Application of Differential Calculus

A Micro Economics

1 Utility

1.1 Theory of Consumer Behaviour- Maximisation of Utility

The problem of a consumer consists of three things.

Objective To maximise the satisfaction

Constraints Unable to satisfy all his/her wants

Decision In the course of maximising satisfaction, the consumer makes a

decision about how much of any product will be used
Method to 1. Utility Approach
decide 2. Indifference Curve Approach

1.1.1 Utility Approach Developed by Marshal in

Assumption:

i. Utility can be measured cardinally (in numbers).

ii. Consumer is rational
iii. The consumer has to spend his total income on two products X1 and X2

Objective:

Maximise U = f(x1, x2)…………………………………………(1.1)

Y= (x1p1 + x2p2)…………………..……………………………… (1.2)

Where U = consumer’s total utility function,

Y =consumer’s income
x1, & x2 = Quantities of commodities, X1, and X2 and
p1, & p2 = Prices of the commodities X1 and X2
x1, x2 are endogenous and p1, p2 are exogenous variable

Y −x 1 p 1
x2¿ ……………………………………… (1.3)
p2

Y −x 1 p 1
U = f(x1, )
p2

dU/dx1 = f1 + f2 ( -p1/p2)=0…………………………………..(1.4)

or, f1/p1 = f2/p2 where f1 and f2 are marginal utility of x1 and x2

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So, MU1/p1 = MU2/p2 ………………………………………………(1.5)

extending equation 1.5 to ‘n’ items

MU1/p1 = MU2/p2= MU3/p3 =……………=MUn/pn……………… (1.6)

The sufficient condition to maximise the utility is proved from the second order derivative of
(1.4), which will be negative.

Criticisms of the Utility Theory

1. Cardinal measurement (1, 2, 3……) of utility as assumed by A. Marshall is

not possible.
2. Marginal utility was considered independent, but they are interdependent in
the case of substitute and complementary goods.
3. The marginal utility of money is not constant. It decreases as the stock of
money increases.
4. It is based on the assumption of Ceteris Paribus (Latin- all other things being
unchanged or constant). However, in real word it does not happen.

1.1.2 Indifference Curve 1. Prof. Edgeworth ( a British Economist) first introduced

the use of indifference curve in 1881.
2. In 1906, Vilfredo Pareto (an Italian Economist) applied
the Edgeworth Technique’ in the Welfare Economics.
3. Prof. JR Hicks and Prof. RGD Allen popularised and
extended the use of indifference curve analysis in 1930’s
Assumption of Indifference Curve

i. Ordinal measurement as lower, higher, or highest is used to show the level of

satisfaction.
ii. There is transitivity among consumers. If a consumer prefers A to B and B to
C. Then, they must prefer A to C.
iii. The indifference curve will always be downward sloping as consumers
always prefer more of a good to less.
iv. Preference for a combination of two products must be continuous.
v. As a consumer consumes more and more of one good, s/he Iis willing to
sacrifice less and less of the second good, leading to a convex shape of
indifference curve.

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 i.Indifference curve can be defined
as a locus of points indicating
different combinations of
Commodity X1 and X2.
ii. IC1< IC2< IC3 are showing
different level of satisfaction.
iv. AB is the budget line where
p1 is price of commodity X1 and
p2 is the price of commodity x2.
v. AS is the budget line.
vi. All points within ABO are
under the reach of the consumer.
vii. At point E will give the
consumer maximum satisfaction
On x axis= x1
where IC2 is tangent to the Budget
Y axis = x2
line.
Marginal Rate of Substitution of X2 for X1 = MU1/MU2

And, Slope of the Budget Line = p1/p2

For equilibrium condition, the marginal rate of substitution (MRS) = the slope of the price
line.

All points at an indifference curve is constant we have

U= f (x1, x2)

As you know, for maximiztion,

dU = f1dx1+f2dx2 = 0

or, f1dx1 = -f2dx2……………………………………1.7)

or, f1/f2= - dx2/dx1 which is MRS = negative slope of the indifference curve.

Where – dx1 is the amount given away and

+ dx2 is the amount added to the consumption,

Thus, - dx1 =+ dx2 ……………………………………(1.8)

So, it can be said that f1dx1 is the amount of utility or satisfaction which is consumer gives
up to get f2dx2 satisfaction from the commodity X2.

