Economics Whole Slide

Scope of Managerial Economics
 Managerial economics deals with the application of the economic concepts,

theories, tools, and methodologies to solve practical problems in a business.
 It is the combination of economics theory and managerial theory. It helps the

manager in decision-making and acts as a link between practice and theory.
 It is sometimes referred to as business economics and is a branch of economics

that applies microeconomic analysis to decision methods of businesses or other
management units.
Dr Purna Bahadur Khand, School of Business, Pokhara University

 The scope of managerial economics means the fields of study which managerial
economics cover. Hence, scope of managerial economics includes the subject
matter of managerial economics.
 The scope also covers the relationship of managerial economics with other subjects.

 Following specific aspects constitute scope of managerial economics or its subject

matter:
 1. Demand analysis and forecasting:

 The fundamental objective of demand theory is to identify and analyze the basic
determinants of consumer demans. A forecast of future sales is essential before
making production schedules of employing resources.

 2. Cost and production analysis:

 The cost estimate is essential for planning purposes. The factors determining costs
are not always known or controllable which gives rise to cost uncertainty. It is
required to find out the costs and cost control for profit planning.
 The factors of production are scarce (limited) and have alternative uses. The factors
of productions may be allocated in a particular way to get maximum output. Due to
this, production analysis is also importance in managerial economics.

 3. Pricing decisions and techniques:

 Pricing decisions take up an important place in managerial economics because the
main objective of a firm is the maximization of profits that depends on suitable
pricing decisions. So price is the source of the revenue, and the success of a firm
depends on the correctness of the pricing decisions.

 4. Profit and capital management:

 Profit provides the index of success of a business firm. So the business firms are
organized for making profits. Similarly, there is a difficult problems of a business
manager is relating to firm’s capital investments. Capital management focuses on
planning and control of capital expenditures.

 5. Objective of business firm:

 A firm should fix its objective at the initiation of the business. The objective may be
many ranging from profit maximization to sales maximization to utility maximization
to satisfying. It is assumed that manager consistently makes decisions towards the
objectives.

Concepts of Demand and Supply
 This chapter presents one of the most powerful tools of economics for analyzing how market
works. The market forces that determine prices and quantities of production in competitive
market are demand and supply. Thus, the basic framework of demand and supply analysis is
more essential.
 The market is divided into two different groups of participants: consumers and producers.
Demand analysis focuses on the behavior of consumers, while supply analysis examines the
behavior of producers.
 The demand and supply together determine the price and output that occur in a market. The
impact of changing market circumstances on equilibrium price and output is determined by
making the appropriate shifts in either demand or supply and comparing equilibriums before and
after the change.

Concepts of Demand
 Quantity Demanded (Qd)

The amount of good or service consumers are willing and able to purchase during a given period
of time.
 Variables that influence quantity demanded (Qd)

1. Price of good or service (P)
2. Incomes of consumers (M)
3. Prices of related goods & services (P r)
4. Taste patterns of consumer (T)
5. Expected future price of product (Pe)
6. Number of consumers in market (N)

Concepts of Demand
 Generalized Demand Function

Qd = f(P, M, Pr, T, Pe, N)
If the demand function is expressed in linear form:

Qd = a + bP + cM + dPr + eT + fPe + gN
Where, b, c, d, e, f, & g are slope parameters which measure effect on Qd of changing one of the
variables while holding the others constant. For example, b (=ΔQd/ΔP) measures the change in
quantity demanded per unit change in price holding M, P r, T, Pe and N constant. Sign of
parameter shows how variable is related to Qd. Positive sign indicates direct relationship and
negative sign indicates inverse relationship.

Concepts of Demand
 Normal good
A good or service for which an increase in income causes consumer to demand more of the
good, holding all other variable in generalized demand function constant.
 Inferior good
A good or service for which an increase in income causes consumer to demand less of the good,
holding all other variable in generalized demand function constant.
 Substitutes
Two goods are substitutes if an increase in the price of one of the goods causes consumers to
demand more of the other good, holding all other factors constant.
 Complements
Two goods are complements if an increase in the price of one of the goods causes consumers to
demand less of the other good, holding all other factors constant.

Concepts of Demand
 The generalized linear demand function can sometimes be simplified to include just three
variables.
Qd = a + bP + cM + dPr
For example: Qd = 1800 – 20P + 0.6M – 50Pr

Concepts of Demand
 Demand Function or Demand

The relation between price and quantity demanded per period of time, when all other factors that
affect demand are held constant, is called a demand function or simply demand.
A demand function can be expressed in the most general form as the equation:
Qd = f(P)
A demand function expresses quantity demanded as a function of product price only.

Concepts of Demand
 Demand functions – whether expressed as equations, tables or graphs – give the quantity
demanded at various price, holding constant the effects of income, price of related goods,
consumer taste, expected price, and the number of consumer.
 Demand equation is a mathematical equation showing quantity demanded is a function of price,

Ceteris Paribas.
 Demand schedule is a table showing a list of possible product prices and corresponding
quantities demanded.
 Demand curve is a graph showing the relation between quantity demanded and price when all
other variables influencing quantity demanded are held constant.

Concepts of Demand
 Inverse Demand Function

In the graph of the equation, Qd = 12 – 4P, the independent variable P is plotted along the
vertical axis and dependent variable Qd is plotted along the horizontal axis. This switch is
traditional among economists.
The equation plotted in the figure is the inverse of the demand equation since the price is
expressed as a function of quantity demanded i.e. P = f(Qd) or P = 3 – 0.25Qd.

Concepts of Supply
 Quantity Supplied (Qs)

Amount of a good or service offered for sale during a given period of time.
 Variables that influence quantity supplied (Q s)

1. Price of good or service (P)
2. Input prices (P i )
3. Technological advances (T)
4. Expected future price of product (Pe)
5. Number of firms producing product (F)

Concepts of Supply
 Generalized Supply Function

Qs = g(P, Pi, T, Pe, F)
If the supply function is expressed in linear form:

Qs = h + kP + lPi + nT + rPe + sF
Where, k, l, n, r, & s are slope parameters which measure effect on Q s of changing one of the
variables while holding the others constant. For example, k (=ΔQd/ΔP) measures the change in
quantity supplied per unit change in price holding P i, T, Pe and F constant. Sign of parameter
shows how variable is related to Qs. Positive sign indicates direct relationship and negative sign
indicates inverse relationship.

Concepts of Supply
 The generalized linear supply function can sometimes be simplified by including few variables
as:
Qs = h + kP + lPi + sF
For example: Qs = 50 + 10P – 8Pi + 5F
Technology and the expected price of the product in the future have been omitted to simplify this
illustration.

Concepts of Supply
 Supply Function or Supply

The relation between price and quantity supplied per period of time, when all other factors that
affect supply are held constant, is called a supply function or simply supply.
A supply function can be expressed in the most general form as the equation:
Qs = f(P)
A supply function expresses quantity supplied as a function of product price only.

Concepts of Supply
 Supply functions – whether expressed as equations, tables or graphs – give the quantity
supplied at various price, holding constant the effects of input prices, prices of goods related in
production, the state of technology, expected price, and the number of firms in the industry.
 Supply equation is a mathematical equation showing quantity supplied is a function of price,

Ceteris Paribas.
 Supply schedule is a table showing a list of possible product prices and corresponding quantities
supplied.
 Supply curve is a graph showing the relation between quantity supplied and price when all other
variables influencing quantity supplied are held constant.

Concepts of Supply
 Inverse Supply Function

In the graph of the equation, Q s = – 1 + 2P, the independent variable P is plotted along the
vertical axis and dependent variable Q s is plotted along the horizontal axis. This switch is
traditional among economists.
The equation plotted in the figure is the inverse of the supply equation since the price is
expressed as a function of quantity supplied i.e. P = f(Q s ) or P = 0.5 + 0.5Qs .

Market Equilibrium
 Market Equilibrium
A Situation in which, at the prevailing price, consumer can by all of good they wish and producer
can sell all of the good they wish. Thus, it the situation at which Qd = Qs .
 Equilibrium Price
It is the price at which Qd = Qs .
 Equilibrium Quantity
 The amount of good bought and sold in market equilibrium.

Market Equilibrium
 Excess Supply (Surplus)

Exists when quantity supplied exceeds quantity demanded.
 Excess Demand (Shortage)

Exists when quantity demanded exceeds quantity supplied.
 Market Clearing Price

The price of good at which buyers can purchase all they want and sellers can sell all they want
at that price. This is another name for equilibrium price.

Problem_01
The generalized demand function for good A is
Qd = 600 – 4P – 0.03M – 12Pr + 5T + 6Pe + 1.5N
Where Qd = quantity demanded for good A each month, P = price of good A, M = average
household income, P r = price of related good B, T = consumer’s taste index ranging in value
from 0 to 10 (the highest rating), Pe = price consumers expect for next month for good A and N =
number of buyers in the market for good A.
a. Interpret the intercept parameters in the generalized demand function.

b. What is the value of the slope parameter for the price of good A?
Does it have the correct algebraic sign? Why?
c. Interpret the slope parameter for income. Is good A normal or inferior? Explain.
d. Are goods A and B substitutes or compliments? Explain.
Interpret the slope parameter for the price of good B.
e. Are the algebraic signs on the slope parameters for T, Pe and N correct? Explain.
f. Calculate the quantity demanded for good A when P = $15, M = $25000, P r = $40, T = 6.5,
Pe = $5.25 and N = 2000.

Problem_02
Consider the generalized supply function:
Qs = 60 + 5P – 12Pi + 10F
Where Qs = quantity supplied, P = price of the commodity, P i = price of a key input in the
production process, and F = number of firms producing the commodity.
a. Interpret the slope parameters on the P, P i and F.

b. Derive the equation for the supply function when P i = $90 and F = 20.
c. Sketch a graph of the supply function on part b. At what price does the supply curve intersect
the price axis? Give an interpretation of the price intercept of this supply curve.
d. Using the supply function from part b, calculate the quantity supplied when the price of the
commodity is $300 and $500..
e. Derive the inverse of the supply function in part b. Using the inverse supply function, calculate
the supply price for 680 units of commodity. Give an interpretation of this supply price.

Problem_03
Suppose that the demand and supply functions for good X are:
Qd = 50 – 8P
Qs = - 17.5 + 10P
a. What are the equilibrium price and quantity?

b. What is the market outcome if price is $2.75? What do you expect to happen? Why?
c. What is the market outcome if price is $4.25? What do you expect to happen? Why?
d. What happens to equilibrium price and quantity if the demand function becomes
Qd = 59 – 8P?
e. What happens to equilibrium price and quantity if the supply function becomes
Qs = – 40 + 10P?

Concepts of Elasticity
 In general, the elasticity of any function is defined as the percentage change in the
dependent variable Y that is caused by a one percent change in the independent
variable X while all other independent variables are held constant.
 This general concept of elasticity is applicable to any function.
 The equation for calculating elasticity is

Elasticity = Percentage change in Y / Percentage change in X

 In theory, the demand function has an elasticity for each of its many independent
variables. However, we shall confine our discussion to the four demand elasticities
that are most widely discussed in the literature of demand theory. These are:
 1. Price elasticity of demand

 2. Income elasticity of demand
 3. Cross elasticity of demand

 Price Elasticity of Demand

 The price elasticity of demand measures the responsiveness or sensitivity of
consumers to changes in the price of a good. Or, it is the responsiveness of the
quantity demanded to changes in price of the product, holding constant the values
of all other variables in the generalized demand function.
 More specifically, price elasticity of demand is defined as the percentage change in

the quantity demanded that is caused by a one percent change in price while all
other variables are held constant.


 There are two types of elasticity measurement – point elasticity and arc elasticity.
 Point elasticity measures elasticity at a given point on a demand function. The point
elasticity concept is used to measure the effect on a dependent variable Y of a very
small or marginal change in an independent variable X.
 Price elasticity of demand using point elasticity method is
𝜕Q P
e=
𝜕P Q


 Arc elasticity measures the average elasticity over a given range of a demand
function. Although the point elasticity concept can often give accurate estimates of
the effect on Y of large scale changes in X, it is not used to measure the effect on Y
of large scale changes. To assess the effects of large scale changes in X, the arc
elasticity concept is used.
 Price elasticity of demand using arc elasticity method is
(Q2−Q1) (P2 +P1 )

e=
(P2−P1) (Q2 +Q1)

 Elastic verses Inelastic

 The coefficient of price elasticity (determined by either the point or arc formula)
consists of two components: sign and magnitude. The sign indicates the relative
direction of movement between the two variables. If the sign is negative, they move
in opposite directions. If it is positive, they move in the same direction. The
magnitude (absolute value) of the coefficient indicates the degree of sensitivity of
the quantity demanded to change in price.

 Elastic verses Inelastic
 If |ϵ| = 1, the function is unit elastic, meaning that 1 percent change in price will
cause a 1 percent change in quantity demanded.
 If |ϵ| > 1, the function is elastic, meaning that 1 percent change in price will cause a
greater than 1 percent change in quantity demanded.
 If |ϵ| < 1, the function is inelastic, meaning that 1 percent change in price will cause
a less than 1 percent change in quantity demanded.

 Total Revenue and Price Elasticity

 One of the most important features of the price elasticity concept is that it provides a
useful summery measures of the effect of a price change on revenues. Depending
upon the degree of price elasticity, a reduction in price can increase, decrease or
leave total revenue unchanged.
 Total revenue (TR) = P × Q

 Where P is price and Q is quantity demanded which is also function of price P.


 Derivative of total revenue with respect to price is:
dTR dQ dQ P
 Q P QQ  Q(1  e)
dP dP dP Q


 The relationship price changes, elasticity and total revenue may be summarized as
follows:
 1. If demand is elastic (|ϵ| > 1), total revenue rises when price falls or total revenue
falls when price rises.
 2. If demand is inelastic (|ϵ| < 1), total revenue rises when price rises or total
revenue falls when price falls.
 3. If demand is unit elastic (|ϵ| = 1), total revenue remains unchanged when price
changes

 Marginal Revenue and Price Elasticity

 Marginal revenue is derived from total revenue, it is also related to price elasticity of
demand.
 Total revenue (TR) = P × Q

 Where P is price and Q is quantity demanded and P is also function of price Q.
Marginal revenue (MR) can be derived if TR is differentiated with respect to Q.


 Differentiating TR with respect to Q is:
dTR dP dP Q 1
PQ  PP  P(1  )
dQ dQ dQ P e


 The relationship price elasticity and marginal revenue may be summarized as
follows:
 1. In the elastic range of demand function (|ϵ| > 1), marginal revenue is positive and
total revenue increases as the quantity sold increases.
 2. In the inelastic range of demand function (|ϵ| < 1), marginal revenue is negative
and total revenue decreases as the quantity sold increases.
 3. In the unit elastic demand function (|ϵ| = 1), marginal revenue is zero as the
quantity sold increases.

 Factors Affect Price Elasticity

 Decision makers need to be aware not only of the relationships among price, price
elasticity, total revenue and marginal revenue, but also of the reasons why different
products have different price elasticities. There are many such reasons, but they
can be generally lumped into four categories: availability of substitutes, relative size
of expenditure, consumer’s perceptions of necessities verses luxurious, and the
time period to which the demand curve pertains.

