Capitulos Guia

Block 4: Consumer choice
Introduction
This block introduces another two fundamental concepts in
microeconomics: indifference curves and the budget constraint. Indifference
curves illustrate a consumer’s preferences, while the budget constraint
shows what it is possible for them to consume, given a limited budget and
the prices they face. Put together, these concepts are used to determine the
consumer’s consumption decisions. In this way, we can see how the demand
curves you learned about in Block 2 are derived.
After studying the demand curve in Block 2, it is important to realise that
this curve is the direct result of the assumptions of rationality and individual
decision making as discussed in Block 1. This block, on consumer choice,
draws on the idea of opportunity cost as well as individual preferences to
derive the demand curve.
You will need a good understanding of the intuition behind the models
in this block. It is important that you gain a good grasp of them, because
we use an equivalent set of concepts in analysing how firms make their
production decisions (Block 5), and they are also used to determine
household’s labour supply (Block 10). As well as this, you will also need
to practise drawing the graphs in this chapter, since they will help to
understand the concepts, and since you may need to be able to reproduce
them for your exam. In particular, practise drawing the income and
substitution effects for normal and inferior goods, since many of the key
concepts are summarised in these graphs.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• define the relationship between utility and tastes for a consumer
• describe the concept of diminishing marginal utility
• describe the concept of diminishing marginal rate of substitution and
calculate the marginal rate of substitution (MRS)
• represent tastes as indifference curves
• derive a budget line
• explain how indifference curves and budget constraints explain
consumer choice
• describe how changes in consumer income affect quantity demanded
• describe how a price change affects quantity demanded
• define income and substitution effects
• show how the market demand curve relates to the demand curves of
individual consumers.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 5 including the appendix.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapter 3; UK edition, Chapter 4.
Witztum (AW), Chapter 2.
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EC1002 Introduction to economics
Synopsis of this block

The chapter starts by introducing the concept of utility, and the
assumptions that are commonly made by economists about utility. It then
explains indifference curves and the budget constraint and shows how
these are combined to determine the consumer’s choices. The impact of
changes in the consumer’s income and changes in price are examined in
detail, including the decomposition of the effects of price changes into
income and substitution effects. The chapter also demonstrates how
these ideas are used to derive the individual demand curve, and then the
market demand curve. The relationship to elasticity, particularly cross-
price elasticity, is also discussed. Finally, the chapter explores whether the
consumer benefits more from cash transfers or transfers in kind.
Consumer choice and demand decisions

► BVFD: read section 5.1 and concepts 5.1 and 5.2 of Chapter 5.
Utility
The concept of ‘utility’ was introduced by Jeremy Bentham, in his 1789
book Principles of morals and legislation. He defined it as follows: ‘By utility
is meant that property in any object, whereby it tends to produce benefit,
advantage, pleasure, good, or happiness, (all this in the present case comes
to the same thing) or (what comes again to the same thing) to prevent the
happening of mischief, pain, evil, or unhappiness to the party whose interest
is considered.’ The philosophy of ‘utilitarianism’ (the ‘greatest happiness
principle’) was invented by Bentham and has been very influential. The
textbook defines utility much more simply as ‘the satisfaction consumers
get from consuming goods’ (p.84). As you can read in the appendix to
Chapter 5, in the 19th century, economists believed that utility levels could
be measured, and used a unit of measurement called ‘utils’. Nowadays,
economists assume that utility is not measurable in this way, however, utility
is still a useful concept that underlies much of microeconomics.
Marginal utility
As discussed in Block 1, consumers and firms make decisions at the
margin. This idea is very important in relation to utility. The marginal
utility of a good or service is the extra utility a person gains from
consuming one more unit of that good or service.
Activity SG4.1
Linking the shape of the indifference curves to the assumptions regarding consumer tastes.
The various assumptions that lie behind indifference curves are reflected in certain
aspects of the shape of the curve. Match the assumption to the characteristic of the curve
and explain why.
Diminishing marginal rate of substitution Lines never cross

Consumers prefer more to less Any bundle is on some
(non-satiation) indifference curve
Completeness Indifference curves convex to the
origin (ICs look like ‘smiles’ when
seen from the origin)
Transitivity Downward sloping
The meaning and representation of preferences and hence the assumptions behind
indifference curves are discussed in detail in AW section 2.2.2.
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The slope of the indifference curve is the marginal rate of

substitution
The marginal rate of substitution (MRS) between two goods, as you know
from the definition on p.86, measures the quantity of a good the consumer
must sacrifice to increase the quantity of the other good by one unit
without changing total utility. On p.88, in the paragraph discussing how
the slope of a typical indifference curve gets steadily flatter as we move to
the right, there is an important gem of information: ‘The marginal rate of
substitution … is simply the slope of the indifference curve’. On the graph
below, the tangent T shows the slope of the indifference curve and the
MRS at point b.1 1
Some textbooks define
the MRS as the slope of
The figure and table below are analogous to L&C international edition: the indifference curve,
Figure 3.2 and Table 3.2; UK edition: Figure 4.2 and Table 4.2, where that is as a negative
you can also find a good explanation of these concepts. The MRS is the quantity, others as the
absolute value of the ratio of the change in clothing to the change in food. ‘absolute value’ of the
Since these two changes always have opposite signs, the MRS (slope of an slope (i.e. as a positive
quantity). This is simply
indifference curve) is obtained by multiplying ΔC/ΔF by –1.
a matter of convention
and it doesn’t matter
which convention is
followed, as long as one
is consistent.
35
30 a
Clothing
25
20 b
15 c
d e
10 f
T
5
0 5 10 15 20 25 30 35
Food
Figure 4.1: The marginal rate of substitution is the slope of the indifference
curve.
Movement Change in clothing Change in food Marginal rate of substitution

From a to b –12 5 (–12/5)*–1 = 2.4
From b to c –5 5 (–5/5)*–1 = 1.0
From c to d –3 5 (–3/5)*–1 = 0.6
From d to e –2 5 (–2/5) * –1 = 0.4
From e to f –1 5 (–1/5) * –1 = 0.2
Table 4.1
You should remember from Block 3 that Δ (delta) means change.
Examining the movement from a to b and b to c etc. gives us a good
approximation of the slope of various sections of the curve. An even more
accurate way is to examine the change in utility due to a one unit change
in either of the goods: this gives us the marginal utility of each good at
a point on the curve. In fact, the MRS is given by –MUC/MUF, (i.e. the
marginal utility of clothing at a certain point on the indifference curve,
divided by the marginal utility of food at that point, multiplied by –1).
We will come back to this again at the end of the block (as it is covered in
more detail in the third part of the appendix and Maths A5.1).
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Figure 5.5 on p.90 of BVFD also helps to illustrate this idea, showing
indifference curves for people with different tastes. The glutton is more
willing to substitute films for food than the weight-watching film buff and
has a higher MRS. Drawing a tangent to any part of their indifference
curves shows that the slope of the gluttons indifference curve is steeper –
reflecting his higher MRS between meals and films.
The slope of a typical indifference curve gets steadily flatter as we move to
the right, reflecting a diminishing marginal rate of substitution.
For example:
Clothing
A
b
Food
Figure 4.2: Changes in the slope of an indifference curve reflect a diminishing
marginal rate of substitution.
The slope of the tangent A shows the MRS of food for clothing at point a.
Similarly, the slope of the tangent B shows the MRS at point b. We can see
that the slope flattens as we move from a to b, reflecting a diminishing
MRS. At point a, the person has quite a lot of clothing and is willing to
substitute a fair bit of this for a certain amount of food. At point b, the
person has much less clothing but quite a lot of food and is only willing
to substitute a very small amount of clothing to gain the extra amount of
food. Going back to table 4.1, you can also see the diminishing MRS, as
the amount of clothing the person is willing to substitute for 5 additional
units of food continues to fall.
Activity SG4.2
Draw a map of indifference curves, marking out bundles and comparing them to each
other based on the following story: Mark likes jeans and cowboy boots. He is indifferent
between a bundle with 3 pairs of jeans and 2 pairs of cowboy boots (bundle A) and
a bundle with 2 pairs of jeans and 4 pairs of cowboy boots (bundle B). However, he
would prefer to have a bundle with 4 pairs of jeans and 5 pairs of cowboy boots (bundle
C). He is also indifferent between a bundle with 2 pairs of jeans and 1 pair of cowboy
boots (bundle D) and a bundle of 1 pair of jeans and 3 pairs of cowboy boots (bundle
E), although these last two options are his least preferred options. How do you think he
would feel about a bundle with 3 pairs of jeans and 3 pairs of cowboy boots?
Remember:
•• An indifference curve shows all the consumption bundles yielding a particular level of
utility.
•• Any point on a higher indifference curve is preferred to any point on a lower
indifference curve.
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Indifference map
Budget constraint
Activity SG4.3
The slope depends only on the relative prices of the two goods. Draw budget constraints
for the following three price combinations, assuming a total income of £120.
A: PX = £12
PY = £20
B: PX = £10
PY = £20
C: PX = £12
PY = £15
What is the interpretation of the slope of the budget constraint? It

represents the rate at which the consumer can substitute good x for good
y in the market, or the opportunity cost of x in terms of y. To see this,
suppose the consumer wishes to consume a little more x, ∆x. This will
cost her ∆xPx. Assuming she was spending all her income on x and y (on
her budget line) then she will have to reduce her expenditure on y by the
same amount. So ∆xPx=-∆yPy, (i.e. the slope ∆y/∆x=–Px/Py).
► BVFD: read Maths 5.1.
You should be familiar with the general form of the budget constraint used
in this section, (i.e. where pX is the price of good X, pY the price of good Y, x
the quantity of good X, y the quantity of good Y and M the money income
available to the consumer). Note that the first term on the left-hand side
of this equation is the consumer’s expenditure on X and the second term
is expenditure on Y. Since we assume that the consumer spends all her
income on these two goods, the amount spent on the two goods sums up
to M which is her income. One important point from this Maths box is that
the slope of the budget constraint is given by –pX /pY i.e. the price ratio.
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The figure in this Maths box shows how you can represent a general case,
where you don’t have specific quantities and prices. The intercepts will
then be M/PY and M/PX respectively. This is likely to be how you will draw
a budget constraint most often.
Utility maximisation and choice

Indifference curves and the budget constraint together indicate the
choice a consumer will make to maximise their satisfaction. This can be
represented by the following diagram:
Step 1 Step 2
Preferences Budget Constraint
(What the individual wants to do) (What the individual can do)
Step 3
Decision
(Taking constraints into account, the individual attempts
to reach the highest level of satisfaction)
Figure 4.3: Consumer choice and the decision rule.
Decision rule
The point which maximises utility is the point at which the consumer
reaches the highest indifference curve that the budget constraint allows.
For the ‘standard’ indifference curves we have been looking at, this
decision rule says that the consumer should choose the consumption
bundle where the slope of the budget line and the slope of the indifference
curve coincide. In other words, it is the point at which the indifference
curve is tangent to the budget constraint.
► BVFD: read the first part of the appendix for Chapter 5 of, the material in
the appendix applies whether or not utility can actually be measured.
We can describe the consumer’s optimal decision using equations as

follows: At the chosen bundle, the marginal rate of substitution between
the two goods must equal their relative price, i.e. MRS =–MUx/MUy =–Px/
Py . Rearranging this gives MUX/PX= MUY/PY .
We can also describe their decision graphically, as follows: The consumer
choses the bundle where the indifference curve is tangent to their budget
constraint. The slope of the indifference curve (MRS = –MUx/MUy) and
the slope of the budget constraint (–Px/Py )must be equal. The tangency
thus implies –MUx/MUy = –Px/Py . Rearranging this gives MUX/PX=MUY/PY.
52
Good Y
M/Py
u0
M/Px Good X
Figure 4.4: A budget constraint and an indifference curve.
MUX/PX=MUY/PY has the intuitive interpretation that the marginal utility
derived from the last pound spent on X must be equal to the marginal
utility of the last pound spent on Y. Otherwise the consumer would adjust
their consumption pattern and increase their utility.
Imagine that MUX/PX > MUY/PY. This implies that the consumer derives
more utility from the last pound spent on good X than the last pound spent
on good Y. In this case, by consuming one pound more of good X and one
pound less of good Y, they can increase their utility level without spending
any more money. The consumer should continue to adjust their spending
in this way until MUX/PX=MUY/PY.
It is important to understand the intuitive explanation of the consumer’s
decision, as well as being familiar with the relevant equations and graphs.
Activity SG4.4
Jeremy has £M and wants to buy some combination of books and shoes. Books cost PB
each and shoes cost PS per pair. Both of these goods are normal goods to him. Describe
graphically and in equations how he will decide on an optimal combination of the two
goods which will maximise his total utility. What is the intuition behind this?
► BVFD: read section 5.2.
53
Activity SG4.5
Draw budget constraints and possible indifference curves for the following scenario:
Susan buys cabbages and carrots. Cabbages cost £1 per kilo and carrots cost £0.80 per
kilo. Her income falls from £20 to £16. Carrots are a normal good, but cabbages are an
inferior good.
► BVFD: read section 5.3 and cases 5.1 and 5.2.
Activity SG4.6
Page 98 contains a suggestion of two diagrams you should draw to check your
understanding, complete this in the boxes below:
A fall in the price of meals An increase in the price of films
Income and price changes

Substitution and income effects
Decomposing the effects of a price change into income and substitution
effects is an important piece of economic analysis with many real world
applications. Case 5.1 shows one such application; others relate to the
effects of changes in wages on labour supply and changes in interest rates
on savings decisions. Remember:
• The substitution effect is always negative.
• The income effect is negative for normal goods and positive for inferior
goods.
• For normal goods, the income and substitution effects reinforce each
other.
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• For inferior goods, the income and substitution effects work in

opposite directions.
• For inferior goods, if the income effect dominates the substitution
effect, the good is called a Giffen good (in practice, these are very
rare).
Activity SG4.7
For a choice between Good X and Good Y, complete the graphs below, clearly indicating the
income and substitution effects in each case. You will find figures 5.14 and 5.16 helpful for
this activity, and you might want to repeat it a few times on a separate sheet of paper until
you are really comfortable with these concepts. The following order is generally best:
1. Draw the original budget line and indifference curve.
2. Draw the new budget line.
3. Draw the hypothetical budget line parallel to the new budget line and tangent to the
original indifference curve. This gives you the substitution effect.
4. Draw the new indifference curve (where you place this depends on what type of good it
is). This gives you the income effect.
Normal goods, price of X rises Inferior good, price of X rises
Normal goods, price of X falls Inferior good, price of X falls
NB: The method used in the textbook and in this activity to break a price change into
income and substitution effects follows an approach suggested by the economist John Hicks
and the effects are known as the Hicksian substitution and income effects. There is also an
alternative approach following the economist Eugen Slutsky. If you are interested to know
more about this, it is explained in AW 2.3.1. However, you are only required to know the
Hicksian approach (as in BVFD) for this course.
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Deriving demand: ‘The individual demand curve’

In Block 2 we introduced demand and supply and learned about the
demand curve. Now we are able to derive the individual demand curve
from the choices of consumers.
Activity SG4.8
Derive the individual demand curve from the information in figure A. Can you now explain
why the demand curve is downward sloping?
A
Sunglasses
(Price per sandwich = p1)
e4 Price-consumption curve
e3
e2
e1 (Price per sandwich = p3)
0 x1 x2 x3 x4 Sandwiches
B
Price per Sandwich
0 Sandwiches
Figure 4.5: Deriving the individual demand curve.
► BVFD: read the second part of the appendix: deriving demand curves.
This explains why, for normal goods, a fall in price leads to an increase in quantity
demanded, due to both substitution and income effects.
Demand curves and consumer surplus

We have now shown the theoretical underpinnings of a downward sloping
demand curve. In particular we have gone beyond general statements such
as ‘at lower prices existing consumers want to purchase more and new
consumers enter the market’ and shown that at each point on the demand
MU
curve consumers are maximising their utility by equating their MRS ( MU ) x
y
P
with the relative price ( P ) where x is the good on the horizontal axis and
x
y the good on the vertical axis. This enables us to give further intuition to
the price at any given quantity and to the whole demand curve.
56
To do this, we can put some numbers on a given utility maximising point

corresponding to a set of prices for x and y and a given income. For
example, let Px = £4, Py = £2 and income = 40. This is shown on the
diagram below. This diagram shows the consumer’s utility maximising
combination of x and y (x1, y1) at A in the upper panel and the demand
for x at Px = £4, Py = £2, M = £40 in the lower panel. How much is an
extra unit of x worth to the consumer at A/? At A, due to the tangency,
MRS = –2. This means our consumer would give up 2 units of y in order
to have another unit of x – that is the meaning of MRS = –2; one unit of
x has the same value to her as 2 units of y. Since y costs £2 per unit, two
units of y are worth £4, an extra unit of x must also be worth £4 as an
extra unit of x is worth the same as two units of y at A. Another way of
saying this is that at A and A/ the consumer’s willingness to pay for
another unit of x is £4. So price can be interpreted as the willingness to
pay for an extra unit of the good, given income and prices of other goods.
Similarly, the demand curve can be interpreted as a willingness to pay
curve (its downward slope implying that the more x the consumer has, the
lower her willingness to pay for an extra unit). Although we do not do the
mathematics here, you can see intuitively that because price at a given x
represents the willingness to pay for a marginal unit of x, the area under
the demand curve up to that level of x shows the total willingness to
pay for that amount (the sum of the willingness to pay for each separate
unit). This also makes it easier to see that the consumer surplus (a concept
introduced in Block 2) at any given price and quantity is the difference
between the total willingness to pay for that amount minus what is
actually paid – the prevailing price times the quantity.
y
20 At A, MRS = −Px/Py = −4/2 = −2
y1 A
Indifference curve
x
x1 10
Px
4 A/
Demand curve for x
x1 x
Figure 4.6: Willingness to pay and consumer surplus.
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Deriving demand: ‘The market demand curve’

The market demand curve is the horizontal addition of the demand curves
of all the individuals in that market. In the following activity we assume
that there are only three consumers, but the method can be applied to
much larger numbers; in such cases kinks in the market demand curve
would tend to be smoothed out.
Activity SG4.9
Complete the fourth graph, showing the market demand curve. Why might the three
consumers have different demand curves?
PRICE
PRICE
PRICE
PRICE
Consumer 1 Consumer 2 Consumer 3 Market demand
12 12 12 12
8 8 8 8
4 4 4 4
0 7 2 4 6 5 10
Figure 4.7: Deriving the market demand curve.
Complements and substitutes

► BVFD: read section 5.5 of and the part of 5.3 which addresses cross-
price elasticities of demand.
The section on complements and substitutes (section 5.5) introduces the

fact that goods are not always substitutes for each other, but may in fact be
complements. This means that if the demand for a good rises, the demand
for other complementary goods will rise as well.
You will remember from Block 3 that cross-price elasticities are negative
when two goods are complements and positive when two goods are
substitutes. The section on cross-price elasticities (in section 5.3) details
three factors which impact on income and substitution effects and can
make the cross-price elasticity for good Y either positive or negative
(responding to a change in the price of good X). These are: whether the
two goods are good substitutes for each other; the income elasticity of
demand of good Y; and good Y’s share of the consumer’s total budget.
This section also shows that not all indifference curves are convex to the
origin as in Figures 5.2 and 5.3 of BVFD. How well the two goods can
be substituted for each other is reflected in the shape of the indifference
curves as follows:
• Figure 5.20, LHS – perfect substitutes – indifference curves are straight
lines – full substitution from one to the other if the price of one good
falls below the price of the other good.
• Figure 5.18 – good substitutes – indifference curves are quite flat –
large substitution effect of a price change.
• Figure 5.17 – poor substitutes – indifference curves are very curved –
small substitution effect of a price change.
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• Figure 5.20, RHS – perfect complements – indifference curves are

perpendicular lines – no substitution effect of a price change, the
consumer will consume more (or less) of both in the same proportion.
Activity SG4.10
Draw the indifference curves for perfect complements together with a budget line. Now
draw a new budget line for a change in the price of one of the goods. Indicate the income
and substitution effects (if any) of the price change.
Perfect complements
Activity SG4.11
Barbara likes peanut butter and jam together on her sandwiches. However, Barbara is very
particular about the proportions of peanut butter and jam. Specifically, Barbara likes 2
scoops of jam with each scoop of peanut butter. The cost of ‘scoops’ of peanut butter and
jam are 50p and 20p, respectively. Barbara has £9 each week to spend on peanut butter
and jam. (You can assume that Barbara’s mother provides the bread for the sandwiches.)
If Barbara is maximising her utility subject to her budget constraint, how many scoops of
peanut butter and jam should she buy?
Activity SG4.12
Suppose that a consumer considers coffee and tea to be perfect substitutes, but he requires two
cups of tea to give up one cup of coffee. This consumer’s budget constraint can be written as 3C
+ T = 10. What is this consumer’s optimal consumption bundle?
Cash transfers versus transfers in kind

