Chapter 2: Market forces Supply & Demand

This chapter includes four important elements:

1. A change in quantity demanded or supplied as a result of a change in the
current price.
This is a movement along the demand or supply curve. This helps us understand the
slope of demand or supply with respect to the price and then estimate their own price
elasticities.
2. A shift or change in the demand or supply as a result of a change in a
relevant factor other than the current price. This change represents a change in
the entire demand or supply or a shift. Understanding the factors that shift the
demand or supply help us specify and estimate a demand or supply equation and
estimate the other factors elasticities
How do we distinguish a change in quantity demanded or supplied from a change
in demand or supply? If the factor that changes is on any of the axes (such as the
current price is on the vertical axis), then there is a change in quantity demanded or
supplied. But if the change is in a factor that is not on any of the axes such as
income or cost of production, then there is a shift or change in demand or supply.
The student should define the slope of direct demand or supply with respect to current
price as change in quantity over change in price. Not the other way!
Example:
(Direct) demand: Qdx = 6,060 3Px. Slope of demand = Q/P = -3
Inverse demand: Px = 2020 -1/3Qdx. Slope of inverse demand = P/Q= -1/3

3. Consumer and producer surplus

What is the usefulness of calculating the consumer surplus for the manager? The
manager can use it in price discrimination and in valuing full economic prices.
Whats the usefulness of knowing the producer surplus? The producer can use it
to bargain with the distributor over the surplus above minimum cost of producing
the good accruing to the distributor.

4. Market equilibrium and disequilibrium (or price restrictions)

Market equilibrium means supply equals demand and there is no surplus or
shortage. This helps determine equilibrium price and quantity.
Market disequilibrium means that supply and demand do not intersect or are not
equal at any price in the market. In this case, we have either a surplus (quantity
supplied exceeds quantity demanded) or a shortage (quantity demanded exceeds
quantity supplied). This helps us determine the size of shortage or surplus.

When a government intervenes in the market and buys the surplus to set a price above
the equilibrium price, then there is a price floor as is the case with agricultural
products.
If the government issues a decree and sets the price below the equilibrium price then
there is a price ceiling or control which leads to shortages. Some governments set a
rent control for apartments.

THE SUPPLY FUNCTION

Supply function and Shifts in Market Supply
Supply Specification: The simple supply equation is defined as:
Qs = a + bP
and the slope with the respect to the price Q/P is positive. That is the supply curve is
upward sloping.
The general (direct) market supply equation can be expressed as a function.
QS = f (P; Production cost, Taxes, Expected Price).
where P is the current period price for this good and is different from the expected
future price. Change in current price causes a change in quantity supplied or a movement
along the curve. The other factors (after the semi colon) are the shifters which cause a
change or a shift in the entire supply. Production cost includes the cost of labor,
represented by the wage rate PW, capital cost represented by PR, the rental price of
capital (equipment), and the price of raw materials PM. T will represent taxes and Pex
represents the expected future price for this good. Then the general (direct) supply
function can be rewritten as QS= f (P; PW, PR, PM, T, Pex)

For example, Qs = 2000 + 3P PW - 4PR 2PM T + - Pex.

where (direct) slope of supply with respect to (w. r. t.) current price P, Q/P, is +3, and
the slope w.r.t., PW, Q/PW, is -1, and w. r. t. PR , Q/PR , is -4, Q/Pex > 0 or <0.

If PW = $20, PR = $40, PM = $10, T = $100 and Pex = $15, then after substitution for the
constant shifters, the general (direct) supply equation collapses to the simple (direct)
supply equation:
Qs = 1715 + 3P, which is generally written as Qs = a + bP.
All the other variables have been lumped with the intercept and the simple direct slope
is Q/P = +3. In the simple (direct) supply equation, all the variables after the ; are
the factors that are held constant and are usually lumped together to form the intercept a.
They are the Shifters. As indicated above, simple direct supply equation is given by:

Qs = a + bP. (Here, a is the horizontal intercept and b is the direct slope).

The simple inverse supply function is P = -a/b + (1/b)Qs
where +1/b is the inverse supply slope and -a/b is the vertical intercept.
A graph of the simple supply function is given by S1 below (P is placed on the vertical
axis). Using the above example, P = -1715 / 3 + 1/3*Qs where 1/3 is the inverse slope.

S1

S2

P1

QS 1

QS2

QS ,

Examples of shifts in Supply: Suppose labor production cost decreases and also assume
no changes in the other variables including the current price P. A reduction in
production cost implies an increase in profit (the difference between total revenues and
costs), which should increase quantity supplied. The increase in the quantity supplied
while the current price is assumed constant implies a right shift (an increase) in the
supply curve from S1 to S2 in the graph below. The sign for wage rate should be -.

In conclusion, a decrease in the wage rate (W) implies an increase in the quantity
supplied QS, assuming P is constant, which means a rightward shift in supply curve, and
vice versa for an increase in (W), which implies a shift in supply to the left.
The same logic applies to decreases or increases in PR and PM.
Changes in Expected Future Price (Pex): These changes are applied to the price expected
to prevail in the next period. Their effect on quantity supplied in this period depends on
the storability of the good in question.

POil
P1

S2

QS 21

QS1

S1

QS0il

(Storable Good; e.g., oil)

In the special case when the good is storable (e.g., oil, gold, etc) then an increase in
the expected price implies storing the good instead of producing more of it. Then at the
current price, current quantity supplied decreases, representing a shift to the left in the
supply curve.
In general, an increase in expected price should shift the supply curve to the right, which
is the normal case. This is particularly true for non-storable goods. If the good is nonstorable such as milk, then an increase in Pex leads to an increase in current QS because the
production of non-storable goods does not take much time to bring them on stream and
thus, the firms worry about maintaining their market shares. Therefore, the supply curve
shifts to the right, assuming the other variables are constant.

S1

P Milk

QS 1

QS2

S2

QSMilk

(Non-Storable Good; e.g., milk)

Taxes: There are basically two types of taxes: Specific and ad valorem. The specific tax
is a fixed amount of money per unit sold (e.g., 10 cents per pound), while ad valorem is
proportional to the value or the price (e.g., 10% of the price) which may not be constant.
An example of a specific tax is the excise tax, which is a constant $ tax on each unit sold
and the tax revenue is collected from the supplier. In this case the (inverse) supply curve
shifts up in a parallel fashion by the amount of the tax.

Fig. 2.7 A per Unit (Excise) Specific Tax

If the tax is ad valorem, then if the price increases, the amount of the proportional tax
increases with the price. Suppose the tax rate =20%. If P =$10 then the tax amount is $2.
If P=$20, then the tax is $4. In this case the shift in supply is really an upward rotation.
Note that after tax, P1= S1 = (1+t%)*S0 where supply S0 =P0 is expressed as an inverse
supply equation:

P0 = -a/b+ (1/b)Qs0 which is S0, where P0 is price before tax.

Then S1 is

P1= (1+ t%)*P0 = (1+ t%)*[-a/b + (1/b)Qs0], where P1 is price after tax.
Solve for Qs1 as a function of P1.
Direct supply after tax: Qs1 = a + (b/(1+t%))P1=

a + bP1 + t*bP1

(note that (1+ t%) = 1+ 20%) = 1.20 in the above example)

Fig. 2-8 An Ad Valorem Tax (t=20%)

That is, inverse S0 rotates upward to S1.

Producer Surplus

The points on the supply curve measure the minimum amounts (or prices) the producers
are willing to accept for producing the good because the supply curve is a cost curve.
Those amounts are tantamount to minimum costs necessary to produce different levels of
the good, and these costs are usually lower than the market price. Supply price is a
minimum price.
Suppose the (direct) supply equation for TVs is given by:

Qs = 2000 + 3P PW - 4PR = 2000 + 3P 2000 - 4*100 = -400+ 3P.

where PR is the rental price of monitors (a complement) per unit representing
capital cost and PW is the price of an input like labor or the wage rate.
Suppose PR = $100 and PW = $2000.
Then the simple (direct) supply equation is: Qs = -400 + 3P (where -400 is horizontal
intercept).
The inverse supply equation is: P = 400/3 + (1/3) Qs (400/3 is vertical intercept).

Fig. 2.9: Producer surplus

In Fig 2.9 (Producers Surplus), the cost per unit to produce the first unit of the good is
$400/3 (point C) and to produce the 800 units per unit is $400 (point B).In this figure,
suppose the market price is $400 and this market price applies to all units. Upon
substitution, the quantity is 800 units Then the sales revenues received by the producers
are P*Q = $400 * 800 = $320,000. This is the area of rectangle [0 A B 800].
The area under the supply curve up to the point where the price line intersects the supply
curve is the minimum cost associated with producing 800 units (an integral). Then
7

Producer Surplus = Revenues received minimum amount necessary to produce

the good or PS = TR VC where VC is variable cost.
= Area of the triangle ABC
=*H*B
= *($400 400/3)*800
= $106,668. (for the wholesaler A)
Graphically, PS is the area below the price line and above the supply curve. It is a
powerful tool for managers. In the above figure, suppose that the 800 units are 800
pounds of meat supplied by the meat wholesaler to the retailer which is the producer of
steak (the restaurant). In this case, the restaurant manager (the retailer) can bargain with
the meat wholesaler over the producer surplus (a maximum of $106,668) to capture some
of it in the form of a lower price. Thus, the retailer can use the PS against the wholesaler.
MARKET DEMAND FUNCTION:
Specification as a general (direct) function:

QDX = f(PX ; Income, Prices of related goods, Advertising, other variables) or

QDX = f(PX; M, PY, PZ, A,H)
where goods X and Y are substitutes, and X and Z are complements. The
variables after the semi colon are the shifters of the demand curve.
The simple (direct) demand depends on current own price and assumes all the other
variables are constant. QD = c - dP (add or subtract the shifters to or from horizontal
intercept). Direct price slope QD /P = - d.
When it comes to income (M), there are two types of goods: Normal and Inferior. In case
of normal goods, an increase in income (holding the other variables constant), would lead
to an increase in purchasing power, which manifests itself in an increase in demand.
Demand curve shifts to the right, assuming no change in current price. QDX /M > 0

D1

D2

P
P
*1
D
Q

D
1

D
2

QD
8

(An Increase in Income: Normal Good)

In case of inferior goods, an increase in income leads to a reduction in quantity demanded
at the same price. Thus, the demand curve shifts to the left. QDX /M < 0
D2
D2

D1

P1

QD2

QD1

QD

An Increase in Income: Inferior Good

Related goods can be substitutes or complements.
If goods X and Y (Tea and Coffee) are substitutes, then an increase in PY (of coffee)
would lead to a decrease in quantity demanded of Y(coffee). On the other hand, it is
assumed that there is no change in PX (tea) then people switch from coffee to tea, which
means quantity demanded of tea (QX) increases at the same price of tea PX. This implies
a shift in demand for tea (X). Relation between PY and QX is QDX /PY > 0.
Dy

PX

Py
P2

D2X
D1X

P1

P1
QD2

QD1

Coffee
Y Good)
(Inferior

QYD

QD1

QD2

QX

Tea
X

If the two goods X and Z (Printers and Computers) are complementary, then an increase
in price of computers (PZ) would lead to a leftward shift in demand for printers (DX).
Relation between PZ and QX is negative, QDX /PZ < 0.
PZ
DZ
P2
P1

D2X
9

PX

D1X

P1

Q2

Q1

QZD

Computers (Z)

Q2

Q1

QX

Printers (X)

Advertising (A) also shifts the demand curve. An increase in advertising shifts the
demand curve to the right. There are two types of advertising: informative advertising
which provides information about the existence or quality of a product, and persuasive
advertising which alters the underlying taste of the consumer You must buy it or The
only thing you should buy. QDX /A > 0.
Consumer Expectations (changes in expected prices, expected income etc): Demand for
durable goods (e.g., cars) is affected by changes in expected prices. However, demand for
perishable products (e.g. milk, eggs) is not affected much by expectation of higher prices.
Other factors (H) are special factors related to certain products such as Health Scares
related to cigarettes or the birth of a baby related to diapers.

The general linear (direct) demand equations can be written as

QDX = b0 - b1PX + b2PY - b3PZ + b4M + b5A.
The own direct slope with respect to PX is: QDX /PX = -b1 < 0 (simple demand
has a negative slope). (Whats the indirect demand slope for the simple
demand?) Is it -1/b1?
The sign for income (M) depends on whether good X is normal or inferior.
For example, if the slope with respect to M is QDX / M = +b4 (then the good is
normal). If QDX / M is negative, the good is inferior.
The slope with respect to PY is: QDX /PY = +b2 >0 (positive means X and Y are
substitutes). If QDX /PZ = -b3 < 0 then X and Z are complements. QDX /Z = b5
Demonstration Problem 2-1
A firms manager was given the estimate of the direct demand function or equation for
his/her firms product X:

10

Qdx = 12,000 3Px + 4Py 1M + 2Ax

Please answer the following questions:
1. What type of goods are X and Y (with respect to the price of Y)?
2. What type of good is X (with respect to income)? Normal? Inferior? Why?
3. How does advertising affect this firm product?
4. Let Py = $400, M =$1,000 and A = $100. Derive the simple inverse demand and
calculate the inverse slope (hint: plug the numbers in the equation and solve for

Px).
Is it: QX =12,800/3 -1/3QS ?
Consumer Surplus (area below the demand curve above the price line)
Points on the demand curve signals the maximum amount a consumer is willing to pay
per unit for a certain amount of a product. This maximum amount falls as more of a
product is consumed and it is also different from the market price. Demand price is a
maximum price.
Lets us look at the demand for water. Suppose at zero the consumer is willing to pay $5
to have the first liter of water (see Fig. 2-5a).

Fig. 2-5: Consumer Surplus

In discrete terms, after this consumer consumes the first liter he/she is willing to pay $4
for the second liter. Once this consumer has enjoyed 2 liters, it is willing to pay $3 per
liter and so on.
For the continuous, case, what is the total value (benefit) of 2 liters of water? (Area
under the demand curve to the horizontal axis = area of rectangle + area of triangle).
Max total benefits = $3 x (2 liters) + *($5 - $3)*(2 liters) = $6 + $2 = $8.

11

In the market, the consumer does not pay different prices for different units. Here, the
market price after buying the second liter is $3. Total consumer expenses are $3x2 units =
$6.
Consumer Surplus = Total Maximum Willingness to pay - Total expenses = $8 - $6=$2.
This concept is useful in disciplines that emphasize price discrimination where producers
try to capture CS from consumers. You can also calculate CS directly by calculating the
area of the shaded triangle above. CS = *H*B = *($5 - $3)*(2 liters) = $2.

Market Equilibrium
Market Equilibrium: Supply intersects demand. It includes the equilibrium quantity Qe
(or Q*) and equilibrium price Pe (or P*). After the equilibrium, there is no shortage or
surplus. Quantity supplied equals quantity demanded as shown in the graph below.

Pe =

Qe

QS , QD

(Fig. 2-10: Market Equilibrium)

Demonstration Problem 2-4:
Simple Direct Market Demand: QD = 6 - 0.5*P.
Simple Direct Market Supply:

QS = 4 + 2*P.

Market Equilibrium: QD = QS .
6 0.5Pe = 4 + 2Pe
0.5Pe + 2Pe = 6 - 4
2.5Pe = 2
12

Solve for Pe. Then

Pe = 2 / 2.5 = $ 0.8 (equilibrium price also called P*).
Plug Pe in either supply or demand equation to determine the equilibrium quantity:
Qe = 4 + 2Pe = 4 + 2(0.8) = 5.6 units (equilibrium quantity)
Thus, market equilibrium = (Pe; Qe) = ($0.8; 5.6 units).
The graph of this market equilibrium is given by

P1

Pe =
$
0
.
P28

Qe = 5.6

QS , QD

(Fig. 2-10: Market Equilibrium)

Free Market Mechanism: The tendency of the market price to change as a result of
market forces in order to clear the market (i.e., to equate QS and QD).

If P1 > Pe then QS > QD (Surplus).

Then there would be a downward pressure on P, and once , until QS = QD at Pe.

If P2 < Pe, then QD > QS (shortage) and there would be an upward pressure on the price,
shrinking the shortage, until QS = QD at Pe.