 Factors Affect Price Elasticity
 1. Availability of substitutes.
The more substitutes there are for a product, the more price elastic is the good.
 2. Relative size of expenditure.

 If the price of the product constitutes relatively less of consumer’s total budget, price
inelastic is the good, and vice versa.

 Factors Affect Price Elasticity (contd.)
 3. Necessities verses luxurious.

Demand for necessities tends to be less price elastic and the demand for luxurious
tends to be more price elastic.
 4. Time period to which the demand curve pertains.

Over a long period of time, consumer adjust their budgets to price change in a
particular commodity so price inelastic. In contrast, for short-run, consumer finds a
substitute for it so price elastic.

 Applications of Price Elasticity

Price elasticity has many uses in both private decision making and public decision
making. Some of its uses are:
1. Pricing policy for goods and services.

2. Pricing policy for factors of products.
3. Tax policy.
4. Foreign trade policy.
5. Exchange rate policy.

 Income Elasticity of Demand
Income elasticity of demand measures the responsiveness of demand to changes in

income, holding constant the effect of all other variables that influence demand. It is
percent
More specifically, income elasticity of demand is defined as the percentage change

in the demand that is caused by a one percent change in income of a consumer
while all other variables are held constant.


 Income point elasticity is defined as:
𝜕Q I
 ∈=
𝜕I Q
Where ϵ is income elasticity of demand, Q is demand and I is income.


 Income arc elasticity is defined as:
(Q2 −Q1 ) (I2 +I1 )

∈=
(I2 −I1 ) (Q2 +Q1 )
 Arc income elasticity provides a measure of the average responsiveness of demand

for a given product to a relative change in income over the range from I 1 to I2.

 Income and quantity purchased may or may not move in the same direction. More
typical products, whose demand is positively related to income, are defined as
normal goods. In the contrary, goods whose demand is inversely related to
income, are defined as inferior goods.
 1. For normal goods or superior goods, ϵ > 0.

 2. For inferior goods, ϵ < 0.


 Income elasticity of demand is applicable to a broad range of planning and strategy
making.
 For example, if ϵ for a particular product is 0.3. This means that a 1% increase in
income causes demand for the product to increase by only 0.3%. Given growing
national income over time, such a product would not maintain its relative importance
in the economy. This might be the reason why farmer’s living standard not
significantly increase when the economy flourished.


 Another product might have an income elasticity of 2.5; its demand increases 2.5
times as fast as income. Firms can enjoy producing income elastic goods during
economic prosperity.
 If, on the other hand, firms which are producing particular goods with ϵ < 0, face
hard time even in prosperous economy.

 Cross Elasticity of Demand

 The demand for most products is clearly influenced by the prices of other product as
well as its own price. The concept of cross elasticity is used to examine the
responsiveness of demand for one product to changes in the price of another.
 The cross elasticity of demand measures the percentage change in the demand of
X due to one percent change in the price of Y, holding constant the effect of all other
variables that influence demand of X.

 Point cross elasticity is given as:
𝜕Qx P y
 ϵ=
𝜕 P y Qx
Where ϵ is cross elasticity, Qx is demand for X good and Py is the price for Y good.

 Arc cross elasticity is given as:
(Qx2 −Qx1 ) (P y2 +P y1)

 ∈=
(P y2 −P y1) (Qx2 +Qx1 )
 Where ϵ is average cross elasticity between the demand range of Q x1 and Qx2 of X
goods when price of related goods Y ranges between P y1 and Py2 respectively.


 Cross elasticity for substitutes is always positive; the price of one good and the
demand for the other move in the same direction (ϵ > 0).
 Cross elasticity is negative for complements; price and quantity move in opposite
directions for complementary goods (ϵ < 0).
 Cross elasticity is zero or nearly zero for unrelated goods where variations in the
price of one good have no effect on demand for the second (ϵ = 0).

 Price Elasticity of Supply

 When price changes, there will not only a change in the quantity demanded, but
also a change in the quantity supplied. Frequently, we will want to know just how
responsive quantity supplied is to a change in price. The measure we use is the
price elasticity of supply.
 Price elasticity of supply is defined as the percentage change in the quantity

supplied caused by a one percent change in price of the goods while all other
variables are held constant.


 Formula for price elasticity of supply may be adapted from general formula:
 1. Point elasticity of supply

𝜕Qs P
 ϵs =
𝜕P Qs
 2. Arc elasticity of supply

(Qs2 −Qs1 (P 2 +P 1 )
 ∈s =
(P 2 −P 1 ) (Qs2 +Qs1


 Price elasticity of supply is positive. Calculating elasticity at a point will involve the
point method and calculating elasticity for a range between two points will involve
the arc method.
 Price elasticity of supply is positive. Supply is likely to be elastic if firms have plenty
of spare capacity, like extra supply of raw materials, overtime labor supply, etc. The
less these conditions apply, the less elastic will supply be.

 Example – 01
 Assume a demand function of Qx = 100 – 5Px

a. What is price elasticity of demand at the point where the price is Rs 5 if the price
increases to Rs 7?
b. What is the average price elasticity between these two points?

 Solutions:
a. If Px = Rs 5, Qx = 100 – 5(5) = 75
If Px = Rs 7, Qx = 100 – 5(7) = 65
 Price elasticity at the point (5, 75) is

𝜕Q P 5 25
 e= = −5 =− =−0.33
𝜕P Q 75 75
 b. The average elasticity is calculated by arc formula:

(Q2 −Q1 ) (P 2 +P 1 ) (65−75) (7+5)
 e= = = −0.43
(P 2 −P 1) (Q2 +Q1 ) (7−5) (65+75)

 Example - 02
 The generalized linear demand function for good X is estimated to be Q = 250000 –
500P – 1.5M – 240Pr
 Where P is price of good X, M is average income of consumers who buy good X,
and Pr is the price of related good R. The values of P, M and Pr are expected to be
$200, $60000 and $100 respectively. Use this values at this point on the demand to
make the following computations.
 a. Compute the quantity of good X demanded for the given values of P, M and Pr.
 b. Calculate the price elasticity of demand. At this point on the demand for X, is
demand elastic, inelastic, or unit elastic? How would increasing the price of X affect
total revenue? Explain.

 c. Calculate the income elasticity of demand. Is good X normal or inferior? Explain

how a 4 percent increase income would affect demand for X, all other factors
affecting the demand for X remaining the same.
 d. Calculate the cross price elasticity. Are the goods X and R substitutes or
compliments? Explain how a 5 percent decrease in the price of related good R
would affect demand for X, all other factors affecting the demand for X remaining
the same.

 Example – 03
After a careful statistical analysis, the Child seater company concluded that the
demand function for its product is
Q = 500 – 3P + 2Pr + 0.1I
Where Q is the quantity demanded of its product, P is the price of its product, Pr is
the price of its rival’s product, and I is the per capita disposable income in dollars. At
present, P = $10, Pr = $20 and I = $6000.
 a. What is the price elasticity of demand for the firm’s product?
 b. What is the income elasticity of demand for the product?
 c. What is the cross price elasticity of demand between its product and its rival’s
product?
 What is the implicit assumption regarding the population?

 The Constant Elasticity Demand Function

 Demand function may not linear all the time, i.e. quantity demanded of a product
may not be linear function of its price, the prices of other goods, consumer’s income,
and other variables. Another mathematical form that is frequently used is the
constant price elasticity demand function.
 Consider a non-linear demand function

 Q = aP-bIc
 Where Q is quantity demanded, P is the price of the product and I is the consumer’s
income.

 Q = aP-bIc
 dQ/dP = -b aP-b-1Ic = (-b/P) aP-bIc = (-b/P) Q = -b (Q/P)
 (dQ/dP) P/Q = -b
 The left hand side of the equation is price elasticity of demand, it follows that the
price elasticity of demand equals –b, a constant whose value does not depend on P
or I.
 Similarly, (dQ/dI) I/Q = c and is not depend on P or I.

 Example – 04
The McCauley Company hires a marketing consultant to estimate the demand
function for its product. The consultant concludes that this demand function is
Q = 100 P–3.1I2.3A0.1
Where Q is the quantity demanded per capita per month, P is the product’s price in
dollars, I per capita disposable income in dollars, and A is the firm’s advertising
expenditures in thousands of dollars.
 a. What is the price elasticity of demand? Will increase in price result in increase or
decrease in the amount spent on McCauley’s product?
 b. What is the income elasticity of demand?
 c. What is the advertising elasticity of demand?
 d. If population in the market increases by 10 percent, what is the effect on the
quantity demanded if P, I and A are held constant?

Supply, Demand and Govt. Policies
 Government in most countries today play an important role in product pricing.

Generally, supply force and demand force determine the price of a good and the
quantity of good sold.
 If it is felt that market price of a good is unfair to buyers or sellers, price control
mechanisms are usually enacted by policy makers or governments.
 There are several ways through which governments influence pricing.

 Most common mechanisms for price control or governments interventions are:
 a. Direct method – Price ceiling and price floor

 b. Indirect method – Taxes

Price Ceiling
 If the government imposes a legal maximum on the price beyond which it is not
allowed to rise, such legislated maximum is called a price ceiling.
 For example, rent control law dictates a maximum rent that landlord may charge
tenants.
 If the equilibrium price or market determined price that balances supply and demand
is below the price ceiling, The price ceiling is not binding. Market forces move the
economy smoothly and the price ceiling has no effect on the price or quantity sold.

Price Ceiling (Not Binding)
Price
Supply
Price
ceiling
Equilibrium
price
Demand
Quantity
Equilibrium
quantity

Price Ceiling - binding

 If the equilibrium price or market determined price that balances supply and demand
is above the price ceiling, The price ceiling is binding constraint on market. This
leads to an excess demand.

Price Ceiling (Binding)
Price
Supply
Equilibrium
price
Price
Shortage ceiling
Demand
Q(S) Q(D) Quantity

Price Ceiling
 The excess demand creates many problems like who would get the product in what
quantity or how to distribute the product among the consumers.
 If distribution is conducted first come first serve basis, there would be long queue
which would result wastage of time, tensions and fights caused by queue breakers.
 It gives rise to black marketing.

Price Floor
 If the government imposes a legal minimum on the price beyond which it is not
allowed to fall below, such legislated minimum is called a price floor.
 For example, minimum wage law dictates the lowest wage that firms must pay
workers.
 If the equilibrium price is above the floor, the price floor is not binding. Market forces
move the economy smoothly and the price floor has no effect.

Price Floor (Not Binding)
Price
Supply
Equilibrium
price Price
floor
Demand
Quantity
Equilibrium
quantity
Price Floor
 If the equilibrium price is below the floor, the price floor is a binding constraint on the
market. This leads to excess supply.

Price Floor (Binding)
Price
Supply
Surplus
Price
floor
Equilibrium
price
Demand
Q(D) Q(S) Quantity

Price Floor
 Excess supply also creates many problems. If any, storage requires or need to
export it to the foreign market.
 Since storage requires, it costs in terms of space, transport in and out of storage
place, loss through spoilage, etc. Similarly, there is no guarantee about the
availability of foreign market. Workers may loose their job.

 Example 1:
 The local government in a West Coast College town is concerned about a recent
explosion in an apartment rental rates for students and other low income renters. To
combat the problem, a proposal has been made to institute rent control that would
place $900 per month ceiling on apartment rental rates. Apartment supply and
demand conditions in the local market are: Qs = – 400 + 2P and Qd = 5600 – 4P.
Where Q is the number of apartments and P is the monthly rent.
 Determine the quantity demanded, quantity supplied and shortage with a $900 per
month ceiling on apartment rental rates.
 Determine the change in social welfare and deadweight loss due to rent control.

Tax
 Governments levy taxes to raise revenue for public projects. Taxes discourage
market activity. When the government levies a tax on a good, the equilibrium
quantity of the good falls. A tax on a good places a wedge between the price paid by
buyers and the price received by sellers.
 Buyers pay more and sellers receive less, compare to before the tax, regardless of
whom the tax is levied on.

Tax
 Consider demand and supply equations as:
Qd = 200 – 100/3 P and Qs = - 50 + 50P
Equilibrium price and quantity are respectively $3 and 100.
 If $0.50 is levied on buyer, new demand and supply equations will be Qd = 200 –
100/3 (P + 0.50) and Qs = - 50 + 50P respectively.
 Solving the two equations, price paid by buyer (P + 0.50) = 3.30 and price received
by seller (P) = 2.80

Tax on buyer
Price
Price Supply, S1
buyers
pay
$3.30 Equilibrium without tax
Tax ($0.50)
Price 3.00 A tax on buyers
without 2.80
shifts the demand
tax downward
by the size of
Price Equilibrium The tax ($0.50)
sellers with tax
receive
D1
D2
90 100 Quantity

Tax
 Consider demand and supply equations as:
Qd = 200 – 100/3 P and Qs = - 50 + 50P
Equilibrium price and quantity are respectively $3 and 100.
 If $0.50 is levied on seller, new demand and supply equations will be Qd = 200 –
100/3 P and Qs = - 50 + 50 (P – 0.50) respectively.
 Solving the two equations, price paid by buyer (P) = 3.30 and price received by
seller (P – 0.50) = 2.80

Tax on seller
Price A tax on sellers

Price Equilibrium S2 shifts the supply
buyers with tax curve upward
pay
S1 by the amount of
$3.30
Tax ($0.50) the tax ($0.50).
Price 3.00
without 2.80 Equilibrium without tax
tax
Price
Sellers
receive
Demand, D1
90 100 Quantity

Tax
 Buyers and sellers share the tax burden. The incidence of tax (that is, the division of
the tax burden) does not depend on whether the tax is levied on buyers or sellers.
 The incidence of a tax depends on the price elasticity of supply and price elasticity
of demand.

 Example 2:
Suppose that the market for tires is described by the following demand and supply
equations:
Qs = – 500 + 15P
Qd = 700 – P
a. Solve for equilibrium price and quantity of tires.

b. Suppose that a tax of $ 5 is placed on buyers of tires, calculate the price
received by sellers, price paid by buyers and the quantity sold.
c. What is the total tax revenue?
d. If a tax of $ 5 is placed on sellers of tires, calculate the price
received by sellers, price paid by buyers and the quantity sold.

 Example 3:
The inverse demand and inverse supply functions of a commodity are given by
P = 5 – 2Qd and P = 0.5 (Ds + 5) respectively. Find the equilibrium price and
quantity. If subsidy of Rs 2.5 per unit is given to the producer, find equilibrium price
and quantity. Also find total amount of subsidy given in this case.
Also calculate deadweight loss due to subsidy.