Figure 4.8 below replicates Figure 5.21 from the textbook, but includes
indifference curves for the case where the consumer starts at e’. If the
consumer receives a cash transfer, they may move to point c, where their
utility level is indicated by the curve u1. However, if they receive food
stamps (a transfer in kind), they cannot choose point c, and may move
instead to the feasible point B. At point B, their utility level is indicated by
the curve u0. This is clearly lower than the utility level the consumer could
have reached with a cash transfer. Furthermore, point B is not a tangency
solution: the slope of the indifference curve is not equal to the slope of the
budget constraint. This shows that non-tangency solutions may sometimes
arise from government policy, and also reaffirms the conclusion made
by the textbook: ‘In so far as people can judge their own self-interest …
people are better off, or at least no worse off, if they get transfers in cash
rather than transfers in kind’ (p.108).
59
Films c
u1
A u0
B
e’
F F’ Food
Figure 4.8: Transfers in cash and in kind. Figure adapted by author from BVFD.
► BVFD: read Appendix part 3 and Maths A5.1.
The section of the appendix entitled ‘ordinal utility and indifference

curves’ introduces utility functions. As is written, although no one
really knows anyone’s utility function for any good, expressing utility
numerically through a utility function can be very useful. The maths
box shows how marginal utility can be found using the delta notation
or calculus. If you are familiar with calculus, you may find this makes
marginal analysis much easier. However, it is also possible to use the delta
notation to find marginal utility, or else this will be given to you, as per the
activity below.
Activity SG4.13
Calculate the optimal quantity of each of two goods (x and y) and the consumer’s total
utility given px = 1, py = 2, M = 80, and U(x,y) = xy, where MUx = y and MUy = x. How
would you represent this graphically?
► BVFD: read the summary and work through the review questions in
Chapter 5.
Overview
This block started by introducing utility and indifference curves, as
well as the budget constraint. Indifference curves represent consumer
tastes, while the budget constraint shows the possibilities open to the
consumer, given their limited budget. Putting these together, we learned
the decision rule that determines consumer choice, under the assumption
that consumers maximise utility. In particular, we saw that consumers
will chose the bundle of goods such that MUX/PX = MUY/PY. Expressed
graphically, this means that the highest reachable indifference curve is
tangent to the budget constraint. We then explored how their choices are
affected by changes in income and prices, looking in particular at income
and substitution effects of a price change. This helped us identify normal
and inferior (and Giffen) goods. We also further examined complements
and substitutes. Understanding how consumers make choices lets us see
what lies behind the – individual and market – demand curves. Finally, the
analysis of budget constraints and indifference curves also made it possible
to evaluate the relative benefits of cash transfers versus transfers in kind.
60
Reminder of your learning outcomes

Now go back to the list of learning outcomes at the start of the block and
be sure that they have been achieved
Sample examination questions

Multiple choice questions
For each question, choose the correct response:
1. The price of car transport is 30 cents per mile. The price of bus
transport is 60 cents per mile. The marginal utility of Mario’s last mile
of car transportation is 80 utils, and the marginal utility of his last mile
of bus transportation is 150 utils. Hence:
a. Mario is currently maximising his utility.
b. Mario could increase his utility by decreasing his consumption of
car transportation.
c. Mario could increase his utility by increasing his consumption of
car transportation.
2. If an agent has a utility function of the form u(x,y)=xy then:
a. They will be indifferent between (6,4) and (3,8).
b. They will prefer (6,4) over (5,5).
c. They will be indifferent between (6,4) and (5,5).
d. None of the above.
3. The slope of the demand for an inferior good is steeper than that of a
normal good because:
a. Income and substitution effects enhance each other.
b. Substitution effect for a normal good is greater than that of an
inferior good.
c. Income effect of a normal good is smaller in magnitude (absolute
value) than the income effect of an inferior good.
d. Income and substitution effects offset each other.
4. Judith spends all her money buying wine and cheese and wants to
maximise her utility from consuming these two goods. The marginal
utility of the last bottle of wine is 60, and the marginal utility of the
last block of cheese is 30. The price of wine is £3, and the price of
cheese is £2. Judith:
a. is buying wine and cheese in the utility-maximising amounts
b. should buy more wine and less cheese
c. should buy more cheese and less wine
d. is spending too much money on wine and cheese.
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Long-response questions
1. a. Susan buys bread rolls and cheese. One bread roll costs £1 and
cheese costs £3 per 500g block. Susan has £12 income to spend on
bread and cheese.
i. Draw Susan’s budget constraint and a possible indifference
curve. Explain the assumptions behind the shape of the
indifference curve you have drawn.
ii. If the price of bread falls to £0.80 per loaf, how will this affect
her purchases? Answer in words and graphically, clearly
indicating income and substitution effects of the price change.
iii. If Susan only enjoys bread and cheese when she has 500g of
cheese for every bread roll that she eats, draw her indifference
curves. How much bread and cheese should she buy to
maximise her utility? Assume Susan has £12, one bread roll
costs £0.80 and cheese costs £3 per 500g block.
b. Now let’s assume that Susan grows 100 potatoes each year and
all of her income comes from selling them. She spends all of her
income each year consuming potatoes and other goods. For Susan,
potatoes are a Giffen good, in that if her income is fixed in some
way (i.e. ignoring the fact that she sells potatoes and just fixing her
income at some value) her consumption of potatoes will rise when
their price rises. The price of potatoes falls and she consumes more
potatoes. Taking into account the fact that her income actually
comes from selling potatoes, explain how the last statement can be
consistent with those that precede it.
2. I consume two goods, ice cream and biscuits. I shop once a week,
spending £100, at either Sainsbury or Tesco (two well-known UK
supermarkets). Interestingly, I’ve noticed that the bundle I purchase
when I visit Tesco costs more at Sainsbury. Similarly, the bundle I
purchase when I visit Sainsbury costs more at Tesco. And yet, I find
that I get the same utility from shopping at either store (i.e. the
Sainsbury shopping bundle gives me the same utility as the Tesco
shopping bundle). Explain how it is possible for all of these statements
to be true. (Hint: draw a single indifference curve and have me
maximise utility given a £100 budget and different prices in the two
stores).
62
Block 5: The Firm I
Block 5: The Firm I
Introduction
The two most important concepts in microeconomics are demand and
supply. In the previous block, we saw what lies behind the demand curve
and how this is driven by consumer preferences and the constraints
imposed by their budgets. In this and the following blocks, we will explore
what lies behind the supply curve. Basically, supply depends on the
technology available to firms, the cost of inputs, and the market structure
the firm operates in (e.g. the number of other sellers, which affects price
and revenue at each level of output). This block provides an introduction
to the analysis of the firm.
Many of the concepts introduced in this block are quite straightforward,
especially the early material in Chapter 6 of BVFD. Although you will need
to be familiar with this to have a context for the more detailed analysis, you
should concentrate your attention on the material from Chapter 7 (especially
the appendix) and the later parts of Chapter 6. Numerical examples are
provided in the block to help you calculate the firm’s optimal level of output.
You should also practise representing these concepts graphically.
Learning outcomes
• distinguish between economic and accounting definitions of cost
• describe the relationship between revenue, cost and profit
• describe the production function
• identify the point of diminishing marginal returns
• demonstrate how the choice of production technique depends on input
prices
• use isoquants and isocost curves to derive the firm’s total cost curve
• calculate marginal cost and marginal revenue
• find the profit maximising level of output, given the firm’s demand
curve and total cost curve.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 6; Chapter 7 sections
7.1, 7.2 and appendix.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapter 4; UK edition,
Chapter 5.

This block introduces the firm, including types of firms, the concept
of economic cost and how this differs from accounting cost, and the
arguments in favour of and against the frequently made assumption that
firms intend to maximise their profits. It examines why firms chose a
certain level of output, by firstly introducing the production function, as
well as isoquants and isocost curves (more on these later) and using them
63
to derive the firm’s total cost curve. It also shows how the demand curve
facing the firm can be used to derive the firm’s total revenue curve. Profit
is equal to revenue minus cost, thus through understanding the firm’s
revenue and costs, we can find the profit function. The block concludes by
introducing the concepts of marginal cost and marginal revenue. Providing
that it is profitable for the firm to operate at all, it will choose its level of
production such that marginal cost and marginal revenue are equal.
► BVFD: read section 6.1–6.3, including concepts 6.1 and 6.2 and case 6.1.
Introduction to the firm

Section 6.1 outlines the most common forms of business enterprises: sole
traders, partnerships and limited liability companies. Section 6.2 discusses
a firm’s accounts. If you have taken any accounting courses, you will be
familiar with these concepts, though here they are approached from an
economic perspective. In particular, the discussion of accounting profit
versus economic profit and the concepts of zero economic profit and
supernormal profit are especially important to understand. Section 6.3
introduces the principal agent problem. These sections provide useful
background knowledge to the economic analysis of the firm.
Activity SG5.1
What is the economic cost of studying for an undergraduate degree?
The firm’s supply decision

Section 6.4 briefly discusses cost, revenue and profit. Since it is assumed
that firms behave so as to maximise their profits, profit is the key variable
in the analysis of the firm, and profit is equal to revenue minus cost:
Profit = Revenue – Cost
Or in the notation frequently used in economics texts (including BVFD):
π = TR–TC
now total revenue is price per unit (P) multiplied by quantity sold (Q) so
we can write profit (π) as:
π = P*Q–TC
This section of the textbook looks at these three elements quite briefly, but
using some of the material in Chapter 7 and some additional graphs, we
will explore them in somewhat greater detail. At the end of the paragraph
on cost minimisation is a footnote pointing to the appendix of Chapter 7.
We will work through the appendix in detail, as this will allow us to derive
the firm’s total cost function. However, first we need an introduction to
the production function – this can be found in sections 7.1 and 7.2. After
working through some parts of Chapter 7 relating to cost, we will come
back to Chapter 6 to examine revenue and then use these two concepts
(cost and revenue) to find the firm’s profit function.
The production function

We begin with production. The hill-shaped structure depicted below is

the production set, the set of technically feasible combinations of output
64
Block 5: The Firm I
Q, measured vertically, and inputs, K and L on the horizontal plane.

It includes all the area on the surface and in the interior of the hill. A
technically efficient production decision will be a point ‘on’ the hill, while
points ‘in’ the hill represent technically inefficient production decisions
in the sense that the input combination corresponding to the point is
capable of producing more output. The production function Q= f(K, L)
is only the surface (and not the interior) of the hill, and denotes the set
of technologically efficient points of the production set (i.e. for a given
combination of inputs, K and L, output Q is the maximum feasible output).
The contours of the hill (i.e. the cross-sections of the ‘hill’ parallel to the
K-L plane) are comparable to the isoquants in the appendix of Chapter 7,
showing combinations of capital and labour that generate a given output.
The slope of the hill viewed from the origin represents returns to scale,
which will be explored in the next block. Note that the production function
as used by economists is a very simplified summary of the relationship
between inputs and output; an engineer setting up a production process
for mobile phones or motor cars (to use two examples from the textbook)
would have a much more detailed blueprint of the production process.
Output
Q=f (K,L)
Figure 5.1: The production set.
The total output curve (also known as the total product curve), shown in
Figure 7.2 of the textbook, is a reduced form of the production function
for the short-run, when only one input is allowed to vary and the other is
held fixed. We can find this curve by ‘slicing’ the hill in Figure SG5.1 above
vertically at the level K0. The reduced production function Q = ƒ (L, K0), is
thus a vertical section of the hill.
Activity SG5.2
Describe how the phrase ‘too many cooks spoil the broth’ can demonstrate the law of
diminishing returns.
65
► BVFD: read case 7.1 and Maths 7.1.
Activity SG5.3
Define the following terms and give a formula for (b) and (c):
a. total product
b. average product
c. marginal product.
Activity SG5.4
Complete the following table:
Quantity of Total Product Average Product Marginal Product

Labour (L) (TP) (AP) (MP)
1 129
2 480
3 1,053
4 1,800
5 2,625
6 3,456
7 4,116
8 4,608
9 4,968
10 5,250
11 5,445
12 5,580
The point where marginal product reaches a maximum is called the point of diminishing
marginal returns. At what quantity of labour does diminishing marginal returns set in?
Graph the Total Product curve in the upper section and the marginal and average product
curves in lower section of the boxes below:
66
Block 5: The Firm I
Isoquants and isocost lines

► BVFD: read the appendix to Chapter 7.
The appendix to Chapter 7 starts with isoquants. ‘iso’ (or ‘ίσο’ using Greek
letters) is a Greek word which means equal. Isoquant means equal
quantity, isocost means equal cost. An isoquant is very similar to an
indifference curve – while an indifference curve shows different
combinations of goods which generate a certain level of utility, an isoquant
shows different combinations of inputs which generate a certain output.
Read about isoquants on pp.166–67.
Activity SG5.5
Based on the production function: Q(L, K) = L0.5 * K0.5 , where Q is output, L is
labour and K is capital, fill in the blanks below and draw isoquants for the three output
levels on a large graph on a separate piece of paper, or using scatter plots in Excel.
(NB: remember x 0.5 = √x).
Output = 10 Output = 20 Output = 24

Labour Capital Labour Capital Labour Capital
1 – – 4
4 4 64
5 20 6.25 64 16
10 16 16
20 5 64 6.25 64
4 4
1 – – – –
On the isoquant reflecting an output level of 10 units – what is the MRS between labour
and capital when labour changes from 4 to 5 units?
To find the optimal combination of labour and capital, the second tool we
need to use is called the isocost line, the line showing all combinations of
labour and capital (these being our two inputs in the current example)
which generate the same total cost, given the prices of the two inputs–
read about the isocost line on pp.167–68. It is worth pointing out that
on p.167, the textbook uses the term ‘cost function’ for the C=wL+rK.
However, this term is usually reserved for the equation showing cost as a
function of output, not input. Given that there are only two inputs, L and K
with prices w and r respectively C=wL+rK is an identity (something that is
always true) – this is how we define total cost.
Activity SG5.6
If r = £2/hr and w = £12.50/hr, draw three isocost lines onto the diagram you created in
Activity SG5.4 for when cost is equal to £50; to £100; and to £150. What is the optimal
(i.e. the least-cost or cost-minimising) combination of labour and capital for an output
level of 10? What is the cost?
Equation A7 has an intuitive explanation, namely, that the firm must buy
resources such that the last pound spent on K adds the same amount of
output as the last pound spent on L. This can be easily seen by further
rearranging the equation such that:
–r/w = –MPK/MPL (A7)
–r/MPK = –w/MPL (A7b)
67
In the case of consumer choice, the budget line was fixed at the consumer’s
budget, and the consumer maximised their utility by choosing the
combination of goods which put them on the highest possible indifference
curve. For the firm, for a given level of output, the firm minimises cost by
choosing the combination of inputs that puts them on the lowest possible
isocost line. As such, the isoquants together with the isocost curve can be
used to derive the firm’s total cost function at different levels of output.
Read about this on p.168.
Activity SG5.7
Use the information below to draw isoquants and isocost lines and find four points on the
firm’s total cost curve.
Rental rate of capital = £2 per hour
Wage = £2 per hour
Cost levels: £12, £16, £20 and £24.
Output combinations:
Qx = 25 Qx = 50 Qx = 75 Qx = 100
Capital Labour Capital Labour Capital Labour Capital Labour
A 1 8 2 10 3 10 4 10
B 2 5 3 6 4 7 5 8
C 3 3 4 4 5 5 6 6
D 5 2 6 3 7 4 8 5
E 8 1 10 2 10 3 11 4
What is the slope of the isocost lines?

What is the MRS at the points where the isoquants are tangent to the isocost lines?
What does this imply about the firm’s total cost curve?
Productive efficiency
The fact that the total cost curve shows the least-cost method of producing
each output level implies that the points on the long-run total cost curve
are productive efficient. It is important to note that every point on a firm’s
average total cost curve is, by definition, productive efficient – not just the
minimum point. Productive efficiency occurs when a certain quantity of a
good is produced at the lowest possible input cost. Saying the same thing
in a different way – productive efficiency means that the firm is obtaining
the maximum possible output from its inputs.
Activity SG5.8
A firm Sam’s Lamps has the production function Q(L, K) = L*K. Given labour of 5
and capital of 7, are they producing efficiently by producing 12 units? What level
of production is the productive efficient level? What reasons might there be for not
producing efficiently? Now suppose that Sam’s Lamps has decided to produce 100 lamps
and the price of labour is £5 per unit and the price of capital is also £5 per unit. The firm
decides to employ 50 units of capital and 10 units of labour. Is this efficient? Hint: with
this production function the marginal product of labour is equal to K and the marginal
product of capital is equal to L.
68
Block 5: The Firm I
Input price changes and input sustainability

The discussion of the effects of changes in the price of inputs (the wage
level or the rental price of capital) on p.169 is equivalent to the discussion
of the change in the price of goods for consumer choice. In that case, we
identified income and substitution effects of a price change – here, we
identify output and substitution effects.
The shape of the isoquants reflects how easy or difficult it is to
substitute between inputs such as labour and capital. This is called the
‘substitutability of inputs’. The two figures below display isoquants for
different production functions. Figure (a) reflects a production function
where there are only limited opportunities for input substitution. If labour
is increased significantly (in this example, eight-fold), capital can still
only be reduced by a small amount (5 units) for the level of production
to be maintained. On the other hand, figure (b) reflects a production
function with more abundant opportunities for input substitution – if the
firm increases its employment of labour from 25 to 200, it can reduce its
employment of capital substantially, from 80 to 35.
K K
a
80
40 a
b b
35 Q = 50 35 Q = 50
25 200 L 25 200 L
(a) Production function with limited (b) Production function with abundant
input substitution opportunities input substitution opportunities
Figure 5.2: The shape of isoquants and opportunities for substitution.
Activity SG5.9
To produce a subject guide, one author and one computer are perfect complements in
production. One author and two computers would not be more productive. Two authors
is more productive – but (probably) only if they each have a computer. Draw the relevant
isoquants for this case. Now imagine that there is a machine that does exactly the same
thing as a human in regards to the production of a certain good. Labour and capital will
be perfect substitutes in production in this case. Draw the relevant isoquants for when the
inputs are labour and this type of machine.
Profit = Total revenue – Total cost

► Now come back to section 6.4 of BVFD.
Having used isoquants and isocost lines to derive the total cost curve, we
can now come back to section 6.4. Table 6.3 on p.124 contains data for
a certain firm – we can use this to graph the firm’s total cost function, as
follows:
69
140 TC
120
100
Pounds 80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10
Output
Figure 5.3: Total cost.

This curve shows how much it costs the firm to produce any output level
for given technology. It represents the total economic cost of production at
various levels of output.
The firm knows its total cost curve. We also assume it knows the demand
curve it faces. Knowing the demand curve, the firm can calculate the
revenue it would receive at various output levels and derive its total
revenue curve.
25
20
15
Price
10
5
0
0 1 2 3 4 5 6 7 8 9 10
Quantity
Figure 5.4: Demand curve.
140
120 X TR
100
Pounds
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10
Output
Figure 5.5: Total revenue.
For example, point X on the demand curve shows the firm will sell 7 units
of output at £15, generating revenue of £105. Point X on the total revenue
curve therefore shows the combination of 7 units of output and revenue of
£105.
Putting the total cost and total revenue curves together allows us to find
the profit function (profit as a function of output). For example, when
total cost and total revenue are equal, profit is zero. At 6 units of output,
the gap between the two curves is greatest, and this is the highest point on
the profit curve, showing a profit of £27.
70
Block 5: The Firm I
140 TC
120
100 TR
Pounds
80
60
40
20
0 Output
0 2 4 6 8 10 12
Profit
140
120
100
80
Pounds
60
40
20
0 Output
–20 0 2 4 6 8 10 Profit 12
Figure 5.6: Total cost, total revenue and profit.
► BVFD: read section 6.5, section 6.6, Maths 6.1 and Maths 6.2.
Marginal analysis
Marginal analysis is one of the key analytical tools in economics. We
have already covered marginal utility in the previous block. This section
introduces marginal cost and marginal revenue. ‘Marginal cost’ (MC) is the
change in total economic cost due to the production of one more unit of
output. ‘Marginal revenue’ (MR) is the change in total revenue due to the
sale of one more unit of output. At the profit maximising level of output,
marginal cost and marginal revenue are equal.
Both maths boxes involve calculus, which helps to simplify the analysis.
You should work through these maths boxes to understand the principles
they are expounding.
Activity SG5.10
If the firm faces the demand curve: P = 25 – 2Q:
a. fill in the blanks in the table below
b. draw the marginal cost and marginal revenue curves
c. find the profit maximising output level for this firm. How much profit is the firm
earning at that point? Assume output must be in integers.
Output Price Total Total Marginal Marginal Profit

revenue cost Revenue cost
0 8
1 23
2 34
3 42
4 49
71
5 55
6 65
7 78
8 93
9 110
10 130
► BVFD: read the summary and work through the review questions.
Overview
As well as providing an introduction to the basic unit of production – the
firm – this block has demonstrated what lies behind the firm’s production
decisions. Using isoquants and isocost curves, the firm can determine the
least-cost combination of inputs to produce a given quantity of output. From
there, the firm’s total cost curve can be derived. It is assumed that firms
pursue a goal of profit maximisation, and one key point from this block is
that Profit = Revenue – Cost. Knowing the demand curve it faces, the firm
can derive its revenue curve, and since it knows both revenue and cost, the
profit-maximising level of output can easily be found. At this level of output,
we have also seen in this block that marginal cost and marginal revenue
are equal. Marginal analysis is a very useful tool in economic analysis, as
we have seen here in the case of the firm. As the textbook also clarifies, the
economic analysis of the firm provides a useful model for understanding
firms’ behaviour – it is not meant to be a practical system for real world
firms to follow, rather, it provides an analytical framework which helps
explain the behaviour of individual firms and the market as a whole.
Reminder of learning outcomes

be sure that they have been achieved.