Numerical Example-1
Given Total Utility function, U = x1x2

Price of the commodity x1, p1= Rs4; Price of commodity x2, p2 = Rs. 20 and consumer’s
income=Y=Rs. 100. Find out the equilibrium level of consumption of commodity x1 and x2

Solution-

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Budget constraint as

Y = p1x1+p2x2

Or, 100 = 4x1+20x2

Or, x2 = (100-4x1)/20 = 5- x1/5

Substituting the value of x2 in the utility function,

U = x1x2 = x1(5- x1/5) = 5x1 -x12/5

For maximisation,

first degree differentiation =0 and second degree differentiation = negative.

Ans= x1= 12.5 and x2 = 5

2 Demand

2.1 Elasticity of Demand

Demand of a product depends on many factors as price of the product, price of other
product, income of the consumer, weather, taste, fashion etc.

Differentiation of quantity of a product with other independent variables shows the magnitude
of depends of the dependent variable with respect to change in independent variables when

2.1.1 Price Elasticity of Demand

Price Elasticity -∞<ed<0= Normal Goods

of Demand If, ed=1 -unit price elasticity
ed =dx/dp.p/x ed>1; (Luxury commodity)
where x = quantity ed<1 (necessary commodity)
p =price ed >0 Inferior good

Numerical Example-2
If the demand is given by x=25 -4p+p2

Find the nature of elasticity of demand.

Marginal Function
ed = - dx/dp.p/x or, ed= …………………………………….(2.1)
Average Function

Exercise- 2: If the demand function X= 20/(p+1) find ed when price p=4

MR= P (1-1/e)

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TR = PX

MR = d(TR)//dX = P+X.dp/dx

= P (1+X/P.dp/dx) = P(1-+1/ed) [as ed = -dx/dp.p/x]

= AR (1+1 /ledl) if ignore the sign of ed

1. ed = 1 MR=0
2. ed > 1 MR>0
3. ed <1 MR <0
2.2 Cross Elasticity of Demand

Cross Elasticity of Demand (i) ed>0 = Product X1 and X2 are

Substitute goods
ed* = dx1/dp2.p2/x1 (ii) ed=0 Product X1 and X2 are not at all
related to each other
(iii) ed<0 = Product X1 and X2 are
complimentary good

Numerical Example-3
The demand function of the commodity X1 and X2 are

x1 = P1 -1.3 p2 0.7

x2 =P1 0.6 p2 -0.5

Find out whether two commodities X1 and X2 are substitute or complementary

goods.

Answer- Substitute goods

2.3 Income Elasticity of Demand

Income Elasticity of Demand i. In case of an inferior good and Geffen

eY= dX/dY.Y/X goods; eY < 0
where, ii. In case of a normal good eY >0
x – commodity iii. In case of a luxury good eY >1
Y – Income iv. In case of a necessary good eY <1

2.4 Advertisement Elasticity of Demand

Advertisement eA = dx/dA.A/x Though it has become very

Elasticity of where X= output important ingredient of
Demand and marketing in the recent time,
A = amount of money generally
spent on advertisement If eA >1 Luxury
commodity

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 eA <1 Necessary commodity

A2.5. Elasticity of Substitution

Elasticity of substitution may be defined as the extent to which one commodity can be
substituted for another as a consequence of a given change in the ratio. Symbolically,

∂❑ ( xy )
❑ x
∂ ( )
x/ y y Px / Py
es = = .
( ) X /Y
2
Px px
∂ ∂( )
Py Py
Px /Py

Where X/Y = ratio commodities X and Y

And, Px/Py = ratio of the price of x and y.

SN Elasticity of Implications
Substitution
1. es = ∞ Two commodities are perfect substitute. In this case, the
rate of substitution between them will be constant or
uniform. A fall in the price of commodity X, assuming
that price of commodity Y be constant, will lead the
consumer to substitute commodity X completely for Y.
But in real life we do not find such cases. In case the two
commodities are perfect substitutes, then they should be
considered as one commodity.
2. es >1 [or, 0<es<∞] Two commodities can be substituted for each other
3. es = 0 No possibility of any substitution

2.6 Mathematical Relationship between Price Elasticity of Demand, Elasticity

of Substitution and the income elasticity of demand

The price elasticity of demand depends on the elasticity of substitution, on the one hand, and
the income elasticity of demand on the other. As the price effect is divided into two parts – the
substitution effect and the income effect: the price-elasticity of demand can also be divided
into two parts: the elasticity of substitution and income elasticity of demand.