Price Ceiling
Price
1400 Qs = -400+2P
1050
1000
900 Pc =900
200
Qd = 5600-4P
00 1600 00
14 20 Quantity
TS1=CS1+PS1=320000+640000=960000
TS2=CS2+PS2=455000+490000=945000
TS1-TS2=960000-945000=15000=DWL
Alternatively,
DWL=0.5 x 200 x 150 = 15000
Tax Levied on Buyer
Price
Qs = –50 + 50P
6
3.3
3
2.8
Qd = 200 – 100/3 P
1
Qd* = 200 – 100/3 (P + 0.5)
0 Quantity
90 10
Qs=Qd =>–50+50P=200–100/3 P => P=3; Q=100

Qs=Qd* => –50+50P=200–100/3 (P+0.5) => P => P=2.8; Q=90
CS1=0.5x100x3=150; PS1=0.5x100x2=100;
TS1=CS1+PS1=150+100=250
CS2=0.5x90x2.7=121.5; PS2=0.5x90x1.8=81; TR=90x0.5=45
TS2=CS2+PS2+TR=121.5+81+45=247.5
ΔTS=TS1–TS1=250–247.5=2.5; DWL=0.5x10x0.5=2.5
Subsidy to the producer
Price
Qs=–5+2p
3.5
3
2.5
Qs*=2p
1
Qd=2.5–0.5P
1 2 Quantity
P=5–2Qd => Qd=2.5–0.5P; P=0.5((Qs+5) => Qs=–5+2P

Qs=Qd => –5+2P=2.5–0.5P => P=3, Q=1
CS1=0.5x1x2=1; PS1=0.5x1x0.5=0.25=0.25; TS1=CS1+PS1=1+0.25=1.25
Qd=2.5–0.5P; Qs*=–5+2(P+2.5) => Qs*=2P

Qs*=Qd => 2P=2.5–0.5P => P=1, Q=2
CS2=0.5x2x4=4; PS2=0.5x2x1=1; GC=–(2x2.5)=–5; TS2=4+1–5=0
ΔTS=TS2–TS1=0–1.25=–1.25; DWL=0.5x1x2.5=1.25
Gain & Loss of an Importing Country
Price
Sd
A
P
B C D
Pw
E Import
Dd
Sd Dd Quantity
Before After
Int’l trade Int’l trade Change
Consumer surplus A A+B+C+D B+C+D
Producer surplus B+E E –B
Total surplus A+B+E A+B+C+D+E C+D
(Gain from Int’l trade)
Gain & Loss of an Exporting Country
Price
Export Sd
A
Pw
B C D
P
F
E
Dd
Dd Sd Quantity
Before After
Int’l trade Int’l trade Change
Consumer surplus A+B+C A –(B+C)
Producer surplus E+F B+C+D+E+F B+C+D
Total surplus A+B+C+E+F A+B+C+D+E+F D
(Gain from Int’l trade)
Gain & Loss from Tariff
Price
Sd
A
P
B C
Pw+t
D E F G
Pw
H
Import w/ tariff Dd
Sd Sd* Dd* Dd Quantity
Before After
tariff tariff Change
Consumer surplus A+B+C+D+E+F+G A+B+C –(D+E+F+G)
Producer surplus H D+H D
Govt surplus – F F
Total surplus A+B+C+D+E+F+G+H A+B+C+D+F+H –(E+G)
(Loss from tariff)
Quota_1
Price
0+P
s =5
Q
250
150
Qd=
500
– 2P
50 200
Quantity
Qs=50+P; Qd=500–2P
Qs=Qd => 50+P=500–2P => P=150; Q=200
CS1=0.5x200x100=10000
PS1=0.5x(50+200)x150=18750
TS1=10000+18750=28750
Quota_2
Price
0+P
s =5
Q
250
150
Qd=
500
– 2P
Pw=50
400
50 100 200
Quantity
Pw=50; Qd*=500–2Pw; Qs*=50+Pw

Qd*=500–2Pw=500–2x50=400; Qs**=50+Pw=50+50=100
M=Qd*–Qs*=400–100=300
CS2=0.5x400x200=40000; PS2=0.5x(50+100)x50=3750
TS2=40000+3750=43750
ΔTS=TS2–TS1=43750–28750=15000
=0.5x300x100=15000
Quota_3
Price
0+P
s =5
Q
250
150
Qd=
P**=110 500
– 2P
50
400
50 100 Qs** 200 Qd** Quantity
=160 =280
Qd**=500–2P**; Qs**=50+P**; X=120

Qd**–Qs**=120 => (500–2P**)–(50+P**)=120 => P**=110; Qd**=280; Qs**=160
CS3=0.5x280x140=19600; PS3=0.5x(50+160)x110=11550;
Quota rent=120x60=7200
TS3=19600+11550+7200=38350
ΔTS=TS3–TS2=38350–43750=–5400
(0.5x60x60)+(0.5x120x60)=1800+3600=5400
Quota_1b
Price
P
5 0+
=–
Qs
250
183.33
Qd=
500
–2P
50
133.33
Quantity
Qs=–50+P; Qd=500–2P
Qs=Qd => –50+P=500–2P => P=183.33; Q=133.33
CS1=0.5x133.33x66.67=4444.55
PS1=0.5x133.33x133.33=8888.44
TS1=4444.55+8888.44=13333
Quota_2b
Price
P
5 0+
=–
Qs
250
183.33
Qd=
500
–2P
50
400
133.33
Quantity
Qs*=–50+Pw=–50+50=0; Qd*=500–2Pw=500–2x50=400
M=Qd*–Qs*=400–0 =400
CS2=0.5x400x200=40000
PS2=0
TS2=40000+0=40000
ΔTS=TS2–TS1=40000–13333=26667
=0.5x400x133.3333=26666.66≈26667
Quota_3b
Price
P
5 0+
=–
Qs
250
143.33
Qd=
500
– 2P
50
400
93.33 213.34
Quantity
X=120; Qs**=–50+P**; Qd**=500–2P**

120=(500–2P**)–(–50+P**) => P**=143.33
Qd**=500–2x143.33=213.34; Qs**=–50+143.33=93.33
CS3=0.5x213.34x106.67=11378.49; PS3=0.5x93.33x93.33=4355.24
Quota rent=120x93.33=11199.6; TS3=11378.49+4355.24+11199.6=26933.33
ΔTS=TS3–TS2=26933.33–40000=–13066.67
=(0.5x93.33x93.33)+(0.5x186.66x93.33)=4355.24+8710.49=13065.73
Demand Estimation
 Introduction – Demand Estimation

 Demand estimation is to explore the factors that influence demand and to establish
the relationship between the demand and the demand influencing factors.
 It is the derivation of empirical demand function where the demand equation is

derived from the actual market data. From the empirical demand function, manager
can get quantitative estimates of the effects on demand or sales by the changes in
price of the product, the income of the consumer; the prices of competing or
complement products and so on.
Demand Estimation
 The demand estimation here is intended to provide an introductory treatment of

empirical demand analysis. Thus, this demand estimation is limited to the simpler
method and this method is widely used in business to analyze the market demand.
The more advanced techniques of empirical demand analysis that you will
encounter in your advanced statistics and econometrics courses.
Demand Estimation
 Steps on Demand Estimation

 Step – 1: Identification of casual variables.
The first task is to identify variables which influence demand for the product. Recall
from the generalized demand function that the quantity demanded depends on the
price of the product, consumer income, the price of related goods, consumer tastes
and preferences, expected price and the number of buyers or the population. Given
the difficulties inherent in quantifying taste and price expectation, we will ignore
these variables as in commonly done in many empirical demand analysis.
Demand Estimation
 Step – 2: Collection of data for the variables.

 Once the variables have been identified, data for the corresponding variables must
be obtained. Data may be time series or cross-sectional or pooled (mix of time
series and cross sectional).
 Sample size – Perfect result might be expected if we could work with a census
which consists of entire population. Usually, limitation on time and money available
for the data collection, forces us to use sampling method. The size of sample is a
trade off between the rising cost of data collection and the diminishing of sampling
error as the sample size grows larger.
 A good rule of thumb is that a properly specified model will require at least three to
four times as many observations as independent variables.
Demand Estimation
 Step – 3: Specification of the demand function.

 In order to estimate a demand function for a product, it is necessary to use a
specific functional form. Here, we will consider both linear and non linear demand
relation.
Demand Estimation
 Linear Empirical Demand Specification

A simplest demand function is one that specifies a linear relation. In linear form, the
empirical demand function is specified as:
Q = a + bP + cM + dPr
 In this equation, the parameter b measures the change in quantity demanded that
would result from a one-unit change in price. That is, b = ΔQ/ΔP, which is assumed
to be negative.
Demand Estimation
 The parameter c measures the change in demand that would result from a one-unit
change in consumer income. That is, c = ΔQ/ΔM, which is assumed to be positive
for normal good and negative for inferior good.
 The parameter d measures the change in demand that would result from a one-unit
change in the price of related goods. That is, d = ΔQ/ΔPr, which is assumed to be
positive for substitute good and negative for complement good.
Demand Estimation
 Non-linear Empirical Demand Specification

The most commonly employed nonlinear demand specification is the log-linear (or
constant elasticity) form. A log-linear demand function is as:
Q = aPbMcPrd
The obvious potential advantage of this form is that it provides a better estimate if
the true demand function is indeed nonlinear.
Demand Estimation
 This specification allows us for the direct estimation of the elasticities. Specifically,
the value of parameter b measures the price elasticity of demand. Likewise, c and d,
respectively, measure the income elasticity and cross-price elasticity of demand.
 Although we have presented only two functional forms as possible choices for
specifying the empirical demand equation, there are many possible functional forms
from which to choose. Unfortunately, the exact functional form of the demand
equation is not known to the researcher. Sometimes researcher employ a series of
regressions to settle on a suitable specification of demand.
Demand Estimation
 Step – 4: Estimation of the demand function.

 Estimation of the function is the estimation of parameters – a, b, c and d. We shall
use the least-squared method of regression analysis for the estimation of the
function such that the squired deviations between calculated and observed value of
demand is minimized.
Demand Estimation
Derivation of sum of squared deviation:

Q = a + bP + cM + dPr + e
e = Q – (a + bP + cM + dPr)
e = Q – a – bP – cM – dPr
e2 = (Q – a – bP – cM – dPr)2
Σe2 = Σ(Q – a – bP – cM – dPr)2
For least squared estimation:

δΣe2/δa = 0; δΣe2/δb = 0; δΣe2/δc = 0; δΣe2/δd = 0; δΣe2/δe = 0
δΣe2/δa = δΣ (Q – a – bP – cM – dPr)2 / δa = 2 (Q – a – bP – cM – dPr) (1) = 0

=> Q – a – bP – cM – dPr = 0
=> Q = a + bP + cM + dPr = 0
Demand Estimation
δΣe2/δa = δΣ(Q – a – bP – cM – dPr)2 / δa = Σ2(Q – a – bP – cM – dPr) (1) = 0

=> 2Σ(Q – a – bP – cM – dPr) = 0
=> Σ(Q – a – bP – cM – dPr) = 0
=> ΣQ – na – bΣP – cΣM – dΣPr = 0
=> ΣQ = na + bΣP + cΣM + dΣPr = 0
δΣe2/δb = δΣ(Q – a – bP – cM – dPr)2 / δb = Σ2(Q – a – bP – cM – dPr) (–P) = 0

=> –2Σ(Q – a – bP – cM – dPr)(P) = 0
=> ΣP(Q – a – bP – cM – dPr) = 0
=> ΣPQ – aΣP – bΣP2 – cΣPM – dΣPPr = 0
=> ΣPQ = aΣP + bΣP2 + cΣPM + dΣPPr
Demand Estimation
δΣe2/δc = δΣ(Q – a – bP – cM – dPr)2 / δc = Σ2(Q – a – bP – cM – dPr) (–M) = 0

=> –2Σ(Q – a – bP – cM – dPr)(M) = 0
=> ΣM(Q – a – bP – cM – dPr) = 0
=> ΣMQ – aΣM – bΣMP – cΣM2 – dΣMPr = 0
=> ΣMQ = aΣM + bΣMP + cΣM2 + dΣMPr
δΣe2/δd = δΣ(Q – a – bP – cM – dPr)2 / δd = Σ2(Q – a – bP – cM – dPr) (–Pr) = 0

=> –2Σ(Q – a – bP – cM – dPr)(Pr) = 0
=> ΣPr(Q – a – bP – cM – dPr) = 0
=> ΣPrQ – aΣPr – bΣ PrP – cΣPrM – dΣPr2 = 0
=> ΣPrQ = aΣPr + bΣ PrP + cΣPrM + dΣPr2
Demand Estimation
Normal equations are:

ΣQ = na + bΣP + cΣM + dΣPr
ΣPQ = aΣP + bΣP2 + cΣPM + dΣPPr
ΣMQ = aΣM + bΣPM + cΣM2 + dΣMPr
ΣPrQ = aΣPr + bΣPPr + cΣMPr + dΣPr2
Demand Estimation
ΣQ n ΣP ΣM ΣPr a
ΣPQ 2
ΣP ΣP ΣPM ΣPPr b
 =
ΣMQ ΣM ΣMP ΣM 2 ΣMPr c
ΣPrQ ΣPr ΣPrP ΣPrM ΣP 2 d
−1
a n ΣP ΣM ΣPr ΣQ
2 ΣPQ
b ΣP ΣP ΣPM ΣPPr
 =
c ΣM ΣMP ΣM 2 ΣMPr ΣMQ
d ΣPr ΣPrP ΣPrM ΣP 2 ΣPrQ
Demand Estimation
 Solving these normal equations, values of estimated parameters a, b, c and d can

be obtained. There are many computer software to estimate the parameters, such
as Excel, SPSS, Eviews, Stata, R, etc.
Demand Estimation
 Step – 5: Interpretation of the estimated parameters.

 It interprets the sign and the magnitude of the estimated of parameters – a, b, c and
d.
Demand Estimation
 Step – 6: Evaluation and testing of the results.

 a. Estimating R2, adjusted R2 and Standard error of the estimation and interpreting
them.
 b. Performing the various hypothetical tests (e.g. the overall significance test of the
model and individual partial regression coefficient test)
 c. Checking if the model is free from serial autocorrelation, multi-collinearity and
heteroscedasticity. Further, there is normality test which see if the residuals are
normally distributed , etc.
Theory of Consumer Behaviour
 Utility and Utility Function

 Utility is the benefits or satisfaction that consumer obtains from the consumption of
goods and services. Utility depends on the commodities and their quantities.
 U = f(X, Y)
 Where,
U = utility or benefit obtained
X = quantity of commodity X consumed
Y = quantity of commodity Y consumed

 Some Examples of Utility Function
2 3
 U = X Y = 22 x 33 = 2 x 2 x 3 x 3 x 3 = 108
 If per unit of X and per unit of Y give 2 unit and 3 unit of benefits, consumer obtains
108 units benefit from the consumption of 2 units of X and 3 units of Y.
 U = 4XY + 3Y = (4 x 1 x 2) + (3 x 2) = 8 + 6 = 14
 If per unit of X and per unit of Y give 2 unit and 3 unit of benefits, consumer obtains
14 units benefit from the consumption of 1 unit of X and 2 units of Y.

 Consumer is said to be in equilibrium when the consumer chooses that combination

of goods (goods X and goods Y in our example) that gives maximum benefit or
satisfaction with the given income and prices for goods.
 Hicks and Allen explained the concept of consumer’s equilibrium using indifference
curve (which shows the consumer’s preference) and budget line (which shows the
consumer’s ability for purchasing goods).
 Consumer is in equilibrium when he chooses the point on highest possible

indifference curve which is attainable by his income or budget line.

