 (2K) K =1
0.125 . K=1
2

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1
K 
K= 0.125 2

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8

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16
L = 2K 
2 2
16 8
Therefore, least cost combination of L and K are
2 2

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and

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respectively.
 16   8 
10

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160
  
2
The least cost is C = 5  + 

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
2
=$ 2

Chapter Four
Theory of Costs of Production
Introduction
To produce goods and services, firms need factors of production or simply inputs. To acquire these inputs,
they have to buy them from resource suppliers. Cost is, therefore, the monetary value of inputs used in
production of an item. 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. Because, the next- best alternative of the raw material (such as barely) used for the
production of beer is sacrificed. When the beer factories buy barley from the market, the amount of
barely available for consumption by society may

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be reduced and the price may become dearer. Hence, the production of beer imposes an indirect cost on the
society, moreover, by its nature; the production of beer emits bad chemicals to the environment, which
pollutes waters, air, etc. To control the understandable consequences of the production process on the
environment and their property, the society incurs 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:
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 the 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 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 0firm uses his own building
for production purpose, the cost of using this building for production is estimated by the rent income
foregone. If the producer is a teacher with salary of 1000 birr per month and fruits his job to manage his
factory, then the next best alternative of his labor is the salary that he sacrificed to be the manager of his
factory. The estimated cost of the non- purchased inputs is called implicit costs.

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Thus, in economics the cost of production includes the costs of all inputs used in the production process
whether the inputs are purchased from the market or owned by the firm himself that is:
Economic cost: Explicit cost plus Implicit cost

ii) Accounting Cost

For accountant, the cost of production includes the cost of purchased inputs only. Accounting cost is the
explicit cost of production only. Moreover, accountant’s doesn’t consider the cost of production from the
opportunity cost of the resources point of view.

4.1 Short run Costs

Economics theory distinguishes between short run costs and long run costs. Short run costs are the costs
over a period during which some factors of production (usually capital equipment and management) are
fixed.
In the traditional theory of the firm, total costs are split into two groups: total fixed costs and total variable
costs:
TC = TFC + TVC
Where – TC is short run total cost
TFC is short run total fixed cost TVC is
short run total variable cost
By fixed costs, we mean a cost which doesn’t vary with the level of output. The fixed costs include:
a. Salaries of administrative staff
b. Expenses for building depreciation and repairs
c. Expenses for land maintenance
d. The rent of building used for production , etc
All the above costs are regarded as fixed costs because whether the firm produces much output or zero
output, these costs are unavoidable, and the firm can avoid fixed costs only if he / she shut down the
business stops operation.

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Variable costs, on the other hand, include all costs which directly vary with the level of output. The
variable costs include:
a. The cost of raw materials
b. The cost of direct labor
c. The running expenses of fixed capital such as fuel, electricity power, etc.

All these costs are regarded as variable costs because their amount depends on the level of output. For
example, if the firm produces zero output, the variable cost is zero.
Graphical presentation of short run costs.

Total fixed cost (TFC)

Graphically, TFC is denoted by a straight line parallel to the output axis. The point of intersection of the
TFC line with the cost axis (vertical axis) shows the amount of the fixed. For example if the level of fixed
cost is $ 100, it can be shown as.

Cost
$100

TFC

Fig 4.1 Total Fixed Cost

Output
Total variable cost (TVC)

The total variable cost of a firm has an inverse s- shape. The shape indicates the law of variable proportions
in production. According to this law, at the initial stage of production with a given plant, as more of the
variable factor (s) is employed, its productivity increases. Hence, the TVC increases at a decreasing rate.
This continues until the optimal

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COST
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combination of the fixed and variable factors is reached. Beyond this point, as increased quantities of the
variable factors(s) are combined with the fixed factor (s) the productivity of the variable factor(s) declined,
and the TVC increases by an increasing rate. Thus, the TVC has an inverse s-shape due to the law of
diminishing marginal returns.

TVC

Output

Fig 4.2 Total variable cost curve

Total Cost (TC)

The total cost curve is obtained by vertically adding the TFC and the TVC i.e., by adding the TFC and the
TVC at each level of output. The shape of the TC curve follows the shape of the TVC curve. i.e. the TC has
also an inverse S-shape. But the TC curve doesn’t start from the origin as that of the TVC curve. The TC
curve starts from the point where the TFC curve intersects the cost axis.
Cost

TC

TVC

TFC

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Output

Fig 4.3 Total cost curves

The TC and TVC curve has an inverse S- shape. The vertical distance between them (TFC) is constant.

Per unit costs (average costs)

From total costs we can derive per-unit costs. These are even more important in the short run analysis of
the firm. Average fixed cost (AFC) - is found by dividing the TFC by the level of output.

Graphically, the AFC is a rectangular hyper parabola. The AFC curve is continuously decreasing curve, but
decreases at a decreasing rate and can never be zero. Thus, AFC gets closer and closer to zero as the level
of output increases, because a fixed amount of cost is being divided by increasing level of output.
Cost

AFC

Output

Fig 4.4 Average Fixed Cost Curve

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The average fixed cost curve is derived from the total fixed cost, and it represents the slope of
straight lines drawn from the origin to a given point on the TFC curve.

Average variable cost (AVC)

The AVC is obtained by dividing the TVC with the corresponding level of output.
TVC
AVC 
X

Graphically, the AVC at each level of output is derived from the slope of a line drawn from the origin to
the point on the TVC curve corresponding to the particular level of output.
The following graph clearly shows the process of deriving the AVC curve from the TVC curve.