1. Labour Productivity at Shakespeare’s Pies:
Number of workers 0 1 2 3 4 5 6
Output of pies 0 10 26 36 44 49 52
Note: Pies are sold competitively at £3 each. Labour is the only
variable input and costs £14 per worker. Capital costs are £80. These
are short-run and long-run costs and productivities (i.e. there is no
possibility of using different production techniques or combinations in
the long run).
Using the information above, which describes the number of pies
produced as a function of the number of workers at Shakespeare’s
Pies, and focusing just on the decision to hire workers (ignoring
the shut-down condition and just trying to pick the best number of
workers), Shakespeare’s Pies maximises its profit if it hires:
a. 1 worker
b. 3 workers
72
Block 5: The Firm I
c. 5 workers
d. 6 workers.
2. Anita owns a grocery shop. These are her annual revenues and costs:
Revenues £250,000
Supplies £25,000
Electricity and heating £6,000
Employees’ salaries £75,000
In addition to the above, Anita pays herself a salary of £80,000. If she
closed her shop she could rent out the land and building for £100,000.
Due to her experience at running her own shop the local supermarket
would offer her a job and pay her £95,000.
a. Anita’s revenue exceeds her economic costs so she should continue
running her business.
b. Anita’s economic costs exceed her accounting costs so she should
shut down her business.
c. Anita’s economic costs exceed her revenue so she should shut
down her business.
d. Anita’s salary is less than what the supermarket would pay so she
should shut down her business.
3. Choose the statement which is false:
When long-run costs for a firm are at a minimum
a. The ratio MPL/MPK = wage / rental.
b. MPL = MPK.
c. The extra output we get from the last dollar spent on an input
must be the same for all inputs.
d. The firm’s production is economically efficient.
Long response question

1. a. What is an isoquant?
b. Why does an isoquant get flatter as you move towards the right?
c. Draw an isoquant and an isocost line which have a point of
tangency and indicate the productive efficient level of output. How
will this change if there is an increase in the wage level? Clearly
indicate output and substitution effects.
d. Use the following information to derive the total cost curve for Ice
Cream Inc. (indicating three points on the curve will be sufficient):
Production function: Q(K, L) = K*L
Rental rate of capital = £15 per hour
Wage = £15 per hour
73
2. a. Fill in the blanks in the table below
Q P TC TR MR MC π
0 5 5
1 5 10
2 5 13
3 5 14
4 5 16
5 5 19
6 5 23
7 5 28
8 5 34
Explain the difference between economists and accountants

definitions of profit. What assumption is required such that the
profit levels you calculated in the table above represent economic
profit?
b. What is the profit maximising level of output? What can you
say about the relationship between marginal cost and marginal
revenue at this point?
c. Draw a graph of a generic marginal cost schedule and a generic
marginal revenue schedule (not based on the figures above) and
indicate the profit maximising level of output.
d. Demonstrate graphically how a fall in the price of the raw
materials will affect the profit maximising level of output.
e. Demonstrate graphically how a fall in demand will affect the profit
maximising level of output.
74
Block 6: The Firm II
Introduction
As in Block 5, we assume that firms attempt to maximise profit and profit
is equal to revenue minus cost. This block extends the analysis of the
firm’s costs – from total cost to fixed and variable costs, average costs as
well as marginal costs, and the relationships between all of these. While
the previous block looked at diminishing marginal returns (a short-run
concept), this block includes a discussion of increasing, constant and
decreasing returns to scale (a long-run concept). The following blocks will
provide more detail on the firm’s revenues, which are linked to the market
structure in which the firm operates. This current block shows how the
supply curves of individual firms are determined, while the following block
(Block 7) will continue this story by explaining how the market supply
curve is found (this depends on the number of firms in the market, which
is a crucial aspect of market structure – the topic of Block 7).
Learning outcomes
• identify fixed and variable factors in the short-run
• analyse total, average and marginal cost, in the short-run and long-run
• draw the relevant cost curves and explain why they have certain
shapes
• define returns to scale and their relation to average cost curves
• describe how a firm choses output, in the short-run and the long-run
• describe the relationship between short-run cost and long-run cost.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 7, sections 3 to 9.
Further reading
Chapter 5.

The textbook chapter discusses production, costs and the output decision
in the short-run (where at least one factor of production is fixed), followed
by production, costs and the output decision in the long-run (where all
inputs are variable). There is also a more detailed discussion of returns to
scale. The chapter concludes by discussing the relationship between short-
run and long-run costs.
Cost, production and output

The first few sentences of this section state that the firm’s production
function can be translated into a relationship between cost of production
and output. In the jargon of economic theory there is a ‘duality’ between
75
cost and production. We do not explore this duality rigorously; however,

it should be evident that when the costs of inputs are given to the firm,
then how much it costs to produce some level of output will depend on the
amount of inputs needed to produce that output and that the latter will
reflect the firm’s production function. The following diagram shows how
total and marginal product are related to total and marginal cost:
Output
Output
TP
decreasing
marginal increasing
increasing
returns marginal
marginal
returns returns decreasing
marginal MP
returns
L L
Cost
Cost
costs costs
increase increase MC
TC
at a at a
decreasing decreasing
rate costs rate costs
increase increase
at an at an
increasing increasing
rate rate
Q Q
Figure 6.1: Relationships between total and marginal product and total and
marginal cost.
The top left figure shows the total product curve, which is initially
displaying increasing marginal returns and then displays decreasing
marginal returns after the dotted line. This is a mirror image of the total
cost curve depicted in the figure below it. When marginal returns are
increasing, costs are increasing at a decreasing rate, and vice versa. The
slope of the TP curve gives the marginal product, while the slope of the
TC curve gives marginal cost. The total product curve is also related to
the marginal product curve (top left figure). The marginal product curve
displays increasing marginal returns by increasing up to a maximum point,
and then falling when marginal returns are decreasing. The marginal
cost curve below is the mirror image of the marginal product curve
and demonstrates the rate of change of costs more explicitly – it falls
when costs are increasing at a decreasing rate and rises when costs are
increasing at an increasing rate.
76
Activity SG6.1
This section introduces various cost curves – practise these in the boxes below as
indicated:
STC, SVC, SFC SATC, SAVC, SAFC, SMC
Activity SG 6.2
Why does the SMC curve cut the SAVC and SATC curves at their minimum points?
Provide an intuitive answer.
► BVFD: read Maths 7.2.
This maths box provides formulas for the various short-run costs based on
a short-run total cost function. You need to remember that:
• Total cost = Fixed cost + Variable cost
• Marginal cost is the change in total cost as quantity produced changes
• Average costs are calculated by dividing the cost by the quantity
produced; this applies to average fixed cost, average variable cost and
average total cost.
Activity SG 6.3
Find the short-run fixed cost, variable cost, marginal cost, average fixed cost, average
variable cost and average total cost for the short-run total cost function STC = M + aQ2,
for which the first derivative is 2aQ.
•• short-run fixed cost
•• variable cost
•• marginal cost
•• average fixed cost
•• average variable cost
•• average total cost.
The output decision

► BVFD: read section 7.4 and complete activity 7.1.
This section discusses how the firm chooses its level of output in the short
run. Two points are important: firstly, the firm chooses the output level
where marginal cost is equal to marginal revenue. Secondly, the firm
must check whether the price it receives at this output level enables it to
generate a profit, to cover all of its costs, to cover only its variable costs
and perhaps contribute a little towards the fixed costs, or not even cover
its variable costs. This will show the firm if it should produce at all in the
short run.
77
In this example, price is not necessarily equal to marginal revenue. In fact,

this will depend on the demand curve the firm faces. If the demand curve
is horizontal, marginal revenue will always equal price. If the demand
curve is downward sloping, the marginal revenue curve will also be
downward sloping, as in Figure 7.7, and price will be higher than marginal
revenue. Whether the demand curve is horizontal or downward sloping
depends on whether or not the firm is a price taker, passively accepting the
market price. We will come back to this in detail in the following blocks
where we examine perfect competition and pure monopoly – two market
structures where the demand curves facing the firm are quite different.
It is important to note that: The firm’s short-run supply curve is its
marginal cost curve above the average variable cost curve. The
firm will supply the output at which SMC is equal to MR, provided that
price is not less than the firm’s SAVC.
Production, costs and output in the long run

We now move on to the long run, and will examine production, costs
and the output decision as we did for the short run. The contents of this
section should be familiar to you already because we covered the appendix
of Chapter 7 in the previous block and this material is a descriptive version
of what is in the appendix. Read through carefully and make sure you are
familiar with these ideas, including the concept of factor intensity.
Activity SG6.4
How does the switch in technique in the final sub-section of section 7.5 relate to the
analysis of a change in factor prices using isocost lines and isoquants (See Figure 7.A4)?
► BVFD: read section 7.6
The U-shaped average cost curve is important to understand and is

discussed further in the following section. The relationship between
average and marginal costs is also important and applies both in the short
run and in the long run. To see why average cost must rise if marginal cost
is above the average and fall if marginal is below average, imagine you
calculate the average age of people in a room full of university students –
if the next person to walk into the room (the marginal person) is an old
lady, the average age in the room will rise. Similarly, if a baby crawls into
the room, the average age will fall.
Activity SG6.5
Draw the long-run cost curves in the boxes below as marked:
LTC LATC, LMC
78
► BVFD: read section 7.7, cases 7.2 and 7.3 and Maths 7.3.
If five workers and five machines can produce 1,000 soft toys, how many
soft toys could be produced if we employed 10 workers and 10 machines?
This question has to do with returns to scale in production. Does doubling
inputs result in more than double, less than double or exactly double the
original output? This will tell us if there are increasing, decreasing or
constant returns to scale.
Some textbooks, but not BVFD, make a semantic distinction between
returns to scale in production and economies of scale in costs. Thus,
on the production side if there are constant returns to scale then a doubling
of all inputs leads to a doubling of output; and with increasing (decreasing)
returns to scale a doubling of all inputs more (less) than doubles output
(see Maths box 7.3). As long as input prices are held constant then the
relationship between returns to scale in production and economies of scale
in costs is straightforward: if doubling inputs more than doubles output then
cost per unit of output is smaller at higher output. However, if input prices
change as output increases or decreases then the effect of these changes, as
well as underlying scale effects in production, will affect average costs. The
fact that BVFD equates the two concepts implies an underlying assumption
that input prices are not changing as output increases or decreases.
The figure to the right demonstrates varying returns to an increase in
inputs at different levels of input. First let us describe what is meant by
the ‘composite input’ on the x-axis. This is a combination of labour and
capital where the proportions of each are held constant. Thus, for example,
if we double labour, we also double capital and the capital–labour ratio
remains the same. A change in scale doesn’t have to do with changing
the composition of inputs, but rather with changing the amount that is
employed.
Long-run production function

Output
Composite Input
Figure 6.2: Long-run production function.
We can now see how this curve demonstrates initially increasing, then
constant, and finally decreasing returns to scale. The vertical bars rising
up from the x-axis are evenly spaced. However, the quantity of output
generated from these input levels varies greatly. At low levels of input,
increasing the units of input increases the level of output more than
proportionally, representing increasing returns to scale. At high levels of
inputs and outputs, the opposite is the case, since increasing the level of
inputs increases the level of outputs less than proportionally, representing
decreasing returns to scale.
79
Section 7.7 discusses some real-world reasons behind returns to scale and
discusses why firms may face a U-shaped long-run average cost curve. You
should understand the reasons why LRAC may fall initially, be constant for
some time, and then increase.
Activity SG6.6
Increasing returns to scale can be expressed as saying that a certain increase in inputs
leads to a more than proportional increase in output. Equivalently, it can also be
expressed by saying that a certain increase in output requires a less than proportional
increase in inputs. Use this idea and the following isoquant map to derive a production
function (with a composite input on the horizontal axis), assuming that the level of output
represented by each successive isoquant increases by an equal amount each time.
X7
X6
X5
X4
X3
X2
X1
X0
L
Figure 6.3: Returns to scale: the relationship between increases in inputs and
increases in output.
The relationship between the level of input and the level of output is
discussed further in AW Section 3.1.2 (which the above activity is based
on).
The only difference to the analysis of the output decision in the short run
is that there are no fixed and variable costs, since all inputs are variable
in the long run. For this reason, the concept of it being worthwhile to
produce as long as variable costs are more than covered has no relevance
and the firm simply choses its output level where MR = LMC, and then
checks if this is profitable using the LRAC curve.
The firm’s long-run supply curve is its marginal cost curve
above the average cost curve. The firm will supply the output at
which LMC is equal to MR, provided that price is not less than the firm’s
LRAC.
The short-run cost curve shows the costs for when one input is fixed at a
certain level. If it were fixed at a different level, the short-run cost curves
would also be different. For example, if the level of capital was fixed at a
higher level, short-run costs for producing a given level of output may be
lower, if each worker is more productive with more capital to work with.
There is a different short-run cost curve for each quantity of the fixed
input. This is sometimes described as a family of short-run cost curves. In
the long run the firm chooses the plant size with the lowest average cost
for any given level of output. The LAC includes one point (assuming there
are a large number of feasible plant sizes) from each SAC (not necessarily
80
the minimum point of the short-run curve, as the text explains). The long-
run average cost curve can be described as an envelope of these short-run
curves.
Activity SG6.7
Draw six short-run average cost curves, each with a single point of tangency to a long-run
average cost curve showing increasing, constant and then decreasing returns to scale.
Overview
This block introduces the distinction between the short run (when one
factor of production is fixed) and the long run (where all inputs are
variable). The production function, which summarises the technical
possibilities faced by the firm, can be used to derive the firm’s total cost
curve. Short-run total cost is equal to short-run fixed cost plus short-
run variable cost. Average costs are found by dividing cost by quantity
produced. Average cost is falling if marginal cost is below average cost,
and rising if marginal cost is above average cost. The short-run marginal
cost curve reflects the marginal product of the variable factor (usually
labour). It cuts the SATC and SAVC curves at their minimum points.
In the short run, the firm choses its output level where MC = MR, but
only produces at all if the price received at this level of output at least
covers all variable costs and makes some contribution to fixed costs. The
long-run total cost curve represents the economically efficient (least-
cost) production method for each level of output when all inputs can be
varied. The long-run average cost curve is usually U-shaped, representing
increasing, constant and then decreasing returns to scale as output rises.
In the long-run, the firm supplies the output at which MR = LMC as long
as the price is no less than LAC at that level of output. The LAC curve is an
envelope of many SAC curves which all touch the LAC at just one point.
This block showed how the short-run and long-run supply curves of an
individual firm can be found. The following block contains the derivation
of the short-run and long-run industry supply curves for different types
of industries. This block provides a detailed introduction to costs. The
following blocks will also look more in detail at revenue, in relation to the
market structure in which the firm operates.
You need to be able to reproduce the output curves and cost curves
covered in this block. Since there are quite a few, the best way to do this
is to understand what they mean, why they have certain shapes, and
how they are related to each other. Approaching this with understanding
(rather than memorisation) will be an easier and more effective method in
the long run. Furthermore, the examination will test your understanding
81
of these cost concepts (rather than just your capacity for memorisation).
The output and cost curves you need to know for this block are
summarised below. This is a good chance to practise them and make sure
you understand what they represent, where they come from, and how they
are related to each other.
TP MPL
(labour on horizontal axis)
STC, SVC, SFC SATC, SAVC, SAFC, SMC
LTC LATC, LMC
LATC envelope of SATC curves
82


1. Labour Productivity at Shakespeare’s Pies:
Number of workers 0 1 2 3 4 5 6
Output of pies 0 10 26 36 44 49 52
Note: Pies are sold competitively at £3 each. Labour is the only
variable input and costs £14 per worker. Capital costs are £80. These
are short-run and long-run costs and productivities, i.e. there is no
possibility of using different production techniques or combinations in
the long run.
Refer to the information above which describes the number of pies
produced as a function of the number of workers at Shakespeare’s
Pies and the note, which highlights that capital costs (fixed costs) are
£80 in the short and the long run. Assuming wages and prices don’t
change, Shakespeare’s Pies should:
a. shut down immediately
b. stay open in the short run but shut down in the long run
c. stay open in the short run and the long run
d. shut down in the short run but reopen in the long run.
2. If short-run average total cost equals short run marginal cost, then:
a. Short-run average total cost is at a minimum.
b. Short-run marginal cost is at a minimum.
c. Both a. and b. are correct.
d. Neither a. nor b. are correct.
3. Which of the following statements best summarises the law of
diminishing marginal returns?
a. In the short run, as more labour is hired, output diminishes.
b. In the short run, as more labour is hired, output increases at a
diminishing rate.
c. In the short run, the amount of labour a firm will hire diminishes
as output increases.
d. As more labour is hired, the length of time that defines the short
run diminishes.
4. Let the production function be q=ALaKb where q is output, L is labour
and K is capital. The function exhibits increasing returns to scale if:
a. a + b = 1
b. a + b > 1
c. a + b < 1
d. cannot be determined with the information given.
83
5. Suppose the short-run total cost of producing T-shirts can be

represented as STC = 50 + 2q where q is the level of output. The
average and marginal costs of the 5th T-shirt are:
a. 50 and 2
b. 12 and 2
c. 50 and 10
d. 12 and 10.
Long response questions

1. The isocost line is the graph of factor inputs such that their total
combined cost is equal to a given constant. Suppose a firm uses two
factor inputs, labour (L) and capital (K). Per day, the wage rate for
labour is £15 while renting units of capital costs £60.
a. Depict on a graph the isocost line for a firm spending C* = £3,000
on factor inputs. Put on this graph a typical isoquant for output
level, say Q*, to illustrate the optimal input levels N* and K* at
cost C*.
b. The government introduces a minimum wage for labour at £20.
With capital fixed at K* in the short run, show graphically and
describe how much it costs the firm to continue to produce Q*.
c. Taking the minimum wage as given, show graphically and describe
how the optimal factor input mix to produce Q* changes in the
long run. How does the eventual production cost compare to that
in the short run and that before the minimum wage?
2. a. Bob Smith manages a branch office of a large financial services
firm. He uses computers (capital, K) and people (labour, L) to
produce consulting advice Q, according to the production
function: Q = K × L.
Employing people costs the wage rate w = 1 while renting
computers costs the rental rate r. Suppose computers cost twice
what people do (i.e., r = 2w = 2). For now the number of
computers in the branch is fixed at K = K.
i. How much labour does Mr Smith employ if he needs to
produce output Q? Show that total cost is C(Q) = 2K + Q/K
ii. Given that the first derivative of the total cost function above
is 1/K, derive average and marginal cost. How do average and
marginal cost vary with output?
iii. Corporate headquarters has just authorised Mr Smith
to upgrade the branch office by varying the quantity of
computers. What is the optimal (cost-minimising) mix of
capital and labour? Using the production function given above,
the marginal product of labour is equal to K and the marginal
product of capital is equal to L.
84
b. In the diagram below choose levels of output for the three

unlabelled isoquants such that from a to b there are increasing
returns to scale, from b to c constant returns to scale and from c to
d decreasing returns to scale.
d
8
Q4=?
c
4
Q3=?
2 b
Q2=?
1 a
Q1=?
1 2 4 8 L
85
Notes
86
Block 7: Perfect competition
Introduction
Our study of microeconomics now looks in greater depth at different
types of market structure, which refers to the economic environment
in which buyers and sellers in an industry operate. It is generally
defined according to four characteristics: the size and number of buyers
and sellers, the extent of substitutability of different sellers’ products,
the extent to which buyers are informed about prices and available
alternatives and the conditions of entry/exit. Although BVFD covers the
two extremes of market structure, perfect competition and pure monopoly,
in one chapter, this subject guide devotes a block to each, enabling some
issues to be covered in a bit more depth.
In perfect competition (Block 7), there is an infinite (or very large)
number of firms and free entry and exit, whereas in monopoly (Block 8),
there is a single firm which supplies the whole market, and very large
barriers to entry into the market. While many real-world firms do not fit
neatly into these two extremes, it is nonetheless worthwhile to study them
first, partly because they do approximate some real-world markets (see
below for examples), but also because they provide a benchmark that is
very useful for comparison with other market structures which are more
commonly encountered in the real world. Perfect competition is a desirable
market structure in terms of maximising the welfare of market participants
and for this reason is often used by economists as a kind of first-best
standard in order to evaluate the welfare losses caused by deviations from
the competitive ideal. The subsequent block (Block 9) will introduce other
market structures (monopolistic competition and oligopoly) which sit on
the continuum in between these two extremes.
As this and the following block utilise material from Blocks 5 and 6, it
is vital that you are familiar with the material contained therein. If you
are not, you should revise them now. In particular, you need to fully
understand why choice of the profit maximising output requires firms to
equate marginal cost and marginal revenue. You should also recall that the
return needed to keep a firm from leaving the industry is already included
in its cost curves, which include all opportunity costs – including the next
best alternative return to operating in the current market. In the long
run if a firm is earning a price above average cost it is earning abnormal,
supernormal, or economic profits (these three terms tend to be used
synonymously in economic texts).
Learning outcomes
• define perfect competition
• describe why a perfectly competitive firm equates marginal cost and
price
• demonstrate how profits and losses lead to entry and exit
• draw the industry supply curve
• carry out comparative static analysis of a competitive industry.
87
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 8, sections 1 to 4
(which builds on Chapter 7 which you should revise if necessary).
Further reading
Chapter 6.