Where, ep =es ± λ ey

ep = price elasticity; es= elasticity of substitution; ey = income elasticity

Example-

A3 Elasticity of Supply

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The elasticity of supply can be defined as a percentage change in quantity supplied
divided by a percentage change in the price.

η =dx/dp.p/x

dx = change in supply
dp= change in price
x- quantity supplied
p= price of the product
That is 0< η < ∞
If η = ∞ Perfectly elastic supply curve
η =0 Perfectly inelastic supply curve
η>1 More than unit elastic supply curve
η<1 Less than unit elastic supply curve
η =1 Unit elastic supply curve
Elasticity of supply at different points of the supply curve is different as it is different at the
Demand curve.

RATE OF CHANGE IN MR IS TWICE THE RATE OF CHANGE IN AR:

If any demand function P= f(X)

Total revenue (TR) = P.X [price multiplied by quantity]

Or, d(TR)/dX = P+X. dP/dX

Y=Price

R T

S K

AR

O M X=
Quantity

MR

At point, T, TM=P and OM= X

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 KM = MR=d(TR)/dX

Or, KM = P+X.dP/dX

Or, KM = TM+OM.(dP/dX) [dP/dX is the slope of average revenue at point T]

dP/dX = - AR/RT

OR, KM= TM+ OM(-AR/RT) [But OM= RT]

or, KM = TM-AR

or, KM = TM- TK

or, TM –AR = TM-TK

or, AR = TK = RS

or, AR = RS

or, AS= 2AR

AR AMD MR ARE RELATED THROUGH ELASTICITY

Total revenue (TR) = P.X [price multiplied by quantity]

Or, d(TR)/dX = P+X. dP/dX

= P(1+ X/P. dP/dX)

{Since, ed = - dX/dP.P/X ]

Or, MR =AR (1- 1/ǀedǀ )

Or, MR = AR(1-!/ed ) [ed is always taken a positive)

A.3 Production and cost

Laws of Return Return to Scale

1. Only one input is changed while All input are changes
keeping others as constant
2. Short run Long run
3.

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 4. Increasing Law of Return Increasing Return to scale
Constant Law of Return Constant Return to Scale
Diminishing Law of Return Diminishing Return to Scale

Example-

Production Function

It gives exact mathematical relationship between input and output.

Example-

3.1 Cost

Expenses of production are known as the explicit cost of production and, a producers’ effort
and sacrifices, incurred in production (rent cost of production)are known as the implicit costs
of production. Both explicit and implicit cost need to be calculated. Mathematically,

C= f(x) ………………………………………………. (3.1)

Where C= Total cost function

X = output; There is a positive relationship between C and x.
Short-run Cost Function- Short-run is a period in which a firm is unable to change all of its
inputs of production. In this time period, they can only change variable factors of production.
So shor run cost function:
C = f(x) + a…………………………………………(3.2)
Where, a= fixed cost which is independent of the level of output

TC = f(x) + a = TVC +TFC

AC = TC/x = Average cost function

AFC – a/x

AVC = f(x)/x

MC- df(TC)/dx = Marginal Cost function

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3.2 The Concept of Cost Elasticity

The cost elasticity measures the responsiveness of cost to changes in output. It can be defined
as the ratio of proportionate change in total costs to proportionate change in output.

Mathematically,

Ec= dTC/dX.X/TC ……………………………………….(3.3)

Where TC = Total Cost

Minimization
of Cost

Situation:
Minimize total cost TC

Where, TC = f (L, K) = PL.L + PK.K ………………..(3.4)

PL and Pk are price of labour and capital

Constraint: produce amount Xo = f(L,K) where X0 = fixed level of output

To obtain the Lagrangean expression for this constrained into the standard form,
Xo - f(L,K) =0…………………………………………………..(3.5)

Multiply 3.5 by λ, and adding it to the expression for TC in (3.4), which the firm is trying to
minimize:
Lagrangean expression as

Z = TC + λ[X0-f(L,K)]
= PL.L + PK.K + λ[X0-f(L,K)] …………………… (3.6)
To minimize equ. 3.6, each of the partial derivative need to be equal to zero as,
δZ/ δL = PL - λ f1L =0 ……………………… (3.7)
δZ/ δK = PK -λ f1K=0 ………………………… (3.8)
δZ/ δλ = X0- f (L, K) =0 ……………………… (3.9)

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from equ. 3.7 and 3.8, we get
F1L/F1K = PL/PK
The second order condition require that the relevant Bordered Hessian determinant be
positive.