 Consumer equilibrium in ordinal utility theory or indifference curve analysis is

explained with the help of two tools –
1. Indifference curve; and

2. Budget line

Theory of Consumer Behavior
 Indifference curve
 Indifference curve is locus of points representing different bundles of goods, each of
which yields the same level of total utility.
Bundle Good X Good Y Utility

A 1 14 U = 50
B 2 8 U = 50
C 3 4 U = 50
D 4 2 U = 50
E 5 1 U = 50
U (1, 14) = U (2, 8) = U (3, 4) = U (4, 2) = U (5, 1) = 50

 Indifference Curve
 Consumer is equally happy to consume bundle A (contains 1 unit of X and 20 units
of Y) or bundle B (contains 2 units of X and 14 units of Y). Similarly, consumer gets
same level of utility from bundle C or from bundle D or from bundle D.
 Consumer is indifferent to consume bundles A, B, C, D and E. Curve which passes

through these points is called indifference curve.


Theory of Consumer Behavior
Marginal Rate of Substitution (MRS)
Bundle Good X Good Y Utility MRSXY

=ΔY/ΔX
A 1 20 U=50
B 2 15 U=50 –5/1=–5
C 3 11 U=50 –4/1=–4
D 4 8 U=50 –3/1=–3
E 5 6 U=50 –2/1=–2

 Marginal Rate of Substitution (MRS)

 Concept of Marginal Rate of Substitution is an important tool for indifference curve
analysis.
 The rate at which consumer exchanges one good for another to remain at same
level of satisfaction is known as marginal rate of substitution.
 Marginal rate of substitution of good X for good Y is defined as the number of unit of
good Y that must be given up in exchange for one extra unit of good X so that
consumer remains at same level of satisfaction. It is denoted by MRS XY.

 A→B
 ΔX = 1; ΔY = -5
 MRSXY = ΔY/ ΔX = -5
 B→C
 ΔX = 1; ΔY = -4
 C→D
 ΔX = 1; ΔY = -3
 D→E
 ΔX = 1; ΔY = -2

 Marginal Rate of Substitution (MRS)

 The slope at any point on the indifference curve equals the rate at which consumer
is willing to substitute one good for another and this rate is the marginal rate of
substitution.
 MRSXY = – 𝜕Y/𝜕X
 Marginal rate of substitution diminishes gradually.

 Causes for Diminishing MRS

 Changes in intensity of want: If consumer gets more and more goods, the intensity
of his want or degree of want for that good goes on declining. Higher degree of want
exchanges with higher units of second good, and lesser degree of want exchanges
with lesser unit of second good.
 If consumer looses goods gradually, the intensity of want for that good goes on
increasing. So he is ready to exchange lesser and lesser amount of loosing goods
with other goods.
 Goods are not perfectly substituted to each other.

 Properties of Indifference Curve

1. Higher indifference curve gives higher level of satisfaction.
2. Indifference curve are downward sloping.
3. Indifference curve do not intersect.
4. Indifference curve is convex to the origin.

 Budget Line
 A budget line describes the limits to consumption choices and depends on a
consumer’s budget and the prices of goods and services.
 Budget equation
 B = PXX + PYY
 Where, B is the consumer’s budget or income, P X is the price of X and PY is the

price of Y. The consumer consumes X units of X and Y units of Y.
 Slope of budget line

 B = PXX + PYY
 PYY = B – PXX => Y = B/PY – (PX/ PY) X
 Slope = – (PX/ PY)

 Budget Line
 Example
 Px = 5; Py = 10, B = 100
 Equation of budget line

 5X + 10Y = 100
 Rs 100 can buy different combination of goods X and Y

 Such as: A(X=0, Y=10), B(X=2, Y=9), C(X=4, Y=8), …, J(X=20, Y=0)
 Line that joins A, B, C, …, J yields budget line.

Y If all income is spent
 Budget Line on Y, this is the amount
of Y that can be purchased
B/PY
Slope of budget line = – PX/PY
If all income is spent

on X, this is the amount
of X that can be purchased
B/PX X

 Budget Line
 A budget line is the locus of bundles (various combination of goods X and Y) that
can be purchased at given prices if the entire money income is spent.
 Budget line shifts when budget changes.
 Budget line rotates on the X-axis when PX changes and rotates on the Y-axis when
PY changes.

 Consumer’s Equilibrium – Mathematical Derivation

 Maximize the utility
U = U(X,Y) (1)
 Subject to income or budget constraint
B = PXX + PYY (2)
 Lagrangian Function
L = U(X,Y) + λ(B – PXX – PYY) (3)

 First order condition

𝜕L/𝜕X = 𝜕U/𝜕X – λPX = 0 (4a)
𝜕L/𝜕Y = 𝜕U/𝜕Y – λPY = 0 (4b)
B – PXX – PYY = 0 (4c)
 Combining equation (4a) and (4b)

MUX / MUY = PX / PY (5)
Where,
MUX = 𝜕U/𝜕X; and
MUY = 𝜕U/𝜕Y

 MUX / MUY = 𝜕U/𝜕X / 𝜕U/𝜕Y = 𝜕Y/𝜕X

 𝜕Y/𝜕X = PX / PY
 −𝜕Y/𝜕X = −PX / PY
 slope of indifference curve = −PX / PY
 From equation (4c)

 B – PXX – PYY = 0
 Y = B – (Px / PY) X
 slope of budget line = −PX / PY
 Hence, consumer is in equilibrium if budget line is tangent to the indifference curve.

 Consumer’s Equilibrium
Y
A The individual cannot have point C

because income is not large enough.
C
B Point B is the point of utility
maximization.
U3
U2
U1 The individual can do better than point A
by reallocating his budget.
X

 Utility is maximized where the indifference curve is tangent to the budget constraint
Y
B
−𝜕Y/𝜕X = −PX/PY
U2

 The tangency rule is only necessary condition. For sufficient condition, we assume
that MRS is diminishing. If MRS is diminishing, then indifference curves are strictly
convex. If MRS is not diminishing, then we must check second-order conditions to
ensure that we are at a maximum.

 Consumer’s Equilibrium – Numerical Example

 Example – 01
 Find optimum commodity purchase for a consumer whose utility function is U = (X +
2)(Y + 1), price per unit of X and Y are Rs 2 and Rs 5 respectively. His total income
is Rs 51.
 Max U = (X + 2)(Y + 1) (1)

 Budget constraint: 2X + 5Y = 51 (2)
 Lagranrian function:
 L = (X + 2)(Y + 1) + λ (51 – 2X – 5Y) (3)
 First order conditions:

 𝜕L/𝜕X = 0 => Y + 1 – 2λ = 0 (4a)
 𝜕L/𝜕Y = 0 => X + 2 – 5λ = 0 (4b)
 𝜕L/𝜕λ = 0 => 51 – 2X – 5Y = 0 (4c)

 Dividing (4a) by (4b)

 (Y + 1) / (X + 2) = 2λ / 5λ => 5Y + 5 = 2X + 4 => 5Y = 2X – 1
 Y = 0.4X – 0.2 (5)
 Substituting Y = 0.4X – 0.2 in (4c)

 51 – 2X – 5 x (0.4X – 0.2 ) = 0 => 51 – 2X – 2X + 1 = 0 => 4X = 52
 X = 13
 Substituting Y = 0.4X – 0.2 in (5)

 Y = 0.4 x 13 – 0.2 = 5
 U = (X + 2)(Y + 1) = (13 + 2) x (5 + 1) = 15 x 6 = 90
 2X + 5Y = (2 x 13) + (5 x 5) = 26 + 25 = 51

 Example – 02
 Find the optimum commodities purchase for a consumer whose utility function is U=
X2Y3. Price per unit of X and Y are Rs 1 and Rs 4, and his total income is Rs 100.
 Max U = X2Y3 (1)

 Budget constraint: X + 4Y = 100 (2)
 L = X2Y3 + λ (100 – X – 4Y) (3)

 𝜕L/𝜕X = 0 => 2XY3 – λ = 0 (4a)
 𝜕L/𝜕Y = 0 => (X2)3Y2 – 4λ = 0 (4b)
 𝜕L/𝜕λ = 0 => 100 – X – 4Y = 0 (4c)


 2XY3 / 3X2Y2 = λ / 4λ => 2Y / 3X = 1 / 4 => 8Y = 3X
 Y = 0.375X (5)
 Substituting Y = 0.375X in (4c)

 100 – X – (4 x 0.375X) = 0 => 100 – 2.5X = 0 => 2.5X = 100
 X = 40
 Substituting X = 40 in (5)
 Y = 0.375 x 40 = 15
 U = X2Y3 = (40)2 x (15)3 = 5400000

 X + 4Y = (40) + 4 x (15) = 40 + 60 = 100

 Example – 03
 A certain consumer has $100 to spend on beef, chicken, and fish. Suppose that his
utility functions are:
 TUB = 400QB – 10QB2
 TUC = 550QC – 20QC2
 TUF = 200QF – 5QF2
 Where subscripts B, C and F indicate beef, chicken and fish respectively. Also
suppose that the average prices per pound are P B = $4.00, PC = $2.50 and PF =
$4.00 respectively.
 How will this consumer’s $100 be spent to maximize total utility?

 Max U = U(QB, QC, QF)

 = 400QB – 10QB2 + 550QC – 20QC2 + 200QF – 5QF2 (1)
 Budget constraint: 4QB + 2.5QC + 4QF = 100 (2)
 L = U(QB, QC, QF) + λ(100 – 4QB – 2.5QC – 4QF) (3)

 𝜕L/𝜕QB = 0 => 400 – 20QB – 4λ = 0 (4a)
 𝜕L/𝜕QC = 0 => 550 – 40QC – 2.5λ = 0 (4b)
 𝜕L/𝜕QF = 0 => 200 – 10QF – 4λ = 0 (4c)
 𝜕L/𝜕λ = 0 => 100 – 4QB – 2.5QC – 4QF = 0 (4d)


 (400 – 20QB) / (550 – 40QC) = 4λ / 2.5λ
 1000 – 50QB = 2200 – 160QC
 160QC = 1200 + 50QB
 QC = 7.5 + 0.3125QB (5a)
 Dividing (4a) by (4c)

 (400 – 20QB) / (200 – 10QF) = 4λ / 4λ
 400 – 20QB = 200 – 10QF
 10QF = 20QB – 200
 QF = 2QB – 20 (5b)

 Substituting QC = 7.5 + 0.3125QB from (5a) and QF = 2QB – 20 from (5b) in (4d)
 100 – 4QB – 2.5(7.5 + 0.3125QB) – 4(2QB – 20) = 0
 100 – 4QB – 18.75 – 0.78125QB – 8QB + 80 = 0
 161.25 = 12.78125QB
 QB = 161.25 / 12.78125 = 12.62
 Substituting QB = 12.62 in (5a)

 QC = 7.5 + 0.3125QB = 7.5 + 0.3125 x 12.62 = 11.44
 Substituting QB = 12.62 in (5b)

 QF = 2QB – 20 = 2 x 12.62 – 20 = 5.24

 U = 400QB – 10QB2 + 550QC – 20QC2 + 200QF – 5QF2

 = (400 x 12.62) – (10 x 12.62 2) + (550 x 11.44) – (20 x 11.44 2)
 + (200 x 5.24) – (5 x 5.242)
 = 5048 – 1592.644 + 6292 – 2617.472 + 1048 – 137.288
 = 3455.356 + 3674.528 + 910.712
 = 8040.596
 4QB + 2.5QC + 4QF

 = (4 x 12.62) + (2.5 x 11.44) + (4 x 5.24)
 = 50.48 + 28.6 + 20.96
 = 100

 Decomposition of Price Effect into Substitution Effect and Income Effect

 (mathematical illustration)
 Example 04:
 Find the substitution effect, income effect and total effect when price of X increases
from $5 to $10. The consumer has the income of $20, and, price of Y is $2 and his
utility function is U = X0.5Y0.5 .
 Initially consumer is in equilibrium at point A of IC 1

 U = X0.5Y0.5; B = 5X + 2Y; L = X0.5Y0.5 + (B – 5X – 2Y)
 X = 2, Y = 5 and U = 3.1623
 When price increases consumer is in equilibrium at point B of IC2

 U = X0.5Y0.5; B = 10X + 2Y; L = X0.5Y0.5 + (B – 10X – 2Y)
 X = 1, Y = 5 and U = 2.2361
 A → B: ΔX = –1, ΔY = 0 => Price Effect (PE) i.e. ΔX and ΔY due to ΔPX

 Price Effect (PE) = Substitution Effect (SE) + Income Effect (IE)
 Assume a point C which contains same composition of X and Y as in IC2 (Y=5X) but
same utility as in IC1 (3.1623)
 U1 = X0.5(5X)0.5 => 3.1623 = 50.5X => X = 1.4, Y = 7
 A → C: ΔX = 1.4 – 2 = – 0.6, ΔY = 7 – 5 = 2 => Substitution Effect (SE)
 Income Effect (IE) = Price Effect (PE) – Substitution Effect (SE)

 = (–1) – (– 0.6) = – 0.4, 0 – 2 = – 2
 C → B: ΔX = – 0.4, ΔY = – 2 => Income Effect (IE)


 Price Rise Condition

 Normal goods: (PE<0) = (SE<0) + (IE<0), |SE|>/</=|IE|
 Inferior goods: (PE<0) = (SE<0) + (IE>0), |SE|>|IE|
 Giffen goods: (PE>0) = (SE<0) + (IE>0), |SE|<|IE|
 Price Fall Condition

 Normal goods: (PE>0) = (SE>0) + (IE>0), |SE|>/</=|IE|
 Inferior goods: (PE>0) = (SE>0) + (IE<0), |SE|>|IE|
 Giffen goods: (PE<0) = (SE>0) + (IE<0), |SE|<|IE|

Production Theory
 Production Function
 Production function is the quantitative or physical relationship between quantity of
inputs and quantity of output, other things remain constant. Other thing implies time,
technology, price and other exogenous factors like socio-political, cultural, religious
conditions.
 Q = f(K, L, Ld, O), ceteris-paribus

Where,
Q = quantity of output; K = quantity of capital;
L = quantity of labor; Ld = quantity of land; and
O = entrepreneurship

Production Theory
 For the sake of simplicity, let us take simple case which contains only two input
factors – K and L, later it can be generalized for more factors of production.
 Q = f(K, L)
 There are two types of production function regarding the variability of factor inputs –
short run production function and long run production function.
 Q = f(K , L) →short-run production function

 Q = f(K, L) →long-run production function

Production Theory
 In the short-run, labor can be changed easily, whereas, capital like land, buildings
and machinery can not be changed easily. However, in the long-run all the factors
can be changed easily. Thus, in short-run at least one factor is variable, whereas in
the long-run all the factors are variable.
 Accordingly, short-run production is explained by law of variable proportion and

long-run production is explained by law of returns to scale.

Production Theory
 Law of Variable Proportion

 Law of variable proportion examines short-run production function with one factor
input as variable keeping other factor inputs constant. It explains how output
changes due to change in variable input keeping other inputs constant.
 The law of variable proportion states that when one factor is increased gradually to
fixed factors, initially total product, then average product and then marginal product
increase. But later (beyond a certain point), first marginal product, then average
product and then total product decline.

Production Theory
 Assumptions
 Technology of the production remains constant.
 One factor input is variable and the other factor inputs are constant.
 Variable factor input is uniformly and homogeneously divisible.
 Any proportions of variable factor and fixed factor can be employed in production
process.