This block introduces the market structure perfect competition. It starts
by outlining the underlying assumptions and the implications of these,
notably that firms in a perfectly competitive market face a horizontal
demand curve and act as price takers, with no ability to influence the
market price. This also means that MR = P for perfectly competitive firms.
The block then describes the firm’s short-run supply decision and short-
run supply curves. In the short run, firms will stay in business if P > AVC,
even if they are making a loss, however, in the long run, they will exit the
market unless P ≥ AC. The firm’s long-run supply curve is flatter than the
short-run supply curve since it can adjust all inputs in the long run. The
industry supply curve is the horizontal summation of all the individual
firms’ supply curves. In the long run, firms can exit and enter the market.
This provides a further reason why the long-run industry supply curve is
flatter than the short-run industry supply curve. The chapter also discusses
how firm and industry supply curves are affected by an increase in costs or
a change in the market demand curve.
Assumptions and implications

► BVFD: read the introduction to Chapter 8, section 8.1 and concept 8.1.
Perfect competition is a model of market structure. It rests on the

following assumptions:
1. Many firms, each negligible in size relative to the entire industry.
2. All firms produce homogenous goods.
3. Perfect information regarding prices and available alternatives.
4. Free entry and exit.
From these assumptions, the key implication is that the individual firms in
this market face a horizontal demand curve. All act as price-takers, with
no ability to influence the market price.
The textbook mentions the market for corn as a market which closely
resembles a perfectly competitive market. Other examples of markets
which may approximate perfect competition – at least along certain
dimensions – include forex (foreign exchange) and agricultural
commodities such as cocoa.
Activity SG7.1
For the forex market (e.g. selling US dollars), note down how and to what extent each of
the four assumptions above are met.
In reality, there are not many markets which are truly perfectly
competitive. Nonetheless, for the reasons described in concept 8.1, it is
still a very useful model to study.
88
The firm’s supply decision

In the previous section, it was established that the negligible size of

individual firms in a competitive market means that each firm faces a
horizontal demand curve. At the beginning of this section, it is shown that
this means, for price taking firms, that price equals marginal revenue. Be
sure you understand this; if you do you will also understand why MR < P
for a firm facing a downward sloping demand curve. We will return to this
point when we discuss monopoly.
For an individual firm, we can write its revenue as TR = P*Q. Dividing by
Q we have
TR
= AR = P
Q
Because the firm is a price taker, P is a constant term in this equation.

Therefore, changes in TR come about via changes in Q.
∆TR = P∆Q
or
∆TR
= MR = P
∆Q
Marginal revenue, the increase in total revenue when output increases by
one unit, is just the price received for that output.
We can show TR as a function of Q graphically as follows:
TR
TR
Slope=P
Q
Figure 7.1: Total revenue for a competitive firm.
This enables us to provide a diagrammatic treatment of profit
maximisation for a competitive firm.
89
TC
TR
TR, TC
Panel (a)
Q1 Q2 Q3 Q4 Q (output)
Profit, π
Profit, π, (TR–TC)
Panel (b)
£ MC
AC
D=AR=MR
Profit, π
Panel (c)
Figure 7.2: Profit maximisation for a competitive firm.

In panel (a), a total cost curve (with fixed costs in the short run and increasing
marginal cost) is superimposed on the TR curve. Profit, which we denote by
π, is the vertical distance between total revenue and total cost. It is positive
between Q1 and Q4. For output lower than Q1 or greater than Q4 the firm makes
a loss. Geometrically, profit is maximised when the vertical distance TR–TC is
greatest (between Q1 and Q4). This occurs at Q3, where the slope of TR is equal
to the slope of TC. These two slopes are MR and MC respectively, so profit is
maximised when output is chosen such that MR = MC (or P = MC, as MR = P).
Panel (b) simply graphs profit, π, against output. Profit maximisation means
getting to the top of the ‘profit hill’, again at Q3, of course.
Panel (c) shows the same process in a third equivalent way, using the firm’s
demand and cost curves (the MC and AC curves corresponding to the TC
curve in panel (a)). Profit maximising output is at Q3 where MC = MR. The
shaded area shows the firm’s actual profit; it is AR – AC, which is profit per
unit at Q3 multiplied by the number of units this is earned on, namely Q3.
Equivalently it is TR (= AR*Q3) minus TC (= AC*Q3).
90
Thinking of the economic intuition rather than the geometry of the MC =

MR (or MC = P) requirement, we can examine the firm’s position when
MC and MR are not equal, say at Q2 in Figure 7.2. Clearly in panel (b) this
is not at the summit of the ‘profit hill’. Panel (c) shows why. At output Q2,
MR>MC. What does this mean? It signifies that at Q2 increasing output by
one unit adds more to revenue than to cost, so increasing output increases
profit. The marginal benefit of increasing output exceeds the marginal cost.
You should be able to see, by the same reasoning, that if output is greater
than Q3, the marginal benefit of contraction exceeds the marginal cost.
You also need to revise, from section 7.4 of BVFD, the so-called shut down
condition (if price falls below short-run variable cost the firm should not
produce any output). It may initially seem counterintuitive for a firm to
produce output in the short run even if it is making a loss. How can this
be? Think about a firm’s short-run fixed costs, rentals on building and
machines, insurance premiums, contractual management fees, etc. These
are unavoidable even if the firm produces zero output. But losses never
have to be greater than these fixed costs. Any variable costs, costs that
vary with the level of output, can be avoided by not producing. If these
variable costs can be more than covered by producing some output then
the ‘profit’ on the cost of variable inputs can contribute to paying for the
unavoidable fixed costs, even if the firm is making a loss overall.
Short-run supply decision

The firm’s short-run decision can be summarised as follows:
• The price is determined by the market (by market supply and demand).
• For a perfectly competitive firm, P = MR.
• A profit maximising firm produces where MR = MC. Because P = MR,
this means that a perfectly competitive firm operates where P = MC.1 1
In actual fact MR = MC
is a necessary but not
• The optimal quantity to produce is indicated by the SMC curve, which sufficient condition for
is the firm’s short-run supply curve – the firm chooses quantity where profit maximisation.
P = MR = SMC. For certain cost curves
and some output level,
• The firm will only produce if the price lies above its SAVC curve and
MR = MC could maximise
only covers all their costs if it is at least equal to its SATC curve. loss not profit. This
problem is not considered
Activity SG7.2 further on this course, but
in the competitive model
Draw the short-run cost curves of a perfectly competitive firm and indicate prices at which we will always be sure
they … and the quantities they will produce at each of these prices: we are maximising profit
at MR = MC as long as
i. Make supernormal or economic profits
the firm is on the upward
ii. Will not produce in the short run. sloping section of its MC
curve.
iii. Just cover all their costs.
91
The marginal firm

If the price level is below the lowest point on the firm’s LAC curve, firms
will exit the market in the long run, as they would otherwise be making
losses. But how do we know which firms will exit? In theory, firms have
access to the same technology and will thus have the same costs curves in
the long run, when enough time has passed for full adjustment of capital
to be made. This assumption is also made in BVFD – that all firms in the
market and the potential entrants have identical cost curves. In this case,
which firms exit and which stay would be quite random. However, in the
real world, firms will not all have identical cost curves, since technology is
changing continually and firms have different histories. For example, some
firms will have replaced their capital stock more recently than others.
In a situation where no firms are covering their long-run opportunity
costs, the marginal firm will be the first one whose capital comes up for
replacement. This firm will exit first. (This is discussed in L&C, UK edition:
p.135; international edition: p.111).
Activity SG7.3
Reproduce Figure 8.4 from the textbook, except to show exit, not entry.
Industry supply curves

It is crucial to distinguish carefully between supply curves for an individual

competitive firm and supply curves for the industry (the market as a
whole) – the industry supply curves are the horizontal summation of all
the individual firms’ supply curves. In each case it is also important to
distinguish between the short run and the long run. The previous section
showed that the long-run supply curve for a firm is its LRMC curve above
minimum LRAC. Note that this is average total cost not average variable
cost, because while it may be rational to make a loss in the short run (if
variable costs are more than covered and revenues make a contribution to
covering fixed costs), this is not the case in the long run. In the long run,
if a firm cannot cover its costs it should leave the industry. When firms
leave the industry, industry supply shifts inwards and price increases. This
process continues until revenues just cover costs for remaining firms in the
industry. On the other hand, if firms are making abnormal or economic
profits then new firms will enter the industry and drive down the price.
This process continues until firms are just covering all opportunity costs
(i.e. no abnormal profits are being earned). The long-run industry supply
curve is flatter than its short-run counterpart. It is possible that the long-
run industry supply curve is horizontal, and this is the ‘pure theory’ result
with perfectly elastic supply of inputs. However, due to the likelihood that
input prices will increase as an industry expands, as well as due to the fact
92
that, in practice, firms have different cost curves, it is much more likely that
the long-run industry supply curve will be upward sloping.
Comparative statics
This section is vital for your understanding of competitive markets. If you

fully understand the consequences, both at the level of individual firms
and the industry as a whole, of shifts in the market (industry) supply or
demand curves then you will have mastered an important building block of
microeconomic analysis. The essential point is that entry or exit from the
industry ensure that individual firms have zero profits (remember this can
be compatible with a return to management and entrepreneurship – these
are included in the cost function; they are opportunity costs, namely what
managers and entrepreneurs could earn in the next best activity). This
means that in the long run, price must return to the minimum ATC, making
the long-run supply curve horizontal as long as expansion or contraction of
the industry does not change input prices. The two activities are designed
to assist your understanding of this. Note that in this section, at the industry
level, the short-run supply curves hold constant the number of firms in the
industry (at the level of the individual firm the short-run corresponds, as
usual, to one or more of the firm’s inputs being fixed).
Activity SG7.4
Suppose all firms in a perfectly competitive market are initially in both short-run and
long-run equilibrium. Then a lump-sum tax (i.e. a tax that is unrelated to a firm’s output)
is introduced.
a. What impact will this have on each firm in the short-run? (Explain your answer).
b. What impact will this have on market price in the long-run? (Explain your answer).
c. What impact will this have on each firm’s output in the long-run? (Explain your answer).
d. What impact will this have on the number of firms in the industry in the long-run?
(Explain your answer).
Draw a diagram to illustrate the effects of the lump-sum tax on an individual firm and the
whole industry.
The section on shifts in the market demand curve demonstrates that the
short-run industry supply curve is much less elastic than the long-run industry
supply curve. In the short run, firms cannot respond as much to a change in
price and the number of firms is fixed. As such, an increase in demand has a
much greater impact on price in the short run compared to the long run.
Activity SG7.5
Reproduce both graphs in Figure 8.8 but for an increase in demand, rather than an increase
in costs (the textbook also suggests this activity and already provides the industry side).
93
Perfect competition and efficiency

One of the reasons given in concept Box 8.1 for studying competitive
markets is that ‘a perfectly competitive market has some desirable
properties in terms of efficiency of the market outcome’. In fact, perfectly
competitive markets lead to an outcome which is both productive efficient
and allocative efficient. Productive efficiency implies that goods and
services are produced at their lowest cost, such that more output of one
good can only be obtained by sacrificing output of other goods. This is
achieved in perfectly competitive markets because firms produce on their
average cost curves, which are based on the cost-minimising combination
of inputs. This, in turn, implies that there are no excess resources being
used in the production of that good which could be released (without
reducing output) to produce another good.
Allocative efficiency means that it is not possible to make someone better
off without making someone else worse off. This is achieved in perfect
competition because P = MR = MC (such that benefit and cost are
equated) and the sum of producer and consumer surplus is maximised
with no ‘deadweight loss’. This will be explained in more detail in the
following block, where the allocative efficiency of perfect competition is
contrasted to the allocative inefficiency of pure monopoly. Block 11 on
welfare economics also explores these concepts in greater detail. What
the efficiency of the perfect competition model implies is that society will
be producing at a point on (not inside) the production possibility frontier
(PPF), and that this point is the point that aligns the efficient production
possibilities with the needs and preferences of society.
Using the competitive model: a worked example

Assume that the raspberry growing industry in Scotland is perfectly
competitive, and each producer has a long-run total cost curve given by:
TC = 144 + 20Q + Q2
and its marginal cost by:
MC = 20 + 2Q.
The market demand curve is:
∼
Q = 2,488 – 2P
∼
(Q is the demand in the market, Q is the output of an individual firm).
a. What is the long-run equilibrium price in this industry?
b. How many active producers are in the raspberry growing industry in a
long-run competitive equilibrium?
c. Illustrate diagrammatically the long-run equilibrium of the firm and
the industry. Your diagram does not have to be drawn to scale but
should contain the relevant information.
94
Solution
a. The first thing we have to realise is that the question is concentrating
on the long-run, so it is the properties of long-run equilibrium that are
going to be relevant in solving this problem. In the competitive model
free entry and exit ensure that firms are earning zero profit (they just
cover all opportunity costs). This is a vital step in solving the problem.
Zero profit means that TR = TC for each firm, i.e.
PQ = 144 + 20Q + Q2
But this is not yet helpful to us because it is one equation with two
unknowns. What can we do? Well our model of the competitive firm
also tells us that it will produce where P = MC. We are given MC so
we can substitute in to the left hand side of the equation above:
(20 + 2Q)Q = 144 + 20Q + Q2
This gives us Q2 = 144, i.e. Q = 12
Now from P = MC we know P = 20 + 2Q, i.e. P = 44.
b. Now turn to the market demand curve and substitute in this price to
estimate market demand:
∼
Q =2488 – 2 * 44 = 2,400
So now we know that market demand is 2,400 and that each profit
maximising competitive firm produces 12 units.
Therefore the number of firms in the market must be
2,400/12 = 200
c. The diagrams are shown below. Make sure that you label the axes and
any curves or lines in the diagram as well the solution values of prices
and quantities. This should all be obvious but it is surprising how
many examination answers fail to provide these important pieces of
information.
P, AC, MC LRMC P Market demand
LRAC
Market supply
44 44
12 Q 2400 Q
Figure 7.3: Long-run equilibrium of the firm and the industry.
Overview
A market structure is the economic environment in which buyers and
sellers in an industry operate.
This block covered perfect competition and its underlying assumptions,
including that:
• there is a large number of buyers, all small relative to the whole
market and all producing a homogeneous product
• buyers and sellers have perfect information regarding prices and
available alternatives
• there is free entry and exit.
95
In a competitive industry, buyers and sellers are price-takers and have no

influence over the market price. Price is equal to marginal revenue and the
firm choses output where P = MR = MC. In the short run, the firm’s supply
curve is its SMC curve above SAVC. In the long run, the firm’s supply curve is
its LMC curve above its LAC curve. The industry supply curve is obtained by
horizontally adding the supply curves of the individual firms. The long-run
industry supply curve is flatter than the short-run industry supply curve both
because firms can fully adjust their inputs and also because firms can enter or
exit the market. Graphical analysis of short-run and long-run supply curves
was carried out for both the perfectly competitive firm and the perfectly
competitive industry. These are affected by changes in costs and in the market
demand curve, leading to a new equilibrium.

Now go back to the list of learning outcomes at the start of the block and be
sure that they have been achieved.

1. Identify the truthfulness of the following statements for a competitive
profit maximising firm in the short-run:
i. The firm never produces where P<AVC.
ii. The firm never produces where TR<TC.
a. Both i and ii are true.
b. Both i and ii are false.
c. i is true; ii is false.
d. i is false; ii is true.
2. An increase in the cost of capital will have the following effect on a
perfectly competitive market:
a. Short-run average and marginal cost will increase which would lead
to a fall in output and an increase in price. In the long run, firms will
leave and price will rise further.
b. Short-run average and marginal cost will not change but there will
be a fall in output and an increase in price. In the long run, firms will
leave and price will rise further.
c. Short-run average cost will increase but there will be no change in
output or price. In the long run, firms will leave and price will rise.
d. Short-run marginal cost will decrease which would lead to an increase
in output and a decrease in price. In the long-run, firms will enter and
price will become stable.

1. a. i. Define the concept of market structure and list the fundamental
assumptions of the perfect competition model.
ii. Provide a graphical representation of equilibrium in the perfect
competition model in the long run, distinguishing between what
holds for the firm and what holds for the market. Carefully
describe the various components of your graphical representation.
96
iii. Use graphs to illustrate how a decrease in costs changes the long-
run equilibrium of a competitive market. Carefully describe the
various components of your graphical representation.
b. In a perfectly competitive industry all firms have the Total Cost
function TC = 4 + q2, where q is output of the individual firm. The
market (industry) demand is given by Q = 120 – P where P is price
and Q is industry output. The figure shows the individual firm’s AC
and MC.
P, AC, MC
MC
AC
q
2 4
i. Suppose that initially the price is 8. How much output does each
firm produce? In the short run, with the number of firms fixed,
how many firms are there in the industry?
ii. Could this be a long-run equilibrium? Explain why or why not.
iii. What is the long-run equilibrium number of firms in this
industry?
97
Notes
98
Block 8: Pure monopoly
Introduction
Having examined perfect competition in the previous block, this block
now covers pure monopoly, which is a market structure where only one
firm supplies the whole market, and thus there is no competition between
firms. Utilities (such as gas or water) supplying a particular region
are often monopolies (this will be explored in the section on natural
monopolies). Furthermore, patents allow companies to hold a monopoly
over an invention (for example a pharmaceutical drug) for a limited
period of time. Although finding other real-world examples of companies
that are ‘pure’ monopolists can be as difficult as identifying examples of
markets that are ‘perfectly’ competitive, some companies that come close
include Microsoft, in the market for operating systems, and, a historical
example, de Beers diamonds, which controlled an estimated 80 per cent of
rough diamond supply in the 1980s.1 This block examines the theoretical 1
www.economist.com/
aspects of monopoly as a market structure, including how the monopolist node/2921462
determines its price and output, the social cost of monopoly due to
inefficiency, and price-discrimination by monopolists.
Learning outcomes
• define pure monopoly
• find the optimal price and output levels for a monopolist using
MC = MR
• relate PED to monopoly power
• recognise how output compares under monopoly and perfect
competition
• describe how price discrimination affects a monopolist’s output and
profits.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 8 sections 5 to 10.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapter 6; UK Edition,
Chapter 7.

This block introduces the case of pure monopoly, with its own underlying
assumptions – namely that there is only one firm supplying the whole
market and large barriers to entry. The block describes the profit-
maximising output for the monopolist as well as the relationship between
the elasticity of demand and the monopolist’s degree of market power
(measured by how far above marginal cost, and revenue, it can set the
price it charges). The allocative inefficiency of monopoly is demonstrated
by the loss of social surplus compared to the case of perfect competition.
First, second and third degree price discrimination are explained,
including the impact on the monopolist’s output, price and profits. Despite
99
the allocative inefficiency of monopoly, one possible advantage could

be that monopoly profits provide an incentive for firms to innovate.
Natural monopolies display a falling long-run average cost curve over the
whole range of production. Government regulation of monopolies is also
discussed.
Perfect competition and perfect monopoly

We turn now to the case of monopoly, which is at the other end of the
spectrum compared to perfect competition. Like the latter, in its ‘pure’
form it is likely to be rather rare in practice, but studying the pure form
tells us a lot about how firms behave when they have market power (i.e.
when they face a downward sloping demand curve). The table below
summarises how perfect competition and monopoly differ, according to the
four assumptions made to describe perfect competition in section 8.1.
Number of firms Nature of product Information Entry and Exit

Perfect competition Very large, infinite Homogeneous Perfect Free
Monopoly One Homogeneous (One Perfect Large barriers to
product ) entry
Table 8.1: Characteristics of perfect competition and pure monopoly.