Cost Cost
TVC

AVC
K

Panel A Panel XB K
d
Fig 4.5 in the figure above, the AVC at Q1 from panel A is given by the slope of the ray
0a, the AVC at Q2 a isbb given by slope of the ray 0b, and so on. The slope of the rays
T Y T
decreases until Q3 and starts to rise beyond Q3.
X
Y
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Output
0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

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It is clear from this figure that the slope of a ray through the origin declines continuously until the ray
becomes tangent to the TVC curve at Y. To the right of this point (Point Y) the slope of the rays through
the origin starts increasing. Thus, the short run AVC (SAVC now on) falls initially, reaches its minimum
and then start to increase. Hence, the SAVC curve has a U-shape and the reason behind is the law of
variable proportions. Had the TVC not been inverse S-shaped, the SAVC would never assume a U-shape.

Generally, at initial stage of production, the productivity of each additional unit a variable input increases,
thus, the variable input requires to produce each successive units of output decreases at this stage, implying
that the AVC (Variable Cost Incurred to produce a unit of output) decreases. This process continues until
the point of optimal combination between the fixed input and the variable input is reached. Beyond this
point, the productivity of each additional unit of the variable combined with the existing fixed input
decreases because the fixed input is over utilized. As the productivity of such variables decreases, more and
more of the variables are required to produce successive units of the output, implying that the variable cost
incurred to produce each successive unit (AVC) increases.

Average total cost (ATC) or simply, Average cost (AC)

ATC (or AC, now on) is obtained by dividing the TC by the corresponding level of output. It shows the
amount of cost incurred to produce each unit of successive outputs.

TC
AC 
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TVC  TFC
AC 
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TVC TFC
 
Q Or Q
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Q Q
= AVC + AFC
Thus, AC can also be given as the vertical sum of AVC and AFC.

Graphically, AC curve can be obtained by vertically adding the AVC and AFC for each level of
successive outputs. Alternatively, the AC curve can also be derived in the same way as the SAVC curve.
The AC curve is U-shaped because of the law of variable proportions. Observe the figure that follows.

Cost

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TC
d

ATC

c a
b
a

b d
c

0 Q Q2 Q3 Q4

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Output

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Q1 Q2

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Q3 Q4

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Output

Fig 4.6 Panel-A (TC Curve) Panel-B (ATC Curve)

From this figure (Panel A), the AC at any level of output is the slope of the straight line from the origin to
the point on the TC curve corresponding to that particular level of output. That is, for example, the AC of
producing Q1 level of output is given by the slope of the line 0a, the AC of producing Q2 level of outputs
is given by the slope of the line Ob and so on.

Marginal Cost (MC)

The marginal cost is defined as the additional cost that the firm incurs to produce one extra unit of the
output. One thing to be noted here is that, the additional cost that the firm incurs to produce the 10th unit of
output is no0t equal to the additional cost of producing the 1000 th unit. They would be equal if the TC curve
is straight line.

To sum up, the MC is the change in total cost which results from a unit change in output
i.e. MC is the rate of change of TC with respect to output, Q or simply MC is the slope of TC function and
given by:

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dTC
MC 
dQ

In fact MC is also the rate of change of TVC with respect to the level of output.

dTFC  dTVC dTVC

MC  

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dTFC
0
dQ dQ

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, since dQ
Graphically, the MC the TC curve (or equivalently the slope of the TVC curve) obviously, the slope of
curved lines at a given point is measured by constructing a tangent line to the curve at each point. So, the
slope of the curve at a given point is equal to the slope of the tangent line at that specific point. Given the
inverse S-shaped TC (or TVC) curve, the MC curve will be U-shaped. Thus given inverse S-shaped TC or
TVC curve, the slope of the TC or TVC curve (i.e. MC) initially decreases, reaches its minimum and then
starts to rise.

From this, we can logically infer that the reason for the U-shaped ness of MC is also the law of variable
proportion. That is, had the TC or TVC curve not been inverse S-shaped, the MC curve have would never
assumed the U-shape, and obviously, the TC or TVC is inverse S-shaped due to the law of variable
proportions. Observe the figure that follows for more discussion.

C C
c
SMC

c
b

b
a

Q Q

Q1 Q1

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Fig 4.7 Panel-1 (TC Curve) Panel-2 (MC Curve)

In Panel 2 the slope of the tangent lines to the TC curve ( MC) decreases up to point S
and then starts to rise.

In summary, AVC, ATC and MC curves are all U-shaped due to the law of variable proportions. The
simplest total cost function which would incorporate the law of variable proportions is the cubic
polynomial of the following form
TC bo  b1Q  b2Q 2  b3Q3
b0

Q
TFC = b0, AFC = ,
bQbQ bQ3 2

TVC= 1 2 3

b Q  b Q  b Q3 2

1 2 3
AVC  b  b Q  b Q 2
1 2 3
Q
ATC = AFC + AVC

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b0
  b1  b2Q  b3Q 2
Q

The relationship between AVC, ATC and MC

Given ATC = AVC + AFC, AVC is part of the ATC. Both AVC and ATC are u – shaped, reflecting the
law of variable proportions however, the minimum of ATC occurs to the right of the minimum point of the
AVC ( see the following figure) this is due to the fact that ATC includes AFC which continuously
decreases as the level of output increases.

After the AVC has reached its lowest point and starts rising, its rise is over a certain range is more than
offset by the fall in the AFC, so that the ATC continues to fall (over that range) despite the increase in
AVC. However, the rise in AVC eventually becomes greater than the fall in AFC so that the ATC starts
increasing. The AVC approaches the ATC asymptotically as output increases.