Production Theory
 Table - Law of Variable Proportion
K L TP MP AP
5 0 - - -
5 1 5 5 5
5 2 15 10 7.5
5 3 30 15 10
5 4 40 10 10
5 5 45 5 9
5 6 45 0 7.5
5 7 40 -5 5.7

Production Theory
TP = f(K , L)
TP
40
35
30
25
20
15
10
0
0 1 2 3 4 5 6 7 8

Production Theory
TP = f(K , L)
Diagrammtitel
10
0
0 1 2 3 4 5 6 7 8
-2
-4
MP AP

Production Theory
40
TP
35
30
25
20
15
L TP MP AP 10
0 0 5
1 5 5 5 0
0 1 2 3 4 5 6 7 8
2 11 6 5.5
3 19 8 6.33
MP, AP
4 27 8 6.75 10
5 33 6 6.6
8
6 37 4 6.16
7 37 0 5.28 6
8 34 -3 4.25 4
0
0 1 2 3 4 5 6 7 8
-2
-4
MP AP

Production Theory
 Three Stages of Production

 Stage – I
 TP increases at increasing rate till the point of inflexion i.e. maximum of MP. Then,
TP increases at decreasing rate.
 MP increases initially and declines.
 AP increases and reaches at maximum.
 Stage – II
 TP increases at decreasing rate and becomes maximum.
 MP declines continuously and becomes zero.
 AP declines continuously from APmax.

Production Theory
 Stage – III
 TP starts declining from TPmax.
 MP is negative (but both TP and AP are positive).
 AP is declining.

Production Theory
 Reasons to Stage – I
 Quantity of fixed factor is abundant relative to quantity of variable factor. When more
and more variable factor is added, fixed factor is effectively utilized.
 When more variable factor is added, there is introduction of specialization due to

division of labor which increases efficiency.

Production Theory
 Reasons to Stage – II
 Fixed factor becomes more and more scarce relative to variable factor. Variable
factor gets less contribution from fixed factor.
 Indivisibility of fixed factor i.e. since fixed factor is not divisible, no contribution from
fixed factor is obtained for increased variable factor.
 Imperfect substitutability between the factors. As one factor can not be perfectly
substituted to another factor, it causes one factor input scarce.

Production Theory
 Reasons to Stage – III
 Amount of variable factor becomes too excessive to the fixed factor so that variable
factor impairs efficiency of fixed factor.
 Too excessive variable factor itself reduces its efficiency.
 Stage I: irrational
 Stage II: rational
 Stage III: irrational

Production Theory
 Elasticity of Production
 The elasticity of production is the ratio of the marginal product to the average
product. It is different at every point on the total product curve. The elasticity of
production also helps to explain the three stages of production.
∆𝑄
∆𝑄 𝑋 𝑀𝑃
 𝐸𝑝 = ∆𝑋 𝑄
= ∆𝑋
𝑄 = 𝐴𝑃
𝑋
 Stage – I: Ep > 1; Stage – II: 1 > Ep > 0; Stage – III: Ep < 0

Production Theory
Q = f(K, L)
Capital (K)
0 1 2 3 4 5 6 7 8 9 10
0 0 0 0 0 0 0 0 0 0 0 0
1 0 25 52 74 90 100 108 114 118 120 121
2 0 55 112 162 198 224 242 252 258 262 264
3 0 83 170 247 303 342 369 384 394 400 403
Labor (L) 4 0 108 220 325 400 453 488 511 527 535 540
5 0 125 258 390 478 543 590 631 653 663 670
6 0 137 286 425 523 598 655 704 732 744 753
7 0 141 304 453 559 643 708 766 800 814 825
8 0 143 314 474 587 679 753 818 857 873 885
9 0 141 318 488 609 708 789 861 905 922 935
10 0 137 314 492 617 722 809 887 935 953 967

Production Theory
 Law of Returns to Scale

 Law of returns to scale examines long-run production function in which behavior of
output is studied when all inputs vary proportionately together in the same direction.
 The law of returns to scale states that the successive uniform increment in all inputs
reflects three types of returns to scale – increasing returns to scale, constant returns
to scale and decreasing returns to scale.

Production Theory
 If successive uniform increase in all inputs lead more than proportionate increase in
output, it is increasing returns to scale. If proportion of increase in inputs and
proportion of increase in output are same, it is constant returns to scale. If
proportionate increase in output is less than proportionate increase in inputs, then it
is decreasing returns to scale.
 There are some production which reflects all three types of returns to scale in
sequence, such production functions are called non-homogeneous production
functions. There are another category of production which reflects either increasing
or constant or decreasing returns to scale, such production are homogenous
production function.

Production Theory
 The law of returns to scale can be explained in better way by using homogeneous
production function as:
 λnQ = f(λK, λL)

 Where λ shows the identical change in all inputs.
 n > 1 → increasing returns to scale (IRS)

 n = 1 → constant returns to scale (CRS)
 n < 1 → decreasing returns to scale (DRS)

Production Theory
Increasing Returns to Scale
K L Q
5 5 100
10 10 250
15 15 450

Production Theory
Constant Returns to Scale
K L Q
5 5 100
10 10 200
15 15 300

Production Theory
Decreasing Returns to Scale
K L Q
5 5 100
10 10 175
15 15 225

Production Theory
 ISOQUANT
 An isoquant shows the different combination of capital (K) and labor (L) which a firm
can produce a specific quantity of output. It is the case where the firm has only two
factors of production labor and capital, both are variable. Since all factors are
variable, it can be taken as the long-run production function.
 Q = f(K, L)
 Where Q is fixed and both K and L are variables.
 Q = Q(K1, L1) = Q(K2, L2) = Q(K3, L3)

Production Theory
 Q = f(K, L) Combination L K Q MRTSLK=ΔK/ΔL

A 1 12 5
B 2 8 5 - 4/1 = -4
C 3 5 5 - 3/1 = -3
D 4 3 5 - 2/1 = -2
E 5 2 5 - 1/1 = -1
Isoquant Curve
14
12
10
Captal (K)
8
6
4
2
0
1 2 3 4 5
Labour (L)

Production Theory
 Properties of Isoquant
 An isoquant slopes downward or negatively sloped from left to right. This is because when
labor is increased, the quantity of capital must be decreased to keep the same level of output.
 Higher isoquants represent a higher level of output.
 Isoquants cannot cross over each other i.e. two isoquants cannot intersect each other.
 Isoquants are convex to the origin, because, the marginal rate of technical substitution of one
factor in terms of another factor diminishes along an isoquant. In other words, they are
convex to the origin due to diminishing marginal rate of technical substitution.

Production Theory
 Marginal Rate of Technical Substitution
 Movement from A to B, 4 units of K has been exchanged with 1 unit of L to remain in same
level of output. Similarly, movement from B to C, 3 units of K has been exchanged with 1
unit of L, and so on to remain in same level of output 5.
 These rates at which capitals have been exchanged with labors are marginal rates of
technical substitution.
 The marginal rate of technical substitution of labor for capital (MRTSLK) is the amount by
which the input of capital can be reduced when one extra unit of labor is used so that output
remain constant.
Δ𝑌
 MRTSLK = –
Δ𝑋

Production Theory
 Producer’s Budget or Cost Line
 If price per unit of labor and per unit of capital are respectively P L and PK, producer
has budget B, then, budget equation is
 B = PLL + PKK
 Where, L unit of labor and K unit of capital are employed.
 Suppose that the price of labor is $12 and price of capital is $2, and if the producer
has the budget $60, then the budget equation is
 60 = 12L + 2K

Production Theory
 Producer’s Objectives
 1. Maximize production level at given budget.

 2. Minimize cost of production for given output level.
 Production maximization
 Q = f(K,L)
 C = rK + wL
 Lagranzian: Z = f(K, L) + λ(C – rK – wL)
 Cost Minmization
 C = rK + wL
 Q = f(K,L)
 Lagranzian: Z = rK + wL) + λ[Q – f(K, L)]

Production Theory
 Examples
 1. Given the production function Q = AK 0.5L0.5 and prices per unit of K and L are Rs
20 and RS 40 respectively. Determine the firm’s input combination under the
objective of output maximization if total cost is Rs 800.
 Q = AK0.5L0.5 (1)
 800 = 20K + 40L (2)
 Z = AK0.5L0.5 + λ(800 – 20K – 40L) (3)
 First Order Conditions

𝜕Z
 = 0.5AK–0.5L0.5 – 20λ = 0 (4a)
𝜕K
𝜕Z
 = 0.5AK0.5L–0.5 – 40λ = 0 (4b)
𝜕L
𝜕Z
 = 800 – 20K – 40L = 0 (4c)
𝜕λ

Production Theory

0.5AK–0.5L0.5 20λ L 1
 =  =  K = 2L (5)
0.5AK0.5L–0.5 40λ K 2
 Substituting K = 2L from (5) in (4c)

 800 – 20(2L) – 40L = 0
 800 – 80L = 0  L = 10; K = 20
 Q = AK0.5L0.5 = A200.5100.5 = 14.1421A

Production Theory
 2. Consider the Miller Company, for which the relationship between output per hour
(Q) and the number of workers (L) and the number of machines (K) used per hour is
Q=10(LK)0.5. The wage per worker is Rs 8 per hour, and the price of a machine is
Rs 2 per hour. If the Miller Company produces 80 units output per hour, how many
workers and machines should it use?
 C = 8L + 2K (1)
 80 = 10(LK)0.5 (2)
 Z = 8L + 2K + 10 λ[ 80 – 10 (LK)0.5] (3)

𝜕Z
 = 8 – 5λL–0.5K0.5 (4a)
𝜕L
𝜕Z
 = 2 – 5λL0.5K–0.5 (4b)
𝜕K
𝜕Z
 = 80 – 10(LK)0.5 (4c)
𝜕λ

Production Theory

5λL–0.5K0.5 8 K 4
 =  =  K = 4L (5)
5λL0.5K–0.5 2 L 1
 Substituting K = 4L from (5) in (4c)

 80 – 10(LK)0.5 = 0  10[L(4L)]0.5 = 80  20L = 80  L = 4; K = 16
 C = 8L + 2K = (8 x 4) + (2 x 16) = 64
 Q = 10(LK)0.5 = 10(4 x 16)0.5 = 10 x 8 = 80

Production Theory
 3. A firm manufactures a good using K unit of capital and L unit of labor. The
quantity produced is Q=K0.5L0.5. Each unit of capital and labor cost Rs 20 and Rs 5
respectively. Find the minimum cost of producing 20 units of manufactured good.
 C = 20K + 5L (1)
 20 = K0.5L0.5 (2)
 Z = 20K + 5L + λ(20 – K0.5L0.5) (3)

𝜕Z
 = 20 – 0.5λK–0.5L0.5 = 0 (4a)
𝜕K
𝜕Z
 = 5 – 0.5λK0.5L–0.5 = 0 (4b)
𝜕L
𝜕Z
 = 20 – K0.5L0.5 = 0 (4c)
𝜕λ

Production Theory

4 0.5λK–0.5L0.5 4 L
 = => =  L = 4K (5)
1 0.5λK0.5L–0.5 1 K
 Substituting L = 4K from (5) in (4c)

 20 – K0.5L0.5 = 0  20 – K0.5(4K)0.5 = 0  20 = 2K
  K = 10; L = 40
 C = 20K + 5L = 20(10) + 5(40) = 400

 Q = K0.5L0.5 = (10)0.5(40)0.5 = (400)0.5 = 20

Cost Curves
 A firm is a rational economic unit and always tries to maximize profit. Profit is
maximum when revenue is maximum and cost is minimum.
 Max π = max (TR – TC)
 Revenue and cost, thus determine profit. Larger the difference between TR and TC,
larger would be the profit and vice-versa. That is why firm is always interested to its
revenue and cost, and revenue curve and cost curve.

Cost Curves
 Cost
 Cost is expenses of firm during production of goods and services. Producer has to
pay rent for land, wage for labor, interest for capital, producer himself needs profit,
and expenses for raw materials, fuel and energy. These all constitute cost of a firm.
 There are various concepts of cost in economics. However, we focus on the

following costs:
a. short-run cost and long-run cost
b. fixed cost and variable cost

Cost Curves
 Short-run Cost and Long-run Cost
 Short-run Cost
 Short-run is a period when some factors of production such as machineries,
equipments, plants, buildings, etc are fixed and only raw materials, labors, etc are
variable. Thus, there are fixed as well as variable factors of production, and firm can
change its output by changing variable factors only.
 Accordingly, the cost of the firm in the short-run are divided into fixed cost and
variable cost. Sum of fixed cost and variable cost gives total cost in the short-run.

Cost Curves
 Long-run Cost
 Long-run is a period when all the factors of production are variable. The firm can
change machineries, equipments and tools, plants, buildings along with the raw
materials and buildings.
 There is no concept of fixed factor of production in the long-run as all the factors are
variable, so there is no fixed cost in the long-run.

Cost Curves
 Fixed Cost and Variable Cost
 Fixed Cost
 In short-run, there are fixed factors and variable factors in the production process.
Fixed factors are land, buildings, machineries, administrative staff, etc. The cost
corresponding to these factors is called fixed cost. It is same whatever is the size of
production i.e. same for zero production and any production.

Cost Curves
 Fixed Cost and Variable Cost
 Variable Cost
 Variable factors of production are those which are changed along with the change in
output level. Variable factors are raw materials, labors, fuel, energy, etc. The
expenditure made on these variable factors is called variable cost. If output is zero,
variable cost will also zero. And if output increases, variable cost will also increase.

Cost Curves
 Behavior of Short-run Cost
 Total Fixed Cost (TFC)

 Total fixed cost refers to the total cost or expenditure incurred on fixed factors of
production. Thus total fixed cost includes expenditure made on machineries,
equipments, plants, buildings, etc.
 It remains same regardless of quantity of output produced and firm has to incurred
even if output is zero. Thus TFC is constant throughout.

Cost Curves
 Total Variable Cost (TVC)

 Total variable cost refers to the cost incurred on variable factor of production. Total
variable cost includes expenditure made on variable inputs like raw materials,
wages, fuels, etc. It increases with the increase in output level. When output is zero,
total variable cost is also zero.
 Total variable cost increases at a decreasing rate initially, and after a point, it
increases at an increasing rate as the output increases. It is because, initially
increasing returns occurs and later decreasing returns occurs. Thus, it is due to law
of variable proportion.

Cost Curves
 Total Cost (TC)

 Total cost in the short-run consists of total fixed cost and total variable cost.
 TC = TFC + TVC
 As total variable cost increases with the increase of output level, total cost also
increases with the increase of output level. Similarly, total cost increases at a
decreasing rate initially and increases at an increasing rate later with the increase in
output level.

Cost Curves
 Fixed, Variable and Total Costs – TABLE
Output TFC TVC TC

0 20 0 20
1 20 15 35
2 20 25 45
3 20 30 50
4 20 40 60
5 20 55 75
6 20 85 105

Cost Curves
 Fixed, Variable and Total Costs – GRAPH
Cost
TC Curve
TVC Curve
TFC Curve

Cost Curves
 Short-run Average Costs and Marginal Cost

 Average cost and marginal cost are more important than total cost in cost analysis.
Average cost can be divided into three types which are: average fixed cost; average
variable cost; and average total cost.
 AFC, AVC and ATC are derived from TFC, TVC and TC respectively. Similarly,
short-run marginal cost is derived from TVC.

