Microeconomics - I Agec 211 Prepared By: Habtamu R (MSC.)

MICROECONOMICS -I
AgEc 211
Prepared by: Habtamu R (MSc.)
CHAPTER ONE
CONCEPTS OF ECONOMICS
1
Definition and Scope of Economics
• The word economics comes from the Greek word ‗Economicous‘

meaning,
 one who manages a household.
• There are two fundamental facts that provide the foundation for
the field of economics:
 Human or society‘s material wants are unlimited and
 Economic resources are scarce or limited in supply
( nature).
2
Cont…
• Society‘s material wants refers to the desire of:
– consumers,
– businesses, and
– government to get those things that help them realize their respective
goals
Note that:
• goal of consumers is to get Maximum Satisfaction or Utility
• The goal of businesses is to produce goods and services and get profit,
and
• The goal of the government is to satisfy the collective wants of its
citizens
• All of these wants are not only numerous but also multiply through time.
3
Cont…
Scarcity is defined in terms of resource. It is anything which
is used for the production of output.
There are two types of resource
1. Free resource exists at zero cost.
2. Economic resource/scarce resource
• Economic resources refer to anything natural or manmade that can

be used in production of goods and services which cannot be used
at zero price: since economic resources are limited.
• These contradictory facts lay the foundation for the field of

economics.
4
Con…
• Land:- land refers to all natural resources that can be used as inputs to
production ; ex, minerals, water, forest …etc. The payment of land is rent.
• labor:-is defined as the physical and intellectual exertion/contribution of

human beings. The payment is wage.
• Capital:- capital is defined as all man-made/physical assets aids to

production. The payment is interest. Ex, machines and equipment.
• Entrepreneurship: entrepreneurs combine the other factors of production

by buying these factors to produce a saleable product.
• Entrepreneur + Enterprise Entrepreneurship
(person) (object) (process)
• The return for entrepreneurship is called profit.

5
Definition
• Economics is, thus, defined as a social science, which studies how
societies allocate scarce resources in the production and distributes of
goods and services so as to attain the maximum fulfillment of society‘s
material wants.
1.2. Branches of Economics
• Generally, Economics can be divided into two main branches:-
Microeconomics & Macroeconomics

A. Microeconomics: is concerned with economic behavior (action) of
individual economic units, well-defined groups of individual economic
units, and how markets of individual commodities function: (household
and firm)
6
Microeconomics….
• It studies the interrelationships between these units in determining
the pattern of production and distribution of goods and services
• It is concerned with the decisions taken by individual consumers

and firms and these decisions contribute to the setting of prices and
output in various kinds of market
• For example, questions like how does a household maximize

satisfaction,
– how does a particular business enterprise attain maximum

possible profit by producing and selling a product, .etc., are
studied in microeconomics.
7
B. Macroeconomics
 Is the branch of economic analysis that studies economy as whole
and sub aggregates of the economy
It deals with magnitudes such as:
 the total output level in an economy,
 national income of a country,
 the overall level of prices,
 total output and total employment in the economy
 general price level of goods and services in the economy, etc.,
 So, in general, Macroeconomics study about the forest while

microeconomics study about tree in the forest. 8
Macroeconomics Microeconomics
The big picture. Study of the operation of ―A small-scale study‖. Focuses on
the economy as a whole. It looks at individual entities of the economy, such
aggregate data. as households and firms.
Focuses more
at the policy Focuses at
and regulatory the firm
levels. level
• Both areas offer valuable outlook on the economy.

• Both are complementary to each other.
• I.e., macroeconomics cannot be studied in isolation from
microeconomics. 9
THUS,
ECONOMICS
MACROECONOMICS MICROECONOMICS
Studies Studies
Aggregate Economic Events Behavior Individual Agents
e.g. Business Cycles, Economic Growth e.g. Consumers, Firms, Individual Markets
Positive & Normative Analysis:-
Economists often distinguish between positive economics and normative
economics. Positive economics
• Positive economics is concerned with facts. It tells us what was, what is or

what will be. In other words, positive economics is verifiable.
Consider the following statement:
• ‗A decrease in personal income tax will lead to a rise in unemployment.‘
In above statement, both personal income tax and unemployment are

measurable and hence the statement is verifiable. Therefore, the statement is a
positive statement. It is important to take note that a positive statement can be
true or false. What makes the statement a positive statement is not that it is true
but that it is verifiable. In fact, the statement is false.
11
Normative economics
Concerned with value judgments. It tells us what should be. Disagreement
over normative economics cannot be settled by an appeal to facts. In other
words, normative economics is not verifiable.
Consider the following statement:
‗A redistribution of income from the rich to the poor will increase social
welfare.‘ In the above statement, although redistribution of income is
measurable, social welfare is not and hence the statement is not verifiable.
Therefore, the statement is a normative statement. It is important to take
note that a normative statement can be true or false. Although the
statement is true, what makes it a normative statement is not that it is true
but that it is not verifiable.
12
1.3. Methods in Economics
Inductive and deductive reasoning in economics:
In logic, we often refer to the two broad methods of reasoning as

the deductive and inductive approaches.
Deductive reasoning works from the more general to the more specific.
Sometimes this is informally called a “top-down” approach. We might
begin with thinking up a theory about our topic of interest. We then narrow
that down into more specific hypotheses that we can test. We narrow down
even further when we collect observations to address the hypotheses. This
ultimately leads us to be able to test the hypotheses with specific data –
a confirmation (or not) of our original theories.
13
• .
14
Inductive reasoning works the other way, moving from
specific observations to broader generalizations and
theories.
• Informally, we sometimes call this a “bottom up”
approach.
• In inductive reasoning, we begin with specific
observations and measures, begin to detect patterns and
regularities, formulate some tentative hypotheses that we
can explore, and finally end up developing some general
conclusions or theories.
15
• These two methods of reasoning have a very different ―feel‖ to
them when you‘re conducting research. Inductive reasoning, by
its very nature, is more open-ended and exploratory, especially
at the beginning.
Deductive reasoning is more narrow in nature and is concerned

with testing or confirming hypotheses.
In fact, it doesn‘t take a rocket scientist to see that we could

assemble the two graphs above into a single circular one that
continually cycles from theories down to observations and back
up again to theories.
Even in the most constrained experiment, the researchers may

observe patterns in the data that lead them to develop new
theories.
16
.
17
1.4. Scarcity and choice: Opportunity cost
Scarcity
What is the crucial ingredient that makes a problem an economic?
– The crucial economic problem is the problem of scarcity.
scarcity is define as the excess of human wants over what can actually
be produced or an imbalance between want and what is available
• Because of scarcity, various choices have to be made between

alternatives.
Economics is the study of scarcity/the study of allocation of scarce

resources to satisfy human wants.
18
Cont…
• Decisions must be made regarding the following question:
• what to produce,
• how to produce it, and
• for whom to produce. The 3 Economic Questions.
• What to produce involves decisions about the kinds and quantities

of goods and services to produce.
• How to produce requires decisions about what techniques to use and

how economic resources are to be combined in producing output
• The for whom to produce involves decisions on the distribution of

output among members of a society.
19
Cont…
• Economics helps to solve the three important questions of:
• what to produce,
• how to produce it, and
• for whom to produce.
These decisions involve opportunity costs.
• An opportunity cost is what is sacrificed to implement an

alternative action, i.e., what is given up to produce or obtain a
particular goods or service.
20
Choice &opportunity cost
• Choice involves sacrifice. The more food you choose to buy, the less
money you will have to spend on other goods.
• Opportunity cost is the cost of any activity measured in terms of the

best alternative forgone
• For example, if you have 500 birr and you go to the mall and see a
shoes, a jacket, and jeans each costing 500, which would you choose?
• If you rank the shoes as your 1st choice, the jacket as your 2nd ,and
the jeans as your 3rd choice, which would be the opportunity cost?
• The jacket is the opportunity cost because it is your next best

alternative.
21
Economic system
• Economic system is a set of organizational and structural arrangements
established to answer the basic economic questions.
• Based on this we have three types of economic systems:
– Free market economy,
– command or planned economy and
– mixed economy.
• It is useful to analyze the extremes, in order to put the different mixed

economies of the real world into perspective.
22
Con….
1. Free market economy is an economy where all economic decisions
are taken by individual households and firms and with no government
intervention at all.
• It rely on the forces of supply and demand to answer the three
economic questions.
• In a market economy, economic decisions are decentralized and are
made by the collective insight of the marketplace, i.e., prices resolve
the three fundamental economic questions.
• Hence, there is no government intervention in the market to determine
what, how and for whom to produce rather they are determined by the
interaction of market forces.
23
Con…
2. Command or planned economy is an economy where all economic
decisions are taken by the central authorities/government.
• A command economy is one in which the government makes all important

decisions about production and distribution;
• That is, the government owns all the means of production
3. Mixed economy is a market economy where there is some government

intervention.
• Because of the problems of both free-market and command economies,
• all real-world economies are a mixture of the two systems.
• Under mixed economy, some resources are allocated by the government and
the rest by the market system.
24
 Scarcity implies choice
 Choice in turn implies cost(scarification)
 The cost is the forgone opportunity
 Opportunity cost/opportunity lost/:

 is the value of the next best alternative that
must be given up in order to obtain one
more unit of a product
25
Production Possibility Frontier(PPF)
PPF is a graph that shows the various combinations

of output that the economy can possibly produce
given the available factors of production and the
available production technology
Assumptions to draw the PPC/PPF

i. Efficiency
ii. Fixed resource
iii.Two products
iv. Fixed technology
26
Production Possibilities:
• The limit on resources implies limits to total
output that can be produced.
• This means that if production of good X is

increased then production of good Y must be
decreased because resources would be
transferred from Y to X.
Cont…
 Although real economies produce thousands of
goods and services, let‘s imagine an economy
that produces only two goods—cars and
computers
 Together the car industry and the computer

industry use all of the economy‘s factors of
production
28
Cont…
Figure 1
29
Cont…
Figure 1 is an example of a production possibilities
frontier. In this economy, if all resources were used
in the car industry, the economy would produce
1,000 cars and no computers
If all resources were used in the computer industry,

the economy would produce 3,000 computers and no
cars
30
Cont…
 The two end points of the production possibilities
frontier represent these extreme possibilities
 If the economy were to divide its resources

between the two industries, it could produce 700
cars and 2,000 computers, shown in the figure by
point A
 Points on PPF are attainable and efficient
31
Cont…
 By contrast, the outcome at point D is not possible
because resources are scarce: The economy does not
have enough of the factors of production to support
that level of output
 In other words, the economy can produce at any

point on or inside the production possibilities
frontier(attainable but inefficient)
 the economy cannot produce at points outside the

frontier(Unattainable)
32
Cont…
The PPF/C shows one tradeoff that society faces.
Once we have reached the efficient points on the

frontier, the only way of getting more of one good is
to get less of the other.
When the economy moves from point A to point C
For instance, society produces more computers but at

the expense of producing fewer cars
33
Opportunity cost
• Every time scarce resources are used in one way we
must give up the opportunity to use them in other
ways.
• To produce more weapons, you must sacrifice the

opportunity of producing more civilian goods.
• The sacrificed or foregone civilian goods represent

the opportunity cost of producing more weapons.
• The opportunity cost of producing more of good X is

the most desired goods or services foregone in order to
transfer resources to this good.
Cont…
 When society reallocates some of the factors of
production from the car industry to the computer
industry, moving the economy from point A to point
C, it gives up 100 cars to get 200 additional
computers.
In other words, when the economy is at point A, the

opportunity cost of 200 computers is 100 cars
35
Cont…
Opportunity = The amount of the good scarified
The amount of the good gained
Law of Increasing Opportunity Cost – For each

additional unit of a good produced the
opportunity cost increases. Why?
 Because the most efficient use of the resource in

production of a good is used first.
36
Cont…
• Resources are not equally efficient in the production of all
goods and services,
• i.e., they are not equally productive when used to produce an

alternative good.
• This imperfect substitutability of resources is due to differences

in the skills of labor and to the specialized function of most
machinery and many buildings.
• Thus, when the decision is made to produce more car and less
computer, the new resources allocated to the production of car
are usually less productive.
Example: study time
• 4 hours left to study for two exams: economics

and Calculus
• Output = grades on each exam
• No unemployed nor underemployed resources?

