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Managerial Economicies module

Strategic Management (Wollo University)

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DI STAN CE AN D CON TI N U I N G EDU CATI ON

COLLEGE OF BU SI N ESS AN D ECON OM I CS

DEPARTM EN T OF M AN AGEM EN T

DISTANCE MODULE FOR THE COURSE MANAGERIAL ECONOMICS

(MGMT 2171) ; CREDIT HOUR: 3

MODULE WRITERS:

1. TEFERI MENGESHA (MBA)

2. AWOKE TESSEMA (MBA)

EDITOR: SADAM MOHAMMED (MBA)

FEBRUARY, 2020

DESSIE, ETHIOPIA

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Introduction to the module

Dear Distance student! Welcome to the course managerial economics. The success of business
organizations to a great extent depends on the decisions taken by the business managers. The
manager is responsible for organizing, managing and utilizing the resources. As the resources are
scarce, the manager has to make optimum use of the resources in achieving the objectives of the
organization. In modern business world, decision-making is a difficult job due to complexity of
business environment. In such a situation, managerial economics play a very important role. It is
concerned with the application of economic theory and methods to analyze the decision-making
problems faced by business firms. The managerial economists help the organizations in
achieving its predetermined goals with the optimum use of the resources. The growing
complexity of business decision-making has inevitably increased the application of economic
concepts, theories and tools of economic analysis in this area. The application of economic
concepts, theories, logic and analytical tools in the assessment and prediction of market
conditions and business environment has proved to be of great help in business decision-making
and has come to be widely recognized. Consequently, economic theories and analytical tools
which are widely used in business decision-making have crystallized into a separate branch of
management studies, called Managerial Economics. Managerial Economics refers to the firm’s
decision making process. It could be also interpreted as “Economics of Management” or
“Industrial economics “or “Business economics”. This course is devised in the way that both
economic theories and mathematical tools which are critical in making decisions to resolve
managerial problems irrespective of the fact that they are of either profit oriented, non-profit
oriented, private, public, large, or small organizations and/or institutions. The course, having the
set of mathematical techniques and economic theories and principles, will give students a deeply
grounded insight on such matters as to what combination of those theories and techniques should
they employ in what situations in making attempts to address managerial problems. This course
deals with features of market structure and decision making, business and economic forecasting,
econometric model of input output analysis, optimization theory, basic estimation techniques,
and pricing of goods and services, which helps to promote the development of analytical and
critical thinking skills of students.

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Table of contents page

UNIT 1:THE NATURE AND SCOPE OF MANAGERIAL ECONOMICS ..........................1
1.1What Is Managerial Economics? .........................................................................................1
1.2 Opportunity Cost ...............................................................................................................3
1.3 Macroeconomics versus Microeconomics ..........................................................................4
1.4 Fundamental Nature of Managerial Economics ..................................................................5
1.5 Scope of Managerial Economics ........................................................................................8
1.6 Managerial Economics and Other Disciplines .................................................................. 10
1.7 Economic Analysis .......................................................................................................... 11
UNIT 2:FUNDAMENTAL ECONOMIC CONCEPTS ........................................................ 14
2.1 Equilibrium Analysis: Supply And Demand Relationship ................................................ 15
2.1.1. Demand .................................................................................................................... 15
2.1.2. Supply ...................................................................................................................... 17
2.2. Equilibrium..................................................................................................................... 18
2.2.1 Marginal Analysis ..................................................................................................... 20
2.3. Time Value of Money ..................................................................................................... 23
UNIT 3: BASIC OPTIMIZATION TECHNIQUES .............................................................. 25
3.1 Optimisation Concept ...................................................................................................... 25
3.1.1 Unconstrained Optimization Technique ..................................................................... 26
3.1.2 Constrained Optimization .......................................................................................... 28
UNIT 4: ANALYSES OF DEMAND AND DEMAND ELASTICITY ................................. 36
4.1 The Demand Function...................................................................................................... 37
4.2 The Law of Demand ........................................................................................................ 40
4.3 Elasticity of Demand ....................................................................................................... 41
4.3.1 Price Elasticity of Demand ........................................................................................ 41
4.3.2 Arc Elasticity ............................................................................................................ 42
4.3.3 Point Elasticity .......................................................................................................... 44
4.3.4 Measuring Price Elasticity from a Demand Function ................................................. 47
4.3.5 Determinants of Price Elasticity of Demand .............................................................. 51
4. 3.6 Cross-Elasticity of Demand ...................................................................................... 53

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4. 3.7 Income-Elasticity of Demand ................................................................................... 54

4.3.8 Advertisement or Promotional Elasticity of Sales ...................................................... 56
4.4 Elasticity of Price Expectations ........................................................................................ 57
UNIT 5: THEORY OF PRODUCTION................................................................................. 60
5.1 The Role of the Firm ........................................................................................................ 61
5.2 Production Function......................................................................................................... 61
5.2.1 Production Function with One Variable Input ............................................................ 64
5.2.2 Production Function with Two Variable Inputs.......................................................... 69
5.3 The Optimal Combination of Inputs ................................................................................. 75
UNIT 6: THEORY OF COST AND BREAK-EVEN ANALYSIS ........................................ 80
6.1. The Theory of Cost: The Cost-Output Relations.............................................................. 80
6.1.1. Short – Run Cost-Output Relations ........................................................................... 81
6.1.2. Short-Run Cost Functions and Cost Curves .............................................................. 82
6.1.3. Cost Curves and the Law of Diminishing Returns..................................................... 88
6.1.4. Some Important Cost Relationships .......................................................................... 89
6.1.5. Output Optimization in the Short-Run ...................................................................... 90
6.1.6. Long-Run Cost-Output Relations ............................................................................. 90
6.2. Economies and Diseconomies of Scale ........................................................................... 93
6.2.1. Economies of Scale .................................................................................................. 93
6.2.2. Diseconomies of Scale.............................................................................................. 97
6.3. Break-Even Analysis ...................................................................................................... 99
UNIT 7: MARKET STRUCTURE AND PRICING DECISIONS ...................................... 102
7.1 Characteristics of Market Structure ................................................................................ 103
7.2 Perfect Competition ....................................................................................................... 105
7.2.1 Short-run Equilibrium of the Firm and the Industry ................................................. 105
7.3 Monopoly Market Structure ........................................................................................... 115
7.3.1 Source and Types of Monopoly ............................................................................... 116
7.3.2 Demand, Marginal Revenue and cost curves under Monopoly ................................. 116
7.3.3 Short Run Equilibrium of Monopoly ....................................................................... 118
7.3.4 Long Run Equilibrium of Monopoly........................................................................ 120
7.3.5 Price Discrimination ................................................................................................ 122

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7.3.6 Social cost of Monopoly Power ............................................................................... 124

7.4 Monopolistic Competition ............................................................................................. 126
7.4.1 Assumptions of Monopolistic Competition .............................................................. 126
7.4.2 The Concept of Industry and Product "Group”......................................................... 128
7.4.3 Equilibrium Conditions in Monopolistically Competitive Market ............................ 128
7.5 Oligopoly Theory .......................................................................................................... 133
7.5.1 Characteristics of Oligopoly Market ........................................................................ 133
UNIT 8: RISK AND UNCERTAINITY ............................................................................... 136
8.1 Risk and Uncertainty ..................................................................................................... 137
8.2 Measuring Risk: Mean And Variance ............................................................................ 138
8.2.1 Mean (Expected Value) ........................................................................................... 138
8.2.2 Variance .................................................................................................................. 140
8.2.3 Coefficient of Variation ........................................................................................... 141
8.3 Decision Making Under Uncertainty With Complete Ignorance ..................................... 141
8.3.1 Laplace Decision Criterion ...................................................................................... 142
8.4 Market Uncertainty and Insurance.................................................................................. 143

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COURSE INTRODUCTION

The growing complexity of business decision-making has inevitably increased the application of
economic concepts, theories and tools of economic analysis in this area. The application of
economic concepts, theories, logic and analytical tools in the assessment and prediction of
market conditions and business environment has proved to be of great help in business decision-
making and has come to be widely recognized. Consequently, economic theories and analytical
tools which are widely used in business decision-making have crystallized into a separate branch
of management studies, called Managerial Economics. This course is devised in the way that
both economic theories and mathematical tools which are critical in making decisions to resolve
managerial problems irrespective of the fact that they are of either profit oriented, non-profit
oriented, private, public, large, or small organizations and/or institutions. The course, having the
set of mathematical techniques and economic theories and principles, will give students a deeply
grounded insight on such matters as to what combination of those theories and techniques should
they employ in what situations in making attempts to address managerial problems. This course
deals with features of market structure and decision making, business and economic forecasting,
econometric model of input output analysis, optimization theory, basic estimation techniques,
and pricing of goods and services, which helps to promote the development of analytical and
critical thinking skills of students.

Course Objective

Up on completion of this course student will be able to:

 Demonstrate how application of economic theory can improve decision-making, and

enhances the learning experience in managerial economics.
 Apply the economic way of thinking to business decision making.

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UNITONE: THE NATURE AND SCOPE OF MANAGERIALECONOMICS

Unit Objectives

After studying this unit, you should be able to:

 Define managerial economics

 Understand the nature and scope of managerial economics
 Familiarize yourself with economic terminology
 Develop some insight into economic issues
 Acquire some information about economic institutions

Unit Introduction

Managerial economics is constituted of economic theories and analytical tools that are widely
applied to business decision-making. It is, therefore useful to know, ‘What is economics’.
Economics is a social science. Economics is the study of how individuals and societies make
choices subject to constraints. The need to make choices arises from scarcity. From the
perspective of society as a whole, scarcity refers to the limitations placed on the production of
goods and services because factors of production are finite. From the perspective of the
individual, scarcity refers to the limitations on the consumption of goods and services because of
limited of personal income and wealth.

1.1 What Is Managerial Economics?

Economics is the study of how individuals and societies choose to utilize scarce resources to
satisfy virtually unlimited wants. Scarcity describes the condition in which the availability of
resources is insufficient to satisfy the wants and needs of individuals and society. Managerial
economics is the study of economic theories, logic and tools of economic analysis that are used
in the process of business decision making. Economic theories and techniques of economic
analysis are applied to analyze business problems, evaluate business options and opportunities
with a view to arriving at an appropriate business decision. Managerial economics is thus
constituted of that part of economic knowledge, logic, theories and analytical tools that are used

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for rational business decision-making. Let us now look at some representative definitions of
managerial economics.

Some Definitions

“Managerial economics is concerned with the application of economic concepts and economics
to the problems of formulating rational decision making”
Mansfield

“Managerial Economic is the integration of economic theory with business practice for the
purpose of facilitating decision making and forward planning management”

Spencer and Seigelman

“Managerial economics is concerned with the application of economic principles and

methodologies to the decision-making process within the firm or organization. It seeks to
establish rules and principles to facilitate the attainment of the desired economic goals of
management”

Douglas

Managerial economics is the application of economic theory and quantitative methods

(mathematics and statistics) to the managerial decision-making process. Simply stated,
managerial economics is applied microeconomics with special emphasis on those topics of
greatest interest and importance to managers. Managerial economics is the synthesis of
microeconomic theory and quantitative methods to find optimal solutions to managerial
decision-making problems. To illustrate the scope of managerial economics, consider the case
the owner of a company that produces a product.

The manner in which the firm owner goes about his or her business will depend on the
company’s organizational objectives. Is the firm owner a profit maximize, or is management

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more concerned something else, such as maximizing the company’s market share? What specific
conditions must be satisfied to optimally achieve these objectives? Economic theory attempts to
identify the conditions that need to be satisfied to achieve optimal solutions to these and other
management decision problems. If the company’s organizational objective is profit maximization
then, according to economic theory, the firm should continue to produce widgets up to the point
at which the additional cost of producing an additional widget (marginal cost) is just equal to the
additional revenue earned from its sale (marginal revenue).To apply the “marginal cost equals
marginal revenue” rule, however, the firm’s management must first be able to estimate the
empirical relationships of total cost of widget production and total revenues from widget sales. In
other words, the firm’s operations must be quantified so that the optimization principles of
economic theory may be applied.

1.2 Opportunity Cost

The concepts of scarcity and choice are central to the discipline of economics. These concepts
are used to explain the behavior of both producers and consumers. It is important to understand,
however, that in the face of scarcity whenever the decision is made to follow one course of
action, a simultaneous decision is made to forgo some other course of action.When a high school
graduate decides to attend college or university, a simultaneous decision is made to forgo
entering the work force and earning an income. Scarcity necessitates trade-offs. That which is
forgone whenever a choice is made is referred to by economists as opportunity cost.That which
is sacrificed when a choice is made is the next best alternative. It is the path that we would have
taken had our actual choice not been open to us.

Definition: Opportunity cost is the highest valued alternative forgone whenever a choice is
made.

1.3 Macroeconomics versus Microeconomics

Scarcity, and the manner in which individuals and society make choices, are fundamental to the
study of economics. To examine these important issues, the field of economics is divided into
two broad subfields: macroeconomics and microeconomics.As the name implies,
macroeconomics looks at the big picture. Macroeconomics is the study of entire economies and
economic systems and specifically considers such broad economic aggregates as gross domestic

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product, economic growth, national income, employment, unemployment, inflation, and

international trade. In general, the topics covered in macroeconomics are concerned with the
economic environment within which firm managers operate. For the most part, macroeconomics
focuses on the variables over which the managerial decision maker has little or no control but
may be of considerable importance in the making of economic decisions at the micro level of the
individual, firm, or industry.

Macroeconomics is the study of aggregate economic behavior. Macroeconomists are concerned

with such issues as national income, employment, inflation, national output, economic growth,
interest rates, and international trade. By contrast, microeconomics is the study of the behavior
and interaction of individual economic agents.These economic agents represent individual firms,
consumers, and governments. Microeconomics deals with such topics as profit maximization,
utility maximization, revenue or sales maximization, production efficiency, market structure,
capital budgeting, environmental protection, and governmental regulation. Microeconomics is
the study of individual economic behavior. Micro-economists are concerned with output and
input markets, product pricing, input utilization, production costs, market structure, capital
budgeting, profit maximization, production technology, and so on.

Dear learner! Please do the following activity

Activity

Compare and contrast microeconomics with macroeconomics. Although managerial

economics is based primarily on microeconomics, explain why it is also important for
managers to understand macroeconomics.

1.4 Fundamental Nature of Managerial Economics

A close relationship between management and economics has led to the development of
managerial economics. Management is the guidance, leadership and control of the efforts of a
group of people towards some common objective. While this description does inform about the
purpose or function of management, it tells us little about the nature of the management process.

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Koontz and O’Donell define management as the creation and maintenance of an internal
environment in an enterprise where individuals, working together in groups, can perform
efficiently and effectively towards the attainment of group goals. Thus, management is –

 Coordination
 An activity or an ongoing process
 A purposive process
 An art of getting things done by other people.
On the other hand, economics as stated above is engaged in analysing and providing answers to
manifestations of the most fundamental problem of scarcity. Scarcity of resources results from
two fundamental facts of life:

 Human wants are virtually unlimited and insatiable, and

 Economic resources to satisfy these human demands are limited.
Thus, we cannot have everything we want; we must make choices broadly in regard to the
following:

 What to produce?
 How to produce? and
 For whom to produce?
These three choice problems have become the three central issues of an economy as shown in
figure 1.2. Economics has developed several concepts and analytical tools to deal with the
question of allocation of scarce resources among competing ends. The non-trivial problem that
needs to be addressed is how an economy through its various institutions solves or answers the
three crucial questions posed above. There are three ways by which this can be achieved. One,
entirely by the market mechanism, two, entirely by the government or finally, and more
reasonably, by a combination of the first two approaches. Realistically all economies employ the
last option, but the relative roles of the market and government vary across countries. For
example, in India the market has started playing a more important role in the economy while the
government has begun to withdraw from certain activities. Thus, the market mechanism is
gaining importance. A similar change is happening all over the world, including in China. But
there are economies such as Myanmar and Cuba where the government still plays an
overwhelming part in solving the resource allocation problem. Essentially, the market is

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supposed to guide resources to their most efficient use. For example if the salaries earned by
management degree holders continue to rise, there will be more and more students wanting to
earn the degree and more and more institutes wanting to provide such degrees to take advantage
of this opportunity. The government may not force this to happen, it will happen on its own
through the market mechanism. The government, if anything, could provide a regulatory
function to ensure quality and consumer protection.

According to the central deduction of economic theory, under certain conditions, markets
allocate resources efficiently. ‘Efficiency’ has a special meaning in this context. The theory says
that markets will produce an outcome such that, given the economy’s scarce resources, it is
impossible to make anybody better-off without making somebody else worse-off.

Figure 1.2: Three Choice Problems of an Economy

Unlimited Choice Limited Resources

SCARCITY

What to produce? How to produce? For whom to produce?

In rich countries, markets are too familiar to attract attention. Yet, certain awe is appropriate. Let
us take an incident where Soviet planners visited a vegetable market in London during the early

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days of perestroika, they were impressed to find no queues, shortages, or mountains of spoiled
and unwanted vegetables. They took their hosts aside and said: “We understand, you have to say
it’s all done by supply and demand. But can’t you tell us what’s really going on? Where are your
planners and what are their methods?” The essence of the market mechanism is indeed captured
by the supply-anddemand diagram. At the place where the curves intersect, a price is set such
that demand equals supply. There, and only there, the benefit from consuming one more unit
exactly matches the cost of producing it. If output were less, the benefit from consuming more
would exceed the cost of producing it. If output were higher, the cost of producing the extra units
would exceed the extra benefits. So the point where supply equals demand is “efficient”.
However, the conditions for market efficiency are extremely demanding—far too demanding
ever to be met in the real world. The theory requires “perfect competition”: there must be many
buyers and sellers; goods from competing suppliers must be indistinguishable; buyers and sellers
must be fully informed; and markets must be complete—that is, there must be markets not just
for bread here and now, but for bread in any state of the world. (What is the price today for a loaf
to be delivered in Timbuktu on the second Tuesday in December 2014 if it rains?)

1.5 Scope of Managerial Economics

From the point of view of a firm, managerial economics, may be defined as economics applied to
“problems of choice” or alternatives and allocation of scarce resources by the firms. Thus
managerial economics is the study of allocation of resources available to a firm or a unit of
management among the activities of that unit. Managerial economics is concerned with the
application of economic concepts and analysis to the problem of formulating rational managerial
decisions. There are four groups of problem in both decisions-making and forward planning.

Resource Allocation: Scare resources have to be used with utmost efficiency to get optimal
results. These include production programming and problem oftransportation etc. How does
resource allocation take place within a firm?Naturally, a manager decides how to allocate
resources to their respective useswithin the firm, while as stated above, the resource allocation
decision outside thefirm is primarily done through the market. Thus, one important insight you
can drawabout the firm is that within it resources are guided by the manager in a mannerthat
achieves the objectives of the firm.

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Inventory and queuing problem: Inventory problems involve decisions aboutholding of

optimal levels of stocks of raw materials and finished goods over aperiod. These decisions are
taken by considering demand and supply conditions.Queuing problems involve decisions about
installation of additional machines orhiring of extra labor in order to balance the business lost by
not undertaking theseactivities.

Pricing Problem: Fixing prices for the products of the firm is an importantdecision-making
process. Pricing problems involve decisions regarding variousmethods of prices to be adopted.

Investment Problem: Forward planning involves investment problems. These areproblems of

allocating scarce resources over time. For example, investing in newplants, how much to invest,
sources of funds, etc.

Study of managerial economics essentially involves the analysis of certain majorsubjects like:

 The business firm and its objectives

 Demand analysis, estimation and forecasting
 Production and Cost analysis
 Pricing theory and policies
 Profit analysis with special reference to break-even point
 Capital budgeting for investment decisions
 Competition.

Demand analysis and forecasting help a manager in the earliest stage in choosingthe product and
in planning output levels. A study of demand elasticity goes a longway in helping the firm to fix
prices for its products. The theory of cost also essential part of this subject. Estimation is
necessary for making output variations with fixed plants or for the purpose of new investments in
the same line of production or in a different venture. The firm works for profits and optimal or
near maximum profits depend upon accurate price decisions. Theories regarding price
determination under various market conditions enable the firm to solve the price fixation
problems. Control of costs, proper pricing policies, break-even analysis, alternative profit
policies are some of the important techniques in profit planning for the firm which has to work

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under conditions of uncertainty. Thus, managerial economics tries to find out which course is
likely to be the best for the firm under a given set of conditions.

Dear learner! Please do the following activity

Activity

1. Development of managerial economics is the result of close interrelationship between

management and economics. Discuss.
2. Why is decision making by any management truly economic in nature?

1.6 Managerial Economics and Other Disciplines

Managerial economics is linked with various other fields of study.

Microeconomic Theory: As stated in the introduction, the roots of managerialeconomics spring

from micro-economic theory. Price theory, demand concepts andtheories of market structure are
few elements of micro economics used bymanagerial economists. It has an applied bias as it
applies economic theories inorder to solve real world problems of enterprises.

Macroeconomic Theory: This field has little relevance for managerial economicsbut at least
one part of it is incorporated in managerial economics i.e. nationalincome forecasting. The latter
could be an important aid to business conditionanalysis, which in turn could be a valuable input
for forecasting the demand forspecific product groups.

Operations Research: This field is used in managerial economics to find out thebest of all
possibilities. Linear programming is a great aid in decision making inbusiness and industry as it
can help in solving problems like determination offacilities on machine scheduling, distribution
of commodities and optimum productmix etc.

Theory of Decision Making: Decision theory has been developed to deal withproblems of
choice or decision making under uncertainty, where the applicability offigures required for the
utility calculus are not available. Economic theory is based onassumptions of a single goal
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whereas decision theory breaks new grounds byrecognizing multiplicity of goals and
persuasiveness of uncertainty in the real worldof management.

Statistics: Statistics helps in empirical testing of theory. With its help, betterdecisions relating to
demand and cost functions, production, sales or distribution aretaken. Managerial economics is
heavily dependent on statistical methods.

Management Theory and Accounting: Maximisation of profit has beenregarded as a central

concept in the theory of the firm in microeconomics. Inrecent years, organisation theorists have
talked about “satisfying” instead of“maximising” as an objective of the enterprise. Accounting
data and statementsconstitute the language of business. In fact the link is so close that
“managerialaccounting” has developed as a separate and specialized field itself.

Dear learner! Please do the following activity

Activity

How is managerial economics related with other disciplines?

1.7 Economic Analysis

Economic activity is the constant effort to match ends to means because of scarcity of resources.
The optimal economic activity is to maximize the attainment of ends, the means and their
scarcities or to minimize the use of resources, given the ends and their priorities. Decision
making by management is truly economic in nature because it involves choices among a set of
alternatives - alternative courses of action. The optimal decision making is an act of optimal
economic choice, considering objectives and constraints. This justifies an evaluation of
managerial decisions through concepts, precepts, tools and techniques of economic analysis of
the following types:

Micro and Macro Analysis: In micro-analysis the problem of choice is focused on single
individual entities like a consumer, a producer, a market etc. Macro analysis deals with the
problem in totality like national income, general price level etc.

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Partial and General Equilibrium Analysis: To attain the state of stable equilibrium, the
economic problem may be analyzed part by part - one at a time -assuming “other things
remaining the same.” This is partial equilibrium analysis. In general equilibrium analysis the
assumption of “given” or “other things remaining equal” may be relaxed and interdependence or
interactions among variables maybe allowed.

Static, Comparative Static and Dynamic Analysis: This is in reference to timedimension. A

problem may be analysed

- allowing no change at a point of time (static)

- allowing once for all change at a point of time (comparative static)

- allowing successive changes over a period of time (dynamic).

Positive and Normative Analysis: In positive economic analysis, the problem isanalyzed in
objective terms based on principles and theories. In normative economic analysis, the problem is
analyzed based on value judgment (norms). In simple terms, positive analysis is ‘what it is’ and
normative analysis is ‘what itshould be.’ For example, CEOs in private Indian enterprises earn
15 times as much as the lowest paid employee is a positive statement, a description of what is. A
normative statement would be that CEOs should be paid 4-5 times the lowest paid employee.

Dear learner! Please do the following activity

Activity

Discuss the different types of economic analysis.

Self-Assessment Questions

1. Discuss the nature and scope of managerial economics.

2. Managerial economics is the integration of economic theory with business practice for
the purpose of facilitating decision-making and forward planning by manager”. Explain
and comment.

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3. Define scarcity and opportunity cost. What role do these two concepts play in the making
of management decisions?
4. Managerial economics is often said to help the business student integrate the knowledge
gained in other courses. How is this integration accomplished?
5. Justify that managerial economics is economics applied in decision-making.
6. What is the role of managerial economics in preparing managers?
7. Explain how managerial economics is similar to and different frommicroeconomics.
8. Explain why the concept of scarcity is central to the study ofeconomics.
9. The opportunity cost of any decision includes the value of all relevantsacrifices, both
explicit and implicit. Do you agree? Explain.

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UNIT TWO: FUNDAMENTAL ECONOMIC CONCEPTS

Unit Objectives

After successful completion of this unit, you will be able to:

 Discuss some important concepts of demand and supply

 Identify the relationship between demand and supply
 Discuss the concept of marginal cost, marginal revenue, marginal output, and
marginal revenue product
 Discuss the time value of money

Unit Introduction

Managerial economics is the synthesis of microeconomic theory and quantitative methods to find
optimal solutions to managerial decision making problems. In this unit, we will demonstrate
how presumably quantifiable economic functional relationships involving one dependent
variable and one or more explanatory variables may be used to predict market-clearing prices in
idealized, perfectly competitive markets. Students who have made it this far in their economic
studies have already been exposed to the market paradigm of demand and supply. While the
principles of demand and supply presented in this unit may be familiar, the manner in which this
material is presented may not be. The discussion that follows establishes the procedural
framework for much of what is to come.