13

PRICE RESTRICTIONS AND MARKET (DIS)EQUILIBRIUM

There are two types of market disequilibrium: Price controls (or ceiling) and Price floor
(or support). Disequilibrium means supply does not equal demand.
Price Control or Ceiling (PC): Governments intervention (e.g., rent control) prevents
market price from moving up to clear the market and achieve equilibrium. Thus PC < Pe ;
where PC is the ceiling price. That is, price ceiling is below equilibrium price.
http://daphne.palomar.edu/llee/101Chapter08.pdf

Pe
PC

Shortage

QSC Qe QDC

(Figure 2-11a: Price ceiling)

Price controls such as rent controls lead to shortages because the controlled price is too
low.
Total shortages = QCD QCS.
If these are apartments, then the total shortage can be divided relative to equilibrium into
two parts:
Qe - QCS = # of existing apartments that are taken off the market relative to Qe.
QCD Qe = # of new apartments which are sought by new renters relative to Qe
Demonstration Problem 2-5 (apartments)
Demand: QD = 100 5P (where Q is in 10,000 units and P is in $100, and the zeros can
be ignored).
Supply: QS = 50 + 5P
a. Calculate market equilibrium

14

QD = QS
100 5Pe = 50 + 5Pe Pe = $5 (one hundred) and Qe = 75 (0,000) units
b.

Assume ceiling PC = $1 (one hundred). Calculate the total shortage.

QCD = 100 - 5PC = 95(0,000) units (total quantity demanded at price ceiling).
QCS = 50 + 5PC = 55 (0,000) units.

c.

Total shortage = QCD QCS = 95 55 = 40 (0,000) apartments.

If the average apartment has three persons, then
# of displaced residents = (3)*(Qe - QCS) =(3)*(75-55) = 60 (0,000) persons
# of new residents = (3)*(QCD Qe) = (3)*(95-75) = 60 (0,000) persons

How Do Businesses Deal with Losses Created by Price Ceilings?

Price ceilings provide a gain for buyers and a loss for sellers. Sellers would like to
avoid the loss if they can.
1. One way to do so is called a black market. In this case, the sellers illegally raise
the price and hope to get away with it. So, for example, tickets to popular events
are sold by scalpers at high prices. (In California, ticket scalping is not illegal if it
is not conducted at the place the event takes place.) While there are many other
examples, black markets are not smart; it is just too easy to be caught. It is also
not smart because of the existence of gray markets.
2. A gray market is a way of getting around the price ceiling without actually doing
anything illegal. There are two forms of gray market. (a) One form of gray
market involves charging for goods or services that were formerly provided free.
If the rent cannot be raised on the apartment, there is nothing preventing the
landlord from charging for the parking space, charging for use of the elevator,
charging for gardening and cleaning services, forcing the tenants to pay for
electricity and water, and so forth. In New York, a rent-controlled apartment near
Central Park might rent for $300 to $400 per month; in a free market, the rent

15

would probably be $2,000 per month. To get in, one needs the key. This has been
known to cost $1,000. This is not a refundable deposit; this is a charge to have the
key. It is obviously worth it to be able to rent the apartment for $300 to $400 per
month. A Berkeley apartment owner converted his apartment into a church. To be
able to live there, one had to pay church dues of $1,200 per year in addition to the
rent. Gasoline stations would commonly charge for washing the windows,
checking the tires, and so forth. The price of oil used in oil changes would be
raised. (Those having oil changes at the station were favored in access to gasoline
during the years of the price ceiling. In these years, Americans had the cleanest
engines in history.) Some gas station owners ran the line to the gasoline pump
through the car wash. One San Diego station forced people to have a $7 car wash
to get to the gasoline pump. ($7 in these years is the equivalent of about $20
today.). This practice was later declared illegal. (b) The second form of gray
market is to provide less service for the same price.

Welfare Impact of Price Ceiling

Since there is a shortage, there should be an allocation mechanism to allocate the
good among the consumers. The most common mechanism is (first come, first served). In
times of severe shortage, consumers must spend some time to wait in line or search for
the good or apartment. Suppose the demand is for gasoline and the consumer wants to
buy 10 gallons. Moreover, assume this consumer must wait for two hours in line to get
the gasoline and that this consumers time is worth $5 an hour. This means the consumer
is spending $1 per gallon in terms of waiting time to purchase gasoline (non-pecuniary

16

price), in addition to the price ceiling per gallon (pecuniary price). This is called the full
economic price.
Example:
Full economic price can be depicted graphically as:

(Figure 2-11b: Full Economic Price and Welfare Impact of Price Ceiling)

Example: Suppose the maximum price the consumers are willing to pay per unit is PF
= $11 (called full economic price and is assumed) and the pecuniary price ceiling per unit
is PC = $5.
Thus (PF PC) = (11-6) = $6 is called the non pecuniary price per unit the consumers are
willing to pay by waiting in line (the implicit price per unit for waiting in line). Full econ
price per unit is PF = PC + (PF - PC)

Full economic price = pecuniary dollar price + non pecuniary price. Note that PF is
greater than the equilibrium price Pe.

Example: Calculating Full Economic Price Using Equations. In the apartment

example above: The supply equation under the ceiling is

17

QSC = 50 + 5PC = 55 units (by plugging PC = $1 in this supply equation) (STEP 1)

Next, set the demand equation under ceiling equal to 55 units and change PC to PF in this
equation:
QDC = 100 5PF = 55 units
(STEP 2)
Then solve this equation for full economic price, PF = (100 - 55)/5 = $9. (STEP 3)
Compare this full economic price to:
Equilibrium Pe = $5 and to ceiling price PC = $1.
The non-pecuniary price of the good is:
(STEP 4)
F
C
P P = $9 - $1 = $8. This is the value of your time waiting in line or searching per
unit.
Non busy consumers with very low opportunity cost of waiting time may benefit from the
price ceiling, while those with high value for opportunity cost of waiting time may be
hurt by the relatively low price ceiling. If a politicians constituents have a relatively low
opportunity cost of time, that politician naturally will attempt to invoke a price ceiling.
Another mechanism to allocate the good that is in short supply is to sell the good to the
regular customers (e.g., gas stations during crises sell to their regular customers).

How to calculate the cost of welfare (CS + PS) lost due to price ceiling? It is
the area of the shaded triangle in Fig. 2-11b.
= 1/2*(PF - Pc)*(Qe Q Sc) = ($9 - $1)*(75- 55) = $80
=1/2 *nonpecuniary price* supply shortage relative to equilibrium
Price Floor or Support: The government sets the price floor (Pf ) above the equilibrium
price to support farmers income. Price support leads to surpluses, which are usually
purchased by the government. Thus,
Pf > P* above equilibrium price.
Because the intervention price (Pf) is set too high, there is a surplus of this agricultural
P
commodity.
D
S
http://daphne.palomar.edu/llee/101Chapter08.pdf
Surplus

P*

QDf Q* QSf

18

Total Surplus = QfS - QfD . For the price to stay at Pf , the government must purchase the
surplus.

Cost of purchasing the surplus is illustrated in Figure 2-12 (A Price Floor).

The cost of purchasing the surplus = amount of surplus * price floor.

How Do Businesses Solve the Surplus Problem?

19

There were many ways to solve the problem of surpluses.

1. Occasionally, a store simply broke the manufacturer's policy. The store
lowered the price to get rid of the surplus. The manufacturer had threatened that
the store would be prohibited from selling the manufacturer's product; the store
either believed that the manufacturer would not carry-out the threat or did not
care. For example, Crown Books began lowering the prices of its books and a
company called Discount Records began lowering the prices of phonograph
records.
2. More likely, stores would try to get around the price floor without actually
violating. (a) One common solution was to provide more service for the same
money. Stereo stores could add free CDs or other free accessories. Washing
machine stores used to virtually give away the dryer. Gas stations gave away
glasses, knives, and Blue Chip Stamps. (b) A second solution was to simply
absorb the surplus. Your textbook producers would have a surplus of textbooks.
At the end of each edition, the books would be returned to the publisher and the
paper was recycled. (c) A third solution was to change the name of the product
in order to reduce the price. Surplus gasoline was sold to independent dealers who
would sell it as Thrifty, 7-11, or Discount Gas at a lower price. Surplus liquor was
bottled with a different label and sold as Slim Price, or Yellow Wrap at a lower
price. Surplus washing machines and refrigerators were sold, for example, to
Sears and marketed as Kenmore at a lower price. When automobiles were fairtraded, the dealers could not lower the price; however, they would give a trade-in
value that was much greater than the trade-in car was actually worth. The main
20

point here is that, even if someone interferes with the market process, there are
powerful forces to return to equilibrium
COMPARATIVE STATICS (within supply /demand framework)
Changes in Demand
Suppose there is an increase in income (the case of normal good), or in the price of the
substitute or in the expected price (the case of a durable good). These variables are
determinants of demand. Then the demand curve will shift up. In the supply/demand
framework, both equilibrium price and quantity change when there is a shift in demand.
Both will increase in this case.
(Figure: Shift in Demand)
P

D1

D2
S

P*2
P
*1

Q*1

Q*2

The opposite shift in demand will happen if there is an increase in price of a

complement.
or increase of income and the good is inferior
Changes in Supply
21

In reality, both P and QS change when supply shifts. For example, if there is an increase

in PR ( rental price of capital) or Pw (wage rate) or the production cost then the supply
curve will shift to the left, creating new market equilibrium with a higher equilibrium
price (P*2) and lower equilibrium quantity (Q*2).

S2
S1

P*2
P*1

(Increase in R)

Chapter 3: Quantitative
S
Q* Q* DemandQAnalysis
,QD
2

22

Chapter 3: Qualitative Demand Analysis

Assignment: The regression spreadsheet at the end of chapter.
This chapter includes three important elements:

1.

In contrast to the previous chapter which examines the direction of change

(positive or negative slope), this chapter examines the magnitude of
change or percentage of change (i.e., elasticities)

2. Elasticities. Any elasticity is defined as a percentage change over a percentage

change. The slope, which is a part of the elasticities, is a change over a change.
There are three elasticities for demand. The own price elasticity helps marketing
mangers in deciding whether to increase the price or decrease it in order to
increase sales revenues. The cross price elasticities help mangers determine the
effect of a change in the price of a substitute or complementary product on the
demand of their product. The income elasticity measures the responsiveness to
changes in income.
THE ELASTCITY CONCEPT
(Elasticity = % / %)
A price elasticity of demand, for example, measures how much quantity will change in
percentage terms when a price changes by a certain percentage. (Direct price Elasticity =
% Q /%P )
Example: suppose:
%P = + 5%; Price elasticity = 2; then %Q = (elasticity)* %P = -2 *5% = -10%.
OWN (direct) PRICE ELASTICITY OF DEMAND
Own means we use the % change in the quantity and the % change in price for the
same good, say x. Direct means % QD / % P and not the inverse.
First, I will present the two definitions of the point elasticities then I will provide the
definition of the midpoint or arc elasticity which is more relevant for the total revenue
test.

First definition: point direct elasticity (moving from say point A to point B).
EPD = % QD / % P.
This definition can be rewritten for a direct demand schedule as
EPD = Q / Q = (Q2 Q1) / Q1
P/P
(P2 P1) / P1

23

Example:
P
$9 (P1 )
7 (P2 )

QD
15 Units Q1
25
Q2

EPD = (Q1 - Q2 )/ Q1
(P1 - P2) / P1
= (25 - 15) / 15
(7 - 9) / 9

=-3

Second Definition: point elasticity (moving from point B to point A)

EPD = (Q1 - Q2 )/ Q2
(P1 - P2) / P2
= -1.4 (the same example above but with different elasticities)

First Def.: Moving From Point A

to Point B

Second Def.: Moving From Point B

to Point A

EPD = (Q2-Q1) / Q1 = (25 - 15)/15

(P2-P1) / P1
(7 - 9) / 9
= -3

EPD = (Q1 - Q2 )/ Q2 = (15 -25)/25

(P1 - P2) / P2
(9 - 7) / 7
= -1.4

P
A
P1 = 9
_
P

Mid Point

P2 = 7

Q1=15

Q2 =25

The third definition: Mid point elasticity

24

In the graph above, we move from point A or B to the midpoint .

EPD = (Q2 - Q1) / (Q1 + Q2) = (Q2 - Q1) / average Q =
(P2 - P1) / (P1 + P2)
(P2 - P1) / average P
where P and Q with bars in the graph are averages for quantities 1/2*(Q1 +Q2) and for
the prices *(P1 + P2), respectively. Those averages are equal to 8 and 20 for quantities
and prices in the above graph, respectively.
Applying the midpoint (arc) elasticity formula to the above example, we have
(25 - 15)/ (15 + 25)
(7 - 9) / (7 + 9)
= -2
The movement is from point A to the midpoint (not to point B as is the case in the point
elasticity in the graph above). See INSIDE BUSINESS 31 P. 80 for an example on
calculating the midpoint (Arc ) elasticity for the housing market over one month change.
Own Price elasticity for a direct demand equation:
Let the direct demand equation be: QD = a bP where QD / P = -b is the direct
price slope. Then the direct elasticity = QD/Q / P/P = (QD / P)*(average P / average
Q) where QD / P is the slope of direct demand and (average P / average Q) is the
location point on the demand curve. To calculate the Averages: Sum up all the values
and then divide the sum by the number of observations.
Example: If QD = 6 - 1.5P
and average P = $ 2
average Q = 5 units.
Recall, direct slope = Q/P = -1.5 in the equation above.
Then EPD = (Q/P)*average P/average Q = (-1.5)*2/5 = - 3/5
Co-efficient of EPD = EPD= absolute value of EPD .
This is used in order to avoid comparing two negative numbers for the elasticity but the
price elasticity of demand is still negative.
Types of Elasticities: (see p. 81, Table 3-2 for real world estimates of elasticity)
If 0 < EPD < 1 (-.3, -.75, -.9 etc); then demand is price inelastic [see INSIDE
BUSINESS 3-2 on demand for prescription drugs on Page 84]

25

If EPD > 1 (e.g., -1.3, -2, -5.6 etc); then demand is price elastic.
If EPD = 1; then demand is unitary price elastic.
If EPD = ; then demand is perfectly price elastic. Here demand is a horizontal line.
If price drops then the quantity can go to infinity. Similarly, if price increases, quantity
can drop to zero by an infinite amount. Thus, %Q = or (%Q / %P = /%P.

P
Perfectly P-elastic
D

QD

If EPD = 0; (%Q / %P = 0/%P) then demand is perfectly price inelastic. Here

demand is a vertical line. The quantity demanded does not change when price changes.

Perfectly P-inelastic

QD

The quantity is not sensitive to changes in the price at al.

Examples: Demand for a heart transplant, demand for insulin.
Demand for illegal drugs is almost vertical. Putting drug pushers in jail is not enough.
Demand for cigarettes by youth smokers? Answer: Inelastic. Is there a difference in price
elasticity of smoking between black and white Youth? Between youth with less educated
26

and more educated parents? Answer: Black youth and youth with less educated parents
have greater price elasticity of demand. The following uses coefficient of elasticity

(these elasticities are coefficients of elasticity but this elasticity is always negative)

Derivation of a Linear Demand Equation (without using regression)

Given two points on the demand curve, we can estimate the direct slope (-b) and the
intercept (a) and have a derived or estimated simple demand equation.
P
Q
$9

15 Units

$7

25 Units

The simple form of a linear demand equation:

QD = a b P
Direct slope = QD / P = -b = (25 15)/ (7 9) = -5
Therefore, b = -5 and QD = a 5P
Then plug this into the general form for demand and solve for the intercept (a) at any one
point, say ($9, 15), we have
15 = a - 5*9
Therefore, a = 60
Thus, the derived linear demand equation is QD = 60 5P.
One can get the same answer by using the second point ($7, 25) to solve for (a).

Estimation of Price Elasticity of Demand along a Linear Demand Curve:

Recall EPD = (Q / P)*(P/Q)
where Q / P is the slope of demand.
Example of a linear demand:
27

Q = 12 3 P
Then the direct slope = Q / P = -3 (constant). Find the endpoints on both axes.

P
A EPD = -

A Elastic B

B EPD =- 1
2

B Inelastic C
C EPD = 0

12

Then estimate the price elasticities along the straight line demand curve as follows:
At point A : EPD = (Q/P)*P/Q= (-3) * (4/0) = - (perfectly price elastic).
At point B : EPD = (-3) * (2/6) = - 1 (unitary price elastic).
At point C : EPD = (-3) * (0/12) = 0 (perfectly price inelastic).
Total revenue Test:
In the following table, compare the change in the price and total revenue. Then relate this
relationship to the type of price elasticity
P

TR= P*D

Mid Point EPD

Conclusion

$9
7
5
3

15
25
35
45

$135
175 increases
175 no change
135 decreases

2
1
0.5

P-elastic
Unitary elastic
P-inelastic

1. If Mid-point EPD > 1 (elastic), P and TR move in Opposite direction.

2. If Mid-point EPD < 1 (inelastic), P and TR move in Same direction.

28

This test can be explained in the figure below which is different from the table above. In
the range where demand is inelastic, an increase in the price corresponds with an increase
in total revenues. In the elastic range, total revenue will decrease if price increases.

Determinants of the Own Price Elasticity of Demand:

Time

1. Availability of substitutes: The greater the number of viable substitutes for a

certain product, the greater the demand elasticity of that product.
(Consumers move to the substitutes as a result of higher price and Q drops)
2. Time: For non-capital products (e.g., gasoline), short-term elasticity is less
than long term elasticity in absolute value. Demand elasticities for these
products grow over time. The opposite is true for capital goods.
3. Importance of a product in total budget: (or share of expenses on a certain
product in the total budget). The lower the share of the product, the lower the
elasticity (less elastic). Example: expenses on salt.
Compare price elasticity of food with that for transportation. Hint: In 2000
PUS consumers spent 14% of their incomes on food and 4% on transportation.
DLR
DSR

Non-Capital
P2 Products (gasoline):
Short run EPD < Long run EPD in absolute value
P1
LR

QLR

SR

QSR Q1

QD

29

In the short run, people would merely drive less. In the long run, in addition to driving
less, people replace their large cars with smaller and more fuel efficient cars. Thus,
LR %QD > SR %QD in absolute value (more elastic in the L/R)
which means for a given % increase in the price, the long-run price elasticity in absolute
value is greater than the short-run price elasticity.
Capital Goods: (Cars) :
In the short run, there will be a deferment of buying new cars by both first-time buyers
and repeat buyers after the increase in the price of cars. But in the long run, the deferment
will be by the first-time buyers only. Thus,
SR % QD > LR % QD in absolute value.
Short-run price elasticity is greater than the long run price elasticity (i.e., more elastic in
the short run).
P
DSR

DLR

P2
P1

LR

Examples: (Table 3-3 on Page 82 for estimates of short-term and long-term elasticities).
SR

QSR
QLR Q1
QD
Other example: Estimates of short- and long-run elasticities for non-capital and capital
goods (gasoline and automobiles).
Non-Capital Goods (Gasoline):
30

The following are estimates of price elasticities of demand for gasoline after the oil price
increased in 1974 and in 1979-80. Those estimates show that the elasticities change in
the long run. The long-run price elasticities grew over time.
Years Following the Gasoline Price Increase
Elasticity
1
2
3.
5..
10.
15
EPD

-0.11

-0.22

-0.32

-0.49

-0.82

-1.17

The conclusion is for non capital goods: EPD SR < EPD LR

Capital Goods (Automobiles)
Years Following the Price Increase
Elasticity
1
2
3.
5..
10.
EPD

-1.20 -0.93

-0.73

-0.55

-0.42

15
-0.40

The conclusion is for capital goods: EPD SR > EPD LR

Marginal Revenue and Own Price Elasticity of Demand
Marginal revenue (MR) is the change of total revenue over the change in quantity. That
is, MR = R / Q. MR is linked to the own price elasticity of demand. Notice first that if
demand curve is linear (straight line), MR revenue bisects the distance on the horizontal
axis between zero and where the demand curve hits the horizontal axis, and thus divides
this distance into two equal parts. In the case MR is twice the slope of the inverse demand
curve.
Example. Suppose direct demand is Q = 30 - 3P. Slope of direct demand Q/P = -3.
Then the inverse demand is given by

P = 10 - 1/3*Q (inverse demand)

Slope of the inverse demand (P/Q) is -1/3.
The slope of MR = 2*(-1/3) = -2/3 (twice slope of inverse demand). Then the equation for
MR which has the same intercept as the inverse demand is:

MR = 10- 2/3*Q
Notice in the graph below, when MR = 0 the own price elasticity of demand is unitary. If
MR is positive the demand is elastic, and if MR is negative the demand is inelastic
Example 2: Direct demand Q = 6 P. Then P = 6 - Q and MR = 6 2Q.

31

Figure 3-3 Demand and Marginal Revenue.

The relationship between MR and the own (direct) price elasticity [E = %Q / %P =
= (Q /P)*(P/Q)] is given by
MR = P*[(1+E)/E], where E is the direct price elasticity of demand.

Calculate MR if E = -2 (elastic). Then MR = P*(1-2)/-2 = 1/2P which is positive.

Calculate MR if E = -1/2 (inelastic) Then MR = P*[(1-1/2)/-1/2] = -P ( which is

negative?)

Calculate MR if E = -1 (unitary elastic). Then MR = 0 (i.e., TR is at its maximum)

CROSS PRICE ELASTICITY OF DEMAND:
Two related goods: X and Y. Our good is X and the price of related good Y changed. Then
the price elasticity of demand for X with respect to a change in price of Y is:
__
%QX
QX
PY
EDXPY = ______ = ____ * ___
% PY
PY
QX
__
__
where PY and QX are average values, or values at a particular point.
If X and Y are substitutes then

EDXPY > 0. That is, the cross price elasticity is positive.

If X and Y are complements then,
32

EDXPY < 0. That is, the cross price elasticity is negative.

Example: Direct demand is given by QXD = 31 2PX + 0.5 PY
Note: The own direct slope with respect to X, QX / PX, is (-2) and the cross slope with
respect to the price of Y, QX / PY, is (+0.5) and positive. In color:
QXD = 31 2PX + 0.5 PY
Suppose the averages are given by:
__
PX

__
PY

__
QX

$8

$10

20 Units

Then own price elasticity of demand for X with respect to own price X is:
QX
EDXPX =
PX

___
PX
* ___
QX

= (-2)*(8/20) = -0.8 (inelastic)

Then price elasticity of demand for X with respect to the cross price of Y is:
___
QX
PY
EDXPY =
* ___
= (+0.5)*(10/20) = +0.25 (Substitutes)
PY
QX
INCOME ELASTICITY OF DEMAND:
EMD = % Q/ %M
EMD = %QD
%M

Q / average Q
M/ average M

Or EMD = Q * average M
M average Q
where Q is the slope of the demand with respect to income.
M
If EMD > 0 (i.e., income slope is positive), then the good is normal (e.g., EMD for food
=+ 0.80 which implies that food is a normal good).
33

If EMD < 0 , then the good is inferior (e.g., EMD for corned beef = -1.94).
If 0 < EMD < 1 , then the normal good is a necessity (e.g., food)
If EM0 > 1 , then the normal good is a luxury (e.g., recreation)
OBTAINING ELASTICITIES FROM DEMAND FUNCTIONS
First we will consider elasticities from linear demand functions which use linear
regression, and the elasticities should be calculated. Then we proceed to elasticities of
nonlinear demand functions which use log linear regression and elasticities are constants.

Linear demand equation (without lagged dependent variable):

Qt = a bPt + cMt + dAt + ePY

where t refers to time period, M denotes income and A denotes advertising.
The coefficients b, c, d and e are direct slopes with respect to P, M, A and PY,
respectively, and these slopes can be used in deriving the elasticities by multiplying them
by the averages (or locations). For example, Q/P= -b. Then to form the price elasticity
we have:
EDP = (QX /PX)*(average PX / average QX) = (-b)*(average PX / average QX) < 0.
Then to form the income elasticity, we have
EDM = (Q /M)*(average M / average Q) = (+c)*(average M / average Q) > <0
Cross price elasticity with respect to PY
EDPy = (QX/Py)*(average Py / average QX) = (e)*(average Py / average QX) > < 0.

Linear demand equation (with lagged dependent variable):

Qt = a bPt + cMt + dAt + ePY + fQt-1

The lagged Q, Qt-1 , quantifies habit forming behavior. If there is a habit of having X
in the last period than we expect last periods quantity to influence the current periods
quantity. Here, we can distinguish between the short-run elasticities and long-run
elasticities. Note the estimate of the slope for Qt-1, which is in the equation is + f.
34

LR Price elasticity= SR EDP / (1- f) < 0, where f is estimated slope for lagged Q, Qt-1,
and the slope should be positive.
LR Income elasticity= SR EDM / (1- f) > or < 0.
LR Cross price elasticity = SR EDPY / (1- f) > or < 0 and so on.

Log linear demand equations (without a lagged dependent variable):

lnQ = a1 b1lnP + c1lnM + d1lnA
where a1 = ln(A) and A is the intercept in the linear case. You can derive the original a
without the log from a1 by calculating the exponential of a1. That is, a= ea1. In this
log-linear case, the parameters b1, c1 and d1 are constant elasticities of price, income and
advertising, respectively. Specifically, -b1 = %Q/%P, c1 = %Q/%M

and so on.

ln is the natural log symbol. Nothing should be done to these parameters because they
are already estimated elasticities and they are not slopes. In excel, = ln(cell).
Note that the above functions can include the lagged dependent variable as one of the
regressors to capture habit forming and in order to calculate both the short- and long-run
elasticities. (see HW assignment for chapter 3)

Log linear Demand Equation (with a lagged Q):

lnQ = a1 b1lnP + c1lnM + e1lnQt-1
Note that the estimates of slope of lagged Q is the estimate of e1.
First, prepare the Excel spreadsheet (Copy the Table). Example for linear and log linear:

Spreadsheet for linear and log linear demand functions with Qt-1
(Three Independent Variables: P, M and lagged Q)
35

Linear equation:

Log Linear equation

Qt = a bPt + cMt + fQt-1

lnQ = a1 b1lnP + c1lnM + e1lnQt-1

Year
1988
1989
1990
1991
1992
1993
1994
1995
1996
Average

Q
6
10
13
18
22
24
27
32
36
22.75

P
28
25
18
17
15
13
12
10
10
15

M
10
10
10
15
15
17
20
22
25
16.75

Lagged Q

lnQt

lnPt

lnMt

lnQt-1

1.791759 3.332205 2.302585

6
10
13
18
22
24
27
32

2.302585 3.218876 2.302585

1.791759

2.564949 2.890372 2.302585

2.302585

2.890372 2.833213

2.70805

2.564949

3.091042

2.70805

2.890372

3.178054 2.564949 2.833213

3.091042

3.295837 2.484907 2.995732

3.178054

3.465736 2.302585 3.091042

3.295837

3.583519 2.302585 3.218876

3.465736

2.70805

No
averages

Skip the first row because Excel cannot run regressions with empty cells. To find the
averages divide the sum by 8 (skip first row) in the example above and you may
exclude the first row in doing the summation.

36

Estimation of a Linear Demand Function with Qt-1 (no price of Y in this example)
Regression Statistics

Multiple R
R Square

0.9971618
0.99433165

Adjusted R
Square
Standard Error
Observations
ANOVA

0.99008039
0.89201694
8
df

Regression
Residual
Total

3
4
7

Slopes

SS
558.3172231
3.182776866
561.5

Standard Error

MS
186.1057
0.795694

t Stat

F
233.891

P-value

Significance F
6.01301E-05

Lower 95%

Upper
95%

Lower
95.0%

Intercept
3.29129981 5.224732673
0.629946 0.562922
-11.21491369 17.79751
-11.2149
Price
-0.132603 0.220193368
-0.60221 0.579505
-0.743959095 0.478753
-0.74396
Income
0.68458864 0.295716861 2.315014** 0.081582
-0.136454693 1.505632
-0.13645
Lagged Q
0.52530978 0.246056519 2.134915** 0.099656
-0.157854049 1.208474
-0.15785
Write the estimates as an equation below (no price of a substitute is included in this equation):

Upper
95.0%
17.79751
0.478753
1.505632
1.208474

Qt = 3.291 - 0.133 Pt + 0.685 Mt + 0.525 Qt-1

(0.63) (-0.60)
where

Q/P =
--0.132603

(2.32)

(2.13)

and Q/M
=0.68458864

and so on

In this linear case, the estimated coefficients are the slopes. All the variables Price, Income and Lagged Q have the correct signs for a demand
equation.
The price is not statistically significant at any level. Use the standard (large sample) ranges for statistical significance (%) and not the table Pvalues given with this regression output (see Question 1 in the HW for t-statistics ranges).

37

Short-run own price elasticity of demand = (The slope of the price) * (Average price / Average quantity)
= - 0.133 *(15/22.75) = - 0.088
See the text for more definitions of elasticities
Long run price elasticity of demand = SR P elasticity/(1-slope of lagged Q) = -0.088/(1-0.525) = - 0.185
or

= [(Slope of price) / (1 - slope of lagged Q)]*(Average price/Average quantity)

= [(-0.133)/(1 - 0.525)]*(15/22.75)
= -0.088/(1-0.525)= - 0.185 where 0.525 is the estimated slope for lagged Q.

The income elasticities can be estimated the same way by using income and average income instead of price and average price in the
above short run and long run formulas. (see P. 31 for more information on the formula for M -elasticity) Try it!! For the cross price
elasticity use PY and average PY to write the cross price elasticity. See P. 28 and P. 30).

Estimation of Log Linear Demand

38

Function with Qt-1 ( no price of Y)

lnQ = a1 b1lnP + c1lnM + e1lnQt-1
Regression Statistics
Multiple R
0.998255
R Square
0.996513
Adjusted R
Square
0.993897
Standard Error
0.034373
Observations
8
ANOVA
df
Regression
Residual
Total

3
4
7

Elasticities
Intercept
Ln Price
Ln Income
Ln Lagged Q

0.689069
-0.08368
0.456731
0.465942

SS
1.350558
0.004726
1.355284
Standard
Error
0.981391
0.224922
0.123854
0.13362

MS
0.450186
0.001182

F
381.0214

Significance
F
2.28E-05

t Stat
0.702134
-0.37203
3.687659
3.487067

P-value
0.521302
0.728742
0.021062
0.02519

Lower 95%
-2.03572
-0.70816
0.112857
0.094952

Upper
95%
3.413853
0.540807
0.800605
0.836931

Lower
95.0%
-2.03572
-0.70816
0.112857
0.094952

Upper
95.0%
3.413853
0.540807
0.800605
0.836931

ln Qt = ln a - a1 lnPt + a2 lnMt + a3 lnQt-1

where: Q is the Quantity. The coefficients a1, a2 and a3 are ELASTICITES.
P is the Price
M is the Income

39

t is the time period

ln is the natural log
The coefficients are elasticities.
a1 = %Q/%P = -0.084 = Short- run Price elasticity of demand (Do not make any changes)
a1/(1- slope of lagged Q) = a1 / (1 - a3) = -0.084/(1- 0.465942) = long-run price elasticity of demand
a2 = %Q / %I = 0.457 = Short- run Income elasticity of demand
a2//(1- slope of lagged Q) = a2/(1 - a3) = 0.457 /(1-0.466) long-run Income elasticity of demand
If income elasticity a2 > 0, then the good is normal

40

REGRESSION ANALYSIS
Please refer to pages 95 to 107 in the textbook for more information on regression
analysis.
Also, see the link
http://www2.chass.ncsu.edu/garson/PA765/regress.htm
We will estimate a demand function using linear and log-linear regressions with lagged
Q.

Linear Regression (three independent variables): The following demand

function has three regressors P, M and Qt-1 .

Qt = a + bPt + cMt + dQt-1

where: Q is the Quantity (dependent variable)
P is the Price
M is the Income
Qt-1 is the lagged Q
t is the time period

Input or copy the data on an EXCEL sheet, clearly specifying the dependent Y
variable to be the quantity (Qt) (highlight its column), and the independent X
variables to be the price (Pt), income (Mt) and the lagged Qt-1 or as the situation
warrants.. Here we have three regressors: (Pt), income (Mt) and the lagged Qt-1
(highlight all of them at the same time).

To enter values for the lagged Qt-1, you may copy the whole data under Qt and
paste it in a new column added to the given sheet under the lagged Qt-1. Pasting
should start such that the first observation under Qt will be the first observation
under the lagged Qt-1 starting with the second row.

Click on Excel icon on top left, Excel Options at the bottom of pop up menu,
Add-ins in the left hand column, then Analysis Toolpak, then hit ok.

if it does not come up, then hit go and make sure that Analysis Toolpak is
checked.

then under Data, Data analysis, Regression, ok.

If you have Analysis Toopak in your computer, then the road to

regression is shorter. Click on Excel icon, Data, Data Analysis in
the up far right then Regression.

41

 Go to TOOLS menu and click DATA ANALYSIS. Pick up REGRESSION from

the ANALYSIS TOOLS presented in the pop up menu and click OK.
First highlight the dependent variable (Qt) cell range from the spreadsheet
starting from the second row (skip the row with the empty cell), and click OK on
the REGRESSION pop up menu to insert the selected data range in the Input Y
range box. Similarly select the relevant data range for all the independent
variables together including lagged Q and insert the selected data range in the
Input X range box. Double check your cell ranges.
Click on LABEL to include the symbols or names of variables in the regression
output.
In the OUTPUT OPTIONS, click New Worksheet Ply and say OK. The
Regression output will be available to you on a newly created worksheet.

How to add DATA ANALYSIS to your TOOLS menu?

If the TOOLS menu in your computer does not have DATA ANALYSIS, you can
add it by doing the following.
Open TOOLS
Click on ADD-INS
Include ANALYSIS TOOLPACK from the pop up menu dialog box and click
OK.
Go back to TOOLS and you will find DATA ANALYSIS at the bottom of the
menu.

The Questions required for the homework assignment are listed

Below:

42

Homework assignment: Questions

QUESTION 1:
Copy the database below into an excel sheet.
Run QX on the four regressors: PX, M, PY and lagged Qx.
Write down the estimated linear demand equation with t-statistics under the
estimated coefficients as done above. In addition, write down the R-square and
explain what it means. Explain the statistical significance of the t-statistics for each
regressor. Significance of T-statistics is usually given by the P-values in the
regression output. We will not use it in here because we have a small sample which
will bias the P-values. There are three levels of significance: 1%, 5% and 10%
represented by ***, ** and *, respectively. Do not use the computed P-values of this
small sample regression. Instead, use the following conventional t-statistics
significance ranges used for large data:1.63 <t < 1.96 (10%); 1.96 < t < 2.54 (5%);
and t > 2.54 (1%). This means in your regression output, look at the t-statistics
column for each regressor. Then place the value of that computed t-statistic in one of
the above ranges. The P-values given in the regression output are sensitive to sample
size and are not accurate.
QUESTION 2
Check the signs of the estimated coefficients. Do the signs follow the theory as
expected? Examine the sign for each regressor and point out what they mean.
QUESTION 3:
Calculate the short-run and long-run price and income elasticities of demand for
good X using the averages for the quantity, price and income? Based on the income
elasticity, what type is good X?
Short Run P elasticity for a linear Eq. = [slope of price]*(Average Price/Average
quantity)
Long Run P elasticity for a linear Eq. = (SR P elasticity) /(1- slope of lagged Q)
or = [slope of price / (1- slope of the lagged variable)]*(Average Price/Average
quantity).
They are the same.
Average = sum/n, skipping first row.
The short-run and long run income elasticities are calculated the same way. Here the
slope is for income and the average for income (see page 31 or the solved regression on
pp 32-33). What type of good is X with respect to income elasticities?
Short Run Income elasticity for a linear Eq. = [slope of Income]*(Average
Income/Average quantity)

43

Long Run Income elasticity for a linear Eq. = (SR Income elasticity)/(1- slope of lagged
Q)
QUESTION 4:
Calculate the short-run and long-run cross price elasticities with respect to Py (see p.
28 and p. 30 in the notes). What type of goods are X and Y with respect to these
elasticities?
QUESTION 5
Can you think of another independent variable that you may add to the above
equation? What will the sign of this variable be? Specify the name of this variable.
Do not include Weather in this equation.
QUESTION 6
Is this a supply or demand equation? Why? Forget about signs. Look for other clues in
the equation.
SEE DATA BELOW:
Copy the data from Word to excel.
After transferring the data set from Word to excel, make sure you follow these
steps;
Highlight all the cells in excel.
Right click on any cell in the data sheet in excel.
Click on FORMAT CELLS.
Under CATEGORY, click on NUMBER.
Then click OK.

44

Spring 2010: Regression Assignment Data Sheet (linear case only))

When you copy in Excel 2007: COPY, PASTE SPECIAL then TEXT.
Year
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010

Qx
9
10
12
14
16
17
18
21
26
28
29
30
33
35
38
39
40
42
45
46
50
55
57
58
61
65
66

Px
29
28
25
23
20
19
17
16
14
12.5
12
10
14
15
18
19
21
18
18
17
15
14
12
10
9
8.5
7

14
15
18
20
23
26
29
34
37
35
38
41
44
47
51
55
58
61
63
65
66
68
70
73
74
79
80

Py Lagged QX
11
12

14
15
17
19.5
21
22
23
23.5
25
23
20
19
20
21
22
23
25
26
21
25
27
28
28.5
30
31

10
12
14
16
17
18
21
26
28
29
30
33
35
38
39
40
42
45
46
50
55
57
58
61
65

45

Chapter 4: The Theory of Individual Behavior

CONSUMER BEHAVIOR
In any economy, there are many goods and services, and the consumers buy baskets (or
bundles) of these goods and services. Consumers compare goods and services before they
buy them. Comparison of possible baskets is based on tastes or preferences and not in
terms of costs and prices. If there is a comparison, we say that there is a preference
ordering.
Example: Alternative Baskets for Food and Clothing
Basket
A
B
D
E
G
H

Units of Food
20 units
10
40
30
10
10

Units of Clothing
30 units
50
20
40
20
40

Basic Properties of Preference Ordering:

The theory of consumer behavior begins with three basic assumptions about peoples
preferences.
1. Property 4-1: Completeness. Preferences are assumed to be complete in the
sense that consumers can compare and rank all possible baskets. This means
that for any two baskets say A and B a consumer will prefer A to B, B to A or
is indifferent between them. In the above example, take baskets A and E. The
consumer prefers E to A (more of both). If you take baskets A and B, the
consumer cannot rank these baskets. Thus, completeness does not hold for all
possible baskets in the above example. The consumer is needed to express her
or his preference or indifference among baskets. This assumption is needed
for the manager to predict the consumers consumption patterns with
reasonable accuracy.
2. Property 4-2: All goods are good not bad (i.e., desirable). Consumers prefer
more of any good to less. Graphically, this assumption means the direction of
increase in satisfaction is the Northeast. What will be the direction if one of
the two goods is bad? Northwest?
3. Property 4-3: Transitivity. For any three bundles: S, T and U, if S is preferred
to T and T is preferred to U, and then S is preferred to U if transitivity holds.
This assumption rules out the possibility that the consumer will be caught in a
perpetual preference ordering cycle in which it will never be able to make a
choice at the end.

46

Since not all the baskets can be compared and ranked (that is completeness is not
satisfied) we need additional information on preferences to rank all bundles. This
additional information is the indifference curve.
Indifference Curves:
An indifference curve includes all the baskets (points) that generate the same level of
satisfaction. If we graph the above example we can produce an indifference curve that
compares the baskets which we could not compare before. This indifference curve (1)
can include the baskets (A, B and D) without violating any of the above assumptions.
This means that A is indifferent to B and D, and vice versa. We cannot include H in here.

Clothing

B (10,50)

50
40

E (30, 40)

H (10,40)
30

A (20, 30)

20
D (40, 20)
20

G (10, 20)

10

1
20

30

40

Food

In this case we can compare and rank any two baskets using the three basic assumptions
and the indifference curve.
For Example:
E is preferred to A
A is Preferred to G
E is preferred to G (transitive preference).
Characteristics of Indifference curves:
i. Indifference curves are person-specific and time-specific, changing time period may
change the curvature of the curves for the same person. A set of indifference curves
curves may be steeper than another set. Steeper curves signal that stronger preference
is given to the good on the horizontal axis than to the one on the vertical axis and vice
versa. Curve is relatively flat when more preference is given to good on vertical axis
ii. An indifference curve between two goods such as food and clothing slopes downward
(has a negative slope) C/F < 0. This is because all goods are good (desirable) and
thus, if one good is increased the other should be decreased to maintain the same

47

satisfaction or moving along the same indifference curve.

iii. Any point that lies above and to the right of a given indifference curve, say 1, is
preferred to any point on the curve 1, and vice versa for any point below this curve.
This should define the direction of increase of satisfaction for an indifferent map. This
is a result of Property 4-2 of preferences.
C

1 < 2 < 3

Direction of
increase in
satisfaction
3
2
1

F
iv. Indifference curves can not intersect for the same person, the same time period. This is
a result of Properties 4-2 and 4-3 of preferences.

A
B
D
A R B (by assumption; they lie on the same curve) (R indicates indifferent
to)
F
The Marginal Rate of Substitution:

Marginal Rate of Substitution

Example: Preferences between food and clothing are given in the following table.
48

Basket
A
B
D
E

Satisfaction
1
1
1
1

Slope=C/F

MRS

14

10

-4/1

+4

-3/1

+3

-1/1

+1

Starting at point A and moving to point B, the individual consumer is willing to

give up 4 units of good C to obtain one unit of good F, while keeping satisfaction
the same (moving along the same indifference curve) and so on. Giving up a
certain amount of one good to obtain more of another good while keeping
satisfaction the same is called the marginal rate of substitution (MRS).

Clothing

15

10

D
E
5

1
1

Food

MRSF,C = maximum amount of good C that will be given up for one additional
unit of good F, keeping satisfaction the same (i.e., moving along the same
indifference curve).
MRSF,C = - C / F = - slope of indifference curve > 0 (absolute value of slope).
In the above diagram, marginal rate of substitution is diminishing.
The value and the change in this rate reveal information about the shape of the
indifference curves, which in turn has to do with locating the consumer

49

equilibrium or choice. Some indifference curves are straight lines, convex, rightangled, vertical lines or horizontal lines. Straight line curves give corner solutions.
4. Property 4-4 Diminishing MRS. This 4th assumption implies that the indifference
curves are convex. In the above example, moving from point A to point B, MRS is 4.
Then moving from B to D, MRS is 1 (MRS is diminishing). This means that the
preference ordering in this example most likely gives rise to convex indifference
curves, and in this case the solution or the equilibrium includes positive amounts of
both goods (internal solution). This assumption if imposed rules out other shapes of
indifference curves. (What will be the solution if indifference curves are straight lines?)

CONSTRAINTS: The Budget Constraint:

The Budget Constraint includes all baskets (points) where total expenditures on the goods
included in any given basket equal to income.
Let:
Pf be the price per unit of food.
F be the quantity of food
Pc be the price of clothing per unit.
C be the quantity of clothing
M be the income
Then the budget constrain equation is Pf *F + PC*C = M
Total expenditure on F and C = Income.
For the budget or opportunity set, the equation is written as an inequality:

Pf *F + Pc*C M
Graphs of Budget Constraint and Set:
Since the budget constraint equation is linear it suffices just to determine the end points
(horizontal and vertical intercepts) and then connect them with a straight line.

Pf *F + Pc*C = M

If C = 0 then Pf *F = M and
_
F = M/Pf (horizontal intercept),
_
where F is the maximum amount of food that can be purchased with the whole income.

If F = 0 then Pc*C = M and

_
C = M/Pc (vertical intercept,
__
where C is the maximum amount of clothing that can be purchased with whole income.

50

C
_
C = M/Pc

Budget
Constraint

Budget set
_
F = M/Pf

The budget set includes all the baskets inside the whole triangle.
Slope of the Budget Constraint:
As shown above, the budget constraints standard equation is

Pf*F + Pc*C = M
this equation can be rewritten in the format of the intercept and the slope as

C = M/Pc (Pf / Pc)*F (where M/Pc is the vertical intercept)

Then the slope is C/F = - Pf / Pc is the slope of the budget constraint.
That is, slope of the budget constraint is the price ratio and vertical intercept is M/Pc.
This intercept-slope format of the budget constraint follows the graph where the variable
on the vertical axis is the variable on the left-hand side of the equation:
C = M/Pc (Pf /Pc)*F
This expression of the budget constraint is more in line with the graph and it clearly
shows its slope and its vertical intercept.
Shifts in the Budget Constraint:
Changes in one of the Prices: Outward Rotation of budget constraint:
Suppose Pf decreases from P1f to P2f while PC and M remain the same.
C
P1f > P2f
51
M/P1f

M/P2f

On the other hand, if Pf increases there will be an inward rotation.

Parallel shift

If income (M) increases while the two prices (Px and Py) stay the same, there will
be an upward parallel shift in the budget constraint and no change in the slope.

Fig. 4-5 Changes in Income Shrink or Expand Opportunities.

Demonstration Problem 4-1
Let P1f = $1 /unit, P1c = $2/unit and M = $80
Then the slope of B. C. = - Pf / Pc = -1/2 = slope of the solid line in the graph below:

C
40=$80/$2
units
52

40 = $80/$2

80=$80/$1
units

If Pf increases from $1 to $2 while Pc and I stay the same, the budget constraint rotates
inward (the dotted line). New slope= -2/2 = -1.
CONSUMER EQUILIBRIUM
The consumer maximizes utility or satisfaction by choosing the most desirable basket out
of all the affordable baskets defined by the budget constraint.
Thus consumer choice, equilibrium or the optimal basket must satisfy two conditions:
I. Be affordable or lie on the budget constraint.
II. Give the most preferred combination of goods or services (optimal).
Graphically, this means that the consumer equilibrium is the tangency point between the
budget constraint and the indifference curve that gives the highest satisfaction.

C
1 < 2 < 3
B

A
3
2

B
1

F
Point D is the most desirable but is not affordable.
Point B is affordable but is not the most desirable (it lies on indifference curve 1)
Point B is affordable but is not the most desirable.
Point A is both the most desirable and affordable.
Then Point A is the consumers optimal choice or equilibrium and it is a tangency
between the budget constraint and indifference curve (2)

53

Characterization of Consumer Choice or Equilibrium for Interior Solution:

Slope of the indifference curve = Slope of budget constraint.

C / F = - Pf / PC. Multiply both sides by a minus we will have:
- C / F = Pf / PC
or MRSF,C = Pf / PC (for well-behaved (or convex) indifference curves and for interior
solutions. For other shapes of indifference curves (such as straight lines) this equality
may not hold (and we may have a corner solution).
COMPARATIVE STATITCS
In this section, we change either a price or income at a time and examine the change in
consumer equilibrium. In the case of changes in income we must distinguish between
normal and inferior goods
Fig.4-9: Price Changes and Consumer Equilibrium

C
P0f < P1f < P2f
income I

D
B
A

M / P2f

M / P1f

M / P0f

The budget constraint was rotated twice: once rotated inward when P1f increased to P2f
and the second rotated outward when it decreased to P0f. There are three tangency points
or consumer choices (or equilibria): A, B and D. If you connect these three equilibrium
points, you will get price consumption curve for food (PCCF)
In this section, we change income but keep both prices constant. This implies parallel
shifts in the budget constraints. Assume that the good is normal.

54

Fig. 4-11: Income Changes and Consumer Equilibrium

C
M0 < M1 < M2

M0 / Pf

M1 / Pf

M2 / Pf

There is a tangency point between an indifference curve and each one of the budget
constraints, forming three consumer equilibria. If you connect these three
equilibrium points you will get the income consumption curve. Both goods are
normal goods because their consumption at equilibrium increases when income
increases, and vice versa.
We can examine consumer equilibrium when income changes for the inferior good case.
In Fig. 4-12 below the initial consumer equilibrium is point A. When income increases
from M0 to M1, the consumer moves back from point A to point B, implying a decrease in
the choice of good X. In this case, good X is an inferior good. Examples of inferior goods
include bus trips, used clothes, generic jeans, used booksetc. Fig. 4-12 also shows that
good Y is a normal good because after the increase in income the consumer chose more of
good Y.

55

Fig 4-12 inferior good

(An Increase in Income Decreases the consumption of Good X)
INCOME AND SUBSTITUTION EFFECTS:
Suppose the absolute Pf drops while PC stays the same then the lower relative price of
food Pf / PC has two effects. First, is the Substitution Effect where the relatively cheaper
good (food) is substituted for the more expensive good clothing, keeping satisfaction the
same. Graphically, this effect means moving along the original indifference curve using
the new budget constraint which is defined by the new relative price.
The second is the real (not nominal) income effect, which resulted because of the change
in the relative price. Real income changes with the change in relative price but nominal
income is constant. Graphically, in Fig 4-13a for a normal good, this effect is shown by a
parallel shift in the new budget constraint from the substitution effect point B to point D.
The whole movement is the price effect from A to D. Thus,
P.E. = S.E. + I.E

Fig 4-13a. Substitution and Income effects for Normal Goods (S.E. and I.E)

56

C*A

F*A

F*B
S.E.

F*D

I.E.

The movement from A to B along the original indifference curve 1 is the substitution
effect while the movement from B to D (jumping from the new budget constraint) to its
parallel at point D is the real income effect. In the case of normal goods, I. E. reinforces
S. E. The whole movement from A to D is the price effect for a normal good. Food
increases from F*A to F*D.
Inferior Goods (S.E. and I.E)
The substitution effect is the same for both the normal and inferior goods. The difference
is in the income effect which is negative for inferior goods. In the normal good case,
income effect is positive while for inferior good this effect is negative or an increase in
real income reduces the quantity as shown by the movement from B to D in Fig 4-13b
below. Income effect partially offsets substitution effect.
Footnote: The original budgets constraint which is tangent to indifference curve is
missing in Fig -13b. I cannot add it because I do not have the software.

Fig 4-13b. Substitution and Income effects for Inferior Goods (S.E. and I.E)
C

57
D

2
A

F
F

APPLICATIONS OF INDIFFERENCE CURVE ANALYSIS

APPLICATION 1. The Bonus case:
Suppose there are two goods: X and Y.
PX = $4/Unit
PY = $2/Unit
M = $80
Draw the Budget constraint; placing X on the Horizontal axis:
PX*X + PY*Y = M
$4X + $2Y = $80
Suppose there is a promotional plan, which pays Six units of X for the first Ten
units of X purchased. There are no bonuses after this. Draw the budget constraint.
Y
_
Y = M / PY =
80/2 = 40

Slope = - PX/PY = - 4/2 = -2

_
X = M / PX = 80 / 4 = 20 Units
a) Assume X = 0 (no bonus in this case);
X then B.C. is 0 + PY*Y = $80.
_
Y = 80/2 = 40 units.
58

b) Assume X < 10 units (right before bonus). The budget constraint is:
PX*X + PY*Y = $80
If X = 10 (eligible for bonus), then the budget constraint becomes:
$4*10 + $2*Yb = 80 or Yb = ($80 -$4*10)/$2 = 20 units.

Yb = 20 Units (subscript b is a notation that refers to the bonus case).

Fig.4-14: Buy Certain Units; Get other Units Free (the bonus case)

Y
50
_
Y = M/PY = 40
Slope = - PX / PY = - 2
Yb= 20

6=Bonus

Slope = - PX / PY = - 2

10

16

20

26

30

40

50

c) The Bonus Case. Add the SIX bonuses to X without any change in Yb = 20. This
means there is a horizontal portion to the budget constraint from X = 10 to X = 16 units,
while Yb = 20 units.
d) Assume Y = 0 (with the X bonus); then the budget constraint equation becomes
PX*X + 0 = 80 +$Bonus on X
where $Bonus on X = PX*Bonus X = $4*6 = $24
Substitute:
4 X + 0 = $80 + $24 = $104
__

59

Maximum X =104 / 4 = 26 units.

APPLICATION 2. The in-kind Gift Certificate case: Valid at Store X only
The original black budget line is the budget constraint before the consumer receives the
$10-gift certificate for store of good X only. The consumer equilibrium is point A. Once
the consumer receives the gift certificate for X (only), this budget line shifts out in a
parallel way to the lighter line (see Text, page 138 ?) because if it spends all income on Y
it still can use the X-certificate. On the other hand, if Y = 0 then the consumer will spend
all income on X and as well use the X-certificate (new intercept on the horizontal axis).
Consumer equilibrium is now point C as in Fig 4-16
Fig. 4-16: A Gift certificate Valid for Store X

How would you draw the budget constraint if the gift is cash and is not constrained to
store X or Y?
RELATIONSHIP BETWEEN INDIFFERENCE CURVES AND DEMAND CURVES
The budget constraint was rotated twice: once rotated inward when P1f increased to P2f
and the second rotated outward when it decreased to P0f, given income and price of
clothing. There are three tangency points or consumer choices (equilibria) A, B and D.

Fig 4-20: Derivation of Individual demand for Food from indifference curves.
CPf
P2f
P1f
P0f

2
M/P
Af

M / P1Pf 0f < P1f < P2f M / P0f F

60

Df
F*A F*B F*D

The points on this individual demand curve are associated with the consumer choices or
equilibriums.
The individual demand curve has two properties:
1. Each point on this curve is part of a consumer equilibrium which satisfies the
equilibrium condition (MRSF,C = Pf / PC).
2. Utility changes as we move along this curve. The lower the price, the higher the
level of utility.
Note: All points on the demand curve are associated with the same income. If income
changes then the demand curve will shift.
Deriving the Market Demand Curve from Individual demand Curves
Suppose there are two individual consumers whose individual demand curves are given
by D1 and D2. The market demand is DM.
The market demand is the horizontal sum of quantities demanded by all the individual
consumers in a given market for each possible price. For example, at price equals $3,
consumer 1s quantity is 2 units and consumer 2s quantity is 1. The market quantity at
the price of $3 is 4 units on the demand DM. This process is repeated and the locus of the
point on DM is the market demand curve.
Fig. 4-21: Deriving Market Demand

P
P
5

D1

D2

DM

4
3
2
1

61

1 2 3 4
Individual 1

1 2 3 4 5
Individual 2

3 4 5 6 7 Q
Market

62

CHAPTER 5: The Production Process and Costs

In this chapter, we will present tools that help managers in deciding which inputs and
how much of each input to use to produce the output efficiently or optimally.

THE PRODUCTION FUNCTION.

The production function summarizes the technology that is used in converting inputs such
as labor, steel and machinery into output such as an automobile. In this chapter, we will
use two inputs: Capital (K) which involves machines, and labor (L) to produce the
output (Q). The output should be produced efficiently if it is part of a production
function.
This function is an engineering relation that defines the maximum amount of output that
can be produced with a given set of inputs. Mathematically, this function is denoted as
Q = F(K, L),
That is, the maximum amount of output Q that can be produced with given K units of
capital and L units of labor. Production functions assume efficiency.
Specific example (exponential function):

Q = A K1/3 L2/3
This is called Cobb-Douglas type production function. The parameter A is the efficiency
or multi-factor productivity parameter that converts inputs into output.

The ShortRun Vs. the Long Run:

The ShortRun is the time period during at least one of the input is kept fixed and
cannot be changed. This fixed input is usually capital (K*) such as equipment. In
this short run period output can change by varying the intensity of operation, not
the size of the firm. In this case, the S/R production function can be rewritten as
Q = F(K*, L) = f(L) (that is, output is a function of labor L and K* is a constant)

The LongRun is the amount of time it takes to make all inputs variable. Here, the
firm contemplates different sizes of its plants. If it chooses a specific size (capital
or K*) then the firm is in the short run. The long run is just a planning period.

63

Example:
Long run: Q = 10 K0.5 L0.5 (log linear lnQ= ln10+0.5lnK+0.5lnL)
Short run: if K=2 (fixed), then Q = 10 (2)0.5L0.5 = 14.14 L0.5 or Q= f(L) = 14.14 L0.5 .

Inside Business 5-1

Where does Technology Come from? What is the most important means for
companies to acquire technology in the US? R & D? P. 163 (7th ed.).
Measures of Productivity
Here we define measures of productivity of inputs used in the production process. This is
useful for evaluating the cost effectiveness of the production process and for making
input decisions to maximize profit. The three most important measures of productivity
include: total product, average product and marginal product
Total Product (short-run)
Suppose capital is fixed in the short-run, and then the production function is in the short
run and is a function of labor only. Its graph is called the total product curve. In Table 5-1
(the Production Function), the maximum amount of output that would be produced with
a given level of, for example, 5 units (hours or workers) of labor is 1,100 units of output,
given K* = 2. This is a point on the total product curve, and so on.
Table 5-1: Production Function in the Short Run
(2)
(1)
(3)
(4)
L
K*
L
Q
Variable
Fixed Input
Change
Output
Input
(Capital)
in Labor
(Labor)
[Given]
[(2)]
[Given]
[Given]
2
0
0
2
1
1
76
2
2
1
248
2
3
1
492
2
4
1
784
2
5
1
1,100
2
6 workers
1
1,416 units
2
7
1
1,708
2
8
1
1,952
2
9
1
2,124

(5)
Q /L = MPL
Marginal
product of
Labor
[(4)/ (2)]
76
172
244
292
316
316
292
244
172

(6)
Q/L = APL
Average
Product of
Labor
[(4)/(2)]
76
124
164
196
220
236 units
244
244
236

64

2
2

10
11

1
1

2,200
2,156

76
-44

220
196

Average Product (APL)

In many instances, managers are interested in the average productivity of the input they
used. For example, they may be interested in the (average) productivity of the average
worker or average labor hour. This average productivity is measured by dividing the total
product or output (Q) over the quantity of the input used such the number of workers or
the number of labor hours.

APL =Q/L (this gives units of output per worker)

It is the output per worker or per hour. In Table 5-1, six workers together can produce
1,416 units of total output. This amounts to 1,416/6 = 236 units of output per worker
(APL).

Marginal Product (MPL or MPK )

The marginal product of an input is the change in total output attributable to the
last unit increase of an input. Thus MPL is thus the change in total output divided
by the change in labor:
MPL = Q/L
For example in Table 5-1, the marginal product of the 6th worker increases total
output from 1,100 units of output to 1,416 units of output. Thus, its
MPL= (1,416-1,100)/(6-5) = 316 units of output.
The marginal product of capital (in the long run) is defined by

MPK = Q/K
Fig. 5-1 below shows the relationship among total product, average product and marginal
product for labor.

65

Fig. 5-1 Increasing, Decreasing and Negative Marginal Returns

It can be seen from Fig. 5-1 and Table 5-1 that MPL rises as labor increases from one to
five workers or labor hours at point e. This increase in marginal labor productivity is a
result of specialization. In Fig. 5-1 the total product curve between one and five units of
labor or over the range A-E is convex or its slope increases as labor increases. This means
that output increases at an increasing rate. This range is called the Increasing Marginal
Returns to a single factor range for the short run. The single factor here is labor.
Over the second range from E to J or (labor units from 5 to 10), MPL is positive but
decreasing, implying that output increases at a decreasing rate. In this range the total
product curve is concave. This range is called the Diminishing Marginal Returns. The
Law of Diminishing Returns to a Single Factor applies to this stage where Marginal
Product of the variable input starts to decline. This is a short run concept.
Over the third range J to K, total output is decreasing because of labor crowding out and
MPL is negative. This range is called the Negative Marginal Product range. No firm
should employ resources in this range.

66

It can also be seen from Fig. 5-1 that as long as MPL exceeds APL, then APL is rising.
Moreover, APL reaches its maximum when it intersects (equals) MPL.

Roles of Manager in the Production Process

The guiding role of production manger is two fold. (1) She should ensure that production
is efficient or on the production function, which shows the maximum output given the
available inputs (EFFICIENCY). To achieve this role, the manager should institute an
incentive system that induces workers to perform well (e.g., profit sharing). (2) She
should ensure that the firm uses the correct level of inputs or operates at the right point
on the production function (OPTIMALITY). To do so, the manger should choose the
input level according to the profit-maximizing input usage rule in the short run. This rule
requires the manager to hire workers until:

Marginal benefit of the additional worker = Marginal cost of that worker.

To make this rule operational, marginal benefit is defined as the value marginal product
of labor. Then
VMPL = Price of product*MPL = Marginal cost of that worker.

MC of labor is defined by the wage rate. For example, suppose the price of one
unit of output sold is $3 and the cost of each unit of labor is $400. Using Table
5-2 below, how many units of labor should this manager hire? Or which point on
the production function should she choose?
Table 5-2 The Value Marginal Product of Labor
(1)
L
Variable Input
(Labor)
[Given]

(2)
P
Price of
Output
[(2)]

0
1
2
3
4
5
6
7
8

$3
3
3
3
3
3
3
3
3

(3)
Q /L = MPL
= Marginal
product of
Labor
[Column 5 of
Table 5-1]
76
172
244
292
316
316
292
244

(4)
VMPL = P *
MPL =Value
Marginal
Product of
Labor
[(2)*(3)]
$228
516
732
876
948
948
876
732

Le = 9

172

516 >

400

10
11

3
3

76
-44

228 <
-132

400
400

(5)
W
Unit Cost of
Labor
[Given]
$400
400
400
400
400
400
400
400
400

67

The manager should hire 9 units of labor. This is the optimal labor (L* = 9) and optimal
Q* =2,124.. See also Demonstration 5-2 for an algebraic solution in the short-run.
Max Profit = PxQ* -wXL* -rxK + ?? (K is constant and given in the short run).
Graphically, value marginal product curve is concave as in Fig. 5-2. Then using the
profit-maximizing input usage rule, it gives the intersection between the unit labor cost
and the VMPL as the point that the manager should choose to maximize profit. VMPL
defines the demand for labor. It first slopes upward (because MPL slopes upward), then it
slopes downward.

Rule: Price of product*MPL = W

To derive optimal input L* in short run

Fig 5-2: The Input Demand for Labor (optimal labor in the short-run)

68

Algebraic Forms of Production Functions

Linear Production Function: coefficients are slopes

Q = F(K, L) = ak + bL
where a and b are constants and equal:
a = Q /K = MPK and b = Q /L = MPL

(these are slopes)

Thus the coefficients in linear production functions are the marginal products of L and K.

Example, Q = 5K + L

(Linear)

This function says capital is five times more productive than labor or one machine does
the work of five workers. If two machines and six workers are used then the total output
produced is Q = 5(2) + 1(6) = 16 units of output.

Leontief Production Function

Q = F(K, L) = min(bK, cL) and fixed input proportion K/L = c/b in output.
This function is also called the fixed proportions production function because it implies
that inputs are used in fixed proportions in the production process. Example: a word
processor company where one machine (keyboard) is operated with one worker
(keyboarder) is one to one. In this case b = c =1. Then the production function can be
written as

Q = F(K, L) = min(K, L) and the fixed input proportion is K/L = 1/1.

where b = c =1 in this case.
Demonstration 5-1
Suppose the production function is given by the Leontief production function:

Q = F(K, L) = min {3k, 4L}

If K= 2 and L = 6 then the output Q = min {3(2), 4(6)} = min (6, 24) = 6 units of
output. Fixed input proportion is K/L = 4/3.
Cobb-Douglas Production Function
Q = F(K,L) = AKaLb (exponential function).
This can be rewritten as: ln Q = ln A + a*ln K + b*ln L (log-linear),
where powers a and b are constants and can be proved to be percentages or elasticities:

a = lnQ/lnK = % Q /%K = (Q /K)*K/Q = K-elasticity of output

69

b = lnQ/lnL = % Q /%L= (Q /L)*L/Q = L-elasticity of output

An example of a Cobb Douglas is the production function for water desalination is

Q = F0.6H0.4
where F denotes a group of inputs related to pumps and labor and H represents a group
of inputs related to diem levels of heat. Output elasticities for F and H are 0.6 and 0.4,
respectively. How much will output increase if input F increases by 10%? (6%?).How
much will output change if input H increases by 10%? 4%. Which input is more
important? Use the ratio of their elasticities: 0.6/0.4 > 1.Then input F is more.?

Regression
ln Q = ln A + a*ln
K+ b*ln L (log-linear)
SUMMARY OUTPUT

Econ 322
Estimation of a Log Linear Production Function
Regression Statistics
Multiple R
0.9968049

R Square
Adjusted R
Square
Standard
Error
Observations

0.9936
0.9927692
0.0552893
18

ANOVA
df
Regression
Residual
Total

2
15
17
Coefficient
s

ln A
ln L
ln K

SS
7.1411349
0.0458536
7.1869885
Standard
Error

MS
3.570567447
0.003056905

F
1168.034

Significanc
eF
3.44E-17

t Stat

P-value

Lower 95%

2.3434 0.0632274 37.06231409 3.63E-16

0.4527 0.0574264 7.883734499 1.03E-06
0.1882 0.0645684 2.914097063 0.010685

Upper
95%

Lower
95.0%

Upper
95.0%

2.208589

2.478122

2.208589

2.47812

0.330333

0.575136

0.330333

0.57513

0.050534

0.325783

0.050534

0.32578

Ln Q = lnA + *lnL + *ln K

ln Q = 2.343 + 0.453 * ln L + 0.188 * ln K
(37.06)

(7.88)

R Square = 0.99

(2.91)

70

Labor elasticity = % Q / %L = 0.45

Capital elasticity = % Q / %K = 0.19
Returns to Scale =

+ =

0.453 +
0.188

=
0.641

Decreasing returns to scale

71

Algebraic Measures of Productivity (i.e., MP and AP)

Cobb-Douglass production function: Q = AKaLb where A >0 is efficiency param.
* The marginal products of labor and capital can be derived as follows:

MPL = Q/L = bAKaLb-1

MPK = Q/K = aAKa-1Lb
Apply these formulae for the production function Q = 10K1/2L1/2 to calculate the
marginal products. (e.g., MPL = 1/2*10K1/2L1/2 1 = 5K1/2L-1/2 = 5(K/L)1/2)

Average product of labor: suppose 4 units of labor and 9 units of capital are
used. Calculate the average product of labor for the above production
function, Q = 10K1/2L1/2 .
Average product of labor = Q/L= {10(9)1/2 (4)1/2}/4 = 10*1.5 = 15 units of
output.

Linear production function: Q = F(K, L) = ak + bL

The marginal products as cited before are
MPK = Q /K = a
MPL = Q /K = b
The average products can be calculated by inserting the values of L and K in the
definition of each average product Q/ L or Q/K.

Demonstration 5-2 (Calculating optimal labor L* in short run. See pages 6869 for the optimality condition).
Assume the following Cobb-Douglass production function
Q = AK1/2L1/2 where A= 1 or Q = AK1/2L1/2
Suppose in the short-run K is fixed at one machine (K =1), the wage cost is $2 per unit of
labor and the price of output is $10 per unit. How many units of optimal labor (L*)
should the manager hire to maximize profit in the short run?

MPL = b*1*KaLb-1= b*1*(1)aLb-1 =0.5L-0.5

Recall the rule:

VMPL = W (profit-maximizing input usage rule in the short run)

P*MPL = ($10)*(0.5L-0.5) = $2
5L-0.5 = $2
Square both sides (5L-0.5 ) 2 = ($2)2
25 L-1 = 4
72

25 (1/L) = 4
25/4 = L*

Optimal labor input: L* = 6.24 units of labor (K = 1) in short run. Q*=(1)1/2(6.24)1/2

Max Profit = PxQ* -wxL* -rxK (and k is given in the short run).

Isoquants (Long Run)

Our next task is to derive both the optimal capital K* and labor L* in the longrun when these inputs are free to vary. The isoquant describes all combinations (L, K) that
yield the same output. For example, an automobile manufacturer can produce 1,000 (= Q
constant) cars per hour by using 10 workers and 1 robot. It can also produce the 1,000
(Q) cars using 2 workers (L) and 3 robots (K) and so on. Fig. 5-3 depicts a typical set of
isoquants. Bundles or input mixes A and B produce the same level of output. The input
mix A implies a more capital intensive process than the input mix B does. As we move in
the Northeast direction in the figure, each new isoquant is associated with a higher level
of output.
The slope of the isoquant is given by K / L. Since both MPL > 0 and MPK > 0
(both inputs are productive and increase output when they increase), then to keep output
Q constant, it requires that an increase in labor (L > 0) must be matched by a decrease in
capital (K< 0). Then all isoquants slope downward (K / L < 0).
That is, the slope is negative. Moreover, the typical isoquants in Figure 5-3 are convex.
This means that capital and labor are substitutes not perfectly substitutable as is the case
in linear isoquants. This implies that as labor is substituted for capital it takes increasing
amounts of labor to replace each unit of capital to keep output the same.

Substitution among Inputs (long-run):

Suppose the general form of the production function is given by
Q = f(L,K)
Then along a single isoquant, output Q is constant. That is,
_
Q = f(L,K).That is, when Q in the function is fixed, the function is called isoquant.
Then moving from point A to point B along this same single isoquant implies both
increasing labor and decreasing capital without changing the output level Q.

73

The rate at which labor and capital can substitute for each other is called marginal rate of
technical substitution. MRTSL,K (substituting L for K) is the absolute value of the slope of
the isoquant K / L.

K
Ka
Kb

A
B

La

_
Q

Lb

Slope of isoquant = MRTSLK

It can be shown that the absolute value of the slope of the isoquant is the ratio of marginal
product of labor to marginal product of capital.
K / L = MPL / MPK
Slope of isoquant = MRTSLK = ratio of marginal products.
MRTSL,K = the amount of capital that can be reduced when an extra unit of labor is used
so that the output remains constant (or moving along the same isoquant).
Example: The table below contains data for an exponential production function
Using a production schedule (not a function) to calculate MRTS.

Combination

A
B
C
D

1
2
3
4

5
2
1
1/2

K /
L
-3/1
-1/1
-1/2/1

MRTSL,K
-+3
+1
+1/2

MRTSL,K is diminishing which implies that the shape of this isoquant is convex.

Calculating MRTS using a linear production function. Example:

Q = f(L,K) = ak + bL. Example, Q = K + 2L. If Q is fixed then this production

function becomes an isoquant which is a straight line. Recall MPK = a = 1 and MPL = b=
74

2. Slope of isoquant = K/L = - MPL/MPK = - b/a = -2/1 = constant (for linear

production function) as in Fig. 5-4. Here inputs L and K are perfect substitutes.
MRTSL,K = K/L

= + 2. Suppose Q = 20 units = K + 2L. Graph it.

== -2

K
20

Assume Q = 20 = K + 2L (isoquant)
K and L are perfect
substitutes
Slope = -2
isoquant

10

Fig. 5-4: Linear Isoquant for Linear Production Function

L-shaped isoquants for Leontief production function

In this function inputs must be used in fixed proportion and they cannot substitute
for each other. Therefore there is no MRTSLK. This implies that the isoquants of this
function are L-shaped or right angled as in Fig. 5-5. Exemple: Q = 200*min (L, K)
Q1

Q2

No substitution
between L and K

K
3

MPK = 0

Q2 = 400

MPL = 0
Q1 = 200

Fig. 5-5: Leontief Isoquants for Leontief Production Function (one to one)
An example of a fixed proportions production function is the construction of a
sidewalk, using one person and one jack hammer. Another example is film making where

75

there is no substitution between cameras and actors. To produce more films, increase
inputs (cameras, actors) proportionally. Inputs are perfect complements.
Convex isoquants (for example the Cobb-Douglas or exponential production function)
For most production functions, isoquants lie somewhere between straight line
isoquants and the L-Shaped isoquants (the Fixed Proportion isoquants) or between
perfect substitutes and perfect complements (no substitution). In this in-between case, the
isoquants are convex and the inputs are just substitutable but are not perfectly
substitutable as is the case in linear production functions. In Figure 5-6, moving from
input mix B to input mix A, 1 unit of labor is substituted for 1 units of capital to produce
100 units of output. Now moving

K and L are imperfect

substitutes

Fig. 5-6: MRTS for a Convex Isoquant

76

Now moving from mix D to mix C for 1 unit of labor is 3 units of capital and vice versa .
This marginal rate of substitution diminished as more labor substitutes for capital. This
convex type of production functions satisfies the law of diminishing marginal rate of
technical substitution.

Returns to Scale (long-run)

This is a long run concept. All inputs are variable and they change by the same
proportion. If all inputs change by the same proportion, how does output change?
I. If output more than doubles when all inputs double, then there are increasing
returns to scale (IRS). There are two types of firms that fit this category. Large
firms that are capital intensive but need regulations (e.g., Public utilities).
Emerging growth companies have IRS at early production stage. As the firm
specializes, this increases productivity of all inputs.
II. If output doubles when all inputs double, then there are constant returns to scale
(CRS). Size does not affect productivity of factors (e.g., banks in 1980s).
III. If output less than doubles, when all inputs double, there are decreasing returns to
scale. Size leads to decreased productivity because of disorganization and
distortion of signals going through layers of management levels.
Example 1: Q = 5L + 3K (linear production function with a straight-line, isoquant
where labor and capital are perfect substitute).
If we double L and K, will Q double, i.e., Q = 2? Check.
Q = 5(2L) + 3(2K). will Q = 2Q? Factor out 2:

Q = 2 * [5L+3K] = 2Q (doubles) CRS.

Example 2.: Q = 10 L0.8 K0.6 (CobbDouglas type production function)
where 10 is the efficiency co-efficient, 0.8 is labor elasticity of output and 0.6 is capital
elasticity of output. 0.8/0.6 = relative importance of labor.

If %Q / %L = 0.8 then if %L = +10% it implies %Q = (0.8 *10% ) = +8%.

Which factor is more important in this production: L or K? L because . See above.
What is the type of returns to scale? Double all inputs, how will Q change?
Q = 10(2L)0.8 (2K)0.6 (double all inputs)
Q = 20.8 *20.6 * [10L0.8 K0.6]. Substitute Q for [10L0.8 K0.6]

77

Q = 20.8 +0.6 *Q = 21.4*Q > 2Q (output more than doubles)

Q > 2Q. Therefore, IRS.
For the Cobb-Douglas type only Q = AL K., we can follow the following rules:
If alpha + Beta > 1 (where alpha is L-elasticity and Beta is K-Elasticity), then IRS
If alpha + Beta < 1 , then DRS
If alpha + Beta = 1, then CRS

Isocosts (long-run)
Similar to an isoquant, an isocost line includes all input combinations that will cost the
firm the same amount ($C). The formula for an isocost line is for constant C given by
C = w*L + r*K
where w is the wage rate and r is the rental price of capital. Both w and r are constant.
Graph of Isocost Line:
Since the equation for the isocost line is linear, then we only need to locate the two-end
points and then connect them with a straight line to graph the isocost line.
__
Let K = 0 then C = w*L and the maximum amount of L = C/w. This determines a point
on the horizontal axis.
__
Next, let L = 0 then C = r*K and the maximum amount of K = C/r. This determines the
endpoint on the vertical axis. If we connect these endpoints with a straight line, we get
the isocost line associated with cost level $C.
K
__
K = $C0/r

Isocost
Lines

__
L = $C0/W

$C1/W

78

Different $ costs (C ) give different isocost lines. There are two levels of $C: C0 andC1.
Each endpoint on these isocost lines is defined as the ratio of the $C over the respective
price of input, w or r.
Slope of the Isocost Line
We can express the above formula for the isocost line in terms of the intercept and the
slope.

C = wL + rK.
Move K to the left hand side as it is on the vertical axis in the graph, and then solve for K:
rK = C wL

K = C/r (w/r) L
This is the equation for the isocost line expressed in terms of the intercept and the slope.
Thus, along an isocost line, capital K is a linear function of input L with a vertical
intercept of C/r and a slope of w/r.

The last graph in Fig. 5-7 below represents a change in the slope of the isocost
line. In this graph the wage rate w is increased from w0 to w1while the rental price
of capital r is kept the same. This represents an inward rotation in the isocost line
around the vertical endpoint. This means the isocost line has become steeper.

79

Fig.5-7: Isocosts
80

Cost Minimization (long-run): Calculating both Optimal L* and K*

Some organizations such as the non-profit ones do not maximize profit but they
minimize costs. Therefore, since labor and capital are free to vary in the long run, we
need to find a rule that will allow us to choose the optimal input mix of both labor and
capital.
Given the isoquant representing the given output Q1 and the three isocost lines C0,
C1 and C2, in order to minimize cost and find optimal L* and K*, we must look at the
lowest isocost line that is tangent to this isoquant ( i.e., the minimum cost that can
produce output Q1). Input mix B costs more than input mix A although both points lie on
the isoquant and can produce the given output Q1. The isocost line that can finance the
production of the given output is isocost line C1. The tangency point between this lowest
isocost line and the given isoquant determines the optimal input mix (L*, K*). This means
that the optimal input choice is characterized by the condition that

Slope of isoquant = Slope of isocost line (tangency point)

Or

K / L = - (w/r)
K / L

= w/r

Or MRTSL,K = w/r which is the condition for cost-minimization input for optimal
inputs.

Isocost lines
C0 < C 1 < C 2

A
K*
Q1

L*

C0/w

C1/w

C2/w

L
81

Recall: it can be shown that MRTSL,K = MPL / MPK

Then the equilibrium condition for producers input choice can be rewritten as:

MPL / MPK = w / r
Or MPL / w = MPK / r
Demonstration Problem 5-3 (Optimal inputs in the long run)
Example: Calculating optimal input choice (producer equilibrium) L* and K*.
Suppose the Cobb-Douglas production function is given by: Q = 50KL2 , the given
output Q1 = 4,800 units, w = $20 and r = $60.
First, use the equilibrium condition to determine the optimal labor/capital ratio.

MPL / MPK = w/r

MPL = Q / L = (2) 50 KL2-1 = 100KL
MPK = Q / K = (1) 50 K1-1L2 = 50L2
(now set MPL/MPK = w/r). That is, 100KL / 50 L2 = $20 / $60

K*/L* = 1 / 6 or K* = (1/6) L* where 1/6 is the optimal capital labor ratio.

This means each worker is managing 6 machines (6 K*= 1L).
Second, determine. K* and L*. Substitute K* into the production functions and let Q1 =
4,800 units which becomes an isoquant equation (that is, when you fix Q).
4,800 = 50*(1/6 L*) L*2
(4,800 * 6) / 50 = L*3 (take the cubic root of both sides and solve for L*).
(576)1/3 = (L*3)1/3 or (576)1/3 = L*

L* = 8.320 labor hours

Substitute L* into the optimal K/L ratio or K* = 1 / 6 * (8.32) = 1.387 machine hours.
Third: Determine minimum cost:
Substitute the values for L* and K* into the isocost equation.
Min cost C = w*L* + r*K*
= ($20)*(8.32) + ($60)*(1.387) = $249.62
Minimum cost = $249.62. for producing the given output 4,800 units.

Optimal Input Substitution (long-run) after an increase in price of an input

82

A change in the price of an input will lead to a change in the cost-minimizing (optimal)
input mix. Suppose that the initial isocost line in Fig. 5-9 is FG and the firm is costminimizing at input mix A, producing Q0 units of output. Now suppose the wage rate w
increases so that if the firm spent the same $ amount on inputs, its isocost line would
rotate inward to FH. With this new isocost line the firm cannot produce the same output
Q0. To produce this output and taking into account the new higher wage rate, the isocost
line should be parallel to FH and also tangent to the isoquant defined by output level Q0.
This isocost line is IJ which is tangent to the isoquant at input mix B. In this case due to
the increase in price of labor the firm substituted capital for labor and moved from input
mix A to input mix B.

83

Fig. 5-9: Substituting Capital for Labor, Due to Increase in Wage Rate

THE COST FUNCTION

Cost functions summarize information in the production function and they can along with
total revenue be used to find the output level (Q) that maximizes profit (= TR-TC). They
are functions of output that defines an isoquant, and the cost (C) associated with this
isoquant is the minimum cost.

C = F (Q).
Short Run Costs

84

Short-run: is the time period during which at least one of the inputs is fixed. This means
that there is a fixed cost which is the cost of the fixed input, usually capital..
Fixed Cost (FC): Expenditures for plant maintenance, insurance, minimal number of
employees, principal and interest payments, property taxes. FC does not change with
output.
Variable Cost (VC) : Expenditures for wages, salaries and raw materials. VC increases
with the size of output. It starts from the origin.
Total Cost (TC): Sum of VC and FC:
In the short run, TC starts where FC starts. When output is zero, TC = FC. In the graph,
the difference between TC and VC is FC and, thus constant at all output levels.
Fig 5-11 illustrates the cost of producing with the same technology used in Table 5-1 as
can be seen in the first three columns. Price of capital = $1000 per hour and w = $400.
Table 5-3: The Cost Functions
(1)
K
Fixed Input
(Capital)
[Given]
2
2
2
2
2
2
2
2
2
2
2
2

(2)
L
Variable
Input
(Labor)
[Given]
0
1
2
3
4
5
6
7
8
9
10
11

(3)
Q
Output
[Given]
0
76
248
492
784
1,100
1,416
1,708
1,952
2,124
2,200
2,156

(4)
FC
Fixed Cost
[$1,000*(1)]

(5)
VC
Variable
Cost
[$400*(2)]

(6)
TC
Total Cost
[(4)+(5)]

$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000

$0
400
800
1,200
1,600
2,000
2,400
2,800
3,200
3,600
4,000
4,400

$2,000 =FC
2,400
2,800
3,200
3,600
4,000
4,400
4,800
5,200
5,600
6,000
6,400

Fig. 5-11 illustrates the relations among total cost (TC), variable cost (VC) and fixed cost
(FC). FC is a horizontal line because it does not change with output even if output is
85

zero. On the other hand, variable cost is zero if output is zero and it increases with the
increase in the level of output. Total cost equals fixed cost when output is zero and then it
increases with output, as does variable cost.

Fig. 5-11: The Relationship among Costs

Average and Marginal Costs

Average Costs
Average fixed cost (AFC).
AFC = FC/Q

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When the fixed cost (FC) is spread out over a larger quantity of the output (Q), the fixed
cost per unit or the average fixed cost AFC declines as shown in column 5 of Table 5-4
in the textbook.
Average variable cost (AVC).
AVC = VC/Q
The typical variable cost per unit of output declines first then it reaches a minimum and
then it begins to increase as shown in column 6 of Table 5-4 (It is U-shaped). In this
table the AVC reaches a minimum of 1.64 between 1,708 and 1952 units of output.
Average total cost (ATC).
ATC = TC/Q
Or
ATC = AFC + AVC.
In this case
AFC = ATC AVC.
ATC is analogous to AVC. It initially declines and then reaches a minimum before it
begins to increase. This U-shaped pattern for ATC reflects the battle between AFC and
AVC. Initially, AFC wins the battle and ATC declines and reaches a minimum. Then after
that the rising AVC dominates the declining AFC and ATC begins to rise. Column 7 in
Table 5-4 in the book gives the ATC.
Marginal Cost (MC): is the increase in total cost resulting from producing an additional
unit of output. It is the most important cost concept.
MC = TC / Q = (VC + FC) / Q = (VC +0)/ Q = VC / Q (because FC does not
change when Q changes. That is, MC in the short run can be calculated from either total
cost or variable cost because FC is a constant and FC cancels out.
MC declines initially then it starts to increase as shown in column 7 of Table 5-5.

