2016

Intermediate
Microeconomics

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Kotut C Samwel
Moi University, Department of Economics
Saturday, December 07, 2019
Lectures

On

Intermediate

Microeconomics

Kotut c Samwel, M. Phil (Economics)

Moi University.

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CHAPTER ONE
1.0 Introduction

Economics is the science of scarce resource allocation to meet endless human desires. The
modern economics science has two major branches i.e. Micro-economics and Macro-
economics. Compared to micro-economics Macro-economics is a younger branch of
economics. Until the economic depression of 1930s economics was limited to what is
currently Micro-economics.

1.1 Economic Models;

Economic theory aims at the construction of models which describe the economic behavior
of individual economic units;- consumers, firms, government agencies and their
interactions hence creating the economic systems of a region, country or the world at large.

An economic model is a simplified representation of the real world/ situation. It includes

the main features of the real situation which it represents. It implies an abstract of the
reality that is achieved by a set of meaningful and consistent assumptions, which aim at
simplification of the phenomenon or behavioral pattern which the model is designed to
study. The series of assumptions in any particular case are chosen carefully so as to be ;-

Consistent to each other

Retain as much realism as possible

And finally attain a reasonable degree of generality.

A model can be constructed at different levels of aggregation, detailed and sophistication

depending on its purpose. There are two purpose for which a model is constructed;-
Analysis and prediction.

Analysis implies the explanation of the behavior of economic units. From a set of
assumptions we derive certain laws which describe and explain with an adequate degree of
generality the behavior of consumers and producers.

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Prediction implies the possibility of forecasting the effects of changes in some magnitudes
in an economy. For example a model of demand may be used to predict the effects of
imposition of a tax on sales of a commodity.

The validity of a model may be judged may be judged on several criteria. This include;- its
predictive power, the consistency and realism of its assumptions, the extend of information
it provides, its generality (i.e. the range of cases to which it implies), and its simplicity.
However economist have generally agreed that the model’s predictive performance, realism
of its assumptions and the power of the model in explaining the behavior of economic
agents is the most important attributes of a good economic model.

1.1(a) Steps in the construction of microeconomic models

i) Specifying the subject of study and segregating it from the rest of the system
ii) Specifying and definition of the chosen microeconomic variables.
iii) Making assumptions regarding the behavior of selected variables.
iv) Specifying the relationship between the selected variables in the form of
equations, if possible
v) And lastly specifying the criteria for drawing conclusions.

The choice of relevant economic variables is a very important aspect of building economic
models. So is the case with microeconomic models- the choice of relevant microeconomic
variables is essential for building a purposeful microeconomic model. Microeconomic
variables are generally classified as either i) Endogenous variable or

ii) Exogenous variable

Endogenous Variables

Endogenous variables are those whose value is determined within the model. Some typical
endogenous variables used in microeconomic models are consumption, Demand, supply,
investment, price level etc.

Exogenous Variables

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These are those variables that are determined outside the model. E.g. Money supply, etc.
however depending on the objective of analysis, endogenous variables are converted into
exogenous variables, and exogenous variables can be endogenized.

What is important now is to collect the data and test the validity of the model. This is the
empirical testing of the model. The model developed is therefore used to make economic
generalization and hence formulation of policies.

1.1(b) How Relevant are the Models to the Real World

Economic models are only an approximation of apart of the real world chosen for the
purpose of study. The relevance and applicability of this model to the real world will
depend on;-

i) How realistic are the assumptions of the model.

ii) How consistent are the assumptions with one another.
iii) How accurate and relevant are the data to validate the assumptions
iv) And how logical and realistic are equations of the model.

1.1.3 The Basic Analytical Framework of Modern Economics

The basic analytical framework for an economic theory consists of five aspects or steps:
(1) Specification of economic environments,
(2) Imposition of behavioral assumptions,
(3) Adoption of economic institutional arrangements,
(4) Determination of equilibria, and
(5) Evaluation of outcomes resulting from a undertaken institution. The framework is a
framework that uses to deal with daily activities and is used to study particular economic
issues and questions that economists are interested in. Almost of all theoretical economics
papers adopt this framework. As such, to have a solid training in economics and doing
research, it is very important to master this basic analytical framework, specifically, these
five steps. It can helpful at least in the following three aspects:

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(1) Help to understand economic theories and their arguments relatively easily. (2) Help to
find research topics. (3) How to write standard scientific economics papers.
Understanding this basic analytical framework can help people classify possible
misunderstandings about modern economics and can also help them use the basic economic
principles or develop new economic theories to solve economic problems in various
economic environments, with different human behavior and institutional arrangements.
1. Specification of Economic Environments
The first step for studying an economic issue is to specify the economic environment.
The specification on economic environment can be divided into two levels: 1) description
of the economic environment, and 2) Characterization of the economic environment.
To perform these well, the description is a job of science, and the characterization is a job
of art. The more clear and accurate the description of the economic environment is, the
higher the possibility is of the correctness of the theoretical conclusions. The more refined
the characterization of the economic environment is, the simpler and easier the arguments
and conclusions will obtain.
Modern economics provides various perspectives or angles to look at real world economic
issues. An economic phenomenon or issue may be very complicated and be affected by
many factors. The approach of characterizing the economic environment can grasp the
most essential factors of the issue and take our attention to the most key and core
characteristics of an issue so that we can avoid unimportant details. An economic
environment usually consists of
(1) A number of individuals,
(2) The individuals' characteristics, such as preferences, technologies, endowments, etc.
(3) Informational structures, and
(4) Institutional economic environments that include fundamental rules for establishing the
basis for production, exchange, and distribution.
2. Imposition of Behavior Assumptions
The second step for studying an economic issue is to make assumptions on individuals'
behavior. Making appropriate assumptions is of fundamental importance for obtaining a
valuable economic theory or assessment. A key assumption modern economics makes
about an individual's behavior is that an individual is self-interested. This is a main
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difference between individuals and other subjects. The self-interested behavior assumption
is not only reasonable and realistic, but also has a minimum risk. Even this assumption is
not suitable to an economic environment; it does not cause a big trouble to the economy
even if it is applied to the economy. A rule of a game designed for self-interested
individuals is likely also suitable for altruists, but the reverse is likely not true.
3. Adoption of Economic Institutional Arrangement
The third step for studying an economic issue is to adopt the economic institutional
arrangements, which are also called economic mechanisms, which can be regarded as the
rules of the game. Depending on the problem under consideration, an economic
institutional arrangement could be exogenously given or endogenously determined. For
instance, when studying individuals' decisions in the theories of consumers and producers,
one implicitly assumes that the undertaken mechanism is a competitive market mechanism
takes it as given. However, when considering the choice of economic institutions and
arguing the optimality of the market mechanism, the market institution is endogenously
determined. The alternative mechanisms that are designed to solve the problem of market
failure are also endogenously determined. Economic arrangements should be designed
differently for different economic environments and behavior assumptions.
4. Determination of Equilibria
The fourth step for studying an economic issue is to make trade-off choices and determine
the "best" one. Once given an economic environment, institutional arrangement, and other
constraints, such as technical, resource, and budget constraints, individuals will react, based
on their incentives and own behavior, and choose an outcome from among the available or
feasible outcomes. Such a state is called equilibrium and the outcome an equilibrium
outcome. This is the most general definition an economic \equilibrium".
5. Evaluations
The fifth step in studying an economic issue is to evaluate outcomes resulting from the
undertaken institutional arrangement and to make value judgments of the chosen
equilibrium outcome and economic mechanism based on certain criterion. The most
important criterion adopted in modern economics is the notion of efficiency or the \first
best". If an outcome is not efficient, there is room for improvement. The other criterions
include equity, fairness, incentive-compatibility, informational efficiency, and operation
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costs for running an economic mechanism. In summary, in studying an economic issue, one
should start by specifying economic environments and then study how individuals interact
under the self-interested motion of the individuals within an exogenously given or
endogenously determined mechanism. Economists usually use \equilibrium," \efficiency",
\information", and \incentive-compatibility" as focal points, and investigate the effects of
various economic mechanisms on the behavior of agents and economic units, show how
individuals reach equilibria, and evaluate the status at equilibrium. Analyzing an economic
problem using such a basic analytical framework has not only consistence in methodology,
but also in getting surprising (but logically consistent) conclusions.
1.1.4 Methodologies for Studying Modern Economics
As discussed above, any economic theory usually consists of five aspects. Discussions on
these five steps will naturally amplify into how to combine these five aspects organically.
To do so, economists usually integrate various studying methods into their analysis. Two
methods used in modern economics are providing various levels and aspects studying
platforms and establishing reference/benchmark systems.
Studying Platform
A studying platform in modern economics consists of some basic economic theories or
principles. It provides a basis for extending the existing theories and analyzing more deep
economic issues. Examples of studying platforms are:
(1) Consumer and producer theories provide a bedrock platform for studying individuals'
independent decision choices.
(2) The general equilibrium theory is based on the theories of consumers and producers and
is a higher level platform. It provides a basis for studying interactions of individuals within
a market institution and how the market equilibrium is reached in each market.
(3) The m?dZkechanism design theory provides an even higher level of studying platform
and can be used to study or design an economic institution. It can be used to compare
various economic institutions or mechanisms, as well as to identify which one may be an
\optima".

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Reference Systems/Benchmark
Modern economics provides various reference/benchmark systems for comparison and to
see how far a real world is from an ideal status. A reference system is a standard economic
model/theory that results in desired or ideal results, such as efficiency/the \first best".
The importance of a reference system does not rely on whether or not it describes the real
world correctly or precisely, but instead gives a criterion for understanding the real world.
It is a mirror that lets us see the distance between various theoretical models/realistic
economic mechanisms and the one given by the reference system. For instance, the general
equilibrium theory we will study in the notes is such a reference system. With this
reference system, we can study and compare equilibrium outcomes under various market
structures with the ideal case of the perfectly competitive mechanism. The first- best results
in a complete information economic environment in information economics. Other
examples include the Coarse Theorem in property rights theory and economic law, and the
Modigliani-Miller Theorem in corporate finance theory.
Although those economic theories or economic models as reference systems may impose
some unrealistic assumptions, they are still very useful, and can be used to make further
analysis. They establish criterions to evaluate various theoretical models or economic
mechanisms used in the real world. A reference system is not required, in most cases it is
actually not needed, to predicate the real world well, but it is used to provide a benchmark
to see how far a reality is from the ideal status given by a reference system.
The value of a reference system is not that it can directly explain the world, but that it
provides a benchmark for developing new theories to explain the world. In fact, the
establishment of a reference system is very important for any scientific subject, including
modern economics. Anyone can talk about an economic issue but the main difference is
that a person with systematic training in modern economics has a few reference systems in
her mind while a person without training in modern economics does not so he cannot grasp
essential parts of the issue and cannot provide deep analysis and insights.
Analytical Tools
Modern economics also provides various powerful analytical tools that are usually given by
geometrical or mathematical models. Advantages of such tools can help us to analyze
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complicated economic behavior and phenomena through a simple diagram or mathematical
structure in a model. Examples include (1) the demand-supply curve model, (2)
Samuelson's overlapping generation model, (3) the principal-agent model, and (4) the game
theoretical model.
1.1.5 Roles, Generality, and Limitation of Economic Theory
Roles of Economic Theory
An economic theory has three possible roles: (1) It can be used to explain economic
behavior and economic phenomena in the real world. (2) It can make scientific predictions
or deductions about possible outcomes and consequences of adopted economic
mechanisms when economic environments and individuals' behavior are appropriately
described. (3) It can be used to refute faulty goals or projects before they are actually
undertaken. If a conclusion is not possible in theory, then it is not possible in a real world
setting, as long as the assumptions were approximated realistically.
Generality of Economic Theory
An economic theory is based on assumptions imposed on economic environments,
individuals' behavior, and economic institutions. The more general these assumptions are,
the more powerful, useful, or meaningful the theory that comes from them is. The general
equilibrium theory is considered such a theory.
Limitation of Economic Theory
When examining the generality of an economic theory, one should realize any theory or
assumption has a boundary, limitation, and applicable range of economic theory. Thus, two
common misunderstandings in economic theory should be avoided. One misunderstanding
is to over-evaluate the role of an economic theory. Every theory is based on some imposed
assumptions. Therefore, it is important to keep in mind that every theory is not universal,
cannot explain everything, but has its limitation and boundary of suitability. When
applying a theory to make an economic conclusion and discuss an economic problem, it is
important to notice the boundary, limitation, and applicable range of the theory. It cannot
be applied arbitrarily, or a wrong conclusion will be the result.
The other misunderstanding is to under-evaluate the role of an economic theory. Some
people consider an economic theory useless because they think assumptions imposed in the
theory are unrealistic. In fact, no theory, whether in economics, physics, or any other
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science, is perfectly correct. The validity of a theory depends on whether or not it succeeds
in explaining and predicting the set of phenomena that it is intended to explain and predict.
Theories, therefore, are continually tested against observations. As a result of this testing,
they are often modified, refined, and even discarded. The process of testing and refining
theories is central to the development of modern economics as a science. One example is
the assumption of perfect competition. In reality, no competition is perfect. Real world
markets seldom achieve this ideal status. The question is then not whether any particular
market is perfectly competitive, almost no one is. The appropriate question is to what
degree models of perfect competition can generate insights about real-world markets. We
think this assumption is approximately correct in certain situations. Just like frictionless
models in physics, such as in free falling body movement (no air resistance), ideal gas
(molecules do not collide), and ideal fluids, frictionless models of perfect competition
generate useful insights in the economic world.
It is often heard that someone is claiming they have toppled an existing theory or
conclusion, or that it has been overthrown, when some condition or assumption behind it is
criticized. This is usually needless claim, because any formal rigorous theory can be
criticized at anytime because no assumption can coincide fully with reality or cover
everything. So, as long as there are no logic errors or inconsistency in a theory, we cannot
say that the theory is wrong. We can only criticize it for being too limited or unrealistic.
What economists should do is to weaken or relax the assumptions, and obtain new theories
based on old theories. We cannot say though that the new theory topples the old one, but
instead that the new theory extends the old theory to cover more general situations and
different economic environments.