The basic market paradigm presented in this unit is a stylized version of what occurs in the real
world. The model is predicated on a number of assumptions that are rarely, if ever, satisfied in
practice, including perfect and symmetric information, market transactions that are restricted to
private goods and services, and that no market participants having market power. When there is
“perfect and symmetric information,” all that is knowable about the goods and services being
transacted are known in equal measure by all market participants. For markets to operate
efficiently, both the buyer and the seller must have complete and accurate information about the
quantity, quality, and price of the good or service being exchanged. Asymmetric information
exists when some market participants have more and better information about the goods and
services being exchanged. Fraud can arise in the presence of asymmetric information. In extreme
cases, the knowledge that some market participants have access to privileged information may
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result in a complete breakdown of the market, such as might occur if it became widely believed
that stock market transactions were dominated by insider trading.

Goods and services are said to be “private” when all the production costs and consumption
benefits are borne exclusively by the market participants. That is, there are no indirect, third-
party effects. Such third-party effects, called externalities, may affect either consumers or
producers. The most common example of a negative externality in production is pollution.
Finally, “market power” refers to the ability to influence the market price of a good or service by
shifting the demand or supply curve.

A violation of any of the three assumptions just given could lead to failure of the market to
provide socially optimal levels of particular goods or services. When this occurs, direct or
indirect government intervention in the market may be deemed to be in the public’s best interest.

2.1 Equilibrium Analysis: Supply And Demand Relationship

2.1.1. Demand
Demand is an important concept studied in economics. In ordinary usage, demand means desire
of individuals to buy commodity. But in economics it has a special meaning. Mere desire for a
commodity does not considered “demand” in economics.

Definition

Demand can be defined as” quantities of a good/service that people are willing to buy at different
prices”. Demand always refers to a particular price, place and time. Demand has no meaning
when the price of commodity, place its purchase and time were not mentioned. The reason is that
demand changes with a change in price, place and time. Hence demand has a special meaning
and usage in economics.

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2.1.1.1. Law of Demand

The law of demand denotes the quantitative and inverse relationship between the quantity
demanded and its price. According to this law if the price increases, the quantity demanded will
decrease and if the price decreases, the quantity demanded will increase

This means;

 People will buy more quantity of good when the price is less.
 People will buy less quantity of good when the price is high.
 Demand is the buyers’ side of market.

Hypothetical Law of Demand Schedule

Series1, 1,
QUANTITY DEM ANDED

25
Series1, 2,
Quantity
Price 20
Demanded Series1, 3,
15
Series1, 4,
1 25 10
Series1, 5,
2 20 5
PRICE

3 15

4 10

5 5

But it is based on important assumptions. Those assumptions are customer Taste and Preference,
Population, Discovery of substitutes, Income, Price of other goods and Weather conditions. The
law of demand assumes that these conditions never change/ remain constant. If these conditions
change the law does not hold good. For example: if the peoples’ income falls down drastically

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due to draught (especially farmers) people may not be able to buy more quantities of goods even
if the price is less as they do not have enough money to buy

2.1.2. Supply

Like demand, supply also based on certain assumption. Depending the demand and competitive
conditions, the producers arrange their inputs to cater to the requirements of market. Both supply
and demand are essential for the determination of price. These are the two important terms used
in economics. The demand analysis is the buyer side of market, when the supply analysis seller
side of market.

Definition

Supply can be defined as “quantities of a good/service that people are willing to sell at different
prices”.

2.1.2.1. Law of Supply

The law of supply denotes the quantitative and direct relationship between the quantity supplied
and its price. According to this law;

 If the price increases, the quantity supplied will increase

 If the price decreases, the quantity supplied will decrease

This means:

 People will sell more quantity of good when the price is high.
 People will sell less quantity of good when the price is low.
 Supply is the sellers’ side of market.

But it is based on important assumptions. Most of the assumptions of law of demand are
applicable to law of supply. Besides these, there are some other assumptions such as Changes in
the price of inputs, Changes in technology, Number of sellers in the market, Government
Policies, Natural Causes, Strikes (Bands and lockouts). The law of supply assumes that these
conditions never change/ remain constant. If these conditions change the law does not hold good.
For example: if the there is a flood, it will effect on the supply of goods. In this situation even the
price is high also people may not be able to supply more.

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Hypothetical Supply Schedule

LAW OF SUPPLY CURVE

Hypothetical law
of supply schedule Series1, 5, 25

QUNTITY SUPPLIED
Series1, 4, 20
Quantity
Price Series1, 3, 15
Supplied
Series1, 2, 10
1 5
Series1, 1, 5
2 10
PRICE

3 15

4 20

5 25

2.2. Equilibrium

In an ordinary language, equilibrium is nothing but “a state of balance-especially between

opposing forces. In terms of economics, equilibrium is a state of balance between two economic
variables. Equilibrium can be defined as “quantity demanded and quantity supplied are equal at a
given price is called equilibrium”

Analysis of hypothetical equilibrium schedule:

a) According to the table , as the price increase quantity demanded decreases,

quantity supplied increases
b) The quantity demanded and quantity supplies are equal at the price of 3/-
c) At the price of 3/- the quantity demanded is 15 and the quantity supplied is 15. It
is called equilibrium position.

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EQUILIBRUIM CURVE
Hypothetical
Equilibrium Schedule Series1, 1, Series2, 5,
25 25

Series1, 2, Series2, 4,
Quantity Quantity 20 20
Price
Demanded Supplied
Series2, 3,
Series1,
15
1 25 5

2 20 10 QUANTITY DEMENDED/SUPPLIED Series2, 2, Series1, 4,

10 10

3 15 15
Series2, 1, Series1, 5,
5 5
4 10 20

5 5 25

Price

a) Only, at the equilibrium position that all buyers and sellers are satisfied i.e. the
market is cleared.
b) At the higher prices, market surplus exists, which means the quantity supplied is
more than quantity demanded. (SS>DD)
c) At the lower prices, market shortage exists, which means the quantity supplied is
less than quantity demanded. (SS<DD)
d) In the case surplus, there is competition among sellers. Thus, sellers will lower
the price to get rid of the surplus.
e) In the case of shortage, there is a competition among buyers. Thus, potential
buyers will push price as there is shortage.

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2.2.1 Marginal Analysis

Marginal analysis is the corner stone of modern economic analysis. Marginal analysis is about
marginal costs & benefits. Marginal costs & benefits are incremental costs & benefits that are
associated with making a decision. So these are important in economics and managerial decision
making. Marginal costs & benefits are typically defined as “changes in costs and benefits are
associated with very small changes in a decision variable. Whenever manager takes a decision, a
question should be raised. Is it worthwhile? That means Marginal benefits of a particular action
should exceed its marginal costs.

Concept of Margin: The concept of margin is central to economic analysis. The following are
the marginal concepts.

1. Marginal Cost
2. Marginal Revenue
3. Marginal Output/Physical Product
4. Marginal Revenue Product
These are all cut from the same cloth, so to speak. Let’s define each.

1. Marginal Cost
Marginal Cost is the cost incurred by producing one additional/more unit of output.

Hypothetical Marginal Cost Schedule

Output Total Fixed Cost Total Variable Cost Total Cost Marginal Cost

0 100 0 100 0

1 100 30 130 30

2 100 54 154 24

3 100 72 172 18

4 100 96 196 24

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5 100 150 250 54

6 100 216 316 66

7 100 320 420 104

Marginal cost = changes in total cost/Changes in output quantity

2. Marginal Revenue:

Marginal Revenue is the revenue obtained by selling one additional/more unit of output

Hypothetical Marginal Revenue Schedule

Quantity Sold Price Total Revenue Marginal Revenue

1 20 20 20

2 20 40 20

3 20 60 20

4 20 80 20

5 20 100 20

6 20 120 20

7 20 140 20

Marginal Revenue = changes in total revenue/Changes in quantity sold

3. Marginal Output/Physical Product

Marginal Output/Physical Product is the output produced by using one additional/more unit of
input.

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Hypothetical Marginal Output/Physical Product Schedule

Units of Input Total Output Marginal Output

1 15 15

2 29 14

3 41 12

4 51 10

5 58 07

6 62 04

7 63 01

8 63 00

9 62 -01

10 60 -02

Marginal output/physical product = changes in total output/Changes in quantity input

4. Marginal Revenue Product

Marginal Revenue Product is the additional revenue obtained by selling the output produced by
using one additional/more unit of input.

Hypothetical Marginal Revenue Product Schedule

Units Total Price Total Marginal

of Output (Per Unit) Revenue Revenue
Input Product

1 15 10 150 150

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2 29 10 290 140

3 41 10 410 120

4 51 10 510 100

5 58 10 580 070

6 62 10 620 040

7 63 10 630 010

8 63 10 630 000

9 62 10 620 -010

10 60 10 600 -020

Marginal Revenue Product = changes in total revenue/Changes in quantity input

Marginal revenue measures the changes in total revenue that occurs when one additional worker
is hired.

These marginal concepts help us to figure out exactly;

 What price we should charge

 What output we should produce
 What mix of resources we should use In order to maximize our profits?

2.3. Time Value of Money

The time value of money very well reflected to the proverb “a bird in the hand is more valued
than two birds in the bush”. In general, the value of money today is valued more than the value
of money tomorrow. No doubt the cash in hand at present is valued more because, it gives

 Liquidity

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 An opportunity to invest it and earn return (interest) on it.This is called the time value of
money.

Example: suppose that a sum of Birr 100/- held in cash today is deposited in a bank at 10% rate
of interest. After one year, Birr 100/- today will increase to 110/-. The amount (principle +
interest)

100+100(10/100)

100+100(0.1)

100+10

110.

As the time changes the value of money also changes. The term value of money is also
understood with its purchasing power.

In the 1st year Birr 100/- can buy quantity of goods X

In the 2nd year Birr 100/- can buy quantity of goods (X-20%)

We may conclude that the value of money has fallen in the 2nd year as it could purchase less
quantity of goods.

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Self-Assessment Questions

1. Define each of the following terms using your own words.

a. Demand
b. Supply
c. Marginal cost
d. Marginal revenue
2. What does it mean time value of money?
3. Explain the law of Demand and Supply.
4. What is Equilibrium?
5. Discuss the relative importance of marginal analysis for managerial decision making.
6. Discuss the four types of marginal concepts with example.

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UNIT THREE

BASIC OPTIMIZATION TECHNIQUES

Unit Objectives

After studying this unit, you should be able to:

 Identify a wide range of techniques used in managerial economics;

 Apply the techniques to understand the meaning of the results;
 Identifythe strengths and weaknesses of the different methods.
 Explain the difference between constrained and unconstrained optimization

Introduction

The manager needs various techniques to assist and help him in making decisions that will
ultimately maximise the value of the firm. These techniques and tools are quantitative in nature.
The introduction of some commonly used tools used inmanagerial decision making becomes
imperative.An optimization technique is a technique of maximizing or minimizing a function. In
smile words, it is a technique of finding the value of the independent variables(s) that maximizes
or minimizes the value of the dependent variable. For example, some firms may be interested in
finding the level of output that maximizes their total revenue; some firms facing a constant price
may want to find the level of output that would minimize the average cost; and most important of
all, most firms may be interested in finding the level of output that maximizes their profits. In
this unit we are going to discuss some basic techniques which would be helpful inunderstanding
the concept of managerial economics, in turn helping us to applythese techniques as and when
required.

3.1Optimisation Concept

Optimization is the act of choosing the best alternative out of the available ones. It describes how
decisions or choices among alternatives are taken or should be made. All such optimisation
problems have 3 elements:

a) Decision Variables: These are variables whose optimal values have to be determined. For
example, a production manager wants to know at what level to set output in order to achieve

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maximum profit or maximum sales revenue. Here output is the decision or choice variable.
Similarly labour, machine, time and raw materials are choice variables if a works manager wants
to know what amount of these are to be used so as to produce a given output level at minimum
cost.The quantity of any choice variable must be measurable (20kg, 5 labourers, 10 hours, etc.).

b) The Objective Function: It is a mathematical relationship between the choice variables and
some variables whose values are to be maximised or minimised. For example, the objective
function could relate profit to level of output or cost to amount of labour, machine, time, raw
materials, etc. in the above example.

c) The Feasible Set: The available set of alternatives is called a feasible set. A solution to an
optimisation problem is that set of values of the choice variables which is in the feasible set and
which yields maximum or minimum of the objective function over the feasible set.

3.1.1 Unconstrained Optimization Technique

For unconstrained optimization problem involving single independent variable, we need to

satisfy some “conditions”. In economics, the necessary (first order) condition is called the
equilibrium condition and sufficient (second order) condition is called the stability condition
(continuation of state of equilibrium). There may be equilibrium but it may not be stable. Thus
first order condition does not guarantee second order condition. This is summarized in Table 3.1.

Table 3.1: Optimization Conditions

Order Conditions Optimisation Unconstrained

First order Necessary Conditions Maximisation Maximisation

= 0 = 0

Second order Sufficient Conditions < 0 < 0

Y = y (x) (assumed)

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Some economic uses of these conditions are discussed below. Given a firm’s demand function, P
= 45 – 0.5 Q and the average cost function, AC = Q2 – 8Q + 57 + 2/Q, we have to find the level
of output Q which

a) maximises total revenue

b) maximises profits.

Solution

a) Since demand function is P = 45 – 0.5Q the total revenue function will be, TR = PQ = (45
– 0.5Q) Q = 45 – 0.5Q2
To maximise TR, we find the derivative and set it to 0 (the first order or necessary
condition)
Now,dQ

dR

= 45 – 2 (0.5) Q

= 45 – Q = 0

Q = 45
The second order condition (sufficient condition) needs ⁄ to be negative

Since =45-Q

=-1

Which is negative. Hence total revenue is maximised when output is 45 units.

b) From profit function

p =TR – TC

TC = (AC) x Q

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= (Q2 – 8Q + 57 + 2/Q) Q = Q3 – 8Q2 – 57Q + 2

TR = (45 – 0.5 Q) Q

= 45 Q – 0.5 Q2

After substituting TR and TC, we get

p = 45Q – 0.5Q2 – Q3 + 8Q2 – 57Q – 2

dp/dQ = 45 – Q – 3Q2 + 16Q – 57

= –3Q2 + 15 Q – 12

Now set =0

–3Q2 + 15Q – 12 = 0

Dividing by –3

Q2 – 5Q + 4 = 0

or (Q – 4) (Q – 1) = 0

Q = 4 or 1

3.1.2 Constrained Optimization

The maximization techniques discussed above can be called unconstrained optimization

techniques, hence that they assume that firms operate under no constraints on their activity. For
example, in the case of output maximization, firms face no resource constraints: they possess
unlimited resources and can acquire all the inputs, finance, capital equipment, men and raw
materials that they need to maximize output. Some is the case with cost minimization technique.
The firms have all the resources to carry out production activity until average cost is minimized
or cost for a given output is minimized. In the real business world, however, the managers face
serious resource constraints. For example, they need to maximize output with given quantity of
capital and labor time. The technique that is used to optimize the business objective(s) under
constraintsare called constrained optimization techniques. There are three very common

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techniques of constrained optimization, linear programming, constrained optimization by

substitution and Lagrangian multiplier. The linear programming technique has a wide range of
application and is a subject in itself. It has been discussed in some detail with reference to
constrained output maximization. Here, we discuss the two other important techniques of
constrained optimization.

3.1.2.1 Constrained Optimization By Substitution Technique

We will illustrate the application of substitution method of constrained optimization problem to

profit maximization and a cost minimization problem.

i. Constrained profit maximization; let us recall our earlier example of profit

maximization given, reproduced below as Eq. (3.1) for ready reference.
= 100X – 2X2 = XY + 180Y – 4Y2-------------------------(3.1)

We have illustrated above maximization of this profit function without any constraint. That is,
the independent variables, X and Y, were free to take any value in the profit, maximization
solution.

Here we illustrate the maximization of the same profit function with a constraint on output that
the sum of X and Y must be equal to 30 (instead of 40 as in the solution without constraints).
That is,

X + Y = 30---------------------------------------------------------(3.2)

A constrained problem of this kind can be solved by substitution method as illustrated below.
The process of solution involves two steps: (i) express one of the variables in terms of the other
and solve the constraint equation for one of the variables (X or Y) and (ii) substitute the solution
into the objective function to be maximized and solve it for the other variable.

Given the constraint Eq. (3.2), the values of X and Y can be expressed interims of one another as
follows.

X = 30 – Y

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Y = 30 – X

We can now substitute the value of X (or Y) into Eq. (3.1) and find the maximization solution.

By substituting the value of X, the profit function (3.1) can be expressed as

= 100(30 – Y) – 2(30 – Y)2 – (30 – Y)Y + 180

= 3000 – 100Y – 2(900 – 60Y + Y2) – 30Y + Y2 + 180Y – 4Y2

= 3000 – 100Y – 1800 +– 120Y - 2Y2 –2Y2 - 30Y + Y2 + 180Y – 4Y2

= 1200 + 170Y – 5Y2 ----------------------------------------(3.3)

Note that the substitution method converts a constrained problem into an unconstrained one can
now be maximized by obtaining its derivative and setting it equal to zero and solving it or Y.

Thus, = 170 – 10 Y -------------------------------------------(3.4)

By setting Equation equal to zero, we get

170 – 10Y = 0

Y = 17

By substituting 17 for Y in constraint Eq. we get

X = 17 = 30

X = 13

Thus, the optimum solution of the profit maximization problem is X = 13 and & = 17. These
values of X and Y satisfy the constraint. In simple words, we get the optimization solution that
the firm maximizes its profit by producing 13 units of X and 17 units of Y. the answer will be the
same if we substitute 30 – X for Y and solve the equation for X.

Now let us compute the maximized profit under constraints. This can be done by substituting the
values of x and Y into the profit function. By substitution, we get.

= 100(13) – 2(13)2 – (13)(17) + 180(17) – 4(17)2

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= 2645

Note that maximum profit ($2,645) under constraint is less than the maximum profit
under no constraint ($2,800)

ii. Constrained cost minimization- let us now apply the substitution method of
optimization to a problem of constrained cost minimization. suppose that the cost
function of a firm producing two goods X and Y, is given as

TC = 2X2 – XY + 3Y2

And the firm has to meet a combined order of 36 units of the two goods. The manager’s problem
is to find an optimum combination of X and Y that minimizes the cost of production. The
problem can be restated formally as

Minimize TC = 2X2 – XY + 3Y2

Subject to X + Y = 36

Substitution method requires that the constraint equation is expressed in terms of any one of the
two goods and then substituted into the objective function. By expressing X in terms of Y, we
get

X = 36 – Y

By substituting for X in the objective function, we get

TC = 2(36-Y)2 (36 – Y)Y + 3Y2

= 2(1296 = 2Y + y2) – 36Y + Y2 + 3Y2

= 2592 – 144Y + 2Y2 – 36Y + Y2 + 3Y2

= 2592 – 180Y + 6Y2

For the objective function to be minimized, its first derivative must be set to zero. Thus,

Solving for Y, we get

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12Y = 180

Y = 15

By substituting the value of Y in the constraint Eq. we get

X + 15 = 36

X = 21

Thus, we get the optimum solution that X = 21 and Y = 15 minimize the cost of meeting the
order. The minimum cost of producing 21 units of X and15 units of Y can be obtained by
substituting these values in cost function.

Minimum cost = 2(21)2 – (21) (15) + 3 (15)2

= 882 – 315 + 675

= $1,242

3.1.2.2Constrained Optimization By Lagrangian Multiplier Method

The other method of solving constrained optimization problems is the Lagrangian multiplier
method. This method is used to solve the optimization problems of a complex nature and those
which cannot be solved by the substitution method. We will, however, illustrate the Lagrangian
multiplier method in respect of

I. A constrained profit maximization problem, and

II. A constrained cost minimization problem

I. Constrained profit maximization to illustrate reapplication of the Lagrangian multiplier to

solve a profit maximization problem, we will use the profit function given in Eq. with some
constraint imposed.
Let us restate the problem as
Maximize = 100X – 2X2 – XY + 180 – 4Y2

Subject to the constraint X + Y = 30

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The basic approach of the Lagrangian multiplier method is to form a Lagrangian function by
combining the objective function and the constraint equation and then solve it by the partial
derivative method. There is a simple technique of formulating the Lagrangian function. First, set
the constraint equation equal to Zero, i.e.

X + Y – 30 = 0

Second, multiply the resulting equation by (the Greek letter ‘lambda’), i.e.

(X + Y – 30)

And, finally, add the resulting equation to the objective function. Thus, the Lagrangian function
is formed as

L = 100X – 2X2 – XY + 180Y – 4Y2 + (X + Y – 30)

The unconstrained lagrangian function with three unknown, X,Yand . The values of X, Y and

that maximize L maximize also. The Greek letter is the Lagrangian multiplier. It gives the
measure of a small change in the constraint on the objective function.

What we need to do to maximize theL function is to obtain the partial derivative of L with
respect to X, Y and and set each of them equal to zero. This will give us the first order condition
of profit maximization in the form of three simultaneous equations, as shown below.

By solving the simultaneous equations, we get the values of X, Y and that maximize the
objective function. In order to solve these equations for X, Y and we need to reduce the three
simultaneous equationsbelow to two equations. To do this, let us rearrange the terms. By
subtracting we get,

100 – 4x y + =0

180 – x 8y + =0

-80 – 3x 7y – 80 = 0
Now we have two simultaneous equations. Using the method of solving the simultaneous
equations, we multiply Eq. by 3 and add it to Eq. Then we get,

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3x + 3 y - 90 = 0

-3x +3 x 7y – 80 = 0

10y – 170 = 0

X = 17

By substituting 17 for y in the constraint Eq., we get the value of X as

Or X + 17 = 30

X = 13

Note that the values of X and Y are the same as computed above.

The value of can be obtained by substituting the values of X and Y

-13 + 180 – 8(17) + =0

= - 31

The value of has an important economic interpretation. It gives the measure of the change in
the total profit when the output constraint is changed by 1 unit. For example, it output is
increased by 1 unit, i.e., from 30 to 31 units, profit will increase by about 31 ad if output is
decreased by 1 unit, i.e., from 30 to 29 units the profit will decrease by about 31.

II. Constrained cost minimization suppose XYZ company, a carpet manufacturing and exporting
firm, has to supply an order for 500 pieces of woolen carpets of two varieties X and Y to a
German buyer. The joint cost function for the two varieties of carpets is given as
Minimize C = 100 X2 + 150 y2

Subject to X+Y=

In order to solve the cost minimization problem by Lagrangian multiplier method, the problem
has to be converted into a Lagrangian function. The procedure is to set the constraint Eq. equal to

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zero, multiply it by and add the result to the objective function. The cost minimization problem
converted into the Lagrangian function is given below.

Minimize Lc = 100X2 + 150y2 (500 – x – y)

Subject to 500 - X - Y = 0

The objective here is to minimize Eq. subject to x + y = 500 the first order condition of the
solution requires that the derivative of Lc with respect to X, Y and is set equal to zero.

Thus the minimum cost of supplying 500 pieces of woolen carpets works out to $15 million.
This is the minimum cost because any other combination of X and Y varieties of carpets will
make the cost exceed $15 million.

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Self-AssessmentQuestions

1. Economic optimization involves maximizing an objective function, which may or may

not be subject to side constraints. Do you agree with this statement? If not, why not?
2. A transport company plans to ship tourists between Addis Ababa and MizanTeferi. It has
its cost function estimated as given below;
TC = 100 + 50N + 4N2

Where N denotes number of passengers per day. Then find;

a. The average function;

b. Number of passengers per day that minimizes the average cost.
3. Suppose a firm has its TR and TC functions estimated as follows;

TR= 300Q – 3Q2

TC = 500 + 50Q + 2Q2

Then find;

a. Profit function of the firm,

b. The quantity of output (Q) that maximizes the firm’s profit.
4. A company produces two goods X and Y. the profit function of the company is given as
follows;
P = 100x – 2x2 – xy + 180y – 4y2
The company is under obligation to produce a minimum combined output of 30 units.
Find the output of x and y subject to a total of 30 units that maximize total profit by using
both substitution and Lagrangian multiplier methods.
5. Suppose that the manger of a firm is planning to meet an order of 1000 units of two
products X and Y. the manger’s problem is to find the combination of two goods that
minimize its cost. He has the firm’s cost function of two goods estimated as C = 5x2 + 20
y2

By using the Lagrangian multiplier method, find the quantity of X and quantity of Y,
subject to X + Y = 1000, that minimize the cost of meeting the order.

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UNIT FOUR: ANALYSES OF DEMAND AND DEMAND ELASTICITY

Unit Objectives

After studying this unit, you should be able to:

 Define demand and its determinants;

 Describe the different types of demand
 Explain the law of demand;
 Identify differences between firm’s demand curve and market demand curve.
Introduction

Demand refers to the quantities of goods that consumers are willing and able to purchase at
various prices during a given period of time. For your demand to be meaningful in the
marketplace you must be able to make a purchase; that is, you must have enough money to make
the purchase. There are, no doubt, many items for which you have a willingness to purchase, but
you may not have an effective demand for them because you don’t have the money to actually
make the purchase. For example, you might like to have a 3600-square-foot resort in Mussorie,
an equally large beach house in Goa, and a private jet to travel between these places on
weekends and between semesters. But it is likely that you have a budget constraint that prevents
you from having these items. For demand to be effective, a consumer must also be willing to
make the purchase.