Cost Curves
 1. Average Fixed Cost (AFC)

 Average fixed cost can be obtained by dividing total fixed cost by the quantity of
output. It is also called fixed cost per unit output and expressed algebraically as:
 AFC = TFC / Q
 When output increases, AFC reduces gradually. It falls at higher rate initially and at
a lower rate later.

Cost Curves
 2. Average Variable Cost (AVC)

 Average variable cost can be obtained by dividing total variable cost by the quantity
of output. It is also called variable cost per unit output and expressed algebraically
as:
 AVC = TVC / Q
 The trend of AVC depends on the trend of TVC. If TVC increases at a decreasing
rate, the AVC decreases. If TVC increases at an increasing rate, the AVC increases.

Cost Curves
 3. Average Total Cost (ATC)

 Average total cost or average cost is the outcome of total cost divided by quantity of
output. It is also the sum of average fixed cost and average variable cost. It is total
cost per unit output.
 ATC = TC/Q = (TFC+TVC)/Q = TFC/Q+TVC/Q = AFC+AVC
 The trend of ATC depends on the trend of TC. If TC increases at a decreasing rate,
the ATC decreases. If TC increases at an increasing rate, the ATC increases.

Cost Curves
 4. Short-run Marginal Cost (SMC or MC)

 The marginal cost is additional cost made on total cost when one more unit of output
is produced. It is the change in total cost due to change in output produced and
algebraically:
 MC = ΔTC / ΔQ
 Where ΔTC is change in total cost and ΔQ is change in output.

Cost Curves
 Marginal cost is independent of fixed cost, because the fixed cost does not change
when output changes. Change in total cost is due to change in variable cost. Thus
marginal cost is also defined as change in total variable cost due to change in
output produced and algebraically:
 MC = ΔTVC / ΔQ = ΔTC / ΔQ
 Where, ΔTVC is change in total variable cost.

Cost Curves
 Table – AFC, AVC, ATC and MC
Q AFC AVC ATC MC

0 - - - -
1 20 15 35 15
2 10 12.5 22.5 10
3 6.6 10 16.6 5
4 5 10 15 10
5 4 11 15 15
6 3.3 14.1 17.4 30

Cost Curves
 Graph – AFC, AVC, ATC and MC
Cost
40
30 MC Curve
20
ATC Curve
AVC Curve
10
AFC Curve
0 Q
0 1 2 3 4 5 6

Cost Curves
 As output increases, MC falls till TVC increases at decreasing rate, and rises when
TVC increases at increasing rate.
 The MC curve is also of U-shaped. It reaches its minimum point before the AVC and
the AC curves. MC is below AVC when AVC is falling, equals AVC at the lowest
point of AVC curve and is above AVC when AVC is rising.
 Similar relationship exists between MC and AC curves. MC is below AC when AC is

falling, equals to AC when AC is lowest, and above AC when AC is rising.

Revenue Curves
 Revenue is the receipt obtained by a firm from the sale of its products. It is
important for the determination of profit. The difference between the revenue and
the cost becomes profit. Hence, a firm always tries to get more revenue from the
sale of its product.
 There are three revenue concepts:
 Total revenue
 Average revenue
 Marginal revenue
Revenue Curves
 1. Total Revenue (TR)

 Total revenue is the total amount of earning of a firm by selling certain amount of its
product at a given price. It is obtained by multiplying price per unit of product by the
total quantity sold.
 TR = P×Q
Revenue Curves
 2. Average Revenue (AR)

 Average revenue is the price per unit of a product. It is obtained by dividing the total
revenue by the quantity sold.
 AR = TR / Q
Revenue Curves
 3. Marginal Revenue (MR)

 Marginal revenue is the addition to the total revenue as a result of one unit increase
in the sale.
 MR = TRn – TRn – 1 = ΔTR /ΔQ

Revenue Curves
 Revenue Curves under Perfect Competition

 Perfect competition is a market structure where large number of buyers and sellers
exchange homogeneous product at constant price. Each firm in the market is a price
taker because a firm in the market can not influence the market price.
Revenue Curves
 Table – TR, AR and MR under Perfect Competition
Q P TR AR MR
1 5 5 5 5
2 5 10 5 5
3 5 15 5 5
4 5 20 5 5
5 5 25 5 5
Revenue Curves
 Graph – TR, AR and MR under Perfect Competition

Revenue Curves
 Revenue Curves under Imperfect Competition

 (Monopoly)
 Monopoly is a market structure where there is a single seller or producer and large
number of buyers. Due to the only one seller, it can influence price of the product
and can increase its sale by reducing price of the product and earns profit.
 A monopoly firm is a price maker.

Revenue Curves
 Table – TR, AR and MR under Monopoly
Q P TR AR MR
1 10 10 10 -
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
Revenue Curves
 Graph – TR, AR and MR under Monopoly

Revenue Curves
 Relationship between AR and MR

 1. When AR curve is horizontal or parallel to X-axis, MR curve coincides with the AR
curve.
Revenue Curves
 2. When AR curve and MR curve are downward slopped straight lines:

 AR > MR; and
 MR lies on mid-point of the perpendicular line drawn on vertical axis or Y-axis.
Revenue Curves
 3. When AR curve and MR curve are downward slopped convex curves to the
origin, MR curve passes to the left from mid-point of the perpendicular line drawn
from AR curve to Y-axis.
Revenue Curves
 4. When AR curve and MR curve are downward slopped concave curves to the
origin, MR curve passes to the right from mid-point of the perpendicular line drawn
from AR curve to Y-axis.
Revenue Curves
 Relationship bet Price Elasticity with AR & MR

Revenue Curves
 Relationship bet Price Elasticity with AR & MR
 E = AR / (AR – MR)
 This is very useful relationship between price elasticity of demand (e), average
revenue (AR) and marginal revenue (MR) at any level of output.
Objectives of Firm
 Number of models have been advanced to explain the behavior of firms in terms of
their goals and objectives. Traditional model of the firm is profit maximization
objective as its primary goal. In modern society, the emphasis on profit
encompasses uncertainty with time dimension and leads to various alternative
models for firm’s objectives. Some important objectives are:
 1. Profit maximization
 2. Sales revenue maximization
 3. Output level maximization
 4. Minimize cost of production
 5. Firm’s value maximization

Objectives of Firm
 1. Profit maximization:
 Profit as an objective of the firm has emerged from over a century of economic
theory. The behavioral assumption of profit maximization has served economic
theory well. Usually, the main objective of a private sector firms is to maximize its
profit. Profit maximization means increasing profit as much as possible or producing
a level of output which brings the most profit for the firm.
 Sufficient profit must be made to finance capital investments and to distribute as

dividends to shareholders. The profits are not merely an objective, they are the very
reason for the existence of the business enterprise. The assumption of profit
maximization has the enormous advantage.

Objectives of Firm
 2. Sales revenue maximization

 The interests of the company are best served by the maximization of sales revenue,
which brings with it the benefits of growth, market share and status. The size of the
firm, prestige, and aspirations are more closely identified with sales revenue than
with profit.
 William J. Baumol believes that revenue or sales maximization rather than profit
maximization is consistent with the actual behavior of firms. It is regarded as the
short-run and long-run goal of the firm.
 If the sales of a firm are declining, banks, creditors and the capital market are not
prepared to provide finance to it. Its own distributors and dealers might stop taking
interest in it. Consumers might not buy its products because of its unpopularity. But
if sales are large, the size of the firm expands which, in turn, means larger profits.
Thus, the aim of the firm is to maximize its sales rather than profits.

Objectives of Firm
 3. Output level maximization

 For a firm in a perfectly competitive market, output maximization could be the firm
main objective. Firm should not worry about sales revenue and sales advertisement
but should worry to reduce the cost structures. It will spend its funds on increasing
its production rather than on advertising.
 Emphasis on output maximization as against sales maximization may not be a

satisfactory explanation of the objective of a firm. If the firm simply aims at output
maximization without sales maximization, it may not be in a position to survive for
long. Both the objectives are complementary rather than competitive.

Objectives of Firm
 4. Cost minimization:
 In case of budget constraint or limit, cost minimization might be the main objective of
a firm. Cost minimization objective makes full utilization of scarce resources. It
prevents the misuse of the resources. As there is no unlimited resource in the long-
run, the objective helps sustainability of the financial as well as other kinds of
resources.
 Cost minimization do not mean the minimization of cost from the less production, it
is the lowest cost of production for the specified production level by choosing
alternative combination of factors of production.

Objectives of Firm
 5. Firm’s value maximization

 Since most firms are expected to operate for a long period, they are assumed to aim
for maximum long-run profits instead of maximum short-run profit. Thus, if π1
denotes the expected profit in period 1, π2 expected profit in period 2, and so on,
then the firm’s aim is not to seek the maximum value of any one of these profits
(π’s) but maximum value of their sum, adjusted properly for the time value of
money. This is more relevant to choose for investment decision.
 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚

𝜋 𝜋 𝜋𝑛
 = 1 + 22 + ⋯+
(1+𝑖) (1+𝑖) 1+𝑖 𝑛
𝜋
 = 𝑛𝑡=1 𝑡 𝑡
1+𝑖

Objectives of Firm
 The Behavioural Model of Cyert and March

 (R. M. Cyert and J. G. March in 1963)
 The behavioral theory of firm developed by Cyert and March focuses on the
decision making process of the large multi product firm in an imperfect market. They
deal with the large corporate managerial business in which ownership is separated.
Their theory originated from the concern about the organizational problem with the
internal structure of such firms.
 The assumptions underlying the behavioral theories about the complex nature of the
firm introduces an element of realism into the theory of the firm. The firm is not
treated as a single-goal, single decision unit, as in the traditional theory, but as a
multi goal, multi decision organization coalition. The firm is as a coalition of different
groups which are connected with their activities in various ways, like managers,
workers, shareholders, customers, suppliers and so on.

Objectives of Firm
 Each group has its own set of goals or demands. For example, workers want high
wages, good pension schemes, good conditions of work. The managers want high
salaries, power, prestige. The shareholders want high profits, growing capital and
market size. The customers want low prices and good quality and service. The
suppliers want regular contracts for the input materials they sell to the firm, and so
on.

Objectives of Firm
 Tasks of the top management

 The demand of different groups associated with the firm change according to the
time. It is not possible to satisfy the demand of these group at the same time due to
limited resources of the firm. Thus conflicting factors and bargaining between
various members of the coalition firm exist. In this context, the tasks of the top
management can pointed out as:
 To determine the common objectives of the firm

 To reconcile the individual goals with the goal of the firm
 To solve the problems with negotiations arising in different department
 To make the decision making process effectively

Objectives of Firm
 Example 1
 Given the demand function, P = 20 – Q, and the total cost function, C = Q2 + 8Q +
2, determine the optimal output level, total revenue, total cost, and profit, under:
 a. Profit maximization
 b. Sales revenue maximization
 c. Sales revenue maximization subject to profit 8.

Objectives of Firm
 Under profit maximization:

 Profit (π) = TR – TC
 = (20 – Q)Q – (Q2 + 8Q + 2)
 = 20Q – Q2 – Q2 – 8Q – 2
 = 12Q – 2Q2 – 2
 For profit maximization,

 ∂π/∂Q = 12 – 4Q = 0 => 4Q = 12
 Q=3
 TR = 20Q – Q2 = 20 x 3 – 32 = 51
 TC = Q2 + 8Q + 2 = 32 + 8 x 3 + 2 = 35
 π = TR – TC = 51 – 35 = 16

Objectives of Firm
 Sales revenue maximization

 TR = (20 – Q)Q = 20Q – Q2
 For revenue maximization,

 ∂TR/∂Q = 20 – 2Q = 0 => 2Q = 20
 Q = 10
 TR = 20Q – Q2 = 20 x 10 – 102 = 100
 TC = Q2 + 8Q + 2 = 102 + 8 x 10 + 2 = 182
 π = TR – TC = 100 – 182 = –82

Objectives of Firm
 Under sales revenue maximization subject to profit 8:

 – 2Q2 + 12Q – 2 = 8
 – 2Q2 + 12Q – 10 = 0
 2Q2 – 12Q + 10 = 0
 Q2 – 6Q + 5 = 0
 Q2 – Q – 5Q + 5 = 0
 Q(Q – 1) – 5(Q – 1) = 0
 (Q – 1) (Q – 5) = 0
 Q = 1 or 5

Objectives of Firm
 When Q = 1
 TR = 20Q – Q2 = 20 x 1 – 12 = 19
 TC = Q2 + 8Q + 2 = 12 + 8 x 1 + 2 = 11
 π = TR – TC = 19 – 11 = 8
 When Q = 5
 TR = 20Q – Q2 = 20 x 5 – 52 = 75
 TC = Q2 + 8Q + 2 = 52 + 8 x 5 + 2 = 67
 π = TR – TC = 75 – 67 = 8
 Revenue maximization is when Q = 5

Objectives of Firm
 Example 2
 Tamakoshi Electrical Limited has the following demand and cost functions:
 P = 2000 – 10Q
 TC = 1000 + 200Q
 Calculate price (P), output level (Q), total revenue (TR), total cost (TC) and profit (π)
under the objective of:
 a. Profit maximization
 b. Revenue maximization
 c. Revenue maximization subject to profit constraint of Rs 79500

Perfect Competition
 Perfect Competition
The model of perfect competition envisions a market structure with the following
characteristics:
1. Many sellers of a homogeneous product
2. Large number of buyers
3. Free entry and exit
4. Free mobility of economic resources
5. Perfect information
6. The firm is a price taker and quantity adjuster

Perfect Competition
 Profit-maximizing Conditions
 Profit = Total Revenue – Total Cost
π(Q) = TR(Q) – TC(Q)
 Necessary or first order condition

MC = MR
 Sufficient or second order condition

Slope of MC > slope of MR

Perfect Competition
 Short-run Equilibrium
1. Normal Profit (MC=MR, Slope of MC > slope of MR & TR=TC)
2. Excess Profit (MC=MR, Slope of MC > slope of MR & TR>TC)
3. Loss (MC=MR, Slope of MC > slope of MR & TR<TC)
 Long-run Equilibrium

Perfect Competition
 Normal Profit (TR = TC)
Price Price
MC S
AC
0 q Output 0 Q

Perfect Competition
 Excess Profit (TR > TC)
Price Price
MC S
AC
0 q Output 0 Q

Perfect Competition
 Loss (TR < TC)
Price Price
MC S
AC
0 q Output 0 Q

Perfect Competition

Perfect Competition
 Normal Profit (TR = TC)
Price Price
MC S
AC
0 q Output 0 Q

Perfect Competition
 Problem 01
 Zebra Coffee Delight Inc is one of many small independent processors of Brazilian
coffee. The industry’s weekly supply and demand functions are estimated to be
Qs = 5000P and Qd = 90000 – 4000P

Where,
Qs = qty supplied per week in metric tons
Qd = qty demanded per week in metric tons
P = price per metric tons in thousands of US dollars

Perfect Competition
 Zebra’s cost function:

TC = 4 + 4Q +Q2
Questions
a. What is the market price?
b. What is the profit-maximizing level of output by Zebra?
c. What are Zebra’s total revenue, total cost, unit cost and profit?