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LESSON TWO:
CONSUMER THEORY
2.0 Introduction

The basic principles of consumer behavior were introduced by laying a strong foundation on
the theory of demand on which premise the consumer behavior is build upon. The consumer
behavior is introduced as a utility maximizing behavior but subject to consumer’s ability to
purchase. A consumer is portrayed as an agent who goes for the best that he/she can afford.
In the intermediate level we describe more precisely what we mean by ‘best’ and I can afford’,
In the first section, we will examine how to describe what a consumer can afford; the next
section will focus on the concept of how the consumer determines what is best. We will then be
able to undertake a detailed study of the implications of this simple mode of consumer
behavior.

2.1 The Budget Constraint

The consumer can’t just choose any bundle he wants to choose. The bundle has to be
affordable. The budget constraint is the set of all bundles that use up the consumer’s
income, given the prices of the two goods. Suppose that there is some set of goods from which
the consumer can choose. In real life there are many goods to consume but we will consider
two.
Let the consumer’s consumption bundle be (X1 X ), where X represents the number of units
2 1

the consumer chooses of good 1 and X is the number of units of good 2 to be chosen by the
2

consumer.
Let P and P represent the unit prices for the two goods respectively; and M to represent the
1 2

amount of money the consumer has to spend.

The budget constraint of the consumer can be written as:
..............................................1
Where P X is expenditure for good 1 and P X is expenditure on good 2
1 1 2 2

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The budget constraint of the consumer requires that the amount of money spent on the two
good is no more than the total amount the consumer has to spend. The consumer’s affordable
consumption bundles are those that do not costs any more than M. The set of affordable
consumption bundles at prices P ,P income M is called the budget set of the consumer.
1 2

The set of bundles that cost exactly M is called the budget line.

..............................................2
These are the bundles of goods that are affordable at the given prices and income.

X2

X1

The budget set consists of all bundles that are affordable at the given prices and income.
Re- arranging equations (2)

…………………………………… (3)

This is an equation for a straight line with a vertical intercept of and a slope of

The example tells how many units of good 2 the consumer needs to consume in order to just
satisfy the budget constraint, if she is consuming X units of good 1.
1

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The slope of the budget line measures the rate at which the market is willing to substitute good
1 for good 2
X 2 P
 1
X 1 P2

The slope of the budget line is also said to be an opportunity cost of consuming good 1. In
order to consume more of good1, one has to give up some consumption of good 2. Giving up
the opportunity of consume good 2 is the true economic cost of more of good 1 consumption,
and that cost is measured by the slope of the budget line.

2.2 Consumer Preferences

The objects of consumer choice are consumption bundles. This is a complete list of the goods
and services that are involved in the choice problem faced by a consumer.
Suppose there are two consumption bundles (X X ) and (Y Y ).The consumer can rank them as
1 2 1 2

to their desirability. That is, the consumer can determine that one of the bundles is strictly
better than the other, or decide that she is indifferent between the two bundles.
2.2.1 Assumption about preferences
There are five properties that consumer preferences (represented by indifference curves)
typically obey.
1. Preferences are complete. This means that a consumer is able to rank any two bundles.
In other words, for any two bundles that I name A and B, the consumer is able to tell me
that he prefers A, prefers B, or likes both the same. Geometrically, this property means that
we are able to draw indifference curves. If a consumer was unable to say which of two
bundles he preferred, it would be impossible to represent his preferences over these
bundles.
2. Preferences are transitive. This means that if a consumer prefers bundle A to bundle B
and the consumer prefers bundle B to bundle C, then the consumer must prefer bundle A to
bundle C. For example, if I prefer pizza to ice cream, but like ice cream better than carrots,
then I must like pizza more than carrots. Geometrically, transitive preferences imply that
indifference curves cannot cross.

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3. Preferences are continuous. This means that if a consumer prefers bundle A to bundle B,
and if bundle C is only infinitesimally far away from bundle A, then the consumer also
prefers bundle C to bundle B. What this rules out is sudden changes in preference patterns
resulting from tiny changes. Geometrically, this means that indifference curves can be
represented by continuous functions without breaks.
4. Preferences are monotonic. Another way to state this is “more is better”. This just means
that, starting with bundle A, if bundle B contains more of either good, then the consumer
would prefer bundle B to bundle A. In other words, the commodities are “good” and not
“bad”. Preferences over dirty cat litter are not monotonic, since a consumer would prefer to
have less dirty cat litter. Geometrically, this means two things. First, higher indifference
curves (containing more of both goods) are preferred to lower indifference curves. Second,
indifference curves slope downwards – the consumer likes good X, and is willing to give
up some good Y in order to obtain more.
5. Preferences are convex. This is a way of saying that preferences satisfy the law of
diminishing marginal rate of substitution. Geometrically, this means that indifference
curves are convex to the origin – the MRS is high initially and then falls as the consumer
obtains more of good X.
Preferences that are complete and transitive are called rational. Without rational
preferences, it is impossible to do much of anything. Preferences that are complete,
transitive, continuous, monotonic and convex are called well-behaved.
2.2.2 Indifference curves
The whole theory of consumer choice can be formulated in terms of preferences that satisfy the
three axioms above. However, it is convenient to describe preferences graphically using
indifference curves.
Consider a consumer’s consumption of goods 1 and 2

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If (X X ) is a certain consumption bundle, the consumption bundle in the shaded region is
1 2

weakly preferred to (X X ). It is called the weakly preferred set. The bundles on the boundary
1 2

of this set for which the consumer is just different to (X X ) from the indifference curve. It
1 2

consists of all bundles of goods that leave consume indifferent to the given bundle.

2.2.3 Shapes of Indifferent Curves

If no further assumptions about preferences are made. ICs can take very peculiar shapes.

1. Perfect Substitutes
Two goods are perfect substitutes if the consumer is willing to substitute one good for the other
at a constant rate. The simplest care of perfect substitutes occurs when the consumer is willing
to substitute the goods on alone to one basis. ICs for such a consumer are all parallel straight
lines.

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Linear ICs, Perfect Substitution

2. Perfect Complements
Perfect complements are goods that are always consumed together in fixed proportions, e.g
shoes (left and right). The ICs L shaped. With the vertex of the L occurring where the number
of one good equals the number of the other good

3. Bad goods

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A bad is a commodity that the consumer doesn’t like. Suppose that the two commodities are
meat and pepper, the consumer loves meat bud dislike pepper. But suppose there is some trade
of possible between meat and pepper i.e. there would be some amount of meat in samosa that
could compensate the consumer for having to consume a given amount of pepper, If more
pepper is given in the samosa ,more meat has to be given to compensate for having to put up
with the pepper. Thus this consumer will have indifference curves that slope up and to the
right.

4. Neutral Goods
A good is a neutral good if the consumer doesn’t care about it one way or the other. Suppose in
the above case the consumer is just neutral about pepper (X ). The IC would be vertical lines as
2

depicted below. The consumer only cares about the amount of X and doesn’t care at all about
1

how much of X he/she has. The more of X the better but adding more X doesn’t affect him.
2 1 2

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 5. Imperfect Substitutes
If the rate at which one good is substituted for another is not constant, but diminishing, then
the two goods are imperfect substitutes. As more and note of one good is given up
successively larger units of the other good are consumer to compensate the consumer for the
loss. Such goods will have indifference curves that are rounded, i.e. The ICs are strictly
convex.

2.2.4 The Marginal Rate of Substitution

The slope of the IC is known as the Mrs. It measures the rate at which the consumer is just
willing to substitute one good for another.
Suppose that we take a little of good 1; ΔX away from the consumer. Then we give him Δ X
1 2

an amount i.e. just sufficient to put him back on his/her IC, so that he is just as well off after
this substitution of X for X as he was before.
2 1

The ration ΔX is thought as being the rate at which the consumer is willing to ΔX substitute
2 1

good 1 for good 2 and is called the MRS.

The MRS measures an interesting measure of consumer behavior. Suppose that the consumer
has well behaved preferences, i.e. preferences which are monotonic and convex, and currently
consuming some bundle (X X ). The consumer is now offered a trade: to exchange good 1 for 2
1 2

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or good 2 for I in any amount at a “rate of exchange” of E. i.e. If the consumer gives up ΔX
1

units of good1, he can get EΔX units of good 2 in exchange or conversely, if he gives up Δ X ,
1 2

units of good 2, he can get ΔX units of good 1.

2

x 2
MRS  E
x1
x 2  Ex1
x 2
x1  
E
Geometrically, we are offering the consumer an opportunity to move to any point along a line
with a slop E that passes through X X as depicted.
1 2

X 2 P
 1
X 1 P2

Moving up and to the left from X to X involves exchange of good I for good 2,and moving
1 2

down to the right involves exchanging good 2 for good 1. In either movement the exchange
rate is E. Since exchange always involves giving up one good in exchange for another, the
exchange rate E corresponds to slope at E. The point of tangency between the budget line and
the indifference curve is referred to as the consumer equilibrium.
2.2. 5 Behavior of the marginal Rate of substitution

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Perfect substitute’s indifference curves are characterized by the fact that the MRS is constant at
–1. The neutral case is characterized by the fact that the MRS is everywhere infinite .The
preference for perfect complements are characterized by the fact that the MRS is either) or
infinite and nothing is between.

The assumption of monotonicity implies that ICs must have a negative slope, so the MRS
always involves reducing the consumption of one good in order to get mote of another for
monotonic preferences.
The case of convex ICs exhibits yet another kind of behavoiur for the MRS. For Convex ICs,
the MRS decreases as more of X is consumer. Thus the IC exhibits a diminishing Mrs.
1

Convexity of ICs implies that the more of a good consumed, the more willing is a consumer is
to give some of it u- in exchange for the other goods. This seems very natural for a consumer
and hence convexity if ICs becomes both necessary and sufficient conditions for consumer
equilibrium besides just having a point of tangency between the consumer’s budget line and the
IC.

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LESSON THREE

THEORY OF DEMAND

3.0 Introduction

The purpose of the theory of demand is to determine the various factors that affect demand
of a commodity. That is the establishment of the law of demand that states that the market
demand is negatively related to the price.

However the above assumption is misleading since it concentrates on price as the

determinant of demand yet there are other factors determining demand.

Demand is a multivariate relationship, that is; - it is determined by many factors

simultaneously. Some of the most important determinants of demand include; -
commodities own price, consumer’s income, prices of other related commodities,
consumers test and preferences, income distribution, population size, credit availability,
government policy, past levels of demand and past levels of income.

3.1 Theory of Consumer Behavior

The traditional theory of demand starts with the examination of the behavior of the
behavior of the consumer, since the market demand is assumed to be the summation of the
individual consumer demands. Therefore we will first start by deriving the demand curve
of individual consumers.

The consumer is assumed to be rational, given his income and market prices of the various
commodities; he plans the spending of his income so as to attain the highest possible level
of satisfaction or Utility. This is the Axiom of Utility Maximization. It is assumed that the
consumer has full knowledge of all the information relevant to his decision making i.e.
complete knowledge of all available commodities, their prices and his income. In order to
attain this objective the consumer must be able to compare the utility (satisfaction) of the
various baskets of the goods, which he can buy with his income.

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Utility
The theory of consumer behavior has been formulated with an objective of utility
maximization .Utility refers to the ability of a good to satisfy the consumer.
There are several approaches to the study of utility with one theory attaching significance
to the magnitude utility and is known as the cardinal utility theory. In this theory the size of
the utility difference between the bundles of goods is supposed to have some sort of
significance.
Another theory formulates the consumer behavior entirely in terms of consumer
preferences and utility is seen only as a way to describe preferences by ranking bundles
according to utility derived from each bundle. The proponents of this theory recognized
that all that mattered about utility as far as choice behavior was concerned was whether one
bundle had a higher utility than another but how much higher didn’t matter ( ranking was
the only matter). Because of this emphasis on ordering bundles of goods, this kind of utility
is refereed ordinal utility.

The Utility Function

A utility function is a way of assigning a number to every possible consumption bundle
such that more preferred bundles get assigned larger numbers than less preferred bundles.
A utility function is a way to label indifference curves. Since every bundle of an IC must
have the same utility, a utility function is a way to assign number to the different
indifference curves in a way tat higher ICs get assigned larger numbers. As long as ICs
containing more preferred bundles get a larger label than indifference curves containing
less preferred bundles, the labeling will represent the different preferences.
However, not all kinds of preferences can be represented by a utility function for example,
suppose a consumer had intransitive preferences so that A > B > C > A. Then a utility
function for these preferences would have to consist of numbers U(A), U(B) and U(C) such
that U(A) >U(B) > U (C) U(A), which is impossible.
There are two approaches to the problem of comparison of utility; - Cardinalist Approach
and the Ordinalist Approach

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The Cardinalist school of thought postulates that utility is measurable. Various suggestions
have been put forward for the measurement of utility. Under certainty i.e. complete
knowledge of the market conditions and income over the planning period, some economist
have suggested that utility can be measured in monetary terms, by the amount of money the
consumer is willing to sacrifice for an additional unit of the commodity. Others have
suggested the measurement of utility using subjective units called utils.

The Ordinalist school postulated that utility is not measurable, but is an ordinal magnitude.
That the consumer needs not to know in specific units the utility of various commodities to
make his choice. It is sufficient for him/her to be able to rank the various baskets of goods,
according to the satisfaction that each bundle gives him. He should be able to determine the
order of preference among the different goods. The main ordinal approach theories are the
indifference curve and revealed preference theories.