Alternative uses of time
Production possibilities curve
Law of increasing OC
• Law of increasing cost – marginal opportunity cost rises
as the level of an activity increases
Economic Growth
The PPF and Opportunity Cost
• Recall: The opportunity cost of an item
is what must be given up to obtain that item.
 Moving along a PPF involves shifting resources (e.g.,
labor) from the production of one good to the other.
 Society faces a tradeoff: Getting more of one good

requires sacrificing some of the other.
 The slope of the PPF tells you the opportunity cost of

one good in terms of the other.
1.4. Decision making unit and circular flow of economic
activities
 There are three decision-making units in closed

economy.
i. Households
ii. Firm
iii. Government
 These economic agents interact in two markets
i. Resource/Input/Factor markets
ii. Products/Output markets 44
Circular Flow Model
 We can use two models to understand the economic
interaction among economic agents
a. Two sector circular flow model
b. Three sector circular flow model
45
A. 2 SECTOR CFM
Households:
 own the factors of production,
sell/rent them to firms for income
 buy and consume goods & services
Firms Households
The Circular-Flow Model: 2 Sector
Firms Households
Firms:
 buy/hire factors of production,
use them to produce goods and
services
 sell goods & services
From the CFM
• The green arrows represent flows of

income/payments.
• The red arrows represent flows of goods &

services and factors of production.
The Circular-Flow Diagram
Revenue Spending
Markets for
G&S Goods &
G&S
sold Services bought
Firms Households
Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income
profit
Two sector circular flow model
50
A Three sector model
MARKETS
Revenue
FOR Spending
GOODS AND SERVICES
Goods •Firms sell
•Households buy Goods and
and services
Goods services
sold
and services bought
Expenditure
sold
GOVERNMENT
Income support Subsidies
• Provide social
FIRMS services HOUSEHOLDS
•Produce and sell Taxes • Provide supports Taxes •Buy and consume
goods and services • Collect taxes goods and services
•Hire and use factors • Buy goods and •Own and sell factors
Gov’t services Gov’t services
of production services of production
• Hire and uses
factors of production
Factors of Payments
Factors of production Labor, land,
production and capital
MARKETS
FOR
FACTORS OF PRODUCTION Income
Wages, rent,
•Households sell
and profit = Flow of inputs
•Firms buy
and outputs
= Flow of Birr
Copyright © 2004 South-Western

Three sector circular flow model
52
Chapter Two:
Theory of Demand and Supply
The words demand, desire and want are often interchangeably
used to express what an individual needs and what he would like
to acquire.
However, in economics, the term demand has a specific

meaning. It refers to the amount of commodity which an
individual/buyer is willing and able to buy at a given price and
during a given period of time.
53
…cont.
A desire becomes an effective desire or demand only when it is

backed by the following three factors:
 Ability to pay for the good desired,
 Willingness to pay the price of the good desired, and
 Availability of the good itself.
54
Meaning of Demand
 Demand refers to consumers willingness and ability to purchase

certain good/service at a alternative price over a given period (e.g.
a week, or a month, or a year).
 It is defined as the quantity of a good that consumers are willing

and able to buy in a specific time period.
 Demand describes the behavior of consumers. It does not simply

mean the desire to obtain something.
 In economics , a hungry man who can not pay for food has no
demand for it, he has simply want for food.
55
Moreover, demand for a good is always expressed in
relation to a particular price and particular time.
E.g. You may be interested in buying a particular shirt at a

price of Birr 200, but you would not demand it at all if it is
priced at Birr 700.
Similarly, an individual may be willing to buy a room heater

at a price of Birr 1000 during a cold, but he/she may not be
interested in buying it at this price during a hot season.
56
 It states that the consumer must be willing and able to purchase
the commodity, which he desire.
 They do not refer to what people would simply like to

consume. Their desire should be backed by purchasing power.
 Example, a poor person is willing to buy a car; it has no ability

to pay for it so this is not demand.
Law of Demand
 Law of demand states that there is an inverse relationship

between price of a commodity and its quantity demand in the
markets, keeping other factors constant.
57
 There are two possible explanations to why a consumer buys
more of a good when its price falls and less when the prices
rises.
 These are income effect and substitution effect.
 As the price of the commodity falls, the purchasing power of

your limited income increase, is permitting you to buy more of
the products. This is called the income effect of a price fall.
58
 If the price of a good declines while the price of the
substitutes are constant , the good becomes relatively cheaper
than the substitutes.
 In this case , a consumer buys more quantities of the good for
which price is falling, reducing his purchase of the
substitutes. This explanation is known as the substitute
effect.
59
 When we state the law of demand, we assume the determinants of
demand constant. There are many factors which affect the level of
demand among this:-
– Tastes and preference,
– Price of substitute goods,
– Price of complementary goods,
– Income of consumer, P demand

curve
– Expectations of future price changes,
– Advertisement, and Q
– Past demand.
 The demand curve slopes downward from left to right 60

 Demand schedule refers to a table showing the different
quantities of a good that a person is willing and able to buy at
various prices over a given period of time. Demand Schedule are
two types:
1. Individual demand schedule
2. Market demand schedule
Individual demand schedule is a tabular statement which shows
the quantity of a commodity demanded by an individual household
at various alternate prices per time period.
61
2. Market demand schedule is defined as a table showing the
different total quantities of a good that consumers are willing and
able to buy at various prices over a given period of time.
Price (per X’s Y’s Market
kg) demand demand demand (x+y)
10 4 6 10
15 3 4 7
22 1 2 3
The above demand schedule shows the different quantities of goods
demanded by different consumers at different prices.
At Birr 10 per kg X demands 4 kg whereas Y demands 6 kg, so
market demand at Birr 10 per kg is 10 kg. But at Birr 22 per kg X
demands 1 kg whereas Y demands 2 kg, so market demand at Birr
22 per kg is 3 kg. 62
 Demand curve is a graph that shows the inverse relationship
between price and quantity demanded over a given time period
and is plotted from the demand schedule.
 Price is measured on the vertical axis; quantity demanded is

measured on the horizontal axis.
 A demand curve can be for an individual consumer or group of

consumers, or more usually for the whole market.
 It slopes downward from left to right: they have negative slope.
 This indicate the lower the price of the product, the more is the
person likely to buy.
63
But it shows the Price information graphically rather than
in a tabular form.
Demand curves also are of two types
 Individual demand curve
 Market demand curve
64
Determinants of demand
 Price is not the only factor that determines how much of a good
people will buy. Demand is also affected by the following
 Taste or Preference
 The more desirable people find the good, the more they will
demand. (e.g. galaxy buscut, gum, trident, iphone)
 Tastes are affected by advertising, by fashion, by observing

other consumers, by considerations of health and by the
experiences from consuming the good on previous occasions.
65
 The number and price of substitute goods
 Two goods are said to be substitutes, if the consumer can
substitute one for another and still maintain the same satisfaction.
 Consider, for instance, Pepsi and Coca-cola. An increase in the
price of Pepsi will increase the demand for Coca, Oil & butter
 The number and price of complementary goods.
 Two goods are said to be complements, if they are consumed
together.
 Sugar and tea is a typical example. Consider a fall in the price of
sugar, holding all other factors constant, the quantity demanded
of the tea, the complementary good, increases, Mobile & it‘s
battery, livestock and livestock product 66
 Income.
 Changes in income can increase or decrease demand.
 A good whose demand increases with an increase in income is
called a normal good.
 A good whose demand decreases with an increase in income is
called an inferior good
 Expectations of future price changes
 If the consumers, for instance, anticipate that there will be a
future price increase (inflation), then demand for the current
products, with low prices, will increase, expectation of big
holiday, fear of uncertainty (teff).
67
Movements along and shifts in the demand curve
 A demand curve is constructed on the assumption that ‗other

things remain equal‘ (ceteris paribus).
 In other words, it is assumed that none of the determinants of

demand, other than price, changes.
 The effect of a change in price is then simply illustrated by a

movement along the demand curve and
 The effect of change in other determinants being price constant

can shift demand curve inward or shift outward
68
 If a change in one of the other determinants causes demand to rise
– say, income rises – the whole curve will shift to the right and
vice versa.
 This shows that at each price more will be demanded than before.
69
 A shift in the demand curve is referred to as a change in
demand, whereas
 A movement along the demand curve as a result of a change in

price is referred to as a change in the quantity demanded
Demand function:
 Representing the relationship between the market demand for a

good and the determinants of demand in the form of an equation
is called a demand function.
 It can be expressed either in general terms or with specific

values attached to the determinants.
70
 Thus an equation relating quantity demanded to price could be in
the form:
 In a similar way, we can relate the quantity demanded to two or

more determinants
 Where Qd = quantity demanded; p = price of the good; Y= income;

Ps= price of substitute good; Pc= price of complement
71
Definition of Supply
 Supply refers to the various quantities of a product that sellers
(producers) are willing and able to provide at various prices in a
given period of time, citrus paribus.
 Note that quantity supplied and supply are two different concepts
 Quantity supplied refers to a specific quantity that a supplier is

willing and able to provide at a specific price.
 But supply refers to the whole relationship between possible

prices of a product and the corresponding quantities supplied
72
Law of Supply
 Law of supply states that, other things remain unchanged, as price
of a product increases quantity supplied of the product increases,
and vice versa
 From law of supply, we understand that sellers are motivated to

sell more at higher prices than at lower prices.
The Supply Curve, Schedule and Function
 The amount that producers would like to supply at various prices

can be shown in a supply schedule.
73
Supply schedule
From the above table we notice that as price rises, the respective
quantity supplied rises, and vise versa
The direct relationship between price of a product and quantity

supplied, holding other things constant, is called the law of supply. 74
Change in Quantity Supplied and Change in Supply
 Change in quantity supplied refers to the movement along the
same supply curve and it is caused by a change in commodity's
own price.
 In this case only price of a commodity is allowed to vary and

other determinants of supply are held constant.
Price
Supply
P2 b
P112 a
0 Q1 Q2 Quantity
Figure 2.3. Movement along the supply curve
75
Movements along and shifts in the supply curve
• The effect of a change in price is illustrated by a
movement along the supply curve
• If any other determinant of supply changes, the whole
supply curve will shift.
• A rightward shift illustrates an increase in supply.
• A leftward shift illustrates a decrease in supply
Shifts in the supply curve
P
S2 S0 S1
Decrease Increase
O Q
76
Cont…
 A movement along a supply curve is often referred to as a change
in the quantity supplied,
 whereas a shift in the supply curve is simply referred to as a

change in supply.
Supply Function
 The simplest form of supply equation relates supply to just one

determinant.
 Thus a function relating supply to price would be of the form:
77
2.3. Market Equilibrium
 Equilibrium is the point where conflicting interests are balanced
 Only at this point is the amount that demanders are willing to

purchase the same as the amount that suppliers are willing to supply
 It is a point that will be automatically reached in a free market

through the operation of the price mechanism
 When the supply and demand curves intersect, the market is in

equilibrium.
 This is where the quantity demanded and quantity supplied are equal.
 The corresponding price is the equilibrium price or market-

clearing price, the quantity is the equilibrium quantity.
78
Equilibrium price and output:
The Market Demand and Supply of Potatoes (Monthly)
Price of Potatoes Total Market Demand Total Market Supply

(pence per kilo) (Tonnes: 000s) (Tonnes: 000s)
20 700 (A) 100 (a)

40 500 (B) 200 (b)
60 350 (C) 350 (c)
80 200 (D) 530 (d)
100 100 (E) 700 (e)
79
The determination of market equilibrium
(potatoes: monthly)
E e
100
Supply
D SURPLUS d
80
Price (pence per kg)
(330 000)
60
b SHORTAGE B
40
(300 000)
a A
20
Demand
0
0 100 200 300 Qe 400 500 600 700 800
Quantity (tonnes: 000s)
80
Cont…
 If a surplus exist, price must fall in order to attract additional
quantity demanded and reduce quantity supplied until the surplus
is eliminated.
 If a shortage exists, price must rise in order to entice additional

supply and reduce quantity demanded until the shortage is
eliminated.
81
Government regulations: will create surpluses and shortages
in the market.
 Price Floor: is legally imposed minimum price on the market.

Transactions below this price is prohibited.
 Policy makers set floor price above the market equilibrium price
which they believed is too low.
 Price floors are most often placed on markets for goods that are an
important source of income for the sellers, such as labor market.
 Price floor generate surpluses on the market.
 Example: minimum wage.
82
• Price Ceiling: is legally imposed maximum price on the
market. Transactions above this price is prohibited.
• Policy makers set ceiling price below the market

equilibrium price which they believed is too high.
• Intention of price ceiling is keeping stuff affordable for

poor people.
83
 Example:- in mathematical form, the market demand and
supply for banana is illustrated as follows
Qd = 350-100p
Qs = -50+100p
From the above information:-
A. Calculate the equilibrium price and quantity?
B. Determine whether surplus or shortage occurs when price is
3Birr.
C. Can equilibrium be established when price is equal to 3Birr?
D. Who are competing when price is equal to 3Birr?
E. What would be the government regulations?
84
Quiz.1
Suppose that the market demand function of maize product is given by

100,000-2000p and the market supply function is -6000+6000p. From
this
A. Calculate the equilibrium price and quantity?
B. Determine whether surplus or shortage occurs when price is 12Birr.
C. Can equilibrium be established when price is equal to 12Birr?
D. Who are competing when price is equal to 12Birr?
85
Movement to a new equilibrium
• The equilibrium price will remain unchanged only so long as the
demand and supply curves remain unchanged.
• If either of the curves shifts, a new equilibrium will be formed.
• A change in demand; If one of the determinants of demand

changes (other than price), the whole demand curve will shift.
• This will lead to a movement along the supply curve to the new
intersection point.
86
…cont…
Effect of a shift in the demand curve
P
S
i New equilibrium at
Pe point i
2
g h
Pe1
D2
D1
O Qe1 Qe2 Q
87
A Change in Supply
 If one of the determinants of supply changes (other than price), the whole
supply curve will shift.
 This will lead to a movement along the demand curve to the new
intersection point
Effect of a shift in the supply curve
P
S2
S1
k
Pe
3
j g New equilibrium at
Pe1 point k
D
O Qe Qe Q
3 1
88
 A shift in one curve leads to a movement along the other curve
to the new intersection point.
 Sometimes a number of determinants might change.
 This might lead to a shift in both curves.
 When this happens, equilibrium simply moves from the point

where the old curves intersected to the point where the new
ones intersect.
89
Class activity in group
1. What could the equilibrium price and quantity when supply increase and
demand is constant?
2. What could be the equilibrium price and quantity when demand increases and
supply constant?
3. What could be the equilibrium price and quantity, if both supply and demand
increase?
4. What could be the equilibrium price and quantity, if both supply and demand
decrease?
5. What could be the equilibrium price and quantity, if supply increase and
demand decrease?
6. What could be the equilibrium price and quantity, if supply decrease and
demand increase?
90
ELASTICITY OF DEMAND
 Elasticity is a measure of responsiveness of one variable to another.
 Elasticity of demand:- Refers to the degree of responsiveness of
quantity demanded of a good to a change in its price, or change in
income, or change in prices of related goods.
 Accordingly, there are three kinds of demand elasticity:
 price elasticity,
 income elasticity, and
 cross elasticity.
 Price elasticity of demand refers to the percentage change in quantity
demanded for a one percent change in the price of a good.
 The elasticity value is unit free.
91
 Elasticity of demand
 When elasticity is computed, changes in quantity and

prices are expressed as percentages.
 Price elasticity of demand is negative because of the law of
demand.
 Conventionally, we ignore the sign by taking in absolute
terms
 92
The 5 Categories of Price Elasticity of Demand
Depending on its magnitude, elasticity of demand
can be categorized as follows:
1. Perfectly inelastic demand:- in this case
coefficient price elasticity of demand (Ep) is zero, i.e.,
change in price of the commodity does not affect quantity
demanded and the demand curve is vertical.
price
p2 ed=0
p1 Q0 quantity
Perfectly inelastic demand curve
93
Cont…
2. Inelastic Demand: in this case percentage change in quantity
demanded is less than percentage change in price.
 Here the value of demand elasticity lies between 0 and 1,
i.e. 0 < ep < 1.