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ATC

Fig 4.8 Average cost curves

The AVC curve reaches its minimum point at Q1 output and ATC reaches its minimum point at Q2. The
vertical distance between ATC and AVC (AFC) decrease continuously as output increases. MC curve
passes through the minimum point of both ATC and AVC

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)

d ( f (Q))
MC   f (Q)
dQ

TC f (Q)
AC  
Q

Slope of

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Q

d (f
AC d

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(Q))

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( f (Q))Q 


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Q. f (Q)

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MC

MC.Q - f(Q) Q
 

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f (Q)

Slope AC =

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1
MC 
Q

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dQ Q2
f (Q)
AC , where  AC
Q

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Q2 Q
Now,

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i) when MC<AC, the slope of AC is negative, i.e.

AC curve is decreasing (initial stage of production)
ii) When MC >AC, the slope of AC is positive, i.e. the AC curve is
increasing (after optimal combination of fixed and variable inputs.
iii) When MC = AC, the slope of AC is zero, i.e. the AC curve is at its
minimum point.
The relationship between AVC and MC can be shown in a similar fashion.

The relationship between short run per unit production & cost curves
Let’s see the important relation that per unit production curves (i.e. AP and MP of the variable input)
and per unit cost curves (i.e. AVC and MC) have. The relationship is that the short run per unit costs are the
mirror reflection (against the x-axis) of the short run production curves. That is the short run AVC is the
mirror reflection of the short run AP of the variable input. When AP variable input increases, AVC
decreases; when AP variable input reaches its maximum, the AVC reaches its maximum point, and
finally when AP variable input starts to fall, the AVC curve starts to rise. The same relationship exists
between the short run MP of variable input curve the MC curve. This can be shown algebraically by using a
linear short run cost function.
Suppose the firm uses two inputs, labor L (which is variable) and capital (which is fixed input). And
suppose that the prices of both factors are given and equal to w, and r respectively. The total cost of

production is then, TC rK  wL . The first term (i.e. rk) is the fixed cost because both r and k are
constant and the second term (i.e.wL) represents the variable cost.

TVC

Q
TVC = W, AVC =

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1

WL Q
Q
= = W. L
1

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But, L represents APL

Therefore, AVC = W. APL

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Hence, AVC and APL are inversely related.

dTC

MC = dQ

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dTVC

= dQ

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dTC

dQ
(Remember that MC =

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d (W .L)

MC = dQ

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dL

= W. dQ
1

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….............................................(because w is constant)

dL dQ 1 dQ

MC = W. dQ = W. dL

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= W. MPL ……………… (Because dL

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= MPL)

Hence, MC and MPL have also an inverse relation.

Graphically

AP

AVC, MC

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TC

Fig 4.9 short run AVC and MC curves are the mirror reflection (along the
horizontal axis) of short run APL and MPL curves
4.2 Costs in the long run
The basic difference between long-run and short run costs is that in the short run, there are some fixed
inputs which results in some amount of fixed costs. However, in the long run all factors are assumed to
become variable. In the long run the firm can change the quantities of all inputs including the size of the
plant. This implies that all costs are variable in the long-run in the sense that it is always possible to
produce zero units of output at zero costs. That is, it is always possible to go out of business. The long –run
cost curve is a planning curve, in the sense that it is a guide to the entrepreneur in his decision to plan the
future expansion of his plant.

Derivation of the long- run average cost curve

The long run average cost curve is derived from the short run average cost curves. Each point on the long
run average cost (LAC, now on) corresponds to a point on the short run cost curve, which is tangent to the
LAC at that point. Now let us examine in detail how the LAC is derived from the short run average cost
( SAC) curves.

assume that the available technology includes large number (infinite number) of plant sizes, each suitable
for a certain level of output, the points of intersection of consecutive

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plants cost curves (which are the crucial points for the decision of whether to switch to a larger plant) are
numerous and we obtain a continuous curve, which is the planning LAC curve of the firm. The LAC curve
is then the tangent to these SATC curves of various plant sizes and shows the minimum cost of producing
each level of output.

M AV

C4 SAC 2

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S A
LAC
Q

Fig: 4.11 long run average cost curve, assuming large number of plant sizes

In summary, the LAC curve shows the minimum per-unit cost of producing any level of output when the
firm can build any desired scale of plant in the sense that the firm chooses the short –run plant which
allows it to produce the anticipated (in the long run)output at the least possible cost.

Why is the LAC U-shaped?

Similar to the SAC curve, the LAC curve of a firm is also U-shaped, but the reason for the U-shapes ness
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 out put expands from a very low levels increasing returns to scale prevails (i.e., out put
rises proportionally more than inputs), and so the cost per-unit of output falls(assuming that input prices
eventually
remain constant).As output continues expand, the forces of decreasing returns to scale
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.

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Economies of scale is the cost dimension of increasing returns to scale and thus, they are like the two sides
of a coin. If a firm has increasing returns to scale in production (i.e., if it requires the firm less than double
inputs to produce double output) the firm will have economies of scale in costs (it will require the firm less
than double cost to produce double output). Thus, the reason for the decreasing part LAC curve is
increasing returns to scale or economies of scale. Economies of scale may prevail for various reasons such
as specialization of skills, lower prices for bulk-buying of raw materials, decentralization of management
system and etc.

The traditional theory of the firm assumes that economies of scale exists only up to a certain size of plant,
which is known as optimal plant size, because with this plant size all possible economies of scale are
fully exploited. If the plant size increases further than this optimal size diseconomies of scale will start to
prevent, arising from managerial in efficiencies, the price advantage from bulk-buying may also stop
beyond a certain limit etc. These diseconomies of scale will lead to increasing LAC curve. Thus, the
increasing portion of the LAC curve shows the existence of diseconomies of scale or decreasing returns to
scale.