Perfect Competition
 a. market price
 Qs = Qd
 5000P = 90000 – 4000P  9000P = 90000
  P = 10
 b. profit-maximizing level of output by Zebra

 𝜋 = PQ – (4 + 4Q +Q2) = 10Q – 4 – 4Q – Q2 = – 4 + 6Q – Q2

 For maximization, first order condition is

 ∂𝜋/ ∂Q = 6 – 2Q = 0
 Q=3

Perfect Competition
 Second order condition for profit maximization

 ∂2𝜋/ ∂Q2 = – 2 < 0  insures output is at maximizing level
 c. total revenue, total cost, unit cost and profit

 TR = PQ = 10 x 3 =30
 TC = 4 + 4Q +Q2 = 4 + (4 x 3) + 32 = 4 + 12 + 9 = 25
 TC/Q = 25/3
 𝜋 = – 4 + 6Q – Q2 = = – 4 + (6 x 3) – 32 = – 4 + 18 – 9 = 5

Monopoly
 Monopoly
 A monopoly is the sole producer/supplier of a product with no close substitutes . The
most important characteristic of a monopolized market is barriers to entry i.e. new
firms cannot profitably enter the market.
Monopoly
 Monopoly has the following characteristics:

1. Single seller
2. No close substitute
3. No entry allowed
4. Price maker
5. Asymmetric information
Monopoly
 The most common barriers to entry are:

1. Legal restrictions
2. Economies of scale that require very large capital outlays
3. The monopoly’s control over resources
4. Technology controlled by the monopoly
Monopoly

MC = MR

Monopoly
 1. Excess Profit (MC=MR, Slope of MC > slope of MR & TR>TC)
1. Excess Profit (MC=MR, Slope of MC > slope of MR & TR>TC)
Monopoly
MC
AC
a
EP b
D = AR
MR
Monopoly
 2. Normal Profit (MC=MR, Slope of MC > slope of MR & TR=TC)
MC
AC
a
NP
D = AR
MR
Monopoly
 3. Loss (MC=MR, Slope of MC > slope of MR & TR<TC)
MC
AC
b
Loss a
D = AR
MR
Monopoly
MC
AC
a
EP b
D = AR
MR
Monopoly
 Example 1
 Given the demand function and cost function of a monopoly:
 P = 100 – 4Q and TC = 50 + 20Q
 Where P, Q and TC are price per unit, quantity of commodity and the total cost
respectively. Find equilibrium level of output, price, total cost, total revenue and
profit. Also show if the profit is maximized.
 TR = PQ = (100 – 4Q) Q = 100Q – 4Q2

 MR = ∂TR/∂Q = 100 – 8Q
 TC = 50 + 20Q
 MC = ∂TC/∂Q = 20
Monopoly
 Profit maximizing first order condition

 MC = MR
 20 = 100 – 8Q => 8Q = 80 => Q = 10
 Second order condition

 ∂(MR – MC)/∂Q = ∂MR/∂Q – ∂MC/∂Q = – 8 < 0 (profit is maximized)
 P = 100 – 4Q = 100 – (4 x 10) = 60

 TC = 50 + 20Q = 50 + (20 x 10) = 250
 TR = PQ = 60 x 10 = 600
 𝜋 = TR – TC = 600 – 250 = 350
Monopoly
 Price Discrimination
 Price discrimination is the practice of a producer/seller to sell the same product at
different price to different customers. The cost of production is same or not
significantly different. Similarly, product or service is same or not significantly
different.
 A monopolist may charge different prices for same product depending on

consumer’s preferences, their income, their location and ease of availability. These
factors give rise to demand curve with different elasticity in various sectors of the
market.
Monopoly
 Conditions for the implementation of price-discrimination:

 1. The market must be divided into sub-markets with different price elasticity.
 2. There must be effective separation of the sub-markets, so that no reselling can
take place from a low-price market to a high- price market.
Monopoly
 First Degree Discrimination:

 In the first degree price discrimination, for some reason, consumers buy only one
unit from the firm. Knowing exactly how willing they are, the firm charges price so
high that the consumers is almost ready to pay the prices. If all of the consumers
have different tastes, the firm has a different price for each one.
 With first degree price discrimination, the firm extracts the consumer’s entire
surplus. The firm succeeds in getting all the area under the demand curve as
revenue. Each consumer pays a price equal to the marginal utility of that unit for
each unit consumed.
 Discrimination of the first degree is the extreme case and very rarely practiced.
Buying land is one common example.
Monopoly
 Second Degree Discrimination:

 In second-degree price discrimination, firm divides customers into many groups on
the quantity or volume. Goods with various quantity blocks are charged at different
price . In this discrimination, some consumer surplus is left with the consumer.
 For example, consumer obtained less price for voluminous buying.

Monopoly
 Third Degree Discrimination:

 In third-degree price discrimination, firm divides customers into two or more classes
or groups on the basis of age, gender, income, location , time, etc., and charging a
different price to each class of customers. The third degree price discrimination is
most common in practice.
 For example, public utility companies practice price discrimination of the third
degree by grouping their customers into separate markets, such as residential,
commercial and industrial or different times day/night. Airlines charge different fare
for different income group people in the same flight.
Monopoly
 Third Degree Discrimination

 MC = CMR (MR1 + MR2) i.e. horizontal summation of marginal revenues give
combined marginal revenue.
Monopoly
 Example 2
 The Thaitronics was established in 1983 in Bangkok, Thailand, as a wholly owned
subsidiary of FTT Corporation. Thaitronics manufactures memory boards for
computers, which it sells in the United States (Market A) and Europe (Market B).
The daily demand in the United States is Q A = 30 – PA and in Europe is QB = 22 –
PB. The average total cost is 2 + 0.1QT, where QT = total output, in units.
 a. Find optimal sales quantity and price in each market under price discrimination.
 b. Find the maximum profit using price discrimination.
 c. Find the maximum profit without price discrimination.
Monopoly
 Total Revenue (TR)

 TR = PAQA + PBQB = (30 – QA)QA + (22 – QB)QB = 30QA – QA2 + 22QB – QB2
 Total Cost (TC)

 TC = (2 + 0.1QT)QT = 2QT + 0.1QT2 = 2(QA + QB) + 0.1(QA + QB)2
 Profit (𝜋) = TR – TC
 = [30QA – QA2 + 22QB – QB2] – [2(QA + QB) + 0.1(QA + QB)2]
 = 30QA – QA2 + 22QB – QB2 – 2(QA + QB) – 0.1(QA + QB)2
 Profit maximizing first order conditions

 ∂𝜋/∂QA = 0 and ∂𝜋/∂QB = 0
Monopoly
 ∂𝜋/∂QA = 30 – 2QA – 2 – 0.2(QA + QB) = 28 – 2.2QA – 0.2QB = 0

 2.2QA + 0.2QB = 28
 ∂𝜋/∂QB = 22 – 2QB – 2 – 0.2(QA + QB) = 20 – 0.2QA – 2.2QB = 0

 0.2QA + 2.2QB = 20
 2.2QA + 0.2QB = 28 (x 11)

 0.2QA + 2.2QB = 20
 24.2QA + 2.2QB = 308

 0.2QA + 2.2QB = 20
Monopoly
 24QA = 288 => QA = 12

 0.2QA + 2.2QB = 20 => (0.2 x 12) + 2.2QB = 20 => => 2.4 + 2.2QB = 20
 => 2.2QB = 17.6 => QB = 8
 PA = 30 – QA = 30 – 12 = 18
 PB = 22 – QB = 22 – 8 = 14
 Market A: PA = 18; QA = 12
 Market B: PB = 14; QB = 08
Monopoly
 b. Profit (𝜋) = TR – TC
 TR = = PAQA + PBQB = (18 x 12) + (14 x 8) = 216 + 252 = 468
 TC = 2(QA + QB) + 0.1(QA + QB)2 = 2(12 + 8) + 0.1(12 + 8)2 = 40 + 40 = 80
 𝜋 = 468 – 80 = 388
 C. Without price discrimination

 PA = PB = P
 Q = QA + QB = 30 – PA + 22 – PB = 30 – P + 22 – P = 52 – 2P
 P = 26 – 0.5Q
 TR = PQ = 26Q – 0.5Q2
 MR = 26 – Q
 TC = (2 + 0.1Q)Q = 2Q + 0.1Q2
 MC = 2 + 0.2Q
Monopoly
 For profit maximization

 MC = MR
 2 + 0.2Q = 26 – Q
 1.2Q = 24 => Q = 20
 TR = PQ = 26Q – 0.5Q2 = (26 x 20) – (0.5 x 202) = 520 – 200 = 320
 TC = 2Q + 0.1Q2 = (2 x 20) + (0.1 x 202) = 40 + 40 = 80
 𝜋 = TR – TC = 320 – 80 = 240
Monopoly
 Example 3
 Assume that a monopoly multi-plant firm has the following demand and cost
function:
 Demand function: Q = 120 – 10P
 Cost functions: TC1 = 4Q1 + 0.1Q12 and TC2 = 2Q2 + 0.1Q22
 Here, P, Q, Q1 and Q2 are price, demand, individual demand for firm A and
individual demand for firm B.
 Find
 a. Price and total quantity for the multi-plant monopoly firm.
 b. Individual demand for firm A and firm B, and total profit.
Monopoly
 Example 4
 The Thaitronics Corporation, a wholly owned subsidiary of FTT Corporation,
manufactures memory boards for computers, which the firm has been selling in the
United States (Market A) and Europe (Market B). After several months of operation,
the top managers of Thaitronics have obtained sufficient experience to revise their
estimates of demand in the United States and Europe, and they have also decided
to enter a third market in the Far East (Market C). Cost of production remains at
 TC = 2QT + 0.1 QT2
 Their estimates of demand in the three markets now are:
 Market A: (United States) PA = 30 – QA
 Market B: (Europe) PB = 22 – QB
 Market C: (Far East) PC = 32 – QC
 a. Find optimal sales quantity and price in each market under price discrimination.
 b. Find the maximum profit using price discrimination.
 c. Find the maximum profit without price discrimination.
Monopolistic Competition
 Monopolistic Competition
 The extremes of perfect competition and pure monopoly are theoretical models that
are far from many actual market situations. Thus in the late 1920’s and early 1930’s,
many economists attempted to develop models of imperfect competition that could
characterize market structures between those two extremes. One of the most
noteworthy of those models is monopolistic competition.

 Monopolistic Competition
 1. Many firms sell similar but not identical products
 2. Many small buyers
 3. Free entry and exit (e.g. apartments, fast foods)
 4. Downward sloping demand curve
 5. Asymmetric information
 6. Large advertising cost


MC = MR



MC
AC
a
EP b
D = AR
MR

MC
AC
a
NP
D = AR
MR

 3. Loss (MC=MR, Slope of MC > slope of MR & TR<TC)
MC
AC
b
Loss a
D = AR
MR

MC
AC
a
NP
D = AR
MR

 Example
 April Showers Company is a medium-sized manufacturer of sprinkler heads. The
firm has recently developed a square-spraying sprinkler head that greatly improves
lawn watering and requires less water than conventional circular-spraying sprinkler
heads.
 The firms engineering estimates the total cost function to be
 TC = 500000 + 400Q
 Where, Q=output in units of 1000 sprinkler heads.
 The firms marketing department estimates demand will be

 Q = 2500 – 0.5P
 Where P is the price of sprinkler heads.
 Questions
 Determine the profit-maximizing output and price.
 Determine the profit at the optimum output.

 Q = 2500 – 0.5P => P = 5000 – 2Q

 TR = PQ = (5000 – 2Q)Q = 5000Q – 2Q2
 MR = 5000 – 4Q
 TC = 500000 + 400Q
 MC = 400
 Maximum profit occurs when MC = MR

 400 = 5000 – 4Q => 4Q = 5000 – 400 => 4Q = 4600
 Q = 4600 / 4 = 1150; P = 5000 – 2Q = 5000 – (2 x 1150) = 2700
 𝜋 = TR – TC = (2700 x 1150) – [500000 + (400 x 1150)]

 = 3105000 – (500000 + 460000) = 3105000 – 960000 = 2145000
 ∂(MR – MC) / ∂Q = ∂(5000 – 4Q – 400) / ∂Q = – 4

Oligopoly
 Oligopoly Competition
The model of oligopoly competition envisions a market structure with the following
characteristics:
1. Small number of large firms (2 – 10)
(duopoly if only 2 firms)
2. Similar or identical products
3. Barrier to entry
4. Interdependence on price and output determination
5. Importance of advertising and selling cost

Oligopoly
 Classification of Oligopoly:
 (i) Product basis
 Perfect or pure oligopoly: If the firms produce homogeneous products, then it is
called pure or perfect oligopoly. Though, it is rare to find pure oligopoly situation,
yet, cement, steel, aluminum and chemicals producing industries approach pure
oligopoly.
 Imperfect or Impure Duopoly: If the firms produce similar products, then it is called
imperfect or impure oligopoly. For example, passenger cars, cigarettes or soft
drinks. The goods produced by different firms have their own distinguishing
characteristics, yet all of them are close substitutes of each other.

Oligopoly
 Classification of Oligopoly:
 (ii) Cooperation basis
 Collusive oligopoly: If the firms cooperate with each other in determining price or
output or both, it is called collusive oligopoly or cooperative oligopoly.
 Non-collusive oligopoly: If firms in an oligopoly market compete with each other, it
is called a non-collusive or non-cooperative oligopoly.

Oligopoly
 Three distinct pricing models of oligopoly

 a. Cartel
 b. Price Leadership
 c. Kinked Demand Curve

Oligopoly
 Cartel
 Cartel is a kind of collusive oligopoly where firms collude in order to reduce the
uncertainties arising out of the inherent rivalries among them.
 The colluding firms are usually bound by agreements whereby they seek to
maximize the joint profit of the group. OPEC is an example of such type of collusion.

Oligopoly
 Cartel (contd.)
 To analyze let us consider two profit maximizing firms 1 and 2 forming a Collusive
Oligopoly cartel for joint profit maximization.
 The cost conditions are represented in terms of the marginal and average cost
curves (MC and AC respectively). Based on the individual MC curves of the two
firms, we derive the aggregate MC curve (AMC) as the horizontal summation of
MC1 and MC2.
 Given the market demand curve, by equating MR with AMC, we can derive the
industry output and the corresponding industry price.

Oligopoly
Cartel Model

Oligopoly
 Cartel Model
 Cartel model aims at joint profit maximization which is identical to the multi-plant
monopolist
 Max π = π1 + π2
 P = f(Q) = f(Q1 + Q2), C1 = f(Q1), C2 = f(Q2)
 π1 = R1 – C1, π2 = R2 – C2
 π = R1 + R2 – C1 – C2 = R – C1 – C2
 Where, R = R1 + R2
 ∂R/∂Q = ∂R/∂Q1 = ∂R/∂Q2

 MR = MR1 = MR2

Oligopoly
 Cartel Model (contd.)