In relation to the final column, BVFD in this chapter essentially rule out
by assumption the entry to the industry of new firms (which would erode
monopoly profits). You should think about why this happens in practice.
Some barriers to entry are ‘natural’, for example the unique talents of a
singer or sports star (their monopoly profits are not eroded by the entry of
clones) while others are artificial, such as the monopoly position afforded,
perhaps temporarily, by licences, patents, tariffs and the like. Such
artificial barriers to entry can, in principle and often in reality, be removed
to introduce competition into previously monopolised industries.
► BVFD: read section 8.6 and Maths 8.1.
Monopoly analysis
This section shows that profit maximisation for a monopolist, as for
a competitive firm, requires producing where MR = MC. But, unlike
the competitive case, MR is not equal to P – it is less than P (see next
paragraph). This means that in profit maximising equilibrium, where
MR = MC, P > MC and this turns out to be the source of monopoly’s
inefficiency. You need to be sure that you really understand the monopoly
diagram, BVFD Figure 8.11. What follows spells out in a bit more detail
some aspects of the monopoly analysis.
To begin with it is crucial for you to understand why, in the case of
monopoly, MR < P (remember from the previous block that MR = P for
a competitive firm). This is explained in section 8.6, but here it is spelled
out in more detail. The downward sloping demand curve faced by the
monopolist means that if a monopolist wants to sell more output it will
have to lower the price. But the lower price applies to all of its output,
not just the marginal unit. Marginal revenue is the price the monopolist
receives for the marginal unit less the price reduction it must accept on
all the units previously sold at a higher price. This is demonstrated in the
following simple diagrammatic illustration.
100
P TR11 = 9.5 × 11 = 104.5

TR10 = 10 × 10 = 100
MR = TR11 – TR10 = 4.5 = P11 + 10∆P
(∆P is negative)
10
9.5
Q
10 11
Figure 8.1: Marginal revenue when the firm faces a downward sloping
demand curve.
When the price is 10, 10 units are sold and total revenue received by the
firm is 100. To sell an extra unit (the 11th unit) the price must fall to
9.5. This, however is not the firm’s net gain in revenue because it now
sells each of the previously sold 10 units for 9.5 rather than 10. The net
revenue, the marginal revenue, from selling the 11th unit is its price,
9.5, minus the reduced revenue on the first 10 units, i.e. 0.5 * 10 = 5.
Therefore MR = 9.5 – 5 = 4.5. So MR is less than price.
Activity SG8.1
As part of your studies of microeconomics, it is important for you to be able to draw the
cost and revenue curves for a typical monopolist.
a. Reproduce Figure 8.11, making note of the key points (the point where the MC and
MR curves cross, the price level the monopolist chooses, and the average cost at this
quantity) and highlighting the monopolist’s profit.
b. Illustrate a rise in costs (as described in the section ‘comparative statics for a
monopolist’).
c. Illustrate an increase in demand (as described in the section ‘comparative statics for a
monopolist’).
Rise in costs Increase in demand
As noted above, cutting the price increases demand but reduces the
revenue on existing units. The effect on a firm’s total revenue depends on
the price elasticity of demand, as you will remember from Blocks 3 and 5.
This is described in more detail in this section, especially the maths box.
101
The formula in equation 7 (or 8) of the maths box is very useful. Although
the derivation in the box uses calculus, the intuition can be seen by using
the delta notation as follows2 2
In fact, the expression
in the text is an
TR = P * Q approximation. The full
∴∆TR = P∆Q + Q∆P expression for ∆TR is
∆TR = P∆Q + Q∆P
Therefore we can write: + ∆P∆Q. For small
∆TR ∆P changes in P and Q
MR = =P+Q the final term can be
∆Q ∆Q
ignored, giving the
∆Q P
But PED (price elasticity of demand), ε, can be written as ε = . equation in the text.
∆P Q
Substituting into the above we get, after a bit of manipulation:
( 1
( 1
MR = P 1 +
( =P 1–
(
ε |ε|
which is equivalent to equations 7 and 8 in the maths box. Here you can
see straight away that if demand is inelastic, |ε|<1, MR is negative. This
shows concisely what is explained in the text, namely that a monopolist
will never operate on the inelastic portion of the demand curve. Also,
because MR = MC for profit maximisation, some further straightforward
manipulation yields:
P – MC 1
=
P |ε|
1
|ε| , which is the proportionate mark-up of price over marginal cost, is
sometimes used as an index of monopoly power (the Lerner Index). In the
case of perfect competition this index is zero (P = MC, |ε| = ∞ ). What is
the maximum value this could take in the case of monopoly?
The equation:
∆P
MR = P + Q
∆Q
can also be used to show a useful result for MR where the demand curve is
linear. Suppose the (inverse) demand curve is given by P = a – bQ where
∆P
–b is ∆Q , then substituting into the above equation gives MR = a – 2bQ.
(Maths 8.1 shows the same result using calculus). Remember that this
is the case for linear (straight line) demand curves only. The marginal
revenue line has the same intercept on the P axis as the demand curve,
but is twice as steep. Thus, in Figure 8.10, the MR curve crosses the x-axis
at exactly half the quantity at which the demand curve crosses the x-axis
– this is due to the fact that when P = a – bQ, the DD curve crosses the
x-axis at a/b. The MR curve corresponding to this demand curve is MR =
a – 2bQ. This curve crosses the x-axis at a/2b: exactly half the quantity at
which the demand curve crosses.
The following question requires you to use the result we have just
explained about the slope of the MR curve relative to the slope of the
demand curve in order to solve for the monopoly equilibrium:
102
Activity SG8.2
A monopolist faces an (inverse) demand curve given by P = 100 – 2Q. Marginal cost is
constant and equal to 16. Profit maximisation is achieved when price is equal to:
a. 45
b. 21
c. 58
d. 82
e. 16.
Using the monopoly model: a worked example

The (inverse) demand curve faced by a monopolist is given by:
P = 210 – 4Q
a. Suppose the monopolist has constant marginal cost equal to 10 (MC
= 10). Use the method shown above to find the monopolist’s marginal
revenue and, using that, calculate the monopolist’s profit maximising
output, price and total revenue.
b. Now suppose that the monopolist’s MC increases to 20. Calculate the
new Q, P, TR.
c. Suppose now that the demand curve given above refers to a perfectly
competitive industry in which each firm has a constant marginal cost
of 10. What is the industry price, output and total revenue?
d. Now in this competitive industry suppose that the MC for each firm
increases to 20. What is the new P, Q and TR for the industry.
e. Compare and comment on the change in TR for the monopoly and the
competitive industry when MC increases from 10 to 20.
103
Solution
a. The MR curve has the same vertical intercept but twice the slope of the
demand curve. i.e.:
MR = 210 – 8Q
P, MR
210
D (AR)
Q
26.25 52.5
Figure 8.2
The monopolist maximises profit when MR = MC, 210 – 8Q = 10. So
Q = 25. Put this into the demand curve to calculate P = 110.
TR = P*Q = 2,750.
b. Following a similar procedure, when MC = 20, Q = 23.75, P = 115,
and TR = 2,731.25.
c. When the industry is perfectly competitive, the industry supply curve
is horizontal at P = MC = 10. At this price the demand curve tells us
that Q=50 and therefore TR is 500 (P*Q).
d. By the same method, when MC = 20, industry output is 47.5, P = 20
(from demand curve) and TR = 950.
e. When MC increases from 10 to 20 the monopolist’s TR falls and the
industry TR increases. Why the difference? The monopolist always
operates on the elastic portion of its demand curve, otherwise
MR would be negative and this is never optimal. So an increase
in price reduces TR – a consequence of an elastic demand curve.
At the competitive output, on the other hand, for the industry
as a whole the demand curve is inelastic (you can check this by
calculating the elasticity or by substituting the competitive output into
the MR equation and noting that MR is negative, implying inelastic
demand). Of course, with inelastic demand an increase in MC and
price will increase TR. For each firm in the competitive industry MR is
positive and equal to price.
Activity SG8.3
Consider two monopolists in two industries. One is the sole postal service operating in
a country. The other is the sole producer of a certain type of cheese (no-one else has the
technology to produce this cheese). Which of these do you think faces a more elastic
demand schedule? Draw a rough sketch of the demand, marginal revenue and cost
curves for each industry and examine the gap between the point where MC = MR and
the price chosen by each monopolist. Which firm has greater market power?
104
Social cost of monopoly

This section establishes the important result that, compared with a

perfectly competitive industry, a monopolist produces less output and
charges a higher price (given the same cost conditions). This is the source
of the social cost of monopoly – the deadweight loss of monopoly.
The intuition for this is that, with price above MC, consumers place a
higher value on extra output than it costs to produce that extra output –
expanding output would be socially productive under such circumstances.
It is this deadweight loss, rather than the existence of monopoly profits,
that economists see as the rationale for ‘competition policy’, discussed in
Case 8.1. Competition or antitrust policy works differently in different
countries, but will seek some mix of attempting to generate more
competition in markets which are currently uncompetitive and regulating
the behaviour of firms with market power, for example by setting price
ceilings. Occasionally it will be decided that monopoly is in the ‘public
interest’ (not an easy concept to pin down!) and therefore its existence
is allowed to continue unchecked by policy. Section 8.9 (Monopoly and
technical change) returns to the potential advantages of monopoly.
The analysis in this section of the textbook uses a horizontal long-run
marginal cost curve. However, remember that Section 8.3 described how,
realistically, industry supply curves are likely to be upward sloping. The
diagram below portrays the social cost of monopoly in the case where the
long-run marginal cost curve slopes upwards. Some consumer surplus
has been lost and has become monopoly profits while some has become
deadweight loss. There is some producer surplus lost compared to the
perfectly competitive model, but this is smaller than the supernormal
profits gained by the monopolist.
Perfectly compeve Pure monopoly

market
P P
D D
PM
S MC
PC PC
MR
QC Q QM QC Q
Consumer surplus Producer surplus Deadweight loss
Figure 8.3: Monopoly and (in)efficiency.

The previous block described how the perfectly competitive model results
in outcomes which are both productive and allocative efficient. Productive
efficiency occurs because firms choose a quantity on their cost curves.
This applies to monopoly in the same way. Although monopolists are
not under pressure from competition to choose the cost-minimising mix
105
of inputs, they are still likely to do this in order to maximise profits. In

terms of allocative efficiency, the perfect competition model is allocative
efficient because the sum of consumer and producer surplus is maximised.
This means it is not possible to make one party better off without making
the other party worse off. By contrast, the monopolist is not allocative
efficient. As there is a deadweight loss, by lowering the price and
increasing the quantity produced, it would be possible to increase the total
surplus available for distribution between the two parties.
Price discrimination
Although this section is titled ‘A monopoly has no supply curve’, which of

course is correct, perhaps the more important material in it is the analysis
of price discrimination. In fact, the basic point is that when firms have
market power (pure monopoly is the extreme case) they can, under certain
circumstances, employ pricing strategies which increase their profits by
‘raiding’ the consumer surplus of their customers. Two such strategies are
discussed in Chapter 8 of BVFD; price discrimination and the two-part
tariff (explained in section 8.10).
Up to this point we have taken it as given that there can be only one single
price charged for a unit of a homogeneous good. Imagine this were not the
case. There would be possibilities for mutual gains via arbitrage – those
charged a low price could sell the good to those charged a high price; at
intermediate prices both parties gain. Arbitrage would continue until a
single price prevailed. Where such secondary markets are impossible or
can be prevented by simple monitoring strategies, firms with monopoly
power can increase their profits by charging different prices to different
consumers. Can you think of examples where it is difficult or impossible
for secondary markets to erode price differences? In the case of third-
degree price discrimination, by far the most common type in practice,3 3
But make sure you
BVFD show that the monopolist must equate MR in both sub-markets understand the rather
remarkable result
(make sure you understand why) and set these equal to the common
that first-degree price
value of MC. This leads to higher prices being charged in the sub-market discrimination eliminates
with the more inelastic demand. We can show this more rigorously using the deadweight loss
the formula for MR derived above (and in Maths 8.1). Suppose in market associated with a single
1 |ε| = 1.5 and in market 2 |ε| =3, then equating MR1 and MR2 gives price monopolist.
P1(1–1/1.5) = P2(1–1/3). This means P1/P2 = 2. The profit maximising
monopolist charges twice as much in the more inelastic market 1 than in
the more elastic market 2.
Activity SG8.4
Define first-, second- and third-degree price discrimination. For first-degree price
discrimination, draw graphs illustrating producer and consumer surplus compared to a
competitive industry and to a non-discriminating monopolist.
The two-part tariff is another strategy that, in essence, transfers surplus

from consumers to the monopolist. In BVFD this is explained in the context
of natural monopoly (section 8.10), but this strategy is found more widely
in the real world, not just in the case of natural monopolies. The basic idea
is simple. As in the case of price discrimination, market power enables
firms to transfer some or all consumer surplus from the buyer to the seller.
It does this by charging an entry or subscription fee and, in addition,
charging per unit of the good or service consumed. The per unit price is
106
set to equal marginal cost and the fixed fee is set to equal the consumer
surplus for an individual consumer.
D
CS
P1 MC
Q
Q1
Figure 8.4: Two-part pricing.

Consider a consumer with the demand curve in the above diagram. At
the price P1 per unit of the good, the consumer consumes Q1 and receives
consumer surplus equal to the shaded area CS. If the firm could charge
CS (or fractionally less) as an entry fee or admission charge, the consumer
will still purchase Q1 if the price stays at P1 (which is shown by the
demand curve). The only difference is that what was formerly consumer
surplus now becomes profit to the firm. There are many examples in the
real world of this type of two-part pricing; an annual subscription to a
tennis club and hourly fee for the use of a court, an admission fee to an
amusement park and a separate price per ride once inside, a monthly or
annual phone fee plus a charge per call. In each case the firm is using
its market power to get its hands on some of the consumer surplus of its
customers.
Activity SG8.5
Suppose that all consumers in the market have an inverse demand curve given by
P = 50 – 0.25Q. Suppose also the firm charges its customers £25 per unit. If it decides
to use a two-part tariff pricing strategy what is the maximum that it could charge each
customer as a fixed entry fee?
When can monopolies be justified?

► BVFD: read sections 8.9 and 8.10.
The pharmaceuticals industry provides one example of the controversy

regarding monopoly and competition law. In this industry, production
costs are very small and most of the costs involved are fixed costs on R&D
to discover and test new medicines. Firms can patent their discoveries
for a period of 10 years, allowing some time when they can sell these at
a monopoly price and earn profits which help cover the R&D costs for
that and other drugs. After this time, generic versions of the drugs start
to be sold by rival firms and the price generally falls. On the one hand,
people argue that life-saving drugs should be made available immediately,
especially to developing countries. On the other hand, it is argued that
without the monopoly period provided by the patent, firms would have no
incentive to invest in R&D and new drugs would not be discovered.
The case of natural monopoly discussed in section 8.10 and in concept
8.2 is important, so make sure you understand this and the issues of
regulation that arise. In Figure 8.17, little would have been lost if the LMC
curve were simply a horizontal line. This would correspond to a long-run
107
total cost curve of the form TC = a + bQ where a is the fixed cost and b
the constant marginal cost. Here the falling AC comes about as the fixed
cost a is spread over larger outputs. Take the case of railways where there
are large fixed costs in setting up the track network but the marginal cost
per journey mile (Q) may be quite low in comparison. In this case it would
be very inefficient to have several providers each installing their own
parallel rail networks.
Overview
This block discussed the case of pure monopoly, where there is only
one firm and large barriers to entry, such that the monopolist faces no
competition from incumbent firms or even from potential entrants.
The profit-maximising output for the monopolist is discussed, with
the monopolist choosing the quantity where MC = MR. Price is higher
than MR for the monopolist. Just how much higher it is depends on the
elasticity of demand and indicates the degree of monopoly power for
that industry. Where a monopolist and a perfectly competitive market
can meaningfully be compared, a monopolist charges a higher price
and supplies a lower quantity of output. The allocative inefficiency of
monopoly is demonstrated by the loss of social surplus (called ‘deadweight
loss’) compared to the case of perfect competition.
A discriminating monopolist charges different prices to different
consumers. First-, second- and third-degree price discrimination are
explained, including the impact on output, price and profits. Monopolists
can also increase their profits by using a two-part pricing strategy. These
strategies transfer surplus from consumers to producers but reduce the
deadweight loss of the monopolist. Despite the allocative inefficiency of
monopoly, one possible advantage could be that monopoly profits provide
an incentive for firms to innovate. Furthermore, there are some industries
which work best as monopolies, these are called natural monopolies
and have a falling long-run average cost curve over the whole range of
production. These are generally industries with very large fixed costs such
as water, electricity and telecommunications, and are generally either
owned or heavily regulated by government.


For each question, choose the best response
1. A monopolist maximises profits when:
Select one:
a. Average revenue equals average cost.
b. Average revenue equals marginal cost.
c. Marginal revenue equals average cost.
d. Marginal revenue equals marginal cost.
108
2. With full (perfect) price discrimination, equilibrium output of the

monopolist is:
Select one:
a. The same as in a non-discriminating monopolist.
b. Less than in a non-discriminating monopolist.
c. The same as perfect competition.
d. The same as in monopolistic competition.
3. A monopolist faces two consumer groups: old and young. The inverse
demand of old clients for the output of the monopolist is Po = 100
– 2Qo. This implies that MRo = 100 – 4Qo. The inverse demand of
young clients for the output of the monopolist is Py = 80 – Qy. This
implies that MRy = 80 – 2Qy. The marginal cost of supplying any type
of client is MC = 10. If the monopolist can price discriminate between
the two groups (i.e., charge a different uniform price to each group),
what price will old and young clients be charged?
a. Po = £45; Py = £55
b. Po = £55; Py = £45
c. Po = £50; Py = £50
d. Po = £40; Py = £60.

1. a. i. List the fundamental assumptions of the monopoly model and
provide a graphical representation of equilibrium in this
model. Carefully describe the various components of your
graphical representation.
ii. Define and discuss the concept of ‘deadweight loss’ of
monopoly using your graphical representation of the monopoly
model.
iii. Provide a graphical representation of a monopolist that
engages in third-degree price discrimination, dividing its
customers into a group with a high elasticity of demand and a
group with a low elasticity of demand. Demonstrate how the
monopolist sets its prices to achieve profit maximisation in this
situation.
b. A monopolist faces a demand curve P = 210 – 4Q. The firm faces a
constant marginal cost MC = 10.
i. Calculate the profit-maximising monopoly quantity and price.
ii. Suppose that all firms in a perfectly competitive equilibrium
had a constant marginal cost MC = 10. Find the long-run
perfectly competitive industry price and quantity.
iii. Compare consumer surplus under monopoly versus perfect
competition. You may find it useful to draw a diagram.
iv. What is the deadweight loss due to monopoly? Is this the same
as the difference between the two consumer surpluses you
calculated in iii.?
109
Notes
110
Block 9: Market structure and imperfect competition
Block 9: Market structure and imperfect

competition
Introduction
Most firms in the real world do not operate within markets described
by the textbook definitions of perfect competition or pure monopoly.
This block introduces a theory of market structure and some models
of imperfect competition. These models help to explain some of the
phenomena we see in real world markets such as advertising, price
wars and product differentiation. Game theory is introduced as a useful
tool for analysing strategic interactions. The maths boxes show how to
find reaction functions of firms competing with each other in a market
structure called duopoly (where there are two firms). You will need to
practise using these to calculate price, output, profits and consumer and
producer welfare and compare these to the outcomes of other market
structures such as monopoly and perfect competition. Although these look
complicated, in fact, they are all based on the simple equations that:
Profit = Total Revenue – Total Cost and
Total Revenue = Price * Quantity.
The formulas for marginal revenue and marginal cost can be derived from
these using calculus. MR, in the case of linear demand, can also be derived
using the result from Block 7 (MR has the same intercept on the P axis and
is twice as steep as the demand schedule).
Learning outcomes
• recognise imperfect competition, oligopoly and monopolistic
competition
• discuss how cost and demand affect market structure
• interpret an N-firm concentration ratio
• describe how globalisation changes domestic market structure
• identify equilibrium in monopolistic competition
• recognise the tension between collusion and competition in a cartel
• describe game theory and strategic behaviour
• define the concepts of commitment and credibility
• analyse reaction functions and Nash equilibrium
• describe Cournot and Bertrand competition
• describe Stackelberg leadership
• recognise why there is no market power in a contestable market
• define innocent and strategic entry barriers.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 9.
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Further reading
Chapter 8.

This block starts by introducing a theory of market structure, focusing
on how market structure depends on the shape of the industry long-
run average cost curve and the position of the market demand curve.
Market structure can be described using an N-firm concentration ratio.
Two specific types of imperfect competition are analysed in this block
– monopolistic competition and oligopoly. One key characteristic of
a monopolistically competitive market is product differentiation. The
long-run equilibrium of this market is described graphically. One key
characteristic of oligopoly is strategic interaction. Oligopoly is often
portrayed using a kinked demand curve, although the usefulness of this
concept is a matter of debate. Firms can either compete or collude. If they
compete, this can be analysed using models from game theory, such as the
prisoner’s dilemma. A specific example of oligopoly is duopoly, where there
are only two firms. They can compete on output (Cournot behaviour)
or price (Bertrand behaviour). If one firm moves first, it is a Stackelberg
leader and will derive different payoffs than the firm which follows. The
outcomes of these interactions are described in this block, and you will
learn how to find these and how to compare them with the outcomes that
arise under monopoly and under perfect competition. The behaviour of
incumbents is affected not only by other firms already in the market, but
also by the threat of entry of new firms. If other firms can enter freely, the
market is called a contestable market, and will exhibit outcomes similar to
perfect competition. Barriers to entry can either be natural (innocent) or
strategic (constructed). Strategic entry deterrence can consist of investing
in spare capacity, in advertising, or in product differentiation, for example.
This can be analysed by use of a decision tree. In all these games, the
concept of Nash equilibrium is important and demonstrates a stable
outcome, from which the players have no incentive to diverge.
A theory of market structure

► BVFD: read the introduction and section 9.1 of Chapter 9.
The crucial determinant of market structure is minimum efficient scale

(the lowest point at which a firm’s LAC curve stops falling) relative to the
size of the total market as shown by the demand curve.
The concentration ratio measures the fraction of total output in an
industry that is produced by some specific number of the industry’s largest
firms. The N-firm concentration ratio leaves this number general. Once it
has been specified, we refer to the five-firm concentration ratio, or three-
firm concentration ratio, for example.
The degree of competition in a market is also affected by globalisation -
the closer integration of markets across countries - since this increases the
ability of foreign producers to compete effectively in the domestic market.
As such, the degree of competition does not only depend on the number of
domestic producers alone.
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Activity SG9.1
1. Calculate the four-firm concentration ratio of an industry with the following
distribution of sales: 40%, 10%, 10%, 10%, 8%, 8%, 6% 4% 2% 1% 1%.
a. 100%
b. 80%
c. 70%
d. 40%.
Monopolistic competition
Monopolistic competition describes a market structure with a large number

of firms, each one selling a product which is an imperfect substitute
for the product of its rivals (this is called product differentiation). Each
firm faces a downward sloping demand curve for its product. Firms in a
monopolistically competitive industry are not price-takers; they have some
market power and can set the price they charge. If they increase price
they will lose some customers, but not all. If they drop their price they
will gain some market share but will not capture the whole market. Since
the number of firms is large, they can ignore any reactions of competitors
when they make their output and pricing decisions. A further important
assumption of this model is that there is free entry and exit. When a new
firm enters the industry, it will take customers from all existing firms,
shifting the demand curve faced by each firm to the left.
The key element that makes monopolistic competition different to perfect
competition is that firms face a downward sloping demand curve rather
than a horizontal demand curve (i.e. demand for their products is not
perfectly elastic as it is in perfect competition). Since this is due to product
differentiation (the assumption that the goods are heterogeneous), firms
have a strong incentive to advertise their products – either to inform
customers about what makes their product different, or to create and
enhance customers perceptions of this difference. If advertising is effective,
it can increase the demand for a product and also decrease the elasticity of
that demand, both of which can lead to an increase in revenue for the firm.
Activity SG9.2
Figure 9.2 shows the short-run and long-run equilibria for a firm in a monopolistically
competitive market. Remember that the demand curves DD and DD’ (and the associated
MR curves) refer to a single firm in the market. The market demand curve, of course,
lies further to the right. Make sure you understand this figure by reproducing it below,
highlighting:
i. the short-run monopoly profits
ii. the tangency of the DD’ curve and the AC curve in long-run equilibrium.
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In the long run, the price charged by firms is equal to the average cost and
they are just breaking even. In industries where there are many producers
but of differentiated products, free entry will tend to eliminate profits in
the long run.
Monopolistic competition and efficiency

The long-run equilibrium point is not on the minimum of the LAC curve as
it would be under perfect competition – this implies inefficiency, as firms
are operating with extra capacity, on the downward sloping section of their
average cost curves. Any point on the LAC curve is by definition productive
efficient. Producing on the downward sloping part of the AC curve implies
a loss of allocative efficiency, as price will be higher than marginal cost
(since the LMC curve passes through the lowest point of the LAC curve).
Because the price is set higher than the marginal cost, consumer surplus
is lower than it would be if prices were set equal to marginal cost at the
lowest part of the firm’s AC curve.
However, people are willing to pay to have differentiated products.
For example, people would not be happy if there was only one type of
restaurant to go to, even if this made prices lower. An optimal outcome
would be achieved where the number of differentiated products was
increased until the marginal gain in consumer’s satisfaction from an
increase in diversity was equal to the loss from having to produce each
existing product at a higher cost (L&C, UK edition p.181; international
edition p.147). Market forces would not necessarily lead to this
outcome, thus it is unclear whether or not the long-run equilibrium of a
monopolistically competitive industry is allocative efficient.
Oligopoly
An oligopoly is a market structure characterised by there being only a few

firms, which interact strategically. Firms are aware that their decisions
affect the actions of other firms and that their own optimal decisions
depend on what the other firms are doing. The basic tension is between
wanting to collaborate to achieve a monopoly outcome, and the incentives
to cheat on any agreement so as to raise one’s own market share and
profits. Examples of oligopolies in the UK include the supermarket
industry (dominated by Tesco, Sainsbury, Morrison and ASDA) and retail
banking (dominated by Barclays, Lloyds, the Royal Bank of Scotland
and HSBC). Note the discussion of OPEC in the section on cartels was
written before world oil prices again plummeted in mid-2014. There has
been much debate about the causes of this downturn in oil prices (in
particular, whether it is primarily demand-driven or supply-driven), but
the unwillingness of the Saudis to restrict output, discussed in BVFD, is
certainly one element in the story
Oligopolistic industries tend to be dominated by a few large
firms. One reason for this is that large firms often have a competitive
advantage because their fixed costs (e.g. research and development) can
be spread out over a greater sales volume so the per unit cost is reduced. A
further reason is that large firms can exploit economies of scale and scope,
which creates natural entry barriers. Economies of scale arise because a
large scale facilitates the division of labour, which increases productivity.
Economies of scope apply to firms that produce multiple products and
arise because firms can share resources or functions between different
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product areas (L&C, UK edition p.184; international edition p.149). In

industries where there are large economies of scale or scope, there is
simply not enough room for a large number of firms, all operating at or
near their minimum efficient scales. Hence, it is more common for a small
number of large firms to dominate the market.
Profits under oligopoly

In some oligopolistic industries, firms manage to approach joint profit
maximisation (in this case, the outcome in terms of market price and
output is similar to pure monopoly). In others, firms compete very
intensely and approach the perfectly competitive output. In the long run,
profits will attract entry, unless there are natural entry barriers such as
large economies of scale.
The kinked demand curve

Figure 9.4 shows the demand curves facing a single firm. Imagine this is
your firm. The assumption is that competitors will match your price-cut
to maintain their market share, but are happy to watch you raise your
price without reacting, since you will lose market share to them if they
keep their price steady when you raise yours. Below Q0, demand is elastic
because if you increase your price by even a little, customers will go away
from you and buy from your competitors, whose prices have remained the
same. Recall from (BVFD, Chapter 4, p.68) that when demand is elastic,
a price rise leads to a fall in total revenue. Above Q0, demand is inelastic
– you won’t gain many more customers by cutting your price because your
competitors will all drop their prices too. Recall also that when demand
is inelastic, a price cut leads to a fall in total revenue. This helps to
provide an explanation for why prices may be sticky at P0, since there is
no revenue incentive to shift prices in either direction. The discontinuity
in the MR curve shows that prices may well be sticky even when a firm’s
costs change and shift its MC curve. The ability to predict and explain
price stickiness is one of the merits of this theory. One of its shortcomings
is that it does not explain how the initial price and quantity, the point of
the kink on the demand curve, is determined.
Game theory
Considering the extent to which game theory has revolutionised much of

modern industrial organisation theory, and oligopoly theory in particular,
the treatment here in BVFD is relatively brief (although the treatment in
this section is expanded in section 9.7 of the text). Game theory is a very
useful approach for analysing strategic interaction. In a game, your best
move depends on what your opponent does. This is helpful for analysing
oligopoly, since one of the key features of this market structure is strategic
interaction between firms. One key concept is a dominant strategy
– a player has a dominant strategy if one strategy is their best response,
regardless of what the other player does. In Figure 9.5, choosing a high
output is a dominant strategy for each firm. Another key concept is Nash
equilibrium – this is a situation where no player has an incentive to
change their strategy, since they are doing as well as they can, given the
strategies chosen by the other players. Note that in Figure 9.5 the Nash
equilibrium is, unsurprisingly, the pair of dominant strategies. However it
is not necessary that both firms have a dominant strategy for there to be a
Nash Equilibrium.
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Activity SG9.3
The high-output/low-output game is based on a famous game called the ‘Prisoner’s
dilemma’. McGraw Hill has a nice interactive version of this which you can access at
http://highered.mheducation.com/sites/007243404x/student_view0/chapter9/interactive_
activities.html# (though the question appears to be slightly misworded). The prisoner’s
dilemma is described below. Read through the scenario and decide what you would do if
you were one of the prisoners
You and your partner were just arrested for the burglary you pulled off last
night, and are being interrogated separately in different rooms. The officer
says to you ‘Well, looks like you’ve got some decisions to make here. You can
confess to the burglary or you can continue to deny any role in it. Your problem
is that the consequence for you depends on what your partner does. If he
confesses and you don’t, we’ll throw the book at you and give him immunity.
You get 10 years in jail and he goes free. Of course, the reverse would be true
if you confess and he doesn’t. If you both confess, you’d both get a lighter
sentence, 5 years. If you both insist on denying the charges, we should have
enough evidence to get you both for 1 year for sure.’
Now answer the following questions:
a. What does the payoff matrix for this game look like? (base this on Figure 9.5) (it is
conventional to make the payoff for the player, on the left hand side of the payoff
matrix, the ‘row player’, the first entry in each cell and the payoffs for the player at
the top of the matrix, the ‘column player’ second).
b. Does either player have a dominant strategy?
c. Does this strategy result in the best joint outcome for the prisoners?
d. Does this strategy result in the best outcome for the police?
The game in Figure 9.5, and the traditional prisoner’s dilemma you have
just worked through are one-off games (sometimes called ‘one shot’
games). Many real world economic decisions, such as firms setting prices
or quantities, relate to repeated actions rather than one off moves. This
can quite dramatically change the expected outcomes. The intuition is
that repeated games provide incentives for cooperation that are absent in
one-off games; in a repeated game, honest behaviour can be rewarded and
cheating can be punished (it is necessary that the threat of punishment is
a credible threat). See the McGraw-Hill interactive version for a second
game on repeated interactions.
Models of oligopoly
► BVFD: read section 9.5, Maths 9.1 and 9.2 and concept 9.2.
This section covers models of oligopoly (illustrated in the two-firm

case, a duopoly) that preceded game theory by many years (Cournot
and Bertrand were 19th-century French mathematical economists and
Stackelberg, a German economist, first published his analysis in 1934).
While it is often possible to reformulate the models in game theoretic
terms, it is instructive to understand the structure of such models.
Cournot model
The graphical analysis of the Cournot model is useful if you find the
mathematics in Maths box 9.1 difficult. If you don’t, the mathematical
treatment is more concise. Note that Maths box 9.1 uses calculus in
deriving the reaction functions. But in the last chapter, we showed that for
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a linear demand curve the MR curve has the same intercept on the P axis,
but is twice as steep. Let us see how this works out in the example BVFD
use in the maths box.
We are given the market demand curve P = a – bQ, which we can write as
P = a – bQA – bQB. Now we want to write firm As MR curve as a function of
its own output, holding its rival’s output constant, so using the result from
the last chapter, MRA= a – 2bQA – bQB .
Although calculus is the most straightforward means, there is an
alternative method of finding MC. Using delta notation as before,
∆TCA = c∆QA. Therefore:
∆TC MC = c
= A
∆QA
a–C a–QB
Now setting MRA = MCA gives us A’s reaction function (QA = ) –
2b 2
and similarly for firm B. Solve the two reaction functions simultaneously
to get the Nash equilibrium in quantities. The same method can be used,
with suitable variations (for example in deriving the MR function for firm
A we first substitute B’s reaction function into the demand curve), in the
case of a Stackelberg leader to replace the calculus in Maths box 9.2.
Activity SG9.4
Consider a market for a homogeneous product with demand given by Q = 37.5 – P/4.
There are two firms, each with a constant marginal cost equal to 40.
a. Determine output and price under a Cournot equilibrium.
b. Compute the deadweight loss as a percentage of the deadweight loss under a non-
discriminating monopolist.
Activity SG9.5
Which model of strategic duopoly interaction (Cournot or Bertrand) would you think
provides a better approximation to each of the following industries, and why?
i. oil refining
ii. insurance.
Stackelberg model
Activity SG9.6
Suppose there are two firms with the same constant average and marginal cost,
AC = MC = 5, facing the market demand curve Q1 + Q2 = 53 – P. Firm 1 is a Stackelberg
leader and makes its output decision before Firm 2 (a Cournot follower).
a. Find the reaction curves that tell each firm how much to produce in terms of the
output of its competitor and use these to calculate how much each firm will produce
and the profits it will make, as well as the market price and the total market profit.
b. If each firm believes that it is the Stackelberg leader, while the other firm is the
Cournot follower, how much will each firm produce, and what will its profit be?
c. In the Stackelberg model, the firm that sets output first has an advantage. Explain
why.
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Contestable market
A contestable market is a market structure in which there are only a few

companies which nonetheless behave in a competitive manner due to the
threat of new entrants. Globalisation has increased the relevance of this
concept, since foreign firms which are already established in overseas
markets can enter more easily into a domestic market than firms which
need to start production from scratch.
This section also refines the concept of barriers to entry, which we
considered in the previous block on monopoly. There, we differentiated
between ‘natural’ and ‘artificial’ barriers to entry, but this was not the only
way to characterise different types of entry barriers. Here BVFD makes a
similar, but not identical, distinction between ‘innocent’ and ‘non-innocent’
barriers to entry. Other texts distinguish between ‘structural barriers’, ‘legal
barriers’ and ‘strategic barriers’, the latter referring to deliberate actions
taken by incumbent firms to deter entry by new firms. These types of entry
barriers are discussed in the next section.
Sequential games
The game discussed in this section is represented again below with an

alternative presentation of the payoffs, for clarity. Sequential games such
as this are often represented with the payoffs at the end of the relevant
path. As stated below the diagram, in each case the first payoff in each
set of brackets is the incumbent’s, the second the potential entrant’s. This
depiction, and that in Figure 9.9, is known as the extensive form of the
game (sometimes also known as a decision tree).
Without strategic With strategic

entry deterrence entry deterrence
Entrant Entrant
In In
Out Out
Incumbent Incumbent
Accept Fight Accept Fight
(1,1) (-1,-2) (5,0) (-2,1) (-1,-1) (2,0)
Payoffs are: (Incumbent, Entrant)
Figure 9.1: Strategic entry deterrence.

Let us start with the case where there has been no strategic entry
deterrence, for example there has been no investment in excess capacity
which can be used to quickly flood the market with extra output. This is
shown as the game on the left above, and in the top row in the matrix in
Figure 9.9. Sequential games can be solved by backwards induction,
which means starting from the final step of the game. In this case, only
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one leg of the decision tree involves a decision by the incumbent (i.e.
the left leg). The incumbent can either choose between a payoff of 1 (if
it accepts the entry without fighting) or –1 (if it fights). It will choose 1.
The threat to fight entry is not a credible one in this case. Now going back
to the first step of the game, where the entrant has a decision to make.
The entrant can either choose a payoff of 1 (if it enters, since it knows the
best move for the incumbent will be to accept its entry) or 0 (if it does
not enter). It chooses 1. The outcome of the game is thus that the entrant
enters and the incumbent accepts. Both make a profit of 1. Now for the
case where the incumbent has taken steps to deter entry – the game on
the right (the second row in Figure 9.9). As described in the textbook, this
could be by investing in spare capacity which is only useful if it chooses to
fight a market entrant. Starting again with the second part of the game,
the incumbent chooses between a payoff of –2 (if it accepts) and –1 (if
it fights). It will choose –1. The entrant thus faces the following choice:
a payoff of –1 (if it enters and the incumbent fights), or a payoff of 0 (if
it doesn’t enter). It will choose 0. Thus the outcome of the game is that
the entrant does not enter and the incumbent makes a profit of 2. As
compared to the first case (no spare capacity) the incumbent’s threat to
fight is credible, it does better by fighting than by accepting. Sequential
games and backward induction are useful tools for analysing this type of
market interaction. However, certain key assumptions are required, for
example that both players have accurate knowledge of the whole decision
tree, including the payoffs of their opponent.
► BVFD: read section 9.8 and the summary, and work through the review
questions.
Overview
Market structure is partly determined by firms’ minimum efficient scale
(the lowest point at which a firm’s LAC curve stops falling) relative to
the size of the total market as shown by the demand curve. Imperfect
competition exists when firms face a downward sloping demand curve.
The most important forms of imperfect competition are monopolistic
competition, oligopoly and pure monopoly. The key characteristic of a
monopolistically competitive market is product differentiation, which gives
each firm some limited monopoly power in its special brand. There is free
entry and exit. In long-run equilibrium, the demand curve is tangent to
the firm’s LAC curve, and price is equal to average cost but is greater than
marginal cost and marginal revenue.
The key characteristic of oligopoly is strategic interaction. Oligopoly is
often portrayed using a kinked demand curve. Firms can either compete or
collude, though many forms of collusion are illegal in domestic markets.
Strategic interaction can be analysed using game theory. The outcome
will depend on whether the game is played once or repeatedly, and if it
is possible for firms to make binding commitments. A specific example of
oligopoly is duopoly, where there are only two firms. In a Cournot duopoly,
each firm treats the other firm’s output as given. In a Bertrand duopoly,
each firm treats the other firm’s price as given. If one firm moves first, that
firm is a Stackelberg leader and will gain higher payoffs than the firm which
follows.
The outcomes of these forms of interaction can be compared with the
outcomes that arise under monopoly and under perfect competition.
In some oligopolistic industries, firms manage to approach joint profit
maximisation (in this case, the outcome in terms of market price and
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output is similar to pure monopoly). In others, firms compete very

intensely and approach the perfectly competitive output. In the long run,
profits will attract new firms into the industry unless there are barriers to
entry. The threat of entry of new firms affects the behaviour of incumbents.
If other firms can enter freely, the market is called a contestable market,
and incumbent firms must mimic perfectly competitive behaviour in order
to avoid being flooded by entrants. Barriers to entry can either be natural
(such as scale economies or absolute cost advantages) or strategic (arising
from credible commitments to resist entry if challenged). The analysis
of imperfect competition helps explain real world phenomena such as
advertising, price wars and product differentiation.


For each question, choose the best response.
1. Refer to the box below. Two bus companies offer a daily service
running from London to Nottingham. Each company can decide to
leave early or leave late. Their buses are somewhat different, so the
payoffs are not symmetric. From the payoff matrix, we can see that:
a. neither company has a dominant strategy
b. only bus company A has a dominant strategy
c. only bus company B has a dominant strategy
d. both companies have a dominant strategy.
Box 1
Note: Lower left payoffs are Bus Company B
A’s. Upper right are B’s Leave Early Leave Late
Bus Company £900 £850
Leave Early
A £1,000 £950
£650 £800
Leave Late
£750 £700
2. Which market structure is characterised by a long-run equilibrium
where price is equal to average cost but is greater than marginal cost
and marginal revenue?
a. perfect competition
b. monopolistic competition
c. oligopoly
d. monopoly.
3. The demand curve faced by a monopolistically competitive firm is
a. elastic
b. unit elastic
c. inelastic
d. perfectly inelastic.
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4. If an imperfectly competitive firm is producing a level of output where

marginal cost is equal to marginal revenue, marginal revenue is below
average variable cost, and price is equal to average total cost, then the
firm:
a. should shut down
b. should decrease output, but should not shut down
c. should increase output
d. none of the above is correct.
5. An industry having a four-firm concentration ratio of 85 per cent:
a. approximates pure competition
b. is monopolistically competitive
c. is a pure monopoly
d. is an oligopoly.