In general, the reason for the U-shaped ness of the LAC curve are the existence of increasing returns to
scale at initial stage of expansion decreasing returns to scale at a later stage of expansion.

Increasing returns to scale

Decreasing returns to scale

C0 constant returns to scale

C1’

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C1

Fig 4.12 the LAC curve is U-shaped due to the combined effects of increasing, constant
and decreasing returns.

The long-run marginal cost curve.

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.

C2’
C2 SAC3

X1 C3
X1’’’’

X2’ X1’’’’

X3 X2 X1’’ LAC
Fig4.13: Long run marginal cost curve; it is derived from the short run marginal cost
curves by connecting the points of intersection of the vertical lines drawn from the point
of tangency of SAC curves with the LAC curves with and the corresponding SMC curves.

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

4.3 Dynamic changes in costs: the learning curve

So far we have suggested one reason why a large firm may have a lower long-run average cost than a small
firm: increasing returns to scale in production it is tempting to conclude that firms which enjoy lower
average cost over time are growing firms with increasing returns to scale .but this need not be true.

In some firms, long-run average cost may decline over time because workers and managers absorb new
technological information as they become more experienced at their job. That is, as workers get experience
their efficiency increases which then reduces the average and marginal costs of producing a unit of product.

As management and labor gain experience with production, the firm’s marginal and average costs of
producing a given level of out put fall for four reasons:

1. Workers often take long-run to accomplish a given task the first few times they do it. As they become
more adept, their speed increases. For example, a worker packing 20 dozens of soups per hour in the first
few months can pack more than 20dozens of soups in latter months when he/she gains experience.
2- Managers learn to schedule the production process more effectively.
3- Engineers who are initially cautious in their product designs may gain enough
experiences to be able to allow for tolerances in design that save costs with though
increasing defects. Better and more specialized tools and plant organization may also
lower cost.
4- Suppliers may learn how to process required materials more effectively and pass on
some of this advantage in the form of lower costs to the firm.

In general, a firm ’learns’ over time as cumulative output increases. Managers can use this learning process
to help plan production and for cast future costs. The following figure illustrates this process in the form
of learning curve: a curve that describes the

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relationship between the firms cumulative output and the amount of inputs needed to produce each
unit of output.

Number of labor required to produce one unit

curve Learning

1
Output

Fig4.14: 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.

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.

Learning vs Economies of scale

A firm’s average cost of production can decline overtime because of growth of sales (output) when
increasing returns to scale prevails in the firm (a move from A to B on curve AC,), or it can decline
because there is a learning curve ( a move from A on AC, to C on AC2).Thus, increasing returns to scale
reduces average cost of production with increase in output, whereas learning shifts the average cost curve
down ward.
Cost per unit of out put

Economies of scale
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A

B
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Learning AC1

AC2
Out put

Fig4.15 Learning shifts the average cost curve down wards.

CHAPTER FIVE
PERFECT COMPETTION MARKET
Introduction
Definition and Assumptions
Perfect competition is a market structure characterized by a complete absence of rivalry among the
individual firms. Thus, perfect competition in economic theory has a meaning diametrically opposite to the
everyday use of this term. Most of the time, we see business men using the word “Competition” as
synonymous to “rivalry”. However, in theory, perfect competition implies no rivalry among firms
Assumptions
The model of perfect competition was constructed based on the following assumptions.
1. Large number of sellers and buyers.

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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 cannot 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.

QO Q
Market P
P=AR=MR

SAC1

Fig 5.1 the demand curve indicates a single market price at which the firm can sell
any amount of the commodity demanded. The demand curve also indicates the
average revenue and marginal revenue of the firm.

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3. Free entry and exit of firms

There is no barrier to entry and exit from the industry. Entry or exit may take time, but firms have
freedom of movement in and out of the industry. If barriers exist the number of firms in the industry
may be reduced so that one of them may acquire power to affect the market price.
4. The goal of all firms is profit maximization.
Of course, firms can have different objectives. Some firms may have the aim of making their product
wise, others may want to maximize their sales even by cutting price, etc. But, in this model, it is
assumed that the goal of all firms is to maximize their profit and no other goal is pursued.
5. No government regulation
By assumption, there is no government intervention in the market. That is there is no tax, subsidy etc.
A market structure in which all the above assumptions are fulfilled is called pure competition. It is
different from perfect competition which requires the fulfillment of the following additional
assumptions.
6. Perfect mobility of factors of production
Factors of production (including workers) are free to move from one firm to another through out 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.
ÂThe price of the product
ÂQuality of the product etc
Thus, a perfectly competitive market is a market which satisfies all the above conditions
(assumptions). In reality, perfectly competitive markets are scarce if not none. But since the theory of
perfectly competitive market helps as a bench mark to analyze the more realistic markets, it is very
important to study it.

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Given the above assumptions (based which the model of perfect competition was built), we will now
examine how the firm operating in such a market determines the profit maximizing out put both in the
short run and in the long run. But to determine the profit maximizing out put, first we have to see what
the revenue and cost functions of the firms operating in perfectly competitive market looks like.
Costs under perfect competition
In the previous chapter, we have said that the per unit cost (AVC &AC) have U – shape due to
the law of variable proportions (in the short run) and the law of returns to scale (in the long run).
There is no exception for firms operating under perfect competition i.e., their cost functions have
the behavior mentioned in the last chapter. Demand 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.