• eg . a change of price by 10%, which caused quantity, demanded
to change only by 5%. Graphically it can be shown as follows.
0 < ep < 1
P1____________
P2_______________
Q1 Q2
Inelastic Demand curve 94
Cont…
• 3. Elastic Demand: When percentage change in quantity
demand is greater than percentage change in price, it is
said to be elastic demand.
• E.g, change in quantity demand by 10% which was caused
by 5% change in price.
ep > 1
P1 _____________
P2 _________________________
Q1 Q2
Elastic Demand
95
Cont…
• 4. Unitary Price Elasticity: here percentage change in price
is equal to percentage change in quantity demanded.
• e.g. As price changes by 10% quantity demand also
changes by 10%.
ep = 1
P1
P2
Q1 Q2
Unit Price Elastic demand curve
96
Cont…
• 5. Perfectly Elastic demand: The percentage change in
price is zero but percentage change in quantity demanded
is high.
• Here elasticity of demand is infinite, ep = 
ep = 
P0 _________________________________ D
Q1 Q2
Perfectly Elastic demand
97
Summary
Value of Elasticity Types of Price Elasticity of Description
of Demand Demand
.
|ed| = 0 erfectly Inelastic Change in price does not affect
demand at all
|ed| < 1 Less than Unit Elastic (inelastic) % change in demand is less than %
change in price
|ed| = 1 Unit Elastic % change in demand is equal to %

change in price
|ed| >1 More than Unit Elastic (elastic) % change in demand is more than %
change in price
|ed| = ∞ Perfectly Elastic Demand changes infinitely

98
Determinants of Price Elasticity of Demand
• i. Availability of substitutes:
– The most important determinants of the price elasticity of demand is the

number and kind of substitutes available for a commodity.
– If a commodity has many close substitutes, its demand is likely to be elastic
• ii. Nature of the commodity: One of the important determinants of price

elasticity of demand is nature of the commodity, that is, whether it is a ‗necessary‘
or a ‗luxury‘ or a commodity of ‗comfort‘.
• Demand for necessities, such as food items, is generally inelastic.
• iii. Proportion of income spent: Elasticity of demand for a commodity depends

upon the proportion of her/his income which the consumer spends on it.
99
Income Elasticity of Demand
 Income elasticity of demand is the ratio of proportionate change in

demand to proportionate change in income.
 This elasticity explains as to what will be the effect on demand

when income of the consumer changes
 In other words, it explains the responsiveness in demand in relation

to changes in the income of the consumer.
 Income elasticity of demand measures % change in quantity dd

due to certain % change in income of the consumer.
100
ey = (Qd/Qd) x 100
(y/y)x 100 Where ey- is income elasticity of demand
Qd- is changed in quantity demand
Y- is change in income of consumers.
i.e ey = [(Q2 - Q1)/Q1)] x 100
[(Y2 - Y1)/Y1] x 100
Where Q1- is quantity demanded at income level Y1 and
Q2- is quantity demanded at income level Y2
 Income elasticity of demand could be positive or negative.
 Positive income elasticity indicates that increases in income are
associated with increase in the quantity of goods purchased

101
 > 0 are normal/superior goods.
 Normal goods are also further classified into necessities and
luxuries.
 A good is said to be necessity if its income elasticity is positive and

less
y than one.
 A good is said to be luxuries if its income elasticity is positive and
grater than one, .if >1 people tends to spend a larger fraction of their
income on luxury items

y
 Goods that have negative income elasticity of demand are called
inferior goods.
102
Cont…
Exercise
1. When the income of the consumer is Birr 1000, the consumer

buys 100 units of a good. If income increases to Birr 1200, the
resulting quantity demanded would be 130 units. Calculate the
income elasticity of demand?
103
Cross Elasticity of Demand
 Responsiveness in the demand for a commodity to the changes in
the prices of its related goods is called cross elasticity of demand.
 cross elasticity of demand may be defined as the ratio of

proportionate change in the demand of one commodity (say y) to
the proportionate change in the price of another commodity (say
x).
 It can be measured as follows:
QY PX
 y.PX  
PX Qy 104
Con…
If two goods has positive cross-price elasticity
of demand they are substitute goods
If two goods has negative cross-price elasticity

of demand they are complement goods
If cross-price elasticity are zero then the two

goods are independent/unrelated.
105
Exercise
The quantity demanded of good Y before change in

the price of good X was 25 units. As good X price
changes from Birr 5 to Birr 10, the quantity
demanded of good Y has increased to 75 units.
1.Calculate the cross price elasticity of demand?
2. Are the two goods substitute or compliment

each other?
106
Price Elasticity of Supply (  )
S
• The price elasticity of supply is a number used to

measure the sensitivity of change in quantity
supplied to a given percentage change in the price
of a good.
• it can be defined as the percentage change in
quantity supplied resulting from a 1% change in
price, ceteris paribus.
%Q s Q s P
s    s
That is: %P P Q
107
• Price Elasticity of Supply can be classified into elastic,
inelastic or unitary elastic.
1. Elastic supply: If is greater than one, then supply of an
item is said to be elastic (i.e. >1).
2. Inelastic supply: If the price elasticity of supply is
greater than or equal to zero but less than one, then supply is
said to be price inelastic
(i.e., = 0 ≤ < 1).
3. Unitary Elasticity of Supply: If the price elasticity of
supply is equal to one ( = 1), then supply is said to be
unitary elastic.
108
Contd…
• The shape of elastic supply curve is horizontal. →
s P
∞
Q
• Inelastic supply: If the price elasticity of supply is

equal or greater than zero but less than one, then
supply is said to be price inelastic
(i.e.,  s = 0 ≤  s < 1).
109
Contd…
• Price elasticity of supply may be perfectly inelastic, i.e.  s = 0,
which is completely unresponsive to price change
P
Q
• Unitary Elasticity of Supply: If the price elasticity of supply is
equal to one (  s = 1), then supply is said to be unitary elastic.
Determinants of Elasticity of Supply:

Time
Availability of factors of production (resources)
Possibility of switching production to other products

110
Cont…
Exercise
A firm produces 100 units of output and sells each unit for
Birr 20 at equilibrium. Suppose the demand for the firm‘s
product has increased and caused a rise in price to Birr 25 a
unit. After the rise in price the quantity that the firm sells has
increased to 120 units.
A. Calculate the price elasticity of supply?
B. Are the price elasticity of supply elastic, inelastic or

unitary elastic?
111
Cont…
• 4. Unitary Price Elasticity: here percentage change in price
is equal to percentage change in quantity demanded.
• e.g. As price changes by 10% quantity demand also
changes by 10%.
ep = 1
P1
P2
Q1 Q2
Unit Price Elastic demand curve
112
Chapter 3
The Theory of Consumer Behavior

Chapter Outline
– Definition of Utility
– Theory of consumer behavior
– Methods of measuring utility
– Total Utility and Marginal Utility
– Utility Maximization
The concept of Utility
• Why do you buy the goods and services you do?
• It must be because they provide you with satisfaction—

you feel better off because you have purchased them.
• Economists call this satisfaction utility.

Introduction
• In our day to day life, we buy different G&S for consumption.
• As consumers, we act to drive satisfaction by consuming

goods and services.
• But have you ever thought of our decision or the decision

made by our parents to buy those consumption G&S?
• This is what we are going to discuss in this chapter.

3.1. The Meaning of utility
• Before discussing the concept of utility, let us first
show some of the assumptions about the average
consumer.
1. An average consumer is rational. That means:
– A consumer has a clear-cut preference, i.e., the
consumer is able to compare any two bundles X and Y
and decide which one he/she prefers.
– A consumer has a persistent (transitive) preference.

E.g. , given three consumption bundles X, Y and Z,
– if X > Y, and Y > Z, then he/she prefers X to Z (X>Z).
Assumptions
2. The consumer is not free in his/her choice. This

means that consumer’s choice is constrained by;
a) His/her income level and
b) the prices of G & S.

Definitions of Utility
Utility is a pleasure/satisfaction that the consumer
obtain by consuming a product/service.
• Is the power of a product to satisfy human wants.

In other words ―Utility is the quality of good to
satisfy a want.‖
• Describe the pleasure or satisfaction or benefit

derived by a person from consuming goods.
• Utility = level of happiness or satisfaction associated

with alternative choices
Important Points to note
1. Utility is Subjective: deals with the mental satisfaction of a man.
G/S may have different utility to different persons.
2. Utility is Relative: As a utility of a commodity varies from time to
time. It varies with time and place.
3. Utility is not essentially Useful: A commodity having utility need

not be useful.
• E.g. Cigarette and Hashish is not useful, but if these things
satisfy the want of addict then they have utility for him.
4. Utility is independent of Morality: It has nothing to do with
morality. Use of hashish may not be proper from moral point of
view, but as these drugs satisfy wants of the person addicted, b/c it
has a utility.
Theory of Consumer Behavior
• Useful for understanding the demand

side of the market.
• Useful for the explanation of how

consumers allocate income to purchase
different goods and services, to maximize
their utility.
 To analyze the behavior of consumers :
• We need to make an important assumption that ;
i. Each consumer has exact and full (perfect) knowledge of

all information relevant to his consumption decisions:
ii. Consumers are generally assumed to be rational and hence,

as an objective, Seek to maximize their satisfaction or
utility from the consumption of goods and services for
given money income.
iii. To achieve the maximization of their objective, consumers,

then, must be able to compare different consumption
bundles according to their desirability.
Definition and Approaches to Utility
 Why does a person demand a certain commodity?
 An obvious reason is that the commodity is expected

to satisfy some need or desire of the consumer.
 Economists call the satisfaction from consumption of

commodities utility.
What is Utility?
 Is a subjective notion in economics
 Why is utility subjective and not objective?
 Because we all have different tastes and preferences
 i.e. each person view goods/decisions differently
– Music, Food, Clothes, Football game etc.

Thus, Utility is:
• Is the amount of enjoyment or

satisfaction or happiness and/or
benefit that a people receive from the
consumption of a certain goods and
services.
Theories of Consumer Behavior
 In relation to the comparison of the
utility from different consumption
bundles,
 There are two consumer utility theory
(approaches):
A. Cardinal utility
B. Ordinal utility
 They take different views or approaches.
Cardinal utility approaches
 Advocated by 19th economists, such as Jevons,
Menger and Walras, assumed that.
 Initially, this approach took the view that: utility is
measurable and additive.
 In this regard a measure called util can be employed.
 On the basis of the amount of utility consumers
derive from consumption of commodities;
 Comparison of the number of utils of different
people and addition of the utility of different people
is, therefore, possible.
A. Cardinal Utility (Measurability)
 Assigns numerical values to the amount of satisfaction
(utility).
 This is based on the premise that utility could be

measured and can be aggregated across individuals.
 It quantitatively measures the preference of an individual

towards a certain commodity.
 Numbers assigned to different goods or services can be

compared.
• By comparing different bundles according to
the number of utils they yield, a consumer
will choose that bundle which gives him the
highest possible number of utils.
• Eg. A utility of 100 utils towards a cup of coffee

is twice as desirable as a cup of tea with a
utility level of 50 utils.
• The only limitation is its subjectivity.