Numerical example: Find the firm’s expansion path expressed in terms of its total
expenditure on its inputs, given the production functions,
X =8log L +20log K
and the price PL = 1 and PK = 5.
Solution:
The objective is to maximize output X, subject to the expenditure (cost outlay) constraint
TC =1L+5K
To solve the problem, a new function is formed using lagrangean multiplier λ as,
V = 8log L +20log K – λ (TC -1L-5K)
Taking the partial derivatives of V with respect to L, K and λ and equate them to zero, we get

δV/ δL = 8/L - λ =0 ……………………………(3.10)

δV/ δK = 20/K - 5λ=0 ………………………… (3.11)
δZ/ δλ = TC- 1L- 5K =0 …………………………(3.12)

From, equ. (3.10) and (3.11) we get, 8/L =4/K

Or, K/L =1/2 or L=2K ……………………………………….(3.13)
Substituting the value in the constraint equation, we get
TC = L+5K;
Putting the value of L as 2K from equation (3.13); TC = 2K+5K
or, K = TC/7

Also, L=2/7C and λ = 28/TC

This constitutes for the required expansion path relationships giving the amount of each input
purchased as a function of total cost, TC.

4. Isoquant
Curve
The isoquant
curve is a graph,
used in the study
of
microeconomics.
Combinations of
two inputs which
yields same level
of production

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Example- Which type of production process will be more appropriate for a
country like India.
Marginal Rate of i. It is the amount by which the quantity of one input has to
Technical be reduced when one extra unit of another input is used,
Substitution so that output remains constant.
(MRTS) ii. It shows the relations between inputs and the
trade-offs amongst them, without changing the
level of total output.
iii.MRTS = slope of Isoquants.
iv. If labour and capital are two inputs
MRTSTK = MPL/MPk
v. Total differential of the Production Function
dP =δP/δL.dL+ δP/δK.dK
where,
δP/δL = Marginal Prouctivity of Labour= MPL
δP/δK = Marginal Productivity of Capital = MPk
vi. Along an Isoquoant, DP=0
vii. So, δP/δL.dL+ δP/δK.dK=0
viii. - δP/δL.dL = δP/δK.dK
ix. or, - MPL/ MPk = dK/dL

Elasticity of It is defined as the ratio of the percentage change in the K/L

• 𝜎 = 𝑑 (𝐾/𝐿)/(𝐾/𝐿). 𝑑 (𝑀𝑅𝑇𝑆)/𝑀𝑅𝑇𝑆
Substitution ratio to the percentage change of the MRTSLK

( )
❑
1
σ =MRTS . L/ K
k ………………
d (MRTS)/d ( )
L
(3.14)

Examples
1. Find the MRTS and Elasticity of Substitution for the following Production
Function.
P = {αK-θ +(1- α )L- θ}-1/ θ
MPL =δP/δL = -1/θ{ αK-θ +(1- α )L- θ}-1/ θ-1 .- θ(1- α )L- θ-1
= (1- α )L- θ-1 { αK-θ +(1- α )L- θ}-1/ θ -1
Similarly, MPK may also be calculated
MPK = δP/δK = -1/θ{ αK-θ +(1- α )L- θ}-1/ θ -1 .- θαK- θ-1
= αK- θ-1 { αK-θ +(1- α )L- θ}-1/ θ -1
MRTS = MRL/MPK
=[(1- α )L- θ-1 { αK-θ +(1- α )L- θ}-1/ θ -1 ]/[αK- θ-1 { αK-θ +(1- α )L- θ}-1/ θ -1]

= (1- α)L- θ-1 / αK- θ-1 = {(1- α )/ α} (L/K) -1- θ

or, {(1- α)/ α} (K/L) 1+ θ
or, б= MRTS. L/K (1/ d(MRTS)/d(K/L) ( as discussed at No.)----------(3.15)
or, d(MRTS)/d(K/L) = 1+θ{(1- α)/ α} (K/L) 1+ θ-1 -----------------(3.16)

( )
❑
1
σ =MRTS . L/ K
or, Putting the value in k =
d (MRTS)/d ( )
L

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 = {(1- α)/ α} (K/L) 1+ θ [1/1+θ{(1- α)/ α} (K/L) θ]
Or, σ = 1/(1+θ)