If, for example, the seller charges higher price than the market price to get larger revenue, no buyers
will buy the product of this ( the price raising) firm since the same product is being sold in the market
at lower price by other sellers. Obviously, the firm will not also attempt to reduce the price. Thus firms
operating in a perfectly competitive market are price takers and sell any quantity demanded at the
ongoing market price.

Hence, the demand function that an individual seller faces is perfectly elastic ( or horizontal line).
Graphically,
P

SMC1

LM
C

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SAC3

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Fig 5.2 the demand curve that a perfectly competitive firm faces is horizontal line with
intercept at the market price. This indicates that sellers sell any quantity demanded at the
ongoing market price and buyers buy any amount they want at the ongoing market price.

From the buyers’ side too, since there is large number of buyers in the market, a single buyer can not
influence the market price.
Thus, in perfectly competitive market, both buyers and sellers are price takers. They take the price
determined by the forces of market demand and market supply.
Given the horizontal demand function at the ongoing market price, the total revenue of a firm operating
under perfect competition is given by the product of the market price and the quantity of sales, i.e.,
TR = P*Q
Since the market price is constant at P*, the total revenue function is linear and the amount of total revenue
depends on the quantity of sales. To increase his total revenue, the firm should sell large quantity.

Graphically, the TR curve is as shown below.

LAC

SMC32
SAC2

Q
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Fig 5.3 the total revenue of firm operating in a perfectly competitive market is linear (and
increasing function) of the quantity of sales.
The marginal revenue (MR) and average revenue (AR) of a firm operating under perfect competition are
equal to the market price. To see this, let’s find the MR and AR functions from TR functions.
TR= PQ
By definition, MR is the change in total revenue that occurs when one more unit of the

dTR
MR  P
output is sold, i.e.

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dQ .Hence MR=P

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TR P.Q
AR   P
Average revenue is the TR divided by the quantity of sales. i.e. Q Q
Hence, AR = P.

Graphically, the demand curve represents the MR and AR of the firm Cost

TFC

Output
curve of an individual firm
Fig: 5.4 the AR curve, MR curve and the demand
operating under perfectly competitive market overlap.

5.1 Short run equilibrium of the firm

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A firm is said to be in equilibrium when it maximizes its profit (). Profit is defined as the difference
between total cost and total revenue of the firm:
= 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 output since
the firm is a price taker.
The level of output which maximizes the profit of the firm can be obtained in two ways:
Ì Total approach
Ì Marginal approach

Total approach
In this approach, the profit maximizing level of output is that level of output at which the vertical distance
between the TR and TC curves is maximum. (Provided that the TR curve lies above the TC curve at this
point).

Graphically TR TC
TC,TR

Q
Q0 Qe Q1
Fig:5.5 The profit maximizing output level is Qe because it is at this output level that the
vertical distance between the TR and TC curves (or profit) is maximum.
For all output levels below Q0 and above Q1 profit is negative because TC is above TR.

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Marginal Approach
In this approach the profit maximizing level of output is that level of output at which: MR=MC and
MC is increasing
This approach is directly derived from the total approach. In figure 4.4, the vertical distance between the
TR and TC curve is maximum where a straight line parallel to the TR curve is tangent to the TC curve. Or
simply, the vertical distance between the TC and TR curves is maximum at output level where the slope of
the two curves is equal. The slope of the TR curve constant and is equal to the MR or market price.

Similarly, the slope of the TC curve at a given level of output is equal to the slope of the tangent line to
the TC curve at that level of output, which is equal to MC. Thus the distance between the TR and TC
curves () is maximum when MR equals MC. Graphically, the marginal approach can be shown as
follows.

MC, MR

MC

MR

Q* Qe

Fig 5.6: the profit maximizing out put is Qe, where MC=MR and MC curve is increasing.
At Q*, MC=MR, but since MC is falling at this output level, it is not equilibrium out put.
For all output levels ranging from Q* to Qe the marginal cost of producing additional

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unit of output is less than the MR obtained from selling this output. Hence the firm should
produce additional output until it reaches Qe.

Mathematical derivation of the equilibrium condition

Profit () = 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, =f (Q)
= TR-TC
To determine the profit maximizing output we find the first derivative of the  function and equate the
result to zero.
d  dTR
 
dQ dQ

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dTC
0
dQ
= MR – MC = 0
= MR = MC ----------------------------------- (First order condition necessary condition)
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.

d 2
dQ 2

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2
d TR
0 2
dQ Ú

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2
d TC
 2
0
dQ

d 2TR

dQ 2

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dMR

dQ

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,thus

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2
d TR

dQ 2

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is the slope MR. Since MR is horizontal (or constant), the

slope of MR is equal to zero.
d 2TC

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dMC

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d 2TC
Likewise, constant

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2
dQ

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dQ
is equal

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and thus,

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2
dQ

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is the slope of MC, which is not

Thus,

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2
d TR

dQ 2

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2
d TC

dQ 2

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means

- Slope of MR < Slope of MC

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- 0 < Slope of MC or
- Slope of MC > 0 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

Conceptually, maximizing the difference between TR & TC means maximizing the area

between the MR and MC curve, i.e., maximizing 

(MR-MC)dQ. And the area between the MC and
MR would be maximal only when the firm produces Qe level of output.

The fact that a firm is in the short run equilibrium does not necessarily mean that the firm gets positive
profit. Whether the firm gets positive or zero or negative profit depends on the level of ATC at equilibrium
thus;

- 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 (see fig5.7below)

Q3
Le
Q
Cum
A
A

C B
Fig 5.7 the firm earns a positive profit because price exceeds AC of production at equilibrium

- If the ATC is equal to the market price at equilibrium, the firm gets zero.

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- If the ATC is above the market price at equilibrium, the firm earns a
negative profit (incurs a loss) equal to the area between the ATC curve
and the price line.( see fig 5.8 below).
C,P

C _
P Out
P
put

Fig 5.8 a firm incurs a loss because price is less than AC of production at equilibrium.

In fact, the firm will continue to produce irrespective of the existing loss as far as the price is sufficient to
cover the average variable costs. In other words, the firm should continue producing as far as the TR
sufficiently covers the total variable costs. This is so because if the firm stops production he will incur a loss
which equals the total fixed cost. But, if it continues to produce the loss is less than the total fixed costs
because the TR will cover some portion of the fixed costs in addition to the whole variable costs as far as it is
greater than TVC.

However, if the market price falls below the AVC or alternatively, if the TR of the firm is not sufficient to
cover at least the total variable cost, the firm should close (shut down) its factory (business). It will only lose
the fixed costs; but if it continues operation while the TR is unable to cover even the variable costs, the loss is
greater than the fixed costs since part of the variable cost is also not covered by the existing revenue.

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To summarize, a firm may continue production even while incurring a loss (when TC > TR). This occurs as
far as the TR is able to cover at least the TVC (TR > TVC). If the TR is less than the TVC, the firm is well
advised to discontinue its operation so that the loss will be minimized. Hence, to continue its operation (or
just to stay in the business) the firm should obtain the TR which can at least cover its variable costs. The
following example will make the discussion clear.

Example:
Suppose a firm has a TFC of $2,000, a TVC of $ 5,000 and a TR of $6,000 at equilibrium. Should the firm
stop its operation? Why?

In fact the firm is incurring a loss of $ 1,000 because TC (2,000 + 5,000=7,000) is greater than the total
revenue. But the firm should continue production because the TR is greater than TVC. If the firm stops
operation, it will lose the fixed cost ($ 2.000). But if it continues production the loss is only $ 1,000 (TR-TC).
Thus, the firm requires a minimum TR of $ 5,000 to continue operation. If the TR is equal to $ 5,000, the firm
is indifferent in between choosing to continue or to discontinue its operations because in both cases the loss is
equal to fixed costs. Thus the level output at which TR and TVCs are equal is called shut down out put level.
In other words, shut down point is the point at which AVC equals the market price.

Equally important point is the point of break-even. Break-even point is the out put level at which market price
is equal to the average cost of production so that the firm obtains only normal profit (zero profit).

Numerical example
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
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?

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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=10
dTR
MR 
dq
Alternatively,
d (10q)
MR  10

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where TR= P.q = 10q

Thus,

MC=

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dTC dq

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dq
d (10q  dq 2  q 3 )

dq

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10  8q  3q 2

 To determine equilibrium output just equate MC& MR And then

solve for q.
10 – 8q + 3q2 = 10
- 8q + 3q2 = 0 q
(-8 + 3q) = 0
q = 0 or q = 8/3
Now we have obtained two different output levels which satisfy the first order (necessary)
condition of profit maximization
i.e. 0 & 8/3

 To determine which level of output maximizes profit we have to use the second order test at the two
output levels i.e. we have to see which output level satisfies the second order condition of increasing MC.

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 To see this first we determine the slope of MC

dMC

dq
Slope of MC = = -8 + 6q
 At q = 0, slope of MC is -8 + 6 (0) = -8 which implies that marginal lost 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) Above, we have said that the firm maximizes its profit by reducing 8/3 units. To
determine the firm’s equilibrium profit we have calculate the total revenue that the firm
obtains at this level of output and the total cost of producing the equilibrium level of
output.
TR = Price * Equilibrium out put
= $ 10 * 8/3= $ 80/3
TC at q = 8/3 can be obtained by substituting 8/3 for q in the TC function, i.e., TC = 10 (8/3)
– 4 (8/3)2 + (8/3)3 » 23.12

Thus the equilibrium (maximum) profit is

 = 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

dQ
That is: =0
Given the TC function: TC = 10q – 4q2 +q3, there is no fixed cost i.e. TC is equal to the TVC.
Hence, TVC = 10q – 4q2 + q3
TVC

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10q 

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2 3
4q  q

q q
AVC = =

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= 10 – 4q + q2
2

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dAVC
0
dq Â

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d (10 

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2
4q  q )
0
dq
= -4 + 2q = 0
 q = 2 i.e. AVC is minimum when out put 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.

The short run supply curve of the firm and the industry
The short run supply curve of the firm
In the previous section, we have demonstrated how a competitive firm determines the
level of output which maximizes its profit for a given market price. The profit maximizing level of output
is defined by the point of equality of MC and market price (because market price is equal to MR in the
perfectly competitive market). By repeating this analysis at different possible market prices, we observe
how the equilibrium quantity supply of the firm varies with the market price.

Now consider the figure 5.9 to understand how to derive the short run supply curve of a perfectly
competitive firm.

Suppose that initially the market price and MR is $6 and the demand curve is shown by line P1. Given the
MC curve, the level of output which maximizes the firm’s profit is defined by the point of intersection of
the MC curve and the demand line (P1), which is equal to 50 units.