Assumptions of Cardinal Utility Theory
1. The total utility of a ‗basket of goods‘ is the
summation of the individual quantities of
commodities.
If there are n commodities in the bundle with

quantities X1, X2…Xn, the total utility is;
U  f ( X 1 , X 2 ,..., X n )
 as the quantity of goods consumed increases the
total utility of the consumer accordingly
increases.
Assumption …
2. Rationality: the consumer is rational.
• Aims at the maximization of his/her utility subject to the
constraint imposed by his/her given income.
• A consumer would wish to have more of everything.
• Yet his/her desire is constrained by his/her limited income.
• Thus, you need to prioritize consumption bundles according

to their desirability.
Assumption …
• Utility is cardinal: the utility derived from each
commodity is measurable. Eg. money: the monetary
units that a consumer is prepared to pay for another unit
of the commodity measure utility.
• Constant marginal utility of money: this assumption is

necessary if monetary units are to be used as the measure
of utility. If the MU of money changes with the level of
income (wealth) , then money cannot be considered as a
measuring rod of utility.
Assumption…
• Diminishing marginal utility: the extra satisfaction gained

from successive units of a commodity diminishes.
• In other words, the MU of a commodity diminishes

as the consumer acquires larger quantities of it.
1. Total Utility (TU)
 The overall level of (total) satisfaction /pleasure
obtained (derived) from consuming specified amount
of good or service at a particular time.
TU= U1 + U2+U3 + U4 + U5
• If you consume n units, then the total Utility (TU) from n

units may be expressed as:
TUn= U1 + U2+ U3 + U4 + U5+…………+ Un

2. Marginal Utility
 Is the additional satisfaction that an individual
derives from consuming an additional unit of a
good or service.
 The change in total utility (TU) resulting from a one

unit change in consumption (X).
MU = TU/ X
Marginal Utility
Mathematically:
• MU= ΔTU Where, ΔTU = change in total utility
ΔQ ΔQ = change in the
amount of the product consumed
dTU
MU 
dQ
Measurement of Utility (TU & MU)
The relationship between TU and MU
• Since MU is the slope of total utility, when:
1. TU increase at a decreasing rate, MU declines

but is positive.
2. TU reaches maximum, MU becomes zero.
3. TU declines, the MU becomes negative.

Table 3.1: diminishing marginal
utility
Cups of tea Total utility(utils) Marginal utility(utils)
consumed per day
0 0 -
1 12 12
2 22 10
3 30 8
4 36 6
5 40 4
6 41 1
7 41 0
8 39 -2
9 34 -5
The relationship between TU and MU
Total utility and marginal utility
 TU, in general, increases with Q
Q TU MU  At some point, TU can start

falling with Q (see Q = 6)
0 0 ---
 If TU is increasing, MU > 0
1 20 20  From Q = 1 onwards, MU is
2 27 7 declining  principle of
3 32 5 diminishing marginal utility 
4 35 3
 As more and more of a good are
5 35 0 consumed, the process of
6 34 -1 consumption will (at some point)
7 36
30 -4 yield smaller and smaller additions
to utility
 The above table shows that when a person consumes
no units of goods,
 He/she gets no satisfaction. His total utility is zero.
 In case he/she consumes one unit, he/she gains 20

units of satisfaction.
 His/her total utility is 20 and his/her marginal utility

is also 20.
TOTAL AND MARGINAL UTILITY
Tips Total Marginal
consumed Utility, Utility, 30
per meal Utils Utils
Total Utility (utils)

20
0 0
1 10 10
0 1 2 3 4 5 6 7
Units consumed per meal

10
Marginal Utility (utils)

8
6
4
2
0
-2
1 2 3 4 5 6 7
Tips Total Marginal

20
0 0
10
1 10 10
0 1 2 3 4 5 6 7

10

8
6
4
2
0
-2
1 2 3 4 5 6 7
Tips Total Marginal

20
0 0
10
1 10 10
8
2 18
0 1 2 3 4 5 6 7

10

8
6
4
2
0
-2
1 2 3 4 5 6 7
Tips Total Marginal

20
0 0
10
1 10 10
8
2 18
6
3 24 0 1 2 3 4 5 6 7

10

8
6
4
2
0
-2
1 2 3 4 5 6 7
Tips Total Marginal

20
0 0
10
1 10 10
8
2 18
6
3 24 0 1 2 3 4 5 6 7
4
4 28
10

8
6
4
2
0
-2
1 2 3 4 5 6 7
Tips Total Marginal

20
0 0
10
1 10 10
8
2 18
6
3 24 0 1 2 3 4 5 6 7
4
4 28
10
2 Marginal Utility (utils)
8
5 30 6
4
2
0
-2
1 2 3 4 5 6 7
Tips Total Marginal

20
0 0
10
1 10 10
8
2 18
6
3 24 0 1 2 3 4 5 6 7
4
4 28
10
8
5 30 6
0 4
6 30 2
0
-2
1 2 3 4 5 6 7
Tips Total Marginal TU

20
0 0
10
1 10 10
8
2 18
6
3 24 0 1 2 3 4 5 6 7
4
4 28
10
8
5 30 6
0 4
6 30 2
-2 0
MU
7 28 -2
1 2 3 4 5 6 7
Tips Total Marginal TU

0 0
20
Observe
10 Diminishing
1 10 10
8 Marginal
2 18
6
3 24 0 1 2
Utility
3 4 5 6 7
4
4 28
10
8
5 30 6
0 4
6 30 2
-2 0
MU
7 28 -2
1 2 3 4 5 6 7
 The above figure shows the relationship between
total and marginal utility.
 Total utility increases as each additional Tips is

purchased through the first five,
 But utility rises at a diminishing rate since each

Tips adds less and less to the consumer‘s satisfaction.
 At some point, marginal utility becomes zero and
then even negative at the seventh unit and beyond.
 If more than six Tips were purchased, total utility

would begin to fall.
 This illustrates the law of diminishing marginal

utility.
The Law of Diminishing Marginal
Utility
 The law of diminishing MU is a generalization
drawn from the characteristics of human
wants.
 The law simply states that other things being
equal, the marginal utility derived from
successive units of a given commodity goes on
decreasing.
 Explains the downward sloping demand curve.
Law of diminishing MU
• law of diminishing marginal utility - marginal utility
declines as more of a particular good is consumed in a
given time period, ceteris paribus
• Even though MU declines, TU still increases as long as

MU is positive.
• TU will decline only if MU is negative

The Law of Diminishing Marginal Utility
 Hence in a short period of time, the more we have of a

thing; the less we want of it, because every successive
unit gives less and less satisfaction.
 The more of a specific product that consumers

obtain, the less they will desire more units of that
product.
Consumer-Equilibrium (Utility maximization)
 The theory of consumer behavior uses the law

of diminishing marginal utility to explain how
consumers allocate their income.
 Goods and services have prices and are scarce

relative to the demand for them.
 Consumers must choose among alternative

goods with their limited money incomes.
Utility Maximization
 In reality, consumers face constraints (income and
prices):
 Limited consumers income or budget

 Goods can be obtained at a price
 The utility maximizing rule explains how

consumers decide to allocate their money incomes
so that the last dollar spent on each product
purchased yields the same amount of extra
(marginal) utility.
Utility Maximization Cont…
 It is marginal utility per dollar spent that is

equalized; that is, consumers compare the extra
utility from each product with its cost.
 As long as one good provides more utility per dollar

than another, the consumer will buy more of the
first good;
 As more of the first product is bought, its MU

diminishes until the amount of utility per dollar just
equals that of the other product.
Example
• A consumer consuming only one commodity say, X, given his income
level(I), he will be at equilibrium level of consumption when:
…………1
• Where: marginal utility of good X

• px Price of good X
• If the consumer can increase his welfare (utility) by
purchasing more of good X.
• If the consumer can increase his welfare by decreasing
consumption of good X(by reducing purchase of good X.
• Thus consumer will be at equilibrium or attains maximum satisfaction

when the additional satisfaction obtained from a good is equal to the
price of the good, and if all of his income is spent for consumption of the
good.
=
In 2 good model
• Suppose there are two goods X and Y on which a consumer has to
spend a given income.
• The consumer’s behavior will be governed by two factors;
1) the marginal utility of the good;
2) The price of the two goods.
 Suppose also that the prices of the two goods are given for the
consumer.
 The consumer will spend his money income on different goods in such
a way that MU of money expenditure of each good is equal.
 Consumer is in equilibrium for the two goods X and Y when;
Px X+ PyY = I
Utility Maximizing Combination
Utility Maximization Rule
MU of product A MU of product B
Price of A
= Price of B
8 Utils 16 Utils
$1
= $2
Table 3.2 MU of good x and y and MU of money expenditure
Let the price of goods x and y be birr 2 and 3 respectively.

Suppose a consumer has money income of birr 24 to spend on the two
goods.
Unit MUX MUY MUX/PX MUY/PY
1 20 24 10 8
2 18 21 9 7
3 16 18 8 6
4 14 15 7 5
5 12 9 6 3
6 10 3 5 1
From the above example
• MUX/ PX is equal to 5 utile when the consumer purchase 6 unit of good
x and MUY/PY is equal to 5 utile when the consumer purchase 4 unit of
good y.
• Therefore the consumer is on the equilibrium when he is buying 6 unit

of good x and 4 unit of good y and will be spending ( 2 ).
• Thus in the equilibrium position where he maximizes his utility;
= 10/2=15/3=5
B. Ordinal Utility (Ranking)
 Also called, indifference curve theory
 OU does not assign numerical values to the amount of
satisfaction,
 Utility can not be quantified/measured

numerically/subjectively.
 Like; 1st, 2nd, 3rd, etc.
 Instead, it uses ranking of preferences (orderly).
 Uses qualitative measures

Basic Assumptions
1. Preferences are complete
– Consumers can rank all market baskets
– If 2 market basket;
a. A>B
b. B>A
c. A≠B indifferent ,
2. Preferences are transitive
– If A > B, and B > C, they must prefer A > C
– E.g. if they prefer
– FORD>TOYOTA and
– TOYOTA>IZUZU,
– Then, they FORD> ISUZU
3. Consumers always prefer more of any good to less
– More is better
Consumer Preferences
• Consumer preferences can be represented
graphically using indifference curves (IC)
• IC represent all combinations of market baskets

that the person is indifferent to
– A person will be equally satisfied with either choice
Chapter 3 167 ©2005 Pearson Education, Inc.

3.2.1. Representing Preferences with IC
 An indifference curve is a curve which represents
all those combinations of goods which give
same levels of satisfaction (happiness) to the
consumer.
 Since all the combinations on an indifference

curve give equal satisfaction to the consumer,
the consumer is indifferent among them.
 i.e. consumer prefers them equally and does not

mind which combination he gets.
CONSUMER PREFERENCES
• Market Baskets
● market basket (or bundle) List with specific quantities
of one or more goods.
TABLE 3.1 Alternative Market Baskets
Market Basket Units of Food Units of Clothing
A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
H 10 40
To explain the theory of consumer behavior, we will ask

whether consumers prefer one market basket to another.
Indifference Curves:
An Example
market basket (or bundle) is the List with specific quantities of
one or more goods.
Market Basket Units of Food Units of Clothing

A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
H 10 40
©2005 Pearson Education, Inc. Chapter 3 170
An Example
• Points such as B & D have more of one good but
less of another compared to A
– Need more information about consumer ranking
• Consumer may decide they are indifferent between

B, A and D
– We can then connect those points with an indifference

curve
An Example
• Indifferent between
points B, A, & D
50 B
Clothin • E is preferred to
g H points on U1
40 E • Points on U1 are
preferred to H & G
A
30
D
20
G U1
10
Food
10 20 30 40
Indifference Curves
• Indifference curves slope downward to the right
– If they sloped upward, they would violate the

assumption that more is preferred to less
• Some points that had more of both goods would be indifferent

to a basket with less of both goods

Indifference Curves
• To describe preferences for all combinations of
goods/services, we have a set of IC – an
indifference map
– Each IC in the map shows the market baskets among

which the person is indifferent

Indifference Map
Market basket A is preferred
to B.
Clothing
Market basket B is preferred
to D.
D
B A
U3
U2
U1
Food

Indifference Maps
• Indifference maps give more information about
shapes of IC
– Indifference curves cannot cross
• Violates assumption that more is better
– Why? What if we assume they can cross?
Chapter 3 176
Indifference Maps
• B is preferred to D
U1 • A is indifferent to B & D
U
Clothing
2
• B must be indifferent to D but
that can’t be if B is preferred to D
B
U2
D
U1
Food
Chapter 3 177
Indifference Curves
• The shapes of IC describe how a consumer is willing to
substitute one good for another
– A to B, give up 6 clothing to get 1 food
– D to E, give up 2 clothing to get 1 food
• The more clothing and less food a person has, the more
clothing they will give up to get more food

Indifference Curves
A
Clothing 16
14 Observation: The amount
-6 of clothing given up for
12 1 unit of food decreases
from 6 to 1
10 B
1
8 -4
D
6 1
-2 E
4 G
1 -1
1
2
Food
1 2 3 4 5
Indifference Curves
• We measure how a person trades one good for another
using the marginal rate of substitution (MRS)
– It quantifies the amount of one good a consumer

will give up to obtain more of another good
– It is measured by the slope of the IC

Marginal Rate of Substitution
Clothing 16 A
MRS = 6
MRS   C
14 F
12
-6
10 B
1
8 -4 MRS = 2
D
6
1
-2 E
4 G
1 -1
2 1
Food
1 2 3 4 5
• Indifference curves are convex
– As more of one good is consumed, a consumer

would prefer to give up fewer units of a second
good to get additional units of the first one
• Consumers generally prefer a balanced market basket
Chapter 3 182
• The MRS decreases as we move down the IC
– Along an IC there is a diminishing marginal rate of

substitution.
– The MRS went from 6 to 4 to 1

Properties of Indifference Curves
1) Higher indifference curves are preferred to

lower ones.
2) Indifference curves are downward sloping.
3) Indifference curves do not cross.
4) Indifference curves are bowed inward

(Convex to the origin).
Property 1: Higher IC are preferred to lower ones.
u Consumers usually prefer more of something

to less of it.
u Higher IC represent larger quantities of goods

than do lower IC.
Property 1: Higher IC are preferred to lower ones.
Quantity
of Pepsi
B D
I2
A Indifference
curve, I1
0 Quantity
of Pizza
Property 2: Indifference curves are downward sloping.
u A consumer is willing to give up one good only if he or

she gets more of the other good in order to remain
equally happy.
u If the quantity of one good is reduced, the quantity of the

other good must increase, total utility decreases and vise
versa
u For this reason, most ICs slope downward.