1. a. Duopoly: There are two firms in a market, both have a linear cost
function C(q) = 2q. The market inverse demand function is given
by P(Q) = 9 – Q.
i. What is the Cournot equilibrium output for each firm? What
price will they charge? How much profit will they each earn?
ii. Assume Firm 1 is the Stackelberg leader and Firm 2 follows
afterwards. What is the Stackelberg equilibrium output for
each firm? What price will they charge? How much profit will
they each earn?
iii. Compare the price, total market output and profits for the two
firms under Cournot and Stackelberg duopoly. Which market
structure does Firm 1 prefer? Firm 2?
iv. Which market structure do consumers prefer? Why?
b. Contestable markets:
i. What is a contestable market?
ii. How is globalisation relevant for the analysis of contestable
markets?
iii. For the payoff matrix given below, draw a decision tree and
find and explain the outcome of the game (the payoff to the
incumbent is listed first in each cell).
Potential entrant
In Out
Incumbent
Accept 15, 10 50, 0
Fight –10, –20 50, 0
2. a. Monopolistic competition:
i. What are the particular characteristics of monopolistic
competition as a market structure?
ii. Draw a short-run equilibrium for monopolistic competition
where the firms are making losses, and show how exit results
in a new, long-run equilibrium.
iii. Is this outcome efficient?
121
b. Concentration ratios:
In the USA, the four-firm concentration ratio for beer increased
from 22 to 95 between 1950 and 2000. Explain what this means
and describe possible reasons for why this occurred.
122
Block 10: The labour market
Introduction
The previous blocks discussed the theory of the firm and various market
structures. Part of the theory of the firm is the way in which firms aim to
combine inputs in the most cost efficient way possible. This gave us the
first taste of the roles of capital and labour in the production process.
In addition to labour and capital, the factors of production also include
land and raw materials, as well as entrepreneurship. These factors will
be briefly explained below. This block then focuses on the labour market.
Some of what you will learn about the labour market is also relevant for
the analysis of the other factors of production; however, there are also
key differences. We will not explore these further in this block. Interested
students can read BVFD Chapter 11 – otherwise, you will most likely cover
the analysis of markets for the other factors of production in later years as
you continue your studies in economics.
The study of the labour market is important – not least from an individual
point of view, as most of us will allocate a substantial fraction of our
time to the labour market in the future (if you are not already doing
so). Furthermore, many social policy issues concern the labour market
experiences of particular groups of workers. Finally, as we have already
mentioned, labour is a key input in the production process. The overall
productivity of an economy depends to a large extent on the productivity
of its labour force. The approach to this subject matter is similar to the
analysis of markets for consumer goods, and the structure of the textbook
chapter will also be familiar to you (covering demand, supply, equilibrium,
and adjustments). However, in some ways the details are quite different.
For example, labour is human effort, thus the supply of labour depends on
individual preferences.
Learning outcomes
• describe the factors of production
• analyse a firm’s demand for inputs in the long run and short run
• recognise marginal value product, marginal revenue product and
marginal cost of a factor
• define the industry demand for labour
• analyse labour supply decisions
• define economic rent
• define labour market equilibrium and disequilibrium
• demonstrate how minimum wages affect unemployment.
Essential reading
Further reading
Lipsey and Chrystal (L&C) international edition, Chapters 8 and 9; UK edition,
Chapters 9 and 10.
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This block first introduces the factors of production and then provides
an analysis of the firm’s demand for factors, building on the analysis
from the blocks on the firm (5 and 6) where the firm’s choice of a cost-
minimising mix of inputs was discussed. Having now analysed various
market structures (Blocks 7–9), the impact of the shape of the demand
curve the firm faces for their output on their demand for inputs (which is
derived demand) is now clarified, focusing on labour. The more elastic the
firm’s demand and marginal revenue curves, the more an increase in the
price of labour leads to a fall in the firm’s demand for labour. In the short
run, at least one factor of production is fixed, but the firm can adjust its
variable input which is labour. Labour is subject to diminishing marginal
returns when other factors are fixed and the marginal physical product
of labour falls as more labour is hired. The firm hires labour until the
marginal cost of labour equals its marginal revenue product. The industry’s
demand for labour is less elastic than the horizontal sum of firm’s short-
run demand curves, because higher industry output in response to a
wage reduction also reduces the output price. In terms of the supply
of labour, this depends on the size of the population, the participation
rate and the number of hours people choose to work. For someone
already in the labour force, a rise in the hourly real wage has both a
substitution effect tending to increase the hours worked and an income
effect tending to reduce the supply of hours worked. Four factors increase
the participation rate: higher real wages, lower fixed costs of working,
lower non-labour income and changes in tastes in favour of working.
The industry supply curve of labour depends on the wage paid relative to
wages in other industries using similar skills. People who would like to
work and are actively seeking work but cannot find a job are unemployed.
Unemployment can be defined as voluntary or involuntary. Possible causes
of involuntary unemployment (representing disequilibrium in the labour
market) are minimum wage agreements, trade unions, scale economies,
inside–outsider distinctions and efficiency wages.
The factors of production

The production of any good or service requires inputs. These are known as
the factors of production. The three main inputs to the production process
are: land, labour and physical capital.
• Land comprises all free gifts of nature such as land, forests, minerals
etc. Although its productivity can be improved through fertiliser and
irrigation (for example), its supply is generally considered fixed, even
in the long run.
• Labour includes the mental and physical effort of people employed in
return for remuneration. Each individual has different skills, qualities
and qualifications. This is known as their human capital.
• Physical capital is the stock of produced goods that are used in the
production of other goods and services by firms (mostly) and also
households. Physical capital is manufactured, which means that the
stock of capital can be increased. It is not completely consumed in the
production process although it does tend to wear down over time –
this is known as depreciation.
124
Supplied by Consumed in production? Speed of adjustment

Land Nature No Never – fixed supply
Labour Individual people No Fast
Capital Firms (generally) Not fully Medium
Table 10.1: Characteristics of key factors of production.
These are the three main inputs to production described in BVFD.
Other textbooks add further inputs, for example: raw materials and
entrepreneurship.
• Raw materials are also provided by nature and are included together
with land in many definitions; however one key difference is that
raw materials (such as oil, coal, cotton, etc.) are fully consumed in
the production process. Thus in one sense, there is little difference
between the analysis of markets for raw materials and markets for
final consumption goods.
• Entrepreneurship is provided by entrepreneurs or innovators and
includes introducing new ideas and business practices as well as
accepting risk to their own resources and possibly also organising the
other factors of production.
You can read more about the factors of production in BVFD sections
11.1 (capital), 11.8 (land) and concept 11.1 (summary); in AW section
3.1, sub-section ‘Means of production’ (pp.105–07); and L&C Chapter 1,
subsection ‘Resources and scarcity’ (UK edition p.9; international edition
pp.5-6) as well as Chapter 9 (UK edition) or 8 (international edition).
Analysis of the labour market

► BVFD: read Chapter 10.
One key difference between our analysis of consumption goods in the

previous blocks and our analysis of labour as an input to production in this
block is that the roles of the key market participants have been reversed.
Previously, when we talked about consumption goods, firms were the
suppliers and individuals were the consumers. In the labour market,
individuals are now supplying their labour, which firms demand. A second
key difference is that the demand for labour is derived demand, in that
the demand for labour depends on the demand for the goods produced by
that labour. Firms’ decisions on how much to produce and how to produce
it imply specific demands for various quantities of inputs.
Labour demand in the long run

When analysing input markets it is important to distinguish between the

short run, when (by definition) the amount of at least one input cannot
be varied by the firm, and the long run, in which the firm is free to vary
all its inputs. This section deals with the labour market in the long run.
Because both labour and capital can be varied, an increase in the price of
labour (the wage rate) will decrease the demand for labour due both to
the substitution effect (capital becomes relatively cheaper so any given
output is produced more capital-intensively) and the output effect (with
higher costs, the profit maximising output level, where MC = MR, falls).
The point made in Figure 10.1 is returned to below in the discussion of
the short-run demand for labour. The final section refers to the appendix
125
where this is demonstrated using budget constraints and indifference

curves. In fact, there is no appendix to this chapter but the analysis is
covered in the appendix to Chapter 7.
Activity SG10.1
Use budget constraints and indifference curves to demonstrate the effect on the demand
for labour of a fall in the wage rate – clearly indicate both substitution and output effects
and accompany your graphs with a written explanation.
Activity SG10.2
A fall in the wage rate will:
a. increase the demand for capital but the effect on the demand for labour is uncertain
b. increase the demand for labour but the effect on the demand for capital is uncertain
c. decrease the demand for capital but the effect on the demand for labour is uncertain
d. decrease the demand for labour but the effect on the demand for capital is uncertain.
This section (BVFD Section 10.1) goes beyond the analysis in Chapter 7
to demonstrate how the elasticity of demand impacts on the output effect
of a change in one of the factor prices. The (perfectly elastic) horizontal
demand curve DD is much more elastic than the downward sloping
demand curve D’D’. If the firm faces the less elastic curve, the output effect
of an increase in costs is smaller – as can be seen in Figure 10.1. This
shows the importance of recognising that the demand for factors is derived
demand such that the characteristics of the demand for the output have an
impact on the demand for the factors of production.
Short-run demand for labour

► BVFD: read section 10.2 and Maths 10.1.
The firm can calculate the optimal amount of capital and labour to use as
inputs in the production process using marginal analysis: the extra value
gained from one more unit of the input must be equal to the unit price of
that input. The extra value gained from one more unit of the input is, in
turn, the marginal physical product of the input multiplied by how much
the firm gets, per unit, from selling that extra output. In the case of a
price taking firm, and section 10.2 only considers competitive firms, the
marginal physical product is just multiplied by the price of output, which
is of course constant for the firm. In the case of a firm facing a downward
sloping demand curve for its product, a monopolist for example, we
cannot just multiply MPL by the original product price to get the monetary
value to the firm of the extra output. Why not? Because to sell more
output the price will have to fall, not just for the marginal unit but for all
units. If you don’t remember why this is, revise the monopoly block and
chapter. When the demand curve is downward sloping the optimal rule
for hiring an input is, in the case of labour, to hire labour until the wage is 1
Some textbooks using
equal to the marginal revenue product of labour (MRPL)1, i.e. until the term marginal
revenue product for
W = MRPL = MRQ * MPL both competitive and
non-competitive firms,
where MRQ is the marginal revenue that the firm gets from selling an extra
others, such as BVFD,
unit of output. Recalling from block 7 that: reserve the term MVPL
( 1
MRQ = P 1 +
( for the competitive case
ε where MR=P.
126
where ε is price elasticity of demand for output, the hiring rule becomes to
hire labour up to the point where
( 1
W=P 1+
(
.MPL
ε
in the case of perfect competition where ε =-∞ this just reduces to
W = P * MPL, or W = MVPL in the textbook. Note that because ε is negative,
the labour demand curve for a non-competitive firm lies below the labour
demand curve for a competitive firm with the same MPL curve and is steeper.
As in Figure 10.1, output, and hence the derived demand for labour, is less 2
This is the basis for one
responsive to wage changes the less elastic is the demand for output.2
of the Hicks-Marshall
laws of derived demand:
Activity SG10.3 other things equal the
elasticity of labour
Imagine you are the manager of a small firm which makes and sells doughnuts and you
demand with respect to
need to decide how many workers to employ. Use the information below to make your the wage is high when
decision. A doughnut sells for £1.50. All workers work an eight-hour shift and the wage the price elasticity of
rate given is the hourly rate. The market for doughnuts is perfectly competitive. Explain the demand for output is
reasoning behind your decision. high.
Workers Output per hour MPL MVPL(£) Wage rate (£)

1 20 7
2 30 7
3 37 7
4 42 7
5 44 7
Industry demand curve for labour

As explained in this short section and the accompanying diagram, the

industry demand curve for labour is steeper than the industry MVPL
schedule, the horizontal addition of the original MVPL curves of each firm
in the industry, since a lower wage increases industry output, leading to
a fall in equilibrium price and a shift in the MVPL schedule. The industry
demand curve for labour connects points on multiple MVPL schedules.
The slope of the labour demand curve reflects the elasticity of demand for
the product being produced, since demand for labour is derived demand,
depending on demand for the output.
Labour supply
► BVFD: read section 10.4 and Maths 10.2, as well as case 10.1.
This section applies the theory of consumer choice to an individual’s

decisions of how to allocate their time between hours of leisure and
hours of paid work3 for individuals who are in the labour force as well as 3
In this basic model
the decision about whether or not to participate in paid work in the first these are the only
uses of an individual’s
place. You should treat Maths 10.2 as an integral part of this section, not
time. The model can
an optional extra. In fact, even the diagrammatic treatment in Maths 10.2 be extended/modified
does not go far enough in that, although it indicates whether the income to incorporate other
or substitution effect dominates for a given wage change, it does not show important uses of time
these effects separately in the first diagram of the Maths box. You are such as unpaid work in
now asked to remedy this shortcoming by drawing for yourself a choice the home.
diagram which does show the separate income and substitution effects.
127
Activity SG10.4
On a blank piece of paper, draw a large diagram showing a budget constraint and
indifference curve for three different wage levels, such that it can be used to derive a
backwards-bending labour supply curve. For each of the two increases in the wage level,
clearly indicate the income and substitution effects, noting which is larger in each case
(you may need to refer back to Figure 5.14 in Chapter 5 to remember how income and
substitution effects can be distinguished graphically).
This section of the text assumes that leisure is a normal good4, more of it 4
In fact they make
will be consumed as real income increases. This is likely to be a realistic the even stronger
claim that leisure is
assumption, in practice, for most people. However, suppose that leisure is, in
probably a luxury good.
fact, an inferior good. How would this change the analysis of income versus Remind yourself of the
substitution effects? Could there be a backward bending labour supply curve distinction between a
in such circumstances? normal and a luxury
good (Block 3 – BVFD
Participation rates section 4.6).
One important concept from this section is the reservation wage – the
lowest wage a worker is willing to accept to work in a given occupation.
For this section, pay attention to the way that the four main factors which
increase participation are represented graphically, as per Figure 10.5.
Activity SG10.5
Match the factor which increases participation to the description of the graphical
representation of this factor in Figure 10.5.
Higher real hourly wage rate Shorter distance AC
Lower fixed costs of working Shorter distance BC
Lower non-labour income Flatter indifference curves
Changes in tastes in favour of Steeper budget constraint line

more work and less leisure
Supply of labour to an industry

As is mentioned in this section, the supply of certain types of labour to the
economy as a whole is relatively fixed in the short run. In the long run,
population growth and education and training can increase the supply. How
elastic the supply of a certain type of labour is to a particular industry depends
in part on how large that industry is relative to the economy as a whole.
Labour market equilibrium

► BVFD: read section 10.5 and case 10.2 as well as concept 10.1.
Labour mobility
The extent of labour mobility into and out of an industry affects the slope of
the industry’s labour supply curve and the extent to which this curve shifts
when there is a change in wages in other industries. When there is a high
degree of labour mobility, wage increases in one industry easily flow over
into other industries. Labour mobility is a crucially important determinant
of a country’s economic efficiency, both in static terms, ensuring labour is
128
allocated to its most productive uses and in dynamic terms, facilitating

the emergence of new activities and industries while allowing for the
orderly decline of some existing activities and industries where output
demand is falling. Geographic mobility, and in particular international
migration, is perhaps the most important dimension of labour mobility, but
occupational mobility, the ability of workers to undertake new tasks
in an ever-changing economy is also important for efficiency and growth.
Labour mobility is a subject which has attracted increasing attention,
both politically and in terms of economic research, in recent years, but is
perhaps too much of a specialised topic for an introductory course and
is more typically reserved for specialised courses in labour economics.
However, a bit of basic supply and demand analysis can help us to see that
some of the more extreme positions taken on international migration are
likely to be misleading. Below we show the market for a particular type of
labour, it could be nurses, builders, etc. Let us take the latter case.
Wage
Domestic supply
W1
Total supply
W2
Demand
N3 N1 N2 Employment
Figure 10.1: International migration and labour supply.
If only domestic builders supply the market, N1 will be employed and
the wage will be W1. Suppose now that there is immigration of builders
shifting the total supply outwards (and possibly, as in the diagram, making
it more elastic). Employment increases to N2 and the wage falls to W2.
We see that immigrant builders do not displace domestic builders on a
1 for 1 basis (as some crude views of immigrant labour would have us
believe). N2–N1 immigrant builders are employed, while the employment
of domestic builders falls by the smaller amount N1–N3. It is equally wrong
of course to say that building wouldn’t get done at all without immigrant
builders. Without the immigrant builders, the higher wages of builders
leads to a fall in the amount of building that gets done, but there is, again,
equilibrium in the market for building and builders.
Monopsony
A single purchaser in any market is called a monopsonist. When an
employer is a monopsonist, workers must either accept the wage offered,
or move to a different market. The analysis of monopsony in the labour
market is, in effect, the mirror image of the monopoly analysis of a firm
in the product market. The labour supply curve is upward sloping, since
more workers will be willing to work when the wage is higher. The
upward sloping labour supply curve represents the average cost curve
of labour for the monopsonist. The marginal cost of labour lies above
129
this curve, because if a non-discriminating monopsonist hirers one more

worker, they must also pay the higher wage to all the workers who are
already employed. The monopsonist is aware that by hiring more workers,
it is increasing the price of labour – as such, it will hire fewer workers
than under a competitive market structure. The employment decision of a
firm with monopoly power in its output market has been dealt with above
(
where the rule to hire labour up to the point where W = P 1 + 1 .MPL was
(
ε
discussed.
► BVFD: read section 10.6 and case 10.3c.
Many of the concepts in this chapter are analogous to concepts from the
general demand and supply analysis of Chapter 3. For example, economic
rent – payment to a worker in excess of their reservation wage – is
analogous to producer surplus, and is represented graphically by the
area above the labour supply curve and below the equilibrium wage. The
diagram (Figure 10.8) presented in the section refers to the market but,
of course, some individuals with reservation wages well below the market
wage of W0 can earn very substantial economic rents.
Disequilibrium in the labour market

► BVFD: read section 10.7 and concept 10.2.
This section introduces five reasons why labour markets may not clear –
minimum wage laws, trade unions, scale economies, the insider–outsider
dichotomy, and efficiency wages. If wages are fully flexible, they will be
able to rise and fall to the equilibrium level where demand and supply
are equated and the labour market clears. These five factors provide an
explanation why wage levels may stay above the equilibrium rate, leading
to some of the labour force being unemployed. There is something of a
semantic issue involved in the use of the market clearing concept here.
What is really meant by a non-clearing market in this section is that the
equilibrium wage is above the competitive wage. Nevertheless, it could be
argued that in each of these cases the market does in fact clear, subject to
the institutions in place at the time. Take the case of the minimum wage
in Figure 10.9. The minimum wage essentially rules out that part of the
labour supply curve below W2. Although some workers would be prepared
to work at W < W2, the law of the land does not permit firms to employ
them at these wages, so the supply curve is essentially horizontal at W2
until it hits the supply curve at L = L2. Firms wanting to hire labour in
excess of L2 will have to pay above the minimum wage. So one could say
that the market clears where this modified supply curve intersects the
demand curve (at L = L1). In concept 10.2 this is the argument used in the
sentence just below the diagram.
The case of efficiency wages is another example where it is not really clear
that this is a disequilibrium situation. Firms pay above a market clearing
wage but get higher productivity as a result. Workers may collectively
accept a slightly lower probability of employment as a price worth paying
for the higher wages under such arrangements.
Incidentally, one of the most famous historical cases of efficiency wages
is the case of the Ford Motor Company just over 100 years ago. In 1913
the daily wage at the company was $2.50. Turnover and absenteeism
were high but there was a plentiful supply of workers willing to work at
that wage. Then, at the beginning of 1914 Henry Ford doubled the daily
rate to $5 (for workers who had been with the company for at least six
130
months) as well as shortening the working day. Workers queued outside

Ford factories for employment on the new terms. Quit rates, absentee rates
and firing rates fell dramatically; productivity increased and company
profitability did not suffer in spite of this huge pay rise.5 5
Raff, D.M. G. and
Summers, L.H. ‘Did
Henry Ford pay efficiency
Wage discrimination wages?’ Journal of
Labor Economics, (1987)
► BVFD: read section 10.8. Pt 2 pp.S57–S86.
Wage discrimination refers to a situation where equally productive

workers are paid differently based on a characteristic such as age, race
or gender. This section discusses two explanations for this – taste-based
discrimination and statistical discrimination. Taste-based discrimination
means the employer (themselves or possibly due to their customers) has
some distaste for hiring a particular type of worker and reduces their
objective MRPL by some factor to a subjective amount MRPL – d. This
leads to fewer of this type of worker being employed and those that are
being employed at a lower wage rate.6 Statistical discrimination means 6
If you initially find
that employers may act on the idea that membership of a particular Figure 10.12 difficult
to ‘read’, note that in
group may carry information about a person’s productivity. Underlying
the left hand panel the
uncertainty regarding an applicant’s true productivity can motivate the employment of minority
employer to examine statistics about the average performance of the group workers increases as we
to which the applicant belongs and to use this to predict their productivity move leftwards from the
and making hiring decisions on this basis. This can benefit members of vertical wage axis. This is
high-productivity groups and be a disadvantage for members of lower- the reason why the MCL,
ACL and MRPL curves
productivity groups.
have opposite slopes
When observing two groups with different wages we may be interested in from the corresponding
what part of the raw wage differential is due to productivity differences curves in the right
hand panel where
and what part is due to discrimination. In the BVFD treatment it is
employment of majority
assumed that the two groups are equally productive, but this may not workers increases as we
always be the case. In practice, the raw wage differential may be partly move rightwards.
due to productivity differentials and partly due to discrimination. Take the
case of the lower earnings of older workers. In some industries, especially
where productivity depends on physical strength, older workers may
indeed be less productive, but there may also be age discrimination in
the labour market. Effective anti-discrimination policy needs to target the
discrimination part of the raw differential. Statistical techniques have been
devised to decompose the raw differential into its separate productivity
and discrimination components. While these decomposition techniques
are quite widely used in the empirical labour economics literature they are
subject to a number of well known weaknesses.
Overview
The three main factors of production are labour, capital and land. Labour
includes all forms of effort supplied by people to those who employ them
for monetary remuneration. Physical capital is the stock of produced
goods that are used in the production of other goods and services. Land
comprises all free gifts of nature such as land, forests, minerals etc.
Firms choose a production technique to minimise the cost of producing
a particular output level. By considering each level of output, they can
construct a total cost curve. Factor demand curves are derived demands.
A shift in the output demand curve for the industry will shift the derived
factor demand curve in the same direction. A firm will hire a variable
131
factor until its marginal cost equals its marginal value product (or
marginal revenue product in the case of a firm which is not a price taker).
A rise in the price of a factor reduces the quantity demanded of that factor
due to both substitution and output effects. A rise in the price of another
factor leads to an increase in demand due to the substitution effect and a
decrease in demand for that factor due to the output effect. It is unclear
which of these effects will dominate.
The supply of labour depends in part on the decisions of individuals to
participate in the labour force and also on the number of hours they
choose to supply. Four things raise the participation rate in the labour
force: higher real wage rates, lower fixed costs of working, lower non-
labour income and changes in tastes in favour of working. Higher wages
impact on the hours of work decision through both a substitution effect,
tending to increase the supply of hours worked, and an income effect,
which at high wage levels tends to reduce the supply of hours worked.
This leads to the labour-supply curve being backward bending. The
industry supply curve of labour depends on the wage paid relative to
wages in other industries using similar skills. Workers in unpleasant jobs
are often paid compensating wage differentials. Workers earning above
their reservation wage are said to be earning economic rent.
The wage is the rental price of labour but certain factors may lead to
wage levels being above the equilibrium level, leading to unemployment
in the labour market. These factors include minimum wage agreements,
trade unions, scale economies, insider–outsider distinctions and efficiency
wages. Discrimination may lead to workers from different groups being
paid different wages.