Now assume that the market price increases to $7. This is shown by an upward shift of the demand curve
(MR) to P2. Given the positive slope of MC, this higher demand (MR) curve cuts the MC curve at higher
output level, 140. That is, when the market price increases from $6 to $7, the equilibrium quantity supplied
by the firm increases from 50 units to 140 units. As the price increases further (say to $8), the
equilibrium output

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increases to 200 units. This implies that the quantity supplied by the firm increases as the market price
increases.
P, C P
MC
AC
E2 AVC
$8 P3= MR3 $8

E2
$7 P2= MR2 $7

E1
$6 P1= MR1 $6

AC P MC

Fig,5.9 The short run supply curve of a perfectly competitive firm P= ARis obtained
_ _ by
connecting different equilibrium points E1, E2, E3 that occurs at successive price levels
p1, p2 and p3 respectively. When the market price is $6, the firm supplies 50 units to
maximize its profit. As the price increases to $7, the equilibrium quantity supplied
increases to 140 units and so on.

The firm, given its cost structure, will not supply any quantity ( will shut down) if the price falls below $6,
because at a lower price than $6, the firm cannot cover its variable costs. Thus, supply is zero for all price
levels below $6 (minimum AVC). If we plot the successive equilibrium points on a separate graph we
observe that the supply curve of the individual firm over laps with (is identical to) to part of its MC curve
to the right of the shutdown point.

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

Before we discuss the derivation of short run supply curve of the industry, let us see what the word
‘industry’ refers to in this unit. The word ’industry’ is defined as group of firms producing homogeneous
products. Thus the industry supply is the total supply or market supply.

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The industry –supply curve is the horizontal summation of the supply curves of the individual firms. That
is, the total quantity supplied in the market at each price is the sum of the quantities supplied by all firms at
that price. This is based 0n the assumption that the factor prices and the technology are given.

For detailed information as to how to derive the short run industry supply curve from the supply of
individual firms, consider the following figure. S 1, S2 and S3 denote the supply curves of firms existing in a
given industry. The industry supply curve is obtained by adding the quantities supplied by all the firms at
each price. For example, at price which equals $ 6, firm 1 supplies 50 units, firm 2 supplies 80 units & firm
3 supplies 120 units. The market supply at $ 6 price is thus 250 units (50+80+120 units). The short run
industry- supply is derived by repeating the above process at each price levels.

Output
S1 S2 S3

Q
8
6

50 60 120
Fig, 5.10 the industry- supply curve is the horizontal summation (at each price) of the supply
curves of all firms in the industry.

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When the market price falls below $ 4, only firm2 exists in the market. Thus, for prices below$ 4, the
industry supply curve is identical with the supply curve is identical with the supply curve of firm 2.
Similarly, for price levels ranging from $4 to $5, only firm1 and firm2 are producing and searching in the
market. Thus, the industry- supply curve for this range of price is the sum of the quantities supplied by firm
1 and firm 2, and so on.

Short run equilibrium of the industry

In our previous discussions, we have seen the short run equilibrium of the individual firm. At that time, we
have said that the short run equilibrium of the firm is defined by the point of intersection of the horizontal
MR curve (or the demand curve that the individual firm faces) and MC curve (or the supply curve of the
firm). In other words, the short run equilibrium of an individual firm is defined by equality of MC of firm
and the market price.

Short run equilibrium of the industry is defined by the intersection of the market demand and market
supply. The intersection of market demand and market supply of a given commodity determines the
equilibrium price and quantity of the commodity in the market.

While discussing the short run equilibrium of an individual firm we have said that the demand curve that an
individual firm faces is horizontal line (perfectly elastic). This is due to the fact that; since there are large
numbers of sellers in the market, an individual firm is too small to influence the market price. Rather, the
firm sells any amount demanded at the prevailing market price.

Unlike the individual demand curve, the market demand curve (the total demand curve that the industry
faces) is down-ward sloping, indicating that as the market price of the commodity increases, the total
quantity demanded for the product decreases and vise versa.In fig.5.11 the industry is in equilibrium at
price Pe, at which the quantity demanded

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and supplied is Qe. At this equilibrium market price, individual firms can earn a positive profit, zero profit
(normal profit) or even can incur a loss depending on their cost structure.

Firm 1 Firm 2
M 1 1
P 200 MC
Pe
Market
Q Q
L
MR Loss P Q
oss

M AC P Pe
C MR C

Fig5.11:- short run equilibrium of the industry. Short run equilibrium of the industry is defined by
the intersection of the market demand and the industry supply Curve. At equilibrium price, Pe
firm 1 gets a positive profit because the average cost of the firm at equilibrium is less than the
market Price, pe. On the other hand, firm 2 is incurring a loss as its average cost is higher than
the market price.

5.2 The long-run Equilibrium of the firm and an industry

1-Equilibrium of an individual firm in the long run
In the long run, firms are in equilibrium when they have adjusted their plant size so as to produce at the
minimum point of their long run Ac curve, which is tangent (at this point) to the demand curve defined by
the market price. That is, the firm is in the long run equilibrium when the market price is equal to the
minimum long run AC. Thus since price is equal to long run AC (LAC now on) at the long run
equilibrium, firms will be earning just normal profits (zero profits), which are included in the LAC. Firms
get only normal profit in the long run due to two reasons.

First, if the firms existing in the market are making excess profits (the market price is greater than their
LACs) new firms will be attracted to the industry seeking for this excess profit. The entry of new firms
results in two consequences:

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A. The entry of new firms will lead to a fall in market price of the commodity (which is
shown by the down ward shift of the individual demand curve). This happens because
entry of new firms will increase the market supply of the commodity (which is shown by
the right ward shift of the industry supply), resulting in the lower market price. Moreover,
if firms are getting excess profit, they have an incentive to expand their capacity of
production, which increases the market supply and then reduces the market price.