Property 2: Indifference curves are downward sloping
Quantity
of Pepsi
Indifference
curve, I1
0 Quantity
of Pizza
Property 3: Indifference curves do not cross
 Points A and B should make the consumer equally happy.
 Points B and C should make the consumer equally happy.
 This implies that A and C would make the consumer

equally happy.
 But C has more of both goods compared to A.

Property 3: Indifference curves do not cross.
Quantity
of Pepsi
0 Quantity
of Pizza
Property 4: Indifference curves are bowed inward
u People are more willing to trade away goods that they

have in abundance and
u Less willing to trade away goods of which they have

little.
u These differences in a consumer‘s MRS cause his or her

IC to bow inward.
Property 4: Indifference curves are bowed inward.
Quantity
of Pepsi
14
MRS = 6
A
8
1
4 MRS = 1 B
3 Indifference
1
curve
0 2 3 6 7 Quantity
of Pizza
3.2.3.The Marginal Rate of Substitution
u The slope at any point on an IC is the marginal

rate of substitution.
u It is the rate at which a consumer is willing to

substitute one good for another.
u It is the amount of one good that a consumer

requires as compensation to give up one unit
of the other good.
• The marginal rate of substitution for X with Y, MRSXY, is the
rate at which a consumer must adjust Y to maintain the same
level of well-being when X changes by a tiny amount, from a
given starting point
MRS XY   Y X
• Tells us how much Y to take away to compensate for gaining a

little bit of X
4-194
To make a link between MRS and utility
We need a new concept;
• Marginal utility is the change in a consumer’s utility

resulting from the addition of some good, divided by the
amount added
MU X  U X
4-195
Utility Functions and MRS
MRS XY  MU X
MU Y
• Small change in X, DX, causes utility to change by MUXDX
• Small change in Y, DY, causes utility to change by MUYDY
• If we stay on same IC,

Then,
–DY/DX =MUX/MUY
4-196
B. The Budget Constraint
The budget constraint depicts the consumption ―bundles‖
that a consumer can afford.
People consume less than they desire because their

spending is constrained, or limited, by their income.
• It shows the various combinations of goods the consumer

can afford given his or her income and the prices of the
two goods.
The Budget Line
– Indicates all combinations of two commodities for which
total money spent equals total income
– We assume only 2 goods are consumed, so we do not

consider savings
• Let;
• F equal the amount of food purchased, and
• C is the amount of clothing
• Price of food = PF
• price of clothing = PC
• PFF is the amount of money spent on food, and
• PCC is the amount of money spent on clothing
The Budget Line
• The budget line then can be written:
PF F  PC C  I
All income is allocated to food (F) and/or clothing

(C)

The Budget Line
• Different choices of food and clothing can be
calculated that use all income
– These choices can be graphed as the budget line

Budget Constraints
Example:
Assume income of $80/week, PF = $1 and PC = $2
Market Food Clothing Income

Basket PF = $1 PC = $2 I = PFF + PCC
A 0 40 $80
B 20 30 $80
D 40 20 $80
E 60 10 $80
G 80 0 $80
©2005 Pearson Education, Inc. Chapter 3 201
The Budget Line
Clothing
A
(I/PC) = 40 C 1 PF
Slope   - -
B F 2 PC
30
10 D
20
20
E
10
G
Food
0 20 40 60 80 = (I/PF)
The Budget Line
• As consumption moves along a budget line from the intercept,
the consumer spends less on one item and more on the other
• The slope of the line measures the relative cost of food and
clothing
• The slope is the negative of the ratio of the prices of the two
goods
• The slope indicates the rate at which the two goods can be
substituted without changing the amount of money spent
• Chapter
That 3
mean, mathematically, 203 ©2005 Pearson Education, Inc.
The Budget Line
I  PX X  PY Y
I  PX X  PY Y
I PX
 X Y
PY PY

Budget constraint
1. Points on the budget line, such as point a, indicate consumption bundles that
used up the entire income.
 If you are on the BL, you can only increase the consumption of one by
reducing the consumption of the other,
 B/c the entire income has been spent.
Budget constraint cont…
2. Points below the budget line, such as c, indicate combinations of
commodities that COST LESS than the income.
• When an individual consumes a consumption bundle inside the
budget set, since there is income which is not spent, it is possible
to improve utility by increasing consumption.
3. Points above the budget line, such as b, indicate combinations of

commodities that COST MORE than the total budget (income).
Thus, points outside the budget set are not attainable for a given
income, and are irrelevant for decision making.
The Consumer‘s Budget Constraint
Any point on the budget constraint line indicates the

consumer‘s combination or tradeoff between two goods.
E.g., if the consumer buys no pizzas,

he can afford 500 pints of Pepsi (point B).
If he buys no Pepsi,
he can afford 100 pizzas (point A).
The Consumer‘s Budget Constraint...
Quantity
of Pepsi
500 B
Consumer’s
budget constraint
A
0 100 Quantity
of Pizza
Alternately, the consumer can buy 50

pizzas and 250 pints of Pepsi.
The Consumer‘s Budget Constraint...
Quantity
of Pepsi
B
500
C
250
Consumer’s
budget constraint
A
0 50 100 Quantity
of Pizza
 The slope of the budget constraint line equals the

relative price of the two goods, that is, the price of one
good compared to the price of the other.
 It measures the rate at which the consumer will trade

one good for the other.
Optimization: What the Consumer Chooses
Consumers want to get the combination of goods on

the highest possible indifference curve.
However, the consumer must also end up on or below

his budget constraint.
Optimization: What the Consumer Chooses
Combining the IC and the budget constraint

determines the consumer’s optimal choice.
Consumer optimum occurs at the point where

the highest IC and the budget constraint are
tangent.
The Consumer’s Optimal Choice
The consumer chooses consumption of the two goods so

that the MRS = relative price.
At the consumer’s optimum, the consumer’s valuation of

the two goods equals the market’s valuation.
The Consumer’s Optimum...
Quantity
of Pepsi
Optimum
B
A
I3
I2
I1
Budget constraint
0 Quantity
of Pizza
Effect of Change in Income and Price
• As incomes and prices change, there are changes in
budget lines
• We can show the effects of these changes on

budget lines and consumer choices

The Budget Line - Changes
• The Effects of Changes in Income
– An increase in income causes the BL to shift outward,

parallel to the original line (holding prices constant).
– Can buy more of both goods with more income
– A decrease in income causes BL to shift to the left

– Can buy less of both goods with less income
Clothing
(units
per week) An increase in
income shifts
80
the budget line
outward
60
A decrease in
40 income shifts
the budget line
inward
20 L3
(I = L1 L2
$40) (I = $80) (I = $160)
Food
0 40 80 120 160 (units per week)
• The Effects of Changes in Prices
– If the price of one good increases, the BL shifts inward, pivoting
from the other good‘s intercept.
– If the price of food increases and you buy only food (x-
intercept), then you can’t buy as much food.
– The x-intercept shifts in.
– If you buy only clothing (y-intercept), you can buy the same
amount.
– No change in y-intercept.
– If the price of one good decreases, the BL shifts outward,
pivoting from the other good‘s intercept.
– If the price of food decreases and you buy only food (x-
intercept), then you can buy more food.
– The x-intercept shifts out.
– If you buy only clothing (y-intercept), you can buy the same
amount.
– No change in y-intercept.
Clothing A decrease in the price of

(units food to $.50 changes
per week) the slope of the budget line
and rotates it outward.
An increase in the price of

food to $2.00 changes the
40 slope of the budget line and
rotates it inward.
L3 L1 L2
(PF = 1) (PF = 1/2)
(PF = 2) Food
40 80 120 160 (units per week)
If the two goods increase in price
– If the two goods increase in price, but the ratio of the

two prices is unchanged, the slope will not change
– However, the BL will shift inward parallel to the

original budget line

If the two goods decrease in price
The Effects of Changes in Prices
– If the two goods decrease in price, but the ratio of the two
prices is unchanged, the slope will not change
– However, the BL will shift outward parallel to the original

BL

Consumer Choice
• Given preferences and budget constraints,
• How do consumers choose what to buy?
• Consumers choose a combination of goods that

will maximize their satisfaction, given the limited
budget available to them

Consumer Choice
• The maximizing market basket must satisfy two conditions:
1. It must be located on the budget line
– They spend all their income – more is better
2. It must give the consumer the most preferred combination

of goods and services

Consumer Choice
• Graphically, we can see different IC of a consumer
choosing between clothing and food
• U3 > U2 > U1 for our indifference curves
• Consumer wants to choose highest utility within their

budget

Consumer Choice
Clothing •A, B, C on budget line
(units per •D highest utility but not affordable
week)
•C highest affordable utility
40 •Consumer chooses C
A
30 D
20 C
U3
U1
B
0 20 40 80 Food (units per week)
Consumer Choice
• Consumer will choose highest IC on budget line
• Point C is where the IC is just tangent to the budget line
• Slope of the BL equals the slope of the IC at this point
PF C
Slope   MRS  
PC F

Consumer Choice
• Therefore, a consumer’s optimal consumption point,
PF
MRS 
PC
 Satisfaction is maximized when MRS (of F and C) is equal to the
ratio of the prices (of F and C)
 Note this is ONLY true at the optimal consumption point

Consumer Choice
• If MRS ≠ PF/PC then individuals can reallocate basket to
increase utility
• If MRS > PF/PC
– Will increase food and decrease clothing
– until MRS = PF/PC

• If MRS < PF/PC
– Will increase clothing and decrease food
– Until MRS = PF/PC

Chapter 4: Theories of Production
• In microeconomics, production is the act of making things; in

particular the act of making products that will be traded or
sold commercially.
• In other words, Production is the act of transforming the

factors of production into goods and services that are desired
for consumption and investment.
• Some economists define production broadly as all economic

activity other than consumption.
231
 Production:- refers to the process of transferring inputs in to
outputs.
 Inputs are resources that can be used in the production process.
 Input includes labor, land, capital, and entrepreneurship.
 Production also involves the activity of creating intangible

output or services.
 For example the doctor/teacher/lawyer is in the production

activity by delivering services.
232
 In general, economists have characterized the production
process as a combination of four factors: land, labor, capital
and organization or entrepreneurships.
 Land plays role in agriculture sector, while other factors have

prominence in industrial sector.
 The entrepreneur who looks after the organizational aspects of

production & decision maker through the combination of the
factors and then produces outputs.
 entrepreneur is often considered as an innovator.
233
Production Function
 It is a technical relation ship between inputs and output.
 It shows the maximum output that can be produced with a fixed

amount of inputs and the existing technology.
 The production function can be described by a table, or a graph, or

an equation. For example you can describe production function as
follows;
Q=ƒ(X1, X2, X3, X4, XN)
 Where Q: is the maximum output produced
X1 X2, X3, X4… XN are different types of inputs.

234
 All inputs can be divided in to two categories-
 Fixed inputs are inputs whose quantity remains fixed for a

given period of time.
 Variable inputs refer to inputs whose quantity can be increased

or decreased during a given period of time. For example, a
farmer requires land surface, water, capital goods etc.
 Labor can be considered as variable input while land and capital

goods are fixed inputs assuming that the size of the plot of land
and capital goods available for production remain fixed.
235
The Period of Production
 Depending on the nature of economic adjustment in a firm to changing

economic environment, production period is divided in to short-run and
long-run
 Short-run Production Period
 This refers to a period of time in which at least one input is fixed while
others are variable.
 That is, short run is a period of time in which a firm can alter its level of
output by increasing or decreasing only the use of the variable inputs.
 Long-run Production Period

 Refers to a period of time which is long enough to allow changes in the levels of
all inputs. In the long run all inputs are variable and there is no fixed input.
236
Definition of Short-Run Production
Short-run production is an analysis of the production
decision made by a firm in the short run, with the ultimate
goal of explaining the law of supply and the upward
Sloping supply curve.
A variable input provides the extra inputs that a firm needs
to expand short-run production. As larger quantities of a
variable input, like labor, are added to a fixed input like
capital, the variable input becomes less productive.
237
This is, by the law of diminishing marginal returns. The
central feature of this short—run analysis is therefore, the
law of diminishing marginal returns,
This analysis of short-run production is but the first step in
a quick walk toward a better understanding of supply.
Further steps include the cost of short-run production,
especially marginal cost, and the market structure in which
a firm operates, such as - perfect competition or monopoly.
238
 Short run production Function: Total, average and marginal
products
 We have defined short-run production function to be a function

that shows the relation ship b/n the maximum product and the
level the fixed and the variable input.
 Total Product
 It refers to the total output (say wheat) produced by a given

amount of a variable input (say labor) keeping the quantity of
other inputs fixed (say land).
 Average Product
 It is total product divided by the amount of variable input used to
produce that product.
Average product of labor = Total Product
Total Labor
 Marginal Product
 Marginal product is the extra or additional out put obtained when one
extra unit of the variable input (labour) is increased while other factors
remain fixed.
Marginal product of labour = Change in total product
Change in Total Labour
Amount of Amount of Total Product Average Marginal
Labor, L Land, A(in TP(Q) product product
acres) AP(=TP/L) MP(=ΔTP/ΔL)
0 10 0 - -
1 10 10 10 10
2 10 30 15 20
3 10 60 20 30
4 10 80 20 20
5 10 95 19 15
6 10 108 18 13
7 10 112 16 4
8 10 112 14 0
9 10 108 12 -4
10 10 100 10 -8
The law of diminishing returns
• This law is the major factor behind the relation ship between
TP, MP, and AP.
• It states that as the number of units of the variable input

increases, other inputs held constant, the marginal product of
the variable input declines after a certain point.
• E.g. In the simple case of the farm with only two factors –
namely, a fixed supply of land (Ln) and a variable supply of
farm workers (Lb)
• The production function would be: TPP = f (Ln, Lb).

243
• It states that total physical product (i.e. the output of the farm) over
a given period of time is a function of (i.e. depends on) the quantity
of land and labour employed.
Relationship between Average Product and Marginal Product
 When MPL>APL, APL keeps on increasing
 When MPL <APL, APL keeps on decreasing
 When MPL=APL, APL is constant (maximum)
As the quantity of Input increases, our TP curve first exhibits

increasing marginal returns and then diminishing marginal returns.
Up to certain point, extra units of L increase TP at an increasing rate.
Beyond that point, extra units of L increase TP but at a decreasing rate.
This is called the law of diminishing returns.

Wheat production per year from a particular farm (tonnes)
Number of TPP APP MPP
Workers (Lb) (=TPP/Lb) (= TPP/ Lb)
(a) 0 0 -
3
1 3 3
7
2 10 5
(b) 14
3 24 8
12
(c) 4 36 9
4
5 40 8
2
6 42 7
(d) 0
7 42 6
-2
8 40 5
• Table 3.2 Wheat production per year from a particular farm
245
Stage of production in the short-run production function
 Stage-I (increasing return to factor); This the region up to the

highest point on the MP curve (point L1 ) where if additional
units of labor are employed, TP increase at an increasing rate
(MP).
 Stage-II (diminishing return to factor (labor)); This is the

region from the highest point on the MP curve up to the zero MP,
where if additional units labor are employed TP still increase but
it increase at a diminishing rate.
 Stage-III (negative return to factor (labor)); this is the region

where MP is negative and this makes the total product falling.
246
247
Stage of production in the short-run production
function….
 A unit increase in labor initially has an increasing output
yields up to the L1 unit of labor, in the first stage of
production – increasing marginal returns. At the L2 point the
average product (AP) is at its maximum value.
 Starting from the L2 unit of labor, as the input increases by

one unit, output production still increases but at a decreasing
rate, i.e., each additional increment on labor generates a
smaller increase in output than the last, this is exhibited in the
second stages of production – diminishing marginal returns.
248
 This continues until output reaches its maximum, i.e., the
second stage provides the optimum amount of labor at the
L8 unit of labor.
 Any further additional labor unit after this point will result
in a decline in output, such a movement happens at the third
stage of production - negative marginal returns.
 Stage 3 implies that an increase in the variable input (labor)

results in a decrease in total product. As a result, a rational
producer will never choose to produce at this stage.
 Even if the producer gets labor for free s/he cannot
increase total output by engaging more laborer. On the
contrary s/he can increase output by using less labour.
 Stage 1 on the other hand implies an increase in the

variable input results in an increase in total product. At this
stage, a rational producer will not stop production. S/he
will expand his or her out put further and make use of the
fixed input effectively and efficiently.
 If a firm does not produce either in stage 1 or in stage 3,

the efficient stage of production is stage 2. 250
 From the origin to point A, the firm is experiencing increasing
returns to variable inputs. As additional inputs are employed,
output increases at an increasing rate. Both marginal product
(MP) and average product (APP) are rising.
 The inflection point A, defines the point of diminishing marginal

returns, as can be seen from the declining MP curve beyond point
X. From point A to point C‘, the firm is experiencing positive but
decreasing returns to variable inputs. As additional inputs are
employed, output increases but at a decreasing rate.
 Point B is the point of diminishing average returns, as shown by

the declining slope of the average product curve (AP) beyond
point Y. Beyond point B the marginal curve must be below the
average curve.
251
Example. suppose that the production function for wheat is
given by
Q=KL -0.8K2 -0.2L2
Where, Q - represents the annual quantity of wheat produced
K - annual capital input
L - annual labor input. Suppose K=10
A) Determine the average product
B) At what level of labor does total product reach maximum?
Solution
A) APL=TP/L=Q/L
AP= KL -0.8K2 -0.2L2 =10 - 80 - 0.2L
L L
B) Total product is maximum when MP is zero. But MP=ΔTP/ΔL=dTP⁄dL
MP=K-0.4L
=10-0.4L
Thus, TP is maximum when MP=0
=>10-0.4L=0
=>L=25
 so total product will be maximum when the firm employ 25

units of labour.
There are three important geometrical relationship (as summary).
 TP is at its maximum where MP = 0. MP is the rate of change in TP so
whenever TP is maximized, MP =0. When TP falls, MP is negative.
 MP is at its maximum where TP changes shape from increasing at an

increasing rate to increasing at a decreasing rate. The point where MP
changes is called its inflection point. Again, since MP is the rate of
change in TP, MP would begin to fall at outputs after the inflection
point. MP is the slope of the TP curve.
 When AP is rising, MP> AP and where AP is falling, MP <AP. Hence MP

= AP where AP is at its maximum
254
The law of diminishing returns state that as a firm uses
more of a variable input, with the quantity of fixed inputs
held constant, its marginal product eventually diminishes.
In the short-run, we examined the change in output associated

with an input change on the assumption all other inputs
remained unchanged. The three possibilities were
diminishing. constant and increasing marginal product.
255
The Long Run Production Function
• The long run production function shows the
maximum amount of output that could be produced
when all inputs vary.
• Assume we have only two inputs labor and capital
for ease of analysis. Thus, Q=F (L,K)
• For the analysis of a production function with two
variables factors, we make use of a concept known
as isoquants or equal product curves.
256
Isoquant
• An isoquant is a curve that shows the different
technically efficient combination of the two
inputs that can produce the same level of output.
it is also called equal product curve or product
indifference curve.
• Since an isoquant represents those combination of

two inputs which will capable of producing an
equal quantity of output the producer will be
indifferent b/n them. Example. Isoquant table
(schedule)
257
Each combination of labor and capital produce the same
level of output, say 100 quintals of wheat.
If we plot the above data on the xy plane we get the iso-
product or isoquant curve.
Input Labor( Capital( Maximum

combination L) K) output
A 1 12 100
B 2 8 100
C 3 5 100
D 4 3 100
E 5 2 100
258
Properties of Isoquants
1. They are down ward slopping (negatively slopped)
2. They are convex to the origin. This happens because of the

law of diminishing marginal rate of technical substitution.
3. Two isoquants never cross each other. If two isoquants

cross each other, a single combination of the two inputs (K
and L) will represent two different levels of output, which is
false.
4. Isoquants from the origin represent higher levels of output.

259
Returns to Scale
• So far we have examined the effects of increasing
one input while holding the other input constant (the
shift from one isoquant to another) or decreasing the
other input by an offsetting amount (the movement
along an isoquant).
• We now turn to determine the amount by which
output changes if a firm increases all its inputs
proportionately (by the same percentage).This is
what we mean by returns to scale.
• It shows the percentage change in output as the firm
changes all its inputs by the same proportion.
• We have three types of returns to scale.
260
1. If output rises more than in proportion to an equal percentage
increase in all inputs the production function is said to exhibit
increasing returns to scale (IRS).
2. If output rises less than in proportion to an equal percentage

increase in all inputs, the production function exhibits decreasing
returns to scale (DRS).
3. If output rises by the same proportion to an equal percentage

increase in all inputs, the production function exhibits constant returns
to scale.
261
Chapter 5: Concepts and Types of costs
5. Concept of costs
 As you may remember, outputs and cost are the two view
points through which we look at business firms.
 you learned the output aspect of business firms.
 you will be looking at the firm from the view point of costs.
 You will be also looking more directly at the difference between

the long and short run from the perspective of cost.
 In the short run, we have two major categories of costs: fixed

costs and variable costs.
 In the long run, all costs are variable 262

• Short run is fixed-plant period, the long run is a variable-
plant period.
 Short run costs are cost incurred over a short period

during which some inputs are fixed while others are
variable.
 Long run costs are costs incurred over a long period

where all inputs are variable. Hence, long run costs refer
to a firm cost where there is no fixed input.
263
Therefore, at the end of this Unit, you will be able to:
 define the idea of cost;
 explain how costs of production change as output are changed
 analyze short run patterns of total, average and marginal costs
 identify the relevance of the law of diminishing returns to total

average and marginal costs;
 analyze long run cost patterns of total, average and marginal

costs &
 distinguish between increasing returns to scale, constant

returns to scale and decreasing returns to scale.
264
Concept of costs
 Cost and revenue are the two important factors that profit
maximizing firm needs to monitor continuously.
 It is the level of cost relative to revenue that determines the firm‘s

overall profitability.
 In order to maximize profits, a firm tries to increase its revenue and

lower its costs.
 The cost can determine the level of revenue either by producing the
optimum level of output using least cost combination of inputs, or
increasing factor productivities.
265
 The firm output level is determined by cost.
 Cost is therefore, the monetary value of inputs used in
the production of an item.
 Product price are determined by the interaction of the
market forces of demand and supply in perfect market.
 The basic factor underlying the ability and willingness of
firms to supply a product in the market is the cost of
production
 Cost function is a relationship between cost and output.
 It can be represented by a table, a graph, or an equation.
Economic Costs
• Costs exist because resources are scarce and have
alternative uses. To use a bundle of resources in
producing some particular good means that certain
alternative production opportunities have been
forgone.
• Costs in economics deal with forgoing the
opportunity to produce alternative goods and
services/means opportunity cost
267
Types of costs
 There are many types of costs that a firm may consider relevant
for decision making under varying situation
A. Explicit and implicit costs
 Explicit cost is refers to the expenses which are incurred by a

firm in buying goods and services directly.
 Implicit cost is the expenses which are imputed or self owned.
 Expense for self-employed resources, salary of the owner of the

firm, rent on own building…etc., are called implicit costs.
268
• Economic profits are equal to total revenue
less opportunity costs.
• Opportunity costs are the sum of implicit and

explicit costs and include normal profit to the
entrepreneur.
• Accounting profits are equal to revenue less

accounting (explicit) costs.
269
B. Money cost and Real cost
 Money costs: a firm usually incurs money expenses for

producing a commodity.
 It may spend money on wages, salaries, raw materials,

plant, equipment…etc., These are called money expenses.
 Real costs: Real costs are those where the member of

society make sacrifices in their efforts to produce a
commodity.
 These sacrifices and efforts are real cost of production.

270
 Workers forego leisure/time, capitalists save and
invest, land lord for production.
 These kinds of sacrifices and effects of the members of

the society are called cost of production
C. Fixed and variable costs/nature of cost
 Fixed cost is defined as a cost of production that does

not vary with the level of output.
 It must be paid even if the firm‘s of rate output is zero.

 Such costs as interest are borrowed capital, rental payments, a
portion of deprecation charges of equipment and buildings‘,
salary of top management, key personal are generally fixed
costs.
 Variable cost is a cost of production that varies directly with the

level of output.
 They include payment for raw materials, charge on fuel and

electricity, wage and salary of temporary staff, depreciation
charge associated with wear and tear of assets, and sales
commissions…etc.
272
 A firm‘s costs of producing any output will depend not only on
prices of needed resources, but also on technology and the
quantity of resources it takes to produce that output.
 It is the technological aspect of costs which we not consider.
 In the short run a firm can change its output by adding variable
resources in a fixed plant.
 Fixed costs are costs of production that does not change with
changes in the quantity of output produced by a firm in the
short run. At any and all levels of output, fixed cost is the
same. It doesn‘t change.
273
• Variable costs are costs of production that changes with changes
in the quantity of output in the short run. Variable cost depends
on the level of output. As a firm produces more output, then
variable cost is greater.
• If a firm produces no output, then variable cost is zero. The type
of variable cost includes payments for materials, fuel,
transportation services, most of Labor, and similar variable
resources.
• The idea here is that labor is a much more flexible resource
than capita1 investment.
• TC = TFC + TVC
274
Fixed Cost Versus Sunk Cost
Fixed cost and sunk cost are often confused
• Fixed Cost
– Cost paid by a firm that is in business regardless of
the level of output
• Sunk Cost
– Cost that has been incurred and cannot be
recovered
275
• Total fixed cost is denoted by a straight line parallel to the
output axis.
• This is because such costs do not vary with the level of output.
Total variable cost (TVC): The total variable cost of a firm has
an inverse S-shape.
• The shape indicates the law of variable proportions in
production.
• At the initial stage of production with a given plant, as more of
the variable factor is employed, its productivity increases.
• Hence, the TVC increases at a decreasing rate.
• This continues until the optimal combination of the fixed and
variable factor is reached.
• Beyond this point, as increased quantities of the variable factor
are combined with the fixed factor, the productivity of the
variable factor declines, and the TVC increases at an
increasing rate.
Total Cost (TC)
• The total cost curve is obtained by vertically adding TFC

and TVC at each level of output.
• The shape of the TC curve follows the shape of the TVC

curve, i.e. the TC has also an inverse S-shape.
• It should be noted that when the level of output is zero,

TVC is also zero which implies TC = TFC
--
Average and marginal costs
 Average cost (AC) is cost per unit of production:
AC = TC/Q
 Like total cost, average cost can be divided into the two components, fixed
and variable.
 In other words, average cost equals average fixed cost plus average
variable cost.
AFC = TFC/Q)
AVC = TVC/Q):
AC = AFC + AVC
 Marginal cost (MC) is the extra cost of producing one more unit: that is, the
rise in total cost per one unit rise in output:
MC = ΔTC/ ΔQ
281
282
Note that all marginal costs are variable, since,
by definition, there can be no extra fixed costs as
output rises.
it is possible to derive the AFC, AVC, AC and

MC for each output.
The typical shapes of the APP and MPP curves are
283
Average and marginal physical product
c
Output
APP
MPP
Quantity of the variable factor

Average fixed cost (AFC)
 AFC falls continuously as output rises, since total
fixed costs are being spread over a greater and greater
output.
 Average variable cost (AVC)
 The shape of the AVC curve depends on the shape of
the APP curve.
 As the average product of workers rises the average
labour cost per unit of output (the AVC) falls:
Thereafter, as APP falls, AVC must rise. 285
Fig 3.4 Average and marginal costs
Average and marginal costs
MC
AC
AVC
Costs (£)
x
AFC
Output (Q)
 Average (total) cost (AC)

 AC is simply the vertical sum of the AFC and AVC curves.
 Note that as AFC gets less, the gap between AVC and AC
narrows.
286
The Relationship between Average Cost and Marginal Cost
 As long as new units of output cost less than the average, their
production must pull the average cost down.
 That is, if MC is less than AC, AC must be falling.
 If new units cost more than the average, their production must
drive the average up.
 If MC is greater than AC, AC must be rising.
 Therefore, the MC crosses the AC at its minimum point
 Since all marginal costs are variable, the same relationship holds
between MC and AVC.
287
===
The Least Cost Rule
• To produce a product at the least cost, the firm
should spend its money in such a way that the
last birr spent on each factor of production
brings equal marginal products. Mathematically
it is stated as:
• MPL = MPK
PL PK
Where, PL = price of labor

PK = price of capital
289
Long-run Production Cost : So far we have seen the short-run in cost theory.
• We have defined ―the long run” as “a period long enough so that all inputs are
variable‖. This includes, in particular, capital, plant, equipment, and other
investments that represent long-term commitments. Thus, here is another way to
think of ―the long run:‖ it is the perspective of investment planning.
• Suppose you were planning to build a new plant perhaps to set up a whole new
company and you know about how much output you will be producing. Then you
want to build your plant so as to produce that amount at the lowest possible
average cost.
• We will couch our analysis in terms of ATC, making no distinction between fixed
and variable costs because all resources, and therefore all costs, are variable in
the long run.
290
• Therefore, the long run average cost (LRAC) the
lowest average cost for each output range is
described by the ―lower envelope curve,‖ shown by
the thick, shaded curve that follows the lowest of the
three short run curves in each range.
• Therefore, the long-run cost or expansion path of a

firm is considered to be sequence of short-run (SR)
scenarios for varying scale of plant and equipment.
291
• Long-run average-total-cost curve is made up of
segments of the short-run curves of various-sized
plants from which the firm might choose. The
curve links the minimum points of each short-nm
cost curve is known as envelope curve. Each point
on the envelope curve shows the least unit cost
attainable for any (when the firm has the time to
make all desired changes in its plant size).
292
Chapter Six
PRICE AND OUTPUT DETERMNATION
UNDER PERFECT COMPETTION
 In the previous chapter we have seen the nature of

production and cost.
 In this chapter you will see how a particular firm
makes decision as to how to maximize profit.
 Firms decision to achieve this goal is dependent on
the type of market in which it operates.
Cont..
In economics, market is a place where buyers and
sellers are exchanging goods and services.
The structure of a market is identified by referring to
variables like,
 Number of seller and buyer.,
Freedom of entry and exit out of the market;
Control over price;
Type of the product traded and etc.
The types of market structure are:
Cont…
Perfectly Competitive market structure
Assumptions (A market is said to be PC, if the following
assumptions hold true)
 Large number of sellers and buyers.
• Therefore the action of a single seller or buyer can not influence the market price of
the commodity, since the firm or (the buyer) is too small in relation to the market.
 Products of the firms are homogeneous :
• uniform in terms of quantity, quality and the services associated with sales and
delivery are identical.
• i.e., products are perfect substitutes for one another.
 Free entry and exit of firms
 no barriers to new firms entering the industry
 no barriers to existing firms leaving the industry.
 The goal of all firms is profit maximization
 No government regulation:
 There are no discriminator taxes or subsidies, no allocation of inputs by the
procurement, or any kind of direct or indirect control.
 Perfect knowledge about market conditions : all sellers and buyers have a complete
knowledge
The price of the product
Quality of the product etc 296
Cost , Demand and Revenue functions under
perfect competition
 AVC & AC have U –shape due to the law of variable
proportions (in the short run) and the law of returns to
scale (in the long run).
 Under PC market structure large number of sellers selling
homogenous products and each seller is a price taker.
 If the seller charges higher price than the market price to get
larger revenue, no buyers will buy the product .
 Thus firms operating in a PC market sell any quantity
demanded at the ongoing market price and buyers buy any
amount they want at the ongoing market price.
297
Cont…
 Hence, the demand function that an individual seller faces is
perfectly elastic (horizontal line) Graphically,
 Individual firm Demand Curve under PCM is horizontal line

P
with intercept at the market price.
 The demand curve indicates a single market price at which
the firm can sell any amount of the commodity demanded.
P D = MR = P= AR
Q 298
Qe
Revenue of a Perfectly Competitive Market
Revenue: The revenues of a firm are the receipts that it
obtains from selling its products.
 Similar to costs, revenues have three main categories:
Total Revenue (TR), Average Revenue (AR), and Marginal
Revenue (MR).
Total Revenue (TR): Total Revenue refers to the total
amount of money that the firm receives from the sale of a
given amount of its output.
Total revenue can be estimated by multiplying the
quantity sold by its selling price,
TR = P*Q
299
Cont.
• Since the market price is constant at P*, the total revenue
function is linear and the amount of TR depends on the
quantity of sales.
300
Cont…
• The MR and AR of a firm operating under PC are equal to the market price.
• To see this, let’s find the MR and AR functions from TR functions.
• By definition, MR is the change in total revenue that occurs when one more unit of the
output is sold, i.e.,
𝑑𝑇𝑅 𝑑(𝑃𝑄) 𝑑𝑄
𝑀𝑅 = = =𝑃× =𝑃
𝑑𝑄 𝑑𝑄 𝑑𝑄
• Hence, for a firm operating under PCM, 𝑀𝑅 = 𝑃.
• Average revenue is the TR divided by the quantity of sales, i.e.,
𝑇𝑅 𝑃𝑄
𝐴𝑅 = = =𝑃
𝑄 𝑄
• Hence, for a firm operating under PCM,𝐴𝑅 = 𝑃 and since 𝑃 = 𝑀𝑅, it follows that:
𝑃 = 𝑀𝑅 = 𝐴𝑅
• Note that since 𝑃 is constant at 𝑃 , the expressions 𝑑(𝑃𝑄) and 𝑃 × 𝑑𝑄 are the same.
301
TR, MR and AR under Perfect Competition.
Assuming that price per unit of a commodity is Birr 5,
Unit of a TR(birr) MR (birr) AR or Price

goods
0 0 0 0
1 5 5 5
2 10 5 5
3 15 5 5
4 20 5 5
5 25 5 5 302
Profit Maximization or Producer’s Equilibrium
in the Short Run of the firm
 Under PC, the firm is said to be in equilibrium when
it produces that level of output which maximizes its
profit, given the market price.
 Short run equilibrium of the firm can be obtained in
two ways:
 Total approach
 Marginal approach
1. Total Approach
 The profit maximizing level of output is that level of
output at which the vertical distance between the TR
and TC curves is maximum. (Provided that the TR
curve lies above the TC curve at this point). 303
Total Approach
 The profit maximizing
output level is Qe because it is
at this out put level that the
vertical distance between the
TR and TC curves (or
profit) is maximum.
 For all out put levels below
Q0 and above Q1 profit is
negative because TC is above
TR.
• TR>TC profit
• TR< TC loss
• TR=TC neither profit nor
loss( break-even point)
304
Cont…
2. Marginal Approach
 The profit maximizing out put is Qe, where
 The profit maximizing level of MC=MR and MC curve is increasing. At Q*,
output is that level of output at MC=MR, but since MC is falling at this output
which: level, it is not equilibrium out put. firm should
produce additional output until it reaches Qe.
MR=MC and given MC is
increasing
 This approach is directly derived
from the total approach.
 The slope of the TR curve
constant and is equal to the MR or
market price and the slope of the
TC is equal to MC.
 The distance between the TR and
TC curves () is maximum when
MR equals MC.
305
How to Determine total profit graphically
If the ATC is below the market price at equilibrium, the firm earns a positive
profit equal to the area between the ATC curve and the price line up to the
profit maximizing output. The firm earns a positive profit because price exceeds AC
of production at equilibrium.
 If the ATC is equal to the market price at equilibrium, the firm gets zero.
 Break-even point is the output level at which market price is equal to the
average cost of production so that the firm obtains only normal profit (zero
profit).
 If the ATC is above the market price at equilibrium, the firm earns a
negative profit (incurs a loss) equal to the area between the ATC curve and
the price line.a firm incurs a loss because price is less than AC of production at
equilibrium.
• The firm will continue to produce regardless of the existing loss as far as
the price is sufficient to cover the average variable costs.
• If the market price falls below the AVC or alternatively, if the TR of the
firm is not sufficient to cover at least the total variable cost, the firm should
close (shut down) its factory (business). 306
CONT…
307
Example:
Suppose a firm has a TFC of $2,000, a TVC of $ 5,000 and a TR of
$6,000 at equilibrium. Should the firm stop its operation? Why?
• The firm is incurring a loss of $ 1,000 because TC (2,000 +
5,000=7,000) is greater than the TR.
• But the firm should continue production because the TR TVC.
• If the firm stops operation, it will lose the fixed cost ($ 2.000).
But if it continues production the loss is only $ 1,000 (TR-TC).
 Thus, the firm requires a minimum TR of $ 5,000 to continue
operation.
 If the TR is equal to $ 5,000, the firm is indifferent in between
choosing to continue or to discontinue its operations because in
both cases the loss is equal to fixed costs.
 Thus The level output at which TR and TVCs are equal is called
shut down out put level.
 Shut down point is the point at which AVC equals the market
price.
308
Numerical example
1. Suppose that the firm operates in a PC market. The market
price of his product is $10. The firm estimates its cost of
production with the following cost function:
TC=-4Q2+Q3+10Q+2
A. What level of out put should the firm produce to maximize its profit?
B. Determine the level of profit at equilibrium.
C. What minimum price is required by the firm to stay in the market?
Solution
Given: p=$10
TC=-4Q2+Q3+10Q+2
A. The profit maximizing output where;
MC=MR &
MC is rising
In Perfectly competitive market, P=MR=10
309
Cont…
MC=ꝺTC/ꝺQ = -8Q+3Q2 +10
P=MC = 10= -8Q+3Q2 +10
-8Q+3Q2 +10-10=0 , Solve for quantity
Q=8/3 (2.67)
B. The firm maximizes its profit by reducing 8/3 units.
Profit = TR-TC, TR = Price * Equilibrium out put
= $ 10 * 8/3= $ 80/3= 26.67
TC at q = 8/3 can be obtained by substituting 8/3 for
q in the TC function, i.e.,
TC=-4Q2+Q3+10Q+2
TC = – 4 (2.67)2 +(2.67)3 +10(2.67) +2  19.23
Thus the equilibrium (maximum) profit is
 = TR – TC = 26.67 – 19.23 = $ 7.44 310
Cont…
C. To stay in operation the firm needs the price which
equals at least the minimum AVC.
 Thus to determine the minimum price required to stay in
business, we have to determine the minimum AVC.
 AVC is minimal when derivative of AVC is equal to zero that
is
Given the TC function:
TC=-4Q2+Q3+10Q+2 , there is fixed cost i.e. TC is equal to the
TVC+TFC. Hence, TVC = -4Q2+Q3+10Q
derivative of AVC = -4 + 2Q = 0
Q= 2 i.e. AVC is minimum when out 0utput is equal to 2 units.
 The minimum AVC is obtained by substituting 2 for q in the
AVC function i.e., Min AVC = -4Q+Q2++10
= – 4 (2) + 22 +10 = 6
 Thus, to stay in the market the firm should get a minimum
price of $ 6.
311
The short run supply curve of the firm and the
industry
 The profit maximizing level of output is