3.1(a) Cardinal Utility Theory

Assumptions

a) Rationality

The consumer is assumed to be rational. i.e. he aims to maximize his utility subject
to the budget constrain

b) Cardinality

That the utility of each commodity is measurable. Utility is a cardinal concept; the
most convenient way of measurement is monetary terms. This is the amount of
money that the consumer is willing to pay for an additional unit of a commodity.

c) Constant Marginal Utility

This assumption is necessary when money is used as a measurement of utility, the

essential feature of a standard unit of measurement is that it should be constant.
Therefore if the marginal utility of money changes as income increases (or

Page 24 of 116
 decreases) the measuring rod for utility becomes like an elastic ruler, hence
becoming inappropriate for measurement.

d) Diminishing Marginal Utility

The utility gained from successive units of a commodity diminishes. i.e. the
marginal utility of a commodity diminishes as the consumer acquires larger
quantities of it. This is the axiom of diminishing marginal utility.

e) Total utility of a basket of goods depends on the quantities of the individual

commodities. If there are n commodities in the bundle with quantities x 1, x2,
x3,……….,xn the total utility is

U  f ( x1 , x2 , x3 .............xn )

Equilibrium of the consumer

Let’s begin with the simple model of a single commodity x. the consumer can either buy x
or retain his money income Y. under this conditions the consumer is in equilibrium when
the marginal utility of x is equated to its market price (Px). Symbolically this can be
represented as

MU X  PX

If the marginal utility of X is greater than its price, the consumer can increase his welfare
by purchasing more units of x. similarly if the marginal utility of x is less than its price the
consumer can increase his total satisfaction by cutting down the quantity of x and keeping
more of his income unspent. Therefore, he attains the maximization of his utility when
MUx = Px

if there are more commodities, the condition for the equilibrium of the consumer is the
equality of the ratios of the marginal utilities of the individual commodities to their prices.
i,e;-

Page 25 of 116
 MU X MU Y MU n
  ...................
PX PY Pn

Mathematical derivation of the equilibrium of the consumer

The utility function is given as;-

U  f (q x )

Where utility is measured in monetary units. If the consumer buys qx his expenditure is
qxpx. Presumably the consumer seeks to maximize the difference between his utility and his
expenditure

U  PX q x

The necessary condition for a maximum is that the partial derivative of the function with
respect with to qx be equal to zero. Thus

U  ( p x q x )
 0
q x q x

Rearranging we obtain

U
 p x or MU X  PX
q x

The utility derived from spending an additional unit of money must be the same for all
commodities. If the consumer derives greater utility from any one commodity, he can
increase his welfare by spending more on that commodity and less on the others, until the
above equilibrium condition is fulfilled.

Derivation of the consumer demand curve

The derivation of consumer demand curve is based on the axiom of diminishing marginal
utility. The marginal utility of a commodity x may be depicted by a line with a negative
slope (see figure 3(b)). Geometrically the marginal utility of x is the slope of the total

Page 26 of 116
utility function U=f(qx). The total utility increases but at a decreasing rate, up to quantity x,
and the starts declining (fig 3(a)). Accordingly the marginal utility of x declines
continuously, and becomes negative beyond quantity x. if the marginal utility is measured
in monetary units the demand curve for commodity x is identical to the positive segment of
the marginal utility curve. At x1 the marginal utility is MU1 which is equal to P1. Similarly
at X2 the marginal utility is MU2 which is also equal to P2. Hence at P2 the consumer will
buy X2, and so on. The negative section of the MU curve does not form part of the demand
curve since negative values does not make sense in economics.

Page 27 of 116
 Ux MUx

TU

0 x qx

3(a)

MUx Px

P1

P2

P3

0 x1 x2 x3 MUx Qx 0 x1 x2 x3
Qx

3(b) 3(c)

Figure 3.0

Page 28 of 116
Weaknesses of the Cardinal Utility Theory

There are three major weaknesses of the cardinal utility theory these are;-

a) The assumption of cardinality is doubtful, in that utility derived from the various
commodities cannot be measured objectively.

b) The assumption of constant utility of money is also unrealistic, as income increases

the marginal utility of money changes. Therefore making money to be a poor
measuring rod of utility.

c) And lastly the axiom of diminishing marginal utility is just a psychological law which
is must be taken for granted.

The indifference-curves theory

Assumptions

a) Rationality the consumer is assumed to be rational, that is he aims at maximization

of his utility, given his income and market prices. it is assumed he has full
knowledge of all the relevant information

b) Utility is ordinal. It is taken as axiomatically true that the consumer can rank his
preferences (that is ordering the various baskets of goods) according to satisfaction
of each basket. He needs not to know precisely the amount of satisfaction. It is
sufficient that he expresses his preference for the various bundles of commodities.

c) Diminishing marginal rate of substitution. Preferences are ranked in terms of

indifference curves, which are assumed to be convex to the origin. This implies that
the slope of the indifference curves increases. The slope of the indifference curve is
called the marginal rate of substitution of the commodities. The indifference curve
theory is based, thus on the axiom of diminishing rate of substitution

d) The total utility of the consumer depends on the quantities of the commodities
consumed. That is U  f (q1 , q 2 ..........q x , q y ,....................q n )

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 e) Consistency and transitivity of choice. It is assumed that the consumer is
consistent in his choice, in that if in one period he chooses bundle A over B, he will
not choose B over A in another period if both bundles are available to him. The
consistency assumption may be symbolically written as;- ifA  B, thenB  A

Similarly it is assumed that the consumer’s choices are characterized by transitivity;

if bundle A is preferred to B, and B is preferred to C the bundle A is preferred to C.
this can be represented as

If A>B and B>C the A>C

Equilibrium of the consumer

To define equilibrium of the consumer which is the choice of the bundle that maximizes his
utility, lets introduce the concept of indifference curves and of their slopes(the marginal
rate of substitution), and the concept of the budget line, which are the basic tools of the
indifference curve approach

Indifference curves. An indifference curve is the locus of points- particular combinations

or bundles of goods- which yield the same l3evel of satisfaction to the consumer, so as that
he is indifferent as to the particular combinations to consume.

An indifference map shows all the indifference curves which rank the preferences of the
consumer. Combinations of goods situated on an indifference curve yield higher level of
satisfaction and are preferred. Combinations of goods on a lower indifference curve yield a
lower utility.

Page 30 of 116
An indifference curve and map is shown below

Y Y

0 X 0
X

Figure 3.1

It is assumed that the commodities y and x can substitute one another to a certain extend
but are not perfect substitutes. The negative of the slope of an indifference curve at any one
point is called the marginal rate of substitution of the two commodities, x and y, and is
given by the slope of the tangent at that point;-

 slopeof 
indiferenc e   dy  MRS
  dx
x, y

curve 

The marginal rate of substitution of x for y is defined as the number of units of commodity
y that must be given up in exchange for an extra unit of commodity x so as to remain in the
same level of satisfaction. With this definition the proponents of indifference curve theory
avoided the assumption of diminishing individual marginal utilities and need for their
Page 31 of 116
measurement. The concept of marginal utility is implicit in definition of MRS. Since it can
be proved that the marginal rate of substitution (the slope of the indifference curve) is equal
to the ratio of the marginal utilities of the commodities involved in the utility function.

MU x MU y
MRS x , y  or MRS y , x 
MU y MU X

Properties of indifference curves

a) An indifference curve has a negative slope; this denotes that if the quantity of one
commodity y decreases, the quantity of the other x must increase, if the consumer has
to stay in the same level of satisfaction.

b) The further away the indifference curve is from the origin the higher the level of
satisfaction denotes, bundles of goods on a higher indifference curve are preferred to
those in a lower indifference curve

c) Indifference curves do not intersect one another, if they do so the point of their
intersection will represent a point of two levels of satisfaction

The budget constraint of the consumer

The consumer has a given income which sets limits to his maximizing behavior . Income
acts as a constraining variable in the attempt to maximize utility. The income constrain in
this case of two commodities, may be written as;-

Y  Px q x  Py qY

This can be presented graphically by the budget line, whose equation is derived from the
expression by solving for qy

1 p
qy  Y  x qx
py py

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Assigning successive values to qx (given income Y and the commodity prices, px and py)
we may find the corresponding values of qy. Thus, if qx= 0 the consumer can buy Y/py units
of y.

Similarly if qy= 0 (that is if the consumer spends all his income on x) the consumer can buy
Y/px units of x. this are shown by point A and B

y1 a

y2

0 x1 x2 X

Figure 3.2

If we join these points with a line we obtain the budget line, whose slope is the ratio of the
prices of the two commodities. Geometrically the slope of the budget line is

OA Y / Py Px
 
OB Y / Px Py

Mathematically the slope of the budget line is the derivative

q y Px

q x Py

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 Y
y
Py

Y
Px

0 B x
Figure 3.3

Derivation of the equilibrium of the consumer

The consumer is in equilibrium when he maximizes his utility, given his income and the
market prices. Two conditions must be fulfilled for the consumer to be in equilibrium.

The first condition is that the marginal rate of substitution be equal to the ratio of
commodity prices

MU x Px
MRS x , y  
MU y Py

This is the necessary but not sufficient condition for equilibrium.

Page 34 of 116
The second condition is that the indifference curves be convex to the origin. This condition
is fulfilled by the axiom of diminishing MRSx,y, which states that the slope of the
indifference curve decreases (in absolute term) as we move along the curve from left to
right

Graphical presentation of the equilibrium of the consumer

Given the indifference map of the consumer and his budget line, the equilibrium is defined
by the point of tangency of the budget line with the highest possible indifference curve
(point e)

Figure 3.4

At the point of tangency the slopes of the budget line (Px/Py) and of indifference curve
(MRSx,y = MUx/MUy) are equal:
Page 35 of 116
 MU x Px

MU y PY

Thus the first order condition is denoted by the point of tangency of the two relevant
curves. The second order condition is implied by the convex shape of the indifference
curves. The consumer maximizes his utility by buying x* and y* of the two commodities.

Mathematical derivation of the equilibrium

Given the market prices and his income, the consumer aims at the maximization of his
utility. Assume that there are n commodities available to the consumer, with given market
prices P1, P2,……….Pn) the consumer has money income (Y), which he spends on the
available commodities.

Formally the problem can be stated as follows

Maximize U  f (q1 , q 2, ...............q n )

n
Subject to q p
i 1
i i  q1 p1  q 2 p 2  .................  q n p n  Y

We use the Lagrangian multiplies method for the solution of this constrained maximization

The steps involved in this method may be outlined as follows

i) Rewrite the constraint in the form

q1 p1  q2 p2  ...............  qn pn  Y  0

ii) Multiply the constraint by a constant λ, which is the Lagrangian multiplier

 (q1 p1  q2 p2  ...........  qn pn  Y )  0

iii) Subtract the above constraint from the utility function and obtain the composite
function

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   U   (q1 p1  q2 p2  ........  qn pn  Y )

It can be shown that maximization of the composite function implies maximization of the
utility function.

The first order condition for the maximization of a function is that its partial derivatives be
equal to zero. Differentiating ϕ with respect to q1, q2……...…qn, and λ and equating to zero
we obtain

 U
   ( p1 )  0
q1 q1
 U
   ( P2 )  0
q 2 q 2
.
.
.
 U
   ( Pn )  0
q n q n

 (q1 p1  q 2 p 2  ........  q n p n  Y )  0


From this equations we obtain

U
 P1
q1
U
 P2
q 2
.
.
.
U
 Pn
q n

But

Page 37 of 116
 U U U
 MU 1 ,  MU 2 , ……………….  MU n
q1 q 2 q n

Substituting and solving for λ we find

MU 1 MU 2 MU n
   .............
P1 P2 Pn

Alternatively, we may divide the preceding equation corresponding to commodity x, by the

equation which refers to commodity y and obtain

MU x Px
  MRS x , y
MU y Py

We observe that the equilibrium conditions are identical in cardinalist approach and in the
indifference curves approach. In both we have

MU 1 MU 2 MU x MU y MU n
  ............    ................ 
P1 P2 Px Py Pn

Thus, although in the indifference curve approach cardinality of utility is not required, the
MRS requires knowledge of the ratio of the marginal utilities, given that the first order
condition for any two commodities may be written as

MU x Px
  MRS x , y
MU y Py

Hence the concept of marginal utility is implicit in the definition of the slope of the
indifference curves, although its measurement is not required by this approach. What is
needed is diminishing marginal rate of substitution, which of course does not require
diminishing marginal utilities of the commodities involved in the utility function.

Derivation of the Demand Curve Using the Indifference Curve Approach

Graphical derivation of the demand curve As the price of a commodity, for example x,
falls the budget line of the consumer shifts to the right, from its initial position (AB) to a

Page 38 of 116
new position (AB’) due to increase in the purchasing power of the consumer. With the
more purchasing power in his possession the consumer can buy more x and y. The point of
equilibrium will shift to the right of the original equilibrium (for normal goods) showing
that as price falls more of the commodity will be bought. If the price of commodity x falls
continuously and join the points of tangency of successive budget lines and the highest
possible indifference curves we obtain price consumption curve. For which we derive the
demand curve for commodity x.

At point e1 the consumer buys x1 at price y1. At point e2 the price y2 is lower than y1 and the
quantity demanded increases to x2 and so on. When we plot this we obtain the demand
curve of commodity x

Price-consumption curve

Ic3

Ic2

Ic1

0 B B* B**

px

P1

P2

P3

Page 39 of 116
 D

0 x1 x2 x3 qx

Figure 3.5

The demand curve for normal commodities will always have a negative slope, denoting the
law of demand.