12. Labour You can measure employee productivity with the labor
Productivity productivity equation:
total output / total input.
Let's say your company generated $80,000 worth of goods or
services (output) utilizing 1,500 labor hours (input). To
calculate your company's labor productivity, you would divide
80,000 by 1,500, which equals 53.
Example- You can measure employee productivity with the labor productivity
equation: total output / total input. Let's say your company generated $80,000
worth of goods or services (output) utilizing 1,500 labor hours (input). To calculate
your company's labor productivity, you would divide 80,000 by 1,500, which
equals 53.

13. Capital Capital productivity is calculated on the basis of the balance

Productiv valuation of the fixed production assets (depreciation costs
ity included), using either the average value over the year or the
value as of the end of the year. Capital productivity is the
reciprocal of the capital-output ratio.
Step no. General Step Example
Cobb-Douglas Production X = 10·L2/3 K1/3
Function Xo = 40
PL = Rs.50, PK = Rs 200
1. take partial derivatives of X to get MRTS = MPL/MPK
the tangency condition (TC): So here, MRTS =
MPL/MPK = PL/PK ((2/3)/(1/3)) . K/L = 2.K/L
PL/PK = $50/$200 = 1/4
So TC 2.K/L = ¼
Or,
2. rearrange the tangency (2) 2.K/L = 1/4 => K=L/8
condition to express K as
the dependent variable.
3. plug the expression for K (3) Qo = 10·L2/3 K1/3
into the output constraint to 40 = 10·L2/3 (L/8)1/3
solve for L. 40 = 5.L
L=8
4. plug the solution for L into (4) K = L/8 = 8/8 = 1
the formula for K derived in
Step 2 to solve for K.
5. Plug your solutions for L and K into (5) TC = $50.8 + $200.1 =
.
the cost equation (TC = PL L + $600.
PK.K) to find out the minimum cost
of producing Qo.
To check your answers: Checking results:
Is the tangency tc: MRTS: 2.K/L = 2.(1/8)

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 condition met? = 1/4
Are you producing PL/PK = $50/$200 =
your targeted level of output 1/4.
(Qo)? Qo: Q = 10.(8)2/3 (1)1/3 =
10.4.1 = 40.

Try the following example:

Given: Q = L1/2K1/2
PL = $4, PK = $1
Goal: Produce Qo = 16 units as cheaply as possible.

(1) Solve for the cost-minimizing input combination:

L = ______ K = ______ TC = ______

(2) Depict the optimum in the diagram to the right. Use actual numerical values to
label (a) your isocost line endpoints, (b) your isoquant, and (c) the values of L and
K at your optimum.

A.4 Market

Maximization
of Profit

Example-

4.1 Monopoly

Only one producer

Industry = Firm

Exercise 4 - Consider a monopolist who faces a linear demand function= p= 100-4x

and a total cost function TC= 50+20x. Determine the optimum level of output.

Solution:

Total Revenue (TR) = x.p = (100- 4x)x = 100x -4x2 -------------------------------------------------

(4.1)

total cost function TC= 50+20x

Π (profit) = TR-TC --------------------------------------------------------------- (4.2)

Or, 100x-4x2 – 50-20x = 0

or, 80x – 4x2 -50 =0;

dπ/dX = 80-8X = 0 (necessary condition)

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Or, x= 10

or, d2x/dp2 = -8<0 (sufficient condition hence proved

4.2 Discriminating Monopoly

A monopolist can sell its product at two different market at two different price given

i. The two markets are not connected to each other.

ii. The price elasticity of demand is different in two markets. Price will be
higher in the market where the price elasticity is lower in the market
where price elasticity is more.

Assumption

i. There are only two markets i.e. market 1 and market 2 where the monopoly firm sells
its product.

Ii The monopoly firm sells its product in such a way that revenue of the firm is
maximised. So, MR1=
MR2...............................................................................................................(4.3)

MR1= MR2= MC .......................................................................................................

(4.4)

Unless the Discriminating Monopoly achieves condition of equ 4.3 and equ. 4.4, it is not in
equilibrium.

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Π = TR1 +TR2 – MC (X1+X2).................................................................................................
(4.5)

Maximixe the equation 4.5 by first degree partial derivative = 0 and second order partial
derivative is negative.