B. Moreover, the entry of new firms results in an upward shift of the cost curves. This
happens because, when new firms enter into the market the demand for factors of
production increases which exerts an upward pressure on the prices of factors of
production. An increase in the price of factors of production in turn shifts the cost curves
upward. These changes (decrease in the market price and upward shift of the cost curves)
will continue until the LAC becomes tangent to the demand curve defined by the market
price. At this time, entry of new firms will stop since there is no positive profit (since P =
LAC) which attracts new firms in to the market.

Second, if the firms are incurring losses in the long run (P < LAC) they will leave the industry (shut down).
This will result in higher market price (because market supply of the commodity decreases) and lower costs
(because the market demand for inputs decreases as the number of firms in the market decreases). These
changes will continue until the remaining firms in the industry cover their total costs inclusive of the
normal rate of profit.
Thus, due to the above two reasons, firms can make only a normal profit in the long run. The following
figure shows how firms adjust to their long run equilibrium position excess profit ( higher price than
minimum lack) if the market price is p, the firm is making excess profit working with plant size whose cost
is denoted by SAC, ( short run average cost1). It will therefore have an incentive to build new capacity or
larger plant size and it moves along its LAC. At the same time new firms will be entering the industry
attracted by the excess profits. As quantity supplied in the market increases(by the increased production of
expanding old firms and by the newly established ones) the

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supply curve in the market will shift to the right and price will fall until it reaches the level of P1, at
which the firms and the industry are in the long- run equilibrium.
M A

MC
AC
M aer k
et P C
MR
Pe Pe
Loss
Mar
C ket

L os s
M R
____Q2
Q1

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 Micro Economics I
Prof it

Q P
Marke P

Fig5.12: Long run equilibrium of the firm. Entry of new firms reduces the market price from p to
p1 (in panel A) and the long run equilibrium is established at E (panel B).

The condition for the long run equilibrium of the firm is that the long run marginal cost (LMC) should be
equal to the price and to the LAC i.e. LMC = LAC = P.

The firm adjusts its plant size to so as to produce that level of output at which the LAC is the minimum
possible, given the technology and prices of inputs. At equilibrium the short – run marginal cost is equal to
the long run marginal cost and the short –run average cost is equal to the long run average cost. Thus, given
the above condition, we have,
SMC = LMC = SAC = LAC = P = MR
This implies that at the minimum point of the LAC the corresponding short run plant is worked at its
optimal capacity so that the minimum of the LAC and SAC coincide.

Long run shut down decision

In the short-run the firm should continue production as far as the market price is greater than the minimum
AVC, If the market price falls below the minimum AVC, the firm is

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well advised to shut down because if it shut down it well loose only the fixed costs but if it continues
production the loss is greater than the fixed cost.

The long-run shut down decision (point) is different from that of the short run. The firm shuts down if its
revenue is less than its avoidable or a variable cost. In the long run all costs are variable because the firm
can change the quantity of all inputs. Thus, in the long run the firm shuts down when its revenue falls
below the long run total cost. In other words, in the long run shut down decision occurs if the market price
falls below the minimum LAC of the firm.

The long-run supply curves the firm

Previously, we have noted that in the long run the firm shuts down if the market price is below the its
minimum long run average cost. Thus, the firm will not supply for all price levels below the minimum
LAC. On the other hand, the firm's long run equilibrium output is defined by the equality of the MR and its
LMC. As a result, a firm’s long- run supply curve is its LMC curve above the minimum of its long-run
average cost curve.

Long run supply curve of the industry

The long run supply curve of the industry is the horizontal sum of the supply of individual firms just like
the case of short run supply curve of the industry. Thus, the long run supply curve of the industry is up
ward sloping, provided that the firms are of different size. This is because, firms with relatively lower
minimum LAC, are writing to inter the market than others. So that as the market price increased in the long
run more firms will find it profitable to inter the market, resulting in upward sloping long-run supply curve
of industry.

Long-run equilibrium of the industry

An industry is in the long-run equilibrium when the price is reached at which all firms are in equilibrium.
That is, when all firms are producing at the minimum point of their LAC curve and making just normal
profits, the industry is said to be in the long-run

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equilibrium. Under these conditions there is no further entry or exit of firms in the industry (since all the
firms are getting only normal profit), so that the industry supply remains stable.

P P1

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e Pe
P
Industry equilibrium Firm’s equilibrium
Fig5.13: long-run equilibrium of the industry is defined by the price at which all individual firms
are in equilibrium, marking just normal profit.
The long-run equilibrium of the industry is shown by fig 5.13.At the market price, P, the firms produce at
their minimum LAC, earning just normal profits. At this price all firms are in equilibrium because
LMC=SMC=P=MR.

In the short run individual firms can earn positive, normal or negative profits depending on the level of
their AC s relative to the equilibrium market price. However, this is not the case in the long-run. That is,
while the industry is in the long run .equilibrium all firms earn only normal profit.

5.3Perfect competition and optimal resource allocation

In the perfect competition, the market mechanism leads to an optimal allocation of resources. The
optimality is shown by the following conditions all of which prevail in the long run equilibrium of the
industry;

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a. The output is produced at the minimum feasible cost. That is all firms produce at
the minimum of their LAC.
b. Consumers pay the minimum possible price which just covers the marginal cost
of production, that is, price equals just opportunity cost so that the consumers are
not exploited.
c. Plants are used at full capacity in the long- run so that there is no waste of
resources. That is, at the long run equilibrium the short run average cost is also
minimum.
d. Firms earn only normal profits.
These conditions justify the fact that perfect competition results in optimal resource allocation.

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