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Table 5-5: Derivation of Marginal Cost

(1)
Q
[Given]
0
76
248
492
784
1,100
1,416
1,708
1,952
2,124
2,200

(2)
Q
[(1)]
76
172
244
292
316
316
292
244
172
76

(3)
VC
[Given]
0
400
800
1,200
1,600
2,000
2,400
2,800
3,200
3,600
4,000

(4)
VC
[(3)]
400
400
400
400
400
400
400
400
400
400

(5)
TC
[Given]
2,000=FC
2,400
2,800
3,200
3,600
4,000
4,400
4,800
5,200
5,600
6,000

(6)
TC
[(5)]
400
400
400
400
400
400
400
400
400
400

(7)
MC= TC/Q
[(6)/(2) or (4)/(2)]
400/76 = 5.26
400/172 = 2.33
400/244 = 1.64
400/292 = 1.37
400/316 = 1.27
400/316 = 1.27min
400/292 = 1.37
400/244 = 1.64
400/172 = 2.33
400/76 = 5.26

It is the reciprocal of Marginal Product of Labor (MPL = Q/L) when there is only one
input (labor) is variable in the short run (VC = w*L). Change both sides with respect to Q
VC / Q = w*L/Q = w*(1/MPL) or MC = w/ MPL
where w is the wage rate or the price of labor and is constant. That is, there is an inverse
relationship between MPL and MC, given w.
Example: (the stage of increasing marginal returns to single factor which is labor
because MPL is increasing)
MPL
2 Units
3
6

w
$6 / hr
$6
$6

MC= w/MPL
$6 /2 = $3 per 1 unit of output
$2 per 1 unit
$1

MC is the $ labor cost per unit of output. It is decreasing in this example.

Relations among Costs
Fig. 5-12 depicts the relations between AFC, AVC, ATC and MC. Note that MC crosses
the AVC and the ATC curves at their minimums.

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Fig. 5-12: The Relationship among Average and Marginal Costs

Fixed and Sunk Costs

Fixed cost is a cost that does not vary with output. Sunk cost is a cost that is paid and lost
forever. For example,

Demonstration 5-4
ACME paid $5,000 to lease a railcar from the Reading Railroad. The lease contract says
that only 1,000 of this fixed payment is refundable if the railcar is returned within two
days.
1. Upon signing the contract how much is ACMEs fixed costs? $5,000.
2. Suppose one day after receiving the railcar, ACME has realized that it does not
need it. Farmer Smith offered to lease it for 4,500 that day and AMCE accepted.
How much is ACMEs sunk cost? $500.
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3. Suppose ACMEs refused to lease it and the two days passed. How much is
ACMEs sunk cost? $5,000.
4. Suppose ACME returned the railcar to Reading Railroad within two days. How
much is the sunk cost? $4,000.
Unlike the variable and total costs, sunk cost doesnt affect the optimal decisions of
the firm. It, however, affects total profitability.

Algebraic Forms of Cost Functions

Cubic cost function:
C(Q) = f + aQ + bQ2 + cQ3.
where FC = f and VC = aQ + bQ2 + cQ3..
Example: TC = 20 + 5Q 4Q2 + 6Q3, where a = 5, b = -4, c = 6.
In this cost function
FC = $20
VC = 5Q 4Q2 + 6Q3
AFC = FC/Q = 20/Q
AVC= VC/Q = (5Q 4Q2 + 6Q3)/Q = 5 - 4Q + 6Q2
ATC = TC/Q = AFC + AVC = 20/Q + 5 - 4Q + 6Q2 (where 20/Q is AFC)

MC = TC / Q = VC / Q = 0 + 1*aQ1-1 + 2bQ2-1 + 3cQ3-1

= a + 2bQ + 3cQ2
where a = 5, b = -4, c = 6. Apply it to the example above,

MC = 5 8Q + 18Q2 OR
MC = TC / Q = 0 + 1*5Q1-1 2*4Q2-1 + 3*6Q3-2 =5 8Q + 18Q2
Long Run Costs
Suppose the firm is unsure about future demand and is considering three
alternative sizes Q0 < Q1 < Q2 (small, medium and large).

Three plant sizes with S/R average costs: ATC0 , ATC1 and ATC2.

90

Suppose Min ATC0 > Min ATC2 > Min ATC1 , the medium size has the lowest
min. Short run MC (SMC) goes through the minimum respective ATC.

ATC

LMC

ATC0

ATC2
ATC1
LRAC

SMC0

SMC2
SMC1
Fig. 5-13 Optimal Plan Size and Long-Run Average Cost

If the firm expects output to be Q0 (small size), it will consider the

smallest plant because this is the size that gives the lowest cost per unit
possible. If Q1 (middle size), then the firm will choose second or medium size
and so on.

That is, the long run average cost LRAC or (LAC) with the three firms is the
cross-hatched portions of the three S/R average cost-curves because these
portions show lowest cost of production for any of the three output levels.

If there are infinitely many plant sizes that can be built, then RLAC (or LAC)
will be the envelope that touches infinitely many short-run ATCs and this will
generate a smooth U-shaped long run average cost. Each point on LAC is a
min point on a short-run ATC.

Efficient plant sizes correspond to where the short run ATC curves touch the
envelope LRAC curve, usually at the min S/R ATCs.

91

Scale Economies (long-run)

This concept relates changes in output to changes in cost without any restrictions on
input proportions, as is the case under returns to scale. It concentrates on changes in long
run average cost, LRAC (or LAC). Returns to scale are a special case of scale economics.

If doubling output implies doubling cost, then LRAC (= 2*LTC / 2*Q) will not
change and there are constant returns to scale (CRS). LAC is a straight line.

If doubling output implies less than doubling cost (that is, LRAC will decline),
then there are economies of scale. LAC is a declining curve

If doubling output implies more than doubling cost (that is, LRAC will rise), then
there are diseconomies of scale. LAC is an increasing curve

LRA
C
LRAC

CRS
Economies
of Scale

Diseconomies of
Scale
Q

Examples of cost functions:

C = Q0.8 (an exponential function and the exponent is an elasticity).

where 0.8 = %TC / %Q = 8%/10% or the cost elasticity of output. This means that the
8% change in cost is less than the 10 % change in output. There are economies of scale.

Question: Suppose C= Q1.2. Determine the type of scale economies (%TC = ? if

%Q = 10%/)
92

Economic Cost versus Accounting Cost

Accountants:
Take a retrospective view of a firms finances
Their purpose is to evaluate past performance
Equate costs with actual expenses and depreciation expenses
Depreciation expenses are calculated according to tax rules
Economists:
Take a forward-looking view of the firms finances.
Purpose to evaluate future profitability
Equate costs with actual expenses and opportunity costs (including actual costs)
because the firm rearranges resources to minimize cost and increase expected
profitability. The cost = actual expenses + opportunity costs of own time, money,
materials and buildings.
Depreciation expenses = actual wear or tear.
Example :
Owner/manager of a pizza restaurant in his/her own building
Accounting costs
Owners/managers salary = 0
Own building rent = 0
Workers wages > 0
Cheese > 0
Flour > 0
Other expenses > 0

Economic costs
Owners / managers salary = opportunity cost > 0
Own building rent = opportunity cost > 0
Workers wages > 0
Cheese > 0
Flour > 0
other expenses > 0

Total accounting cost

<

Total economic cost

Total economic Cost = Explicit $cost + Implicit cost

Explicit $cost = accounting cost (out of pocket expenses).
Implicit cost = forgone own salary + forgone interest on own money + forgone own rent
In this case, the implicit cost is the sum of opportunity costs.
Based on that:
Accounting profit = TR accounting costs
Economic profit = TR economic costs

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Multiple Output Cost function

Here, we focus on firms that produce multiple outputs. GM, for example,
produces different types of cars and different types of trucks. In this case, the cost
function of the multi product firm depends on all levels of all output types. Suppose the
firm produces two types of products: product 1, Q1, and product 2, Q2. Then the multiple
output cost function is represented by: C(Q1, Q2).

Economies of Scope
Economies of scope exist if
C(Q1, Q2) < C(Q1) + C(Q2)
or

C(Q1) + C(Q2) - C(Q1, Q2) > 0. It can also be written in percentage as

S = [C(Q1) + C(Q2) - C(Q1, Q2)]/ [C(Q1) + C(Q2)] > 0

That is, producing the two products (say steak and chicken) from two separate plants cost
more than producing them from one restaurant. If the two products are produced from
two separate restaurants will be a duplication of the cost of building, equipment and
maybe labor. (This concept E. of Scope uses Total Cost and not MC).

Cost Complementarity
Cost complementarity exists in a multi-product cost function when the marginal cost of
producing one product (Q1) is reduced when the product of another output (Q2) is
increased. (Cost complementarity uses MC and not TC).
Let C(Q1, Q2) be the cost function for a multi (two)-product firm.
Let MC1(Q1, Q2) = C/ Q1 be the marginal cost of producing the first product.
The cost function exhibits cost complementarity if

MC1(Q1, Q2) / Q2 < 0.

That is, if an increase in the output of product 2 decreases the marginal cost of product 1.
Similarly, the cost function exhibits cost complementarity if

MC2(Q1, Q2) / Q1 < 0.

That is, if an increase in the output of product 1 decreases the marginal cost of product 2.

94

Example of cost complementarity is the production of doughnuts and doughnuts holes.

The firm can produce these products jointly or separately. But the (MC) cost of making
doughnut holes additional to making doughnuts is lower when workers roll out the
dough, punch the holes and fry both the doughnuts and the doughnut holes instead of
making the holes separately.

Multi-product Quadratic Cost Function: Example

C(Q1, Q2) = f + aQ1Q2 + (Q1)2 + (Q2)2, where f is the fixed cost and aQ1Q2 is the
interaction term for producing the two products under one roof. We hope that this term is
negative to reduce cost.
The single product cost functions for Q1 and Q2 separately are:

C(Q1) = f + (Q1) 2
C(Q2)= f + (Q2)2
Marginal costs for products Q1 and Q2 in the multiproduct cost function are:
MC1 = C/ Q1 = aQ2 + 2Q1 (MC is for product 1 and a can be positive or
negative), and
MC2 = C/ Q2 = aQ1 + 2Q2 (MC for product 2 and a can be positive or
negative)
1. Examine whether economies of scope exist for this quadratic multi-product cost
function. Check if this condition for total costs holds:

C(Q1) + C(Q2) - C(Q1, Q2) > 0.

[ f + (Q1)2 ] + [ f + (Q2)2 ] [ f + aQ1Q2 + (Q1)2 + (Q2)2]
[ f + (Q1)2 ]+ [ f + (Q2)2 ] f - aQ1Q2 - (Q1)2 - (Q2)2

Things cancel out and we have

95

f - aQ1Q2 > 0
(where a can be positive or negative and f is FC). You can have many scenarios
for f and the interaction costs. Obviously, the higher the fixed cost, the greater that
economies of scope exist.
Then if f > aQ1Q2 (FC is greater than the interaction term), then there are
economies of scope. THIS is THE CONDITION YOU CHECK FOR
ECONOMIES OF SCOPE. You do not need to go over the whole math if the
functions are quadratic. Just use the result above to check for econ of scope.
Special case: If a < 0, then Economies of Scope exist because f , Q1 and Q2 in
f - aQ1Q2 are always positive, and in this case -aQ1Q2 is also a positive number. If a
is positive, then -aQ1Q2 is negative. Then one has to calculate the difference
f - aQ1Q2 and see if it is positive.
2. Check if the quadratic cost function exhibits multi-product cost
complementarity (use here marginal costs to check and not TC). That is, check
whether MC1/ Q2 < 0.
MC1 = C/ Q1 = aQ2 + 2Q1

Then

MC1/ Q2 = a. If a < 0, there are cost complementarities.

If you have cost complementarities, you will have economies of scope because .

The opposite is not always true.

Demonstration 5-7
Suppose the quadratic cost function of firm A which produces two goods is given
by
C = 100 - 0.5Q1Q2 + (Q1)2 + (Q2)2

(note here a = -0.5)

The firm wishes to produce 5 units of good 1 and 4 units of good 2.

1. Do complementarities exist? Do economies of scope exist?
96

MC1 = C/ Q1 = - 0.5Q2 + 2Q1

For complementarity check whether: MC1/ Q2 = a = -0.5 < 0.

Here a = -1/2 is negative. Then cost complementarities exist.

Check for Economies of Scope. Check whether f - aQ1Q2 > 0. Note that a = -.5,
and substitute 5 units of good 1 and 4 units of good 2.

f - aQ1Q2 =
100 (-.5)(5*4) = 110 > 0. Yes

Example 2:
C = 50 + .8Q1Q2 + (Q1)2 + (Q2)2
And Q1 = 15 units and Q2 = 10 units.
Do we have economies of scale? Cost complementarity?
f - aQ1Q2
MC1 = C/ Q1 = +0.8Q2 + 2Q1

MC1/ Q2 = a = 0.8 >0 ???

Final Remark:
If Economies of Scope exist then there is a benefit of merging two distinct firms into a
single firm because there will be a reduction in costs relative to the costs of the separate
firms. The additional cost that occurs as a result of joint production under Economies of
Scope may not be significant. Look at it the other way around. Selling off unprofitable
subsidiaries when Economies of Scope exist could only result in minor reductions in
costs. Example: C(Q1)=$100, C(Q2) = $80 but C(Q1, Q2) = $110.

Chapter 7: The Nature of Industry

97

Much of the material in this chapter is factual and is intended to acquaint the
students with aspects of the real world related to Managerial Economics. These
statistics on industries are important for managers and they affect how those mangers
make decisions. Although those numbers change over time they are still informative and
they can explain how information affects managerial decisions.
In this chapter we will discuss the factors that affect market structure across
industries. We will also examine the conduct or behavior as well as performance across
industries.

MARKET STRUCTURES
Market structure refers to several factors including: number of firms in the
market; size of firms; size distribution or degree of market concentration; technological
and cost conditions; and ease of entry and exit in the market or industry. Different
industries may have different structures and these structures affect managerial decisions.

Market Power and Market Structure

Monopoly

Duopoly

One Producer

Two Producers

Oligopoly

Monopolistic
Competition

Perfect
Competition

Few producers
Homogeneous Product

Many producers with

Or Differentiated Product

Many Producers.

Differentiated products

homogeneous
Free entry/exit

Equilibrium Conditions:

MR = MC
P=equation

MR = MC

MR = MC

MR = MC

P = MC

P=eq

P=eq

P=equation

P=constant

The following subsection provides a summary of the major structural factors

98

Firm size
Some firms are larger than others. Table 7-1 lists the sales of the largest firm in
each of 26 industries. General Motors is the largest firm in the motor vehicles and

parts industry, with sales of over $184 billion in 2001. In contrast, the largest firm in the
furniture industry is Leggett and Platt, with sales of only 4.3 billion. One important
lesson that can be derived from the table is that some industries naturally give rise to
larger firms than other industries.

Industry concentration
This factor deals with the size distribution or concentration within an industry or a
market. Some industries are dominated by few large firms. There are two measures of
share concentration.

99

The fourfirm concentration ratio: This ratio measures the fraction of total industry sales
produced by the four largest firms in the industry or market. Let S1, S2, S3 and S4 denote
the $ sales of the four largest firms in an industry. Additionally, let ST represent the $ total
sales of all firms in the industry or market. This ratio is given by
C4 = (S1 + S2 + S3 + S4)/ST
This ratio can also be expressed in terms of market shares (%):
C4 = (S1/ST) + (S2/ST) + (S3/ST) + (S4/ST) or
0 < C4 = w 1 + w 2 + w 3 + w 4 1
where wi = (Si/ST) (i = 1,2,3,4) are the four firms market shares. If C4 is close to zero it
indicates there are many small sellers, giving rise to much competition (see wood
containers and pallets C4 = 6% in Table 7-2). If it is close to one, it implies little
competition (see breweries C4 = 90%). When there are four or less companies in the
industry, then C4 =1.

100

Demonstration 7-1
Suppose the industry has six firms. The four largest firms have sales of $10 each and the
remaining two firms have sales of $5 each.
Total industry ST = (4*10) + (2 * 5) = $50
The fourfirm concentration ratio is = (4*10) /$50= $40/$50 = 0.80
This means the four largest firms account for 80% of total industry sales.
The HerfindahlHirschman index (HHI)
Let firm is share of total industry output denoted by

w i = S i / ST
HHI is defined as the sum of the squared market shares of all firms in an industry.

HHI = [ {(w1)2 + (w2)2 + .. + (wn)2 }*10,000]

The multiplication by 10,000 is to eliminate the need for decimals, squaring the
shares means giving higher weights to higher shares in the index.

101

0 < HHI 10,000

If HHI = 10,000 it means there is a single firm in the industry and w1 = 1 (monopoly).
A value close to zero means there are many very small firms in the industry
(competition). The government cutoff point for high concentration is 1,800. In this
case the industry is considered highly concentrated and the Justice Department
may block a horizontal merger if increases the HHI by more than 100 points. It will
challenge it depending on the values of those two statistics. More information on this
index is given below under horizontal integration. Here, we have two statistics.
The difference between HHI before and after the merger is:

HHI = [2wiwj]*10,000 where firms i and j want to merge. Suppose firm 3 with a
market share of 20% and firm 4 with a market share of 23% proposed to merge. How
much is potential H? If HHI>100, then this is another statistical evidence for the
government to question the merger. [2*0.2*0.23]* 10,000 = ? Thus, the government
uses two statistics: HHI and HHI, in addition to other factors.
Demonstration 7-2
Suppose an industry has three firms. The largest firms sales are $30 and the
remaining two have sales of $10 each. Calculate both the HHI and the four-firm
concentration ratio.
HHI = 10,000*[(30/50)2 + (10/50)2 + (10/50)2 ] = 4,400
The four-firm concentration ratio is:
C4 = (30+10+10)/50 = 1,
because the three firms account for all industry sales.
On balance, the HHI and C4 usually signal the same pattern of concentration (see
Table 7-2). However there are exceptional cases where they are not in synch, as can be
seen in the two industries: tires and the snack food in Table 7-2. Why is it possible that
these two industries can give un-similar pattern? HHI covers all the firms in the industry
while C4 includes the four largest firms. Another reason is that HHI is biased toward the
larger firms because of the squared shares.
102

Limitations of Concentration Measures

1. Global markets: The indices take into account the national firms and ignore foreign
firms operating in the domestic industry. With fewer firms included, this leads to
overestimation of concentration (see example, the brewery industry)
2. National, Regional and Local Markets: Consider, for example, the market for gas
stations. Suppose we are interested in the local gas station market in Kansas City. The
national or regional gas stations are not relevant for the local market in Kansas City. If
the local concentration ratio for gasoline in Kansas City is measured at the national level,
then this measure underestimates concentration because it will have too many irrelevant
firms included.
3. Industry Definitions and Product Classes: In constructing indices of market structure,
there is considerable aggregation across product classes. Consider for example, the soft
drink industry. C4 for this industry is 47%. This number may seem surprisingly low when
one considers how Coca-Cola and Pepsi dominate the product class for cola. However,
the soft drink industry as defined by the Bureau of Census includes many more types of
bottled and canned drinks including birch beer, root beer, fruit drinks, ginger ale, iced tea,
lemonade, etc. Cross price elasticity is used to determine close substitutes that belong to a
product class.

Technology
Some industries are very labor intensive, while others are very capital intensive and
require large investments. The differences in technologies give rise to differences in
production techniques across industries. In the petroleum-refining industry, for example,
firms utilize about one employee for each $ 1 million in sales. In contrast, the beverage
industry utilizes about 17 workers for each $1 million in sales.
Technology is also important within a given industry where one firm has superior
technology and it dominates the industry (e.g., Intel).

Demand and market conditions

103

Industries can also differ with respect to demand and market conditions.
Industries (e.g., refrigerator or elevator) with low demand may be able to sustain few
firms, while those with strong demand (e.g., shoes) may require many firms to produce
the output.
Information available to consumers may vary across markets or industries. In
some industries such as the airlines it is easy to find the lowest prices. In contrast, it is
much more difficult to get information on a used car. Market structures and decisions of
managers will vary depending on the amount of information available in the market.
Finally, industry elasticity of demand will vary from one industry to another.
Moreover, within the same industry, the individual firms demand elasticity may be much
more elastic than that of the industry as a whole because of the availability of substitutes
from similar firms within the same industry (see Inside Business 7-2). For example, for
the whole food industry price elasticity is -1.0 and for the representative firm it is -3.8.
One measure of elasticity of industry demand for a product relative to that of an
individual firm is the Rothschild index. This index is defined as the sensitivity of quantity
demanded of the whole industry to the price of the product group (industrys demand
elasticity) relative to the sensitivity of the quantity demanded of the individual firm to its
own price (firms demand elasticity). That is,

Rothschild index (R) = ET/EF and 0 =< R =<1,

(where closer to zero means more competition and closer to one means more monopoly)

where ET the industrys demand elasticity and EF is the firms own demand elasticity. This
index takes on a value between 0 and 1. When the firms elasticity is much greater than
the industrys elasticity when there are many substitutes, the R-index is close to zero. But
if the firms elasticity is the same as that of the industry, the index is one (Tobacco) and
there is monopoly power. In case of perfect competition, the index is zero.
Table 7-3 provides estimates of the firm and industrys elasticities and the
Rothschild indices for 10 US industries. Notice these indices for the tobacco and
chemical are unity. What do these indices mean in terms of substitution? What does the
index of (0.26) mean for the individual food firm?
Demonstration 7-3
104

The industry elasticity for airline travel is -3 and the elasticity for an individual carrier is
-4.Calcutale the Rothschild index for this industry. R = -3 /-4 = 0.75.
Table 7-3: Market and Representative Demand elasticities and Rothschild Index
for Selected US industries

Potential for Entry

In some industries, it is relatively easy for new firms to enter the markets with high
competition, while in other less competitive markets it is more difficult because of
barriers to entry. There are many factors that create barriers to entry including high
explicit costs (such as capital investment), patents and economies of scale. In some
industries (e.g., public utilities) only one or two firms can exist in the industry because of
economies of scale. Other firms cannot enter because they cannot generate the scale or
volume that will give the low average cost (LAC) associated with economies of scale.
CONDUCT OR BEHAVIOR

105

Industries differ not only in terms of market structure but also in terms of conduct or
behavior regarding pricing, production, advertising, R& D, merging etc. Some
industries charge higher markups than other industries. Some industries are more
susceptible to mergers or takeovers than others.

Pricing Behavior (Behavior #1)

Firms in some industries charge higher prices than firms in other industries. The
index that economists use to measure pricing behavior and market power is the Lerner
Index which is given by

L = (P MC)/P (= cents per $1 of sales and 0 =< L =<1 measures

market power), where P is the price of a product and MC is the marginal cost of
producing an incremental unit of the product. This index defines the markup level as a
percentage of the price (it gives cents of markup per dollar of sales). If the typical firm
sets price equal to marginal cost as is the case in perfect competition, where firms are
very small and price-takers, then the index equals zero. In contrast, in highly
monopolized industries where firms do not compete for customers the index takes on a
value of one. Firms in other industries come in between.
We can express this index as a markup factor by rearranging the variables:

P = [1/(1-L)]MC = (Markup factor)* MC

where 1/(1-L) is the markup factor. When the markup index L is zero, the markup factor
is 1 and the price is exactly equal to MC. If the markup index is 1/3, the markup factor is
1.5. If index is 0.5 then the markup factor is 2 times MC. Try it if the index is 2/3. The
higher the Lerner index, the higher the markup factor, and the price as a multiple of
marginal cost.
Table 7-5 provides estimates of the Lerner index and the markup factor for 10 US
industries. There are considerable differences in these measures across industries. The
tobacco industry has the highest Lerner index (76 cents markup per each $1 of sales) and
markup factor of (4.17). The textiles industry has the lowest Lerner index (with a markup

106

of 21 cents per $1 of sales) and a markup factor of 1.27. The goal in this section is to help
the manager determine the optimal markup for a product.

Demonstration 7-4
Suppose; P = $300, MC = $200. What are the Lerner index and the markup factor?
Lerner index or mark up: L = (P MC)/P = (300-200)/300 = 1/3.
Markup factor = 1/(1-L) = 1/(1-1/3) =1.5

Integration and Merger Activity (Behavior # 2)

Integration refers to uniting of productive resources and it can occur through a
merger or unification of two or more existing firms into a single, larger firm. Integration
can also occur during the formation of a firm. Of course, integration results in larger
firms. There are three types of mergers: vertical, horizontal and conglomerate.

Vertical integration:
Various stages in the production of a single product are integrated out in a single firm.
Example, a firm that produces leather merges with a firm that produces clothes. Another
example of vertically integrated firm is the automobile manufacturer that produces its

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own steel, uses the steel to make car bodies and engines and finally sells the single
product automobile. How about the merging of a semiconductor company with a PC
company? Thus, a vertical merger is the integration of two or more firms that produce
components for a single final product. Firms vertically integrate to reduce the
transaction costs associated with acquiring inputs which are outputs of other firms.

Horizontal Integration
This integration refers to merging the production of similar products into a single
firm. For example, horizontal integration occurs if two computer companies merge into a
single company. Another example is the Merging of Exxon and Mobil. How about two
banks?
The primary reason for firms to engage in horizontal integration is:
1. To enjoy the cost saving of economies of scale and scope.
If horizontal integration allows for cost savings then these types of
horizontal mergers are socially beneficial (Social benefits).
2. To enhance their market power.
Since this merger reduces the number of firms that compete in the market.
This tends to increase both C4 and HHI (Social costs).
The social benefits due to cost savings should be weighed against the social costs
associated with a more concentrated industry. Under its current Merger Guidelines, the
Justice Department views industries with HHI in excess of 1,800 to be highly
concentrated and may block the horizontal merger if it will increase HHI by more than
100 points. However, the Justice department permits the merger in industries that
have high HHI if there is evidence of significant foreign competition, an emerging
new technology, increased efficiency or when one of the firms has financial
problems.
Industries with HHI below 1,000 are generally considered unconcentrated by
the Justice Department and mergers are usually allowed. If HHI is between 1,000 and
1,800 (moderately concentrated) the Justice Department relies on other factors such as
economies of scale.

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Conglomerate Mergers
This means merging firms that produce different products into a single company. An
example is merging a cookie manufacturer with a cigarette maker and a soft drink maker
into one single company. The advantage of conglomerate mergers is that they can
improve firms cash flows because revenues derived from one product at a time when it
has a high demand can be used to generate working capital when demand for another
product is low. This reduces the variability of a firms earnings and gives it better access
to capital markets. Example, GE? How many divisions does it have?
The Link between Market Power and Market Concentration
In the case of a single firm, the incremental market power for one firm is defined
by the Lerners markup rule index as
L= (P- MC)/P = - 1/EPD > 0

(*)

where P is the price, MC is marginal cost and EPD = %Q/%P = (Q/P)*P/Q is the
(direct) market price elasticity of demand, which is negative. More elastic demand
implies less market power because of the availability of substitutes.
In the case of multiple firms i = 1, 2 , .., N, the ith firms monopoly power is
defined by
(P- MCi)/P = - wi /EPD > 0

(**)

where wi is the market share of firm i (that is, wi = Si/ST where Si is firm is sales in
dollars and ST is the total industry sales in dollars).
To express Equation (**) in terms of
HHI = [ (w1)2 + (w2)2 + + (wn)2] (without 10,000)

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which is a measure of market concentration without the multiplication by 10,000, we will

follow the following mathematical manipulation.
Multiply both sides of Equation (**) by the ith market share wi, we have
wi*(P- MCi)/P = - (wi)2/EPD

(***)

Sum both sides in Equation (***) over i = 1,2 , , N, we have

Ni= 1 wi*(P- MCi)/P = - Ni= 1 (wi)2/EPD

Notice that in this case HHI = Ni= 1 (wi)2
Upon substitution of HHI, we have

Ni= 1 wi*(P- MCi)/P = - HHI/EPD

(****)

Notice that Ni= 1 wi*P = P* Ni= 1 wi = P*1 = P because the sum of the shares is equal
to 1.
Denote Ni= 1 wi*MCi = MC as the weighted average MC for the industry.
Then Equation (****) can be rewritten for the industry as
(P- MC)/P = - HHI/EPD
1> = (P- MC)/P = - HHI/EPD >= 0

(*****)

Market power for the average firm = - market concentration/demand elasticity

Recall that EPD or price elasticity of demand is negative . So the RHS is positive. (1) the
higher HHI or market concentration, the greater the market power. (2) More elastic

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demand is, the less the market power because of many available substitutes. For
example, the market power is lower with demand elasticity = -2.1 than with elasticity =
-1.7.
Example, Assume there are six firms in the industry whose individual sales are as given
in the table below. Assume that market EPD = - 4.1. How much is the market power for
the average firm? (Hint: Since we do not have information on P and MC, we can use the
right-hand side of Equation (****)).
Firm
1
2
3
4
5
6
Total

Si ($ m)
$10 m
$10
$10
$10
$5
$5
$50

wi= Si/ST
1/5
1/5
1/5
1/5
1/10
1/10
Ni= 1 wi =

MCi ($)

wi*MCi

(wi)2
(1/5)2
(1/5)2
(1/5)2
(1/5)2
(1/10)2
(1/10)2
HHI = ?
0.18000?
??

Then use the formula:

0 < (P- MC)/P = - HHI/EPD

= -0.18000???/-4.1 = ?? <= 1

Advertising (behavior # 3)
Firms in certain industries spend considerably more money on advertising than firms in
other industries. For example, firms in the food industry such as Kellogg spent about 9%
of their sales revenues on advertising in 2000, while firms in the rubber and plastic
products such as Goodyear spent less than 2% of their sales revenues (see Table 7-6).

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PERFORMANCE
Performance refers to both the profit and the social welfare (sum of consumer and
producer surplus) that result in a given industry. It is important for future managers to
recognize that those two measures of performance vary considerably across industries.

Profit
Profit varies from one industry to another. Moreover, big firms do not always earn big
profits as percentage of sales. In Table 7-6, Ford generated more sales than any other firm
on the list. Yet, its profit as a percentage of sales is one of the lowest listed (2.5%).

Social Welfare
This is defined as the sum of consumer and producer surplus. Dansby and Willig
proposed a useful index for measuring performance in terms of social welfare. The
Dansby-Willig (DW) index measures how much social welfare would improve if firms in
an industry increased output in a socially efficient manner. If the DW index is zero, it
means that consumer and producer surplus is maximized and there is no social benefit
increase from altering output. On the other hand, industries with a large index value
show low performance and they can generate improvement in social welfare if they
expand output.
The DW index can be used to rank industries in terms of their abilities to improve
social welfare if they alter their outputs. If the DW is large and the industry is ranked low,

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then it means that the industry shows low performance and thus can alter output.
Industries operating under high competition, they usually exhibit high efficiency and have
low DW index.
Table 7-7 below shows that the textiles industry has the lowest DW index among
the nine industries listed. It thus has the best social welfare performance on the list.
Chemicals, petroleum and paper have the worst performances on this list.

OVERVIEW OF THE REMAINDER of the BOOK

In the remaining chapters of the book, we examine the optimal managerial
conduct (e.g., pricing, output, advertising, etc) under a variety of market structures. There
are four basic market structures.

Perfect Competition
Under this market structure, there are many buyers and sellers in any given
market. The firms produce homogeneous (identical products) and each has no perceptible

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impact on the price which is determined by the market as a whole. The concentration
ratios (such as C4 and HHI), the Rothschild index, Lerner index and the Dansby-Willig
index for industries characterized by this market structures are close to zero.

Monopoly
In this market structure, there is only one firm that produces a product that does
not have close substitutes. An example of industry that has this market structure is public
utilities operating in a certain region or city which enjoy considerable economies of scale.
These public utilities constitute a local natural monopoly. In this market structure, the
monopolist restricts output and charges higher prices.
The C4 concentration ratio and Rothschild index are equal to unity (1) for
monopolies. Moreover, the Lerner index is close to unity and the social welfare
performance is low and the DW index is high.

Monopolistic Competition
In this market structure, there are many small firms and consumers just as in
perfect competition but the products are differentiated. The products are substitutable but
ate not perfect substitutes. Thus, the concentration ratio C4 or HHI is close to zero.
However, unlike under perfect competition, each firm under monopolistic competition
produces a product that is slightly differentiated and is not homogeneous. An example of
monopolistic competition is the restaurant industry in a city or a metropolitan area.
Therefore, because of imperfect substitutes the Rothschild indexes are greater than zero
(the firms elasticity is not infinity) and higher than in perfect competition whose
products are perfect substitutes and firms are infinity.
Because the products are differentiated the monopolistically competitive firm has
some market power or control over prices. Lerner index is greater than zero. When the
firm increases its price some of its customers have brand loyalty and wont switch to
other brands. But some will switch to other brands. For this reason, firms in this market
structure often spend considerable sums on advertising in an attempt to convince
consumers that their brands are better than other brands.

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Oligopoly
In an oligopoly market structure, there are few firms that dominate the market,
giving rise to high concentration of market share. Examples of this market include the
airline, automobile, and aerospace industries. One firms actions affect the other firms
profitability and leads to reactions from those firms. Thus the distinguishing feature of an
oligopoly market is mutual interdependence among firms in the industry.
The interdependence of profits in this market structure gives rise to strategic
interaction among firms. So a manager of an oligopolistic firm should consider how
managers of the other rival firms in the industry would react to her decisions and make
her strategic plan accordingly. Therefore, it is very difficult to manage firms operating in
oligopolistic markets.

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