Important Theorem

MR1= MR2 does not necessarily imply that

P1 =P2. It will be lower in the market with price elasticity of demand >1

and vice –versa.

Proof:

We know, MR1= MR2

and MR1= P1 (1-1/e1)

MR2 = P2 (1-1/e2)

Where P1 = Price or Average Revenue of Market 1

P2 = Price or Average Revenue of Market 2

e1 = Price Elasticity of Market 1

e2 = Price Elasticity of Market 2

therefore, P1 (1-1/e1) = P2 (1-1/e2)

or, P1 / P2 = (1-1/e2)/ (1-1/e1)

if, e1 = 2; e2 = 4 ( market 2 is more elastic than the market 1)

or, P1 =3/2 P

or, P1> P2

So, Price is more in the less elastic market than in the more elastic market, even if
MR1=MR2.

Hence Proved

Example.1: Given the following demand for two separate markets and the total cost function
of the monopoly firm,

P1 =17-2X1
P2 = 25-3X2
TC = 2+X1+X2

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 What will be the prices, output and marginal reveunues in the two markets and monopolist’s
total profits under Price Discrimination?

Solution: TR1 = P1X1 = 17X1 -2x12; MR1= 17 -4X1 ............................................................................................................

(6)

TR2 = P2X2 = 25X2-3X22 or, MR2 = 25-

6X2 ..................................................................................(7)

Π = TR1 +TR2 – MC (X1+X2)

After putting the value of TR1, TR2 and TC

Π =17X1 -2x12 + 25X2-3X22 - 2-X1-X2 = 16X1 -2x12 + 24X2-3X22 - 2................................

(8)

First degree partial derivative =0 second degree ,0

(Marginal Revenue)d Π1 = 16-4X1 or, X1= 4; P1 = 9 putting value MR1 = 1 Answer

(Marginal Revenue) d Π2 = 24 -6X2 or, X2 = 4; P2 =13; MR2 = 1 Answer

Π = 78 Answer

Example-
Example.2: Find the Value of Example.1; Find the corresponding value of Π, MR1, MR2; P1;
P2, if the monopoly cannot discriminate.

Solution – If a monopolist cannot discrimination then,

P1 = P2

In such a green, profits of the monopolist must be maximised subject to the constraint, P1=P2

or, 17-2X1 = 25-3X2; or, 17-2X1 – 25+3X2 =0

or, 8- 3X2 + 2X1=0 ..................................................................... (9)(equation of
Constraint)

Using the Langrangian expression

Π* = π+λ (8 -3X2 +2 X1)......................................................................................(10)

Where, λ = Langrangian multiplier to the constraint

Put the value of π function from the (8) in the equation (10),

Π* = 16X1 -2X12 + 24X2 -3 X22 -2 +λ (8 -3X2 +2 X1)

Taking the partial derivative of Π* with respect to X1, X2 and λ, and equate them equal
to zero, we get

δΠ*/δX1 = 16 -4X12+ 2λ

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λ = (-16 +4X12)/2 = 2X12 – 8 ..................................................................................................(11)

δΠ*/δX2 = 24 -6X2 -3 λ = 0

or, λ = 8- 2X2 ..........................................................................................................(12)

δΠ*/δ λ = 8 -3X2 +2 X1 = 0 ..............................................................................................(13)

From equation (11) and (12)

2X1 +2X2 -16 =0...........................................................................................................(14)

Solving equation, (13) and (14)

X1 = 3.2; X2= 4.8; and λ = -1.6

And substituting these values in the relevant functions, we have,

δΠ* = 16X1 -2X12 + 24X2 -3 X22 -2 +λ (8 -3X2 +2 X1)= 74.80

Monopoly Discriminating Monopoly

Profit 74.80 78

Example-

Example- A company manufactures two types of typewriters – electrical (E) and manual (M).
The revenue function of the company, in thousands, is: TR=8E+ 5M + 2EM – E 2 - 2M2 +20,
Determine the quantity of electrical and manual typewriters which lead to maximum revenue.
Also calculate the maximum revenue.