In the indifference curve approach the law of demand is derived from the what is known as
the slutsky’s theory which states that the substitution effect of a price change is always
negative ( relative to price, if the price increases, the quantity demanded decreases and vice
versa)

We observed that a fall in the price of x from p1to p2 resulted in an increase in the quantity
demanded from x1 to x2. This is the total price effect which may be split into two separate
effects, Substitution effect and income effect.

Substitution effect is the increase in the quantity bought as the price of the commodity falls
after adjusting income so as to keep the real purchasing power of the consumer the same as
before. This adjustment in income is called compensating variation and is shown
graphically by a parallel shift of the new budget line until it becomes tangent to the initial
indifference curve. The purpose of compensating variation is to allow the consumer to
remain on the same level of satisfaction as before the price change. The compensated
budget line will be tangent to the original indifference curve Ic1 at e2 to the right of the
original tangency e1 because this line is parallel to the new budget line which is less steep
than the original one when the price of x falls this is the substitution effect of a price
change. The consumer buys more of commodity x now that now that it is cheaper,
substituting y for x.

However the compensating variation only isolates the substitution effect but does not take
into account of the new equilibrium obtained e3 define from the higher indifference curve
Ic2. The consumer has in fact a higher purchasing power and if the commodity is a normal
good he will spend his increased real income on x thus moving from x 2 to x3. This is the
Income effect of a price change. The income effect of a price change is negative for
normal goods and it reinforces the negative substitution effect. If however the commodity
Page 40 of 116
is inferior, the income effect of the price change will be positive as the purchasing power
increases, less of x will be bought and still the negative substitution effect off sets the
positive income effect, therefore the total price effect will be negative. Hence the negative
substitution effect is sufficient to explain the law of demand.

When the income effect is positive and strong against the substitution effect that the law of
demand does not hold hence the case of Giffen goods which are inferior and have a
positive demand curve

e3

e1 Ic2

Income effect e2 Compensated budget line

Substation effect Ic1

x1 x2 B x3 B*

Figure 3.6

The change in demand due to the change in the rate of exchange between the two goods-is
called the substitution effect. The second effect-the change in demand due to having more
purchasing power-is called the income effect. These are only rough definitions of the two
effects. In order to give a more precise definition we have to consider the two effects in
greater detail. The way that we will do this is to break the price movement into two steps:
first we will let the relative prices change and adjust money income so as to hold
purchasing power constant, and then we will let purchasing power adjust while holding the
relative prices constant.
Compensated Demand Curves

Page 41 of 116
The quantity demanded changes as a price changes in three different contexts: holding
income fixed (the standard case), holding purchasing power fixed (the Slutsky substitution
effect), and holding utility fixed (the Hicks substitution effect). We can draw the
relationship between price and quantity demanded holding any of these three variables
fixed.
This gives rise to three different demand curves: the standard demand curve, the Slutsky
demand curve, and the Hicks demand curve.
The analysis of this chapter shows that the Slutsky and Hicks demand curves are always
downward sloping curves. Furthermore the ordinary demand curve is a downward sloping
curve for normal goods. However, the Giffen analysis shows that it is theoretically possible
that the ordinary demand curve may slope upwards for an inferior good.
The Hicksian demand curve the one with utility held constant-is sometimes called the
compensated demand curve. This terminology arises naturally if you think of
constructing the Hicksian demand curve by adjusting income as the price changes so as to
keep the consumer's utility constant. Hence the consumer is "compensated" for the price
changes, and
his utility is the same at every point on the Hicksian demand curve. This is in contrast to
the situation with an ordinary demand curve. In this case the consumer is worse off facing
higher prices than lower prices since his income is constant.
The compensated demand curve turns out to be very useful in advanced courses, especially
in treatments of benefit-cost analysis. In this sort of analysis it is natural to ask what size
payments are necessary to compensate consumers for some policy change. The magnitude
of such payments gives a useful estimate of the cost of the policy change. However, actual
calculation of compensated demand curves requires more mathematical machinery than we
have developed in this text.

Mathematical Derivation of the Demand Curve under Indifference Curve Approach

(Ordinal)

The demand curve may be derived from the equilibrium condition

MU x MU y MU n
  .......... 
Px Py Pn

And the budget constraint

n
Y   Pi qi
i 1

Assume that there are only two commodities and that the total utility function is
multiplicative of the form
Page 42 of 116
 1
U qx q y
4

The marginal utilities of x and y are

U 1
MU x   q
q x 4 y
and
U 1
MU y   q
q y 4 x

Substituting the marginal utilities in the equilibrium condition we obtain

( 1 )q y ( 1 )q x
4  4
Px Py
or
q y p y  qx px

(Note that the equality of the expenditures of the two commodities is note a rule, the
expenditure depend on the specification of the utility function)

We may therefore derive the demand for commodity x by substituting qypy in the budget
constraint

q y p y  qx px  Y
2q x p x  Y
1
qx  Y
2 px

Thus the demand for x is negatively related to its own price px and positively to income Y

Similarly the demand for y is obtained by substituting qxpx in the budget constraint and we
obtain

1
qy  Y
2 py

The Revealed Preference Hypothesis

Samuelson introduced the term revealed preference into the economics science in 1938.
Since then there have been tremendous improvement in the literature. The revealed
Page 43 of 116
preference theory have been considered a major breakthrough in the theory of demand,
because it has made possible the establishment of the law of demand on the basis of reveled
preference axiom, Without the use of indifference curves and its restrictive assumptions.
Regarding the ordering of consumers’ preference, the revealed hypothesis have the
advantage over Hicks-Allen approach of establishing the existence and convexity of the
indifferences curves.

Assumptions

i) Rationality. The consumer is assumed to be rational, in that he prefers bundles of

goods that include more quantities of the commodities of the commodities.

ii) Consistency. The consumer behaves consistently, that is if he chooses bundle A

over B in a situation where both where available for him, he will not choose B
over A in any other situation if both bundles are available for him.

iii) Transitivity. If in any particular situation A>B and B>C then A>C

iv) The Revealed preference Axiom. The consumer, by choosing a collection of goods
in any one budget situation, reveals his preference for that particular collection.
The chosen bundle is revealed to be preferred among all other alternative bundles
available under the budget constraint. The chosen basket of goods maximizes the
utility of the consumer. The revealed preference for a particular collection of
goods implies (axiomatically) the maximization of the utility of the consumer.

Derivation of the demand curve

Assume that the consumer has the budget line AB in the figure below and chooses the
collection of goods denoted by Z, thus revealing his preference for this batch. Suppose
that the price of x falls so that the new budget line facing th e consumer is AC. We will
show that the new batch will include a larger quantity of x.

Page 44 of 116
 y

A*

Z N

0 X1 X2 B X3 B* C x

Firstly there is a compensating variation of the income, which consists in the reduction of
income so that the consumer has just enough income to enable him/her to continue
purchasing Z if he si wishes. The compensating variation is shown in the figure above by
a parallel shift of the new budget line so that the compensating budget line A*B* passes
through Z. since the collection Z is still available to him, the consumer will not chose any
bundle to the left of Z on the segment A*Z, because his choice would be inconsistent,
given that in the original situation all the batches on A*Z were revealed inferior to Z.
hence the consumer will either continue to buy Z (where the substitution effect is Zero) or
he will choose a batch on the segment ZB* e.g at w, which includes a larger quantity of x
e.g X2. Secondly, if we remove the reduction income and allow the consumer to move on
the new budget line AC, he will choose a batch e.g N to the right of w (if the commodity x
is a normal good with a positive income effect). The new revealed equilibrium position (N
includes a larger quantity of x (i.e. X3) resulting from the fall in its price. Thus the revealed
preference axiom and the implied consistency of choice open a direct way to the derivation
of the demand curve: - as price falls, more of x is purchased.

Page 45 of 116
The Consumers’ Surplus

The Marshallian Surplus

The consumers surplus is a concept introduced by Marshall, who maintained that it can be
measured in monetary terms and is equal to the difference between the amount of money
that a consumer actually pays to buy a certain quantity of a commodity x, and the amount
that he would be willing to pay for this quantity rather than do without it.
Graphically the consumers’ surplus may be found by his demand curve for commodity x
and the current market price, which (it is assumed) he cannot affect by his purchases of his
commodity. Assume that the consumer’s demand or x is straight line (AB in the figure
below)
And the market price is P. at this price the consumer buys q units of x and pays an amount
(q).P for it. However, he would be willing to pay P1 for q1, P2 for q2 and P3 for q3 and so on.
The fact that the price in a market is lower than the price he would be willing to pay for the
initial units of x implies that the actual expenditure is less than he would be willing to
spend to acquire the quantity q. this difference is the consumer’s surplus, and is the area of
triangle PAC in the figure below.
Px

A
P1
P2
P3

P E

0 q1 q2 q3 q B Qx

The Marshallian consumers’ surplus can also be measured using indifference curve
analysis.

Page 46 of 116
In the figure below the consumers budget line is MM* and its slope is equal to the price of
commodity x. (Px) the consumer is in equilibrium at E he buys 0q quantity of x and pays
AP of his income to for it, being left with 0M amount of money to spend on all other
commodities.

It is important to determine the amount money that the consumer is willing to pay for 0q
quantity of x rather than remain without it. This is attained by drawing an indifference
curve passing through M. under the Marshallian assumption that the MU of money is
constant, this indifference (and any other indifference map) will be vertically parallel to the
indifference curve I1; the indifference curves will have the same slope at any given quantity
of x. e.g at q the slope of I1 is the same as the slope of I0

 slopeI 1 
 forQ   MRS 
MU x
 MU x
  x , M
1
Unitsofx

(given that MUm=1)

M
Income
M

A E

B I1

A* I0

0 Q M* x

Page 47 of 116
The indifference curve I0 shows that the consumer would be willing to pay A*M for
quantity 0Q, since point B shows indifference of the consumer between having 0Q of x and
0A of income spend on other goods, or having none of x and spending all his income M on
other goods. Ie A*M is the amount of money that the consumer would be willing to pay for
0Q rather than do without it.

The difference A*M – AM = AA* = EB

Is the indifference between what the consumer actually pays (AM, given P x) and what he
would be willing to pay from 0Q of x. that is, this difference is the Marshallian consumers’
surplus.

Applications of indifference curve analysis

The leisure-income trade off and need for overtime rates higher than the normal wage
rates.

First derive the income leisure curve of an individual consumer. This curve shows the
different combinations of income, earned by working and leisure time. Assume that the
maximum time available for both leisure and work is OZ, the individual can either use OZ
hours for leisure in this case earns Zero income, or he can chose to work all the OZ hours,
and therefore earn the maximum money income OM given wage rate w or alternatively he
can work part of the AZ hours and leisure part OA in which case he would earn OM. The
MZ is the income-leisure curve, which shows how much of his leisure time an individual
must give up if he wants to earn a certain income. The slope of this curve equals to the
market wage rate.

Constructing an indifference map of the individual, which shows the ranking of his
preferences between income and leisure, Each indifference curve shows various
combinations of income and leisure the give the consumer equal level of satisfaction
(Utility).

The individual’s equilibrium is determined by the point of tangency of his income-leisure

line and the highest possible trade off line (point e), given the wage rate w the individual
maximizes his utility by working L1Z hours, earning incomeOM1 and using the remaining
timeOL1 for leisure.

Page 48 of 116
 Income Income

M slope = w

M1 H IC3

IC2

IC1

0 A Z Leisure
Leisure

Leisure Work

Individual’s equilibrium

Income

M2 e*

M1 e

IC4

IC3

0 L2 L1 Z Leisure

Evaluation of alternative government policies using indifference curves analysis

Assume that the government considers either the adoption of a food subsidization policy
for pensioners or granting a supplementary income for them. The question is which of this
measure will cost less to the government and what are the effects of these policies to the
demand patterns of the pensioners? Assume there is a single pensioner and two
commodities (x food and Y Money income).
Page 49 of 116
 Income(y)

C
cost of supplementary income

A e3

Z e1

cost of subsidy L e2

0 x1 x 3 x2 B D B* food (x)

The initial equilibrium of the pensioner is at point e1 where his budget line AB is tangent to
indifference curveI1 he consumes OX1 units of food, paying ZA of his income, and having
OZ Income left over to spend on other commodities. The goal of the government is to make
it possible for pensioners to move to the higher level of welfare (satisfaction) denoted by
the indifference curve I2

The effect of food subsidy

Assume the government provides food coupons to pensioner which allows him to buy at
half the price. Hence the budget line of the pensioner shifts to AB* which is tangent to IC2
at e2. At this new equilibrium the pensioner buys OX1

Effect of a supplementary income policy.

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Elasticity of Demand

There are many elasticities of demand as its determinants. The most important ones are the
price elasticity, the income elasticity, and the cross elasticity.

a) The price elasticity of demand.

The price elasticity measures the responsiveness of demand to the changes in the
commodity’s own price. If the changes in price are very small we use as a measure of the
responsiveness of demand the point elasticity of demand. If the changes in price are not
small we use the arc elasticity of demand as the measure.

The point elasticity of demand is defined as the proportionate change in the quantity
demanded resulting from a very small proportionate change in price. Symbolically this can
be presented as;-

dQ
ep  Q
dP
P
or
dQ P
ep  .
dP Q

If the demand curve is linear

Q  b0  b1 P

dQ
Its slope is  b1 . Substituting in the elasticity formula we obtain
dP

P
e p  b1 .
Q

Which implies that elasticity changes at various points of the linear-demand curve,
Graphically the point elasticity of a linear demand curve is shown by the ration of the
segments of the line to the right and to the left of the particular point. In the graph below
FD *
the elasticity of the linear-demand curve at point F is the ratio
FD

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 P

P1 F

P2 E F*

0 Q1 Q2 D* Q

Proof

P  P1 P2  EF
Q  Q1Q2  EF *
P  0 P1
Q  0Q1

If we consider very small changes in P and Q then P  dP and Q  dQ . Thus,

substituting in the formula for the point elasticity we obtain.

dQ P Q1Q2 0 P1 EF * 0 P1
ep  .  .  .
dP Q P1 P2 0Q1 EF 0Q1

From the figure we can also see that the triangles FEF* and FQD* are similar because each
corresponding angle is equal. Hence

EF * Q1 D * Q1 D *
 
EF FQ1 0 P1

Thus

Q1 D * 0 P1 Q1 D *
ep . 
0 P1 0Q1 0Q1

Furthermore the triangles DP1F and FQ1D* are similar so that

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 Q1 D * P1 F 0Q1
 
FD * FD FD

Rearranging we obtain

Q1 D * FD *

0Q1 FD

Thus the price elasticity at point F is

Q1 D * FD *
ep  
0Q1 FD

Given this graphical measurement of point elasticity it is obvious that at the mid-point of a
linear-demand curve ep=1 (point M in the diagram below).

P ep  

ep  1

ep  1

M ep  1

ep  0

0 D* Q

At any point to the right of M the point elasticity is less than unity (ep < 1); and at any point
to the left of M ep > 1.

The price elasticity is always negative because of the inverse relationship between Q and P
implied by the law of demand. However the negative sign is always omitted when writing
the formula of elasticity.

The range of values of elasticity are;- 0  e p  

That is;-
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If ep=0, the demand is perfectly inelastic

If ep= 1, the demand has unitary elasticity

If ep =  , the demand is perfectly elastic

if 0  e  1 we say that the demand is inelastic

if 1  e   , we say that the demand is elastic

P P P

P D

0 ep=0 Q 0 ep=1 Q 0 ep   Q

The basic determinants of the elasticity of demand of a commodity with respect to

its own price are;-

a) The availability of substitutes; the demand for a commodity is more elastic if

there are close substitutes for it.

b) The nature of the need that the commodity satisfies. In general, luxury goods
are price elastic, while necessities are price inelastic

c) The time period. Demand is more elastic in the long run.

d) The number of uses to which a commodity can be put. The more the possible
uses of a commodity the greater its price elasticity will be.
Page 54 of 116
 e) The proportion of income spent on the particular commodity.

The above formula for the price elasticity is applicable only for infinitesimal changes in the
price. If the price changes appreciably we use the following formula, which measures the
arc elasticity of demand.

P1  P2
Q 2 Q ( P1  P2 )
ep  .  .
P Q1  Q2 P (Q1  Q2 )
2

The arc elasticity is a measure of the average elasticity, that is, the elasticity at the midpoint
of the chord that connects the two points (A and B) on the demand curve defined by the
initial and new price levels. It should be clear that the measure of arc elasticity is an
approximation of the true elasticity of the section AB of the demand curve, but not the
intermediate ones. The more convex to the origin the demand curve is the poorer the linear
approximation attained by the elasticity formula.

P1 Arc elasticity

P2 B

0 Q1 Q2 Q

The Income Elasticity of Demand

The income elasticity is defined as the proportionate change in the quantity demanded
resulting from a proportionate change in income. Symbolically we write as

dQ dY dQ Y
eY  /  .
Q Y dY Q

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The income elasticity is positive for normal goods. Some writers have used income
elasticity in order to classify goods into luxuries and necessities. A commodity is
considered to be a luxury if its income elasticity is greater than unity. A commodity is a
necessity if its income elasticity is small (less than unity)

Determinants of income elasticity

The main determinants of income elasticity of demand are;-

a) The nature of the need that the commodity covers; the percentage of income spent on
food declines as income increases (this is the Engel’s law )

b) The initial level of income of a country. For example a TV is a luxury in an

underdeveloped country while it is a necessity in a developed (one with high per
capita income)

c) The time period, because consumption patterns adjust with a time lag to changes in
income.

The Cross-Elasticity of Demand

The cross-elasticity of demand is defined as the proportionate change in quantity
demanded of x resulting from a proportionate change in price of y. symbolically this is
given as

dQ x
Qx dQ x Py
e xy   .
dPy dPy Q x
Py

The sign of cross elasticity of demand is negative if x and y are complementary goods,
and positive if x and y are substitutes. The higher the value of cross-elasticity the stronger
is the degree of complementarity or substitutability of x and y.

The main determinant of cross elasticity is the nature of the commodities relative to their
uses. If two commodities can satisfy equally well the same need, the cross elasticity is
high and vice versa.

Lesson Four
The Theory of Production
1.0 Introduction

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 1.1 The production Function for a single product

A production function is a purely technical relation which connects factor inputs and
outputs, it describes the laws of production;- that is the transformation of factor inputs into
products (outputs) at any particular time period. The production function represents the
technology of a firm of an industry, or the economy as a whole. The production function
includes all the technically efficient methods of production,

A method of production is a combination of factor inputs required for the production of one
unit of output. Usually a commodity may be produced by various methods of production.
For example, a unit of commodity x may be produced by the following process;

Process P1 process P2 Process P3

Labour units 2 3 1

Capital units 3 2 4

Activities may be presented graphically by the length of lines from the origin to the point
determined by the labour and capital units. The three processes above may be presented as

4 P1

3 P2

2 P3

0 1 2 3 4 5 L

Method of production A is technically efficient relative to any other method B, if A uses

less of at least one factor and no more from the other factors as compared with B, e.g for a
commodity x can be produced by two methods

A B
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Labour 2 1

Capital 3 4

Method B is technically inefficient as compared with A. The basic theory of production

concentrates only on efficient methods. Inefficient methods will not be used by rational
entrepreneurs.

If a process A uses less of some factors(s) and more of some others as compared with any
other process B, then A and B cannot be directly compared on the criterion of technical
efficiency. Check the following production function

A B

Labour 2 1

Capital 3 4

In this case both processes are considered as technically efficient and are included in the
production function (the technology). The choice of the particular method will entirely
depend on the individual price of the factors of production. Therefore note that a
technically efficient method may not necessarily be a economically efficient method.

An Isoquant is a locus of all the technically efficient methods (or all the combinations of
factors of production) for producing a given level of output. The production isoquant may
assume various shapes depending on the degree of substitutability of factors. This include:-

Linear isoquant this type assumes perfect substitutability of factors of production, in this
case a given product may be produced by using only capital or labour, or by infinite
combinations of the factors,

Input-Output Isoquant this assume strict complementarity (i.e Zero substitutability) of the
factors of production. There is only one method of production for any one commodity. The
isoquant takes the shape of right angled triangle.

Kinked Isoquant this assumes limited substitutability of K and L. there are only a few
process for producing any one commodity, substitutability of the factors is possible only at
the kinks. This type is also called “activity analysis-isoquant” or “Linear programming
Isoquant”

Smooth, convex isoquant This form assumes continuous substitutability of K and L only
over a certain range, beyond which factors cannot substitute each other. The isoquant
appears as a smooth curve convex to the origin.

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 X

Linear Isoquant Input-Output Isoquant

P1 P2 P3

X B

Note that the Kink isoquant are more realistic, production is considered discrete rather than
continuous array. However tradition economic theory has mostly adopted continuous
isoquants, because they are mathematically simpler to handle by the simple rules of
calculus.

The production function describes not only a single isoquant, but the whole array of
isoquants, each of which shows a different level of output. It shows how output varies as
the factor inputs change.

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Production functions involve (and can provide measurements of) concepts which are useful
tools in all fields of economics. The main concepts are;-

i) The marginal productivity of the factors of production

ii) The marginal rate of substitution and elasticity of substitution

iii) Factor intensity

iv) The efficiency of production

v) Returns to scale

These concepts may be discussed as;-

The general mathematical form of the production function is

Y  f ( L, K , R, S , ,  )

Where

Y=Output

L=Labour input

K= capital Output

R= raw materials

S= land Input

υ= returns to scale

γ= efficiency parameter

All variables are flows; that is they are measured per unit of time, in its general form the
production function is a purely technological relationship between quantities of inputs and
quantities of output. Prices of factors of production do not enter into the production
function

Raw materials and land input are constant therefore the production function will be
described as X  f ( L, K , ,  ) this therefore can be presented graphically as

x x

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 x  f ( L)  x  f (k ) 
K 3 , , L ,

L K

The slope of the Isoquant curve represents the marginal products of the factors of
production. The marginal product of the factors is defined as the change in output resulting
from a very small change of the factors, keeping all other factors constant.

Mathematically the marginal product of each factors is the partial derivative of the
production function with respect to this factor. Thus

X X
MPL  and MPK 
L K

Graphically the marginal product of labour is shown by the slope of the production
function

X  f 1 ( L) 
k , ,

And the marginal product of capital is shown by the slope of the production function;-

X  f 2 (K ) 
L , ,

In principle the marginal product of a factor may assume any value, positive, Zero, or
negative, however the basic production theory concentrates only on the efficient part of the
production function. Hence we say that the theory of production concentrates only on the
levels of employment of factors over which their marginal products are positive, i.e

( MP) L
MPL  0 But  0 for the case of Labour in the first equation and
L

( MP ) K
MPK  0 But  0 for the case of capital in the second equation
K

Formally the above can be presented as;-

X  f ( L, K , ,  )

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X 
 0
L 
 Positive marginal products
X
 0
K 

2 X 
 0
L 2

 The slope of marginal product curves is negative
 X
2
 0
K 2 

These implies that the traditional theory of production concentrates on the range of
isoquants over which their slope is negative and convex to the origin.

By construction the higher to the right an isoquant is, the higher the level of output it
depicts. By construction isoquants do not intersect one another, the locus of points of
isoquants where the marginal products of the factors are zero form the ridge lines. The
upper ridge line implies that the MP of capital is Zero. The lower ridge line implies that the
MP for labour is Zero. The production techniques are only (technically) efficient inside the
ridge lines. Outside the ridge lines the marginal products of factors are negative and the
methods of production are inefficient, since they require more quantities of both factors for
producing a given level of output. Such inefficient methods are not considered by the
theory of production since they imply irrational behavoiur of the firm. The condition for
positive but declining marginal products of the factors defines the range of efficient product
(the range of isoquants over which they are convex to the origin) K
Upper ridge line

Lower Ridge line

X3

X2

X1

The slope of the isoquant ( K / L) defines the degree of substitutability of the factors of
production

Page 62 of 116
 K

b x

0 L

At point a and b the slope of the tangent is K / L .

Slope of the isoquant decreases (in absolute terms) as we move down wards along the
isoquant, showing the increasing difficulty in substituting K for L. The slope of the
isoquant is called the rate of technical substitution, or the marginal rate of substitution
(MRS) of the factors.

K
  MRS L , K
L

It can be proofed that the MRS is equal to the ratio of the marginal products of the factors

K X / L MPL
MRS L, K    
L X / K MPK

Proof

The slope of a curve is the slope of the tangent at any point of the curve, the slope of the
tangent is defined by the total differential. In the case of the isoquant the total differential is
the total change in X resulting from a small change in both factors K and L. clearly if we
change K by K , the output X will change by the product K times the marginal product
 X 
of capital. (K ) 
 K 

Similarly, if we change labour by an infinitesimal amount L , the resulting change in X is

 X 
(L) 
 L 

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Now along any isoquant the quantity X is constant, that the total change in X (the total
differential) must be equal to zero. Thus

 x   X 
dX  (K )   (L) 0
 K   L 

Solving for K / L we obtain

K X / L MPL
  
L X / K MPK

Along the ridge lines the MRS=0. In particular along the upper ridge we have

X / K 0
MRS K , L   0
X / L X / L

and along the lower ridge

X / L 0
MRS L , K   0
X / K X / K

The marginal rate of substitution as a measure of the degree of substitutability of the factors
has a serious weakness;- that is;- it depends on the units of measurement of the factors. A
better measure of the ease of factor substitution is provided by the elasticity of substitution.
The elasticity of substitution is defined as the percentage change in the capital labour,
divided by the percentage change in the technical substitution

%inK / L

%inMRS

d ( K / L) /( K / L)
Or 
d ( MRS ) /( MRS )

The elasticity of substitution is purely independent of the units of measurement of K and L,

since both the numerator and the denominator are measured in the same units.

The factor intensity of any process is measured by the slope of the line through the origin
representing the particular process. Thus the factor intensity is the capital-labour ratio, in
the figure below process P1 is more capital intensive than process P2.

K1 K 2

L1 L2

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The upper part of the isoquant includes more capital-intensive process. The lower part of
the isoquant includes more labour-intensive techniques.

K1 P1

K2 P2

0 L1 L2 L

Example

Let us illustrate the above concepts with a specific form of production function, namely the
Cobb-Douglas production function. This is the most popular in applied research, because it
is easier to handle mathematically.

The Cobb-Douglas function is of the form

X  b0 .Lb1 .K b2

1. The Marginal products of factors

a) The MPL

X
MPL   b1 .b0 .Lb1 1 .K b2
L
 b1 (b0 Lb1 K b2 ) L1
X
 b1 .  b1 ( APL )
L

Where APL is the average product of labour

Similarly

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 X
MPK  b2 .  b2 .( APK )
K

2. The marginal rate of substitution is

X
b1
X / L L  b1 . K
MRS L , K  
X / K X b2 L
b2
K

3. The elasticity of substitution is

d ( K / L) /( K / L)
 1
d ( MRS ) /( MRS )

Proof

Substitute MRS in the above equation and obtain

d ( K / L) /( K / L)

 b K   b  K 
d  1 .  /  1  
 b2 L   b2  L 
 K  b 
d   1 
 L  b2 
 1
 b1   K 
 d  
 b2   L 

Given that b1/b2 is constant and does not affect the derivative

4. Factor intensity. In a Cobb-Douglas function factor intensity is measured by the ratio

b1/b2. The higher this ratio the more labour intensive the technique. Similarly the lower
the ratio b1/b2 the more capital intensive is the technique.

5. The efficiency of production. The efficiency of production in the organization of

factors of production is measured by the coefficient b0. Intuitively it is clear that if two
firms have the same K, L, b1, and b2 and still produce different quantities of output, the
difference can be due to the superior organization and entrepreneurship of one of the

Page 66 of 116
 firms, which results in different efficiencies. The more efficient firm will have a larger
b0 than the less efficient one.

6. The returns to scale. This is a long run analysis concept. This concept will be
developed next

Laws of Production

The laws of production describe the technically possible ways of increasing the level of
production. We realize that output may increase in various ways, for example output may
be increased by using more of the variable factors while holding capital constant. However
the marginal product of the variable will decline eventually as more and more of these
quantities are combined with the other constant factors. The expansion of output with one
factor constant is described by the law of diminishing returns of the variable factor, which
is often referred to as the law of variable proportions.

a) Long-Run analysis of production;- Laws of Return to Scale.

In the long run expansion of output may be archived by varying all factors, in the long-
run all factors are variable. The laws of return to scale refer to the effects of scale
relationship.

In the long-run output may be increased by changing all factors by the same proportion,
or by different proportions. The returns to scale, refers to the change in output as all
factors change by the same proportion.

Suppose we start from an initial level of inputs and output

X 0  f ( L, K )

And increase all the factors by the same proportion w. we will clearly obtain a new level
of output X*, higher than the original level X0

X *  f (wL, wK )

If w can be factored out (that is, may be taken out of the brackets as a common factor),
then the new level of output X* can be expressed as a function of w (to any power v) and
the initial level of output

X *  w v f ( L, K )

Or

X *  wv X 0
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 And the production function is called homogenous. If w cannot be factored out, the
production function is non-homogenous. Thus

A homogenous function is a function is such that if each of the inputs is multiplied by w,

then w can be completely factored out of the function. The power v and w is called the
degree of homogeneity of the function and is a measure of returns to scale;

If v=1 we have constant returns to scale. This production function is sometimes called
linear homogeneous.

If v<1 we have decreasing returns to scale.

If v>1 we have increasing returns to scale.

Returns to scale are measured mathematically by the coefficients of the production

function. For example, in a Cobb-Douglas function

X  b0 L K 

The returns to scale are measured by the sum (α + β) = v

Proof

Let L and K increase by w. the new level of output is

X *  b0 ( wL) ( wK ) 
 (b0 L K  ) w  

Or X *  w   X

Thus v = (α + β)

Production Lines
A production line shows the (physical) movement from one isoquant to another as we
change both factors or a single factor. A product curve is drawn independently of the
prices of factors of production. It does not imply any actual choice of expansion, which is
based on the prices of factors and is shown by the expansion path. The product line
describes the technically possible alternative paths of expanding output. What path will
actually be chosen by the firm will depend on the prices of factors.
The product curve passes through the original if all factors are variable. If only one factor
is variable ( the other being kept constant) the product line is a straight line parallel to the
axis of the variable factor. The K/L ration diminishes along the product line.

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 Product line

Product line for K Homogenous productionn

Among all possible product lines of particular interest are the so-called Isoclines. An
Isoclines is the locus of points of different isoquants at which the MRS of a factor is
constant.

If the production is homogenous the isoclines are straight lines through the origin. Along
any one isoclines the K/L ratio is constant (as is the MRS of the factors). Of course the K/L
ratio (and the MRS) is different for different isoclines.

If the production function is non-homogenous the isoclines will not be straight lines, but
their shape will be twiddly. The K/L ratio changes along each isoclines (as well as on
different isoclines)

Graphical Presentation of returns to scale

The returns to scale may be shown graphically by the distance (on an Isocline) between
successive multiple-level-of-output isoquants, that is, isoquants that show levels of output
which are multiples of some base level of output, e.g X, 2X, 3X etc

Constant Returns to Scale along any isoclines the distance between successive multiple-
isoquants is constant. Doubling the factor inputs achieves double the level of the initial
output; trebling inputs achieves treble output, and so on

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 L

Decreasing returns to Scale, The distance between consecutive multiple-isoquants

increases. By doubling the inputs, output increases by less than twice its original level. In
the figure below the point a defined by 2K and 2L, lies on an isoquant below the one
showing 2X

Decreasing returns to scale 0a<ab<bc

Increasing Returns to Scale. The distance between consecutive multiple-isoquants

decreases, By doubling the inputs, outputs is more than doubled. In the figure below
doubling K and L leads to point b which lies on an isoquant above the one denoting 2X.

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 L

b) The Law of Variable Proportions; short-Run analysis of production.

Recall that in the long-run analysis if one factor is variable while the others are kept
constant, the production line will be a straight line parallel to the axis of variable factor. If
the production function is homogenous with constant or decreasing returns to scale
everywhere on the production surface, the productivity of the variable factor will
necessarily be diminishing. If, however, the production exhibits increasing returns to
scale, the diminishing returns arises from the decreasing marginal product of the variable
factor (labour) may be offset, if the returns to scale are considerable. This however, is
rare. In general productivity of a single-variable factor is diminishing (ceteris paribus)

If the production function is homogenous with constant returns to scale everywhere, the
returns to a single-variable factor will be diminishing. This is implied by the negative slope
and the convexity of the isoquants. With constant returns to scale everywhere on the
production surface, doubling both factors (2K,2L) leads to doubling of output, in the figure
above point b on the isoclines 0A lies on the isoquant 2X. However, if we keep K constant
(at the level K) and we double only the amount of L, we reach point c, which clearly lies on
a lower isoquant than 2X. If we wanted to double output with the initial capital K, we
would require L* units of labour. Clearly L*>2L, Hence doubling L, with K constant, less
than doubles output. The variable factor L exhibits diminishing productivity (diminishing
returns)

Page 71 of 116
If the production function is homogenous with decreasing returns to scale, the returns to a
single-variable factor will be, a fortiori, diminishing. Since returns to scale are decreasing,
doubling both factors will less than double output. In the figure below we find that with 2L
and 2K output reaches the level d which is on a lower isoquant than 2X, if we double only
labour while keeping capital constant, output reaches the level c, which lies on a still lower
isoquant

K K

If the production function shows increasing returns to scale, the returns to the single-
variable factor L will in general be diminishing, unless the positive returns to scale are so
strong as to offset the marginal productivity of the single-variable factor. The last figure
above show a very strong returns to scale which offsets the diminishing productivity of L.

Page 72 of 116
Equilibrium of the Firm; Choice of Optimal Combination of Factors of Production

Assumptions

a) The goal of the firm is profit maximization;- that is, the maximization of the
difference   R  C

Where π is profits

R is revenue

C is costs

b) The price of output is given Px

c) The price of factors are given

W is the given wage rate

R is the given price of capital services (rental price of machinery).

A) Single Decision of the Firm

The problem facing the firm is that of constrained profit maximization, which may take
one of the following forms;

a) Maximize profits π, subject to a cost constraint. In this case total cost and prices

  
are given (C , r , w, p) , and the problem may be stated as follows


max   R  C
 
  Px X  C

Maximization of π is achieved in this case if X is maximized, since C and Px are

given constants by assumption.

b) Maximize profits π, for a given level of output. For example, a contractor wants
to build a bridge (X is given) with the maximum profit. In this case we have

max   R  C
 
  Px X  C
Maximization of π is achieved in this case if cost C is minimized, given that X
and Px are given constraints by assumptions

Page 73 of 116
Graphical presentation;

Given the isoquant and isocline curve

K K c/r

c/w

0 L 0 B
L

Recall that the slope of the isoquant is given as

K MPL X / L
  MRS L, K  
L MPK X / K

The isocost line is defined by the cost equation

C  (r )( K )  ( w)( L) \

Where w= wage rate, and r= price of capital services

The isocost line is the locus of all combinations of factors the firm can purchase with a
given monetary cost outlay.

The slope of the isocost line is equal to the ratio of the prices of the factors of production;

w
Slope of isocost line =
r

Proof

Assume that the total cost outlay the firm undertakes is C . If the entrepreneur spends all

the amount C on capital equipment, the maximum amount he can buy from this factor is

C
0A 
r
Page 74 of 116
 If all cost outlay is spent on labour the maximum amount of this factor that the firm
can purchase is

C
0B 
w

The slope of the isocost line is


0A C / r w
 
0 B C / w r

It can be shown that any point on the line AB satisfies the cost equation ( C = r.K + w.L),
so that for given prices of the factors and for given expenditure on them, the isocost line
shows the alternative combinations of K and L that can be purchased by the firm. The
equation of the isocost line is found by solving the cost equation for K;

C w
K  L
r r

By assigning various values to L we can find all the points of the isocost line.

Case 1: Maximization of output subject to cost constraint (financial constraint)

We assume; (a) a given production function

X  f ( L, K , ,  )

And (b) given factor prices, w, r for labour and capital respectively

The firm is in equilibrium when it maximizes its output given its total cost outlay and the
prices of the factors, w and r.

The equilibrium is the point of tangency between isoclines and the highest possible
isoquant, in this case point a above equilibrium are desirable but not attainable due to the
cost constrain. This can be presented as follows;-

Page 75 of 116
 Ke e Iq3

Iq2

Iq1

0 Le B L

At the point of tangency (e) the slope of the isocost line (w/r) is equal to the slope of
isoquant (MPL/MPK). This is the first condition for equilibrium. The second condition is
that the isoquant be convex to the origin. That is to say

a) Slope of isoquant =slope of isocost

w MPL X / L
   MRTS L, K
r MPK X / K

b) The isoquant must be convex to the origin. If the isoquant is concave the point of
tangency of the isocost and the isoquant curves does not define an equilibrium
position.

Isoquant X

0 L

Formal derivation of the equilibrium condition

A rational entrepreneur seeks to maximize his output, given his total cost outlay and the
prices of the factors, the problem is

Maximize X  f ( L, K )


Subject to C  wL  rK (cost constraint)

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 This problem of constraint maximization and the above conditions for equilibrium may be
obtained from its solutions

This maximization problem is solved by the Lagrangian Multipliers method;

Steps

i) Rewrite the constrain in the form


C  wL  rK  0

ii) Multiply the constrain by a constant  which is the Lagrangian Multiplier


 (C  wL  rK )  0

iii) Form the composite function by subtracting the above equation from the
production function

  X   (C  wL  rK )

It can therefore be shown that maximization of the composite function implies

maximization of output.

The first order condition for maximization of a function is that its partial derivative
be equal to Zero. The partial derivatives of the above function with respect to L, K
and  are;-

 X
   (W )  0
L L
 X
   (r )  0
K K
 
 C  wL  rK  0


solving the first two equations we obtain;-

X X / L MPL
 w or  
L w w

X X / K MPK
 r or  
K r r

It therefore follows that

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 X / L X / K

w r

Hence

X / L w MPL
 
X / K r MPK

The firm will be in equilibrium when it equates ratio of the marginal productivities of
factors to the ratio of their prices.

It can be shown that the second order conditions for equilibrium of the firm require that the
marginal product curves of the two factors have a negative slope.

The slope of the marginal product curve of labour is the second derivative of the production
function;

2 X
Slope of MPL curve 
L2

Similarly for capital

2 X
Slope of MPK curve 
K 2

The second-order conditions are

2 X 2 X
 0 and 0
L2 K 2

And
2
 2 X   2 X   2 X 
 2     
 L  K   LK 
2

These conditions are sufficient for establishing the convexity of the isoquants.

Case two: Minimization of cost for a given level of output

The condition for equilibrium are the same as the case of maximization of output in the
first case above.;- that there must be tangency between isoquant and the lowest possible
isocost curve, and the isoquant must be convex to the origin. However the problem in this
Page 78 of 116
case is that the entrepreneur aims at cost minimization. Therefore in this case we have a
single isoquant which denotes the desired level of output and a set of isocost curves, curve
closer to the origin shows a lower total-cost outlay. The isocost lines are parallel because
they are drawn on the assumption of constant prices of factors: since w and r do not
change, all the isocost curves have the same slope w/r

K K

0 L 0
L

The firm minimizes its costs by employing the combination of K and L determined by the
point of tangency of the isoquant with the lowest isocost line. As shown below

Ke

0 Le L
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Mathematically

Maximize C  f ( X )  wL  rK


Subject to X  f ( L, K )

Rewrite the constraint in the form


X  f ( L, K )  0

Pre-multiply the constraint by the Lagrangian multiplier 


{ X  f ( L, K )}  0

Form the composite function


  C  { X  f ( L, K )}

Or

  ( wL  rK )  { X  f ( L, K )}

Take the partial derivatives of  with respect to L,K and  then equate to zero.

 f ( L.K ) X
 w  0  w
L l L
 f ( L, K ) X
 r   0  r 
K K K
 
 { X  f ( L, K )}  0


Form the first two expressions we obtain;-

X
w
L
X
r
K

Solving these expressions we obtain

w X / L
  MRTS L , K
r X / L
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The second order condition concerning the convexity of the isoquant is the same as the first
case of maximization of Output, it is fulfilled by the assumption of negative slopes of the
marginal products of factors
2
2 X 2 X  2 X   2 X   2 X 
 0, 0 and  2     
L2 K 2  L  K   LK 
2

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LESSON FIVE;

THE THEORY OF MARKETS LEARNING

LEARNING OBJECTIVES
The following concepts will be explored in this Topic:
 Perfect competition
 Assumptions
 Types of monopoly
 Monopoly pricing
 Short-run and long-run equilibrium analysis of a monopoly
 Pricing policy of a multi-plant monopoly
 Dominant firm
 Relationship among product differentiation, perceived and actual demand curves
in monopolistic competition
 Short-run and long-run equilibrium analysis of monopolistic competition
 Optimal advertising in monopolistic competition
 Oligopoly

6.1 PERFECT COMPETITION

The model of perfect competition describes a market situation in which there are:-
 Many buyers and sellers to the extent that the supply of one firm makes a
very insignificant contribution on the total supply. Both the sellers and
buyers take the price as given. This implies that a firm in a perfectly
competitive market can sell any quantity at the market price of its product and
so faces a perfectly price elastic demand curve.
 The product sold is homogenous so that a consumer is indifferent as to
whom to buy from.
 There is free entry into the industry and exit out of the industry.
 Each firm aims at maximizing profit.
 There is free mobility of resources i.e. Perfect market for the resources.
 There is perfect knowledge about the market.
 There is no government regulation and only the invisible hand of the
price allocates the resources.
 There are no transport costs, or if there are, they are the same for all
the producers.

Short run Equilibrium of The Firm

A firm is in equilibrium when it is maximizing its profits, and can’t make bigger profits
by altering the price and output level for its product or service. In Short-run the firm
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 may make super-normal profits as shown below:

AC MC

MC MR P R = MR

AR

C q OUTPUT

The firm will produce output q where Marginal Revenue is equal Marginal Cost. At
this level of output, the average cost is C. Hence the firm will make super-normal
profits shown by the shaded area.
In the Short-Run however the firm does not necessarily need to make profits or cover all
its cost. It may only need to cover Total Variable Cost.

The firm’s short-run supply curve will be represented by the part of the Marginal Cost
curve that lie above the AVC. The firm shall not produce unless the price is equal to P1.
Below the price P1 the firm minimizes its cost by shutting down.
Normal and Supernormal Profits
Normal profit refers to the payment necessary to keep an entrepreneur in a particular
line of production.
In economics, it is generally believed that any capital invested in business has an
opportunity cost. The business must offer the investor a prospective return on capital
at least equal to the return available on the next best alternative.
The minimum return required to keep an entrepreneur in a particular line of production is
Page 83 of 116
what economists call Normal Profits. Since it represents the opportunity cost of risk
capital to the business it is treated as part of the firm’s fixed cost which have to be paid if
the firm is first to come into existence and then survive in the long run. Normal profits,
therefore are included in the calculations which produce the AC curve. Therefore, when
price exceeds average cost, the firm is said to be earning abnormal /supernormal profits –
it is earning a surplus over and above what is necessary to keep it in that business (the
surplus is often referred to in economics as Economic rent).
Long Run Equilibrium for The Firm
Since there is freedom of entry into the industry the surplus profits will attract new firms
into the industry. As a result the supply of the product will increase and the price
will fall. The individual firm will face a falling perfectly elastic demand curve,
and the surplus profits will be reduced.

INDUSTRY FIRM

D S1

S2

P1

P2 D2 S1 S2 D q q

This will go on until the firm is no longer making surplus profits, i.e. when it is just
covering its production costs. At this stage no more firms will be attracted to the
industry. This will happen when the price is equal to the average cost and the
demand curve is tangent to the average cost curve at the minimum point. The firm is
said to be making normal profits.

Advantages of Perfect Market

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 It achieves, subject to certain conditions, an allocation of resources which is: socially
optimal” or “economically efficient” or “pareto efficient”.

Perfectly competitive firms are technically efficient in the long run, in that they produce
that level of output, which minimizes their average costs, given their small capacity.
Perfect competition achieves an automatic allocation of resources in response to changes
in demand. The consumer is not exploited. The price of goods, in the long run will be as
low as possible. Producers can only earn a normal profit, which are the minimum levels
of profits necessary to retain firms in the industry, due to the existence of free entry into
the markets.

Disadvantages of Perfect Competition

i) There is a great deal of duplication of production and distribution facilities
amongst firms and consequent waste.
ii) Economies of scale cannot be taken advantage of because firms are operating
on such a small scale. Therefore although the firms may be highly
competitive and their prices may be as low as is possible, given their scale of
production, nevertheless it is a higher price that could take advantage of
economies of scale.
iii) There may be lack of innovation in a situation of perfect competition.
Two reasons account for this:

i) The small size and low profits of the firm limit the availability of funds for
research and development

ii) The assumption of free flow of information, and no barriers to entry, implies
that innovations will immediately be copied by all competitors, so that
ultimately individual firms will not find it worthwhile to innovate.

Realism of Perfect Competition

The assumptions of perfect competition are obviously at variance with the conditions
which actually exist in real world markets. Some markets approximately conform to
individual assumptions, for example, the stock exchange is characterized by a fairly free-
flow of information but the information requires expertise to grasp. However no markets
exactly conform to the assumption of the model, with peasant agriculture probably the
nearest to the mark.

We however study the model of perfect competition to enable us to see:

How competition operates in the real world situation, within a highly simplified model.
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 The advantageous features of perfect competition which governments may wish to
encourage in real world markets.

The disadvantageous features of perfect competition which the governments may wish to
avoid. A standard against which to oil the degree of competition prevailing in a given
market. We can discuss how closely a specific market resembles the perfectly
competitive ideal

OUTPUT AND REVENUE IN COMPETITIVE MARKETS

Since the firm is a place taker, the total revenue depends on the amount sold.

TR = P.Q

TR
MR  P
Q
TR
AR  P
Q

P  AR  MR

P = AR = MR

P P = MR = AR

The SMC curve cuts the ATC at its minimum

MR = MC
At equilibrium
Slope of MC > slope of

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 P,C

SATC

SM

P P = AR =MR

Q Q

Page 87 of 116
 π = TR – Tc

F.O.C for Π max


0
Q

 TR TC
  0
Q Q Q

TR TC

Q Q

MR – MC

But MR = P for competitive market. At Equilibrium P = MC

The S.O.C for profit maximization requires that

 2
0
Q 2

 2  2TR  2TC
  0
Q 2 Q 2 Q 2

 2TR  2TC

Q 2 Q 2
Slope of MR = slope of MC
The MC must be steeper than MR curve hence MC rising.

5.2 Monopoly and Monopolistic Competition

Monopoly is the other extreme case in the market structure spectrum. While market
conditions facing a monopolist are much different from those of perfectly competitive
firms, both types of firms have at least one thing in common - they do not have to have a
competitor.
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Monopolistic competition is like a cross between perfect competition and monopoly.
There are many firms in the market but they all produce slightly different products so
they all have some degree of market power. In perfect competition, the demand curve of a
firm is horizontal. In monopolistic competition, the demand curve of a firm is
downward sloping but not as steep as that of the monopoly.
Monopoly
Monopoly is the sole seller in a market.
Characteristics of Monopoly
The characteristics that define a monopoly are:
i) There is only one seller and large numbers of infinitely small buyers in the
market. This means the demand curve faced by the monopolist is the downward
demand curve for the market. Therefore, the monopolist is a price setter.
ii) The product produced by the monopolist must be highly differentiated from other
products. The inability of the buyers to substitute for other products gives rise to
the firm’s monopolistic status.
iii) To maintain its monopoly status in the long run, the monopolist must be able
prevent entry into its market.
Types of Monopoly
There are many types of monopoly and the following four are the most common ones:
 Monopoly on Inputs
One of the most important bases for monopoly lies in the control of inputs.
Example:
Prior to the Second World War, Aluminium Company of America (Alcoa) owned
almost every sources of bauxite, a necessary ingredient in the production of
aluminium, in the US.
 Natural Monopoly

Natural monopoly arises from huge economies of scale. It comes into place when
the MES is sufficiently large to satisfy the market demand. It is called natural
monopoly in the sense that it is the natural result of market forces.
Example: Most public utilities.
 Market Franchise
A market franchise is actually a contract entered into by a governmental
organization and a business firm providing the firm with an exclusive right to
market a good or services within its jurisdiction.
Example: Oakland Raiders has the franchise granted by the National Football
League for operating a football team in the city of Oakland.
 Technical Superiority
A firm whose technical expertise vastly exceeds that of potential competitors can
maintain a monopoly position.
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Example: Intel in computer chip making.

Monopoly Pricing and Short-Run Equilibrium

In a monopolistic market, the market demand curve is the monopoly demand curve.
Consequently, the pricing behaviour of a monopoly is different from perfectly
competitive firms. A monopolist is a price setter rather than a price taker.

The objective of a monopolist is no different from a competitive firm. It maximises its

profit  :
  pQ  C (Q)
Where p = price,
Q = output,
C(Q) = the total cost function, which is a cubic function.

The important distinction between the monopolist and a perfectly competitive firm is that
the monopolist has the power to set output and price simultaneously. We can write the
monopoly price as a function of output and the profit function is rewritten as:

  p(Q)Q  C (Q)
Applying the decision rule that the profit-maximizing output occurs at the point where

MR = MC, we have

 1 
P 1    MC
 Ed 

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 Where MR = p(1+1/E D ),

E D = the price elasticity of demand,

MC = a function of output Q.

If the monopoly demand curve is linear, then the rate of decline of MR is twice the rate of
decline of price, that is, the MR curve is halfway between the demand curve and the
vertical axis.
Example:

Suppose the linear demand curve is given by the following equation:

p  a  bQ
Where a and b are constants. The total revenue TR of the monopolist is
TR  pQ  aQ  bQ 2
And the MR is

TR
MR  a  2b
Q

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In short run, the monopolist maximizes its profit if
MR = MC
the slope of the MC curve is greater than the slope of the MR curve at the point of
intersection.

A typical case is depicted in Figure 7.1. The short-run equilibrium occurs at point E
where MC is equal to MR. The monopoly sets the price at p* (read the price off the
demand curve at Q*) and sells Q* units of output. Average cost at Q* is denoted by AC*.
The short-run profit is indicated by area p*ABAC*.

p*
AC
MC

A
AC*
B

E
D = AR
MR
Q
Q*

Figure 5.1: Short-run equilibrium of monopoly

Exercise 5.1
Given the monopoly demand curve is:
p = 100 – 5Q
Calculate the equation of and plot the TR and MR curves.
Answer
The equation of the TR curve is TR = 100Q – 5Q2. The equation of the MR curve is MR =

100 – 10Q.

Exercise 5.2
Suppose the short-run total cost function and demand function of a monopoly are:
TC = 1/3Q3 – 10Q2 + 120Q + 1,000
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And p = 600 – 8Q, respectively. Calculate the profit-maximizing output, the price, and
the profit.

Answer

The profit-maximising output, the price, and the profit are Q = 24 units, p = $408 and
 = $7,064, respectively.

MC = Q2 - 20Q + 120

TR = 600Q - 8Q2

MR = 600 - 16Q

Q2 - 20Q + 120 = 600 -16Q

Q2 - 4Q -480 = 0
(Q - 24)(Q + 20) = 0

Q = 24

p = 600 - 8(24) = 408

 = 408(24) - [(1/3)(24)3 - 10(24)2 + 120(24) + 1,000]

= 7,064

Long-Run Equilibrium
Long-run equilibrium occurs where long-run marginal cost LMC is equal to marginal
revenue MR. The pricing mechanism is the same as in short-run except the average cost
LAC* is achieved by choosing the scale of operation that results in the corresponding
short-run MC and AC curves. Note that the AC* incurred at Q* is greater than the
minimum LAC. This means that monopoly does not produce at minimum LAC in the long
run and long-run profit for a monopoly is extra-normal.

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 P AC*

SMC* SAC* MC

p*

Q
Q*

Figure5. 2: Long-run equilibrium of monopoly

Multi-plant Monopoly
We shall now examine the case of a monopolist who produces products in different
production facilities. Suppose the monopolist operates two plants, 1 and 2, with different
cost structures. The monopoly has to make two decisions:
 How much to produce altogether? What price to charge to maximize its profit?
 How to allocate the production of the optimal output between the two plants?
Mathematically, the profit function is:

  p(Q)Q  C1 (Q1 )  C2 (Q2 )

where Q = Q1 + Q2 ,
C 1 (Q 1 ) is the total cost of producing Q 1 units of output in plant 1.

C 2 (Q 2 ) is the total cost of producing Q 2 units of output in plant 2.

The condition for profit maximization turns out to be:

MR = MC 1 = MC 2

Exercise 5.3
Suppose the monopolist’s demand curve, the total cost of plant 1, and the total cost of
plant 2 are:

p = 100 – 0.5Q
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 C 1 = 10Q 1
and
C 2 = 0.25Q 2 2,respectively.

a) Calculate the profit-maximizing output for each plant.

b) Calculate the profit and the price.

Answer
a) The profit maximizing output for plants 1 and 2 are Q 1 = 70 and
Q 2 = 20, respectively;

Q = Q1 + Q2

p = 100 – 0.5(Q 1 + Q 2 )

TR = 100(Q 1 + Q 2 ) - 0.5(Q 1 + Q 2 )2

MR 1 = MR 2 = 100 - Q 1 - Q 2

MC 1 = 10

MC 2 = 0.5Q 2

100 - Q 1 - Q 2 = 10

Q 1 = 90 -Q 2

100 - Q 1 - Q 2 = 0.5Q 2

100 - (90 - Q 2 ) - Q 2 = 0.5Q 2

Q 2 = 20

Q 1 = 90 - 20 = 70

a) The firm’s profit and price are  = Ksh4,150 and p = $55, respectively.

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 p = 100 – 0.5(70 + 20) = 55

 = 55(70 + 20) – 10(70) – 0.5(20)2

= 4150

DEMAND AND PRICE OF A MONOPOLIST

He sets the price hence the amount he sells depend on price ,i.e the demand is a
decreasing function of price i.e
Q = f (p) f

Specifically

Q = b0 – b1 p

The demand curve is assumed to be linear with changing elastics at every one point.

ℓp = ∞

ℓ p =1

A ℓp = 0

0 Q

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OQ
 b1
OP

OQ
p 
OP

At point B,

P
 p  b1 
O

Page 97 of 116
 0
At point C,  p  b 0
O
At point A, ℓ p = 1
Now

TR = P.Q
But Q  b0  b1 p

b0 b
P  q
b1 b1
TR = P.Q

b b 
  0  Q Q
 b1 b1 
b 1
 0 Q  Q2
b1 b1
b0 1
AR   Q
b1 b1
b0 2
MR   Q
b1 b1

The MR is a straight line with the same interrupt as the demand curve but twice as steep
as:

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 P

MR AR = D Q

The AR is the demand curve for a monopolist

Equilibrium requires that MR = MC and slope of MC scope of MC slope of slope of MP

at intersection.

SATC

SMCP

Qm MR AR = D Q

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 (Q)  TR(Q)  TC (Q)
 TR TC
  0
Q Q Q
MR  MC

 2  2TR  2TC
  0
Q 2 Q 2 Q 2

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Slope of MR < slope of MC

e.g

Q = 50 – 0.5,C= 50 + 40Q
P = 100 – 2Q
TR = PQ = (100 – 2 Q) Q
= 100Q – 2 Q2

TR
MR   100  4Q
Q

FOC
MR – MC
100 – 4Q = 40
60 – 40
60 = 4Q
Q = 15
P = 100 – 2 (15)

= 100 – 30

= 70 units

SOC
MR
 4
Q
MC
O
Q
40

THE MULTIPLANT MONOPOLIST

- A monopolist who produces a homogenous product in different plants
- For simplicity we shall assume two plants.

Assume the monopolist operates two plants A & B with a difference cost structure. He
has to make two decisions.

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 (i) How much output to produce altogether and at what price to sell it so as to
maximize profit.
(ii) How to allocate the proportion of the optimal output between the two plants.

The monopolist is assumed to know his market demand and the corresponding MR curve
and the cost structure of the different plants.
The total MC curve is a horizontal summation of the MC curve of the individual plants.

MC  MC1  MC2
The monopolist maximizes his profit by utilizing each plant up to the level at which the
marginal cost are equal to each other and to the common Mr. This is *,if the MC of the
one plant say plant A is lower than the MC of plant B, the monopolist wound increase his
profit by increasing the production in A and decreasing it in B until.

MC  MC2  MR

Given that the market demand

p  f (Q)  f (Q1  Q2 )

And the cost structure of the plant

C1  f (Q1 )
C 2  f (Q2 )

The monopolist aims at the allocation of his production between plant 1 and 2.
To maximize profits

  TR  (TC1  TC2 )
F.O.C
 
 0, 0
Q1 Q2

 TR TC
  0
Q1 Q1 Q1

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MR1  MR2

 2 TR TC
  0
Q 2 Q2 Q2

MR2  MC 2

But MR1 = MR2 = MR given that each unit of the homogenous output will be sold at the
same price P and will yield the same MR1 irrespective of the plant

MR  MC1 
 MR  MC1  MC 2
MR  MC 2 

S.O.C
 2TR  2TC

Q 2 Q 2
and

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 2TR  2TC

Q 2 Q 2

Q  200  2 p

P  100  0.5Q

C1  10Q1
C 2  0.25Q22

  TR  TC1  TC 2

TR  PQ
 100Q  O.5Q 2

MR  100  (Q1  Q2 )
MC1  10
MC 2  0.5Q2

MR  MC1
100  Q1  Q2  10
100  Q1  Q2  0.5Q2

Q1  Q2  90
 0.5Q2  10
Q2  20

 Q1  70
Q  20  70
 90
P  100  0.5(90)
5

Obtain profit.
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PRICE DISCRIMINATING MONOPOLIST
Exist when the same product is sold at different prices to different buyers.
The conditions necessary which must be fulfilled for the implementation of price
discrimination are:
(i) The market must be divided into sub market
(ii) Different submarkets must have different prices elasticities.
(iii) There must be effective separation of sub markets, so that no reselling
can take place from a low price market to a high price market.. This
condition explains why price discrimination is easier to apply with
commodities like electricity or gas or services e.g. Doctor which are
consumed by the buyer and cannot be resold.
The reason for a monopolist to apply price discrimination is to obtain an increase in his
total revenue and his profit. By selling the quantity defined by the equation of his
marginal cost and marginal revenue at different prices the monopolist realize higher total
revenue and hence higher profits as compared with the revenue he would receive by
charging a uniform price. Taking a simple case of a monopolist who sells his product at
two different prices In, the first market profit is maximized when, MR1 =MC. In the
second market profit is maximized when MR2 =MC. Clearly the total profit is
maximized when the monopolist equates the common MC to individual revenues.
MC  MR1  MR2
If MR is one market were larger, the monopolist would sell more in that market and less
in the other, until the above condition is restored.

Illustration:
Assume that the total demand is X = 50-5P and the total demand functions for the
segmented markets are X1 =32-0.4P1,X2= 18-0.1p2. Required: to find Xs, prices and
profits.

MR Vs price elasticity

TR =PQ

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 TR PQ QP
MR   
Q Q Q
P
MR  P  Q
Q
But
Q P
p  .
P Q
1 P Q
 .
p Q P
P 1 P
 .
Q  p Q

5. The Impact of Taxes on a Monopolist

For simplicity let us consider a firm with constant MC. When a quantity tax is imposed
the Mc will go up by the amount of the tax. What happens to the price?
We consider a linear demand curve

P = a by

Where p is price

Y is output

TR  PY  (a  bY )
 aY  by 2
MR  a  2bY

After a quantity tax t, the MC shifts up to the MC + t

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 After tax

p before tax MC + t
MC =C AR =P

0 Q Q Quantity

MR

The equilibrium moves to the left after the tax. Since the demand curve is half as steep as
the MR curve, the price goes up by half the amount of the tax.
Equilibrium before tax

MR = MC

But after the tax the MC increases by the text sush that:

MR=MC + t

But MC=C

a – 2by = c +t
a- c –t= 2by
2by = a-c-t

y = a-c-t

2b

∆y = -1

∆t = 2b

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 Recall that equal price is

P= a – by

∆p = - b

∆y

∆p = ∆p ∆y

∆t ∆y ∆t chain rule

= -b – 1 b = 1

2 2

Hence the price changes by less than tax. Specifically for the linear dd, the price rise by

½ the tax.

Generally: A tax may increase the price by more or less than the amount of tax. Since the
monopolistic will always operate where the demand is elastic then he passes on more
than the amount of the tax.
Inefficiency of Monopoly

Recall, in a competitive market, P=MC

In a monopoly, P>MC
The price will be higher and the output lower, if a firm behaves monopolistically rather
than competitively. For this reason, customers will typically be worse off in an industry
organized monopolistically.

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 However, the firm will be better off by the same taken into considerations monopoly
situation below.

MC

MC

P AR=P
P

Y Y MR out put

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 Alternatively, if the firm recognized its influence on the market price and chose its level
of output so as to maximize profit, we would see the monopoly price and output P m Y m.
Recall that an economic arrangement is Pareto efficient if there is no way to make anyone
better off without somebody worse off.
Therefore is the monopoly level of output Pareto efficient?

Recall the invest dd curve p(y) measures how much people are waiting to pay for an
additional unit of the good. Since (y) is greater than MC(Y) for all the output levels
between Ym and Yc, there is a whole range of output where people are willing to pay
more for a unit of output than it costs to produce it. Clearly there is a potential for pareto
improvement her. Hence a monopoly would be inefficient.

But just how inefficient is he? Can we measure the total loss in efficiency due to
monopoly?

The consumers surplus in the monopoly structure is P m e m A which would go up by

area A +B if the monopolist behaves competitively.
On the other hand, the area a would just be a transfer from the monopolist to the
consumer.
Under competition, the producer surplus would include area C. however due to the
monopoly charging the price Pm, he denies the customer surplus (A+B). out of this
surplus, only A benefits the producer while B is lost. Area C is also lost since the
producer sells Y m instead of Y c.
The area B+C is known as the dead weight loss due to the monopoly. If provides a
measure of how much worse off people are paying the monopoly price than paying the
competitive price.
It measures the value of the lost output by valuing each unit of the lost output at the price
that people are willing to pay for that unit.

6.3 Monopolistic Competition

The characteristic that firms compete in the same market produce a homogenous product
does not fit the real world. Furthermore, the model of perfect competition cannot explain
advertising and other marketing strategies practiced widely by businesses. In reality, there
is a wide range of products offered in the same market, yet they are often close
substitutes of each other. The model of monopolistic competition was advanced in the
1930s to explain these anomalies.
Characteristics of Monopolistic Competition
The two major characteristics that define a monopolistically competitive market are:

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  There are large numbers of infinitely small sellers and buyers.
 All the firms produce slightly differentiated (heterogenous)
products, yet they are close substitutes to each other. The aim
of product differentiation is to make the product unique in
the minds of the consumers. Yet the product differentiation
must leave the product closely related if they are to be
included in the same product group.

Demand Curves in Monopolistic Competition

The major effect of product differentiation is on the demand curve of a monopolistically
competitive firm. Product differentiation makes the product of a firm unique in the minds
of its consumers to create customer loyalty. It is this uniqueness and customer loyalty that
give rise to market power and negatively sloping demand curve. However, a monopolistic
competitive firm still faces keen competition because of close substitutes offered by other
firms. This means the positions of all demand curves are somewhat dependent on the
interactions between the firms. There are in fact two demand curves for each firm, one
perceived and one actual, as illustrated in Figure 5.3.

p*

q
Q*

Figure 6.3: Demand curves of a monopolistically competitive firm

The perceived demand curve d is the demand curve that a monopolistically competitive
firm anticipated. This perceived demand curve is highly price elastic because of the fact
that there are a large number of firms in the market and the assumption that rival firms
will not react to changes in this particular firm’s price. In fact, rival firms do react to
changes in this particular firm’s price. The actual demand curve D faced by this firm
when the actions of all the firms in the same product group are the same. The actual
Page 111 of 116
demand curve is also known as the “share-of-the-market” demand curve.

Short-Run Equilibrium

There is virtually no difference between the short-run analysis of monopoly and

monopolistic competition. Short-run profit maximization occurs at the intersection of the
MR and MC curves, as shown in Figure .4. The only difference between the two market
structures is that you expect the demand curve under monopolistic competition to be
much flatter.

MC AC
A

p* B
AC* d
E

Q*
MR
q

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Figure5. 4: Short-run equilibrium of monopolistic competition

Long-Run Equilibrium
The long-run equilibrium of monopolistic competition, like perfect competition, is
achieved by both price adjustments and new entry. In Figure 5.5, the initial equilibrium is
at point A with extra-normal profit. This attracts new entry to the market and the actual
demand curve D shift from D 1 to D 2 with point B being the intermediate
equilibrium point. With normal profit, some firms may attempt to increase their
competitiveness by lowering their prices, thus depressing the profitability of all firms.
Some financially weaker firms will leave the market and the actual demand curve D
shift to the right and eventually settle at position D 3 . The final equilibrium is point E
where the perceived demand curve d 3 tangents the long-run average cost curve
LAC and normal profit prevails.

p
LMC
A
B LAC

d1
E
p*
d2 D1
D3
D2 d3 Q
MR

Figure 6.5: Long-run equilibrium of monopolistic competition

It is again important to point out that monopolistic competition does not produce at the
minimum of the LAC, which means monopolistic competition produces less and charges
a higher price than perfect competition.

Page 113 of 116

Page 114 of 116
5.4 Oligopoly

Oligopoly is the study of market interactions with a small number of firms. Such an
industry usually does not exhibit the characteristics of perfect competition, since
individual firms' actions can in fact influence market price and the actions of other firms. The
modern study of this subject is grounded almost entirely in the theory of games discussed
in the last chapter. Many of the specifications of strategic market interactions have been
clarified by the concepts of game theory. We now investigate oligopoly theory primarily from
this perspective by introducing four models.

Definition 1 (Oligopoly).
Oligopoly is a market where a small number of firms act independently but are aware of
each other’s actions.
5.4.1. Typical assumptions for oligopolistic markets.
 Consumers are price takers.
 All firms produce homogeneous products.
 There is no entry into the industry.
 Firms collectively have market power: they can set price above marginal cost.
 Each firm sets only its price or output (not other variables such as advertising).

5.4.2 Summary of results on oligopolistic markets.

 The equilibrium price lies between that of monopoly and perfect competition.
 Firms maximize profits based on their beliefs about actions of other firms.
 The firm’s expected profits are maximized when expected marginal revenue
equals marginal cost.
 Marginal revenue for a firm depends on its residual demand curve
(market demand minus the output supplied by other firms)

5.4.4 Behavior of firms in oligopolistic games.

 Firms are rational.
 Firms reason strategically.

5.4.5. Elements of typical oligopolistic games.

 There are two or more firms (not a monopoly).

 The number of firms is small enough that the output of an individual firm has a
measurable impact on price (not perfect competition). We say each firm has a few,
but only a few, rivals.
 Each firm attempts to maximize its expected profit (payoff).
1|Page

 Each firm is aware that other firm’s actions can affect its profit.
 Equilibrium payoffs are determined by the number of firms, the rules of the games
and the length of the game.

5.4.6. Comparison of oligopoly with competition. In competition each firm does not take
into account the actions of other firms. In effect they are playing a game against an
impersonal market mechanism that gives them a price that is independent of their own
actions. In oligopoly, each firm explicitly takes account of other firm’s expected actions in
making decisions.

Intermediate Microeconomics Kotut Mogo