There are many products that you could afford (that is, you have the ability to buy them), but for
which you may not be willing to spend your income. Each of us has a unique perspective on our
own personal satisfaction and the things that may enhance that satisfaction. The important point
is that if you do not expect the consumption of something to bring you added satisfaction, you
will not be willing to purchase that good or service. Therefore, you do not have a demand for
such things despite the fact that you might be able to afford them. When we discuss demand, we
are always referring to purchases made during a given period of time.

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4.1The Demand Function

The demand function sets out the variables, which are believed to have an influence on the
demand for a particular product. The demand for different products may be determined by a
range of factors, which are not always the same for each of them. The presentation in this section
is of a generic demand function which includes some of the most common variables that affect
demand. For any individual product, however, some of these may not apply. Thus, any attempt
by the firm to predict demand for a product on the basis of the demand function will require
some initial knowledge, or at least informed guesswork, about the likely influences on it.

The demand function can be written as:

Qd = f (Po, Pc, Ps, Yd, T, A, CR, R, E, N, 0)

The first three variables in the function relate to price. They are the own price of the product
(Po), the price of complements (Pc) and the price of substitutes (Ps) respectively. In the case of
the own price of a good, the expected relationship would be, the higher the price the lower the
demand, and the lower the pricethe higher the demand. This is the law of demand which is
explained in greater detail in the next section. In the case of complements, if the price of
complementarygoodsincreases, we would expect demand to fall both for it and for the good that
it is complementary to. This is the case as fewer people would now wish to buy either good
given that the complementary good is now more expensive and this has the effect of reducing
demand for the other good as well. In contrast, if the price of a substitute good rises, then
demand for the good that it is a substitute for would be expected to rise as people switched to
buying the latter rather than its more expensive substitute. Complements and substitutes are also
explained in detail later on.

The fourth variable in the demand function, Yd stands for disposable income, that is, the amount
of money available to people to spend. The greater the level of disposable income, the more
people can afford to buy and hence the higher the level of demand for most products will be.
This assumes of course that they are ‘normal’ goods, purchases of which increase with rising
levels of income, as opposed to ‘inferior’ goods that are purchased less frequently as income

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rises. The use of disposable income rather than just income is justified on the grounds that people
do not have total control over their gross incomes. There will, for example, be deductions to be
made in the form of taxes. Thus the level of disposable income can change over time, for
example changes in tax rates. The effect of changes in disposable income on the demand for
individual products will of course be determined by the ways in which it is spent. This is where
the fifth variable, tastes (T), needs to be taken into account.

Over a period of time, tastes may change significantly, but this may incorporate a wide range of
factors. For example, in case of food, greater availability of alternatives may have a significant
effect in changing the national diet. Thus, in India for instance, the demand for bajra has fallen
over the past 10 years as people have switched to eating rice and wheat instead. Social pressures
may also act to alter tastes and hence demand. For example, tobacco companies have been forced
to seek new markets as smoking has become less socially acceptable in the USA and Western
Europe, thus reducing demand in these areas. Changes in technology may also have an impact.
For example, as the demand for colour televisions increased, the demand for black and white
televisions fell as tastes changed and the latter were deemed to be inferior goods. Thus there are
a number of ways in which tastes may change over time. The next set of variables, the A
variable, relates to levels of advertising, representing the level of own product advertising, the
advertising of substitutes and the advertising of complements respectively. The relationships here
are as follows.

In general, the higher the level of own advertising for a good, the higher demand for that good
would be expected, other things being constant. Likewise, the higher the level of advertising of a
complementary good, the higher the demand for it and the good(s) which it is complementary to
will be, given their symbiotic relationship. Conversely, however, the higher the level of
advertising of a substitute good, the lower the demand for the good for which it is an alternative
and people buy more heavily promoted good. The overall effect of advertising will depend on the
extent to which each of these forms of advertising is used at any given point of time as they may,
at least in part, cancel each other out. This is something the firm will also need to know in order
to determine its optimal advertising strategy.

The variablesCR and R are also related. The former represents the availability of credit while
the latter represents the rate of interest that is the price of credit. These variables will be most

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important for purchases of consumer durable goods, for example cars. Someone’s ability to buy a
car will depend on his or her ability to raise money to pay for it. This means that the easier credit
is to obtain, the more likely they are to be able to make the purchase. At the same time credit
must be affordable, that is the rate of interest must be such that they have the money to pay.
These two variables have traditionally been regarded as exogenous to the firm that is, they
cannot be ‘controlled’ by it. In recent years, however, major car manufacturers have increasingly
sought to bring them under their control through the provision of finance packages.

The letter E in the demand function stands for expectations. This may include expectations about
price and income changes. For example, if consumers expect the price of a good to rise in future
then they may well bring forward their purchases of it in order to avoid paying the higher price.
This creates an increase in demand in the short term, but over the medium term, demand may fall
in response to the higher price charged. The firm will need to adjust its production accordingly.
An example of this might be when increased taxes are expected to be levied on particular goods,
for example an increase in excise duties on alcohol or cigarettes, as is usually the case after the
Central Budget. Consumers of these products may buy more of them prior to the implementation
of the duty increases in order to avoid paying the higher prices arising from the higher level of
duties. Alternatively, expectations about incomes may be important. For example, people who
expect their incomes to rise may buy more goods, whereas those who expect their incomes to fall
will buy less. At the level of the individual consumer this may not be significant but when
aggregated across a country’s population it can be. Thus during a boom in the economy the
additional expected purchasing power of consumers will lead to increases in demand for a
significant number of products. Conversely, the expectation that incomes will fall, perhaps as a
result of redundancy during a recession, will reduce demand as consumers become more
cautious.

The variable N stands for the number of potential customers. Each product is likely to have a
target market, the size of which will vary. The number of potential customers may be a function
of age or location. For example, the number and type of toys sold in a particular country will be
related to its demographic spread, in this case the number of children within it and their ages.

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Finally, we come to 0 which represents any other miscellaneous factors which may influence the
demand for a particular product. For example, it could be used to represent seasonal changes in
demand for a particular product if demand is subject to such fluctuations rather than spread
evenly throughout the year. Examples of such products might include things such as umbrellas,
ice creams and holidays. In sum, this is a ‘catch all’ variable which can be used to represent
anything else which the decision maker believes to have an effect on the demand for a particular
product. Thus each product will have its own particular demand function depending on which of
the above variables influence the demand for it.

Activity Dear distance learner

Name any five variables which may be included in the demand function and explain
its impact on demand.

4.2 The Law of Demand

For most goods, consumers are willing to purchase more units at a lower price than at a higher
price. The inverse relationship between price and the quantity consumers will buy is so widely
observed that it is called the law of demand. The law of demand is the rule that people will buy
more at lower prices than at higher prices if all other factors are constant. This idea of the law of
demand seems to be a pretty logical and accurate description of the behaviour we would all
expect to observe and for now, this will suffice.

The law of demand states that consumers are willing and able to purchase more units of a good
or service at lower prices than at higher prices, other things being equal. Have you ever thought
about why the law of demand is true for nearly all goods and services? Two influences, known as
the income effect and the substitution effect, are particularly important in explaining the negative
slope of demand functions. The income effect is the influence of a change in a product’s price on
real income, or purchasing power. If the price of something that we buy goes down, our income
will go farther and we can purchase more goods and services (including the goods for which
price has fallen) with a given level of money income. The substitution effect is the influence of a

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reduction in a product’s price on quantity demanded such that consumers are likely to substitute
that good for others that have thus become relatively more expensive.

4.3 Elasticity of Demand

4.3.1 Price Elasticity of Demand

Price elasticity of demand is generally defined as the responsiveness, or sensitiveness of demand

for a commodity to the changes in its price. More precisely, elasticity of demand is the
percentage change in demand as a result of one percent change in the price of the commodity. A
formal definition of price elasticity of demand (ep) is given as

ep=

A general formula for calculating coefficient of price elasticity, derived from this definition of
elasticity, is given as follows:

÷ = x

= x

Where Q = original quantity demanded, p = original price, ∆Q = change in quantity demanded

and ∆p = change in price.

It is important to note here that a minus sign (-) is generally inserted in the formula before the
fraction it view to making the elasticity coefficient a non negative value.

The elasticity can be measured between two points on a demand curve (called are elasticity) or
on a point (called point elasticity).

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4.3.2Arc Elasticity

The measure of elasticity of demand between any two finite points on a demand curve is known
as arc elasticity. For example, measure of elasticity between points j and k (fig. 4.1) is the
measure of arc elasticity. The movement from point j to k on the demand curve (Dx) shows a fall
in the price from $ 20 to $ 10 so that ∆p = 20 – 10 = 10. The fall in price causes an increase
demand from 43 units to 75 units so that ∆Q = 43 – 75 = - 32. The elasticity between points j and
k (moving from j to k) can be calculated by substituting these values into the elasticity formula
as follows;

= x = 1.49
This means that a one percent decrease in price of commodity X results in a 1.49 percent
increase in demand for it.

35-

33-

30-

25-

Price(Px)20- J

15-

10- K

5- Dx

0 20 40 43 60 75 80 100 108

Quantity (Q)

Figure 4.1 Linear Demand Curve

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Problem in using arc elasticity; the arc elasticity should be measured, interpreted and used
carefully; otherwise it may lead to wrong decisions. Arc elasticity coefficients differ between the
same two finite points on a demand curve if direction of change in price is reversed. For
instance, as estimated, the elasticity between points j and k moving from j to equal 1.49. It may
be wrongly interpreted that the elasticity of demand for commodity X between point’s j and k
equals 1.49 irrespective of direction of price change. But it is not true. A reverse movement in
the price, i.e., the movement from point k to j implies a different elasticity co-efficient (o.43).
Movement from point k to j gives p = 10, ∆p = 10 – 20 = -10, Q = 75 and ∆Q = 75 – 43 = 32. By
substituting these values into the elasticity formula, we get

ep = - = 0.43

Some Modifications; some modifications have been suggested in economic literature to resolve
the problems associated with arc elasticity.

First, the problem arising due to the change in the direction of price change may be avoided by
using the lower values of p and Q in the elasticity formula, so that

ep = -

Where p1 = 10 (the lower of the two prices) and Q1 = 43 (the lower of the two quantities). Thus,

=- = 0.74

This method is however devoid of the logic of calculating percentage change because the choice
of lower values of P and Q is arbitrary – it is not, in accordance with the rule of calculating
percentage change.

Second; another method suggested to resolve this problem is to use the average of upper and
lower values of p and Q in fraction p/Q. in that case the formula is

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= x

Where subscripts 1 and 2 denote lower and upper values of prices and quantities. Substituting the
values from our example, we get,

ep = -

= 0.81

This method has its own drawbacks as the elasticity co-efficient calculated through this formula,
refers to the elasticity mid-way between p1 p2 and Q1 Q2. The elasticity co-efficient (0.81) is not
applicable for the whole range of price-quantity combinations at different points between j and k
on the demand curve it only gives a mean of the elasticity between the two points.

4.3.3 Point Elasticity

Point elasticity on a linear demand curve. Point elasticity is also a way to resolve the problem in
measuring the elasticity. The concept of point elasticity is used for measuring price elasticity
where change in price is infinitely small. Point elasticity is the elasticity of demand at finite point
on a demand curve, e.g., at point p or b on the linear demand curves MN. This is in contrast to
the arc elasticity between points p and B. A movement form point B towards P implies change in
price (∆p)Becoming smaller and smaller, such that point p is almost reached. Here the change in
price is infinitesimally small. Measuring elasticity for an

Price (P) R P

0 Q N

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Quantity (Q)

Figure 4.2 Point elasticity

infinitesimally small change in price is the same as measuring elasticity at a point. The formula
for measuring point elasticity is given below.

Point elasticity (ep) = is the formula for point elasticity.

Note that has been substituted for

The derivative is reciprocal of the slope of the demand curve MN. Point elasticity is thus the

product of price-quantity ration at a particular point on the demand curve and the reciprocal of
the slope of the demand line. The reciprocal of the slope of the straight line MN at point P is

geometrically given by therefore,

Note that at point p, price p = PQ and Q = 0Q. By substituting these values in Eq. (4.14), we get

ep = . =

Given the numerical values for QN and OQ, elasticity at point p can be easily obtained. We may
compare here the arc elasticity between points j and K point elasticity at point j. At point J.

ep = = = 1.51

Note that ep = 1.51 is different from various measures of arc elasticity’s (i.e., 1.49, 0.43, 0.7, and
0.81).

As we will see below, geometrically, QN/OQ = PN/PM. Therefore, elasticity of demand at point
p (fig. 4.) may be expressed as

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ep=

It may this be concluded that the price elasticity of demand at any point on a linear demand curve
is equal to the ration of lower segment to the upper segments of the line i.e.,

ep =

Point elasticity on a non-linear demand curve the ratio ∆D/∆P in respect of a non –linear
demand curve is different to each point. Therefore, the method used to measure point elasticity
on a linear demand curve cannot be applied straightaway. A simple modification in technique is
required. In order to measure point elasticity on a non-linear demand curve, the chosen point is
first brought on a linear demand curve. This is done by drawing a tangent through the chosen
point.

M D

Price (P) R P

0 Q N

Quantity (Q)

Figure: 4.3 Price and Demand

For example, suppose we want to measure elasticity on a non-linear demand curve, DD (fig. 4.8)
at point P. for this purpose, a tangent MN is drawn through point P. since demand curve DD and
the line MN pass through the same point (P), the slope of the demand curve and that of the line at
this point is the same. Therefore, the elasticity of demand curve at point P will be equal to that of
the line at this point. Elasticity of the line at point P can be measured as:

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ep =

As proved above, geometrically,

To conclude, at midpoint of a linear demand curve, eP=1, as shown at point P inthefigure. It

follows that at any point above the point P, eP> 1 and at any point below the point P, eP<
1.According to this formula at the extreme point N, eP= 0, and at extreme point M, eP is
undefined because division by zero is undefined. It must be noted here that these results are
relevant between points M and N and that the elasticities at the extreme points M and N are, in
effect, undefined.

Priceep> 1 ep =

ep =1

ep<1

Quantity (Q) N

Figure:4.4 Point elasticity of Demand

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4.3.4Measuring Price Elasticity from a Demand Function

The price elasticity of demand for a product can be measured directly from the demand function.
In this section, we will describe the method of measuring price elasticity of demand for a product
from the demand function-both linear and nonlinear. It may be noted here that if a demand
function is given are elasticity can be measured simply be measured simply by assuming two
prices and working out ∆P and ∆Q. we will, therefore, confine ourselves here to point elasticity
of demand with respect to price.

a. Price Elasticity from a Linear Demand Function; Suppose that a linear demand
function is given as:

Q= 100- 5P

Given the demand function, point elasticity can be measured for any price. For example, suppose
we want to measure elasticity at P = 10. We know that:

The term in the elasticity formula is the slope of the demand curve. The slope of the
demand curve can be found by differentiating the demand function. That is,

Having obtained the slope of the demand curve as = -5 ep at p = 10 can be calculated as

follows. Since, p=10, Q = 100-5(10) =50. By substituting these values into the elasticity formula,
we get,

ep= (-5)

Similar at P= 8, Q= 100-5(8) = 60 and

ep= 5(8/60)= -40/60= -0.67

P = 15, Q = 100 -5 (15) = 25, and

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ep= 5(15/25)= -75/25= -3

b. Price Elasticity from a Nonlinear Demand Function; suppose a nonlinear demand

function of multiplicative form is given as follows.

Q=

And we want to compute the price elasticity of demand. The formula for computing the price
elasticity is the same, i.e.

What we need to compute the price-elasticity coefficient is to find first the value of the first term,
/ , i.e., the slope of the demand curve. The slope can be obtained by differentiating the
demand function, thus,

= - ba

By substitution, epcan be expressed as

- ba

As the above equation shows that when a demand function is of a multiplicative or power form,
price elasticity coefficient equals the power of the variable p. this means that price elasticity in
the case of a multiplicative demand function remains constant regardless of a change in price.

c. Price Elasticity and Total Revenue

A firms aiming at enhancing its total revenue would like to know whether increasing or
decreasing the price would achieve its goal. The price-elasticity coefficient of demand for its
product at different levels of its price provides the answer to this question. The simple answer is
that if ep> 1, then decreasing the price will increase the total revenue and if e q< 1, then increasing

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the price will increase the total revenue. To prove this point, we need to know the total revenue
(TR) and marginal revenue (MR) functions and measures of price-elasticity are required. Since
TR = Q.P, we need to know P and Q. this information can be obtained through the demand
function. Let us recall our demand function given as.

Q = 100 – 5P

Price function (P) can be derived from the demand function as

P = 20 – 0.2p

Given the price function, TR can be obtained as

TR = P.Q = (20 – 0.2Q)Q

= 20Q – 0.2Q2

From this TR-function, the MR-function can be derived as

MR= = 20 – 0.4Q

The TR-function is graphed in panel (a) and the demand and MR functions are presented in panel
(b) of fig. 4.11. As the figure shows, at point p on the demand curve, e = 1 where output, Q = 50.
Below point p,e< 1 and above point P,e> 1. It can be seen in panel (z) of fig. 4.11 that TR in
ceases so long as e > 1; TR reaches its maximum level where e = 1; and it decreases when e < 1.

The relationship between price-elasticity and TR is summed up in Table 4.3. As the table shows,
when demand is perfectly inelastic (i.e., ep = 0 as in the case of a vertical demand line) there is
no decrease in quantity demanded when price is raised and vice versa. Therefore, a rise in price
increases the total revenue and vice versa.

In case of an inelastic demand (i.e., ep<1), quantity demanded increases by less than the
proportionate decrease in price and hence the total revenue falls when price falls. The total
revenue increases when price increases because quantity demanded decreases by less than the
proportionate increase in price.

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If demand for a product is unit elastic (ep = 1) quantity demanded increases (or decreases) in the
proportion of decrease (or increase) in the price. Therefore total revenue remains unaffected.

If demand for a commodity has ep> 1, change in quantity demanded is greater than the
proportionate change in price. Therefore, the total revenue increases when price falls and vice
versa.

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600- (a)

500- M TR = Q.P

Total Revenue

300-

180-

100

0 10 20 30 40 50 60 7080 90 100 110

Quantity (Q)

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20-

(b)

Price and MR 18-

ep>1

15Q = 100-5P

10

P ep=1

5 ep<1

Dx

0 10 20 30 40 50 60 70 80 90 100 110

Quantity (Q)

MR

The case of infinitely elastic demand represented by a horizontal straight line is rare. Such a
demand line implies that a consumer has the opportunity to buy any quantity of a commodity and
the seller can sell any quantity of a commodity, at a given price. It is the case of a commodity
being bought and sold in a perfectly competitive market. A seller, therefore, cannot charge a
higher or a lower price.

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Table 4.1. Elasticity, Price-change and Change in TR

Elasticity Change in price Change in TR

e=0 Increase Increase

Decrease Decrease

e<1 Increase Increase

Decrease Decrease

e=1 Increase No charge

Decrease No charge

e>1 Increase Decrease

Decrease Increase

e> Increase Decrease to zero

Decrease Infinite increase

4.3.5Determinants of Price Elasticity of Demand

We have noted above that price-elasticity of a product may vary between zero and infinity. The
price-elasticity of a product within this range depends on the following factors:

1. Availability of substitutes;One of the most important determinants of elasticity of

demand for a commodity is the availability of its close substitutes. The higher the degree
of closeness of the substitutes, the greater the elasticity of demand for the commodity.
For instance, coffee and tea may be considered as close substitutes for one another. If
price of one of these goods increases, the other commodity becomes relatively cheaper.
Therefore, consumers buy more of the relatively cheaper good and les of the costlier one,
all other thins remaining the same. The elasticity of demand for both these goods will be
higher. Besides, the wider the range of the substitutes, the greater the elasticity. For

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instance, soaps toothpastes, cigarettes, etc., are available in different brands, each brand
being a close substitute for the other. Therefore, the price-elasticity of demand for each
brand is much greater than that for the generic commodity. On the other hand, sugar and
salt do not have close substitutes and hence their price-elasticity is lower.

2. Nature of commodity;The nature of a commodity also affects the price-elasticity of its

demand. Commodities can be grouped as luxuries, comforts and necessities. Demand for
luxury goods (e.g., high-price refrigerators, TV sets, cars, decoration items, etc) is more
elastic than the demand for necessities and comforts because consumption of luxury
goods can be dispensed with or postponed when their prices rise. On the other hand,
consumption of necessary goods, (e.g., sugar, clothes, vegetables) cannot be postponed
and hence their demand is inelastic. Comforts have more elastic demand than necessities
and less elastic than luxuries. Commodities are also categorized as durable goods and
perishable or non-durable goods. Demand for durable goods is more elastic than that for
non-durable goods, because when the price of the former increase, people either get the
old one repaired instead of replacing it or buy a ‘second hand’.

3. Weight & age in the total consumption; another factor that influences the elasticity of
demand is the proportion of income which consumers spend on a particular commodity.
If proportion of income spent on a commodity is large, its demand will be more elastic
and vice versa. Classic examples of such commodities are salt, matches, books, pens,
toothpastes, etc. these goods claim a very small proportion of income. Demand for these
goods is generally inelastic because in decrease in the price of such goods does not
substantially affect the consumer’s budget. Therefore, people continue to purchase almost
the same quantity even when their prices increase.

4. Time factor in adjustment of consumption pattern. Price-elasticity of demand depends

also on the tie consumers need to adjust their consumption pattern to new price: the
longer the time allowed, the greater the elasticity. The reason is that over a period of
time, consumers are able to adjust their expenditure pattern to price changes. For
instance, if the price of TV sets is decreased, demand will not increase immediately
unless people posses excess purchasing power. But over time, people may be able to

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adjust their expenditure pattern so that they can buy a TV set at a lower (new) price.
Consider another example. If price of petrol is reduced, the demand for petrol is unlikely
to increase significantly. Over time, however, people may be encouraged by low petrol
prices to buy automobiles resulting in a significant rise in demand for petrol.

5. Range of commodity use; the range of uses of a commodity also influences the price-
elasticity of its demand. The wider the range of the uses a product, the higher the
elasticity of demand for the decrease in price. As the price of a multiuse commodity
decreases, people extend their consumption to its other uses. Therefore, the demand for
such a commodity generally increases more that the proportionate increase in its price.
For instance, milk can be taken as it is and in the form of curd, cheese, ghee and butter-
milk. The demand for milk will therefore be highly elastic for decrease in rice. Similarly,
electricity can be used for lighting, cooking, heating and for industrial purposes.
Therefore, demand for electricity has a greater elasticity. However, for the increase in
price, the commodity has a lower elasticity because the consumption of a normal good
cannot be cut down substantially beyond a point when the price of the commodity
increases.
6. Proportion of market supplied; the elasticity of market demand also depends on the
proportion of the market supplied at the ruling price. If less than half of the market is
supplied at the ruling price, price-elasticity of demand will be higher than 1 and if more
than half of the market is supplied e < 1. That is the demand curve is more elastic over
the upper half than over the lower half.

4. 3.6 Cross-Elasticity of Demand

The cross-elasticity is the measure of responsiveness of demand for a commodity to the changes
in the price of its substitutes and complementary goods. For instance, cross-elasticity of demand
for tea is the percentage change in its quantity demanded with respect to the change in the price
of its substitute, coffee. The formula for measuring cross-elasticity of demand for tea (et, c) and
the same for coffee (ec, t) is given below.

e1,c =

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= .

And e1,c = .

The same formula is used to measure the cross-elasticity of demand for a good with respect to a
change in the price of its complementary goods. Electricity to electrical budgets, petrol to
automobile, butter to bread, sugar and milk to tea and coffee, are the example of complementary
goods. It is important to note that when two goods are substitutes for one another, their demand
has positive cross-elasticity because increase in the price of one increases the demand for the
other. And the demand for complementary goods has negative cross-elasticity, because increase
in the price of a good decreases the demand for its complementary goods.

4. 3.7 Income-Elasticity of Demand

Apart from the price of a product and its substitutes, consumer’s income is another basic
determinant of demand for a product. As noted earlier, the relationship between quantity
demanded and income is of positive nature, unlike the negative price-demand relationship. The
demand for goods and services increases with increase in consumer’s income and vice-versa.
The responsiveness of demand to the changes in income is known as income-elasticity of
demand.

Income-elasticity of demand for a product, say X, (i.e., ey) may be defined as:

= .

(Where Xq = quantity of X demanded; Y = disposable income; X q = change in quantity of X

demanded; and Y = change in income)

Obviously, the formula for measuring income-elasticity of demand is the same as that for
measuring the price-elasticity. The only change in the formula is that the variable “income’ (Y)
is substituted for the variable “price” (P). Here, income refers to the disposable income, i.e.,
income net of taxes..all other formulae for measuring price-elasticity may be adopted to measure

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the income-elasticity, keeping in mind the difference between them and the purpose of
measuring income-elasticity.

Unlike price-elasticity of demand, which is always negative, income-elasticity of demand is

always positive because of a positive relationship between income and quantity demanded of a
product. But there is an exception to this rule. Income elasticity of demand for an inferior good is
negative, because of the inverse substitution effect. The demand for inferior goods decreases
with increase in consumer’s income and vise-versa. The reason is that when income increases,
consumers switch over to the consumption of superior substitutes, i.e., they substitute superior
goods for inferior ones. For instance, when income rises, people prefer to buy more of rice and
wheat and less of inferior food grains; buy more of meat and less of potato, and travel more by
plane and less by train.

Nature of commodity and income- elasticity: for all normal goods, income-elasticity is positive
though the degree of elasticity varies in accordance with the nature of commodities. Consumer
goods of the three categories, viz., necessities, comforts and luxuries have different elasticity.
The general pattern of income elasticity of different kinds of goods for increase in income and
their effect on sales are given in Table 4.2.

Consumer goods Co-efficient of income- Effect on sale

elasticity

1. Essential goods Less than one (ey<1) Less than proportionate

change in sale

2. Comforts Almost equal to unity (ey 1) Almost proportionate change

in sale

3. Luxuries Greater than unity (ey>1) More than proportionate

increase in sale

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The income-elasticity of demand for different categories of goods may, however, vary from
household to household and from time to time, depending on the choice and preference of the
consumers, levels of consumption and income, and their susceptibility to ‘demonstration effect.’
The other factor which may cause deviation from the general pattern of income-elasticity is the
frequency of increase in income. If frequency of rise in income is high, income –elasticity will
conform to the general pattern.

Uses of income-elasticity in business decisions

While price and cross elasticities are of greater significance in the pricing of a product aimed at
maximizing the total revenue in the short period, income-elasticity of a product is of a greater
significance in production planning and management in the long run, particularly during the
period of a business cycle. The concept of income-elasticity can be used in estimating future
demand provided that the rate of increase in incomes and income-elasticity of demand for the
products are known. The knowledge of income elasticity can thus be useful in forecasting
demand, when a change in personal incomes is expected, other things remaining the same. It also
helps in avoiding over production or under-production.

4.3.8 Advertisement or Promotional Elasticity of Sales

The expenditure on advertisement and on other sales-promotion activities does help in promoting
sales, but not in the same degree at all levels of the total sales. The concept of advertisement
elasticity is useful in determining the optimum level of advertisement expenditure. The concept
of advertisement elasticity assumes a greater significance in deciding on advertisement
expenditure, particularly when the government imposes restriction on advertisement cost or there
is competitive advertising by the rival firms. Advertisement elasticity (ey) of sales may be
defined as where S = sales; ∆S = increase in sales; A = initial advertisement cost, and ∆A =
additional expenditure on advertisement.Interpretation of advertisement-elasticity; the
advertisement elasticity of sales varies between eA = 0 and eA = . Interpretation of some
measures of advertising elasticity is given below.

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Elasticity’s Interpretation

eA = 0 Sales do not respond to the advertisement expenditure

eA> 0 but < 1 Increase in total sales is less than proportionate to the increase in
advertisement expenditure

eA = 1 Sales increase in proportion to the increase in expenditure on advertisement.

eA> Sales increase at a higher rate than the rate of increase of advertisement
expenditure.

Determinants of Advertisement Elasticity; some of the important factors which determine

advertisement elasticity are the following:

i. The level of total sales; in the initial stages of sale of a product, particularly of one which is
newly introduced in the market, the advertisement elasticity is greater than unity. As sales
increase, the elasticity decreases. For instance, after the potential market is supplied, the
function of advertisement is to create addition demand by attracting more consumers to the
product, particularly those who are slow in adjusting their consumption expenditure to
provide for new commodities. Therefore, demand increases at a rate lower than the rate of
increase in advertisement expenditure.

ii. Advertisement by Rival firms; in a highly competitive market, the effectiveness of

advertisement by a firm is also determined by the relative effectiveness of advertisement by
the rival firms.
iii. Cumulative effect of past advertisement; in case expenditure incurred on advertisement in
the initial stages is not adequate enough to be effective, elasticity may be very low. But over
time, additional doses of advertisement expenditure may have a cumulative effect on the
promotion of sales and advertising elasticity may increase considerably.
iv. Other factors; advertisement elasticity is also affected by other factors affecting the demand
for a product, e.g., change in products’ price, consumers’ income, growth of substitutes and
their prices.

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4.4 Elasticity of Price Expectations

Sometimes, mainly during the period of price fluctuations, consumer’s price expectations play a
much more important role in determining demand for commodity than any other factor. The
concept of price-expectation-elasticity was devised and popularized by J.R. Hicks in 1939. The
price-expectation-elasticity refers to the expected change in future price as a result of change in
current prices of a product. The elasticity of price-expectation is defined and measured by the
formula given below.

Where Pc and Pf are current and future prices, respectively.

The coefficient ex gives the measure of expected percentage change in future price as a result of
1 percent change in present price. If ex > 1, it indicates that future change in price will be greater
than the present change in price, and vice versa. If ex = 1, it indicates that the future change in
price will be equal to the change in the current price.

Self-Assessment Questions. Dear distance students

1. Discuss the determinants of market demand for a commodity?

2. Explain the following concepts separately;
i. Income elasticity of demand,
ii. Price elasticity of demand
iii. Elasticity of price expectations
iv. Arc elasticity
v. Point elasticity
vi. Cross-elasticity
3. Suppose that the demand equations for heart surgery and cosmetic surgery are both linear.
The demand for heart surgery is more price inelastic than the demand for cosmetic surgery.
Do you agree? Explain.
4. The price elasticity of demand of gasoline is more elastic in the long run than it is in the short
run. Do you agree? Explain.

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5. Suppose that you are a portfolio manager for a large, diversified mutual fund.The fund’s
chief economist is forecasting a slowdown in aggregate economic activity (i.e., a recession).
How would you use your knowledge of estimated income elasticities of demand to alter the
composition of the portfolio?
6. Where Q2 is the number of metric tons of newsprint demanded (in thousands). What is the
price elasticity of demand for newsprint in the north eastern Indian states if price equals
Rs.500 per metric ton? (d) Based on this study, will the 1995 price increase result in an
increase or decrease in the amount spent on newsprint in the northeastern Indian States?
Why?
7. What is the advertising elasticity of demand? What, if anything, can you say about the effect
of advertising expenditures on company profits?
8. The price elasticity of demand of a good at a given price is more elastic for wealthy
individuals than for individuals who are less affluent. Do you agree? Explain.

9. Consider the price and sales data in Activity 2, reproduced for easy reference.
Price Sales
3.50 80
3.40 85
3.30 90
3.20 95
3.10 100
3.00 105
2.90 110
2.80 115
2.70 120
2.60 125
A. Does this relationship follow the law of demand? Explain.
B. Calculate the value of the arc price elasticity for a change in price from Rs.3.40 to
Rs.3.30. Is demand elastic or inelastic in this region?
C. Plot these 10 observations with price on the Y-axis and quantity on the x axis
connects them to form a demand curve.

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D. Based on this graph, how many units would you expect the firm to sell at a price of
Rs.2.95?
E. The algebraic equation for the firms demand function based on the data is P = 5.10
– 0.02Q
F. If the firm has a target sales level of 118 units, what price should be used?
G. Find the algebraic expression for the firms’ total revenue (TR) as a function of sales
(Q).
H. What is the algebraic equation for marginal revenue (MR)?
I. Based on these algebraic functions, find the price and the corresponding level of sales
that would maximize total revenue for the firm.
J. Rewrite the firms demand function with Q as a function of P rather than P as a
function of Q, as given earlier.
K. What is the point price elasticity of demand at a price of Rs.3.15? Is demand elastic or
inelastic at this point?

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UNIT FIVE

THEORY OF PRODUCTION

Unit Objectives

After going through this unit, you should be able to:

 Familiarize with the concepts and rules relevant for production decision analysis
 Discuss production function
 Understand the economics of production
 Understand the set of conditions required for efficient production
Unit Introduction

The discussion thus far has focused primarily on the demand side of the market. We have seen,
for example, that a firm’s total revenue will depend, in part, on the selling price of the product,
which is determined by the interaction of consumer and producer behavior in the market. We
have also investigated the conditions under which a firm might increase its revenues by changing
the selling price of its product. In spite of all that has thus far been accomplished, we have yet to
examine the conditions under which firms produce the goods and services that are demanded by
consumers, and perhaps more importantly from the perspective of senior management, the
associated costs of production. If we are to investigate more closely the first-order and second-
order conditions for a firm to maximize its profits, we must understand not only the revenue
component of the profit equation, but the cost component as well. In this chapter we will
examine the general problem of transforming productive resources in goods and services for sale
in the market.

Production process involves the transformation of inputs into output. The inputs could be land,
labour, capital, entrepreneurship etc. and the output could be goods or services. In a production
process managers take four types of decisions: (a) whether to produce or not, (b) how much
output to produce,(c) what input combination to use, and (d) what type of technology to use.

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5.1 The Role of the Firm

The firm is an organizational activity that transforms factors of production, or productive inputs,
into outputs of goods and services. Economics itself is the study of how society chooses to
satisfy virtually unlimited human wants subject to scarce productive resources. In fact, this
economic problem can be viewed as a constrained optimization problem in which the objective is
to maximize some index of human happiness, which is assumed to be a function of the
consumption of limited, or scarce, amounts of goods and services

Productive resources, or inputs, or factors of production are used by firms to produce goods and
services. These productive resources may conceptually be divided into two broad categories—
human and nonhuman resources. Nonhuman resources may be further classified as land, raw
materials, and capital. While these classifications are arbitrary, they are conceptually convenient

5.2 Production Function

Suppose we want to produce apples. We need land, seedlings, fertilizer, water, labour, and some
machinery. These are called inputs or factors of production. The output is apples. In general a
given output can be produced with different combinations of inputs. A production function is the
functional relationship between inputs and output. It shows the maximum output which can be
obtained for a given combination of inputs. It expresses the technological relationship between
inputs and output of a product.

In general, we can represent the production function for a firm as:

Q = f (x1, x2, ….,xn)

Where Q is the maximum quantity of output, x1, x2, ….,xn are the quantities of various inputs,
and f stands for functional relationship between inputs and output. For the sake of clarity, let us
restrict our attention to only one product produced using either one input or two inputs. If there
are only two inputs, capital (K) and labour (L), we write the production function as:

Q = f (L, K)

This function defines the maximum rate of output (Q) obtainable for a given rate of capital and
labour input. It may be noted here that outputs may be tangible like computers, television sets,

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etc., or it may be intangible like education, medical care, etc. Similarly, the inputs may be other
than capital and labour. Also, the principles discussed in this unit apply to situations with more
than two inputs as well.

Economic Efficiency and Technical Efficiency

We say that a firm is technically efficient when it obtains maximum level of output from any
given combination of inputs. The production function incorporates the technically efficient
method of production. A producer cannot decrease one input and at the same time maintain the
output at the same level without increasing one or more inputs. When economists use production
functions, they assume that the maximum output is obtained from any given combination of
inputs. That is, they assume that production is technically efficient.

On the other hand, we say a firm is economically efficient, when it produces a given amount of
output at the lowest possible cost for a combination of inputs provided that the prices of inputs
are given. Therefore, when only input combinations are given, we deal with the problem of
technical efficiency; that is, how to produce maximum output. On the other hand, when input
prices are also given in addition to the combination of inputs, we deal with the problem of
economic efficiency; that is, how to produce a given amount of output at the lowest possible
cost.

One has to be careful while interpreting whether a production process is efficient or inefficient.
Certainly a production process can be called efficient if another process produces the same level
of output using one or more inputs, other things remaining constant. However, if a production
process uses less of some inputs and more of others, the economically efficient method of
producing a given level of output depends on the prices of inputs. Even when two production
processes are technically efficient, one process may be economically efficient under one set of
input prices, while the other production process may be economically efficient at other input
prices.

Let us take an example to differentiate between technical efficiency and economic efficiency. An
ABC company is producing readymade garments using cotton fabric in a certain production
process. It is found that 10 percent of fabric is wasted in that process. An engineer suggested that
the wastage of fabric can be eliminated by modifying the present production process. To this

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suggestion, an economist reacted differently saying that if the cost of wasted fabric is less than
that of modifying production process then it may not be economically efficient to modify the
production process.

Short Run and Long Run

All inputs can be divided into two categories: i) fixed inputs and ii) variable inputs. A fixed input
is one whose quantity cannot be varied during the time under consideration. The time period will
vary depending on the circumstances. Although any input may be varied no matter how short the
time interval, the cost involved in augmenting the amount of certain inputs is enormous; so as to
make quick variation impractical. Such inputs are classified as fixed and include plant and
equipment of the firm.

On the other hand, a variable input is one whose amount can be changed during the relevant
period. For example, in the construction business the number of workers can be increased or
decreased on short notice. Many ‘builder’ firms employ workers on a daily wage basis and
frequent change in the number of workers is made depending upon the need. The amount of milk
that goes in the production of butter can be altered quickly and easily and is thus classified as a
variable input in the production process. Whether or not an input is fixed or variable depends
upon the time period involved. The longer the length of the time period under consideration, the
more likely it is that the input will be variable and not fixed. Economists find it convenient to
distinguish between the short run and the long run. The short run is defined to be that period of
time when some of the firm’s inputs are fixed. Since it is most difficult to change plant and
equipment among all inputs, the short run is generally accepted as the time interval over which
the firm’s plant and equipment remain fixed. In contrast, the long run is that period over which
all the firms’ inputs are variable. In other words, the firm has the flexibility to adjust or change
its environment.

Production processes of firms generally permit a variation in the proportion in which inputs are
used. In the long run, input proportions can be varied considerably. For example, at
MarutiUdyog Limited, an automobile dye can be made on conventional machine tools with more
labour and less expensive equipment, or it can be made on numerically controlled machine tools
with less labour and more expensive equipment i.e. the amount of labour and amount of

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equipment used can be varied. Later in this unit, this aspect is considered in more detail. On the
other hand, there are very few production processes in which inputs have to be combined in fixed
proportions. Consider, Ranbaxy or Smith-Kline-Beecham or any other pharmaceutical firm. In
order to produce a drug, the firm may have to use a fixed amount of aspirin per 10 gm of the
drug. Even in this case a certain (although small) amount of variation in the proportion of aspirin
may be permissible. If, on the other hand, no flexibility in the ratio of inputs is possible, the
technology is described as fixed proportion type. We refer to this extreme case later in this unit,
but as should be apparent, it is extremely rare in practice.

Activity dear Distance learner

1 What is a production function? How does a long run production function differ from a
short run production function?
2 When can we say that a firm is: (a) technically efficient, (b) economically efficient? Is it
necessary that a technically efficient firm is also economically efficient?

5.2.1 Production Function with One Variable Input

Consider the simplest two input production process - where one input with a fixed quantity and
the other input with is variable quantity. Suppose that the fixed input is the service of machine
tools, the variable input is labour, and the output is a metal part. The production function in this
case can be represented as:

Q = f (K, L)

Where Q is output of metal parts, K is service of five machine tools (fixed input), and L is labour
(variable input). The variable input can be combined with the fixed input to produce different
levels of output.

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Total, Average, and Marginal Products

The production function given above shows us the maximum total product (TP) that can be
obtained using different combinations of quantities of inputs.Suppose the metal parts company
decides to know the output level for differentinput levels of labour using fixed five machine
tools.

Table 5.1: Total, Average and Marginal Products of labour (with fixed capital at five
machine tools)

Number of Total output (TP) Marginal product Average product

workers (L) (thousands per year) (MPL = W Q/WL) (APL = Q/L)

(Q)

0 0 — —

1 10 10 10

2 28 18 14

3 54 26 18

4 76 22 19

5 90 14 18

6 96 6 16

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7 96 0 13.5

8 92 –4 11.5

Table 5.1 explains thetotal output for different levels of variable input. In this example, the TP
riseswith increase in labour up to a point (six workers), becomes constant betweensixth and
seventh workers, and then declines.

Two other important concepts are the average product (AP) and the marginal product (MP) of
an input. The AP of an input is the TP divided by theamount of input used to produce this
amount of output. Thus AP is theoutput-input ratio for each level of variable input usage. The
MP of an input isthe addition to TP resulting from the addition of one unit of input, when
theamounts of other inputs are constant. In our example of machine partsproduction process, the
AP of labour is the TP divided by the number ofworkers.

APL = Q/L

As shown in Table 5.1, the APL first rises, reaches maximum at 19, and then declines thereafter.
Similarly, the MP of labour is the additional output attributable to using one additional worker
with use of other input (service of five machine tools) fixed.

MPL = W Q/WL

Where W means ‘the change in’. For example, from Table 7.1 for MP4 (marginal product of 4th
worker) WQ = 76–54 = 22 and WL = 4–3 =1.Therefore, MP4 = (22/1) = 22. Note that although
the MP first increases with addition of workers, it declines later and for the addition of 8th
worker it becomes negative (–4).

Figure 5.1: Relationship between TP, MP, and AP curves and the three stages of
production

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100

. TP

70- (a) 11- (b)

Machinepartsin(000)60- 10-

50- 8-

40- 6-

30- 4-

20- Stage1 Stage 2 stage 3 2- AP

10-

0 1 2 3 4 5 6 7 8 9 10 11 12 0 1 2 3 4 5 6 7 8
9 10 11 12

Labour Labour MP

Figure 5.1 Total, Average, and Marginal Products

The graphical presentation of total, average, and marginal products for our example of machine
parts production process is shown in Figure 5.1.

Relationship between TP, MP and AP Curves

Examine Table 7.1 and its graphical presentation in Figure 7.1. We can establish the following
relationship between TP, MP, and AP curves.

1. (a) If MP > 0, TP will be rising as L increases. The TP curve begins at the origin,
increases at an increasing rate over the range 0 to 3, and then increases at a decreasing
rate. The MP reaches a maximum at 3, which corresponds to an inflection point (x) on
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the TP curve. At the inflection point, the TP curve changes from increasing at an
increasing rate to increasing at a decreasing rate.
b) If MP = 0, TP will be constant as L increases. The TP is constant between workers 6
and 7.

c) If MP < 0, TP will be declining as L increases. The TP declines beyond 7. Also, the

TP curve reaches a maximum when MP = 0 and then starts declining when MP < 0.

2. MP intersects AP (MP = AP) at the maximum point on the AP curve. This occurs at
labour input rate 4.5. Also, observe that whenever MP AP, the AP is rising (upto number
of workers 4.5) — it makes no difference whether MP is rising or falling. When MP <
AP (from number of workers 4.5), the AP is falling. Therefore, the intersection must
occur at the maximum point of AP. It is important to understand why. The key is that AP
increases as long as the MP is greater than AP. And AP decreases as long as MP is less
than AP. Since AP is positively or negatively sloped depending on whether MP is above
or below AP, it follows that MP = AP at the highest point on the AP curve.

The Law of Diminishing Marginal Returns

The slope of the MP curve in Figure 7.1 illustrates an important principle, the law of diminishing
marginal returns. As the number of units of the variableinput increases, the other inputs held
constant (fixed), there exists a pointbeyond which the MP of the variable input declines. Table
7.1 illustrates thislaw. Observe that MP was increasing up to the addition of 4th worker
(input);beyond this the MP decreases. What this law says is that MP may riseorstay constant for
some time, but as we keep increasing the units of variableinput, MP should start falling. It may
keep falling and turn negative, or maystay positive all the time. Consider another example for
clarity. Singleapplication of fertilizers may increase the output by 50%, a second applicationby
another 30% and the third by 20% and so on. However, if you were toapply fertilizer five to six
times in a year, the output may drop to zero.

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Three things should be noted concerning the law of diminishing marginal returns.

1. This law is an empirical generalization, not a deduction from physical or biological laws.
2. It is assumed that technology remains fixed. The law of diminishing marginal returns
cannot predict the effect of an additional unit of input when technology is allowed to
change.
3. It is assumed that there is at least one input whose quantity is being held constant (fixed).
In other words, the law of diminishing marginal returns does not apply to cases where all
inputs are variable.
Stages of Production

Based on the behaviour of MP and AP, economists have classified production into three stages:

Stage 1: MP > 0, AP rising. Thus, MP > AP.

Stage 2: MP > 0, but AP is falling. MP < AP but TP is increasing (because MP > 0).

Stage 3: MP < 0. In this case TP is falling.

These results are illustrated in Figure 7.1. No profit-maximising producer would produce in
stages I or III. In stage I, by adding one more unit of labour, the producer can increase the AP of
all units. Thus, it would be unwise on the part of the producer to stop the production in this stage.
As for stage III, it does not pay the producer to be in this region because by reducing the
labourinput the total output can be increased and the cost of a unit of labour can be saved. Thus,
the economically meaningful range is given by stage II. In Figure 5.1 at the point of inflection
(x), we saw earlier that MP is maximised. At point y, since AP is maximized, we have AP = MP.
At point z, TP reaches a maximum. Thus, MP = 0 at this point. If the variable input is free then
the optimum level of output is at point z where TP is maximized. However, in practice no input
will be freely available. The producer has to pay a price for it. Suppose the producer pays Rs.
200 per worker per day and the price of a unit of output (say one apple) is Rs. 10. In this case the
producer will keep on hiring additional workers as long as (price of a unit of output) * (marginal
product of labour) > (price of a unit of labour). That is, marginal revenue of product (MRP) of
labour> PL.

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On a similar analogy, (price of a unit of output) * (marginal product of capital) > (price of a unit
of capital) That is, marginal revenue of product (MRP) of capital > PK. The left side denotes the
increase in revenue and the right side denotes the increase in the cost of adding one more unit of
labour. As long as the increment to revenues exceeds the increment to costs, the profit of the
producer will increase. As we increase the units of labour, we see that MP diminishes. We
assume that the prices of inputs and output do not change. In this case, as MP declines, revenues
will start falling, and a point will come when the increase in revenue equals the increase in cost.
At this point the producer will stop adding more units of input. With further addition, since MP
declines, the additional revenues would be less than the additional costs, and the profit of the
producer would decline. Thus, profit maximization implies that a producer with no control over
prices will increase the use of an input until— Value of marginal product (MP) = Price of a unit
of variable input

5.2.2 Production Function with Two Variable Inputs

Now we turn to the case of production where two inputs (say capital and labour) are variable.
Although, we restrict our analysis to two variable inputs, all of the results hold for more than two
also. We are restricting our analysis to two variable inputs because it simply allows us the scope
for graphical analysis. When analysing production with more than one variable input, we cannot
simply use sets of AP and MP curves like those discussed in section 5.2, because these curves
were derived holding the use of all other inputs fixed and letting the use of only one input vary.
If we change the level of fixed input, the TP, AP and MP curves would shift. In the case of two
variable inputs, changing the use of one input would cause a shift in the MP and AP curves of the
other input. For example, an increase in capital would probably result in an increase in the MP of
labour over a wide range of labour use.

Production Isoquants

In Greek the word ‘iso’ means ‘equal’ or ’same’. A production isoquant (equal output curve) is
the locus of all those combinations of two inputs whichyields a given level of output. With two

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variable inputs, capital and labour, theisoquant gives the different combinations of capital and
labour, that produces thesame level of output. For example, 5 units of output can be produced
usingeither 15 units of capital (K) or 2 units of labour (L) or K=10 and L=3 or K=5and L=5 or
K=3 and L=7. These four combinations of capital and labourarefour points on the isoquant
associated with 5 units of output as shown in Figure7.2. And if we assume that capital and labour
are continuously divisible, there would be many more combinations on this isoquant.

Now let us assume that capital, labour, and output are continuously divisible in order to set forth
the typically assumed characteristics of isoquants. Figure 7.3 illustrates three such isoquants.
Isoquant I shows all the combinations of capital and labour that will produce 10 units of output.
According to this isoquant, it is possible to obtain this output if K0 units of capital and L0 units
of labour inputs are used. Alternately, this output can also be obtained if K1 units of capital and
L1 units of labour inputs or K2 units of capital and L2 units of labour are used. Similarly,
isoquant II shows the various combinations of capital and labour that can be used to produce 15
units of output. Isoquant III shows all combinations that can produce 20 units of output. Each
capitallabour combination can be on only one isoquant. That is, isoquants cannot intersect. These
isoquants are only three of an infinite number of isoquants that could be drawn. A group of
isoquants is called an isoquant map. In an isoquant map, all isoquants lying above and to the
right of a given isoquant indicate higher levels of output. Thus, in Figure 7.3 isoquant II indicates
a higher level of output than isoquant I, and isoquant III indicates a higher level of output than
isoquant II.

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Figure 5.2: Production Isoquant: This iisoquant shows various combinations of capital
andlabour inputs that can produce 5 units of output.

22

Capital 20

Input 18

16

14

12

10

2 Q=5

0 1 2 3 4 5 6 7 8 9 10 11

Labour Input

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Figure 5.3: Isoquant Map: These isoquants shows various combinations of capital and
labour inputs that can produce 10, 15, and 20 units of output.

Capital input

K2

K1Q3=20

Q2=15

K0 Q1=10

L2 L1 L0

Labour input

In general, isoquants are determined in the following way. First, a rate of output, say Q0, is
specified. Hence the production function can be written as

Q0 = f (K,L)

Those combinations of K and L that satisfy this equation define the isoquant for output rate Q0.

Marginal Rate of Technical Substitution

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As we have seen above, generally there are a number of ways (combinations of inputs) that a
particular output can be produced. The rate, at which one input can be substituted for another
input, if output remains constant, is called the marginal rate of technical substitution (MRTS). It
is defined in case of two inputs, capital and labour, as the amount of capital that can be replaced
by an extra unit of labour, without affecting total output.

MRTSL for K=

It is customary to define the MRTS as a positive number, since WK/WL, the slope of the
isoquant, is negative. Over the relevant range of production the MRTS diminishes. That is, more
and more labour is substituted for capital while holding output constant, the absolute value of
WK/WL decreases. For example, let us assume that 10 pairs of shoes can be produced using
either 8 units of capital and 2 units of labour or 4 units each of capital and of labour or 2 units of
capital and 8 units of labour. From Figure 7.4 the MRTS of labour for capital between points a
and b is equal to WK/WL = (4–8) / (4–2) = –4/2 = –2 or | 2 |. Between points b and c, the MRTS
is equal to –2/4 = –½ or | ½ |. The MRTS has decreased because capital and labour are not
perfect substitutes for each other. Therefore, as more of labour is added, less of capital can be
used (in exchange for another unit of labour) while keeping the output level constant.

Figure 5.4: Marginal Rate of Technical Substitution

10

Capital 8 a

Input 6

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4 b

0 2 4 6 8 10

Labour Input

There is a simple relationship between MRTS of labour for capital and the marginal product
MPK and MPL of capital and labour respectively. Since along an isoquant, the level of output
remains the same, if WL units of labour are substituted for WK units of capital, the increase in
output due to WL units of labour (namely, WL * MPL) should match the decrease in output due
to a decrease of WK units of capital (namely, WK * MPK). In other words, along an isoquant,

WL * MPL = WK * MPk

Which is equal to = =

However, as we have seen earlier WK/WL is equal to MRTSL for K, and hence, we get the
following expression for MRTS of L for K as the ratio of the corresponding marginal products.

MRTSL for K =

There are vast differences among inputs in how readily they can be substituted for one another.
For example, in some extreme production process, one input can perfectly be substituted for
another; whereas in some other extreme production process no substitution is possible. On the
other hand, in most of the production processes what we see is imperfect substitution of inputs.
These three general shapes that an isoquant might have are shown in the figure. In panel I, the

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isoquants are right angles implying that the two inputs a and b must be used in fixed proportion
and they are not at all substitutable. For instance, there is no substitution possible between the
tyres and a battery in an automobile production process. The MRTS in all such cases would,
therefore, be zero. The other extreme case would be where the inputs a and b are perfect
substitutes as shown in panel II. The isoquants in this category will be a straight line with
constant slope or MRTS. A good example of this type would be natural gas and fuel oil, which
are close substitutes in energy production. The most common situation is presented in panel III.
The inputs are imperfect substitutes in this case and the rate at which input a can be given up in
return for one more unit of input b keeping the output constant diminishes as the amount of input
b increases.

Figure 5.5: Three General Types of Shapes of Isoquants

Input b

Input b

Q2 Q2

Q1 Q1

Input a Input a

Panel I Panel II

Input b

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Q2
Q1

Input a

Panel III

The Economic Region of Production

Isoquants may also have positively sloped segments, or bend back upon themselves, as shown in
Figure 5.6. Above OA and below OB, the slope of the isoquants is positive, which implies that
increase in both capital and labour are required to maintain a certain output rate. If this is the
case, the MP of one or other input must be negative. Above OA, the MP of capital is negative.
Thus output will increase if less capital is used, while the amount of labour is held constant.
Below OB, the MP of labour is negative. Thus, output will increase if less labour is used, while
the amount of capital is held constant. The lines OA and OB are called ridge lines. And the
region bounded by these ridge lines is called economic region of production. This means the
region of production beyond the ridge lines is economically inefficient.

Figure 5.6: Economic Region of Production

Capital

Input

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Labour Input

5.3 The Optimal Combination of Inputs

In the above section you have learned that any desired level of output can be produced using a
number of different combinations of inputs. As said earlier in the introduction of this unit one of
the decision problems that concerns a production process manager is, which input combination to
use. That is, what is the optimal input combination? While all the input combinations are
technically efficient, the final decision to employ a particular input combination is purely an
economic decision and rests on cost (expenditure). Thus, the production manager can make
either of the following two input choice decisions:

1. Choose the input combination that yields the maximum level of output with a given level
of expenditure.
2. Choose the input combination that leads to the lowest cost of producing a given level of
output.

Thus, the decision is to minimize cost subject to an output constraint or maximize the output
subject to a cost constraint. We will now discuss these two fundamental principles. Before doing
this we will introduce the concept isocost, which shows all combinations of inputs that can be
used for a given cost.

Isocost Lines

Recall that a universally accepted objective of any firm is to maximise profit. If the firm
maximises profit, it will necessarily minimise cost for producing a given level of output or
maximise output for a given level of cost. Suppose there are 2 inputs: capital (K) and labour (L)
that are variable in the relevant time period. What combination of (K,L) should the firm choose
in order to maximise output for a given level of cost?

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If there are 2 inputs, K,L, then given the price of capital (Pk) and the price of labour (PL), it is
possible to determine the alternative combinations of (K,L) that can be purchased for a given
level of expenditure. Suppose C is total expenditure, then

C= PL* L + Pk* K

This linear function can be plotted on a graph.

Figure 5.7: Isocost line

C/Pk A

0 C/PL L

If only capital is purchased, then the maximum amount that can be bought is C/Pk shown by
point A in figure 5.7. If only labour is purchased, then the maximum amount of labour that can
be purchased is C/PL shown by point B in the figure. The 2 points A and B can be joined by a
straight line. This straight line is called the isocost line or equal cost line. It shows the alternative
combinations of (K,L) that can be purchased for the given expenditure level C. Any point to the
right and above the isocost is not attainable as it involves a level of expenditure greater than C

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and any point to the left and below the isocost such as P is attainable, although it implies the firm
is spending less than C.

Optimal Combination of Inputs: The Long Run

When both capital and labour are variable, determining the optimal input rates of capital and
labour requires the technical information from the production function i.e. the isoquants be
combined with market data on input prices i.e. the isocost function. If we superimpose the
relevant isocost curve on the firm’s isoquant map, we can readily determine graphically as to
which combination of inputs maximise the output for a given level of expenditure.

Consider the problem of minimising the cost of a given rate of output. Specifically if the firm
wants to produce 50 units of output at minimum cost. Two production isoquants have been
drawn in Figure 5.9. Three possible combinations (amongst a number of more combinations) are
indicated by points A, Z and B in Figure 5.9. Obviously, the firm should pick the point on the
lower isocosti.e point Z. In fact, Z is the minimum cost combination of capital and labour. At Z
the isocost is tangent to the 50 unit isoquant. Alternatively, consider the problem of maximising
output subject to a given cost amount. You should satisfy yourself that among all possible output
levels, the maximum amount will be represented by the isoquant that is tangent to the relevant
isocost line. Suppose the budget of the firm increases to the amount shown by the higher of the
two isocost lines in Figure 5.9, point Q or 100 units of output is the maximum attainable given
the new cost constraint in Figure 5.9.

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Figure 5.9: Optimal combination of inputs

10 A

1 C B

0 2 4 6 8 10 12 14 16 18 20 L

Regardless of the production objective, efficient production requires that the isoquant be tangent
to the isocost function. If the problem is to maximize output, subject to a cost constraint or to
minimise cost for a given level of output, the same efficiency condition holds true in both
situations. Intuitively, if it is possible to substitute one input for another to keep output constant
while reducing total cost, the firm is not using the least cost combination of inputs.

In such a situation, the firm should substitute one input for another. For example, if an extra
rupee spent on capital generates more output than an extra rupee spent on labour, then more
capital and less labour should be employed. At point Q in Figure 5.9, the marginal product of

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capital per rupee spent on capital is equal to the marginal product of labour per rupee spent on
labour. Mathematically this can be shown as Figure 5.9.

Self-Assessment Questions

1. Fill in the blanks in the following Table.

Units of labour Total product Average product Marginal product

1 40

2 48

3 138

4 44

5 24

6 210

7 29

8 -27

2. The marginal product of labour is known to be greater than the average product of labour at
a given level of employment. Is the average product increasing or decreasing? Explain.
3. Explain the law of diminishing marginal returns and provide an example of the
phenomenon.
4. Explain why a profit maximising firm using only one variable input will produce in stage-
II.
5. Explain why an AP curve and the corresponding MP curve must intersect at the maximum
point on the AP curve.
6. Explain why MP is greater than (less than) AP when AP is rising (falling).
7. Suppose a firm is currently using 500 labourers and 325 units of capital to produce its
product. The wage rate is Rs. 25, and price of capital is Rs. 130. The last labourer adds 25
units of total output, while the last unit of capital adds 65 units to total output. Is the

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manager of this firm making the optimal input choice? Why or why not? If not, what
should the manager do?

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UNIT SIX

THEORY OF COST AND BREAK-EVEN ANALYSIS

Unit Objectives

Upon a successful completion of this chapter, you will be able to:

 Beware about the cost concepts which are relevant to business operations and
decisions,
 Discuss the short-run and long-run cost-output relations,
 Discuss some analytical cost concepts,
 Explain cost curves and the law of diminishing returns,
 Identify economies and diseconomies of scale,

Unit Introduction

In the previous unit, we have discussed the input-output relations in terms of physical quantities
of input and output. However, business decisions are generally taken on the basis of money
values of the inputs and outputs. Inputs multiplied by their respective prices and added together
give the money value of the inputs, i.e., the cost of production. The cost of production is an
important factor in almost all business analysis and decisions, especially those pertaining to (a)
locating the weak points in production management; (b) minimizing the cost; (c) finding the
optimum level of output; (d) determination of price and dealers’ margin; and (e) estimating or
projecting the cost of business operation. Also cost analysis assumes a great significance in all
major business decisions because the term ‘cost’ has different meaning under different settings
and is subject to varying interpretations. It is therefore, essential that only the relevant concept of
costs is used in the business decisions.

6.1. The Theory of Cost: The Cost-Output Relations

The theory of cost deals with the behavior of cost in relation to a change in output. In other
words, the cost theory deals with cost-output relations. The basic principle of the cost behavior is
that the total cost increases with increase in output. This simple statement of an observed fact is

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of little theoretical and practical importance. What is of importance from a theoretical and
managerial point of view is not the absolute increase in the total cost but the direction of change
in the average cost (AC) and the marginal cost (MC). The direction of change in AC and MC-
whether AC and MC decrease or increase or remain constant – depends on the nature of the cost
function. A cost function is a symbolic statement of the technological relationship between the
cost and output. The general form of the cost function s written as

TC = f (Q), ∆TC/∆Q>0 … (6.3)

The specific form of the cost function depends on whether the time framework chosen for cost
analysis is short-run or long-run. It is important to recall here that some costs remain constant in
the short-run while all costs are variable in the long-run. Thus, depending on whether cost
analysis pertains to short-run or to long run, there are two kind of cost functions; (i) short-run
cost functions, and (ii) long-run cost factions, accordingly, the cost output relations are analyzed
in short-run and long-run framework.

6.1.1. Short – Run Cost-Output Relations

Before we discuss the cost-output relations, let us first look at he cost concepts and the
components used to analyses the short-run cost-output relations.

The basic analytical cost concepts uses in the analysis of cost behavior are total, average and
marginal costs. The total cost (TC) is defined as the actual cost that must be incurred to produce
a given quantity of output. The short-run TC is composed of two major elements; (i) total fixed
cost (TFC). And (ii) total variable cost (TVC). That is, in the short-run,

TC = TFC + TVC … (6.4)

As mentioned earlier, TFC (i.e., the cost of plant, building, etc) remains fixed in the short-run,
whereas TVC varies with the variation in the output.

For a given quantity of output (Q), the average total cost, (AC), average fixed cost (AFC) and
average variable cost (AVC) can be defined as follows.

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AC = = … (6.5)

AFC =

AVC

AC = AFC + AVC

Marginal cost (MC) is defined as the change in the total cost divided by the change in the total
output, i.e.,

MC = … (6.6)

Or as the first derivative of cost function, i.e.

It may be added here that since ∆TC = ∆TFC + ∆TVC and, in the short-run, ∆TFC = 0, therefore,
∆TC = ∆TVC. Furthermore, under the marginality concept, where ∆Q = 1, MC = ∆TVC. Now
we turn to cost function and derivation of cost curves.

6.1.2. Short-Run Cost Functions and Cost Curves

The cost-output relations are determined by the cost function and are exhibited through cost
curves. The shape of the cost curves depends on the nature of the cost function. Cost functions
are derived from actual cost data of the firms. Given the cost data, cost functions may take a
variety of forms, yielding different kinds of cost curves. The cost curves produced by linear,
quadratic and cubic cost functions are illustrated below.

1. Linear Cost FunctionA linear cost function takes the following form.
TC = a + bQ … (6.7)
(Where TC = total cost, Q = quantity produced, a = TFC, and bQ = TVC).

Given the cost function (Eq. 6.7 AC and MC can be obtained as follows.

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AC = = +b … (6.8)

And MC = =b

Note that since ‘b’ is constant, MC remains constant throughout in case of a linear cost function.

Assuming an actual cost function given as

TC = 60 + 10Q

The cost curves (TC, TVC and TFC) are graphed in

AC = + 10

and shows the behavior of TC, TVC and TFC the straight horizontal line shows TFC and the line
marked TVC = 10Q shows the movement in TVC.

The total cost function is shown by TC = 60 + 10Q.

200

180 TC

160

Cost140

120 TC = 60+10Q TVC

100 TVC=10Q

80

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60 TFC

40 TFC=60

20

0 1 3 4 5 6 7 8 9 10 11 12

Output

Figure: Linear Cost Function

More important is to notice the behavior of AC and MC curves in fig. Note that, in case of a
linear cost function, MC = AVC and it remains constant, while AC continues to decline with the
increase in output. This is so simply because of the logic of the linear cost function.

70

AC and MC

60

50

40

30

20 AC

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10 MC

0 1 2 3 4 5 6 7 8 9 10 11 12
Output
Figure: AC and MC Curves Derived From Linear Cost Function
2. Quadratic Cost Function A quadratic cost function is of the form
TC = a + bQ + Q2 … (6.9)
Where a and b are constants and TC and Q are total cost and total output, respectively.
AC and MC can be obtained as follows.

AC = = … (6.10)

= +b+Q

MC = … (6.11)

From cost functioneqs. (6.9) Let the actual (or estimated) cost function be given as
TC = 50 + 5Q + Q2
Given the cost function,AC = Q+5 … (6.12)

And MC = = 5 + 2Q … (6.13)

200 60 Average and Marginal Costs

180 50

160 40

Cost140 TC=50+5Q+Q2

120 TVC=5Q+Q2 30

100

80 20 MC

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60 FC (=50) AC

40 10 AVC

20

0 1 3 4 5 6 7 8 9 10 11

0 1 3 4 5 6 7 8 9 10 11

Output (Q) Output (Q)

Figure: Cost Curve Derived From Quadratic Cost Function

The cost curves that emerge from the cost function (6.13) are graphed in fig. (a) and (b). As
shown in panel (a), while fixed cost remains constant at 50, TVC is increasing at an increasing
rate. The rising TVC sets the trend in the total Cost (TC) panel (b) shows the behavior of AC,
MC and AVC in a quadratic cost function. Note that MC and AVC are rising at a constant rate
whereas AC first declines and then increase.

3. Cubic Cost Function A cubic cost function is of the form

TC = a + bQ – cQ2 + Q3 … (6.14)

Where a, b and c are the parametric constants.

The cost function AC and MC can be derived as follows.

AC = … (6.15)

= + b – cQ + Q2

And MC = … (6.16)

Let us suppose that the cost function eqs. 6.14 is empirically estimated as

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TC = 10 + 6Q – 0.9Q2 + 0.05Q3 …. (6.17)

80

Cost70 TC TVC

60

50

40

30

20

10 TFC

0 2 4 6 8 10 12 14 16 18

Output

Figure: TC, TFC, and TVC Curves

The TC and TVC, based on Eqs. (6.16) and (6.17), respectively, have been calculated for Q = 1
to 16 and presented in table 6.1 the TFC,TVC can TC have been graphically presented in fig.
as the figure shows, TFC remains fixed for the whole range of output, and hence, takes the form
of a horizontal line – TFC. The TVC curve shows that the total variable cost first increases at a
decreasing rate and then at an increasing rate with the increase in the output. The rate of increase
can be obtained from the slop of TVC curve. The pattern of change in the TVC stems directly
from the law of increasing and diminishing returns to the variable inputs. As output increases,

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larger quantities of variable inputs are required to produce the same quantity of output due to
diminishing returns. This causes a subsequent increase in the variable cost for producing the
same output.

Table 6.1 cost –output relations

Q FC TVC TC AFC AVC AC MC

(1) (2) (3) (4) (5) (6) (7) (8)

0 10 0.0 10.00 - - - -

1 10 5.15 15.15 10.00 5.15 15.15 5.15

2 10 8.80 18.80 5.00 4.40 9.40 3.65

3 10 11.25 21.25 3.33 3.75 7.08 2.45

4 10 12.80 22.80 2.50 3.20 5.70 1.55

5 10 13.75 23.75 2.001.67 2.75 4.75 0.95

6 10 14.40 24.40 1.43 2.40 4.07 0.65

7 10 15.05 25.05 1.25 2.15 3.58 0.65

8 10 16.00 26.00 1.11 2.00 3.25 0.95

9 10 17.55 27.55 1.00 1.95 3.06 1.55

10 10 20.00 30.00 0.90 2.00 3.00 2.45

11 10 23.65 33.65 0.83 2.15 3.05 3.65

12 10 28.80 38.80 0.77 2.40 3.23 5.15

13 10 35.75 45.75 0.71 2.75 3.52 6.95

14 10 44.80 54.80 0.71 3.20 3.91 9.05

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15 10 56.25 66.25 0.67 3.75 4.42 11.45

16 10 70.40 80.40 0.62 4.40 5.02 14.15

From Eqn. (6.17), we may derive the behavioral equations for AFC, AVC and AC. Let us first
consider AFC.

Average fixed cost (AFC) as already mentioned, the costs that remain fixed for a certain level of
output make the total fixed cost in the short-run. The fixed cost is represented by the constant
term ‘a’ in Eq. (6.14) and a = 10 we know that

AC = … (6.18)

Substituting 10 for TFC in Eq. (6.18) we get

AFC = … (6.19)

Eq. (6.19) expresses the behavior of AFC in relation to change in Q. the behavior of AFC for Q
from 1 to 16 is given in table (col. 5) and presented graphically by the AFC curve in Fig. The
AFC curve is a rectangular hyperbola.

Average variable cost (AVC) as defined above, AVC = … (6.20)

Given the TVC function (Eq.6. 20), we may express AVC as follows.

AVC = …. (6.21)

= 6 – 0.9Q + 0.05Q2

Having derived the AVC function in Eq. (6.21) we may easily obtain the behavior of AVC in

response to change in Q. the behavior of AVC for Q = 1 to 16 is given in Table 6.1 (col. 6), and

graphically presented in Fig. by the AVC curve. MC

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16 AC

14

AFC,AVC,AC and MC 12

10 AVC

2 AFC

0 2 4 6 8 10 12 14 16 18

Output

Figure: Short-run Curves

6.1.3. Cost Curves and the Law of Diminishing Returns

We now return to the law of variable proportions and explain it through the cost curves. And
present the short-term law of production i.e., the law of diminishing returns. Let us recall the
law: it states that when more and more units of a variable input are applied, other inputs held
constant, the returns from the marginal units of the variable input may initially increase but it
decreases eventually. The same law can also be interpreted in terms of decreasing and increasing
costs. The same law can also be interpreted in terms of decreasing and increasing costs. The
same law can also be interpreted in terms of decreasing and increasing costs. The law can then be
stated as, if more and more units of a variable input are applied to a given amount of a fixed

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input, the marginal cost initially decreases, but eventually increases. Both interpretations of the
law yield the same information- one in terms of marginal productivity of the variable input, and
the other in terms of the marginal cost. The former is expressed through a production function
and the latter through a cost function.

Fig. presents the short-run laws of return in terms of cost of production. As the figure shows, in
the initial stage of production, both AFC and AVC are declining because of some internal
economies. Since AC = AFC + AVC, AC is also declining. This shows the operation of the law
of increasing returns. But beyond a certain level of output (i.e., 9 units in our example), while
AFC continues to fall, AVC starts increasing because of a faster increase in the TVC:
Consequently, the rate of fall in AC decreases. The AC reaches its minimum when output
increases to 10 units. Beyond this level f output, AC starts increasing which shows that the law
of diminishing returns comes into operation. The MC curve represents the change in both the
TVC and TC curves due to change in output. A downward trend in the MC shows increasing
marginal productivity of the variable input due you mainly to internal economy resulting from
increase in production. Similarly, an upward trend in the MC shows increase in TVC, on the one
hand, and decreasing marginal productivity of the variable input, on the other.

6.1.4. Some Important Cost Relationships

Some important relationships between costs used in analysing the short-run cost behavior may
now be summed up as follows.

i. Over the range of output AFC and AVC fall, AC also falls because AC = AFC +
AVC.
ii. When AFC falls but AVC increases, change in AC depends on the rate of change in
AFC and AVC.
a. If decrease in AFC > increase in AVC, then AC falls,
b. If decrease in AFC = increase in AVC, AC remains constant, and
c. If decrease in AFC < increase in AVC, then AC increase.
iii. The relationship between AC and MC is of a varied nature. It may be described as
follows:

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a. When MC falls, AC follows over a certain range of initial output. When MC is

falling, the rate of fall in MC is greater than that of AC because in the case of MC
the decreasing marginal cost is attributed to a single marginal unit while, in case
of AC, the decreasing marginal cost is distributed over the entire output.
Therefore, AC decreases at a lower rate than MC.
b. Similarly, when MC increases, AC also increases but at a lower rate for the reason
given in (i) there is, however, a range of output over which the relationship does
not exist. Compare the behavior of MC and AC over the range of output from 6
units to 10 units (see fig. ) over this range of output, MC begins to increase
while AC continues to decrease. The reason for this can be seen in table 6.1 when
MC starts increasing, it increases at a relatively lower rate which is sufficient only
to reduce the rate of decrease in AC-not sufficient to push the AC up. That is why
AC continues to fall over some range of output even if MC increases.
c. MC intersects AC at its minimum point. This is sampling a mathematical
relationship between MC and AC curves when both of them are obtained from the
same TC function. In simple words, when AC is at its minimum, it is neither
increasing nor decreasing: it is constant. When AC is constant, AC = MC.

6.1.5. Output Optimization in the Short-Run

The technique of output optimization has already been discussed in chapter four. Optimization of
output in the short-run has been illustrated graphically in fig.6.5 optimization technique is
repeated here for completeness.

Let us suppose that a short run cost function is given as

TC = 200 + 5Q + 2Q2 …. (6.26)

We have noted above that an optimum level of output is one that equalizes AC and MC. In other
words, at optimum level of output, AC = MC. Given the cost function in Eq. (6.26),

AC = … (6.27)

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= + 5 + 2Q

And MC= = 5 + 4Q … (6.28)

By equating AC and MC equations, i.e., Eqs (6. 27) and (6. 28), respectively, and solving them
for Q, we get the optimum level of output. Thus,

+ 5 + 2Q + 5 +4Q … (6.29)

= 2Q

2Q2 = 200

Q = 10

Thus, given the cost function (Eq. 6.29), the optimum output is 10.

6.1.6. Long-Run Cost-Output Relations

By definition, long-run is a period in which all the inputs become variable. The variability of
inputs is based on the assumption that in the long-run supply of all the inputs, including those
held constant in the short-run, becomes elastic. The firms are, therefore, in a position to expand
the scale of their production by hiring a larger quantity of all the inputs. The long-run-cost-output
relations, therefore, imply the relationship between the changing scale of the firm and the total
output, whereas in the short-run this relationship is essentially one between the total output and
the variable cost (labour).

STC3 LTC

Total Cost

STC1 STC2

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0 Q1 Q2 Q3

Output

(b) SAC1 SAC3

SAC2 LAC

Average Cost C1 C3

C2

0 Q1 Q2 Q3

Output

Figure: Long-run Total and Average Cost Curves

Long-run total cost curve (LTC) in order to draw the long-run total cost curve; let us begin with a
short-run situation. Suppose that a firm having only one plant has its short-run total cost curve as
given by STC1, in panel (a) of fig. Let us now suppose that the firm decides to add two more
plants to its size over time, one after the other. As a result, two more short-run total cost curves
are added to STC1, in the manner shown by STC2 and STC3 in fig. 10.6(a). The LTC can now be
drawn through the minimum points of STC1, STC2 and STC3 as shown by the LTC curve
corresponding to each STC.

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Long-run Average Cost Curve (LAC) the long-run average cost curve (LAC) is derived by
combining the short-run average-cost curves (SACs). Note that there is one SAC associated with
each STC. Given theSTC1, STC2, STC3 curves in panel (a) of fig, there are three
corresponding SAC curves as given by SAC1, SAC2, and SAC3 curves in panel (b) of fig. Thus,
the firm has a series of SAC curves, each having a bottom point showing the minimum SAC. For
instance, C1Q1 is minimum AC when the firm has only one plant. The AC decreases to C2Q2
when the second plant is added and then rises to C3Q3 after the addition of the third plant. The
LAC curve can be drawn through the SAC1, SAC2 and SAC3 as shown in fig. (b) The LAC
curve is also known as the ‘Envelope curve’ r ‘planning curve’ as it serves as a guide to the
entrepreneur in his plans to expand production.

The SAC curves can be derived from the data given in the STC schedule, from STC function or
straightaway from the LTC curve similarly, LAC and can be derived from LTC-schedule, LTC
function or form LTC-curve.

The relationship between LTC and output and between LAC and output can now be easily
derived. It is obvious form the LTC that the long-run cost-output relationship is similar to the
short-run cost-output relation. With the subsequent increases in the output. LTC first increases at
a decreasing rate and then at an increasing rate As a result, LAC initially decreased until the
optimum utilization of the second plant and then it begins to increase. These cost-output relations
follow the ‘laws of returns to scale’. When the scale of the firm expands, unit cost of production
initially decreases, but ultimately increases as shown in fig.(b). the decrease in unit cost is
attributed to the internal and external economies and the eventual increase in cost, to the internal
and external diseconomies. The economies and diseconomies of scale are discussed in the
following section.

Long-run marginal cost curve (LMC) the long-run marginal cost curve (LMC) is derived from
the short-run marginal cost curves (SMCs) the derivation of LMC is illustrated in fig. In which
SACs and LAC are the same as in fig. (b) To derive the LMC, consider the points of tangency
between SACs and the LAC, i.e., points A, B and C in the long-run production planning; these
points determine the output levels at the different levels of production. For example, if we draw

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perpendiculars from points A, B and C to the X-axis, the corresponding output levels will be
0Q1, 0Q2 and 0Q3. The perpendicular AQ1 intersects the SMC1 at point M. it means that at output
0Q1; LMC is MQ1.If output increases to 0Q2, LMC reprises to BQ2. Similarly, CQ3 measures the
LMC at output 0Q3. A curve drawn through points M.B and N, as shown by the LMC,
represents the behavior of the marginal cost in the long-run. This curve is known as the long-run
marginal cost curve, LMC. It shows the trends in the marginal cost in response to the changes in
the scale of production.

Some important inferences may be drawn from fig. The LMC must be equal to SMC for the
output at which the corresponding SAC is tangent to the LAC. At the point of tangency, LAC =
SAC. Another important point to notice is that LMC intersects LAC when the latter is at its
minimum, i.e., point B. there is one and only one short-run plant size whose minimum SAC
coincides with the minimum LAC. This point is B where

SAC2 = SMC2 = LAC = LMC

6.2. Economies and Diseconomies of Scale

As shown in fig. LAC decreases with the expansion of production scale up to 0Q2 and then it
begins to rise. This behavior of LAC is caused by the economies and diseconomies of scale.
Economies of scale result in cost saving and diseconomies lead to rise in cost. Economies and
diseconomies of scale determine also the returns to scale. Increasing returns to scale operate till
economies of scale are greater than the diseconomies of scale, and returns to scale decrease when
diseconomies are greater than the economies of scale. When economies and diseconomies are in
balance, returns to scale are constant. In this section, we will briefly discuss the various kinds of
economies and diseconomies of scale.

6.2.1. Economies of Scale

The economies of scale are classified as

i. Internal or Real economies, and

ii. External or pecuniary economies.

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1. Internal Economies internal economies, also called ‘real economies’. Are those which arise
from the expansion of the plant-size of the firm and are internalized. This means that internal
economies are exclusively available to the expanding firm. Internal economies may be
classified under the following categories.

 Economies in production;

 Economies in marketing;

 Managerial economies; and

 Economies in transport and storage

1. Economies in production; economies in production arise from two sources: (a)
technological advantages and (b) advantages of division of labour ad specialization.
Technological advantages Large-scale prediction provides an opportunity to avail of the
advantages of technological advances. Modern technology is highly specialized. The
advanced technology makes it possible to conceive the whole process of production of a
commodity in one composite unit of production. For example, production of cloth in a
textile mill may comprise such plants as (i) spinning; (ii) weaving; (iii) printing and
pressing; and (iv) packing, etc. a composite dairy scheme. May consist of plants like (i)
chilling; (ii) milk processing; and (iii) bottling Under small-scale production, the firm
may not find it economical to have all the plants under one roof. It would, therefore, not
be in a position to have the full advantage of a composite technology. But, when scale of
production expands and firms hire more capital and labour, their total output increases
more than proportionately till the optimum size of the firm is reached. It results in lower
cost of production.

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Advantages of division of labour and specialization when a firm’s scale of production

expands, more and more workers of varying skills and qualifications are employed. With
the employment of large number of workers, it becomes increasingly possible to divide
the labour according to their qualifications and skills and to place them in the process of
production where they are best suited. This is known as division of labor. Division of
labour leads to specialization. It increases productivity of labour and, thereby, reduces
cost of production. Besides, specialized workers develop more efficient tools and
techniques and gain speed of work. These advantages of division of labour improve
productivity of labour-per unit of cost and time.

2. Economies in marketing economies in marketing arise from the large-scale purchase of

raw-materials and other material inputs and large-scale selling of the firm’s own
products. As to economies in the purchase of inputs, the large-size firms normally make
bulk purchases of their inputs. The large scale purchase entitles the firm for certain
discounts which are not available on small purchases. As such, the growing firms gain
economies on the cost of their material inputs.

The economies in marketing the firm’s own product are associated with (a) economies in
advertisement cost; (b) economies in large-scale distribution through wholesalers, etc;
and (c) other large-sale economies. With the expansion of the firm, the total production
increases. But the expenditure on advertising the product does not increase
proportionately. Similarly, selling through the wholesale dealers reduces the cost on
distribution of the firm’s production. The firm also gains on sample, etc. this kind of
economy however does not directly affect the production conditions.

3. Managerial Economies managerial economies arise from (a) specialization in

management, and (b) mechanization of managerial functions. For a large-size firm, it
becomes possible to divide its management into specialized departments under
specialized personnel, such as production manager, sales manager, personnel manager,
labour officers, etc. this increases the efficiency of management at all the levels of
management because of the decentralization of decision-making. Large-scale firms have

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the opportunity to use advanced techniques of communication, telephones and telex

machines, computers, and their own means of transport. All these lead to quick decision-
making, help in saving valuable time of the management and thereby, improve the
managerial efficiency. For these reasons, managerial cost increases less than
proportionately with the increase in production scale up to a certain level.

4. Economies in transport and storage economies in transportation and storage costs arise
from fuller utilization of transport and storage facilities. Transpiration costs are incurred
both on production and sales sides. Similarly storage costs are incurred on both raw
materials and finished products. The large size firms may acquire their own means of
transport and they can thereby reduce the unit cost of transportation compared to the
market rate, at least to the extent of profit margin of the transport companies. Besides,
own transport facility prevents delays in transporting goods, some large-scale firms have
their own railway tracks from the nearest railway point to the factory, and thus they
reduce the cost of transporting goods. Some large-scale firms have their own railway
tracks from the nearest railway point to the factory, a d thus they reduce the cost of
transporting goods in and out. For example. Bombay port trust has its own railway tracks;
oil companies have their own fleet of tankers. Similarly, large-scale firms can create their
own good owns in the various centers of product distribution and can save on cost of
storage.
5. External or Pecuniary Economies of Scale external or pecuniary economies accrue to
the expanding firms from the advantages arising outside the firm, e.g., in the input
markets. Pecuniary economies accrue to the large-size firms in the form of discounts and
concessions on (i) large scale purchase of raw material, (ii) large scale acquisition of
external finance, particularly from the commercial banks; (iii) massive advertisement
campaigns; (iv) large scale hiring of means of transport and warehouses, etc. these
benefits are available to all the firms of an industry – they are no specific to any one
particular firm.

Besides, expansion of an industry invites and encourages the growth of ancillary industries
which supply inputs. In the initial stages, such industries also enjoy the increasing returns to
scale. In competitive market, therefore, input prices go down. This benefit accrues to the

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expanding firms in addition to discounts and concessions. For example, growth of the
automobile industry helps the development of tire industry and other motor parts. If LIFAN
MOTOR Limited starts producing tires for its own cars and ancillaries, cost of LIFAN cars may
go up. Consider another example, growth of fishing industry encourages growth of firms that
manufacture and supply fishing nets and boats. Competition between such firms and law of
increasing returns at least in the initial stages reduces the cost of inputs. Reduction in input costs
is an important aspect of external economies.

6.2.2. Diseconomies of Scale

Diseconomies of scale are disadvantages that arise due to the expansion of production scale and
lead to a rise in the cost of production. Like economies, diseconomies may be internal and
external. Internal diseconomies are those which are exclusive and internal to a firm-they arise
within the firm. External diseconomies arise outside the firms, mainly in the input markets. Let
us describe the nature of internal and external diseconomies in some detail.

1. Internal Diseconomies like everything else, economies of scale have a limit too. This
limit is reached when the advantages of division of labour and managerial staff have been
fully exploited; excess capacity of plant, warehouses, transport and communication
systems, etc. is fully used; and economy in advertisement cost tapers off. Although some
economies may still exist, diseconomies begin to overweigh the economies and the costs
begin to rise.

Managerial Inefficiency diseconomies begin to appear first at the management level.

Managerial inefficiencies arise, among other things, from the expansion of scale itself. With
fast expansion of the production scale, personal contacts and communications between (i)
owners and managers, and (ii) managers and labour, get rapidly reduced.

Close control and supervision is replaced by remote control management. With the increase in
managerial personnel, decision-making become complex and delays become inviolable,
implementation of decisions is delayed due to coordination problem. Besides, with the expansion
of the scale of production, management is professionalized beyond a point. As a result, the

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owner’s objective function of profit maximization is gradually replace by mangers utility

function, like job security and high salary, standard or reasonable profit target, satisfying
functions. All these lead to laxity in management and hence to a rise in the cost of production.

Labour Inefficiency another source of internal diseconomy is the overcrowding of labour

leading to a loss of control over labor productivity. On the other hand, increase in the number of
workers encourages labour union activities which simply means the loss of output per unit of
time and hence, rise in the cost of production.

2. External diseconomies external diseconomies are the disadvantages that originate

outside the firm, in the input markets and due to natural constraints, especially in
agriculture and extractive industries. With the expansion of the firm, particularly when all
the firms of the industry are expanding, the discounts and concessions that are available
on bulk purchases of inputs and concessional finance come to an end. More than that,
increasing demand for inputs puts pressure on the input markets and input prices begin to
rise causing a rise in the cost of production. These are pecuniary diseconomies.

On the production side, the law of diminishing returns to scale come into force due to excessive
use of fixed factors, more so in agriculture and extractive industries. For example, excessive use
of cultivable land turns it into barren land; pumping out water on a large scale for irrigation
causes the water table to go down resulting in rise in cost of irrigation; extraction of minerals on
a large scale soon exhausts the mineral deposits on upper levels and mining further deep causes
rise in cost of production; expensive fishing reduces the availability of fish and the catch, even
when fishing boats and nets are increased. These kinds of diseconomies make the LAC move
upward.

6.3. Break-Even Analysis

In traditional theory of firm, the basic objective of the firm is to maximize profit. Maximum
profit does not necessarily coincide with the minimum cost, as far as the traditional theory of
firm is concerned. Besides, profit is maximum at a specific level of output which is difficult to
know beforehand. Even if it is known, it cannot be achieved at the outset of production. In real

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life, firms begin their activity even at a loss, in anticipation of profit in the future. However, the
firms can plan their production better if they know the level of production where cost and
revenue break even, i.e., the profitable and non-profitable range of production. Break-even
analysis or what is also known as profit contribution analysis is an important analytical technique
used to study the relationship between the total costs, total revenue and total profits and losses
over the whole range of stipulated output; the break-even analysis is a technique of having a
preview of profit prospects and a tool of profit planning.

Self-Assessment questions

1. Which of the following costs are paid by the firm?

a. Variable cost
b. Explicit cost
c. Fixed cost
d. Implicit cost
2. Explain with illustration the distinction between the following: (a) fixed cost and variable
costs, (b) acquisition cost and opportunity cost.
3. What is opportunity cost? Give some examples of opportunity cost. How are these costs
relevant for managerial decisions?
4. Which of the following statements is true?
a. When Q = 0, (i) TC = TVC; (ii) TC>TVC; and (iii) TC < TVC;
b. When MC = 0, (i) TC is falling; (ii) TC is increasing; and (ii) TC is constant.
5. When the law of diminishing returns begins to operate, then
a. TVC begins to fall at an increasing rate;
b. TVC rises at a decreasing rate;
c. TVC falls at a decreasing rate;
d. TVC rises at an increasing rate; or
e. TVC remains constant
6. When MC changes, AC changes (a) at the same rate, (b) at a higher rate, or (c) at a lower
rate? Illustrate your answer through a diagram.
7. Explain the relationship between marginal cost, average cost, and total cost assuming a
short run non-linear cost function?

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8. A manufacturing firm produces and sells 3,000 units of a product X, where it’s AC = MC
and makes only normal profit. The firm gets an additional order of 500 units at the ruling
price. Should the firm, a profit maximizing one, accept or reject the order, justify your
answer by using imaginary cost curves.
9. The profit and loss data of company for a particular year are given as follows:

$$

Net sales 1, 00,000

Cost of goods sold:
Variable cost
Fixed cost 40,000
Gross profit
10,000
Selling costs
Variable cost 50,000
Fixed cost
Net profit
10,000

5,000

35,000

a. Compute the break-even point

b. Forecast the profit for the sale volume of $1,60,000 and $ 70,000.
c. What would be sales volume to earn a net profit of $ 55,000?
10. Distinguish between the following:
a. Marginal cost and incremental cost:
b. Business cost and full cost;
c. Actual cost and imputed cost;
d. Private cost and social cost of private business.
11. From the following data find out; (i) PV ration, and (ii) BEP
Selling price $ 50
Cost Price $ 40

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Fixed cost $ 5,000

(Ans. (i) 20; (ii) 250)

12. Which of the following statements are true?

a. Economic rent is the same as economic profit.
b. In putted cost is the rent of hired building
c. When AC=MC, AC is minimum
d. When MC is rising AC > MC
e. Output is optimum when AC = MC
(Ans. (a) (c) and (e))

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UNIT SEVEN: MARKET STRUCTURE AND PRICING DECISIONS

Unit objectives

After going through this unit, you should be able to:

 Understand the concept of market structure and the impact it has on the competitive
behaviour of the firms
 Classify different types of market structures;
 Analysethe factors that influence the pricing decisions of a firm;
Unit Introduction

The structure of a market depicts the existence of firms in a particular market and to what extent
the firms constituting a specified market are functionally interrelated to each other. The term
‘market structure’ refers to the degree of competition prevailing in that particular market. The
power of an individual firm to control the market price by changing its own output determines
the degree of competition and this power varies inversely with the degree of competition. The
higher the degree of competition, the less market power the firm has and vice-versa. Market
power is generally thought to be the ability of the firm to influence price.

One of the most important decisions made by a manager is how to price the firm’s product. If the
firm is a profit maximizer, the price charged must be consistent with the realities of the market
and economic environment within which the firm operates. Remember, price is determined
through the interaction of supply and demand. A firm’s ability to influence the selling price of its
product stems from its ability to influence the market supply and, to a lesser extent, on its ability
to influence consumer demand, as, say, through advertising.

One important element in the firm’s ability to influence the economic environment within which
it operates is the nature and degree of competition. A firm operating in an industry with many
competitors may have little control over the selling price of its product because its ability to
influence overall industry output is limited. In this case, the manager will attempt to maximize
the firm’s profit by minimizing the cost of production by employing the most efficient mix of

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productive resources. On the other hand, if the firm has the ability to significantly influence
overall industry output, or if the firm faces a downward-sloping demand curve for its product,
the manager will attempt to maximize profit by employing an efficient input mix and by
selecting an optimal selling price. Definition: Market structure refers to the environment within
which buyers and sellers interact.

7.1 Characteristics of Market Structure

There are, perhaps, as many ways to classify a firm’s competitive environment, or market
structure, as there are industries. Consequently, no single economic theory is capable of
providing a simple system of rules for optimal output pricing. It is possible, however, to
categorize markets in terms of certain basic characteristics that can be useful as benchmarks for a
more detailed analysis of optimal pricing behavior. These characteristics of market structure
include the number and size distribution of sellers, the number and size distribution of buyers,
product differentiation, and the conditions of entry into and exit from the industry.

Number and Size Distribution of Sellers

The ability of a firm to set its output price will largely depend on the number of firms in the same
industry producing and selling that particular product. If there are a large number of equivalently
sized firms, the ability of any single firm to independently set the selling price of its product will
be severely limited. If the firm sets the price of its product higher than the rest of the industry,
total sales volume probably will drop to zero. If, on the other hand, the manager of the firm sets
the price too low, then while the firm will be able to sell all that it produces, it will not maximize
profits. If, on the other hand, the firm is the only producer in the industry (monopoly) or one of a
few large producers (oligopoly) satisfying the demand of the entire market, the manager’s
flexibility in pricing could be quite considerable.

Number and Size Distribution Of Buyers

Markets may also be categorized by the number and size distribution of buyers.When there are
many small buyers of a particular good or service, each buyer will likely pay the same price. On
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the other hand, a buyer of a significant proportion of an industry’s output will likely be in a
position to extract price concessions from producers. Such situations refer to monopsonies (a
single buyer) and oligopsonies (a few large buyers).

Product Differentiation

Product differentiation is the degree that the output of one firm differs from that of other firms in
the industry. When products are undifferentiated, consumers will decide which product to buy
based primarily on price. In these markets, producers that price their product above the market
price will be unable to sell their output. If there is no difference in price, consumers will not care
which seller buy from. A given grade of wheat is an example of an undifferentiated good. At the
other extreme, firms that produce goods having unique characteristics may be in a position to
exert considerable control over the price of their product. In the automotive industry, for
example, product differentiation is the rule.

Conditions of Entry and Exit

The ease with which firms are able to enter and exit a particular industry is also crucial in
determining the nature of a market.When it is difficult for firms to enter into an industry, existing
firms will have much greater influence in their output and pricing decisions than they would if
they had to worry about increased competition from new comers, attracted to the industry by
high profits. In other words, managers can make pricing decisions without worrying about losing
market share to new entrants. Thus if a firm owns a patent for the production of a good, this
effectively prohibits other firms from entering the market. Such patent protection is a common
feature of the pharmaceutical industry. Exit conditions from the industry also affect managerial
decisions.Suppose that a firm had been earning below-normal economic profit on the production
and sale of a particular product. If the resources used in the production of that product are easily
transferred to the production of some other good or service, some of those resources will be
shifted to another industry. If, however, resources are highly specialized, they may have little
value in another industry.

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In this and the next two chapters we will examine four basic market structures: perfect
competition, monopoly, oligopoly, and monopolistic competition. For purposes of our analysis
we will assume that the firms in each of these market structures are price takers in resource
markets and that they are producing in the short run. The result of these assumptions is that the
cost curves of each firm in these industries will have the same general shape as those presented.

7.2 PERFECT COMPETITION

7.2.1 Short-run Equilibrium of the Firm and the Industry

Perfect competition is a market structure by a complete absence of rivalry among the individual
firms. Thus, perfect competition in economic theory has a meaning diametrically opposite to the
everyday use of this term. In practice businessmen use the word competition as synonymous to
rivalry. In theory perfect competition implies no rivalry.

The model of perfect competition is based on following assumption.

I. Assumptions:

1. Large numbers of sellers and buyers: The industry or market includes a large number of
firms (and buyers), so that each individual firm, however large, implies only a small part of
the total quantity offered in the market. The buyers also numerous; that no monopolistic
power can affect the working of the market. Under these conditions each firm alone cannot
affect the price in the market by changing its output.
2. Product homogeneity: The industry is defined as a group of firms producing a
homogeneous product. The technical characteristics of the product as well as the services
associated with its sale and delivery are identical. There is no way in which a buyer could
differentiate among the products of different firms.
3. Free entry and exit of firms: There is no better to entry or exit from the industry. Entry or
exit may take time, but firms have freedom of movement in and out of the industry. This
assumption is supplementary to the assumption of large numbers.
4. Profit Maximization: The goal of all firms is profit maximization. No other goals are
pursued.

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5. No government regulation: No government intervention is there in the market (tariffs,

subsidies, rationing of production or demand and so on are ruled out).The above assumptions
are sufficient for the firm to be a price-taker and have an infinitely elastic demand curve.
The market structure in which the above assumptions are fulfilled is called pure competition.
It is different from perfect competition which requires the fulfillment of the following
additional assumptions.
6. Perfect mobility of factors of production: factors of production are free to move from one
firm to another throughout the economy. Workers can move between jobs, which imply that
skills can be learned easily. Raw materials and other resources are not monopolized and
labour is not unionized. There is perfect competition in markets of factors of production.
7. Perfect knowledge: it is assumed that all sellers and buyers have complete knowledge of the
prevailing and future period conditions of the market. Information is free and costless.
Uncertainty about the future development in the market is ruled out. Under the above
assumptions we will examine the equilibrium of the firm and the industry in the short run and
in the long run.

II. Short-run equilibrium

In order to determine the equilibrium of the industry we need to derive the market supply. This
requires the determination of the supply of the individual firms, since the market supply is the
sum of the supply of all the firms in the industry.

A. Short-run equilibrium of the Firm: The firm is in equilibrium when it maximizes its profits
(П), defined as the difference between total cost and total revenue:
П = TR – TC
Given that the normal rate of profit is included in the cost items of the firm, П is the profit above
the normal rate ofreturn on capital and the remuneration for the risk bearing function of the
entrepreneur. The firm is in equilibrium when it produces the output that maximizes the
difference between total receipts and total costs. The equilibrium of the firm may be shown
graphically in two ways. Either by using the TR and TC curves, or the MR and MC curves. In
fig.1 we show the total revenue and total cost curves of a firm in a perfectly competitive market.

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The total revenue curve is a straight line through the origin; showing that the price is constant at
all levels of output. The firm is a price-taker and can sell any amount of output at the going
market price, with its TR increasing proportionately with its sales. The slope of the TR curve is
the marginal revenue. It is constant and equal to the prevailing market price, since all units are
sold at the same price. Thus in pure competition

MR = AR = P.

The shape of the total-cost curve reflects the U shape of the average-cost curve, that is, the law of
variable proportions. The firm maximizes its profit at the output XC, where the distance between
the TR and TC curves is the greatest. At lower and higher levels of output total profit is not
maximized: at levels smaller than XA and larger than XB the firm has losses.
TC
C TR

R
П Max

0 XAXC XB X

The total-revenue-total-cost approach is awkward to use when firms are combined together in the
study of the industry. The alternative approach, which is based on marginal cost and marginal
revenue, uses price as an explicit variable, and shows clearly the behavioral rule that leads to

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profit maximization. In fig.2 we show the average and marginal cost curves of the firm together
with its demand curve.

SMC
C
SATC
P

P=MR

e B

0 XC XX

Fig. 2

The demand curve is also the average revenue curve and the marginal revenue curve of the firm
in a perfectly competitive market. The marginal cost cuts the SATC at its minimum point. Both
curves are U-shaped, reflecting the law of variable proportions which is operative in the short run
during which the plant is constant. The firm is in equilibrium (maximizes its profit) at the level
of output defined by the intersection of the MC and the MR curves (point e in fig. 2). To the left
of e profit has not reached its maximum level because each unit of output to the left of X e brings
to the firm revenue which is greater than its marginal cost. To the right of Xe each additional
unit of output costs more than the revenue earned by its sale, so that a loss is made and total
profit is reduced. In summary:

a. If MR>MC, total profit hasn’t been maximized and it pays the firm to expand its output.
b. If MC>MR, the level of total profit is being reduced and it pays the firm to cut its output.
c. If MC = MR, short-run profits are maximized.
Thus the first condition for the equilibrium of the firm is that marginal cost be equal to marginal
revenue. However, this condition is not sufficient, since it may be fulfilled and yet the firm may
not be in equilibrium. In fig. 3 we observe that the condition MC = MR is satisfied at point e|,
yet clearly the firm is not in equilibrium, hence profit is maximized at Xe>Xe|

The second condition for equilibrium requires that the MC must cut the MR curve from below,
i.e., the slope of the MC must be steeper than the slope of the MR curve. In the fig. 3 the slope

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of MC is positive at e, while the slope of the MR curve is zero at all levels of output. Thus at e
both conditions for equilibrium are satisfied

i. MC = MR and
ii. (slope of MC) > (slope of MR).
It should be noted that the MC is always positive, because the firm must spend some money in
order to produce an additional unit of output. Thus at equilibrium the MR is also positive.

C
SMCSATC |
e

0 X|eXe Fig. 3

The fact that a firm is in short run equilibrium does not necessarily mean that it makes excess
profits. Whether the firm makes excess profits or losses depends on the level of the ATC at the
short-run equilibrium. If the ATC is below the price at equilibrium (fig. 4) the firm earns excess
profits (equal to the area PABe). If, however, the ATC is above the price (fig. 5) the firm makes
a loss (equal to the area FPeC). In the latter case the firm will continue to produce only if it
covers its variable costs. Otherwise it will close down, since by discontinuing its operations the
firm is better off: it minimizes its losses. The point at which the firm covers its variable costs is
called the closing down point. In fig. 6 the closing-down point of the firm is denoted by point w.
If price falls below Pw the firm does not cover its variable costs and is better off it closes down.

P SMC PC SMC
SATC
C
SATC C
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MR P

0 Xe X

Fig. 5

C
SMC

SATC
SAVC
Pw
AFC

0 Xw X Fig. 6

Mathematical Derivation of the equilibrium of the Firm

The firm aims at the maximization of its profit

  R  C , Where,  = Profit, R = Total Revenue, C = Total Cost

Clearly R = f1(X) and C = f2(X), given the price P.

(a) The first order condition for the maximization of a function is that its first derivative be equal
to zero.

  R C
X

X

X
 0 or  R 
 C
 X  X

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The term R / X is the slope of the total revenue curve, that is, the marginal revenue. The term
C / X is the slope of the total cost curve, or the marginal cost. Thus the first-order condition
for profit maximization is

MR = MC.

Given that MC>0, MR must also be positive at equilibrium. Since MR = P the first order
condition may be written as MC = P.

(b) The second order condition for a maximum requires that the second derivative of function be
negative (implying that after its highest point the curve turns downwards). The second
2  2R  2C
orderderivative of the total-profit function is  
X 2 X 2 X 2

 2 R  2C
This must be negative if the function has been maximized, that is  0 , which
 X 2 X 2
 2 R  2C
yields the condition,  , but  2 R / X 2 is the slope of the MR curve and  2C / X 2 is the
X 2
X 2

slope of the MC must cut the MR curve from below. In pure competition the slope of the MR

curve is zero, hence the second-order condition is simplified as follows,  2C , which reads:
0 
X 2

the MC curve must have a positive slope, or the MC must be rising.

B. Short-run Equilibrium of the Industry: Given the market demand and the market supply,
the industry is in equilibrium at that price which clears the market that is at the price at which
the quantity demanded is equal to the quantity supplied. In fig. 7 the industry is in
equilibrium at price P, at which the quantity demanded and supplied is Q. In the long run,
firms that make losses and cannot readjust their plant will close down. Those that make
excess profits will expand their capacity, while excess profits will also attract new firms into
the industry. Entry, exit and readjustment of the remaining firms in the industry will lead to
a long-run equilibrium in which firms will just be earning normal profits and there will be no
entry or exit from the industry.

P D S’ SMC

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P SATC

P’

D
B
S

0 Q X 0 Xe X 0 Xe X

5.3 Long-run equilibrium of the firm and the industry

C. Equilibrium of the Firm in the Long Run: In the long run firms are in equilibrium when
they have adjusted their plant so as to produce at the minimum point of their long-run AC
curve, which is tangent (at this point) to the demand curve defined by the market price.
In the long run the firms will be earning just normal profits, which are included in the LAC. If
they are making excess profits new firms will be attracted in the industry; this will lead to a fall
in price (a downward shift in the individual demand curves) and an upward shift of the cost
curves due to the increase of the prices of factors as the industry expands. These changes will
continue until the LAC is tangent to the demand curve defined by the market price. If the firms
make losses in the long run they will leave the industry, price will rise and costs may fall as
industry contracts until the remaining firms cover the total cost firms inclusive of the normal rate
of profit.

In fig. 1 we show how firms adjust to their long-run equilibrium position. If the price is P, the
firm is making excess profits working with the plant whose cost is denoted by SAC1. It will
therefore have an incentive to build new capacity and it will move along its LAC. At the same
time new firms will be entering the industry attracted by the excess profits. As the quantity
supplied in the market increases (by the increased production of expanding old firms and by the
newly established ones) supply curve in the market will shift to the right and price will fall until

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it reaches the level of P1 (in fig.1) at which the firm and the industry are in the long-run
equilibrium. The LAC in fig.2 is the final-cost curve including any increase in the prices of
factors that may have taken place as the industry expanded.

P P
S LMC
D
C S1 C SAC1 LAC
SMC1

SAC

P P SMC
S1

0 Q Q1 X 0 X

Fig.1 Fig.2

The condition for the long-run equilibrium of the firm is that the marginal cost be equal to the
price and to the long-run average cost

LMC = LAC = P

The firm adjusts its plant size so as to produce that level of output at which the LAC is the
minimum possible, given the technology and the prices of factors of production. At equilibrium
the short-run marginal cost equal to the long-run marginal cost and the short-run average cost is
equal to the long-run average cost. Thus given the above equilibrium condition, we have:

SAC = SMC = LAC = LMC = P = MR

This implies that at the minimum point of the LAC the corresponding (short-run) plant is worked
at its optimal capacity, so that the minima of the LAC and SAC coincide. On the other hand, the
LMC cuts the LAC at its minimum point and the SMC cuts the SAC at its minimum point. Thus,

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at the minimum point of the LAC the above equality between short-run and long-run costs is
satisfied.

D. Equilibrium of the Industry in the Long-run: The industry is in long-run equilibrium when a
price is reached at which all firms are in equilibrium (proceeding at the minimum point of
their LAC curve and making just normal profits). Under these conditions there is no further
entry or exit of firms in the industry, given the technology and factor prices. The long-run
equilibrium of the industry is shown in fig. 3. At the market price, P, the firms produce at
their minimum cost, earning just normal profits. The firm is in equilibrium because at the
level of output X.
LMC = SMC = P = MR.

This equality ensures that the firm maximizes its profits. At the price P the industry is in
equilibrium because profits are normal and all costs are covered so that there is no incentive for
entry or exit. That the firms earn just normal profit (neither excess profits nor losses) is shown
by the equality;

LAC= SAC= P

This is observed at the minimum point of the LAC curve. With all firms in the industry being in
equilibrium and with no entry or exit, the industry supply remains stable, and, given the market
demand (DD|) in fig.3, the price P is a long run equilibrium price.

Since the price in the market is unique, this however, does not mean that all firms in the industry
have the same minimum long-run average cost. This, however, does not mean that all firms are
of the same size or have the same efficiency, despite the fact that their LAC is the same in
equilibrium. The more efficient firms employ more productive factors of production and/or
more able managers. These more efficient factors must be remunerated for their higher
productivity; otherwise they will be bid off by the new entrants in the industry. In other words,
as the price rises in the market the more efficient firms earn a rent which they must pay to their
superior resources. Thus rents of more efficient factors become costs for the individual firm, and
hence the LAC of the more efficient firms’ shifts upwards as the market price rises, even if the
factor prices for the industry as a whole remain constant as the industry expands. In this

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situation the LAC of the old, more efficient, firms must be redrawn so as to be tangent at the
higher market price. The LMC of the old firms is not affected by the rents accruing to its more
productive factors. (It will be shifted only if the prices of factors for the industry in general
increase.)

P D |
P LMC
S
SMC
C C SAC LAC

P P = MR

P S |
D

0 X 0 X
Q X

Fig.Thus, the more efficient firms will be in equilibrium, producing that output at which the
redrawn LAC is at its minimum (at which point the LAC is cut by the initial LMC given that
factor prices remain constant). Under these conditions, with the superior, more productive
resources properly costed at their opportunity cost, all firms have the same unit cost in their long-
run equilibrium. This is shown in fig 4. At the initial price P0 the second firm as not in the
industry as it could not cover its costs at that price. However, at the new price, P1, firm B enters
the industry, making just normal profits. The established firm A earns rents which are imputed
costs, so that its LAC shifts upwards and it reaches a new long-run equilibrium producing a
higher level of output (X|A).

P1 LMCA

| LACB
LMCA LAC A
|
D S

LACA

P1
P1

|
S D

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0 X 0 XA A A X 0 XB X

Market Equilibrium Equilibrium

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7.3 MONOPOLY MARKET STRUCTURE

In a perfectly competitive market each firm's production is such a small proportion of industry
output that an individual firm has to influence on the market price. As we have seen the
competitive firm is a price taker. In this unit we will see the opposite extreme to a purely
competitive firm of pure monopoly a single seller in an industry. The sources of monopoly, price
and output determination in the short and long run periods, price discrimination by a monopoly
and comparison of the price and output with perfect competition are some of the points to be
discussed in this unit.

Definition

A monopoly is a market structure where there is only one firm that produces and sells a
particular commodity or service and there are no close substitutes available. Since the monopoly
is the seller in the market, the industry is a single firm industry and it has no direct competitors.
However it does not necessarily mean that it is a guarantee to get an abnormal profit. Monopoly
power only guarantees that the monopolist can make the best of whatever demand and cost
conditions exist without fear of the entrant of new competing firms.

7.3.1 Source and Types of Monopoly

The rise and existence of monopoly is related to the factors, which prevents the entry of new
firms. The different barriers to entry that are the causes of monopoly are described below.

i. Legal Restrictions: A monopoly, which are created for the interest of the public. For
example the public utility sectors such as water supply, postal, telegraph and telephone
services, radio and TV services, generation and distribution of electricity such monopolies
are known as public monopolies

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ii. Control over key raw materials: some firms may get monopoly power if they posses
certain scarce & key raw materials that are essential for the production of certain goods or if
the supply of a commodity is localized in a single place. This type monopoly is known as raw
material monopoly. For example India possesses manganese mines, the extraction of
diamonds is controlled by South Africa
iii. Efficiency: A primary and technical reason for growth of monopolies is economies of scale.
The most efficient plant (probably large size firm), which can produce at minimum cost,
could eliminate the competitors by cutting down its price for a short period and can acquire
monopoly power. Monopolies created through efficiency are known as natural monopolies.
iv. Patent rights: - The government has granted firms a patent right, for producing a commodity
of specified quantity and character so that firms will have exclusive rights to produce the
specified commodity. Such monopolies are called patent monopolies.
7.3.2 Demand, Marginal Revenue and cost curves under Monopoly

In the analysis of consumer behavior you have seen that the demand curve is generally down
ward sloping showing inverse relationship between price and quantity demanded.

In perfectly competitive market the industry faces down ward sloping demand curve; firms face a
horizontal demand curve because of the existence of large number of producers and homogeneity
of the product, the firm cannot exert power on the total industry supply.

The monopoly industry on the other hand is a single firm industry. A monopoly firm therefore
faces a down ward sloping demand curve. It implies given the demand curve, a monopoly firm
has the option to choose between prices to be charged or output to be sold. But he cannot
simultaneously control both the price and the level of output. He can either decide the level of
output, and leave the price of the output to be determined by consumer demand or he can fix the
price and leave the level of output to be decided by the demand for the product at that price. One
of the fundamental differences between a monopolist and a competitor is therefore the demand
(AR) and marginal revenue curves they face. In the case of perfectly competitive market MR =
AR=P=D. But in the case of down ward sloping demand curve of monopoly marginal revenue

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curve falls twice as much as the fall of average revenue curves i.e. the slope of MR is twice as
steep as the average revenue curve. The following figure illustrates this relationship

D=AR=P

MR
Quantity
0

AR and RM curves for Monopoly

DM is the demand curve and DT is the marginal revenue curve, which bisects the quantity
demanded OM. Thus the distance OT = TM

This can be shown mathematically as follows assuming linear demand function

1. The demand function

P = a - bx where a = constant, x=quantity demanded

2. The total revenue is

T M

R = Px

= (a - bx)x = ( substituting P = a -bx)

= ax -bx2

3. The Average revenue

R Px
AR =   P  a  bx
x x

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Thus the demand curve is also the AR curve of the monopolist with slope = -b

4. The marginal revenue (the first derivative of R)

dR d (ax  bx 2 )

dx dx

=a-2bx

That is the MR is a straight line with the same intercept (a) as the demand curve, but
twice as steep ( i.e slope = -2b)

Note: - the general relation between P and MR is found as follows

R = Px
dx ( P ) d ( p ) x (Product rule of differentiation, you have learned in your quantitative
MR  
dx dx
for economists I course)
xd ( p )
MR  P 
dx dp dx
MR  P  x (But is negative due to the inverse relation between
dx dp
demand & price)

dp dp
MR  P  X  P = MR+x
dx dx

Thus the marginal revenue is smaller than price at all levels of output.

The nature and shape of cost curves confronting a monopolist are similar to those faced by a
perfectly competitive firm. Because cost depends on the production function and input prices,
irrespective of whether a firm is a monopoly or perfectly competitive.

7.3.3 Short Run Equilibrium of Monopoly

As we know, in the short run period the scale of plant is fixed and the firm is unable to change it.
If the monopolist desires to produce more, he can make an intensive use of the variable input.
Since the monopolist has to incur fixed costs in the short run, the minimum price acceptable by
him must be equal to his average variable cost. For this reason the equilibrium condition is the
same as we have explained under perfect competition i.e. equilibrium occurs when marginal
revenue equals marginal cost. But for the monopolist, MR does not equal price. The short run

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price and output determination under monopoly, and also the firm’s equilibrium are illustrated in
the following figure.

The monopolist firm is in equilibrium at point E where SMC interests the MR curve from below.

SMC

A
P1

B SAC
P2

E
AR=D

MR
0
Qe
The profit maximizing (equilibrium) output is Qe and price is 0P1. At OQe level of output, the
average cost is OP2 (or QeB). Thus the monopolist's per unit abnormal profit is equal to AB,
which is the difference between the price OP1,and the corresponding average cost of production
(OP2). The shaded area; P1ABP2 represents the total monopoly profit.
Total revenue = AR x output sold
= OP1 x OQe
= Area OP1AQe
Total Cost = AC x output produced
= OP2 x OQe
= Area OP2 BQe
Profits = TR-TC
= Area OP1AQe - Area OP2BQe
= Area P1AB P2
Does a monopolistic firm always earn an abnormal profit? Have you said no? Good. As we
explain in the introduction part a monopolistic position does not guarantee above normal return
always weather the monopolist gets profit or not, depends up on the conditions of demand and
costs. It is possible that his entire short run average cost curve lies above the demand curve or
AR curve so that he has to incur a loss. The following figure illustrates such a situation.

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P1 D ATC

P2 B AVC
P3 N

B AR=D
MR

0
Qe

As the figure prevails marginal cost equals marginal revenue at point E where Qe level of output
is produced and OP2 is the equilibrium price. But average total cost is OP1 (or QeD). Thus

Total revenue = OP2 x OQeTotal cost = OP1 x OQe

= OP2BQe = Area OP1 DQe
Total revenue exceeds total cost; hence, the firm makes a loss of P2 P1DB. The monopolist would
produce rather than shut down in the short run, since price exceeds the AVC (OP3). If demand
decreases so that the monopolist cannot cover all variable cost at any price, the firm would shut
down and lose only fixed cost.

7.3.4 Long Run Equilibrium of Monopoly

Contrary to perfect competition pure economic profit is not eliminated in the long run under
monopoly... As we already discuss a monopoly exists if there is only one firm in the market. This
statement implies that entry in to the market is closed. If a monopolist should earn a pure profit
in the short run, no other producer can enter the market in the hope of sharing whatever profit
potential exists in the long run. Thus a monopolist will continue to earn abnormal profit even in
the long run. The magnitude of the long run profits will depend up on the cost condition under
which he has to operate production and the demand curve he has to face in the long run.

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If it’s AR> SMC1, it earns a short run profit at output Oq1 as shown in the following figure (area
P1 P2AB). The firm would therefore not only continue in the business but would also expand its
business to the size that yields maximum profit in the long run (a plant with SMC2 and SAC2)

As depicted in the figure, the point of intersection between LMC and MR curves determine the
equilibrium output at Oq2, price Op3. The total long run profit has been shown by the area
P4P3cd(Total revenue (OP3Cq2)-Total cost (OP4Dq2))

Under perfect competition we have seen that in the long run every firm has be of optimum size
where its long run average cost (LAC) is minimum. Does a monopolistic firm always produce at
the optimum size in the long run? In the cost of monopoly, the equilibrium level of output
(where LMC=MR) may or may not have the lowest long run average cost. There are three
possibilities to exist depending on the cost structure of the firm and demand for the product.

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i. Under utilization of capacity:- A case in which the market size and cost conditions lead to
maximize profit at lower than optimum size (i.e LMC &MR intersects out puts less than
where LAC is at its minimum
ii. Over utilization of capacity :- A case where in the market is so large that it forces the
monopolist to maximize profit by over utilizing the capacity ( at out puts greater than where
LAC is at its minimum)
iii. Optimum size of the plant: - This is the case in which the market size and cost conditions
allow. The monopolist to maximize long run profit at exactly equal to the optimum plant.

7.3.5 Price Discrimination

A producer, mostly likely a monopolist need not always charge a single price to his customers
since he is the only producer in the market, he has a control over the supply of the product. He
can charge different prices to different consumers or in different markets. Thus when the same
product is sold at different price to different consumers, it is called price discrimination. The
two most important points to note about the definition of price discrimination are: first, exactly
the same products must have different prices. A trip from BahirDar to Gondar is not the same as
a trip from BahirDar to Dessie because transportation costs are different and this difference
raises the price of the trip. Second, in order for price discrimination to exist, production costs
must be equal. If costs are different, a profit maximizing firm who sets MR=MC will usually
charge different price for a product. This price difference is also due to cost difference not
discrimination.

Consumers are discriminated in respect of price on the basis of their incomes, geographical
location, Age, sex, quantity they purchase, frequency of visits to the shop etc. For instance, price
discrimination on the basis of age in airways, railways, Cinema shows, Musical concerts,
charging lower price for teenagers. Doctors has charged different price for rich and poor persons.
But to implement price discrimination effectively the following conditions has to be full filled.

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1. There must be separate markets, so that no reselling can take place from a low price market
to a high price market. It is most commonly effective for goods that cannot be easily traded
(exchange of services for example, a poor receiving medical care at relatively low price
cannot resell his or her operation to another patient, but a lower price buyer of some raw
material could resell it to someone in the higher price market.
2. Differences in the elasticity of demand. It is the difference in price elasticity that provides
opportunity for price discrimination. If price elasticity of demand in different markets is the
same, price discrimination would not be important (gain full).
Degrees of price discrimination

The main objective of price discrimination is to maximize profit more than that the firm could
obtain by charging the same price defined by the equation of his MC and MR. The degree of
price discrimination, therefore, refers to the extent to which a seller can divide the market and
can take advantage of it in extracting the consumers surplus. Accordingly there are three degrees
of price discrimination practiced by monopolists

a. First degree price discrimination

The discriminatory pricing that attempts to take away the entire consumer surplus is called first-
degree discrimination. Under first price discrimination, the firm treats each individual's demand
separately and each consumer is assumed as a separate market.

b. Second -Degree price Discrimination.

First-degree price discrimination is expense to implement. Because dealing each individual
demand curve needs vast information and it is costly. Second degree price discrimination is
somewhat simpler because it requires the firm to consider groups of consumers. This is
discrimination on the basis of quantity purchased and intends to take only the major part of
consumer surplus rather than the entire.

c. Third degree Price discrimination

Selling the same product with different price in different markets having demand curves with
different elasticity is called third degree price discrimination. Profit in each market would be

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maximum only when his MR=MC in each market. The monopolist there for divides his output
between the markets so that in all markets his MR=MC.

In this case suppose that the monopolist has to sell his product in only two markets A and B. As
a result, the monopolist must allocate output between the two markets in such proportion that the
necessary condition for profit maximization (i.e. MR = MC) is satisfied. The equilibrium
condition is satisfied i.e. MC=MRa =MRb (common MC equal individual MR)

7.3.6 Social cost of Monopoly Power

So far we have seen how output and price is determined in the case of perfect competition and
monopoly. And we have examined the quantity supplied under perfect competition & monopoly;
the price charged by a perfectly competitive and monopolistic firm. Economists are always
criticized monopoly firms in that it is less efficient than competitive firms and it causes social
welfare loss and distortions in resource allocation.

The most common reason for criticism of monopoly is that price is higher and out put is lower
than in a perfectly competitive market. These fore, we compare the long run price and out put
under monopoly and perfect competition using the following graphical analysis assuming a
constant cost industry ( so that LAC =LMC)

As it is prevailed in the above figure given the cost and revenue conditions, the
perfectlycompetitive industry will produce Oq2 at which is LAC = LMC= AR. Its Price will be
OP1.

On the other hand, the monopoly firm produces an output where LMC = MR. Monopoly firm
produces Oq1 and charges price OP2. Thus, if both monopoly and competitive industries are
faced with identical cost conditions, the output under competitive condition is higher than under
monopoly (0q2 >0q1), and price in the competitive industry is lower than in monopoly
(OP1<OP2). Perfect competition is therefore more desirable from

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LAC=LMC=MR=AR=D
D perfect

MR

Price and out put under monopoly & perfect competition

social welfare angle. The loss of social welfare is measured in terms of loss of consumer
surplus. The total consumer surplus equals the difference between the total utility which a
society gains from and the total price which he pays for a given quantity of goods as you have
seen in module one.

 Consumer surplus under competitive market

- The total utility from oq2 = area OALq2
- Total price paid by the society = area OP1Lq2
- Consumer surplus = area OALq2 = area OP1Lq2
= area ALP1

 Consumer surplus under monopoly

- Total utility from Oq2 = area OAJq1
- Total price paid by them society = OP2Jq1
- Consumer surplus = area OAJq1-areaOP2q1
= area AJP2

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 Thus loss of consumer surplus under monopoly equals

Area ALP1 -Area AJP2 = P2JLP1

Of this total loss of consumer surplus (P2JLP1), P2JkP1 is extracted by the monopolist as profit,
the remaining JKL goes to none and it is termed as dead weight loss to the society

7.4 MONOPOLISTIC COMPETITION

In many industries, the products that firms produce are differentiated. For one reason or another,
consumers view each firm's products as different from those of other firms. Product differentiation is
the major characteristic of monopolistically competitive market structure. A monopolistically
competitive market combines the characteristics of competitive and monopoly markets.

7.4.1 Assumptions of Monopolistic Competition

The assumptions of the monopolistic competition are the same as those of perfect competition, with
an exception of homogeneity of products. That is, monopolistic competition is a market structure in
which a large number of sellers sell differentiated products, which are close, but not perfect,
substitutes for one another.One of the assumptions of a perfectly competitive market structure is
firms in the industry produce homogenous products while firms in a monopolistically competitive
market produce a differentiated products otherwise market structures, perfectly competitive and
monopolistic competition, have the same assumptions.

Specifically, the following are some of the basic assumptions of a monopolistic competition market:

 There is a large number of sellers and buyers in market

 The products of the sellers are differentiated, yet they are close substitutes of one another.
 There is free entry and exit of firms in the market
 The goal of the firm is profit maximization both in the short run and long run
 The prices of factors of production (labor, capital, etc) and technology are given

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Product Differentiation

Product differentiation in the monopolistically competitive market may be based up on certain

characteristics of the product itself. Therefore, demand of a product in this market is determined not
only by the price policy of the firm, but also by the style of the product, the services associated
with it, and the selling activities of the firms.

Thus, the demand curve will shift if:

 The style, or the selling strategy of the firm changes

 Competitors change their price, output, services or selling policies
 Tastes, incomes, prices or selling polices of products from other industries change
The Demand Curve

The demand for a product, once preference for a product is created, it gives rise to a negatively
sloping demand curve for the product of the individual firm. That means, since each firm produces a
differentiated product, it holds the monopoly power over its own products and the firm has some
power to influence the market price of its products. As a result, the demand curve for a product of
a firm is downward (or negatively) sloping, as presented below.

Price

X (quantity of output sold)

The demand (dd) curve of a firm for its products in monopolistic competitive is negatively sloped
and highly elastic (or greater than the monopoly) because of the assumption of a large number of
sellers in the market. In other words, products are close substitutes one to the other so that a slight
change in the price of a firm's product brings about a larger change in its output quantity demanded.
Since consumers have a large number of alternatives, if a firm increases its product price (p),
customers will shift to the other producers and hence the demand for a firm's product (x) decreases
and vice versa.

The demand is determined not only by the price policy of the firm but also by the style of the
product and other services. Two important policy variables in the theory of the firm are the product

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itself and selling activities. Thus the dd curve will shift if all other things (other than the firm's price
of its product) are changed. Variables other than firm's price can be style, quality, design,
advertising, etc. They are called product and selling activities.

If a firm introduces good quality or design or extensively advertises its product, the dd curve shifts to
the right, implying at that level of price the quantity demanded (x) increases. However, the change
only in price (other things being constant) leads a movement along the same ddcurve, because p and
x are inversely related.

7.4.2 The Concept of Industry and Product "Group”

An industry under perfectly competitive market is defined as a group of firms that produce
homogenous products. However, this definition cannot be applied in the case of differentiated
products. In the case of homogeneity of products, it is possible to add them horizontally and get the
market demand and supply of the products. But here, in the case of monopolistic competition,
products cannot be added to get the market demand and supply. For this reason, it is very important
to redefine the industry for analytical purpose.

Product differentiation creates difficulties in the analytical treatment of the industry of

monopolistically competitive market structure. Heterogeneous products cannot be added to form the
market demand and supply schedules as in the case of homogeneous products. The monopolistically
competitive industry is a ' group' of firms producing a closely related' commodity, referred to as '
product group'. An operational definition of ‘product group’ is that the demand of each single
product be highly elastic and that it shifts appreciably when the price of other products in the group
changes. In other words, products, forming ‘the group’ or ‘industry ‘, should have high price and
cross-elasticity.

Product differentiation allows each firm to change different prices. There will be no unique
equilibrium price, but an equilibrium cluster of prices, reflecting the preferences of consumers for
the products of the various firms in the group. When the market demand shifts or cost conditions
change in a way affecting all firms, then the entire cluster of prices will rise or fall simultaneously.

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7.4.3 Equilibrium Conditions in Monopolistically Competitive Market

This section tries to analyze how a firm in monopolistically competitive market arrives at its
equilibrium in the short and long run. This equilibrium analysis is very important to determine the
optimum or profit maximizing level of output and price. Further, we will compare the equilibrium
conditions of both monopolistically competitive and perfectly competitive firms.

Models of Equilibrium

In order to be able to analyze the equilibrium of the firm and the product group (industry)
Chamberlin made the following ' heroic assumption ‘that firms have identical demand and cost
curves. This requires that consumers’ preferences be evenly distributed among the sellers, and that
differences between the products be such as not to give rise to differences in costs.

The rule of determining profit maximizing level of output is the same in all market structures, i.e.,
producing the output at which marginal revenue (MR) is equal to marginal cost (MC) and at that
TR
point MC must be rising. MR is the slope of total revenue ( ) or the first derivative of total
Q
dTR
revenue with respect to quantity produced and sold ( ), whereas MC is the slope of total cost (
dQ
TC dTC
) or the first derivative of total cost with respect to quantity produced and sold ( ).
Q dQ

Chamberlin develops three distinct models of equilibrium.

a. Equilibrium with price competition

This model assumes that the number of firms in the industry is optimal (no entry or exit) and long
run equilibrium is reached through price adjustment (price competition) of the existing firms.
Remember that the conditions of profit maximizations are different in the short- run and in the long -
run. In the short- run the time is not
enough to firms to adjust their sizes and entry
is not possible.

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A firm under monopolistic competition faces two types demand curves as shown in the figure above.
One is a firm's anticipated (or expected) demand curve which shows the inverse relationship between
P and X (curves dd’, d1d’1 and d2d’2). That is, the firm can change the price of its product but other
firms do not make any changes in their prices. The other demand curve that the firm faces is the
actual -sales curve (or share of the market curve) at each price after all firms change their own
product prices. It is labeled as DD' in the above figure. DD' incorporates the effects of actions of
competitors to the price changes by the firm.

According to the model the firm cannot learn from its past experience, i.e., the firm suffers from
myopia. The firm continues to behave on the assumption that its new demand curve (d1d’1) will not
shift further; the firm lowers its price again from P1 to P2 expecting to sell x’0 but all other firms also
decrease price, as a result, the actual sale of this firm will be x2 and finally the firm reaches at
equilibrium (point e) with the equilibrium price and output Pe and xe respectively. Thus DD' is the
locus of points of shifting expected demand curves as competitors, acting simultaneously, change
their price .The DD' is steeper than the anticipated demand curves, because the actual sales from a
reduction in price are smaller than expected.

The reduction in price continues. The process stops when the expected demand curve as shifted so
far to the left as to be tangent to the LAC at point e. Any further reduction in price will not be
attempted since the LAC would not be covered. At point e the DD' cuts the expected demand curve,
and the equilibrium price and output are pe and xe respectively. It should be noted that the
equilibrium point e lies to the left of the minimum of LAC, and it is at the falling part of LAC,
though, all firms are making zero profit.

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b. Equilibrium with new firms entering the industry

In this model the existing firms are assumed to be in the short run equilibrium realizing abnormal
profits; existing firms don’t have any incentive to adjust their price, but long run equilibrium is
attained by new entrants who are attracted by the lucrative (rewarding) profit margin. Then the
market will be shared by firms and the demand of the individual firm will shift leftwards followed
by price adjustments. This will continue until the demand of the firm is tangent to the long run
average cost (LAC) at its equilibrium. At such point, firms just breakeven: no incentive to enter as
the firms are earning a normal profit (zero profit)

 Profit= TR-TC=(P-AC)Q, Break Even point (when TR=TC or P=AC) and Profit margin
c. Price Competition and free entry/exit

In actual life equilibrium is achieved both by price competition and by entry and exit of firms into
and out of the industry (or the market). The figure below shows the ultimate equilibrium under
monopolistic competition in the long run.

Here also, as we looked

in the previous model 1, there are two demand curves: price adjustments are shown along the
expected demand curves (dd, d’d’,) while entry and exit cause shifts in DD curve. Therefore this
analysis is based on an integrated analysis of effects of free entry/exit and price competition.

To see how we arrive at the long run equilibrium points, let us assume that firms are initially in short
run equilibrium at e1 and profits are abnormal. New firms are attracted into the market by this excess
profit. As new firms enter into the market, the market share curve (DD) shifts to the left until it

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becomes tangent to LAC at point e2. The left - ward shift of the DD curve means as new firms join
the industry the market share of each firm will fall down, i.e., DD shifts to D’D’.

You may think that e2 is long run equilibrium since normal profits are earned. This is however not
the case once the firms reach point e2, each firm thinks that its demand curve is dd, not D’D’. Then
each firm believes that it can increase its profits by reducing the price and thereby increasing the
sales as we discussed in model 1. Therefore, we observe price competition as individual firm reduces
price from ptop’ in order to increase its sales by assuming all other firms would not decrease price
unfortunately all other firms simultaneously decrease price to p’ to maximize their own profits .

Excess Capacity and Welfare Loss

Now let us compare the long- run equilibrium situations of the perfectly and monopolistically
competitive markets and see how the monopolistically competitive market structure results in
welfare loss.In the long run, firms both in perfectly and monopolistically competitive markets make
zero profit. However, the equilibrium price is higher and output is lower in monopolistic competitive
as compared to the equilibrium price and outputs of the perfectly competitive. The equilibrium point
in the monopolistic competitive is at the falling part of LAC while in the perfectly competitive at the
lowest point on LAC. That means costs are higher in the monopolistic competitive than in the
perfectly competitive. As a result monopolistic competition has been attacked on the ground that
firms are working with ' excess capacity', as measured by the difference between ideal output , XF
and the output actually attained in long -run equilibrium XE in the following figure.

As it has been presented above, the output produced in the perfectly competitive ( xF) is greater than
output produced in monopolistic competition (XE) . The distance between XE and XF, therefore,
gives excess capacity, implies that the firm in monopolistic competitive market is working under
capacity, meaning the firm has still an excess capacity that is not used. If it was used the firm could

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increase output to the level XF. Thus monopolistically competitive market results in welfare loss as it
works to the left of the minimum of the LAC.

7.5 OLIGOPOLY THEORY

Oligopoly is the fourth type of market structure. Oligopoly is a form of market structure in which a
few sellers sell homogeneous or differentiated products. An oligopoly is an industry with small
number of sellers. How small is small cannot be decided in theory but only in practice. Nevertheless,
in principle, the criterion is whether firms take in to account their rivals’ actions in deciding upon
their own action or not. In other words, the essence of oligopoly is recognized interdependence
among firms. Coca-Cola considers the actions and likely future responses of Pepsi when it makes its
decisions (whether concerning product design, price advertising, or other factors).

7.5.1 Characteristics of Oligopoly Market

The basic characteristics of oligopolistic market structure are the following:

A. Keen (or intense) competition between firms: The number of firms is small enough that each
seller takes into account the actions of other firms in its pricing and output decisions. In other
words, each firm keeps a close watch on the activities of the rival firms and prepares itself with a
number of aggressive and defensive marketing strategies.
B. Interdependence: the nature and degree of competition makes firms interdependent in respect of
decision making.
C. Barrier to entry: in oligopoly market firms are small enough in number implies there is barrier
for new firms to enter into the market. Some common barriers to entry are economies of scale,
patent rights, and control over important inputs by existing firms.
In general unpredictable action and reaction will make it difficult to analyze oligopoly market. Firms
may come ‘in collusion with each other’ or ‘may try to fight each other on the death.’ So accordingly
we can classify oligopoly market structure as:

 Non-collusive Oligopoly and

 Collusive Oligopoly
Non- Collusive Oligopoly
Oligopoly firms may cooperate (collude) or may not cooperate (no- collusion) in some activities
with respect to their businesses depending on their interest and agreement. If firms do not cooperate,
their decision-making process is analyzed using the non- collusive model. Under this model we have

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the Cournot's duopoly model, the 'kinked- demand' model, Bertrand Duopoly model and Stackleberg
Duopoly model. We will look how firms arrive at equilibrium points in each model one by one.

Self-Assessment Questions

1. Suppose you are working in a company dealing with fast moving consumer goods. Classify
the products of your company and its competitions under the type of competition it
operates in and why?
2. What is meant by price discrimination? State the necessary conditions for price
discrimination.
3. Why is a firm under perfect competition a price-taker and not a price-maker?
4. Explain whether the firms producing differentiated products are more likely to face price
competition than the oligopolists producing homogeneous products.
5. Suppose a small locality has a single grocery store selling multiple products.
a. Is it a monopoly?
b. If yes, then give arguments in support of your answer.
6. Discuss the relevance of perfect competition and monopoly in the present context.
7. Distinguish between perfect competition and imperfect competition, givingexamples.
8. Which of the following markets could be considered monopolisticallycompetitive?
Explain.
 Cable Television
 Ball pens (low priced)
 Food joints
 Automobiles
9. Suppose a firm is operating in a non-cooperative oligopolistic market structure. Itproduces
400 units of output per period and sells them at Rs. 5 each. At this stageits total revenue is
Rs. 2,000. The firm now thinks of changing its price andincreases it from Rs. 5 to Rs. 6.
The rivals do not change the price and the salesdip from 400 units to 200 units.Now the
firm decides to decrease the price of the product from Rs. 5 to Rs. 4 andexpects the rivals
to match the price decrease so as not to lose sales. Now thesales increase marginally from
400 units to 450 units.
a. Find the total revenue of the firm when its price increases from Rs. 5 to Rs. 6.
b. Find the total revenue of the firm when the price decreases from Rs. 5 to Rs. 4.
c. Plot the changes along with the initial price and quantity sold according to the
concept of price rigidity under oligopoly.

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UNIT EIGH: RISK AND UNCERTAINITY

UNIT OBJECTIVES

After successful completion you will be able to:

 Describe risk and uncertainty

 Identify the different measures of risk
 Understand decision making under certainty and uncertainly

UNIT INTRODUCTION

We have assumed throughout most of this book that the economic decisions were made under
conditions of complete certainty. It was assumed that the decisions of both consumers and
producers were based on complete and accurate knowledge of consumer, firm, and market
conditions. In fact, however, most economic decisions are made with something less than perfect
information, and the consequences of these decisions cannot, therefore, be known beforehand
with any degree of precision. A manager cannot know, for example, whether the introduction of
a new product will be profitable because of the uncertainty of macroeconomic conditions,
consumer tastes, reactions by competitors, resource availability, input prices, labor unrest,
political instability, and so forth.

In addition to the uncertainty associated with decisions made at any point in time, the uncertainty
of outcomes associated with those decisions tends to increase the further we project into the
future. An automobile company that plans to introduce a new model within 2 years is more likely
to successfully satisfy prevailing consumer tastes in terms of styling and options, and therefore to
be better able to capture a significant market share, than a company that takes 5 years to bring a
new product to market. After 5 years, consumer tastes could significantly change, reducing the
probability of the product’s success.

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A formal treatment of the decision-making process under conditions of uncertainty is well

beyond the scope of this book. Nevertheless, this chapter will introduce some of the more
essential elements of decision making in the absence of complete information. We begin with a
formal distinction between risk and uncertainty and move on to a discussion of decision making
with uncertain and risky outcomes.

8.1 RISK AND UNCERTAINTY

When one is examining the decision-making process under conditions of imperfect information,
it is important to distinguish between the closely related concepts of risk and uncertainty. Risky
situations involve multiple outcomes (or payoffs), where the probability of each outcome is
known or can be estimated. An example of a risky situation is the flipping of a fair coin. The
probability that either a head or a tail will result from flipping a fair coin is 50%. Investing in the
stock market is another risky situation.

While the investor cannot know with certainty the rate of return on the investment, it is possible
to estimate an expected rate of return based on a company’s past performance.

Definition: Risk involves choices involving multiple possible outcomes in which the probability
of each outcome is known or may be estimated.

Uncertainty also involves multiple-outcomes situations. What distinguishes risk from

uncertainty, however, is that with uncertainty the probability of each outcome is unknown and
cannot be estimated. In many cases, these probabilities cannot be estimated because of the
absence of historical evidence about the event. Nevertheless, there is a fine line between decision
making under conditions of risk and of uncertainty.

Definition: Uncertainty involves choices involving multiple possible outcomes in which the
probability of each outcome is unknown and cannot be estimated.

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When one is considering the different ways in which managers deal with uncertain outcomes it is
important to distinguish between two types of uncertainty. In situations of complete ignorance,
the decision maker is unable to make any assumptions about the probabilities of alternative
outcomes under different states of nature. In these situations, the decision maker may adopt any
of a number of rational criteria to facilitate the decision-making process.

Situations involving partial ignorance, on the other hand, assume that the decision maker is able
to assign subjective probabilities to multiple outcomes. Whenever the decision maker is able to
use personal knowledge, intuition, and experience to assign subjective probabilities to outcomes,
then decision making under uncertainty is effectively transformed into decision making under
risk. In the next section, we will examine the most commonly used statistical measures of risk.

Much of the discussion that follows will deal with decision making under risk, uncertainty
involving partial ignorance, or uncertainty involving complete ignorance. While the procedures
for evaluating outcomes of decisions made under conditions of risk, or uncertainty involving
partial ignorance, are identical, the process of evaluating outcomes under conditions of complete
ignorance requires alternative approaches to the decision-making process. In spite of these
distinctions, we will refer to all situations in which the probability of each outcome is not known
and cannot be estimated as conditions of uncertainty. It will be clear from the context of each
situation whether this involves risk or uncertainty from partial or complete ignorance.

8.2 MEASURING RISK: MEAN AND VARIANCE

8.2.1 MEAN (EXPECTED VALUE)

The most commonly used summary measures of risky, random payoffsare the mean and the
variance. These random payoffs may refer to profits,capital gains, prices, unit sales, and so on.
In risky situations, the expectedvalue of these random payoffs is called the mean.The mean is the
weightedaverage of all possible random outcomes, with the weights being theprobability of each
outcome. For discrete random variables, the expectedvalue may be calculated using Equation
(14.1)

E(x)= =

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Where xi is the value of the outcome, pi is the probability of its occurrence, and = 1.

When the probability of each outcome is the same as the probability of every other outcome,
then the expected value is the sum of the outcomes divided by the number of observations. In
this case, the expected value of a set of uncertain outcomes may be calculated using Equation
(14.2)

E(x) = =

Definition: The mean is the expected value of a set of random outcomes. The mean is the sum of
the products of each outcome and the probability of its occurrence. When the probability of the
occurrence of each outcome is the same as the probability of every other outcome, the mean is
the sum of the outcomes divided by the number of observations.

Problem 8.1.Suppose that the chief economist of Silver Zephyr Ltd. believes that there is a 40%
(p1 = 0.4) probability of a recession in the next operating period and a 60% (p2 = 0.6)
probability that a recession will not occur. The COO of Silver Zephyr believes that the firm will
earn profits of X1= $100 in the event of a recession and X2= $1,000 otherwise. What are Silver
Zephyr’s expected profits?

Solution.Silver Zephyr’s expected profits are

= = X1P1+X2P2

= (0.4* 100) + (0.6*1000)

=40+600

= $640

Thus, Silver Zephyr’s expected profits for the next operating period are $640.

Problem 8.2.Suppose that Bob mates his brother Nob the following offer. For a payment of
$3.50, Bob will pay Nob the dollar value of any roll, v, of a fair die. For example, for a roll of 1,

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Bob will pay Nob $1. For a roll of 6, Bob will pay Nob $6. How much can Nob expect to earn if
he accepts Bob’s offer?

Solution.Since the probability of any number between 1 and 6 is 1/6, then Bob’s expected
payout is

E (v) = =

= (1+2+3+4+5+6)

= (21)

=$3.50

Since it will cost $3.50 to play this game, Nob’s can expect to earn E(v) - 3.50 = $0. Whether
Nob should accept Bob’s offer will depend on Nob’sattitude toward risk. An individual’s attitude
toward risk will be discussedin the paragraphs to follow.

8.2.2 VARIANCE

The strength of the mean is its simplicity. In a single number, the mean (expected value)
summarizes important information about the most likely outcome of a set of random payoffs.
Unfortunately, this strength hides other important information that is valuable to the decision
maker. For example, suppose that an individual is offered the following fair wager. If the
individual flips a coin and it comes up heads, then the individual wins $10. On the other hand, if
the coin comes up tails, then the individual loses $10.The reader should verify that the expected
value of the wager is $0. Suppose, on the other hand the payoffs were $1,000 and -$1,000 for a
head and tail, respectively. Once again, the reader will verify that the expected value of the
wager is $0.While the expected values of the two wagers are the same, clearly the wagers
themselves are different. While the potential payoff is much greater than in the second scenario,
so too is the potential loss. While the individual may be prepared to accept the first bet, that
person may not be willing to accept the second because the possibility of such a large loss may
be unacceptable. For this individual, the second wager may simply be too risky.

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The second wager is riskier because the spread, or dispersion, of the possible payoffs is greater.
Each has the same expected value, but the swing between a gain and a loss is considerably
greater. It is this dispersion in the possible payoffs that is the distinguishing characteristic of risk.
The most commonly used measure of the dispersion of a set of random outcomes is the variance.
The variance is the weighed average of the squared deviations of all possible random outcomes
from its mean, with the weights being the probability of each outcome. The variance of a set of
random payoffs may be calculated by using Equation.

8.2.3 COEFFICIENT OF VARIATION

Unfortunately, neither the variance nor the standard deviation can be used to compare the
riskiness involving two or more risky situations with different expected values.The reason for
this is that neither measure is independent of the units of measurement. To measure the relative
riskiness of two or more outcomes, we may use the coefficient of variation, which may be
calculated by using Equation. The coefficient of variation allows us to compare the riskiness of
alternative projects by “normalizing” the standard deviation of each by its expected value.

CV=

Definition: The coefficient of variation is a dimensionless number that is used to compare risk
involving two or more outcomes involving different expected values. It is calculated as the ratio
of the standard deviation to the mean.

8.3 Decision Making Under Uncertainty with Complete Ignorance

It was mentioned earlier that whenever the decision maker is able to use personal knowledge,
intuition, and experience to assign subjective probabilities to outcomes, decision making under
uncertainty is transformed into decision making under risk. These situations were described as
decision making under conditions of uncertainty with partial ignorance.When managers are
unable to assign probabilities to alternative outcomes, some other rational decision-making
criteria must be used. As mentioned earlier, this is referred to as decision making under

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conditions of uncertainty with complete ignorance. In this section we will examine four such
rational decision criteria: the Laplace criterion, the Wald (maximin) criterion, the
Hurwiczcriterion, and the Savage (minimax regret) criterion. No single decision rule is
appropriate for all decision-making situations.The choice of the criterion should be appropriate
to the circumstances and consistent with organizational objectives and philosophy.

8.3.1 LAPLACE DECISION CRITERION

Before examining in detail the Laplace decision criterion for selectingamong alternative
strategies under conditions of complete ignorance, consider the situation depicted in Figure
14.14. This figure summarizes thepayoffs from three possible pricing strategies given three
different states ofthe economy: economic expansion, stability, and contraction.The payoffs in the
matrix represent the firm’s expected rates of return. Under conditions of risk or partial ignorance,
however, the decision maker may be able to assign objective or subjective probabilities to the
different states of the economy. These probabilities (in parentheses), and the expected values of
the payoffs from each strategy, E(Si) = mi, are summarized in Figure 14.15. As in the Slumlords’
Dilemma, if management decides to adopt the pricing strategy with the highest expected rate of
return, then the best strategy is to “raise price.” The most significant draw-back of this decision
is that it fails to consider management’s attitude toward risk.

A more complete examination of the alternative strategies under different states of nature
requires an examination of the risk associated with each strategy. In addition to the expected
rates of return from each strategy, Figure 14.15 summarizes the standard deviations of the
expected rates of return as a measure of the riskiness of each strategy. An examination of the
payoff matrix reveals that while a “raise price” strategy has the greatest expected rate of return, it
is also the most risky as measured by the standard deviation. By contrast, a “lower price”
strategy is the least risky, but it also has the lowest expected rate of return. Clearly, the selection
of the optimal strategy cannot be determined on the basis of a comparison of the expected rates
of return and risk alone. In this and many similar situations, it is necessary to examine

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management’s attitude toward risk before determining management’s optimal strategy, as the
following problem I llustrates.

8.4 MARKET UNCERTAINTY AND INSURANCE

Markets operate best when all parties have equal access to all information regarding the potential
costs and benefits associated with an exchange of goods or services.When this condition is not
satisfied, then uncertainty exists and either the buyer or the seller may be harmed, which will
result in an inefficient allocation of resources. In this section, we will examine some of the
problems that arise in the presence of market uncertainty.

ASYMMETRIC INFORMATION

For markets to operate efficiently both the buyer and the seller must have complete and accurate
information about the quantity, quality, and price of the good or service being exchanged.When
uncertainty is present, market participants can, and often do, make mistakes. An important cause
of market uncertainty is asymmetric information. Asymmetric information exists when some
market participants have more and better information than others about the goods and services
being exchanged. An extreme example of the problems that might arise in the presence of
asymmetric information is fraud. The reader will recall from Chapter 13 the discussion of the
“snake oil” salesman, who traveled from frontier town to frontier town in the American West
selling bottles of elixirs promising everything from a cure for toothaches to a remedy for
baldness. Of course, these claims were bogus, but by the time customers realized that they had
been “had” the snake oil salesman was long gone. Had the customer known that the elixir was
worthless, the transaction would never have taken place.

In the extreme case, the knowledge that, some market participants had improperly exploited their
access to privileged information could result in a complete breakdown of the market. In insider
trading, for example, some market participants have access to classified information about a firm
whose shares are publicly traded. Thus an executive who discovers that senior management of
his firm plans to merge with a competitor, which will result in an increase in the firm’s stock

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price, might act on this information by buying shares of stock in his own company. This person
is guilty of insider trading. When insider trading is pervasive, rational investors who are not
privy to privileged information may choose not to participate at all, rather than to put themselves
at risk of buying or selling shares at the wrong price.

The uncertainty arising from asymmetric information affects managerial decisions as well. The
reader will recall from unit 7, for example, that a profit-maximizing competitive firm will hire
additional workers as long as the additional revenue generated from sale of the increased output
(the marginal revenue product of labor) is greater than the wage rate. The marginal revenue
product of labor is defined as the price of the product times the marginal product of labor, P *
MPL. But how is the manager to know the potential productivity of a prospective job applicant?
This is a classic example of asymmetric information. The prospective job applicant has much
better information than the manager about his or her skills, capabilities, integrity, and attitude
toward work. Since the potential cost to the firm of hiring an unproductive worker may be very
high, managers will take whatever reasonable measures are necessary to rectify this asymmetry.
This is why firms require job applicants to submit résumés, college transcripts, letters of
recommendations, and so on. The firm’s human resources officer may require job applicants to
be interviewed by responsible professionals within the firm. Firms may also conduct background
and credit checks, require applicants to sit for examinations to evaluate job skills, mandate
probationary periods prior to full employment, and so forth.

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Self-Assessment Questions

1. What is the difference between risk and uncertainty?

2. What are the most commonly used measures of risk?
3. Can uncertainty be estimated? If not, then why not? Explain.
4. When is the process of decision making under conditions of risk thesame as the process
of decision making under conditions of uncertainty?
5. Decision making under conditions of uncertainty with completeignorance is never the
same as decision making under conditions of uncertainty under partial ignorance. Do you
agree? Explain.
6. What is the difference between the standard deviation and the coefficientof variation as a
measure of risk? When would it be appropriate to use each one?

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Wollo university Department of M anagement

Distance and continued program

M anagerial economics Individual Assignment 35%

Name_______________________________________Id____________________

1. Development of managerial economics is the result of close interrelationship between management

and economics. Discuss.5%

2. Why is decision making by any management truly economic in nature?5%

3. Assuming the unit price of a commodity is defined by: = 90 – 2 , and the cost functionis given as:
= 10 + 0.5 2, 5% FOR A and B

a. Determine the profit-maximizing level of output and the unit price?

b. Determine the cost-minimizing level of output?

4. Aster’s supermarket has estimated the following revenues and expenditures for the next fiscal
year:8%

 Revenues Birr ………...6,800,000

 Cost of goods sold ….…5,000,000
 Cost of labor………….. 1,000,000
 Advertising ………….…100,000
 Insurance …………….…50,000
 Rent ………………….….350,000
 Miscellaneous expenses ..100,000
a. Calculate aster’s accounting profit.
b. Suppose that to open her trilby business, Aster gave up a Birr 250,000 per year job as a buyer
at the exclusive wholesaler store. Calculate Aster’s economic profit.

5.How much money must Mr. Z has to invest today at 6% simple interest if he is to receive Birr 3,100
as an amount in 4 years?4%

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6. What is the total amount of money he invest 8000 birr for 10 year at 10 % simple interest rate.5%

7.Fill the following table production. 8% Marks

NO of workers Total product Average product Marginal product

1 10
2 20
3 30
4 40
5 50
6 60
7 70
8 70
9 75
10 70

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References

Adhikary, M (1987), Managerial Economics (Chapter V), Khosla Publishing

House,Delhi.

Alchain,A.A., and H. Demsetz.“Production, Information Costs, and Economic

Organization,”American Economic Review, 57 (December 1972), pp. 777–795.

Allen, R. G. D. (1938), Mathematical Analysis for Economists. New York: St.

Martin’s Press.

Baumol, W. J. (1977), Economic Theory and Operations Analysis, 4th ed.

Englewood Cliffs, NJ: Prentice Hall.

Baumol, W. J., and A. S. Blinder (1999), Microeconomics: Principles and Policy,

8th ed. New York: Dryden.

Chamberlin, E. (1933), The Theory of Monopolistic Competition. Cambridge, MA:

Harvard University Press.

Chiang, A. (1984), Fundamental Methods of Mathematical Economics, 3rd ed. New

York: McGraw- Hill.

Dholakia, Ravindra, H. and Oza, Ajay, N. (1996), Microeconomics for management

students. Oxford University Press.

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Glass, J.C. (1980), An Introduction to Mathematical Methods in Economics, New York:

McGraw-Hill.

Henderson, J. M., and R. E. (1971), Quandt. Microeconomic Theory: A Mathematical

Approach, 2nded. New York: McGraw-Hill.

Maurice, Charles, S., Thomas, Christopher, R and Smithson, Charles, W. (1992),

Managerial Economics- Applied microeconomice for decision making. Irwin.

Miller, R. L. (1982), Intermediate Microeconomics: Theory, Issues, Applications, 2nd ed.

New York: McGraw-Hill.

Mote, V.L., Paul, Samuel and Gupta, G.S. (1987), Managerial Economics-concepts and

cases. Tata Mcgraw Hill.

Silberberg, E. (1990), The Structure of Economics: A Mathematical Analysis, 2nd ed.

New York: McGraw-Hill.

Thomas J. Webster (2003), Managerial Economics Theory and Practice. Elsevier (USA):

Academic Press.

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