Solution- TR = 8E+ 5M + 2EM – E 2 - 2M2 +20

δ(TR)/δM = 5+2E- 4M = 0

or, 4M-2E =5…………………………………………………………………()

Again, δ(TR)/δE = 8+2M-2E=0

Or, 2E-2M = 8…………………………………..()

From equation () and equation (), we get 4M-2E =5

-2M+2E = 8

M= 6.5

Putting the value of M in the MR equation, 2E-2M = 8

Or, 2E= 8+13 = 21

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Or, E =10.5

A = δ2(TR)/δE2 = -2; B = δ2(TR)/δEM= 2; C= δ2(TR)/δM2 = -4

A&C < 0 and B2>0

TR =8X10..5+ 5X6.5+2X6.5X10.5- (10.5)2 -2(6.5)2 +20 = Rs. 78.25 Ans.

4.3 Perfect Competition

Equilibrium of the Industry

Example- Given the demand Function and Supply Function as

D= 500-100P
S = 50 + 50P
Find out the price and output level of the industry. P= 3 and D=S = 200 Ans

For perfect competition, for firms to be in equilibrium

MR=MC

Example-

Example- Given the demand function and total cost function of the perfect
competition firm as

P=32-X; and C =X2+8X +4,

what level of output will maximise total profit and what are the corresponding value
of price (P) profit (π) and Total Revenue (R).

Solution

For maximization, following two conditions must be satisfied

(i) dπ/dX = 0; MR=MC

(ii) d2π/dX2 <0; X=6; P= 26; TR =156; π= 68 Ans.
4.4 Monopolistic Competititon

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 Example-

Example A firm under monopolistic competition faces a linear demand function and
a linear cost function as

P =16-2X; TC =2+8x

Find the total profit and its monopoly power

Solution

TR = PX = 16X -2X2

Π = TR-TC

16X -2X2 – 2 -8X ;

δΠ/δX = 16 -4X -8 =0

or X=2

MR = 16- 4X = 2 putting the value of X in total profit and MR function we get

Π = 6; P= 12; MR=8

In perfect Competition = MR= Price = 8; In Monopolistic Competition P> MR

The extent to which the price of the monopolistic firm is higher than the MR is
called as Monopolic power. Here the price is 50% more than the MR. Therefore, the
firm has a monopoly power to increase price by 50% more than the price in Perfect
competition.

Example-

Example-

4.5 Oligopoly

The Cournot Solution

Cournot gave a solution of a duopoly problem where two firms are assumed to
produce a homogenous product. He defined the demand function as:

P =f(X1+X2)
………………………………………………………………(4.5.1)

Where, X1= output of duopolist I

X2 = output of the duopolist II
P = price (which is equal to both the duopolists)
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 Also, TRI =x1P = X1f(X1+X2) = TR1(X1,X2)
…………………………………………………..(4.5.2)
Where, TR1= Total revenue function of the duopolist I
TRII =x2P = X1f(X1+X2) = TR2(X1,X2)
…………………………………………………..(4.5.3)
Where, TR1= Total revenue function of the duopolist II
It indicates that total revenue of each duopolist is a function of his own output and that of his
competitor.
The profit function of each duopolist are:
Π1 = TR1(X1, X2)- TC1(X1)…………………………………………….(4.5.4)
Π2= TR2(X1, X2) -TC2(X2) …………………………………………..(4.5.5)
Where, TC1(X1)- Total Cost of the duopolist1
TC2(X2)= Total Cost of the duopolist II
This means that revenue function of each duopolist depends on X1 and X2 while cost function
of each duopolist depends upon his own output level.
The basic requirement of Counot Solution is that each duopolist maximises profit with respect
to his own level assuming that his rival’s output Is unchanging or constant. In other words,
duopolist I maximises π1 with respect to X1 assuming X2 as a parameter and the duopolist II
maximises π 2 with respect to X2 assuming X1 as a parameter.
For maximisesation,
For duopolist I: δπ1/δx1 =δTR1/δx1-δTC1/δx1 =0;
or, δTR1/δx1=δTC1/δx1 ……………………………………. ( 4.5.6)
MR1=MCI
2 2
And, δ TR1/δx1 -δTC1/δx1< 0
or, δ2TR1/δx12< δ2TC1/δx12 …………………………… (4.5.7)
(change in MR1) (Change in MC1)

For duopolist II δπ2/δx2 =δTR2/δx2 -δTC2/δx2=0

Or, δTR2/δx2 =δTC2/δx2 ……………………….(4.5.8)
or, MR2=MC2
And δ2TR2/δx22-δ2TC2/δx22 <0
Or, δ2TR2/δx22< δ2TC2/δx22………………………(4.5.9)
(Change in MR2) (Change in MC2)

The equilibrium solution can be obtained if equations (4.5.6), (4.5.7), (4.5.8), and (4.5.9) are
satisfied. And neither of the duopolists desires to alter his output while the other maximises
his output.

Important Theorem – The Marginal Revenues of the Duopolists (MR1 and MR2 respectively)
are not necessarily equal, but the duopolist with the greatest output will have smaller MR.
Proof:
Total Revenue of both the duopolists is = TR =TR1+TR2 = PX1 +PX2 = P(X1+X2) = PX
Where X =X1+X2
(General Marginal Revenue) MR = δTR/δX = P+X.dP/dX = P+ (X1+X2)dP/dX
Where, dP/dX<0
Let X1> X2 and X2 is a parameter for X1. In such a situation MR1<MR2.
The Cournot Solution includes only two- firms case, but it can be extended to more than two
firms. Here also the basic requirement of profit maximization will be the same.

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Criticised to assume that each duopolist to maximise his profits treating other’s output as a
parameter. However, if Duopolist I and Duopolist II have a collusion to act in union or under
a uniform policy in order to maximise the total profit of the industry ( here comprising of two
firms only). This situation becomes very similar to that of monopoly and is known as
Collusion solution of the oligopoly problem (Willim J. Baumol p. 326)

Example-

Example: If the demand and cost functions are given as

P = 80 – 0.4 (X1+X2)
TC1 = 4X1; TC2 = 0.4X22
Find out X1, X2, P and Π1, Π2. Also prove the second order condition for profit
maximisation. Discuss whether a rise of either duopolist’s output level will cause a reduction
of other’s output level?
Solution: We establish

TR1 = PX1= [80 – 0.4 (X1+X2)]X1 = 80X1 – 0.4X12 -0.4X1X2

TR2 = PX2 = [80 – 0.4 (X1+X2)]X2 = 80X2 -0.4X1X2 – 0.4X22

Now, their profit equations are

Π1 = TR1- TC1 = 80X1 – 0.4X12 -0.4X1X2 - 4X1 = 76X1– 0.4X12 -0.4X1X2

…………………… (4.5.10)

Π2 = TR2-TC2 = 80X2-0.4X1X2-0.4X22-0.4X22 = 80X2-0.4X1X2-

0.8X22……………………………..(4.5.11)

First order condition for profit maximisation

δπ/δX1 = 76 -0.8X1 – 0.4X2 =

0…………………………………………………………(4.5.12)

δπ/ δX2 = 80 – 0.4X1 –

1.6X2=0………………………………………………………(4.5.13)

Solving equation (4.5.12) and (4.5.13), we get X1= 80 and X2 =30

Substituting the value of X1 and X2 we get, P= 36; π1 = 4480 and π 2=720 Ans.

Second order condition for profit maximization

δπ/δX1 - 0.8 <0

δ2π/ δX22 = -1.6 <0 Hence proved

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We may now get the corresponding reaction functions of the duopoilist from the
equ. (4.5.12) and (4.5.13) as:

X1 =(76 -0.4X2)/ 0.8 ……………………………………………………….(4.5.14)

X2 = (80 – 0.4X1)/ 1.6 ………………………………………………….(4..5.15)

The above equation (4.5.14) and (4.5.15) states hat a rise of either duopolist’s output
level will cause a reduction of the other’s optimum output level. Hence each
duopolist acts as if his rival’s output were fixed.

B Macro Economics

B.1. Marginal i.Marginal propensity to consume (MPC) refers to the

Propensity to proportion of extra income that a person spends instead of
consume saving.
iiThe concept made by famed British economist John
Maynard Keynes in the 1930s during the Great Depression.
iii. He noted that individuals have the propensity or
tendency to consume more when their income increases.
iv. Marginal propensity to consume is useful because it
relates to how a government stimulus might affect the
economy.
▲C
MPC =
▲Y

Where C = Consumption; Y = Income

B.2 Incremental i The incremental capital output ratio (ICOR) explains the
Capital-Output relationship between the level of investment made in the
ratio economy and the consequent increase in GDP.
ii ICOR is a metric that assesses the marginal amount of
investment capital necessary for a country or other entity to
generate the next unit of production.

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 Diagram

▲GDP
ICOR =
▲I

Where, GDP= Gross Domestic Product; I - Investment

Example-

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