 π = R1 + R2 – C1 – C2 = R – C1 – C2
 FOC
 ∂π/∂Q1 = ∂R/∂Q1 – ∂C1/∂Q1 = 0 => ∂R/∂Q1 = ∂C1/∂Q1
 ∂π/∂Q2 = ∂R/∂Q2 – ∂C2/∂Q2 = 0 => ∂R/∂Q2 = ∂C2/∂Q2
 ∂R/∂Q = ∂C1/∂Q1 = ∂C2/∂Q2

 MR = MC1 = MC2
 SOC
 ∂2R/∂Q2 < ∂2C1/∂Q12 and ∂2R/∂Q2 < ∂2C2/∂Q22
 MC of each firm must be increasing faster than common MR

Oligopoly
 Example 01
 Assume that market demand is
 P = 100 – 0.5(Q) = 100 – 0.5(Q1 + Q2)
 And that two colluding firms have the cost given by
 C1 = 5Q1, and C2 = 0.5Q22
 Find output to be produced by each firm (Q1, Q2), price (P), and
joint profit (π = π1 + π2) of the two colluding firms.

Oligopoly
 P = 100 – 0.5(Q) = 100 – 0.5(Q1 + Q2)

 TR = PQ = (100 – 0.5Q)Q = 100Q – 0.5Q2 = 100(Q1 + Q2) – 0.5(Q1 + Q2)2
 MR1 = 100 – (Q1 + Q2) = 100 – Q1 – Q2 = MR
 MR2 = 100 – (Q1 + Q2) = 100 – Q1 – Q2 = MR
 MR1 = MR2 = MR
 C1 = 5Q1, and C2 = 0.5Q22

 MC1 = 5
 MC2 = Q2
 MC1 = MR
 5 = 100 – Q1 – Q2
 Q1 + Q2 = 95

Oligopoly
 MC2 = MR
 Q2 = 100 – Q1 – Q2
 Q1 + 2Q2 = 100
 Q1 + 2Q2 = 100
 Q1 + Q2 = 95
 Q2 = 5 => Q1 = 90
 P = 100 – 0.5(Q) = 100 – 0.5(Q1 + Q2) = 100 – 0.5(90 + 5) = 100 – 0.5 x 95 = 52.5
 π = π1 + π2 = (PQ1 – 5Q1) + (PQ2 – 0.5Q22)

 = (52.5 x 90 – 5 x 90) + (52.5 x 5 – 0.5 x 5 x 5)
 = 4725 – 450 + 262.5 – 12.5
 = 4525

Oligopoly
 Price Leadership
 Under price leadership, one firm assumes the role of a price leader and fixes the
price of the product for the entire industry.
 The other firms in the industry simply follow the price leader and accept the price
fixed by the leader and adjust their output to this price.
 The price leader is generally a very large or dominant firm or a firm with the lowest
cost of production. It often happens that price leadership is established as a result of
price war in which one firm emerges as the winner.

Oligopoly

Oligopoly
 Price Leadership
 Low-cost price leader
 It is assumed that for simplicity, that there are only two firms in the industry. The
market demand is defined by the function
 P = a – b(Q) = a – b(Q1 + Q2); Q1 & Q2 are output firms 1 & 2
 The firms have different costs, defined by the functions

 C1 = f(Q1); and C2 = f(Q2); where C1 < C2
 The leader will be the low-cost firm 1.

Oligopoly
 Low-cost price leader
 Firm 1 assumes that the rival firm will produce an equal amount of output to his own,
that is
 Q1 = Q2
 With this assumption, the demand function for firm 1 is

 P = a – 2bQ1
 The low-cost leader will set the price which max his own profit
 Max π1 = TR1 – TC1 = (a – 2bQ1)Q1 – C1

Oligopoly
 FOC: ∂π1/∂Q1 = ∂R1/∂Q1 – ∂C1/∂Q1 = 0

 MR1 (=MR) = MC1
 SOC: ∂2π1/∂Q12 < 0 or ∂2R1/∂Q12 < ∂2C1/∂Q12

 MC1 must rise faster than MR1
 Price P and output Q1 that the leader produce maximizes his profit. Follower will
adopt the same price.

Oligopoly
 Example 02
 Assume that the market demand is
 P = 105 - 2.5Q = 105 - 2.5(Q1 + Q2)
 The cost functions of the two firms are

 C1 = 5Q1, C2 = 15Q2
 Under the price leader model, find profit for firm 1.

Oligopoly
 The leader will be low-cost firm 1: he will set a price which will maximize his own
profit on the assumption that the rival firm will adopt the same price and will produce
an equal amount of output. The demand function for leader is
 P = 105 – 2.5(2Q1) = 105 - 5Q1

 TR = PQ1 = (105 - 5Q1)Q1 = 105Q1 – 5Q12 => MR = 105 – 10Q1
 TC = 5Q1 => MC = 5
 For profit maximization, MC = MR

 5 = 105 – 10Q1 => 10Q1 = 100
 Q1 = 10, P = 105 - 5Q1 = 105 – 5 x 10 = 55
 π1 = TR1 – TC1 = (105Q1 – 5Q12) – 5Q1

 = (105 x 10) – (5 x 102) - (5 x 10) = 1050 – 500 - 50 = 500

Oligopoly
 Kinked Demand Curve Model

 The kinked demand curve model assumes that a firm might face a dual demand
curve for its product based on the likely reactions of other firms to a change in its
price.
 If a firm raises price and other firms leave their prices constant, then the firm would
lose market share and fall in its total revenue making demand relatively price elastic.
 On the other hand, if a firm reduces its price but other firms follow, it leads to a fall
in revenue with little or no effect on market share making demand relatively price
inelastic.

Oligopoly
P/AR/MR/MC
D1
e MC
Pe
MR1 f
g D2
Qe MR2 Quantity

Oligopoly
 Example 03
 (Kink Demand Model)
 Assume that the demand functions for the increase and for the price cuts of an
oligopoly firm for its product "Board Marker" are respectively, Q 1 = 560 – 80P1 (Price
Increase) and Q2 = 200 – 20P2 (Price Cuts), where Q is output and P is price. The
total cost function of the firm is TC = 2Q + 0.0125Q 2
 a. Determine the price and output at the kink on the demand

curve.
 b. Find the value of the total profit of the firm.

Oligopoly
 At the kink, both demand curves intersect, thus
 P1 = P2 = P and Q1 = Q2 = Q
 560 – 80P = 200 – 20P => P = 6, Q = 80
 π = PQ – (2Q + 0.0125Q2)
 =6x80 – 2x80 – 0.0125x802 = 240

Externalities and Market Efficiency
 Externalities
An externality is the impact of one person’s action on the well-being of a bystander
or neighbor. Whenever an action of a buyer (consumer) and/or a seller (producer)
affects a third party who is neither buyer (consumer) nor seller (producer), therefore
the third party and external to the market transaction, there is an externality.

 Example, suppose you buy petrol for your car from a petrol pump. When you drive
your car, you cause pollution to your next door neighbor who has to breathe in
polluted air. Your neighbor is the third party in this transaction who neither has
bought nor sold the petrol and got affected by the transaction between you and the
petrol pump. Therefore the pollution from your car is the externality .

 In the process of production and consumption of goods and services, social values
and social costs often differ significantly from the private values and private costs of
the producer and consumer. The difference between social cost and private cost or
social value and private value is known as externality.
 Private cost is the cost of production that is actually realized by the producer
measured in the free market. Social cost is the true cost of production which include
all relevant cost i.e. cost realized by the producer and cost or harm realized by other
than the producer.

 Private value or benefit is the value realized by the consumer that is measured in
free market. Social value or benefit is the true value which includes all relevant
values i.e. value realized by the consumer and the value realized by other than the
consumer.

 In free market economy, there is no provision to compensate the externalities. The

producer or consumer generating negative externality do not pay the full cost of their
activities. Similarly, the producer or consumer generating positive externality are not
rewarded.
 Due to the presence of these externalities, market does not produce economically
efficient output. As a result, market fails to operate. This gives rise to an active role
of government in the economy.

 Types of Externalities
Consumption and production of goods and services give rise to externalities, thus
there is consumption externalities and production externalities. Consumption
externalities are further divided into positive consumption externalities and negative
consumption externalities. Similarly, production externalities are divided into positive
production externalities and negative production externalities.

 Consumption Externalities
In traditional economics, consumption is supposed to be independent. But in reality,
consumption of an individual generates positive externalities and negative
externalities.
 1. Positive Consumption Externalities

If an individual gets satisfaction without incurring any cost, it is the case of positive
externalities in consumption. In other words, if social value is greater than private
value, there is positive consumption externalities.
As for example, when an individual gets higher education, it increases literacy rate
of that society.

Positive Consumption Externalities
MC, MB
PMC
SMB
PMB
Q
QMKT QOPT
 2. Negative Consumption Externalities

If the society is imposed cost with the activities of an individual due to which social
value is less than private value, it is the case of negative externalities in the
consumption.
 For example, when one gets drunkard, it adversely affect the neighbor.

Negative Consumption Externalities
MC, MB
PMC
PMB
SMB
Q
QOPT QMKT
 In both of the cases, there is difference between social value and the private value.
 social value > private value → positive cons externalities

 social value < private value → negative cons externalities

 Production Externalities
Production of goods and services also creates externalities which may be in the
form of positive production externalities and negative production externalities.
 1. Positive Production Externalities

Positive production externalities occurs when output of one firm creates into the
production function of other firm. In other words, if the activities of one firm reduce
the cost of production for another firm, it is the case of positive production
externalities. Here, private cost is greater than social cost.
 Example, construction of road by a firm reduces cost of production of neighbor firm.

Positive Production Externality
MC, MB
PMC
SMC
PMB
Q
QMKT QOPT

 2. Negative Production Externalities

If the production activities of one firm adversely affects the society i.e. if the
production activities of one firm impose cost in the society, it is the case of negative
production externality. Here, social cost is higher than the private cost.
 Example, a factory produces air pollution and imposes cost to society.

Negative Production Externality
MC, MB
SMC
PMC
PMB
Q
QOPT QMKT

 In both of the cases, there is difference between social cost and the private cost.
 social cost < private cost → positive production externalities

 social cost > private cost → negative production externalities

 When there is positive externalities, market equilibrium quantity is less than

optimum equilibrium quantity, thus, such production or consumption has to increase.
 When there is negative externalities, market equilibrium quantity is greater than

optimum equilibrium quantity, thus, such production or consumption has to
decrease.
 Positive externalities are called efficiency in production or consumption and negative

externalities are called inefficiency in production or consumption.

 Market Failure
 Market failure refers to that situation where resources are not efficiently allocated.
An allocation of resources that maximizes sum of consumer surplus and producer
surplus (social welfare) is said to be efficient. Policy makers are often concerned
with the efficiency.
 In case of market failure, the market wastes scarce resources by either producing
too much of the goods and services (over production) or by producing too little of the
goods and services (under production). When the market does not provide efficient
outcomes for society, economists say that the market has failed.

 Causes of Market Failure

 1. Market failure due to lack of competition: For the market to produce efficient
outcomes, there must be competition. A cartel or monopoly has the power to reduce
supply of the product below the equilibrium quantity in order to maintain a higher
market price.
 2. Market failure due to public goods:

 Public Goods
 A good is said to be public good when it has two characteristics:
1. Non-rival in consumption
2. Non-exclusion in character
 Non-rival in consumption implies that the consumption of one person does not affect
the consumption of other. Similarly, non-exclusion in character implies no one can
be excluded for the consumption of such goods or services.

 For example, road, bridge, street-lamp, etc. When one person is using street-lamp,
it does not reduce the consumption or satisfaction of the other. Similarly, no one is
prohibited to use the light.
 Since, public goods are non-exclusion in character, private firm will not provide or
produce it as it is not sure of making economic profit. Public goods are usually
produce or delivered by the government and financed by public funds like taxes.

 Consumer can take a free ride for the public goods and services. Free-ride principle
says that you can not charge a price to an individual for public goods and any body
can gain benefit from the consumption without paying anything. The name free-rider
comes from a common text book example, someone using public transportation
without paying the fare. If too many people do this, the system will not have enough
money to operate.

 3. Market failure due to the externalities: When cost and benefit arises to a
person not because of his or her own efforts but because of effort made by some
other person, externalities arises. When there is externalities, the resources are not
allocated efficiently i.e. the market fails.
 4. Market failure due to the lack of information: If the consumer does not have
adequate information about the market condition, consumer can not make optimal
decision.

 Correcting Market Failure

 1. Promote competitive market
 2. Manage public goods
 3. Reduce externalities
 4. Reduce asymmetric information i.e. increase consumer awareness
 5. Macroeconomic tools – fiscal and monetary policies

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Scope of Managerial Economics

 Managerial economics deals with the application of the economic concepts,

 It is the combination of economics theory and managerial theory. It helps the

 It is sometimes referred to as business economics and is a branch of economics

Dr Purna Bahadur Khand, School of Business, Pokhara University

Dr Purna Bahadur Khand, School of Business, Pokhara University

 Following specific aspects constitute scope of managerial economics or its subject

 1. Demand analysis and forecasting:

Dr Purna Bahadur Khand, School of Business, Pokhara University

 2. Cost and production analysis:

Dr Purna Bahadur Khand, School of Business, Pokhara University

 3. Pricing decisions and techniques:

Dr Purna Bahadur Khand, School of Business, Pokhara University

 4. Profit and capital management:

Dr Purna Bahadur Khand, School of Business, Pokhara University

 5. Objective of business firm:

Dr Purna Bahadur Khand, School of Business, Pokhara University

Dr Purna Bahadur Khand, School of Business, Pokhara University

 Quantity Demanded (Qd)

 Variables that influence quantity demanded (Qd)

Dr Purna Bahadur Khand, School of Business, Pokhara University

 Generalized Demand Function

If the demand function is expressed in linear form:

Dr Purna Bahadur Khand, School of Business, Pokhara University

Dr Purna Bahadur Khand, School of Business, Pokhara University

For example: Qd = 1800 – 20P + 0.6M – 50Pr

Dr Purna Bahadur Khand, School of Business, Pokhara University

 Demand Function or Demand

A demand function expresses quantity demanded as a function of product price only.

Dr Purna Bahadur Khand, School of Business, Pokhara University

 Demand equation is a mathematical equation showing quantity demanded is a function of price,

Dr Purna Bahadur Khand, School of Business, Pokhara University

 Inverse Demand Function

Dr Purna Bahadur Khand, School of Business, Pokhara University

 Quantity Supplied (Qs)

 Variables that influence quantity supplied (Q s)

Dr Purna Bahadur Khand, School of Business, Pokhara University

 Generalized Supply Function

If the supply function is expressed in linear form:

Dr Purna Bahadur Khand, School of Business, Pokhara University

For example: Qs = 50 + 10P – 8Pi + 5F

Dr Purna Bahadur Khand, School of Business, Pokhara University

 Supply Function or Supply

A supply function expresses quantity supplied as a function of product price only.

Dr Purna Bahadur Khand, School of Business, Pokhara University

 Supply equation is a mathematical equation showing quantity supplied is a function of price,

Dr Purna Bahadur Khand, School of Business, Pokhara University

 Inverse Supply Function

Dr Purna Bahadur Khand, School of Business, Pokhara University

Dr Purna Bahadur Khand, School of Business, Pokhara University

 Excess Supply (Surplus)

 Excess Demand (Shortage)

 Market Clearing Price

Dr Purna Bahadur Khand, School of Business, Pokhara University

The generalized demand function for good A is

Qd = 600 – 4P – 0.03M – 12Pr + 5T + 6Pe + 1.5N

a. Interpret the intercept parameters in the generalized demand function.

Dr Purna Bahadur Khand, School of Business, Pokhara University

Consider the generalized supply function: