Course Module

Department of Business Administration

MARIAN COLLEGE
Ipil, Zamboanga Sibugay
First semester, AY. 2021 – 2022

Marcy Mei Cuartocruz

Course Instructor

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 Chapter 1
INTRODUCTION TO MICROECONOMICS

Learning Outcomes:
1. Define economics, its major branches, scope and limitations.
2. Discuss the concepts of trade-off, prices and market.
3. Relates the importance of microeconomics in real life situations.

Economicss is the study of the allocation of scarce resources to meet unlimited human wants. Main
branches of economics: macroeconomics and microeconomics.
a. Macroeconomics deals with aggregate economic quantities, such as the level and growth rate of
national output, interest rates, unemployment, and inflation. It involves the analysis of markets—for
example, the aggregate markets for goods and services, labor, and corporate bonds. To understand
how these aggregate markets operate, we must first understand the behavior of the firms, consumers,
workers, and investors who constitute them.
b. microeconomics deals with the behavior of individual economic units. These units include
consumers, workers, investors, owners of land, business firms—in fact, any individual or entity that
plays a role in the functioning of our economy.
 Explains how and why these units make economic decisions. For example, it explains how
consumers make purchasing decisions and how their choices are affected by changing prices and
incomes.
 It also explains how firms decide how many workers to hire and how workers decide where to
work and how much work to do.
 Another important concern of microeconomics is how economic units interact to form larger
units—markets and industries. It helps us to understand, for example, why the American
automobile industry developed the way it did and how producers and consumers interact in the
market for automobiles. It explains how automobile prices are determined, how much
automobile companies invest in new factories, and how many cars are produced each year.
 By studying the behavior and interaction of individual firms and consumers, microeconomics
reveals how industries and markets operate and evolve, why they differ from one another, and
how they are affected by government policies and global economic conditions.

The Rolling Stones once said: “You can’t always get what you want.” This is true for almost all people:
that there are limits to what you can have or do is a simple fact of life learned in early childhood. For
economists, however, it can be an obsession. Much of microeconomics is about limits—the limited
incomes that consumers can spend on goods and services, the limited budgets and technical know-how
that firms can use to produce things, and the limited number of hours in a week that workers can allocate
to labor or leisure. But microeconomics is also about ways to make the most of these limits. More
precisely, it is about the allocation of scarce resources. For example, microeconomics explains how
consumers can best allocate their limited incomes to the various goods and services available for
purchase. It explains how workers can best allocate their time to labor instead of leisure, or to one job
instead of another. And it explains how firms can best allocate limited financial resources to hiring
additional workers versus buying new machinery, and to producing one set of products versus another.

The Concept of Trade-Offs

Microeconomics describes the trade-offs that consumers, workers, and firms face, and shows how these
trade-offs are best made.
 Consumers have limited incomes, which can be spent on a wide variety of goods and services, or
saved for the future. Consumer theory, describes how consumers, based on their preferences,
maximize their well-being by trading off the purchase of more of some goods for the purchase of
less of others.
 Workers also face constraints and make trade-offs. First, people must decide whether and when to
enter the workforce. Because the kinds of jobs—and corresponding pay scales—available to a
worker depend in part on educational attainment and accumulated skills, one must trade off working
now (and earning an immediate income) for continued education (and the hope of earning a higher
future income). Second, workers face trade-offs in their choice of employment. For example, while
some people choose to work for large corporations that offer job security but limited potential for
advancement, others prefer to work for small companies where there is more opportunity for
advancement but less security. Finally, workers must sometimes decide how many hours per week
they wish to work, thereby trading off labor for leisure.
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 Firms also face limits in terms of the kinds of products that they can produce, and the resources
available to produce them. General Motors, for example, is very good at producing cars and trucks,
but it does not have the ability to produce airplanes, computers, or pharmaceuticals. It is also
constrained in terms of financial resources and the current production capacity of its factories. Given
these constraints, GM must decide how many of each type of vehicle to produce. If it wants to
produce a larger total number of cars and trucks next year or the year after, it must decide whether to
hire more workers, build new factories, or do both. The theory of the firm describes how these trade-
offs can best be made.

Prices and Markets

All of the trade-offs described above are based on the prices faced by consumers, workers, or firms. For
example, a consumer trades off beef for chicken based partly on his or her preferences for each one, but
also on their prices. Likewise, workers trade off labor for leisure based in part on the “price” that they
can get for their labor (wage). And firms decide whether to hire more workers or purchase more
machines based in part on wage rates and machine prices. Microeconomics also describes how prices are
determined. In a centrally planned economy, prices are set by the government. In a market economy,
prices are determined by the interactions of consumers, workers, and firms. These interactions occur in
market.

Markets - collections of buyers and sellers that together determine the price of a good. Together, buyers
and sellers interact to form markets.
- Markets are at the center of economic activity, and many of the most interesting issues in
economics concern the functioning of markets. For example, why do only a few firms compete
with one another in some markets, while in others a great many firms compete?
- the collection of buyers and sellers that, through their actual or potential interactions, determine
the price of a product or set of products.
- Buyers include consumers, who purchase goods and services, and firms, which buy labor,
capital, and raw materials that they use to produce goods and services.
- Sellers include firms, which sell their goods and services; workers, who sell their labor services;
and resource owners, who rent land or sell mineral resources to firms.
- Economists are often concerned with market definition - Determination of the buyers, sellers,
and range of products that should be included in a particular market.

a. perfectly competitive market has many buyers and sellers, so that no single buyer or seller has
any impact on price. Most agricultural markets are close to being perfectly competitive. For
example, thousands of farmers produce wheat, which thousands of buyers purchase to produce
flour and other products. As a result, no single farmer and no single buyer can significantly affect
the price of wheat.
b. Noncompetitive market; that is, individual firms can jointly affect the price. The world oil
market is one example. Since the early 1970s, that market has been dominated by the OPEC
cartel. (A cartel is a group of producers that acts collectively.)

Arbitrage - practice of buying at a low price at one location and selling at a higher price in another.

market price – refers to the price prevailing in a competitive market.

Market-clearing price – a price that equates quantity supplied and the quantity demanded. That is,
market-clearing price is the equilibrium price.
a. nominal price of a good (sometimes called its “current-dollar” price) is its absolute price. For
example, the nominal price of a pound of butter was about $0.87 in 1970, $1.88 in 1980, about
$1.99 in 1990, and about $3.42 in 2010. These are the prices you would have seen in
supermarkets in those years.
b. real price of a good (sometimes called its “constant-dollar” price) is the price relative to an
aggregate measure of prices. In other words, it is the price adjusted for inflation.

Theories and Models

Microeconomics relies heavily on the use of theory, which can (by simplification) help to explain how
economic units behave and to predict what behavior will occur in the future. Models are mathematical
representations of theories that can help in this explanation and prediction process.

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Positive versus Normative Analysis
Microeconomics is concerned with positive questions that have to do with the explanation and
prediction of phenomena.
a. Positive questions deal with explanation and prediction.
b. Normative questions with what ought to be. But microeconomics is also important for normative
analysis, in which we ask what choices are best—for a firm or for society as a whole. Normative
analyses must often be combined with individual value judgments because issues of equity and
fairness as well as of economic efficiency may be involved.

Learning Assessment – Chapter 1

Introduction to Microeconomics

Questions:
1. What is economics?
2. Differentiate microeconomics and macroeconomics.
3. Discuss the significance of studying microeconomics.
4. Does microeconomics concerns only the economist? Why or why not?

Identification
1.

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 Chapter 2
THE BASICS OF SUPPLY AND DEMAND

Learning Outcomes:
1. Know the basics of supply and demand relationship.
2. Discuss the concept of elasticities, its formulas and graphical presentation.
3. Solve exercises relating to supply and demand functions, elasticities and graphical
illustration.
4. Explain substitutes and complementary goods and provides example.

The basic model of supply and demand is the workhorse of microeconomics. It helps us understand why
and how prices change, and what happens when the government intervenes in a market. The supply-
demand model combines two important concepts: a supply curve and a demand curve.

SUPPLY AND DEMAND CURVE

Supply curve
- Relationship between the quantity of a good that
producers are willing to sell and the price of the
good. We can write this in equation: QS = Qs(P)
- curve slopes upward: The higher the price, the
more that firms are able and willing to produce and
sell.
- If production costs fall, firms can produce the same
quantity at a lower price or a larger quantity at the
same price. The supply curve then shifts to the right
(from S to S’).
- For example, a higher price may enable current
firms to expand production by hiring extra workers
or by having existing workers work overtime (at
greater cost to the firm). Likewise, they may expand
production over a longer period of time by increasing the size of their plants.

Demand curve
- shows how much of a good, consumers are willing to
buy as the price per unit changes. We can write this
relationship between quantity demanded and price as an
equation: QD = Qd(P)
- slopes downward: Consumers are usually ready to buy
more if the price is lower. (Figure in the right)
- For example, a lower price may encourage consumers
who have already been buying the good to consume
larger quantities. Likewise, it may allow other consumers
who were previously unable to afford the good to begin
buying it.

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- The quantity demanded may also depend on other variables, such as income, the weather, and the
prices of other goods. For most products, the quantity demanded increases when income rises. A
higher income level shifts the demand curve to the right (from D to D’).

Changes in the prices of related goods also affect demand.

Substitutes
- Two goods for which an increase in the price of one leads to an increase in the quantity demanded of
the other. For example, copper and aluminum are substitute goods. Because one can often be
substituted for the other in industrial use, the quantity of copper demanded will increase if the price
of aluminum increases. Likewise, beef and chicken are substitute goods because most consumers are
willing to shift their purchases from one to the other when prices change.
Complements
- When an increase in the price of one good leads to a decrease in the quantity demanded of the other.
For example, automobiles and gasoline are complementary goods. Because they tend to be used
together, a decrease in the price of gasoline increases the quantity demanded for automobiles.
Let us now put the supply curve and the demand curve together:

(Figure in the right) shows the demand and supply curve together, intersecting at point (Q 0,P0) which is
called as the equilibrium. Here, quantity supplied = quantity demanded.

 The market clears at price P0 and quantity Q0. At the higher price P1, a surplus develops, so price
falls. At the lower price P2, there is a shortage, so price is bid up.
 Surplus is a situation in which the
quantity supplied exceeds the quantity
demanded. To sell this surplus, or at
least to prevent it from growing,
producers would begin to lower
prices. Eventually, as price fell,
quantity demanded would increase,
and quantity supplied would decrease
until the equilibrium price P0 was
reached.
 Shortage is a situation in which the
quantity demanded exceeds the
quantity supplied. Consumers would
be unable to purchase all they would
like. This would put upward pressure
on price as consumers tried to outbid one another for existing supplies and producers reacted by
increasing price and expanding output. Again, the price would eventually reach P0.
 Equilibrium (or market clearing) price: Price that equates the quantity supplied to the quantity
demanded.

See figure for example, shifts to the right of both supply

and demand result in a slightly higher price (from P1 to
P2 ) and a much larger quantity (from Q1 to Q2 ). In
general, price and quantity will change depending both on
how much the supply and demand curves shift and on the
shapes of those curves. To predict the sizes and directions
of such changes, we must be able to characterize
quantitatively the dependence of supply and demand on
price and other variables.

New equilibrium following shift in demand (Right)

When the demand curve shifts to the right, the market
clears at a higher price P3 and a larger quantity Q3.

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 New equilibrium following shifts in supply and
demand (Left)
Supply and demand curves shift over time as market
conditions change. In this example, rightward shifts of
the supply and demand curves lead to a slightly higher
price and a much larger quantity. In general, changes
in price and quantity depend on the amount by which
each curve shifts and the shape of each curve.

ELASTICITIES OF SUPPLY AND DEMAND

Elasticity - measures the sensitivity of one variable to another.

- a number that tells us the percentage change that will occur in one variable in response to a 1-
percent increase in another variable. For example, the price elasticity of demand measures the
sensitivity of quantity demanded to price changes.
- It tells us what the percentage change in the quantity demanded for a good will be following a 1-
percent increase in the price of that good.
- We use the symbol ∆, a Greek capital letter delta which means “change”.
- We refer to the magnitude of elasticity as its absolute price. For example, E = 2, we say that that
the elasticity is 2 in magnitude.
- Elasticities can be
a. Inelastic, if elasticity is less than 1 in magnitude.
b. Elastic, if elasticity is more than 1.
c. Unitary, if elasticity equals 1.
d. Perfectly inelastic, if elasticity equals 0.

Demand Elasticity

Price elasticity of demand - percentage change in quantity demanded of a good resulting from a 1-
percent increase in its price.
- Can be written as Ep, that is Ep = (%∆Q) / (% ∆P), where
%∆Q means “percentage change in quantity demanded” and
%∆P means “percentage change in price.”
- Thus, we can also write the price elasticity of demand as follows:

- The price elasticity of demand is usually a negative number. When the price of a good increases,
the quantity demanded usually falls. Thus %∆Q / %∆P (the change in quantity for a change in
price) is negative.
- In general, the price elasticity of demand for a good depends on the availability of other goods
that can be substituted for it. When there are close substitutes, a price increase will cause the
consumer to buy less of the good and more of the substitute. Demand will then be highly price
elastic. When there are no close substitutes, demand will tend to be price inelastic.

Income elasticity of demand – refers to the percentage change in the quantity demanded, (Q), resulting
from a 1-percent increase in income (I).
- We can write the income elasticity of demand as

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 .

Cross-price elasticity of demand - refers to the percentage change in the quantity demanded for a good
that results from a 1-percent increase in the price of another good.
- The demand for some goods is also affected by the prices of other goods. For example, because
butter and margarine can easily be substituted for each other, the demand for each depends on
the price of the other.
- We can write the cross-price elasticity of demand as (supposing we want to know the elasticity
of demand for butter with respect to the price of margarine)

Where, Qb is the quantity of butter and Pm is the price of margarine.

- CPE will be positive if goods are substitutes. With this example, because they compete in the
market, a rise in the price of margarine, which makes butter cheaper relative to margarine, leads
to an increase in the quantity of butter demanded. (Because the demand curve for butter will shift
to the right, the price of butter will rise.) But this is not always the case because some goods are
complements.
- CPE will be negative if goods are complements. Because they tend to be used together, an
increase in the price of one tends to push down the consumption of the other. Take gasoline and
motor oil. If the price of gasoline goes up, the quantity of gasoline demanded falls—motorists
will drive less. And because people are driving less, the demand for motor oil also falls. (The
entire demand curve for motor oil shifts to the left.) Thus, the cross-price elasticity of motor oil
with respect to gasoline is negative.

Elasticities of Supply
Elasticities of supply are defined in a similar manner.
a. Price elasticity of supply is the percentage change in the quantity supplied resulting from a 1-
percent increase in price. This elasticity is usually positive because a higher price gives producers an
incentive to increase output.
b. Income elasticity of supply refers to the percentage change in the quantity supplied, resulting from
a 1-percent increase in income (I).
c. Cross-price elasticity of supply refers to the percentage change in the quantity supplied for a good
that results from a 1-percent increase in the price of another good.

See the example below and carefully understand the solution.

THE MARKET FOR WHEAT

Wheat is an important agricultural

commodity, and the wheat market has been
studied extensively by agricultural
economists. During recent decades, changes
in the wheat market had major implications
for both American farmers and U.S.
agricultural policy. To understand what
happened, let’s examine the behavior of
supply and demand beginning in 1981.

From statistical studies, we know that for

1981 the supply curve for wheat was
approximately as follows:

Supply: QS = 1800 + 240P

where price is measured in nominal dollars per bushel and quantities in millions of bushels per year.
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These studies also indicate that in 1981, the demand curve for wheat was

Demand: QD = 3550 - 266P

By setting the quantity supplied equal to the quantity demanded (that is in an equilibrium), we can
determine the market-clearing price of wheat for 1981:

QS = QD
1800 + 240P = 3550 - 266P
506P = 1750
P = $3.46per bushel

To find the market-clearing quantity, substitute this price of $3.46 into either the supply curve
equation or the demand curve equation. Substituting into the supply curve equation, we get

Q = 1800 + (240) (3.46) = 2630million bushels

What are the price elasticities of demand and supply at this price and quantity? We use the demand
curve to find the price elasticity of demand:

EPD = (P/Q) (∆QD/∆P) = (3.46/2630 (-266) = -0.35

Thus, demand is inelastic. We can likewise calculate the price elasticity of supply:

EPS = (P/Q) (∆QS/∆P)

= 3.46 2630 (240) = 0.32

Because these supply and demand curves are linear, the price elasticities will vary as we move along
the curves. For example, suppose that a drought caused the supply curve to shift far enough to the left
to push the price up to $4.00 per bushel. In this case, the quantity demanded would fall to 3550 - (266)
(4.00) = 2486 million bushels. At this price and quantity, the elasticity of demand would be

EPD = (4.00/2486) (-266) = - 0.43

Questions:
1. Suppose that unusually hot weather causes the demand curve for ice cream to shift to the right.
Why will the price of ice cream rise to a new market-clearing level?
2. Use supply and demand curves to illustrate how each of the following events would affect the
price of hamburger and the quantity of hamburger bought and sold: (a) an increase in the price
of hamburger; (b) an increase in the price of ham; (c) a decrease in average income levels.
3. Explain the difference between a shift in the supply curve and a movement along the supply
curve.
4. Given the two goods, chicken meat and beef meat. (a) What can you say about the two goods?
(b) what will likely happen if the price of chicken meat doubles?

Problems:
1. Suppose the demand curve for a product is given by Q = 300 - 2P + 4I, where I is the average
income measured in thousands of pesos. The supply curve is Q = 3P - 50.
a. If I = 25, find the market-clearing price and quantity for the product.
b. If I = 50, find the market-clearing price and quantity for the product.
c. Draw a graph to illustrate your answers.
2. The rent control agency of New York City has found that aggregate demand is QD = 160 - 8P.
Quantity is measured in tens of thousands of apartments. Price, the average monthly rental
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 rate, is measured in hundreds of dollars. The agency also noted that the increase in Q at lower
P results from more three-person families coming into the city from Long Island and
demanding apartments. The city’s board of realtors acknowledges that this is a good demand
estimate and has shown that supply is QS = 70 + 7P.
a. If both the agency and the board are right about demand and supply, what is the free-
market price? What is the change in city population if the agency sets a maximum average
monthly rent of $300 and all those who cannot find an apartment leave the city?
b. Suppose the agency bows to the wishes of the board and sets a rental of $900 per month on
all apartments to allow landlords a “fair” rate of return. If 50 percent of any long-run
increases in apartment offerings comes from new construction, how many apartments are
constructed?

Chapter 3
CONSUMER’S THEORY

Learning Outcomes:
1. Understand how consumer with a limited income decide which goods and services to buy.
2. Define consumers purchasing power parity and identify factors affecting PPP.
3. Define the concept of utility and satisfaction.
4. Explain how utility changes when income or prices change.
5. Differentiate between marginal utility and total utility.

One fundamental issue in microeconomics is how consumers with limited income decide which goods
and services to buy and how much of it can bought. Understanding consumer purchasing decisions will
help us to understand how changes in income and prices affect the demand for goods and services and
why the demand for some products is more sensitive than others to changes in prices and income.

Consumer behavior is best understood in three distinct steps which are the basics of consumer theory.
1. Consumer Preferences: The first step is to find a practical way to describe the reasons people might
prefer one good to another. We will see how a consumer’s preferences for various goods can be
described graphically and algebraically.
2. Budget Constraints: Of course, consumers also consider prices. In Step 2, therefore, we take into
account the fact that consumers have limited incomes which restrict the quantities of goods they can
buy. What does a consumer do in this situation? We find the answer to this question by putting
consumer preferences and budget constraints together in the third step.
3. Consumer Choices: Given their preferences and limited incomes, consumers choose to buy
combinations of goods that maximize their satisfaction. These combinations will depend on the
prices of various goods. Thus, understanding consumer choice will help us understand demand—i.e.,
how the quantity of a good that consumers choose to purchase depends on its price.

Theory of consumer behavior – is a description of how consumers allocate incomes among different
goods and services to maximize their well-being.

CONSUMER PREFERENCES

market basket - refer to such a group of items.

- A list with specific quantities of one or more goods.
- A market basket might contain the various food items in a grocery cart.
- It might also refer to the quantities of food, clothing, and housing that a consumer buys each
month.
- Many economists also use the word bundle to mean the same thing as market basket.

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To better understand the concept of market basket, please refer to the figure below for example.

The table shows several market baskets consisting of various amounts of food and clothing purchased on
a monthly basis. The number of food items can be measured in any number of ways: by total number of
containers, by number of packages of each item (e.g., milk, meat, etc.), or by number of pounds or
grams. Likewise, clothing can be counted as total number of pieces, as number of pieces of each type of
clothing, or as total weight or volume. Because the method of measurement is largely arbitrary, we will
simply describe the items in a market basket in terms of the total number of units of each commodity.
Market basket A, for example, consists of 20 units of food and 30 units of clothing, basket B consists of
10 units of food and 50 units of clothing, and so on.

Basic Assumptions about Preferences

1. Completeness
- Preferences are assumed to be complete. In other words, consumers can compare and rank all
possible baskets. Thus, for any two market baskets A and B, a consumer will prefer A to B, will
prefer B to A, or will be indifferent between the two. By indifferent we mean that a person will
be equally satisfied with either basket. Note that these preferences ignore costs. A consumer
might prefer steak to hamburger but buy hamburger because it is cheaper.
2. Transitivity
- Preferences are transitive. Transitivity means that if a consumer prefers basket A to basket B
and basket B to basket C, then the consumer also prefers A to C. For example, if a Porsche is
preferred to a Cadillac and a Cadillac to a Chevrolet, then a Porsche is also preferred to a
Chevrolet. Transitivity is normally regarded as necessary for consumer consistency.
3. More is better than less
- Goods are assumed to be desirable—i.e., to be good. Consequently, consumers always prefer
more of any good to less. In addition, consumers are never satisfied or satiated; more is always
better, even if just a little better. Of course, some goods, such as air pollution, may be
undesirable, and consumers will always prefer less. We ignore these “bad or uthe undesirable
goods” in the context of our immediate discussion of consumer choice because most consumers
would not choose to purchase them.

Indifference Curves
We can show a consumer’s preferences graphically with the use of indifference curves.
- An indifference curve represents all combinations of market baskets that provide a consumer with
the same level of satisfaction. That person is therefore indifferent among the market baskets
represented by the points graphed on the curve.
- In order to graph a consumer’s indifference curve, it helps first to graph his or her individual
preferences.

Using the previous table of market basket (Figure 3.1), let us graph it below.

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Describing Individual Preferences
- Because more of each good is
preferred to less, we can compare
market baskets in the shaded areas.
Basket A is clearly preferred to basket
G, while E is clearly preferred to A.
However, A cannot be compared with
B, D, or H without additional
information.
- The horizontal axis measures the
number of units of food purchased
each week; the vertical axis measures
the number of units of clothing.
Market basket A, with 20 units of
food and 30 units of clothing, is preferred to basket G because A contains more food and more
clothing (recall our third assumption that more is better than less). Similarly, market basket E, which
contains even more food and even more clothing, is preferred to A. In fact, we can easily compare
all market baskets in the two shaded areas (such as E and G) to A because they contain either more
or less of both food and clothing. Note, however, that B contains more clothing but less food than A.
Similarly, D contains more food but less clothing than A. Therefore, comparisons of market basket
A with baskets B, D, and H are not possible without more information about the consumer’s ranking.

An Indifference Curve
- The indifference curve U1
that passes through market
basket A shows all baskets
that give the consumer the
same level of satisfaction as
does market basket A; these
include baskets B and D.
Our consumer prefers
basket E, which lies above
U1, to A, but prefers A to H
or G, which lie below U1.
- Figure on the right shows an
indifference curve, labeled
U1, that passes through
points A, B, and D. This
curve indicates that the
consumer is indifferent
among these three market
baskets. It tells us that in moving from market basket A to market basket B, the consumer feels
neither better nor worse off in giving up 10 units of food to obtain 20 additional units of clothing.
Likewise, the consumer is indifferent between points A and D: He or she will give up 10 units of
clothing to obtain 20 more units of food. On the other hand, the consumer prefers A to H, which lies
below U1.

Note that the indifference curve above slopes downward from left to right. To understand why this must
be the case, suppose instead that it sloped upward from A to E. This would violate the assumption that
more of any commodity is preferred to less. Because market basket E has more of both food and
clothing than market basket A, it must be preferred to A and therefore cannot be on the same
indifference curve as A. In fact, any market basket lying above and to the right of indifference curve U1
is preferred to any market basket on U1.

Indifference map - graph containing a set of indifference curves showing the market baskets among
which a consumer is indifferent.
- To describe a person’s preferences for all combinations of food and clothing, we can graph map it
using a set of indifference curves.

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- Figure below shows three indifference curves that form part of an indifference map (the entire map
includes an infinite number of such curves). Indifference curve U 3 generates the highest level of
satisfaction, followed by indifference curves U2 and U1.

An Indifference Map
- An indifference map is a set of
indifference curves that describes a
person’s preferences. Any market
basket on indifference curve U3, such
as basket A, is preferred to any basket
on curve U2 (e.g., basket B), which in
turn is preferred to any basket on U1,
such as D.

Can indifference curves intersect?

Let us assume the it that way and see how the resulting graph violates our assumptions about consumer
behavior. Figure below shows two indifference curves, U1 and U2, that intersect at A. Because A and B
are both on indifference curve U1, the consumer must be indifferent between these two market baskets.
Because both A and D lie on indifference curve U 2, the consumer is also indifferent between these
market baskets. Consequently, using the assumption of transitivity, the consumer is also indifferent
between B and D. But this conclusion can’t be true: Market basket B must be preferred to D because it
contains more of both food and clothing. Thus, intersecting indifference curves contradicts our
assumption that more is preferred to less.

Indifference Curves Cannot

Intersect
- If indifference curves U1 and
U2 intersect, one of the
assumptions of consumer
theory is violated. According
to this diagram, the consumer
should be indifferent among
market baskets A, B, and D.
Yet B should be preferred to
D because B has more of
both goods.

Marginal Rate of Substitution (MRS)

Remember that people face trade-offs. The shape of an indifference curve describes how a consumer is
willing to trade one good for another. Look, for example, at the indifference curve in Figure 3.5. Starting
at market basket A and moving to basket B, we see that the consumer is willing to give up 6 units of
clothing to obtain 1 extra unit of food. However, in moving from B to D, he is willing to give up only 4
units of clothing to obtain an additional unit of food; in moving from D to E, he will give up only 2 units
of clothing for 1 unit of food. The more clothing and the less food a person consumes, the more clothing
he will give up in order to obtain more food. Similarly, the more food that a person possesses, the less
clothing he will give up for more food. To quantify the amount of one good that a consumer will give up
to obtain more of another, we use a measure called the marginal rate of substitution (MRS).

12
Still with the same example,
the MRS of food F for clothing
C is the maximum amount of
clothing that a person is
willing to give up to obtain one
additional unit of food.
Suppose, for example, the
MRS is 3. This means that the
consumer will give up 3 units
of clothing to obtain 1
additional unit of food. If the
MRS is 1/2, the consumer is
willing to give up only 1/2 unit
of clothing. Thus, the MRS
measures the value that the
individual places on 1 extra
unit of a good in terms of
another.

When we describe the MRS, we must be clear about which good we are giving up and which we are
getting more of. To be consistent throughout the book, we will define the MRS in terms of the amount
of the good on the vertical axis that the consumer is willing to give up in order to obtain 1 extra unit of
the good on the horizontal axis. Thus, in Figure 3.5 the MRS refers to the amount of clothing that the
consumer is willing to give up to obtain an additional unit of food. If we denote the change in clothing
by ∆C and the change in food by ∆F, the MRS can be written as -∆C/∆F. We add the negative sign to
make the marginal rate of substitution a positive number. (Remember that C is always negative; the
consumer gives up clothing to obtain additional food.
Indifference Curves of Perfect Substitutes and Perfect Complements

Figure in the left (a)

Shows Bob’s preferences for apple juice and orange juice. These two goods are perfect substitutes for
Bob because he is entirely indifferent between having a glass of one or the other. In this case, the MRS
of apple juice for orange juice is 1: Bob is always willing to trade 1 glass of one for 1 glass of the other.
 Two goods are perfect substitutes when the marginal rate of substitution of one for the other is
a constant.
 Indifference curves describing the trade-off between the consumption of the goods are straight
lines.
 The slope of the indifference curves need not be 1 in the case of perfect substitutes.
Suppose, for example, that Dan believes that one 16-megabyte memory chip is equivalent to
two 8-megabyte chips because both combinations have the same memory capacity. In that
case, the slope of Dan’s indifference curve will be 2 (with the number of 8-megabyte chips
on the vertical axis).
13
Figure in the right (b)
Illustrates Jane’s preferences for left shoes and right shoes. For Jane, the two goods are perfect
complements because a left shoe will not increase her satisfaction unless she can obtain the matching
right shoe. In this case, the MRS of left shoes for right shoes is zero whenever there are more right shoes
than left shoes; Jane will not give up any left shoes to get additional right shoes. Correspondingly, the
MRS is infinite whenever there are more left shoes than right because Jane will give up all but one of
her excess left shoes in order to obtain an additional right shoe. Two goods are perfect complements
when the indifference curves for both are shaped as right angles.
 Two goods are perfect complements when the MRS is zero or infinite.
 The indifference curves are shaped as right angles.

Utility - refers to the numerical score representing the satisfaction that a consumer gets from a market
basket.
 Example: If buying three copies of textbook makes you happier than buying one shirt, then we
say that the three books give you more utility than the shirt.

Utility function – is a formula that assigns a level of utility to each market basket. Higher level of utility
is always preferred.

Examples:
1. Suppose that Phil’s utility function for food (F) and clothing (C) is u(F,C) = F + 2C. In that case,
a market basket consisting of:
a. A market basket containing 8 units of food and 3 units of clothing generates a utility of [8 +
(2)(3)] = 14.
b. A market basket containing 6 units of food and 4 units of clothing generates a utility of [6 +
(2)(4)] = 14. On the other hand, either
c. A market basket containing 4 units of food and 4 units of clothing generates a utility of [4 +
(2)(4)] = 12.

Therefore, in this case, Phil is indifferent between this market basket (a) and (b). Either market
basket in (a) and (b) is preferred than market basket (c). The higher the utility a market basket
gives, the more preferred that market basket is.

2. Supposing our example is about food and clothing, the utility function u(F,C) = FC tells us that
the level of satisfaction obtained from consuming F units of food and C units of clothing is the
product of F and C.

The figure in the right, shows a utility function

can be represented by a set of indifference
curves, each with a numerical indicator. This
figure shows three indifference curves (with
utility levels of 25, 50, and 100, respectively)
associated with the utility function, u(F,C) = FC.

The graph was drawn by initially choosing one

particular market basket—say, F=5 and C=5 at
point A. This market basket generates a utility
level U1 of 25. Then the indifference curve was
drawn by finding all market baskets for which
FC = 25 (e.g., F=10, C=2.5 at point B; F=2.5,
C=10 at point D). The second indifference curve,
U2, contains all market baskets for which FC=50
and the third, U3, all market baskets for which
FC=100.

Types of utility function:

1. Ordinal utility function
- a utility function that generates a ranking of market baskets in order of most to least preferred.
Our previous figure under about indifference map shows an example of ordinal utility function.
14
2. Cardinal utility function
- a utility function describing by how much one market basket is preferred to another. Unlike
ordinal utility functions, a cardinal utility function attaches to market baskets numerical values
that cannot arbitrarily be doubled or tripled without altering the differences between the values of
various market baskets.

BUDGET CONSTRAINTS

So far, we have focused on the first element of consumer theory which is about consumer preferences.
We have seen how indifference curves (or, alternatively, utility functions) can be used to describe how
consumers value various baskets of goods. Now we turn to the second element of consumer theory: the
budget constraints that consumers face as a result of their limited incomes.

Budget Constraints
- constraints that consumers face as a result of limited incomes.
Budget Line
- all combinations of goods for which the total amount of money spent is equal to income.

To see how a budget constraint limits a consumer’s choices, let’s consider a situation in which a woman
has a fixed amount of income, I, that can be spent on food and clothing. Let F be the amount of food
purchased and C be the amount of clothing. We will denote the prices of the two goods P F and PC. In that
case, PFF (price of food times the quantity) is the amount of money spent on food and P CC (the amount
of money spent on clothing times quality). The budget line indicates all combinations of F and C for
which the total amount of money spent is equal to income. Because we are considering only two goods
(and ignoring the possibility of saving), our hypothetical consumer will spend her entire income on food
and clothing. As a result, the combinations of food and clothing that she can buy will all lie on this line:

Going back to our previous table:

Plotting the graph, we’ll have:

15
A budget line describes the combinations of goods that can be purchased given the consumer’s income
and the prices of the goods. Line AG (which passes through points B, D, and E) shows the budget
associated with an income of $80, a price of food of P F = $1 per unit, and a price of clothing of P C = $2
per unit. The slope of the budget line (measured between points B and D) is −P F /PC = −10/20 = −1/2.
Points A and G are the intercepts. That is if all income is spent on Clothing there will be 40 of it, if all
income is spent on Food then there will be 80 of it.

Using equation (3.1), we can see how much of C must be given up to consume more of F. We divide
both sides of the equation by PC and then solve for C:

C = (I/PC) - (PF/PC) F (3.2)

Equation (3.2) is the equation for a straight line; it has a vertical intercept of I/P C and a slope of −
(PF /PC).

The slope of the budget line, − (PF /PC), is the negative of the ratio of the prices of the two goods. The
magnitude of the slope tells us the rate at which the two goods can be substituted for each other without
changing the total amount of money spent. The vertical intercept (I/P C) represents the maximum amount
of C that can be purchased with income I. Finally, the horizontal intercept (I/P F) tells us how many units
of F can be purchased if all income were spent on F.

What happens to the budget line if the price of one good changes but the price of the other does
not?
 In that case, the vertical intercept of the budget line remains unchanged, although the slope
changes. A person who consumes only clothing and no food is unaffected by the price change.
However, someone who consumes a large amount of food will experience an increase in his
purchasing power. Because of the decline in the price of food, the maximum amount of food that
can be purchased has doubled. Again, a person who consumed only clothing would be unaffected
by the food price increase.

What happens if the prices of both food and clothing change, but in a way that leaves the ratio of
the two prices unchanged?
 Because the slope of the budget line is equal to the ratio of the two prices, the slope will remain
the same. The intercept of the budget line must shift so that the new line is parallel to the old one.
For example, if the prices of both goods fall by half, then the slope of the budget line does not
change. However, both intercepts double, and the budget line is shifted outward.

16
This exercise tells us something about the determinants of a consumer’s purchasing power—her ability
to generate utility through the purchase of goods and services. Purchasing power is determined not only
by income, but also by prices. For example, our consumer’s purchasing power can double either because
her income doubles or because the prices of all the goods that she buys fall by half.

What will happen if everything doubles?

 Consider what happens if everything doubles—the prices of both food and clothing and the
consumer’s income. (This can happen in an inflationary economy.) Because both prices have
doubled, the ratio of the prices has not changed; neither, therefore, has the slope of the budget
line. Because the price of clothing has doubled along with income, the maximum amount of
clothing that can be purchased (represented by the vertical intercept of the budget line) is
unchanged. The same is true for food. Therefore, inflationary conditions in which all prices and
income levels rise proportionately will not affect the consumer’s budget line or purchasing
power.

Effects of a Change in Price

on the Budget Line
- A change in the price of
one good (with income
unchanged) causes the
budget line to rotate
about one intercept.
When the price of food
falls from $1.00 to
$0.50, the budget line
rotates outward from L1
to L2. However, when
the price increases from
$1.00 to $2.00, the line
rotates inward from L1
to L3.

CONSUMERS CHOICE

Given preferences and budget constraints, we can now determine how individual consumers choose how
much of each good to buy. We assume that consumers make this choice in a rational way—that they
choose goods to maximize the satisfaction they can achieve, given the limited budget available to them.
The maximizing market basket must satisfy two conditions:
1. It must be located on the budget line.
- To see why, note that any market basket to the left of and below the budget line leaves some
income unallocated—income which, if spent, could increase the consumer’s satisfaction. Of
course, consumers can—and often do—save some of their incomes for future consumption. In
that case, the choice is not just between food and clothing, but between consuming food or
clothing now and consuming food or clothing in the future. At this point, however, we will keep
things simple by assuming that all income is spent now. Note also that any market basket to the
right of and above the budget line cannot be purchased with available income. Thus, the only
rational and feasible choice is a basket on the budget line.
2. It must give the consumer the most preferred combination of goods and services.

In our food and clothing example, as with any two goods, we can graphically illustrate the solution to
the consumer’s choice problem as shown in below.

17
Maximizing Consumer Satisfaction
- A consumer maximizes
satisfaction by choosing
market basket A. At this point,
the budget line and
indifference curve U2 are
tangent, and no higher level of
satisfaction (e.g., market
basket D) can be attained. At
A, the point of maximization,
the MRS between the two
goods equals the price ratio.
At B, however, because the
MRS [−(−10/10) = 1] is
greater than the price ratio
(1/2), satisfaction is not
maximized.

Here, three indifference curves describe a consumer’s preferences for food and clothing. Remember that
of the three curves, the outermost curve, U 3, yields the greatest amount of satisfaction, curve U 2 the next
greatest amount, and curve U1 the least.

Note that point B on indifference curve U1 is not the most preferred choice, because a reallocation of
income in which more is spent on food and less on clothing can increase the consumer’s satisfaction. In
particular, by moving to point A, the consumer spends the same amount of money and achieves the
increased level of satisfaction associated with indifference curve U 2. In addition, note that baskets
located to the right and above indifference curve U 2, like the basket associated with D on indifference
curve U3, achieve a higher level of satisfaction but cannot be purchased with the available income.
Therefore, A maximizes the consumer’s satisfaction.

We see from this analysis that the basket which maximizes satisfaction must lie on the highest
indifference curve that touches the budget line. Point A is the point of tangency between indifference
curve U2 and the budget line. At A, the slope of the budget line is exactly equal to the slope of the
indifference curve. Because the MRS (−∆C/∆F) is the negative of the slope of the indifference curve, we
can say that satisfaction is maximized (given the budget constraint) at the point where

MRS = PF / PC.

Satisfaction is maximized when the marginal rate of substitution (of F for C) is equal to the ratio of the
prices (of F to C). Thus, the consumer can obtain maximum satisfaction by adjusting his consumption of
goods F and C so that the MRS equals the price ratio.

The condition given in equation (3.3) illustrates the kinds of optimization conditions that arise in
economics. In this instance, satisfaction is maximized when the marginal benefit, the benefit associated
with the consumption of one additional unit of food is equal to the marginal cost (which is the cost of
the additional unit of food). The marginal benefit is measured by the MRS. At point A, it equals 1/2 (the
magnitude of the slope of the indifference curve), which implies that the consumer is willing to give up
1/2 unit of clothing to obtain 1 unit of food. At the same point, the marginal cost is measured by the
magnitude of the slope of the budget line; it too equals 1/2 because the cost of getting one unit of food is
giving up 1/2 unit of clothing (PF = 1 and PC = 2 on the budget line).

If the MRS is less or greater than the price ratio, the consumer’s satisfaction has not been maximized.
 For example, compare point B in Figure 3.13 to point A. At point B, the consumer is purchasing
20 units of food and 30 units of clothing. The price ratio (or marginal cost) is equal to 1/2
because food costs $1 and clothing $2. However, the MRS (or marginal benefit) is greater than
1/2; it is approximately 1. As a result, the consumer is able to substitute 1 unit of food for 1 unit
of clothing without loss of satisfaction.
Because food is cheaper than clothing, it is in her interest to buy more food and less clothing. If
our consumer purchases 1 less unit of clothing, for example, the $2 saved can be allocated to two
units of food, even though only one unit is needed to maintain her level of satisfaction.
18
The reallocation of the budget continues in this manner (moving along the budget line), until we reach
point A, where the price ratio of 1/2 just equals the MRS of 1/2. This point implies that our consumer is
willing to trade one unit of clothing for two units of food. Only when the condition MRS = ½ = PF / PC
holds, is she maximizing her satisfaction.

Marginal Utility
We showed graphically how a consumer can maximize his or her satisfaction, given a budget constraint.
We do this by finding the highest indifference curve that can be reached, given that budget constraint.
Because the highest indifference curve also has the highest attainable level of utility, it is natural to
recast the consumer’s problem as one of maximizing utility subject to a budget constraint. The concept
of utility can also be used to recast our analysis in a way that provides additional insight. To begin, let’s
distinguish between the total utility obtained by consumption and the satisfaction obtained from the last
item consumed.

Marginal utility (MU)

- measures the additional satisfaction obtained from consuming one additional unit of a good. For
example, the marginal utility associated with a consumption increase from 0 to 1 unit of food
might be 9; from 1 to 2, it might be 7; from 2 to 3, it might be 5. These numbers imply that the
consumer has diminishing marginal utility.
Diminishing marginal utility
- a principle that as more of a good is consumed, the consumption of additional amounts will yield
smaller additions to utility. Imagine, for example, the consumption of television: Marginal utility
might fall after the second or third hour and could become very small after the fourth or fifth
hour of viewing. We can relate the concept of marginal utility to the consumer’s utility-
maximization problem in the following way.

Recall the previously discussed figure below:

- Consider a small movement down an
indifference curve. The additional
consumption of food, ∆F, will generate
marginal utility MUF. This shift results
in a total increase in utility of MUF∆F.
At the same time, the reduced
consumption of clothing, ∆C, will
lower utility per unit by MUC, resulting
in a total loss of MUC∆C.

- Because all points on an indifference

curve generate the same level of utility,
the total gain in utility associated with
the increase in F must balance the loss
due to the lower consumption of C.
Formally,
0 = MUF(∆F) + MUC(∆C).
Now we can arrange this equation so that
− (∆C/∆F) = MUF / MUC

But because −(∆C/∆F) is the MRS of F for C, it follows that

MRS = MUF / MUC
This equation tells us that the MRS is the ratio of the marginal utility of F to the marginal utility of C.
As the consumer gives up more and more of C to obtain more of F, the marginal utility of F falls and
that of C increases, so MRS decreases.

We saw earlier in this chapter that when consumers maximize their satisfaction, the MRS of F for C is
equal to the ratio of the prices of the two goods:
MRS = PF / PC

19
Because the MRS is also equal to the ratio of the marginal utilities of consuming F and C (from equation
3.5), it follows that
MUF / MUC = PF / PC

Or

MUF / PF = MUC / PC
.
This equation gives an important result. It tells us that utility maximization is achieved when the budget
is allocated so that the marginal utility per dollar of expenditure is the same for each good. To see why
this principle must hold, suppose that a person gets more utility from spending an additional dollar on
food than on clothing. In this case, her utility will be increased by spending more on food. As long as the
marginal utility of spending an extra dollar on food exceeds the marginal utility of spending an extra
dollar on clothing, she can increase her utility by shifting her budget toward food and away from
clothing. Eventually, the marginal utility of food will decrease (because there is diminishing marginal
utility in its consumption) and the marginal utility of clothing will increase (for the same reason). Only
when the consumer has satisfied the equal marginal principle (has equalized the marginal utility per
dollar of expenditure across all goods) will she have maximized utility. The equal marginal principle is
an important concept in microeconomics.

Equal marginal principle – the principle which states that utility is maximized when the consumer has
equalized the marginal utility per dollar of expenditure across all goods.

Learning Assessment – Chapter 3

Consumer’s Theory

Questions:
1. What are the basic assumptions about individual preferences? Explain the significance or
meaning of each.
2. Can a set of indifference curves be upward sloping? Explain.
3. Explain why two indifference curves cannot intersect.
4. Describe the indifference curves associated with two goods that are perfect substitutes. What if
they are perfect complements?
5. What happens to the marginal rate of substitution as you move along a convex indifference
curve? A linear indifference curve?

20
 Problems:
1. Connie has a monthly income of $200 that she allocates between two goods: meat and
potatoes.
a. Suppose meat costs $4 per pound and potatoes $2 per pound. Draw her budget constraint.
b. Suppose also that her utility function is given by the equation U(M, P) = 2M + P. What
combination of meat and potatoes should she buy to maximize her utility? (Hint: Meat and
potatoes are perfect substitutes.)
c. Connie’s supermarket has a special promotion. If she buys 20 pounds of potatoes (at $2 per
pound), she gets the next 10 pounds for free. This offer applies only to the first 20 pounds
she buys. All potatoes in excess of the first 20 pounds (excluding bonus potatoes) are still
$2 per pound. Draw her budget constraint.
d. An outbreak of potato rot raises the price of potatoes to $4 per pound. The supermarket
ends its promotion. What does her budget constraint look like now? What combination of
meat and potatoes maximizes her utility?

2. Jane receives utility from days spent traveling on vacation domestically (D) and days spent
traveling on vacation in a foreign country (F), as given by the utility function U(D,F) = 10DF.
In addition, the price of a day spent traveling domestically is $100, the price of a day spent
traveling in a foreign country is $400, and Jane’s annual travel budget is $4000.
a. Illustrate the indifference curve associated with a utility of 800 and the indifference curve
associated with a utility of 1200.
b. Graph Jane’s budget line on the same graph.
c. Can Jane afford any of the bundles that give her a utility of 800? What about a utility of
1200?
d. Find Jane’s utility-maximizing choice of days spent traveling domestically and days spent
in a foreign country

Chapter 4
INDIVIDUAL AND MARKET DEMAND

Learning Outcomes:
1. Differentiate individual demand curve and market demand curve.
2. Analyze the effect of price change and income change to consumption curve.
3. Discuss the income-consumption curve of inferior goods.
4. Understand the income and substitution effect.

Individual demand curve

- Relates the quantity of a good that a single consumer will buy to the price of that good. This demand
curve has two important properties:
1. The level of utility that can be attained changes as we move along the curve.

21
 The lower the price of the product, the higher the level of utility. Note from Figure (a) that a
higher indifference curve is reached as the price falls. Again, this result simply reflects the fact
that as the price of a product falls, the consumer’s purchasing power increases.
2. At every point on the demand curve, the consumer is maximizing utility by satisfying the
condition that the marginal rate of substitution (MRS) of food for clothing equals the ratio of the
prices of food and clothing.

As the price of food falls, the price ratio and

the MRS also fall. In Figure (b), the price
ratio falls from 1 ($2/$2) at E (because the
curve U1 is tangent to a budget line with a
slope of -1 at A) to 1/2 ($1/$2) at G, to 1/4
($0.50/$2) at H. Because the consumer is
maximizing utility, the MRS of food for
clothing decreases as we move down the
demand curve. This phenomenon makes
intuitive sense because it tells us that the
relative value of food falls as the consumer
buys more of it.

Figure 1:
EFFECT OF PRICE CHANGES

A reduction in the price of food, with

income and the price of clothing fixed,
causes this consumer to choose a different
market basket. In (a), the baskets that
maximize utility for various prices of food
(point A, $2; B, $1; D, $0.50) trace out the
price-consumption curve. Part (b) gives the

demand curve, which relates the price of food to the

quantity demanded. (Points E, G, and H correspond to
points A, B, and D, respectively).

Income-consumption curve
- Curve tracing the utility maximizing combinations
of two goods as a consumer’s income changes.

The income consumption curve in Figure in the left slopes

upward because the consumption of both food and clothing
increases as income increases. Previously, we saw that a
change in the price of a good corresponds to a movement
along a demand curve. Here, the situation is different.
Because each demand curve is measured for a particular
level of income, any change in income must lead to a shift
in the demand curve itself. The upward-sloping income-

22
consumption curve implies that an increase in income causes a shift to the right in the demand curve—in
this case from D1 to D2 to D3.

Figure 2:
EFFECT OF INCOME CHANGES

An increase in income, with the prices of all goods fixed, causes consumers to alter their choice of
market baskets. In part (a), the baskets that maximize consumer satisfaction for various incomes (point
A, $10; B, $20; D, $30) trace out the income-consumption curve. The shift to the right of the demand
curve in response to the increases in income is shown in part (b). (Points E, G, and H correspond to
points A, B, and D, respectively.)

Normal vs. Inferior Goods

When the income-consumption curve has a positive slope, the quantity demanded increases with
income. As a result, the income elasticity of demand is positive. The greater the shifts to the right of the
demand curve, the larger the income elasticity. In this case, the goods are described as normal goods ---
Consumers want to buy more of them as their incomes increase.

In some cases, the quantity demanded falls as income increases; the income elasticity of demand is
negative. We then describe the good as inferior goods --- which simply means that consumption falls
when income rises. Hamburger, for example, is inferior for some people because as their income
increases, they buy less hamburger and more steak.

Figure 3:
AN INFERIOR GOOD

Figure in the right shows the income-

consumption curve for an inferior good. For
relatively low levels of income, both hamburger
and steak are normal goods. As income rises,
however, the income-consumption curve bends
backward (from point B to C). This shift occurs
because hamburger has become an inferior good
—its consumption has fallen as income has
increased.

Engel Curves

Engel Curves are curves which relate the quantity of a good consumed to an individual’s income.
Income-consumption curves can be used to construct Engel curves. Figure below shows how such
curves are constructed for two different goods. Figure (a), which shows an upward-sloping Engel curve,
is derived directly from income-consumption curve above. In both figures, as the individual’s income
increases from $10 to $20 to $30, her consumption of food increases from 4 to 10 to 16 units.

Recall that in Figure 2(a) the vertical axis measured units of clothing consumed per month and the
horizontal axis units of food per month; changes in income were reflected as shifts in the budget line. In
Figures 4(a) and (b), we have replotted the data to put income on the vertical axis, while keeping food
and hamburger on the horizontal. The upward-sloping Engel curve in Figure 4 (a) is like the upward-
sloping income-consumption curve in Figure 2(a)—applies to all normal goods. Note that an Engel
curve for clothing would have a similar shape (clothing consumption increases from 3 to 5 to 7 units as
income increases). Figure 4(b), derived from Figure 3, shows the Engel curve for hamburger. We see
that hamburger consumption increases from 5 to 10 units as income increases from $10 to $20. As
income increases further, from $20 to $30, consumption falls to 8 units. The portion of the Engel curve
that slopes downward is the income range within which hamburger is an inferior good.

Figure 4: ENGEL CURVES

23
INCOME AND SUSTITUTION EFFECTS

A fall in the price of a good has two effects:

1. Consumers will tend to buy more of the good that has become cheaper and less of those
goods that are now relatively more expensive.
- This response to a change in the relative prices of goods is called the substitution effect.
2. Because one of the goods is now cheaper, consumers enjoy an increase in real purchasing
power.
- They are better off because they can buy the same amount of the good for less money, and
thus have money left over for additional purchases. The change in demand resulting from this
change in real purchasing power is called the income effect.

Normally, these two effects occur simultaneously, but it will be useful to distinguish between them for
purposes of analysis. The specifics are illustrated in Figure 5, where the initial budget line is RS and
there are two goods, food and clothing. Here, the consumer maximizes utility by choosing the market
basket at A, thereby obtaining the level of utility associated with the indifference curve U1.

Figure 5:
INCOME AND SUBSTITUTION EFFECTS: NORMAL GOOD

A decrease in the price of food has both an

income effect and a substitution effect. The
consumer is initially at A, on budget line RS.
When the price of food falls, consumption
increases by F1F2 as the consumer moves to B.
The substitution effect F1E (associated with a
move from A to D) changes the relative prices
of food and clothing but keeps real income
(satisfaction) constant. The income effect EF2
(associated with a move from D to B) keeps
relative prices constant but increases purchasing
power. Food is a normal good because the
income effect EF2 is positive.

Substitution Effect

24
  is the change in food consumption associated with a change in the price of food, with the level of
utility held constant.
 The substitution effect captures the change in food consumption that occurs as a result of the
price change that makes food relatively cheaper than clothing.
 This substitution is marked by a movement along an indifference curve

Income Effect
 the change in food consumption brought about by the increase in purchasing power, with relative
prices held constant
 Because it reflects a movement from one indifference curve to another, the income effect
measures the change in the consumer’s purchasing power.
 the total effect of a change in price is given theoretically by the sum of the substitution effect and
the income effect. That is,

Total Effect (F1F2) = Substitution Effect (F1E) + Income Effect (EF2)

Figure 6:
INCOME AND SUBSTITUTION EFFECTS: INFERIOR GOOD

- The consumer is initially at A on

budget line RS. With a decrease
in the price of food, the
consumer moves to B. The
resulting change in food
purchased can be broken down
into a substitution effect, F1 E
(associated with a move from A
to D), and an income effect, EF 2
(associated with a move from D
to B). In this case, food is an
inferior good because the
income effect is negative.
However, because the
substitution effect exceeds the
income effect, the decrease in
the price of food leads to an
increase in the quantity of food
demanded.

Learning Assessment – Chapter 4

Individual and Market Demand

Questions:
1. Explain the difference between each of the following terms:
a. a price consumption curve and a demand curve
b. an individual demand curve and a market demand curve
c. an Engel curve and a demand curve
d. an income effect and a substitution effect

2. Suppose that a consumer spends a fixed amount of income per month on the following pairs of
goods; If the price of one of the goods increases, explain the effect on the quantity demanded
of each of the goods.
a. Banana chips and mayo sauce
b. banana chips and potato chips
c. movie tickets and starbucks coffee
d. travel by bus and travel by subway
25
 Exercises:
1. An individual sets aside a certain amount of his income per month to spend on his two
hobbies, collecting wine and collecting books. Given the information below, illustrate both the
price-consumption curve associated with changes in the price of wine and the demand curve
for wine.

2. An individual consumes two goods, clothing and food. Given the information below, illustrate
both the income-consumption curve and the Engel curve for clothing and food.

3. The director of a theater company in a small college town is considering changing the way he
prices tickets. He has hired an economic consulting firm to estimate the demand for tickets.
The firm has classified people who go to the theater into two groups and has come up with two
demand functions. The demand curves for the general public (Qgp) and students (Qs ) are
given below: Qgp = 500 - 5P , Qs = 200 - 4P
a. Graph the two demand curves on one graph, with P on the vertical axis and Q on the
horizontal axis. If the current price of tickets is $35, identify the quantity demanded by
each group.
b. Find the price elasticity of demand for each group at the current price and quantity.
c. Is the director maximizing the revenue he collects from ticket sales by charging $35 for
each ticket? Explain.
d. What price should he charge each group if he wants to maximize revenue collected from
ticket sales?
Chapter 5
PRODUCTION

Learning Outcomes:
1. Identify and categorize the factors of production.
2. Analyze the relationship between input factors and the output of production in short-run and
in the long-run.
3. Explain the concept of diminishing marginal returns.

THEORY OF THE FIRM

Theory of the firm - explanation of how a firm makes cost-minimizing production decisions and how
its cost varies with its output.

The production decisions of firms are analogous to the purchasing decisions of consumers, and can
likewise be understood in three steps. These are the building blocks of the theory of the firm.
1. Production Technology
26
 - We need a practical way of describing how inputs (such as labor, capital, and raw materials) can
be transformed into outputs (such as cars and televisions). Just as a consumer can reach a level of
satisfaction from buying different combinations of goods, the firm can produce a particular level
of output by using different combinations of inputs. For example, an electronics firm might
produce 10,000 televisions per month by using a substantial amount of labor (e.g., workers
assembling the televisions by hand) and very little capital, or by building a highly automated
capital-intensive factory and using very little labor.
2. Cost Constraints
- Firms must take into account the prices of labor, capital, and other inputs. Just as a consumer is
constrained by a limited budget, the firm will be concerned about its cost of production. For
example, the firm that produces 10,000 televisions per month will want to do so in a way that
minimizes its total production cost, which is determined in part by the prices of the inputs it uses.
3. Input Choices
- Given its production technology and the prices of labor, capital, and other inputs, the firm must
choose how much of each input to use in producing its output. Just as a consumer takes account
of the prices of different goods when deciding how much of each good to buy, the firm must take
into account the prices of different inputs when deciding how much of each input to use. If our
electronics firm operates in a country with low wage rates, it may decide to produce televisions
by using a large amount of labor, thereby using very little capital.

Firms take inputs and turn them into outputs (or products). This production process, turning inputs into
outputs, is the essence of what a firm does. Inputs, which are also called factors of production, include
anything that the firm must use as part of the production process. In a bakery, for example, inputs
include the labor of its workers; raw materials, such as flour and sugar; and the capital invested in its
ovens, mixers, and other equipment needed to produce such outputs as bread, cakes, and pastries.
a. Labor inputs include skilled workers (carpenters, engineers) and unskilled workers (agricultural
workers), as well as the entrepreneurial efforts of the firm’s managers.
b. Materials include steel, plastics, electricity, water, and any other goods that the firm buys and
transforms into final products.
c. Capital includes land, buildings, machinery and other equipment, as well as inventories.

Let us denote the following:

L – Labor, C – Capital, q – Quantity of output

Production function
- A function showing the highest output that a firm can produce for every specified combination of
inputs. Firms can turn inputs into outputs in a variety of ways, using various combinations of
labor, materials, and capital. We can describe the relationship between the inputs into the
production process and the resulting output by a production function.

Although in practice firms use a wide variety of inputs, we will keep our analysis simple by focusing on
only two, labor L and capital K. We can then write the production function below. This equation relates
the quantity of output to the quantities of the two inputs, capital and labor.

Q = F(K,L) (eq. 1)

The Short Run Versus the Long Run

It takes time for a firm to adjust its inputs to produce its product with differing amounts of labor and
capital. A new factory must be planned and built, and machinery and other capital equipment must be
ordered and delivered. Such activities can easily take a year or more to complete. As a result, if we are
looking at production decisions over a short period of time, such as a month or two, the firm is unlikely
to be able to substitute very much capital for labor. Because firms must consider whether or not inputs
can be varied, and if they can, over what period of time, it is important to distinguish between the short
and long run when analyzing production.
a. short run refers to a period of time in which the quantities of one or more factors of production
cannot be changed.

27
 - in the short run there is at least one factor that cannot be varied; such a factor is called a fixed
input.
b. long run is the amount of time needed to make all inputs variable.

PRODUCTION WITH ONE VARIABLE INPUT (LABOR)

When deciding how much of a particular input to buy, a firm has to compare the benefit that will result
with the cost of that input. Sometimes it is useful to look at the benefit and the cost on an incremental
basis by focusing on the additional output that results from an incremental addition to an input. In other
situations, it is useful to make the comparison on an average basis by considering the result of
substantially increasing an input. We will look at benefits and costs in both ways.

When capital is fixed but labor is variable, the only way the firm can produce more output is by
increasing its labor input. Imagine, for example, that you are managing a clothing factory. Although you
have a fixed amount of equipment, you can hire more or less labor to sew and to run the machines. You
must decide how much labor to hire and how much clothing to produce. To make the decision, you will
need to know how the amount of output q increases (if at all) as the input of labor L increases.

Average product - output per unit of a particular input.

- Output/labor input
- q/L
Marginal product - additional output produced as an input is increased by one unit.
- Change in output/change in labor input
- ∆q/∆L

Table 1: PRODUCTION WITH ONE VARIABLE INPUT

When labor input is zero, output is

also zero. Output then increases as
labor is increased up to an input of 8
units. Beyond that point, total output
declines: Although initially each unit
of labor can take greater and greater
advantage of the existing machinery
and plant, after a certain point,
additional labor is no longer useful
and indeed can be counterproductive.
Five people can run an assembly line
better than two, but ten people may
get in one another’s way.

Figure 1:
PRODUCTION WITH ONE
VARIABLE INPUT

The total product curve in (a) shows

the output produced for different
amounts of labor input. The average
and marginal products in (b) can be
obtained (using the data in Table 6.1)
from the total product curve. At point
A in (a), the marginal product is 20
because the tangent to the total
product curve has a slope of 20. At
point B in (a) the average product of
labor is 20, which is the slope of the
line from the origin to B. The average
product of labor at point C in (a) is
28
given by the slope of the line 0C. To the left of point E in (b), the marginal product is above the average
product and the average is increasing; to the right of E, the marginal product is below the average
product and the average is decreasing. As a result, E represents the point at which the average and
marginal products are equal, when the average product reaches its maximum.

The average product and marginal product curves are closely related.
 When the marginal product is greater than the average product, the average product is increasing.
This is the case for labor inputs up to 4 in Figure 1.
 Similarly, when the marginal product is less than the average product, the average product is
decreasing. This is the case when the labor input is greater than 4 in Figure 1.
 marginal product is above the average product when the average product is increasing and below
the average product when the average product is decreasing.
 marginal product must equal the average product when the average product reaches its
maximum.

average product of labor

- is the total product divided by the quantity of labor input. At B, for example, the average product
is equal to the output of 60 divided by the input of 3, or 20 units of output per unit of labor input.
This ratio, however, is exactly the slope of the line running from the origin to B in Figure 1 (a).
- In general, the average product of labor is given by the slope of the line drawn from the origin to
the corresponding point on the total product curve.

marginal product of labor

- is the change in the total product resulting from an increase of one unit of labor. At A, for
example, the marginal product is 20 because the tangent to the total product curve has a slope of
20.
- In general, the marginal product of labor at a point is given by the slope of the total product at
that point.
- We can see in Figure 1 (b) that the marginal product of labor increases initially, peaks at an input
of 3, and then declines as we move up the total product curve to C and D. At D, when total
output is maximized, the slope of the tangent to the total product curve is 0, as is the marginal
product. Beyond that point, the marginal product becomes negative. This applies to the principle
of DML.

law of diminishing marginal returns

- states that as the use of an input increases in equal increments (with other inputs fixed), a point
will eventually be reached at which the resulting additions to output decrease.
- When the labor input is small (and capital is fixed), extra labor adds considerably to output, often
because workers are allowed to devote themselves to specialized tasks.
- However, the law of diminishing marginal returns applies: When there are too many workers,
some workers become ineffective and the marginal product of labor falls.

Something to ponder:
MALTHUS AND THE FOOD CRISIS

The law of diminishing marginal returns was central to the thinking of political economist Thomas
Malthus (1766–1834). Malthus believed that the world’s limited amount of land would not be able to
supply enough food as the population grew. He predicted that as both the marginal and average
productivity of labor fell and there were more mouths to feed, mass hunger and starvation would
result. Fortunately, Malthus was wrong (although he was right about the diminishing marginal returns
to labor).

Over the past century, technological improvements have dramatically altered food production in most
countries (including developing countries, such as India). As a result, the average product of labor and
total food output have increased. These improvements include new high-yielding, disease-resistant
strains of seeds, better fertilizers, and better harvesting equipment. Overall food production
throughout the world has outpaced population growth continually since 1960.7 This increase in world
agricultural productivity also shows average cereal yields from 1970 through 2005, along with a
world price index for food.8 Note that cereal yields have increased steadily over the period. Because
29
 growth in agricultural productivity led to increases in food supplies that outstripped the growth in
demand, prices, apart from a temporary increase in the early 1970s, have been declining.

Hunger remains a severe problem in some areas, such as the Sahel region of Africa, in part because of
the low productivity of labor there. Although other countries produce an agricultural surplus, mass
hunger still occurs because of the difficulty of redistributing food from more to less productive
regions of the world and because of the low incomes of those less productive regions.

PRODUCTION WITH TWO VARIABLE INPUTS

We have completed our analysis of the short-run production function in which one input, labor, is
variable, and the other, capital, is fixed. Now we turn to the long run, for which both labor and capital
are variable. The firm can now produce its output in a variety of ways by combining different amounts
of labor and capital.

Isoquant – is a curve that shows all the possible combinations of inputs that yield the same output.

Isoquant map – Graph combining a number of isoquants, used to describe a production function.

Table 2:
Production with two variable inputs
At A, 1 unit of
labor and 3 units
of capital yield
55 units of
output; at D, the
same output is
produced from 3
units of labor
and 1 unit of
capital. Isoquant
q2 shows all
combinations of inputs that yield 75 units of output and corresponds to the four combinations of labor
and capital circled in the table (e.g., at B, where 2 units of labor and 3 units of capital are combined).
Isoquant q2 lies above and to the right of q 1 because obtaining a higher level of output requires more
labor and capital. Finally, isoquant q1 shows labor-capital combinations that yield 90 units of output.
Point C, for example, involves 3 units of labor and 3 units of capital, whereas Point E involves 2 units of
labor and 5 units of capital.
FIGURE 2:
PRODUCTION WITH TWO VARIABLE INPUTS

- Production isoquants show the various

combinations of inputs necessary for the firm
to produce a given output. A set of isoquants,
or isoquant map, describes the firm’s
production function. Output increases as we
move from isoquant q1 (at which 55 units per
year are produced at points such as A and D),
to isoquant q2 (75 units per year at points such
as B), and to isoquant q3 (90 units per year at
points such as C and E).

Isoquant Maps
- When a number of isoquants are combined in a single graph, we call the graph an isoquant map.
Figure 2 shows three of the many isoquants that make up an isoquant map. An isoquant map is
another way of describing a production function, just as an indifference map is a way of
describing a utility function. Each isoquant corresponds to a different level of output, and the
level of output increases as we move up and to the right in the figure.
30
Diminishing Marginal Returns
- Even though both labor and capital are variable in the long run, it is useful for a firm that is
choosing the optimal mix of inputs to ask what happens to output as each input is increased, with
the other input held fixed. The outcome of this exercise is described in Figure 6.5, which reflects
diminishing marginal returns to both labor and capital. We can see why there are diminishing
marginal returns to labor by drawing a horizontal line at a particular level of capital—say, 3.
Reading the levels of output from each isoquant as labor is increased, we note that each
additional unit of labor generates less and less additional output.

- There are diminishing marginal returns to labor both in the long and short run. Because adding
one factor while holding the other factor constant eventually leads to lower and lower
incremental output, the isoquant must become steeper as more capital is added in place of labor
and flatter when labor is added in place of capital. There are also diminishing marginal returns to
capital. With labor fixed, the marginal product of capital decreases as capital is increased.

- The slope of each isoquant indicates how the quantity of one input can be traded off against the
quantity of the other, while output is held constant. When the negative sign is removed, we call
the slope the marginal rate of technical substitution (MRTS). The marginal rate of technical
substitution of labor for capital is the amount by which the input of capital can be reduced when
one extra unit of labor is used, so that output remains constant. This is analogous to the marginal
rate of substitution (MRS) in consumer theory. Like the MRS, the MRTS is always measured as
a positive quantity:

MRTS = - Change in capital input/change in labor input

= - ∆K/∆L (for a fixed level of q) ,

where ∆K and ∆L are small changes in capital and labor along an isoquant.

In Figure 3 the MRTS is equal to 2 when labor increases from 1 unit to 2 and output is fixed at 75.
However, the MRTS falls to 1 when labor is increased from2 units to 3, and then declines to 2/3 and to
1/3. Clearly, as more and more labor replaces capital, labor becomes less productive and capital
becomes relatively more productive. Therefore, we need less capital to keep output constant, and the
isoquant becomes flatter.

FIGURE 3:
MARGINAL RATE OF TECHNICAL SUBSTITUTION

- Like indifference curves,

isoquants are downward
sloping and convex. The slope
of the isoquant at any point
measures the marginal rate of
technical substitution—the
ability of the firm to replace
capital with labor while
maintaining the same level of
output. On isoquant q2, the
MRTS falls from 2 to 1 to 2/3
to 1/3.

The MRTS falls as we move down along an isoquant. The mathematical implication is that isoquants,
like indifference curves, are convex, or bowed inward. This is indeed the case for most production
technologies. The diminishing MRTS tells us that the productivity of any one input is limited. As more
31
and more labor is added to the production process in place of capital, the productivity of labor falls.
Similarly, when more capital is added in place of labor, the productivity of capital falls. Production
needs a balanced mix of both inputs.

As our discussion has just suggested, the MRTS is closely related to the marginal products of labor MPL
and capital MPK. To see how, imagine adding some labor and reducing the amount of capital sufficient
to keep output constant. The additional output resulting from the increased labor input is equal to the
additional output per unit of additional labor (the marginal product of labor) times the number of units of
additional labor:

Additional output from increased use of labor = (MPL) (∆L)

Similarly, the decrease in output resulting from the reduction in capital is the loss of output per unit
reduction in capital (the marginal product of capital) times the number of units of capital reduction:

Reduction in output from decreased use of capital = (MPK) (∆K)

Because we are keeping output constant by moving along an isoquant, the total change in output must be
zero. Thus,
(MPL) (∆L) + (MPK) (∆K) = 0

Now, by rearranging terms we see that

(MPL) (MPK) = - (∆K + ∆L) =

MRTS

This equation tells us that the marginal rate of technical substitution between two inputs is equal to the
ratio of the marginal products of the inputs. This formula will be useful when we look at the firm’s cost-
minimizing choice of inputs.

ECONOMIES AND DISECONOMIES OF SCALE

The term economies of scales includes increasing returns to scale as a special case, but it is more
general because it reflects input proportions that change as the firm changes its level of production.
Economies of scale – situation in which output can be doubled for less than a doubling of cost.
Diseconomies of scale – situation in which a doubling of output requires more than a doubling of cost.

As output increases, the firm’s average cost of producing that output is likely to decline, at least to a
point. This can happen for the following reasons:
1. If the firm operates on a larger scale, workers can specialize in the activities at which they are
most productive.
2. Scale can provide flexibility. By varying the combination of inputs utilized to produce the firm’s
output, managers can organize the production process more effectively.
3. The firm may be able to acquire some production inputs at lower cost because it is buying them
in large quantities and can therefore negotiate better prices. The mix of inputs might change with
the scale of the firm’s operation if managers take advantage of lower-cost inputs.

At some point, however, it is likely that the average cost of production will begin to increase with
output. There are three reasons for this shift:
1. At least in the short run, factory space and machinery may make it more difficult for workers to
do their jobs effectively.
2. Managing a larger firm may become more complex and inefficient as the number of tasks
increases.
3. The advantages of buying in bulk may have disappeared once certain quantities are reached. At
some point, available supplies of key inputs may be limited, pushing their costs up.

Our analysis of input substitution in the production process has shown us what happens when a firm
substitutes one input for another while keeping output constant. However, in the long run, with all inputs
variable, the firm must also consider the best way to increase output. One way to do so is to change the
32
scale of the operation by increasing all of the inputs to production in proportion. If it takes one farmer
working with one harvesting machine on one acre of land to produce 100 bushels of wheat, what will
happen to output if we put two farmers to work with two machines on two acres of land? Output will
almost certainly increase, but will it double, more than double, or less than double?

Returns to scale
- Refers to the rate at which output increases as inputs are increased proportionately. We will examine
three different cases: increasing, constant, and decreasing returns to scale.
1. Increasing returns to scale.
- If output more than doubles when inputs are doubled, there are increasing returns to scale.
This might arise because the larger scale of operation allows managers and workers to
specialize in their tasks and to make use of more sophisticated, large-scale factories and
equipment. The automobile assembly line is a famous example of increasing returns.
- The prospect of increasing returns to scale is an important issue from a public policy
perspective. If there are increasing returns, then it is economically advantageous to have one
large firm producing (at relatively low cost) rather than to have many small firms (at
relatively high cost). Because this large firm can control the price that it sets, it may need to
be regulated.
2. Constant returns to scale.
- Output may double when inputs are doubled. In this case, we say there are constant returns to
scale. With constant returns to scale, the size of the firm’s operation does not affect the
productivity of its factors: Because one plant using a particular production process can easily
be replicated, two plants produce twice as much output. For example, a large travel agency
might provide the same service per client and use the same ratio of capital (office space) and
labor (travel agents) as a small agency that services fewer clients.
3. Decreasing returns to scale.
- Output may less than double when all inputs double. This case of decreasing returns to scale
applies to some firms with large-scale operations. Eventually, difficulties in organizing and
running a large-scale operation may lead to decreased productivity of both labor and capital.
Communication between workers and managers can become difficult to monitor as the
workplace becomes more impersonal. Thus, the decreasing-returns case is likely to be
associated with the problems of coordinating tasks and maintaining a useful line of
communication between management and workers.

FIGURE 4:
RETURNS TO SCALE

- When a firm’s production process

exhibits constant returns to scale as
shown by a movement along line 0A in
part (a), the isoquants are equally
spaced as output increases
proportionally. However, when there
are increasing returns to scale as shown
in (b), the isoquants move closer
together as inputs are increased along
the line.

Learning Assessment – Chapter 5

Production
33
 Questions:
1. What is a production function? How does a long-run production function differ from a short-
run production function?
2. What is the difference between isoquant and indifference curve?
3. Can an isoquant ever slope upward? Explain.
4. Is it possible to have diminishing returns to a single factor of production and constant returns
to scale at the same time? Discuss.
5. Suppose that output q is a function of a single input, labor (L). Describe the returns to scale
associated with each of the following production functions:
a. q = L/2 b. q = L2 + L c. q = log(L).

Exercises:
1. Fill in the gaps in the table below.

2. The production function for the personal computers of DISK, Inc., is given by q = 10K 0.5L0.5
where q is the number of computers produced per day, K is hours of machine time, and L is
hours of labor input. DISK’s competitor, FLOPPY, Inc., is using the production function q =
10K0.6L0.4.
a. If both companies use the same amounts of capital and labor, which will generate more
output?
b. Assume that capital is limited to 9 machine hours, but labor is unlimited in supply. In
which company is the marginal product of labor greater? Explain.

Chapter 6
THE COST OF PRODUCTION

Learning Outcomes:
1. Differentiate between implicit and explicit costs; and accounting and economic costs.
2. Explain opportunity costs and sunk costs.
3. Define and differentiate between marginal, average, and total costs as well as variable
and fixed costs.

Economic Cost versus Accounting Cost

accounting cost
- the cost that financial accountants measure—can include items that an economist would not
include and may not include items that economists usually do include. For example, accounting
cost includes actual expenses plus depreciation expenses for capital equipment, which are
determined on the basis of the allowable tax treatment by the Internal Revenue Service.
economic cost

34
 - costs that economist and manager are concerned of, is the cost of utilizing resources in
production. The word economic tells us to distinguish between the costs the firm can control and
those it cannot. It also tells us to consider all costs relevant to production. Clearly capital, labor,
and raw materials are resources whose costs should be included. Here the concept of opportunity
cost plays an important role.
Opportunity cost
- is the cost associated with opportunities that are forgone by not putting the firm’s resources to
their best alternative use. Consider a firm that owns a building and therefore pays no rent for
office space. The firm’s managers and accountant might say yes, but an economist would
disagree. The economist would note that the firm could have earned rent on the office space by
leasing it to another company. Leasing the office space would mean putting this resource to an
alternative use, a use that would have provided the firm with rental income. This forgone rent is
the opportunity cost of utilizing the office space. And because the office space is a resource that
the firm is utilizing, this opportunity cost is also an economic cost of doing business.

Consider an owner that manages her own retail toy store and does not pay herself a salary. Had our toy
store owner chosen to work elsewhere she would have been able to find a job that paid $60,000 per year
for essentially the same effort. In this case the opportunity cost of the time she spends working in her toy
store business is $60,000.

Suppose that last year she acquired an inventory of toys for which she paid $1 million. She hopes to be
able to sell those toys during the holiday season for a substantial markup over her acquisition cost.
However, early in the fall she receives an offer from another toy retailer to acquire her inventory for
$1.5 million. Should she sell her inventory or not? The answer depends in part on her business
prospects, but it also depends on the opportunity cost of acquiring a toy inventory. Assuming that it
would cost $1.5 million to acquire the new inventory all over again, the opportunity cost of keeping it is
$1.5 million, not the $1.0 million she originally paid.

You might ask why the opportunity cost isn’t just $500,000, since that is the difference between the
market value of the inventory and the cost of its acquisition. The key is that when the owner is deciding
what to do with the inventory, she is deciding what is best for her business in the future. To do so, she
needs to account for the fact that if she keeps the inventory for her own use, she would be sacrificing the
$1.5 million that she could have received by selling the inventory to another firm.1 Note that an
accountant may not see things this way. The accountant might tell the toy store owner that the cost of
utilizing the inventory is just the $1 million that she paid for it. But we hope that you understand why
this would be misleading. The actual economic cost of keeping and utilizing that inventory is the $1.5
million that the owner could have obtained by instead selling it to another retailer.

Note that an accountant may not see things this way. The accountant might tell the toy store owner that
the cost of utilizing the inventory is just the $1 million that she paid for it. But we hope that you
understand why this would be misleading. The actual economic cost of keeping and utilizing that
inventory is the $1.5 million that the owner could have obtained by instead selling it to another retailer.

sunk cost
- an expenditure that has been made and cannot be recovered. A sunk cost is usually visible, but
after it has been incurred it should always be ignored when making future economic decisions.
Consider the purchase of specialized equipment for a plant. Suppose the equipment can be used
to do only what it was originally designed for and cannot be converted for alternative use. The
expenditure on this equipment is a sunk cost. Because it has no alternative use, its opportunity
cost is zero. Thus it should not be included as part of the firm’s economic costs. But what if,
instead, the equipment could be put to other use or could be sold or rented to another firm? In
that case, its use would involve an economic cost—namely, the opportunity cost of using it
rather than selling or renting it to another firm.

Fixed Costs and Variable Costs

Some costs vary with output, while others remain unchanged as long as the firm is producing any output
at all. This distinction will be important when we examine the firm’s profit-maximizing choice of output
in the next chapter. We therefore divide total cost (TC or C) — the total economic cost of production—
into two components.
a. Fixed cost (FC)
35
 - A cost that does not vary with the level of output and that can be eliminated only by going out of
business. Include expenditures for plant maintenance, insurance, heat and electricity, and perhaps
a minimal number of employees. They remain the same no matter how much output the firm
produces.
b. Variable cost (VC)
- A cost that varies as output varies. Include expenditures for wages, salaries, and raw materials
used for production, increase as output increases.

Marginal and Average Cost

To complete our discussion of costs, we now turn to the distinction between marginal and average cost.
In explaining this distinction, we use a specific numerical example of a cost function (the relationship
between cost and output) that typifies the cost situation of many firms. After we explain the concepts of
marginal and average cost, we will consider how the analysis of costs differs between the short run and
the long run.
a. Marginal cost (MC)
- sometimes called incremental cost—is the increase in cost that results from producing one extra
unit of output. Because fixed cost does not change as the firm’s level of output changes, marginal
cost is equal to the increase in variable cost or the increase in total cost that results from an extra
unit of output. We can therefore write marginal cost as MC = ∆VC/∆q = ∆TC/∆q.
b. average total cost (ATC)
- firm’s total cost divided by its level of output. Also referred as average economic cost, ATC has
two components:
a. average fixed cost (AFC) – fixed cost divided by the level of output.
b. average variable cost (AVC) – variable cost divided by the level of output.

Look at the table

on the right
showing a firm’s
costs, and its
graph.

COST CURVES
FOR A FIRM

- In (a) total cost TC is the

vertical sum of fixed cost
FC and variable cost VC.

- In (b) average total cost

ATC is the sum of average
variable cost AVC and
average fixed cost AFC.
Marginal cost MC crosses
the average variable cost
and average total cost
curves at their minimum
points.

36
The shapes of the remaining curves are determined by the relationship between the marginal and
average cost curves. Whenever marginal cost lies below average cost, the average cost curve falls.
Whenever marginal cost lies above average cost, the average cost curve rises. When average cost is at a
minimum, marginal cost equals average cost.

Chapter 7
MARKET STRUCTURE

Learning Outcomes:
1. Identify the characteristics of each of the market structures: perfect competition, monopoly,
monopolistic competition and oligopoly.
2. Compare and contrast the market structures.
3. Analyze the impact of an entrant into an oligopolistic industry.

Market Structure:
- Market structure refers to the nature and degree of competition in the market for goods and
services. The structures of market both for goods market and service (factor) market are
determined by the nature of competition prevailing in a particular market.

Determinants of market structure:

1. Number and Nature of Sellers.
- The market structures are influenced by the number and nature of sellers in the market. They
range from large number of sellers in perfect competition to a single seller in pure monopoly, to
two sellers in duopoly, to a few sellers in oligopoly, and to many sellers of differentiated
products.
2. Number and Nature of Buyers.
- The market structures are also influenced by the number and nature of buyers in the market. If
there is a single buyer in the market, this is buyer’s monopoly and is called monopsony market.
37
 Such markets exist for local labor employed by one large employer. There may be two buyers
who act jointly in the market. This is called duopsony market. They may also be a few organized
buyers of a product, known as oligopsony.
3. Nature of Product.
- It is the nature of product that determines the market structure. If there is product differentiation,
products are close substitutes and the market is characterized by monopolistic competition. On
the other hand, in case of no product differentiation, the market is characterized by perfect
competition. And if a product is completely different from other products, it has no close
substitutes and there is pure monopoly in the market.
4. Entry and Exit Conditions.
- The conditions for entry and exit of firms in a market depend upon profitability or loss in a
particular market. Profits in a market will attract the entry of new firms and losses lead to the exit
of weak firms from the market. In a perfect competition market, there is freedom of entry or exit
of firms.
- But in monopoly and oligopoly markets, there are barriers to entry of new firms. Usually,
governments have a monopoly in public utility services like postal, air and road transport, water
and power supply services, etc. By granting exclusive franchises, entries of new supplies are
barred. In oligopoly markets, there are barriers to entry of firms because of collusion, tacit
agreements, cartels, etc. On the other hand, there are no restrictions in entry and exit of firms in
monopolistic competition due to product differentiation.
5. Economies of Scale.
- Firms that achieve large economies of scale in production grow large in comparison to others in
an industry. They tend to weed out the other firms with the result that a few firms are left to
compete with each other. This leads to the emergency of oligopoly. If only one firm attains
economies of scale to such a large extent that it is able to meet the entire market demand, there is
monopoly.

Forms of Market Structure:

1. Perfect Competition
2. Monopoly
3. Monopolistic Competition
4. Oligopoly

Monopoly and monopsony power are two forms of market power: the ability—of either a seller or a
buyer—to affect the price of a good. Because sellers or buyers often have at least some market power (in
most real-world markets), we need to understand how market power works and how it affects producers
and consumers.

Monopoly – is a market that has only one seller but many buyers.
Monopsony – is just the opposite: a market with many sellers but only one buyer.

Example:
Suppose the cost of production is C(Q) = 50 + Q 2. In other words, there is a fixed cost of $50,
and variable cost is Q2. Suppose demand is given by P(Q) = 40 - Q By setting marginal revenue
equal to marginal cost, you can verify that profit is maximized when Q = 10, an output level that
corresponds to a price of $30.

PERFECT COMPETITION

A perfectly competitive market is one in which the number of buyers and sellers is very large, all
engaged in buying and selling a homogeneous product without any artificial restrictions and possessing
perfect knowledge of market at a time.
- In the words of A. Koutsoyiannis, “Perfect competition is a market structure characterized by a
complete absence of rivalry among the individual firms.”
- According to R.G. Lipsey, “Perfect competition is a market structure in which all firms in an
industry are price- takers and in which there is freedom of entry into, and exit from, industry.”

Characteristics of Perfect Competition:

1. Large Number of Buyers and Sellers:

38
 - The first condition is that the number of buyers and sellers must be so large that none of them
individually is in a position to influence the price and output of the industry as a whole. The
demand of individual buyer relative to the total demand is so small that he cannot influence the
price of the product by his individual action.
- Similarly, the supply of an individual seller is so small a fraction of the total output that he
cannot influence the price of the product by his action alone. In other words, the individual seller
is unable to influence the price of the product by increasing or decreasing its supply. Rather, he
adjusts his supply to the price of the product. He is “output adjuster”. Thus no buyer or seller can
alter the price by his individual action. He has to accept the price for the product as fixed for the
whole industry. He is a “price taker”.
2. Freedom of Entry or Exit of Firms:
- The next condition is that the firms should be free to enter or leave the industry. It implies that
whenever the industry is earning excess profits, attracted by these profits some new firms enter
the industry. In case of loss being sustained by the industry, some firms leave it.
3. Homogeneous Product:
- Each firm produces and sells a homogeneous product so that no buyer has any preference for the
product of any individual seller over others. This is only possible if units of the same product
produced by different sellers are perfect substitutes. In other words, the cross elasticity of the
products of sellers is infinite.
- No seller has an independent price policy. Commodities like salt, wheat, cotton and coal are
homogeneous in nature. He cannot raise the price of his product. If he does so, his customers
would leave him and buy the product from other sellers at the ruling lower price.
4. Absence of Artificial Restrictions:
- The next condition is that there is complete openness in buying and selling of goods. Sellers are
free to sell their goods to any buyers and the buyers are free to buy from any sellers. In other
words, there is no discrimination on the part of buyers or sellers.
- Moreover, prices are liable to change freely in response to demand-supply conditions. There are
no efforts on the part of the producers, the government and other agencies to control the supply,
demand or price of the products. The movement of prices is unfettered.
5. Profit Maximization Goal:
- Every firm has only one goal of maximizing its profits.
6. Perfect Mobility of Goods and Factors:
- Another requirement of perfect competition is the perfect mobility of goods and factors between
industries. Goods are free to move to those places where they can fetch the highest price. Factors
can also move from a low-paid to a high-paid industry.
7. Perfect Knowledge of Market Conditions:
- This condition implies a close contact between buyers and sellers. Buyers and sellers possess
complete knowledge about the prices at which goods are being bought and sold, and of the prices
at which others are prepared to buy and sell. They have also perfect knowledge of the place
where the transactions are being carried on. Such perfect knowledge of market conditions forces
the sellers to sell their product at the prevailing market price and the buyers to buy at that price.
8. Absence of Transport Costs:
- Another condition is that there are no transport costs in carrying of product from one place to
another. This condition is essential for the existence of perfect competition which requires that a
commodity must have the same price everywhere at any time. If transport costs are added to the
price of the product, even a homogeneous commodity will have different prices depending upon
transport costs from the place of supply.
9. Absence of Selling Costs:
- Under perfect competition, the costs of advertising, sales-promotion, etc. do not arise because all
firms produce a homogeneous product.

Perfect Competition vs. Pure Competition

- Perfect competition is often distinguished from pure competition, but they differ only in degree.
The first five conditions relate to pure competition while the remaining four conditions are also
required for the existence of perfect competition. According to Chamberlin, pure competition
means, competition unalloyed with monopoly elements,” whereas perfect competition involves
perfection in many other respects than in the absence of monopoly.” The practical importance of
perfect competition is not much in the present times for few markets are perfectly competitive

39
 except those for staple food products and raw materials. That is why, Chamberlin says that
perfect competition is a rare phenomenon.”

Though the real world does not fulfil the conditions of perfect competition, yet perfect competition is
studied for the simple reason that it helps us in understanding the working of an economy, where
competitive behavior leads to the best allocation of resources and the most efficient organization of
production. A hypothetical model of a perfectly competitive industry provides the basis for appraising
the actual working of economic institutions and organizations in any economy.

MONOPOLY

Monopoly is a market situation in which there is only one seller of a product with barriers to entry of
others. The product has no close substitutes. The cross elasticity of demand with every other product is
very low. This means that no other firms produce a similar product.
- According to D. Salvatore, “Monopoly is the form of market organization in which there is a single
firm selling a commodity for which there are no close substitutes.” Thus the monopoly firm is itself
an industry and the monopolist faces the industry demand curve.
- The demand curve for his product is, therefore, relatively stable and slopes downward to the right,
given the tastes, and incomes of his customers. It means that more of the product can be sold at a
lower price than at a higher price. He is a price-maker who can set the price to his maximum
advantage.
- However, it does not mean that he can set both price and output. He can do either of the two things.
His price is determined by his demand curve, once he selects his output level. Or, once he sets the
price for his product, his output is determined by what consumers will take at that price. In any
situation, the ultimate aim of the monopolist is to have maximum profits.

Characteristics of Monopoly:
1. Under monopoly, there is one producer or seller of a particular product and there is no difference
between a firm and an industry. Under monopoly a firm itself is an industry.
2. A monopoly may be individual proprietorship or partnership or joint stock company or a cooperative
society or a government company.
3. A monopolist has full control on the supply of a product. Hence, the elasticity of demand for a
monopolist’s product is zero.
4. There is no close substitute of a monopolist’s product in the market. Hence, under monopoly, the
cross elasticity of demand for a monopoly product with some other good is very low.
5. There are restrictions on the entry of other firms in the area of monopoly product.
6. A monopolist can influence the price of a product. He is a price-maker, not a price-taker.
7. Pure monopoly is not found in the real world.
8. Monopolist cannot determine both the price and quantity of a product simultaneously.
9. Monopolist’s demand curve slopes downwards to the right. That is why, a monopolist can increase
his sales only by decreasing the price of his product and thereby maximize his profit. The marginal
revenue curve of a monopolist is below the average revenue curve and it falls faster than the average
revenue curve. This is because a monopolist has to cut down the price of his product to sell an
additional unit.

MONOPOLISTIC COMPETITION

A monopolistically competitive market is similar to a perfectly competitive market in two key areas:
There are many firms, and entry by new firms is not restricted. But it differs from perfect competition in
that the product is differentiated: Each firm sells a brand or version of the product that differs in quality,
appearance, or reputation, and each firm is the sole producer of its own brand. The amount of monopoly
power wielded by a firm depends on its success in differentiating its product from those of other firms.

Examples of monopolistically competitive industries includes but not limited to: Toothpaste, laundry
detergent, and packaged coffee

A monopolistically competitive market has two key characteristics:

1. Firms compete by selling differentiated products that are highly substitutable for one another but
not perfect substitutes. In other words, the cross-price elasticities of demand are large but not
infinite.
40
 2. There is free entry and exit: It is relatively easy for new firms to enter the market with their own
brands and for existing firms to leave if their products become unprofitable.

Monopolistic Competition
- Monopolistic competition refers to a market situation where there are many firms selling a differ-
entiated product. “There is competition which is keen, though not perfect, among many firms
making very similar products.” No firm can have any perceptible influence on the price-output
policies of the other sellers nor can it be influenced much by their actions. Thus monopolistic
competition refers to competition among a large number of sellers producing close but not perfect
substitutes for each other.

Features of monopolistic competition:

1. Large Number of Sellers:
- In monopolistic competition the number of sellers is large. They are “many and small enough”
but none controls a major portion of the total output. No seller by changing its price-output
policy can have any perceptible effect on the sales of others and in turn be influenced by them.
Thus there is no recognized interdependence of the price-output policies of the sellers and each
seller pursues an independent course of action.
2. Product Differentiation:
- One of the most important features of the monopolistic competition is differentiation. Product
differentiation implies that products are different in some ways from each other. They are
heterogeneous rather than homogeneous so that each firm has an absolute monopoly in the
production and sale of a differentiated product. There is, however, slight difference between one
product and other in the same category.
- Products are close substitutes with a high cross-elasticity and not perfect substitutes. Product
“differentiation may be based upon certain characteristics of the products itself, such as exclusive
patented features; trade-marks; trade names; peculiarities of package or container, if any; or
singularity in quality, design, color, or style. It may also exist with respect to the conditions
surrounding its sales.”
3. Freedom of Entry and Exit of Firms:
- Another feature of monopolistic competition is the freedom of entry and exit of firms. As firms
are of small size and are capable of producing close substitutes, they can leave or enter the
industry or group in the long run.
4. Nature of Demand Curve:
- Under monopolistic competition no single firm controls more than a small portion of the total
output of a product. No doubt there is an element of differentiation nevertheless the products are
close substitutes. As a result, a reduction in its price will increase the sales of the firm but it will
have little effect on the price-output conditions of other firms, each will lose only a few of its
customers.
- Likewise, an increase in its price will reduce its demand substantially but each of its rivals will
attract only a few of its customers. Therefore, the demand curve (average revenue curve) of a
firm under monopolistic competition slopes downward to the right. It is elastic but not perfectly
elastic within a relevant range of prices of which he can sell any amount.
5. Independent Behavior:
- In monopolistic competition, every firm has independent policy. Since the number of sellers is
large, none controls a major portion of the total output. No seller by changing its price-output
policy can have any perceptible effect on the sales of others and in turn be influenced by them.
6. Product Groups:
- There is no any ‘industry’ under monopolistic competition but a ‘group’ of firms producing
similar products. Each firm produces a distinct product and is itself an industry. Chamberlin
lumps together firms producing very closely related products and calls them product groups,
such as cars, cigarettes, etc.
7. Selling Costs:
- Under monopolistic competition where the product is differentiated, selling costs are essential to
push up the sales. Besides, advertisement, it includes expenses on salesman, allowances to sellers
for window displays, free service, free sampling, premium coupons and gifts, etc.
8. Non-price Competition:
- Under monopolistic competition, a firm increases sales and profits of his product without a cut in
the price. The monopolistic competitor can change his product either by varying its quality,
packing, etc. or by changing promotional programmes.
41
Why free entry is an important requirement?
Let’s compare the markets for toothpaste and automobiles. The toothpaste market is monopolistically
competitive, but the automobile market is better characterized as an oligopoly.
 It is relatively easy for other firms to introduce new brands of toothpaste, and this limits the
profitability of producing Crest or Colgate. If the profits were large, other firms would spend the
necessary money (for development, production, advertising, and promotion) to introduce new brands
of their own, which would reduce the market shares and profitability of Crest and Colgate.
 The automobile market is also characterized by product differentiation. However, the large-scale
economies involved in production make entry by new firms difficult. Thus, until the mid-1970s,
when Japanese producers became important competitors, the three major U.S. automakers had the
market largely to themselves.

Monopolistic competition firms face downward-sloping demand curves. Therefore, they have some
monopoly power. But this does not mean that monopolistically competitive firms are likely to earn large
profits. Because there is free entry, the potential to earn profits will attract new firms with competing
brands, driving economic profits down to zero.

A MONOPOLISTICALLY COMPETITIVE FIRM IN THE SHORT AND LONG RUN

Because the firm is the only

producer of its brand, it faces a
downward-sloping demand curve.
Price exceeds marginal cost and
the firm has monopoly power. In
the short run, described in part (a),
price also exceeds average cost,
and the firm earns profits shown
by the yellow-shaded rectangle. In
the long run, these profits attract
new firms with competing brands.
The firm’s market share falls, and
its demand curve shifts
downward. In long-run equilibrium, described in part (b), price equals average cost, so the firm earns
zero profit even though it has monopoly power.

Is monopolistic competition a socially undesirable market structure that should be regulated? The
answer—for two reasons—is probably no:
1. In most monopolistically competitive markets, monopoly power is small. Usually enough firms
compete, with brands that are sufficiently substitutable, so that no single firm has much monopoly
power. Any resulting deadweight loss will therefore be small. And because firms’ demand curves
will be fairly elastic, average cost will be close to the minimum.
2. Any inefficiency must be balanced against an important benefit from monopolistic competition:
product diversity. Most consumers value the ability to choose among a wide variety of competing
products and brands that differ in various ways. The gains from product diversity can be large and
may easily outweigh the inefficiency costs resulting from downward-sloping demand curves.

OLIGOPOLY

A market in which only a few firms compete with one another, and entry by new firms is impeded. The
product that the firms produce might be differentiated, as with automobiles, or it might not be, as with
steel. Monopoly power and profitability in oligopolistic industries depend in part on how the firms
interact. For example, if the interaction is more cooperative than competitive, firms could charge prices
well above marginal cost and earn large profits.

Oligopoly is a market situation in which there are a few firms selling homogeneous or differentiated
products. It is difficult to pinpoint the number of firms in ‘competition among the few.’ With only a few
firms in the market, the action of one firm is likely to affect the others. An oligopoly industry produces
either a homogeneous product or heterogeneous products.
42
Pure vs. perfect oligopoly
Pure oligopoly is found primarily among producers of such industrial products as aluminium, cement,
copper, steel, zinc, etc. Imperfect oligopoly is found among producers of such consumer goods as
automobiles, cigarettes, soaps and detergents, TVs, rubber tyres, refrigerators, typewriters, etc.

Characteristics of Oligopoly:
1. Interdependence:
- There is recognized interdependence among the sellers in the oligopolistic market. Each
oligopolist firm knows that changes in its price, advertising, product characteristics, etc. may
lead to counter-moves by rivals. When the sellers are a few, each produces a considerable
fraction of the total output of the industry and can have a noticeable effect on market conditions.
- He can reduce or increase the price for the whole oligopolist market by selling more quantity or
less and affect the profits of the other sellers. It implies that each seller is aware of the price-
moves of the other sellers and their impact on his profit and of the influence of his price-move on
the actions of rivals. Thus, there is complete interdependence among the sellers with regard to
their price-output policies. Each seller has direct and ascertainable influences upon every other
seller in the industry. Thus, every move by one seller leads to counter-moves by the others.
2. Advertisement:
- The main reason for this mutual interdependence in decision making is that one producer’s
fortunes are dependent on the policies and fortunes of the other producers in the industry. It is for
this reason that oligopolist firms spend much on advertisement and customer services.
- As pointed out by Prof. Baumol, “Under oligopoly advertising can become a life-and-death
matter.” For example, if all oligopolists continue to spend a lot on advertising their products and
one seller does not match up with them he will find his customers gradually going in for his
rival’s product. If, on the other hand, one oligopolist advertises his product, others have to follow
him to keep up their sales.
3. Competition:
- This leads to another feature of the oligopolistic market, the presence of competition. Since
under oligopoly, there are a few sellers, a move by one seller immediately affects the rivals. So
each seller is always on the alert and keeps a close watch over the moves of its rivals in order to
have a counter-move. This is true competition.
4. Barriers to Entry of Firms:
- As there is keen competition in an oligopolistic industry, there are no barriers to entry into or exit
from it. However, in the long run, there are some types of barriers to entry which tend to restraint
new firms from entering the industry. They may be:
a. Economies of scale enjoyed by a few large firms;
b. control over essential and specialized inputs;
c. high capital requirements due to plant costs, advertising costs, etc.
d. exclusive patents and licenses; and
e. the existence of unused capacity which makes the industry unattractive. When entry is
restricted or blocked by such natural and artificial barriers, the oligopolistic industry can earn
long-run super normal profits.
5. Lack of Uniformity:
- Another feature of oligopoly market is the lack of uniformity in the size of firms. Finns differ
considerably in size. Some may be small, others very large. Such a situation is asymmetrical.
This is very common in the American economy. A symmetrical situation with firms of a uniform
size is rare.
6. Demand Curve:
- It is not easy to trace the demand curve for the product of an oligopolist. Since under oligopoly
the exact behavior pattern of a producer cannot be ascertained with certainty, his demand curve
cannot be drawn accurately, and with definiteness. How does an individual seller s demand curve
look like in oligopoly is most uncertain because a seller’s price or output moves lead to
unpredictable reactions on price-output policies of his rivals, which may have further
repercussions on his price and output.
7. No Unique Pattern of Pricing Behavior:
- The rivalry arising from interdependence among the oligopolists leads to two conflicting
motives. Each wants to remain independent and to get the maximum possible profit. Towards
this end, they act and react on the price-output movements of one another in a continuous
element of uncertainty.
43
Oligopolistic Model
a. Nash equilibrium
- set of strategies or actions in which each firm does the best it can given its competitors’ actions.
Developed by the mathematician John Nash in 1951, this principle is widely acceptable to almost
all oligopolistic market. Because the firm will do the best it can given what its competitors are
doing, it is natural to assume that these competitors will do the best they can given what that firm
is doing. Each firm, then, takes its competitors into account, and assumes that its competitors are
doing likewise.
b. Cournot equilibrium
- equilibrium in the Cournot model in which each firm correctly assumes how much its competitor
will produce and sets its own production level accordingly. In this equilibrium, each firm
correctly assumes how much its competitor will produce, and it maximizes its profit accordingly.
Cournot equilibrium is an example of a Nash equilibrium and is sometimes called a Cournot-
Nash equilibrium. Remember that in a Nash equilibrium, each firm is doing the best it can
given what its competitors are doing. As a result, no firm would individually want to change its
behavior. In the Cournot equilibrium, each firm is producing an amount that maximizes its profit
given what its competitor is producing, so neither would want to change its output.
c. The Stackelberg Model or the First Mover Advantage
- oligopoly model in which one firm sets its output before other firms do. Going first gives Firm
an advantage. This may appear counterintuitive: It seems disadvantageous to announce your
output first. Why, then, is going first a strategic advantage? The reason is that announcing first
creates a fait accompli: No matter what your competitor does, your output will be large. To
maximize profit, your competitor must take your large output level as given and set a low level
of output for itself. If your competitor produced a large level of output, it would drive price down
and you would both lose money. So unless your competitor views “getting even” as more
important than making money, it would be irrational for it to produce a large amount.

Duopoly
- market in which two firms compete with each other. Each firm has just one competitor to take
into account in making its decisions. Although we focus on duopolies, our basic results will also
apply to markets with more than two firms.

Questions:
1. Provide a brief summary of the difference of the different forms of market structures.
2. What are the characteristics of a monopolistically competitive market?
3. Some experts have argued that too many brands of shampoos are on the market. Give an
argument to support this view. Give an argument against it.
4. In the Stackelberg model, the firm that sets output first has an advantage. Explain why.

Chapter 8
GOVERNMENT INTERVENTION, EFFICIENCY AND MARKET FAILURE

Learning Outcomes:
1. Identify common market failures and governmental responses.
2. Explain some common causes of market failure.
3. Give examples of externalities that exist in different parts of society.
4. Analyze the effects of externalities on efficiency.

Key Terms:
 public good – a good that is both non-excludable and non-rivalrous in that individuals cannot be
effectively excluded from use and where use by one individual does not reduce availability to
others.
 merit good – a commodity which is judged that an individual or society should have on the basis
of some concept of need, rather than ability and willingness to pay.
 Externality – an impact, positive or negative, on any party not involved in a given economic
transaction or act.
 free rider – one who obtains benefit from a public good without paying for it directly.
44
  Intervene – to interpose; as, to intervene to settle a quarrel; get involved, so as to alter or hinder
an action.
 Efficient – making good, thorough, or careful use of resources; not consuming extra. Especially,
making good use of time or energy.
 Economic efficiency – is the use of resources to maximize the production of goods.

MARKET FAILURE

Market failure – it is the economic situation defined by an inefficient distribution of goods and services
in the free market. Furthermore, the individual incentives for rational behavior do not lead to rational
outcomes for the group.
- occurs when the price mechanism fails to account for all of the costs and benefits necessary to
provide and consume a good. The market will fail by not supplying the socially optimal amount
of the good.
- Market failure occurs due to inefficiency in the allocation of goods and services. A price
mechanism fails to account for all of the costs and benefits involved when providing or
consuming a specific good. When this happens, the market will not produce the supply of the
good that is socially optimal – it will be over or under produced.

Reasons for market failure include:

a. Positive and negative externalities
- an externality is an effect on a third party that is caused by the consumption or production of a
good or service. A positive externality is a positive spillover that results from the consumption or
production of a good or service. For example, although public education may only directly affect
students and schools, an educated population may provide positive effects on society as a whole.
A negative externality is a negative spillover effect on third parties. For example, secondhand
smoke may negatively impact the health of people, even if they do not directly engage in
smoking.
b. Environmental concerns
- effects on the environment as important considerations as well as sustainable development.
c. Lack of public goods
- public goods are goods where the total cost of production does not increase with the number of
consumers. As an example of a public good, a lighthouse has a fixed cost of production that is
the same, whether one ship or one hundred ships use its light. Public goods can be
underproduced; there is little incentive, from a private standpoint, to provide a lighthouse
because one can wait for someone else to provide it, and then use its light without incurring a
cost. This problem – someone benefiting from resources or goods and services without paying
for the cost of the benefit – is known as the free rider problem.
d. Underproduction of merit goods
- a merit good is a private good that society believes is under consumed, often with positive
externalities. For example, education, healthcare, and sports centers are considered merit goods.

e. Overprovision of demerit goods

- a demerit good is a private good that society believes is over consumed, often with negative
externalities. For example, cigarettes, alcohol, and prostitution are considered demerit goods.
f. Abuse of monopoly power
- imperfect markets restrict output in an attempt to maximize profit.

Prior to market failure, the supply and demand within the market do not produce quantities of the goods
where the price reflects the marginal benefit of consumption. The imbalance causes allocative
inefficiency, which is the over- or under-consumption of the good. The structure of market systems
contributes to market failure. In the real world, it is not possible for markets to be perfect due to
inefficient producers, externalities, environmental concerns, and lack of public goods. An externality is
an effect on a third party which is caused by the production or consumption of a good or service.

EXTERNALITIES

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Externality - action by either a producer or a consumer which affects other producers or consumers, but
is not accounted for in the market price.
- a cost or benefit that affects an otherwise uninvolved party who did not choose to be subject to
the cost or benefit.
- An example of an externality is pollution. Health and clean-up costs from pollution impact all of
society, not just individuals within the manufacturing industries. In regards to externalities, the
cost and benefit to society is the sum of the value of the benefits and costs for all parties
involved.

Types of Externalities
Externalities can arise between producers, between customers, or between consumers and producers.
They can be negative——or positive—when the action of one party benefits another party.
1. Negative externality
- when the action of one party imposes costs on another party.
- a result of a product that inflicts a negative effect on a third party.
- Occurs, for example, when a steel plant dumps its waste in a river that fishermen downstream
depend on for their daily catch. The more waste the steel plant dumps in the river, the fewer fish
will be supported. The firm, however, has no incentive to account for the external costs that it
imposes on fishermen when making its production decision. Furthermore, there is no market in
which these external costs can be reflected in the price of steel.
- Air pollution caused by motor vehicles is an example of a negative externality.
2. Positive externality
- when the action of one party benefits another party.
- An action of a product that provides a positive effect on a third party.
- Occurs when a home owner repaints her house and plants an attractive garden. All the neighbors
benefit from this activity, even though the home owner’s decision to repaint and landscape
probably did not take these benefits into account.
- A homeowner keeps his house maintained, the neighborhood benefits through higher home
values. The homeowner’s neighbors benefit from a positive externality.
- A person may keep bees for her own enjoyment, but gardeners in the area benefit because their
flowers are pollinated. The beekeeper’s transaction of purchasing bees ends up positively
affecting parties who are not involved in the transaction.
- A person becomes inoculated against a disease, those around him benefit because they cannot
catch the disease from him. There was an exchange between the doctor and the patient, but
others also benefit.
- The problem with positive externalities is that the people who create these advantages cannot
charge the beneficiaries; the beneficiaries can “free ride,” or benefit without paying. For
example, assume everyone in a community, except one person, got a flu shot. That one person
could choose to abstain from receiving the shot; since everyone else got inoculated, he can’t get
the disease from the others because they can’t catch the flu. That person would be a free rider
since he would benefit from inoculations without incurring any cost.
- Since parties that create the externality aren’t compensated, they do not have any incentive to
create more. This results in a suboptimal result, because the producers of the externality will
generally create less of the benefit than the larger community needs.

The reason these negative

externalities, otherwise known as
social costs, occur is that these
expenses are generally not included in
calculating the costs of production.
Production decisions are generally
based on financial data and most
social costs are not measured that way.
For example, when a firm decides to
open up a new factory, it will not
account for the cost that residents
accrue by drinking water from a river
the factory polluted. As a result, a

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product that shouldn’t be produced, because the total expenses exceed the return, are made because
social costs were not considered.

In other words, the costs of production represent individual, or private, marginal costs. The private
marginal costs are lower than societal marginal costs, which also capture the true costs of the negative
externalities. As a result, producers will overestimate the ideal quantity of the good to produce.

Because externalities are not reflected in market prices, they can be a source of economic inefficiency.
When firms do not take into account the harms associated with negative externalities, the result is excess
production and unnecessary social costs. Let’s take our example of a steel plant dumping waste in a
river.

a. Marginal external cost

- The firm maximizes profit by producing output at which marginal cost is equal to price. As the
firm’s output changes, however, the external cost imposed on fishermen downstream also
changes. This external cost is given by the marginal external cost (MEC). It is intuitively clear
why total external cost increases with output—there is more pollution. However, our analysis
focuses on the marginal external cost, which measures the added cost of the externality
associated with each additional unit of output produced. In practice, as the firm produces
additional output and dumps additional effluent, the incremental harm to the fishing industry
increases.
b. Marginal social cost
- From a social point of view, the firm produces too much output. The efficient level of output is
the level at which the price of the product is equal to the marginal social cost (MSC) of
production: the marginal cost of production plus the marginal external cost of dumping effluent.
Because only one plant is dumping effluent into the river, the market price of the product is
unchanged. However, the firm is producing too much output and generating too much effluent.
Now consider what happens when all steel plants dump their effluent into rivers. The marginal
external cost associated with the industry output, MEC, is obtained by summing the marginal
cost of every person harmed at each level of output.

ECONOMIC EFFICIENCY AND THE GOVERNEMENT

Economic efficiency is the use of resources to maximize the production of goods; externalities are
imperfections that limit efficiency. An economically efficient society can produce more goods or
services than another society without using more resources.

A market is said to be economically efficient if:

 No one can be made better off without making someone else worse off.
 No additional output can be obtained without increasing the amounts of inputs.
 Production proceeds at the lowest possible cost per unit.

In order to maximize economic efficiency, regulations are needed to reduce market failures and
imperfections, like internalizing externalities. When market imperfections exist, the efficiency of the
market declines. When externalities are present, not everyone benefits from the production of the good
or service.

Positive and negative externalities both impact economic efficiency. Neoclassical welfare economics
states that the existence of externalities results in outcomes that are not ideal for society as a whole. In
the case of negative externalities, third parties experience negative effects from an activity or transaction
in which they did not choose to be involved. In order to compensate for negative externalities, the
market as a whole is reducing its profits in order to repair the damage that was caused which decreases
efficiency. Positive externalities are beneficial to the third party at no cost to them. The collective social
welfare is improved, but the providers of the benefit do not make any money from the shared benefit. As
a result, less of the good is produced or profited from which is less optimal society and decreases
economic efficiency.

In order to deal with externalities, markets usually internalize the costs or benefits. For costs, the market
has to spend additional funds in order to make up for damages incurred. Benefits are also internalized
because they are viewed as goods produced and used by third parties with no monetary gain for the
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market. Internalizing costs and benefits is not always feasible, especially when the monetary value or a
good or service cannot be determined.

Externalities directly impact efficiency because the production of goods is not efficient when costs are
incurred due to damages. Efficiency also decreases when potential money earned is lost on non-paying
third parties.

In order to maximize economic efficiency, regulations are needed to reduce market failures and
imperfections, like internalizing externalities. When market imperfections exist, the efficiency of the
market declines.

In these cases, government intervention is necessary to help “price” negative externalities. Governments
can either use regulation (e.g. outlaw an action) or use market solutions. By instituting policies such as
pollution penalties, permitting civil lawsuits by private parties to recover damages for negligent actions,
and levying environmental taxes, governments can achieve two things. First, these regulations recover
funds to help fix the damage caused by negative externalities. Second, these acts help put a financial
price on social costs. With that information, businesses can arrive at a more accurate figure for the costs
of production. Businesses can then avoid producing products whose financial and social costs exceed the
financial return. During market failures the government usually responds to varying degrees.

Possible government responses include:

a. Legislation
- enacting specific laws. For example, banning smoking in restaurants, or making high school
attendance mandatory.
b. direct provision of merit and public goods
- governments control the supply of goods that have positive externalities. For example, by
supplying high amounts of education, parks, or libraries.
c. Taxation
- placing taxes on certain goods to discourage use and internalize external costs. For example,
placing a ‘sin-tax’ on tobacco products, and subsequently increasing the cost of tobacco
consumption.
d. Subsidies
- reducing the price of a good based on the public benefit that is gained. For example, lowering
college tuition because society benefits from more educated workers. Subsidies are most
appropriate to encourage behavior that has positive externalities.
e. tradable permits
- permits that allow firms to produce a certain amount of something, commonly pollution. Firms
can trade permits with other firms to increase or decrease what they can produce. This is the
basis behind cap-and-trade, an attempt to reduce of pollution.
f. extension of property rights
- creates privatization for certain non-private goods like lakes, rivers, and beaches to create a
market for pollution. Then, individuals get fined for polluting certain areas.
g. advertising
- encourages or discourages consumption.
h. international cooperation among governments
- governments work together on issues that affect the future of the environment.

Government Intervention

The government can respond to externalities in two ways. The government can use command-and-
control policies to regulate behavior directly. Alternatively, it can implement market-based policies such
as taxes and subsidies to incentivize private decision makers to change their own behavior.
a. Command-and-control regulation
- can come in the form of government-imposed standards, targets, process requirements, or
outright bans. Such measures make certain behaviors either required or forbidden with the goal
of addressing the externality. For example, the government may make it illegal for a company to
dump certain chemicals in a river. By doing so, the government hopes to protect the environment
or other companies or individuals that use the river that would otherwise suffer a negative
impact.
b. Market-based policies
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 - use markets, price, and other economic variables to provide incentives for polluters to reduce or
eliminate negative environmental externalities. This seek to address the market failure of
externalities (such as pollution) by incorporating the external cost of production or consumption
activities through taxes or charges on processes or products, or by creating property rights and
facilitating the establishment of a proxy market for the use of environmental services.

PUBLIC GOODS AND COMMON RESOURCES

There are four categories of goods in economics, which are defined based on two attributes.
1. Excludability, or whether people can be prevented from using the good.
2. Rivalrousness, whether a good is rival in consumption: whether one person’s use of the good
reduces another person’s ability to use it.

National defense provides an example of a good that is non-excludable. Our country’s national defense
establishment offers protection to everyone in the country. Items on sale in a store, on the other hand,
are excludable. The store owner can prevent a customer from obtaining a good unless the customer pays
for it. National defense also provides an example of a good that is non- rivalrous. One person’s
protection does not prevent another person from receiving protection. In contrast, shoes are rivalrous.
Only one person can wear a pair of shoes at a time.

Combinations of these two attributes create four categories of goods:

Private goods:
- Private goods are excludable and
rival. Examples of private goods
include food, clothes, and
flowers. There are usually limited
quantities of these goods, and
owners or sellers can prevent
other individuals from enjoying
their benefits. Because of their
relative scarcity, many private
goods are exchanged for
payment.
Common goods: 
- Common goods are non-excludable and rival. Because of these traits, common goods are easily
over-consumed, leading to a phenomenon called “tragedy of the commons. ” In this situation,
people withdraw resources to secure short-term gains without regard for the long-term
consequences. A classic example of a common good are fish stocks in international waters. No
one is excluded from fishing, but as people withdraw fish without limits being imposed, the
stocks for later fishermen are depleted.
Club goods: 
- Club goods are excludable but non-rival. This type of good often requires a “membership”
payment in order to enjoy the benefits of the goods. Non-payers can be prevented from access to
the goods. Cable television is a classic example. It requires a monthly fee, but is non-rival after
the payment.
Public goods: 
- Public goods are non-excludable and non-rival. Individuals cannot be effectively excluded from
using them, and use by one individual does not reduce the good’s availability to others.
Examples of public goods include the air we breathe, public parks, and street lights. Public goods
may give rise to the “free rider problem. ” A free-rider is a person who receives the benefit of a
good without paying for it. This may lead to the under-provision of certain goods or services.

PRIVATE GOOD
- Private good is defined as an asset that is both excludable and rivalrous. It is excludable in that it is
possible to exercise private property rights over it, preventing those who have not paid from using
the good or consuming its benefits. For example, person A may have the means and will to pay $20
for a t-shirt. Person B may not wish to pay $20 or may not be able to do so. Person B would not be
able to purchase the t-shirt. Additionally, the private good is rivalrous in that its consumption by one

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 person necessarily prevents consumption by another. When person A purchases and drinks a bottle
of water, the same bottle of water is not available for person B to purchase and consume.
- A private good is a scare economic resource, which causes competition for it. Generally, people have
to pay to enjoy the benefits of a private good. Because people have to pay to obtain it, private goods
are much less likely to encounter a free-rider problem than public goods. Thus, generally, the market
will efficiently allocate resources to produce private goods.
- In daily life, examples of private goods abound, including food, clothing, and most other goods that
can be purchased in a store. Take an example of an ice cream cone. It is both excludable and
rivalrous. It is possible to prevent someone from consuming the ice cream by simply refusing to sell
it to them. Additionally, it can be consumed only once, so its consumption by one individual would
definitely reduce others’ ability to consume it.

PUBLIC GOOD
- Public good is a good that is both non-excludable and non-rivalrous. This means that individuals
cannot be effectively excluded from its use, and use by one individual does not reduce its availability
to others. Examples of public goods include fresh air, knowledge, lighthouses, national defense,
flood control systems, and street lighting.
- Public goods can be pure or impure. Pure public goods are those that are perfectly non-rivalrous in
consumption and non-excludable. Impure public goods are those that satisfy the two conditions to
some extent, but not fully.
- The production of public goods results in positive externalities for which producers don’t receive full
payment. Consumers can take advantage of public goods without paying for them. This is called the
“free-rider problem. ” If too many consumers decide to “free-ride,” private costs to producers will
exceed private benefits, and the incentive to provide the good or service through the market will
disappear. The market will thus fail to provide enough of the good or service for which there is a
need.
- For example, a local public radio station relies on support from listeners to operate. The station holds
pledge drives several times a year, asking listeners to make contributions or face possible reduction
in programming. Yet only a small percentage of the audience makes contributions. Some audience
members may even listen to the station for years without ever making a payment. Those listeners
who do not make a contribution are “free-riders. ” If the station relies solely on funds contributed by
listeners, it would under-produce programming. It must obtain additional funding from other sources
(such as the government) in order to continue to operate.

The Problem of Free-rider

- The free-rider problem is when individuals benefit from a public good without paying their share
of the cost. It is easy to think about public goods as free. In your everyday life, you benefit from
public goods such as roads and bridges even though no transaction occurs when you use them.
However, even public goods need to be paid for. In the case of roads and bridges, everyone pays
taxes to the government, who then uses the taxes to pay for public goods.
- Public goods, as you may recall, are both non-rivalrous and non-excludable. It is the second trait-
the non-excludability- that leads to what is called the free-rider problem. The free-rider problem
is that some people may benefit from a public good without paying their share of the cost.
- Since public goods are non-excludable, free-riders not only can’t be prevented from using the
good, but actually have an incentive to continue to free-ride. If they will be able to use the public
good whether they pay their share of the costs, they might as well not pay. Take the military, for
example. National security is a public good: it is both non-rivalrous and non-excludable. In order
to have such a public good, everyone pays taxes which are then used by the government to
finance the military. However, there are undoubtedly people who have not paid their taxes.
These people, without having paid their share of the cost of having a military, still benefit from
the protection the military provides. They are free-riders.
- Of course, there are commonly regulations that attempt to discourage free-riding. For
government-provided public goods, the government makes sure that everyone pays their share of
the costs by enforcing tax laws. The threat of fines or jail time are enough of a threat that most
people find it more appealing (in the US, at least) to pay their share of public goods via taxes
than to free-ride.

COMMON GOODS

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- Common goods are goods that are rivalrous and non-excludable. This means that anyone has access
to the good, but that the use of the good by one person reduces the ability of someone else to use it.
A classic example of a common good are fish stocks in international waters; no one is excluded from
fishing, but as people withdraw fish without limits being imposed, the stocks for later fishermen are
potentially depleted.

The tragedy of the commons

- The tragedy of the commons is the depletion of a common good by individuals who are acting
independently and rationally according to each one’s self-interest. Consider, the example of fish
in international waters. Each individual fisherman, acting independently, will rationally choose
to catch some of the fish to sell. This makes sense: there is a resource that the fisherman is able
to use to generate a profit. However, when a lot of fishermen, all thinking this way, catch the
fish, the total stock of fish may be depleted. When the stock of fish is depleted, none of the
fishermen are able to continue fishing, even though, in the long run, each fisherman would have
preferred that the fish not be depleted. The tragedy of the commons describes such situations in
which people withdraw resources to secure short-term gains without regard for the long-term
consequences.
- Not all common goods, however, suffer from the tragedy of the commons. If individuals have
enlightened self-interest, they will realize the negative long-term effects of their short-term
decisions. This would be the same as the fishermen realizing that they should limit their fishing
to preserve the stock of fish in the long-term.
- In the absence of enlightened self-interest, the government may step in and impose regulations or
taxes to discourage the behavior that leads to the tragedy of the commons. This would be like the
government imposing limits on the amount of fish that can be caught.

CLUB GOODS
- Club goods include, cinemas, cable television, access to copyrighted works, and the services
provided by social or religious clubs to their members. 
- Public goods with benefits restricted to a specific group may be considered club goods. For example,
expenditures that benefit all of the children in a household but not the adults. The existence of club
goods for children may offset the effects of sibling competition for private investments in larger
families. While a large number of children in a family would usually reduce private investment
ratios per child, due to competition for resources, the effects of a larger family on club goods are not
as straightforward. 
- For example, a person may not use a swimming pool very regularly. Therefore, instead of having a
private pool, you become member of a club pool. By charging membership fees, every club member
pays for the pool, making it a common property resource, but still excludable, since only members
are allowed to use it. Hence, the service is excludable, but it is nonetheless nonrival in consumption,
at least until a certain level of congestion is reached. The idea is that individual consumption and
payment is low, but aggregate consumption enables economies of scale and drives down unit
production costs.

References/suggested readings:
 Microeconomics, 8th Edition, Robert S. Pindyck and Daniel L. Rubinfeld
 Lecture Notes on the Principles of Microeconmics 3rd Edition (2011), Erick Doviak
 The Principle of Microeconmics, 5th Edition (2020), N. Gregory Mankiw
 An Introduction to Game Theory (2007), Levent Kockesen and Efe

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