defined by the point of equality of MC and
market price (because market price is equal to
MR in the perfectly competitive market).
 By repeating this analysis at different possible
market prices, we observe how the equilibrium
quantity supply of the firm varies with the
market price.
312
The short run supply curve
 When the market price is $6, the  short run supply curve of a PC firm is
firm supplies 50 units to maximize
that part of MC curve which lies above
its profit.
the minimum AVC (Shut down point).
 As the price increases to $7, the
equilibrium quantity supplied
increases to 140 units and so on.
313
Cont…
• This implies that the quantity supplied by the firm
increases as the market price increases.
• The firm, given its cost structure, will not supply any
quantity ( will shut down) if the price falls below $6,
because at a lower price than $6, the firm can not
cover its variable costs.
• Thus, supply is zero for all price levels below $6
(minimum AVC)
• If we plot the successive equilibrium points on a
separate graph we observe that the supply curve of
the individual firm is identical to part of its MC curve
to the right of the shut down point.
314
Short run supply curve of the industry
word ’industry’ is defined as group of firms producing
homogeneous products.
 Thus the industry supply is the total supply or market supply.
 The industry –supply curve is the horizontal summation of
the supply curves of the individual firms.
 The industry supply curve is obtained by adding the quantities
supplied by all the firms at each price.
 For example, at price which equals $ 6, firm 1 supplies 50 units,
firm 2 supplies 80 units & firm 3 supplies 120 units.
 The market supply at $ 6 price is thus 250 units (50+80+120
units).
 The short run industry- supply is derived by repeating the
above process at each price levels.
 315
Profit maximization/Equilibrium in
the long-run
 In the long run, firms are in equilibrium when they have adjusted
their plant size so as to produce at the minimum point of their
long run AC curve, which is tangent to the demand curve defined
by the market price.
 That is, the firm is in the long run equilibrium when the
market price is equal to the minimum long run AC.
 First, if the firms existing in the market are making excess
profits (the market price is greater than their LACs) new firms
will be attracted to the industry seeking for this excess profit.
 The entry of new firms results in two consequences:
A. The entry of new firms will lead to a fall in market price of the
commodity.
B. More over, the entry of new firms results in an upward shift of
the cost curves due to the increase of prices of factors as the 316
industry expends.
Cont…
• Second, if the firms are incurring losses in the long run (P < LAC) they will
leave the industry (shut down).
• Thus, due to the above two reasons, firms can make only a normal profit in
the long run.
 The condition for the long run equilibrium of the firm is that the long run
marginal cost (LMC) should be equal to the price and to the LAC i.e. LMC =
LAC = P.
 In the short-run the firm should continue production as far as the market
price is greater than the minimum AVC,
 If the market price falls below the minimum AVC, the firm is well advised
to shut down.
 In long run the firm should shut down if its revenue is less than its
avoidable or a variable cost.
317
Long run equilibrium of the firm.
The long-run equilibrium of the firm is illustrated in figure below.
• The equilibrium is at E where the LMC curve intersects
the MR curve from below.
• At E, both the conditions of long-run equilibrium – i.e.,
P = LAC, and MC = MR – are satisfied.
318
Long-run equilibrium of the industry
 An industry is in the long-run equilibrium when the price
is reached at which all firms are in equilibrium.
 That is, when all firms are producing at the minimum
point of their LAC curve and making just normal
profits, the industry is said to be in the long-run
equilibrium.
 Under these conditions there is no further entry or exit
of firms in the industry (since all the firms are getting
only normal profit), so that the industry supply remains
stable
319
Questions
1. Consider a profit maximizing firm operating under conditions
of perfect competition. Suppose that the market price is birr
50 and the firm faces a total cost function of TC = 100 + 25Q2,
find:
i. the profit maximizing level of output and
ii. the maximum profit possible.
2. Suppose a perfectly competitive firm has the following total cost
(TC), and total revenue (TR) function.
TC = Q3 – 5Q2 + 12Q + 84, and TR = 9Q
Given the above information, compute
i. Profit maximizing or loss minimizing level of output;
ii. The magnitude of maximum profit or minimum loss;
320
Chapter Seven:
Pure Monopoly
Is the market structure in which there is only one
firms that produces a distinctive product (E.g.
Ethiopian electric power corporation, ethio-telecom,
water supply, etc).
By distinctive product we mean a product which have
no close substitute.
Only one supplier of a product
There is considerable entry barrier for a new firms
due to legal and patent rights, control over essential
raw material, technical, economies of scale, or any
other
A pure monopoly firm is a price setter, not price taker
Pure Monopoly...cont’d
one firm, firm is the industry

unique product or no close substitutes
 Because the monopolist produces a unique product, it makes
no effort to differentiate its product →No close substitutes
market entry and exit difficult or legally impossible
 Product differentiation, Large initial investment, & Control of
raw materials
non-price competition not necessary
It owns a patent or copyright.
It controls the total supply of raw materials in the
industry.
Source and kinds of monopoly
• The fundamental cause of monopoly is barriers to entry
of other firms in to the industry
• The barriers to entry are therefore the sources of
monopoly power.
• The major sources of barriers to entry are
– legal restrictions- are created by law in public
interest such monopoly may be created in both
public and private sectors.
– sole control over the supply of key raw materials
– efficiency and
– patent right,
Government-Created
• Governments may Monopolies
restrict entry by giving a
single firm the exclusive right to sell a
particular good in certain markets.
• Patent and copyright laws are two important

examples of how government creates a
monopoly to serve the public interest.
HOW MONOPOLIES MAKE PRODUCTION AND
PRICING DECISIONS
• Monopoly versus Competition
– Monopoly
• Is the sole producer
• Faces a downward-sloping demand curve
• Is a price maker
• Reduces price to increase sales
– Competitive Firm
• Is one of many producers
• Faces a horizontal demand curve
• Is a price taker
• Sells as much or as little at same price
Figure 2 Demand Curves for Competitive and Monopoly Firms
(a) A Competitive Firm’s Demand Curve (b) A Monopolist’s Demand Curve
Price Price
Demand
Demand
0 Quantity of Output 0 Quantity of Output

A Short run equilibrium under monopoly
• Profit maximizing condition is MR=MC and MC is
rising
• If the monopolist raises the price of its good, consumers buy

less of it.
• Looked at another way, if the monopolist reduces the
quantity of output it sells, the price of its output increases.
A Short run equilibrium under monopoly
• Profit maximizing condition is MR=MC and MC is
rising
• Total Revenue
P  Q = TR
• Average Revenue
TR/Q = AR = P
• Marginal Revenue
TR/Q = MR
Table 1 A Monopoly’s Total, Average,
and Marginal Revenue
Copyright©2004 South-Western
A
• Monopoly’s Revenue
A Monopoly‘s Marginal Revenue
– A monopolist‘s marginal revenue is always less
than the price of its good.
• The demand curve is downward sloping.
• When a monopoly drops the price to sell one more unit,

the revenue received from previously sold units also
decreases.
A Monopoly’s Revenue
• A Monopoly‘s Marginal Revenue
– When a monopoly increases the amount it sells, it
has two effects on total revenue (P  Q).
• The output effect—more output is sold, so Q is higher.
• The price effect—price falls, so P is lower.

Figure 3 Demand and Marginal-Revenue Curves for a Monopoly
Price
$11
10
9
8
7
6
5
4
3 Demand
2 Marginal (average
1 revenue revenue)
0
–1 1 2 3 4 5 6 7 8 Quantity of Water
–2
–3
–4

Profit Maximization
• A monopoly maximizes profit by producing
the quantity at which marginal revenue equals
marginal cost.
• It then uses the demand curve to find the price

that will induce consumers to buy that
quantity.
Figure 4 Profit Maximization for a Monopoly
Costs and
Revenue 2. . . . and then the demand 1. The intersection of the
curve shows the price marginal-revenue curve
consistent with this quantity. and the marginal-cost
curve determines the
B profit-maximizing
Monopoly quantity . . .
price
Average total cost

A
Marginal Demand
cost
Marginal revenue
0 Q QMAX Q Quantity
Profit Maximization
• Comparing Monopoly and Competition

– For a competitive firm, price equals marginal cost.
P = MR = MC
– For a monopoly firm, price exceeds marginal cost.
P > MR = MC
A Monopoly’s Profit
• Profit equals total revenue minus total costs.

– Profit = TR - TC
– Profit = (TR/Q - TC/Q)  Q
– Profit = (P - ATC)  Q
Figure 5 The Monopolist’s Profit
Costs and
Revenue
Marginal cost
Monopoly E B
price
Monopoly Average total cost

profit
Average
total D C
cost
Demand
Marginal revenue
0 QMAX Quantity

A Monopolist’s Profit
• The monopolist will receive economic profits

as long as price is greater than average total
cost.
PRICE DISCRIMINATION
• Price discrimination is the business practice of
selling the same good at different prices to
different customers, even though the costs for
producing for the two customers are the
same.
• Price discrimination is not possible when a
good is sold in a competitive market since
there are many firms all selling at the market
price. In order to price discriminate, the firm
must have some market power.
• Perfect Price Discrimination
– Perfect price discrimination refers to the situation
when the monopolist knows exactly the
willingness to pay of each customer and can
charge each customer a different price.
• Examples of Price Discrimination
– Movie tickets
– Airline prices
– Discount coupons
– Financial aid
– Quantity discounts
Summary
• A monopoly is a firm that is the sole seller in its
market.
• It faces a downward-sloping demand curve for its

product.
• A monopoly‘s marginal revenue is always below the

price of its good.
Summary
• Like a competitive firm, a monopoly maximizes
profit by producing the quantity at which marginal
cost and marginal revenue are equal.
• Unlike a competitive firm, its price exceeds its

marginal revenue, so its price exceeds marginal cost.
Monopoly markets share the following
common characteristics.
1. Single seller and many buyers.
2. Absence of close substitutes
3. Price maker
4. Barrier to entry
• It is quite opposite to perfectly competitive market.
• Consider a single market served by only one firm- called
monopolistic. We may think of this market as a certain
country.
• The market works a s follows:
• First, the monopolist sets its price.
• Second, the Consumers are informed about the price and decide how
much to buy
• The monopolist must produce and sell the quantity demanded.
Classification of Monopoly
Monopolies are classified according to circumstances they
arise from, that is, cost structure of the industry, possibly the
result of law, or by other means.
• Natural Monopoly is a market situation where is a single
firm can supply the entire market due to the fundamental
cost structure of the industry.
• Legal Monopoly is sometimes called as de jure
monopoly, a form of monopoly which the government
grants to a private individual or firm over the product or
services.
• Coercive Monopoly is a form of monopoly whose
existence as the sole producer and distributor of goods and
services is by means of coercion (legal or illegal).
Imperfect markets
 Imperfect competition refers to those market
structures that fall between perfect competition
and pure monopoly.
 It exist when a single firm has a certain degree
of control over the market price of a product
(this happen when one or more condition of
perfect market is violated).
2 Major types of imperfect markets:
Oligopoly market
Monopolistically competitive market
Monopolistic Competition
Is characterized by a relatively large number of sellers
producing differentiated products (clothing, furniture,
books)
Sellers offer differentiated products or similar but not
identical products.
New firms can enter the market easily. However, there is
a greater competition in the sense that new firms have
to offer better features of their products.
There is a limited control of price because of product
differentiation.
Profit maximizing condition is MR=MC and MC is rising
Like the PCM firm MCM firm earn normal profit in the
long run
...cont’d
Summary:
• Monopolistic competition (market power
based on product differentiation)
– large number of small firms acting
independently
– differentiated product
– market entry and exit relatively easy
– non-price competition very important
– Many firms selling products that are similar but
not identical.
Examples: boutiques, restaurants, repair shops...
Oligopoly Market
There are a small number of firms in the market
selling differentiated or identical products.;
The firm has control over price because of the
small number of firms providing the entire supply
of a certain product.
There is an extreme difficulty for new competitors
to enter the market.
...cont’d
They produce standardized or differentiated product
There is non-price competition if the product is
differentiated product
Examples: oil refining, processed foods, airlines,
internet access, cell phone service, etc.
Because of the few sellers, the key feature of
oligopoly is the tension between cooperation
and self-interest.
Competition and Market Types in Economic Analysis
END
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MICROECONOMICS -I

Prepared by: Habtamu R (MSc.)

• The word economics comes from the Greek word ‗Economicous‘

 one who manages a household.

 Human or society‘s material wants are unlimited and

 Economic resources are scarce or limited in supply

There are two types of resource

1. Free resource exists at zero cost.

2. Economic resource/scarce resource

• Economic resources refer to anything natural or manmade that can

• These contradictory facts lay the foundation for the field of

• labor:-is defined as the physical and intellectual exertion/contribution of

• Capital:- capital is defined as all man-made/physical assets aids to

• Entrepreneurship: entrepreneurs combine the other factors of production

• Entrepreneur + Enterprise Entrepreneurship

(person) (object) (process)

• The return for entrepreneurship is called profit.

Microeconomics & Macroeconomics

• It is concerned with the decisions taken by individual consumers

• For example, questions like how does a household maximize

– how does a particular business enterprise attain maximum

It deals with magnitudes such as:

 the total output level in an economy,

 national income of a country,

 the overall level of prices,

 total output and total employment in the economy

 general price level of goods and services in the economy, etc.,

 So, in general, Macroeconomics study about the forest while

• Both areas offer valuable outlook on the economy.

• Positive economics is concerned with facts. It tells us what was, what is or

Consider the following statement:

• ‗A decrease in personal income tax will lead to a rise in unemployment.‘

In above statement, both personal income tax and unemployment are

In logic, we often refer to the two broad methods of reasoning as

Deductive reasoning is more narrow in nature and is concerned

In fact, it doesn‘t take a rocket scientist to see that we could

Even in the most constrained experiment, the researchers may

What is the crucial ingredient that makes a problem an economic?

– The crucial economic problem is the problem of scarcity.

• Because of scarcity, various choices have to be made between

Economics is the study of scarcity/the study of allocation of scarce

• how to produce it, and

• for whom to produce. The 3 Economic Questions.

• What to produce involves decisions about the kinds and quantities

• How to produce requires decisions about what techniques to use and

• The for whom to produce involves decisions on the distribution of

• how to produce it, and

• for whom to produce.

These decisions involve opportunity costs.

• An opportunity cost is what is sacrificed to implement an

• Opportunity cost is the cost of any activity measured in terms of the

• The jacket is the opportunity cost because it is your next best

• Based on this we have three types of economic systems:

– Free market economy,

– command or planned economy and

• It is useful to analyze the extremes, in order to put the different mixed

• A command economy is one in which the government makes all important

• That is, the government owns all the means of production

3. Mixed economy is a market economy where there is some government