For each question, choose the correct response.
1. The labour supply curve:
a. is always upward sloping
b. is always downward sloping
c. slopes upwards when the substitution effect dominates
d. slopes upwards when the income effect dominates.
2. Which of the following could explain a decrease in the demand for
labour in a particular job?
a. additional training that increases the productivity of each unit of
labour in this market
b. an increase in the amount of risk associated with this job
c. a decrease in the amount of risk associated with this job
d. a decrease in the productivity of each unit of labour in this market.
132
3. A profit maximising firm will employ labour up to the point where:

a. Marginal revenue = marginal product.
b. Marginal cost = marginal product.
c. Marginal revenue product = average cost of labour.
d. Marginal revenue product = marginal cost of labour.
4. A monopsony occurs if there is a:
a. major employer of labour in a market
b. highly unionised workforce
c. major provider of employees
d. single seller of products in a market.
5. Compared to a monopolist, a perfectly competitive firm’s demand for
labour is:
a. less responsive to a change in the wage rate
b. more responsive to a change in the wage rate
c. equally responsive to a change in the wage rate
d. the demand for labour does not depend on the wage rate for either
firm.

1.
a. Describe, in words and using graphs, the impact of a change of
hourly wage on a person’s labour supply decision, regarding both
hours of work and their participation decision.
b. Alisha earns £20 per hour for up to eight hours of work per day
and is paid £25 for every hour in excess of this. She receives
£20 per day from the government in child benefit (regardless of
whether or not she works) and pays £8 per hour for childcare for
each hour she works. If she works, she pays £5 per day for an all-
day bus ticket. Graph Alisha’s budget line, for an 18-hour day.
c. Discuss some reasons why labour markets may not clear,
illustrating with diagrams as much as possible.
133
Notes
134
Block 11: Welfare economics
Introduction
This is a good time to think back to the questions from Chapter 1 of
BVFD which asked: what, how and for whom to produce. We have seen
how this question is answered by free markets, concentrating mostly on
markets for a single product or factor. Many economists would agree
that the free market can do quite a good job in allocating resources. But
how can we define what it means to do ‘a good job’? Welfare economics
uses the concepts of efficiency and equity to make normative judgements
about the workings of the market. There are reasons why markets fail in
certain circumstances and this can provide a justification for government
intervention in the economy. This block defines and discusses the concept
of externalities, where there is a clear role for government intervention
in the market. The following block will discuss the tools governments
use including taxation, redistributive spending and regulation. This block
on welfare economics is our first step towards looking at the economy
as a whole system. In contrast to the second part of the course on
macroeconomics, this block still uses microeconomic techniques; however,
it examines welfare at the economy-wide level rather than focusing on a
particular market. As such, the concept of general equilibrium is also an
important part of this block.
Learning outcomes
• define welfare economics
• describe horizontal and vertical equity
• discuss the concept of Pareto efficiency
• recognise how the ‘invisible hand’ may achieve efficiency
• define the concept of market failure
• recognise why partial removal of distortions may be harmful
• identify the problem of externalities and possible solutions
• discuss how monopoly power causes market failure
• analyse distortions from pollution and congestion
• discuss why missing markets create distortions
• analyse the economics of climate change.
Essential reading
Further reading
Chapter 13.
Witztum (AW), Chapters 6 and 7.

This block examines how well markets work without intervention, as
well as various justifications for government intervention in markets. The
concepts of efficiency and equity are used to evaluate and make normative
135
judgements about various outcomes. Definitions are provided for horizontal

and vertical equity, as well as productive, allocative and Pareto efficiency.
Perfectly competitive markets are both productive and allocative efficient.
The concept of general equilibrium is introduced, which refers to a situation
where multiple (or all) markets are simultaneously in equilibrium. This
block also introduces the first and second welfare theorems and uses the
Edgeworth box to illustrate these. Reasons for market failure include
taxes, imperfect competition, externalities, missing markets and imperfect
information. When only one market is distorted, the first-best solution is
to remove the distortion. However, when this is not possible or there are
reasons why governments prefer not to remove the distortion (for example
for equity reasons), the theory of the second-best says it is better to spread
the distortion thinly over many markets than concentrate it in one market.
Governments can also act against externalities and other distortions by
allocating property rights or imposing regulations.
Equity and efficiency

► BVFD: read the introduction to Chapter 13 and section 13.1.
On p.295, in the paragraph beginning Figure 13.2, the fourth sentence should read ‘Any
point inside the frontier is Pareto-inefficient.’ (not Paretoefficient) (NB: this is only incor-
rect in the online ebook).
This section introduces the twin notions of equity and efficiency. It is

particularly important to understand clearly the definitions of Pareto
optimality (an allocation of resources is Pareto efficient if any reallocation
would make at least one person worse off) and Pareto gain/improvement
(a reallocation of resources that makes at least one person better off
without making anyone worse off). Many would argue that governments
should favour reallocations that result in Pareto improvements, although
that is itself a value judgement (note the key word ‘should’). While the
notions of Pareto efficiency and Pareto improvements are useful principles,
they do have their shortcomings when applied to actual policy decisions,
for at least two reasons. Firstly, there are generally many Pareto optimal
allocations so further value judgements are required to choose the best
allocation from the set of such efficient allocations. Secondly, many policy
decisions have both winners and losers; adopting policies of this kind are
not Pareto improvements because some people are made worse off.1 1
It is sometimes
argued that a policy
Equity can be broken down into horizontal and vertical equity. Horizontal
rule would be to
equity is ‘the identical treatment of identical people’ while vertical equity accept a reallocation
has to do with treating people in different situations differently so as to if the winners could
reduce inequalities between them. Vertical equity is the more contentious compensate the losers
of these two principles; it is hard to see why one would not want to treat (in which case there
is a potential Pareto
identical people identically, while the optimal amount of vertical equality
improvement). However
is a matter of considerable debate. if the losers are not
Efficiency has to do with making the best use of scare resources to satisfy actually compensated
then we again require
people’s needs and desires and can be broken down into productive and
value judgements to
allocative efficiency. To discuss efficiency further, it is useful to come decide whether the
back to the production possibility frontier PPF introduced in Block 1 and reallocation is desirable
illustrated below. on equity grounds.
136
Output of
good A
B F
C
D
A
E
Output of good B
Figure 11.1: The production possibility frontier.

Productive efficiency is represented by any point on the PPF. Points beyond
the frontier (such as F) are unattainable and points inside (such as A)
are inefficient. Productive efficiency implies that goods and services are
produced at their lowest cost (recall from Block 5 that this has to do with
firms choosing their cost-minimising mix of inputs using the condition that
their isocost curves and isoquants are tangent to each other). More output
of one good can only be obtained by sacrificing output of other goods.
Allocative efficiency has to do with the choice between different
combinations of output – only one point on the PPF is allocatively efficient.
This is the point that aligns the efficient production possibilities with the
needs and preferences of society. A point on the PPF is allocatively efficient
when it is not possible to move to a different point on the PPF and make
someone better off without making someone else worse off. Allocative
efficiency is achieved when P = MC, since this means that benefit and cost
are equated. Allocative efficiency occurs when the marginal benefit equals
the marginal cost of producing one extra unit.
An equilibrium may be productively efficient without being allocatively 2
Why are these three
efficient. In other words, a market where the output generated is being combinations Pareto
maximised isn’t necessarily maximising social welfare. efficient? If person 1
has no bananas then
As stated above, a Pareto efficient allocation is an allocation there is no any trade that makes
other feasible allocation that makes someone better off without making him better off must
anyone else worse off. It relates to both productive and allocative efficiency. involve him getting at
least twice as many
Equity and efficiency are separate concepts. Efficiency doesn’t
bananas as he gives up
automatically imply equity. in oranges, which results
For example: in person 2 being worse
off. Similarly, if person 2
An economy contains two people and two goods, oranges and bananas. has no oranges then any
Both people like both goods, but value them differently. For person 1, trade that makes her
one orange is exactly equivalent to two bananas, while for person 2, better off must involve
two oranges are exactly equivalent to one banana. In this case, the three her getting at least
twice as many oranges
following allocations are all Pareto efficient:
as she gives up in
• Person 1 has all the oranges and person 2 has all the bananas. bananas, which results
in person 1 being worse
• Person 1 has all the oranges and all the bananas. off. On the other hand,
• Person 2 has all the oranges and all the bananas.2 if person 1 has some
bananas and person 2
It is clear that while options 2 and 3 are both Pareto efficient, they are also has some oranges, then
highly inequitable! by transferring one
banana from person 1
It is often, but not always, the case that there is a trade-off between equity to person 2 and one
and efficiency. An example of a government policy designed to increase orange from person 2 to
equity that can have a negative effect on efficiency is progressive marginal person 1, both of them
taxation, since the high marginal tax rates on those with higher incomes are made better off.
137
can reduce work incentives, reducing GDP and/or growth. In addition,

if everyone had the same income, there would be no incentive to work
hard, to change jobs, or even to get an education. Given the widespread
existence of progressive income taxation it would appear that people are
happy to trade off some efficiency for the improvement in equity, which
progressive income taxes deliver. Although equity and efficiency are often
conflicting objectives, it is important to note that this need not always
be the case. An improvement in efficiency should generally improve the
workings of the economy and generate increased growth for all. Increased
efficiency and greater equity are compatible with each other. Another
possible example of a policy that may not imply a trade off is subsidising
the education of children in low income households; this can lead both to
a more equal distribution of earnings and a more productive workforce.
There is no reason why improved efficiency must necessarily lead to
inequality.
Social welfare function

It remains the case, however, that it will be difficult to choose socially
optimal allocations, due to the fact that there are many efficient
allocations and that they have different equity implications. In principle,
the optimal feasible allocation could be selected using what welfare
economics calls a social welfare function; this is something like a set of
social indifference curves which rank combinations of utilities of members
of society. How, if at all, such a social welfare function could be derived in
practice is highly problematic (Chapter 14 will discuss this further). Here
we simply assume the existence of such a function and show how it is used
in deriving the optimal allocation.
Susie’s
Utility
P
ƽA
ƽC
ƽB
P David’s
Utility
Figure 11.2: Utility possibility curve and social welfare function.

In the diagram the PP curve is a utility possibility curve – it shows, given
the resources of the economy, the maximum utility that David can achieve
for any given level of Susie’s utility and vice versa (it is the locus of the
utility levels on the contract curve in the Edgeworth box explained in
concept 13.2 below). All points on the frontier are Pareto efficient, those
beneath the frontier are inefficient. The indifference curves show social
preferences for the David-Susie utility combinations (the indifference
map is the social welfare function). The combination B, although Pareto
inefficient, is preferred to the combination A which is Pareto efficient
but inequitable (Susie has a lot more utility than David). Of course a
movement from B to C would be a Pareto improvement.
Figure 11.1 is a standard PPF where the horizontal and vertical axes show
the output of goods A and B. Only one point of the PPF in Figure 11.1
is allocative efficient. By contrast, the efficient frontier in Figure 13.2 of
138
BVFD and the utility possibility curve Figure 11.2 above have goods/utility
for Susie and David on the horizontal and vertical axes – thus they both
focus explicitly on allocation. These curves are constructed in such a way
that all points on the curve are Paretoefficient (implying productive and
allocative efficiency) and the optimal choice requires judgements about
equity, as indicated by the social welfare function.
► BVFD: read section 13.2, as well as concepts 13.1 and 13.2.
Efficiency and market structure

We have seen previously (in Block 8) that perfect competition is allocative
efficient because it maximises the sum of producer and consumer surplus
(for further detail on this see AW, section 4.3.1 or refer back to Block 8 for
diagrams showing consumer and producer surplus being maximised under
perfect competition in contrast to the deadweight loss of monopoly).
A further reason is because under perfect competition, marginal cost
will be equal to price in all industries. In order to maximise profits, firms
will produce where MR = MC. Also, MR = P under perfect competition
because the firms face a flat demand curve and therefore have a flat MR
curve which is the same as the demand curve. Thus, P = MC under perfect
competition.
Productive efficiency can occur under a variety of market structures, as
firms will wish to produce at minimum cost in order to maximise profits.
However, allocative efficiency only occurs under perfect competition.
In imperfectly competitive markets, firms are allocatively inefficient as
P > MC.
Perfect competition has consumers trying to maximise their utility and
producers trying to maximise their profits. Market forces ensure that
an equilibrium is reached where gains to all parties are maximised.
Competitive equilibrium ensures that there is no resource transfer between
industries that would make all consumers better off.
General equilibrium
► BVFD: read concept 13.1 – general equilibrium.
Concept box 13.1 takes a general equilibrium perspective. Up to now, we

have examined equilibrium in markets for a single good or a single factor
of production, this is known as a partial equilibrium approach. General
equilibrium refers to a situation where multiple (or all) markets are
simultaneously in equilibrium. For interested students, there is a detailed
explanation of general equilibrium in AW Chapter 6, section 1.
Concept box 13.2 shows a general equilibrium between two consumers
in an exchange economy, but at the level of the market we can use our
basic supply and demand analysis to analyse general equilibrium. We
need to move from a partial to a general equilibrium approach when
there is significant interdependence between markets; where markets
are completely independent of each other, partial equilibrium analysis
suffices. The following activity is designed to help you to understand how
two markets interact and how equilibrium is attained when the goods
are substitutes. The technique is applicable also in input markets and for
complementary goods or factors.
139
Activity SG11.1
Coffee and tea are substitutes. The demand for each depends on its own price as well as
the price of its substitute. Supply and demand curves are given as follows:
Coffee demand: Q DC = 60 – 6PC + 4PT
Coffee supply: Q SC = 3PC
Tea demand: Q DT = 20 – 2PT + PC
Tea supply: Q ST = 2PT
where PC is the price of coffee, PT the price of tea.

a. Find the equilibrium prices and quantities for coffee and tea. Hint: both markets must
be simultaneously in equilibrium.
b. Suppose that there is a major failure in the coffee crop, leading to a large reduction
in supply. Use supply and demand diagrams to trace out the effect in both markets. In
the new equilibrium what happens to the equilibrium price and quantity of tea?
First and second theorems of welfare economics

Section 13.2 also introduces the first and second theorems of welfare
economics. We don’t provide formal proofs of these theorems at this level
of study, although the seven step argument at the beginning of this section
goes some way to proving the first theorem.
First theorem of welfare economics:
When all markets are perfectly competitive, the economy will attain
a Pareto efficient allocation. A perfectly competitive economy induces
selfish individuals independently maximising their private well-being,
to bring the economy to a socially optimal state.
Second theorem of welfare economics:
A planner can achieve any desired Pareto optimal allocation by
appropriately redistributing wealth in a lump-sum fashion and then
letting the market work.
The second welfare theorem provides a theoretical affirmation for the use
of competitive markets in pursuing distributional objectives. Of course, the
lump sum (non-distorting) redistribution of initial endowments (wealth)
required in the second theorem may be quite difficult to achieve in practice.
The Edgeworth box

► BVFD: read concept 13.2 – the Edgeworth box3 3
Named after Francis
Ysidro Edgeworth
The Edgeworth box, here applied to exchange only (there is also a (1845–1926) a pioneer
of neo-classical
production version) is one of the more ingenious diagrams in economics.
economics, especially
It looks complicated and difficult, and it does take a bit of time to master, utility theory (including
but the basic ideas are actually quite straightforward. The key question indifference curves). He
behind the movements within an Edgeworth box is, if the two parties trade, was the founding editor
can they achieve a better allocation compared to their initial endowment, of The Economic Journal,
the most prestigious
and will this outcome be Pareto optimal? In fact, market forces (working
British academic journal
through the price mechanism) will achieve a Pareto-optimal allocation when of economics.
the two parties trade with each other. Furthermore, changes can be made to
the initial endowment so that any particular Pareto-optimal outcome can be
achieved. As such, the Edgeworth box can be used to demonstrate the two
theorems of welfare economics defined above. For interested students, there
is a detailed explanation of the Edgeworth box in AW Chapter 6, section 2.
140
Activity SG11.2
Household A and B of an exchange economy with two goods x and y have the utility
functions UA(xA, yA) = (xA)(yA), and UB(xB, yB) = (xB)(yB). Household A has the initial
endowment (xA0, yA0) = (10,16) and Household B has (xB0, yB0) = (25,12).
a. Illustrate the initial endowment in an Edgeworth box
b. Assuming that this point is not on the contract curve, draw possible indifference
curves for the two households and indicate the area where trade could result in an
improvement for both households (you can draw standard indifference curves without
reference to the utility functions given above).
y
c. Given the utility functions above, the MRS of Household A is MRSA = xAA and the
y
MRS of household B is MRSB = xBB . Use this information to find the Pareto optimal
point when the price of x is £0.80 and the price of y is £1.00 (i.e. the relative price
is £0.80). Clearly state which household sells which quantity of which good and the
final Pareto-optimal allocation.
d. Calculate the utility of the two households at the initial endowment and at the new
optimal point.
e. Draw your solution onto your graph along with the budget constraint and the new
utility curves at this point. Also draw the contract curve on your diagram.
Distortion of the market

This section reviews the effect of a specific tax on a good and emphasises
that, at least in the absence of other distortions, this will lead to a
distortion in the market for the taxed good – the marginal benefit to
consumers is no longer equal to the marginal cost to producers. The fact
that taxes are often distortionary is not an argument against all taxation,
but highlights one important aspect of taxation that must be considered
in designing a tax system. ‘Second best’ has to do with introducing new
distortions to offset existing distortions and improve efficiency. Taxation is
one specific distortion, and the concept of second-best implies widespread
taxation may be more efficient than taxes in a single market, because
this helps to keeps relative prices intact. Chapter 14 (covered in the next
block) goes into more detail on taxation. Another way of stating the theory
of second best is that when there are several distortions in place (taxes
and subsidies on various goods for example) it is not always desirable to
eliminate some of these distortions; if markets were otherwise competitive,
eliminating all distortions would be efficient, but eliminating some but not
others could actually make the situation worse (increase inefficiency). The
intuition is that some of the distortions may have been offsetting others
and piecemeal removal of distortions may destroy this balance.
Sources of market failure

This section introduces the potential sources of market failure that can
prevent a free market allocation of resources from being efficient, but
doesn’t analyse them in depth; subsequent sections do that. The following
is a list of sources of distortions that lead to market failure. Read through
and make sure you understand what each of these means:
141
• market power • asymmetric information

• taxation • common property
• public goods • missing markets
• externalities
Common property
All of these are described in BVFD except common property, which refers
to a resource such as fishing grounds or common grazing land, which is
open to everyone, but where one person’s activities detract from the total
available to everyone (in this sense common property can be thought of
as a kind of externality). For example, fish in the ocean can be caught
by anyone, but once one is caught, no-one else can catch it. Common
property tends to be over used, leading to a degradation or depletion
of the resource. This is because individuals only take into account their
private costs and benefits and neglect the social cost of their actions.
For this reason, various kinds of sea life are nearing extinction due to
overfishing. This problem applies to any common resource which is
unregulated.
Activity SG11.3
Here is a game-theoretic treatment of the common property problem. Suppose both
England and Norway fish in the North Sea. Both countries know that their fish supplies
are being depleted and that this depletion could be slowed down if they both cut their
fishing fleets in half. The matrix below shows the payoff for both countries (England’s
payoff is first entry in each cell) with unchanged and halved fleets. Will they agree
between them to reduce their fleets? (Hint: what is the Nash equilibrium?). Should they?
Norway
10 boats 5 boats
10 boats 300, 300 550, 250
England
5 boats 250, 550 500, 500
Externalities
► BVFD: read section 13.5 and case 13.1.
This section explores in greater detail one of the sources of distortions

listed above – externalities. Externalities can either be positive or negative
and occur when there is a divergence between the private marginal costs
and benefits and the social marginal costs and benefits of production
and consumption. If a restaurant plays loud music, this could be either a
positive or negative externality for the restaurant next door, depending
on whether that restaurant’s clients like the music and are attracted to
eat there because of it, or if it detracts from their dining experience and
makes them less likely to choose that restaurant. In the case of a negative
externality, the restaurant playing the loud music may be required to
compensate its neighbour for their lost customers. In the case of a positive
externality, they could even ask the neighbouring restaurant to contribute
to the costs of playing the music, since that restaurant is also gaining a
benefit from it. The issue with externalities is that these payments will not
generally occur unless there is regulation, because there is no market for
the externality. The amount of noise produced by the first restaurant will
therefore be inefficient – either too much (ignoring the negative impact on
its neighbour) or too little (ignoring the positive impact on its neighbour).
142
Activity SG11.4
Using the equations below, find the level of production which will occur without
regulation and the socially optimal level of production, and calculate the social cost of
the externality. Graph your answers and shade in the area representing the social loss of
inefficient production.
Example 1: Grating, unpleasant music
Demand: DD = £40 – 0.3*Q
Marginal private cost: MPC = £10
Marginal social cost: MSC = £10 + 0.1*Q.
Example 2: Beautiful, pleasant music
Marginal private benefit: MPB = £20 – 0.2*Q
Marginal social benefit: MSB = £24 – 0.2*Q
Marginal cost: MPC = MSC = £4 + 0.2*Q.
As the next section BVFD Chapter 13 will discuss, we live in an age where
the theory of externalities is ever more important; climate change, the
effects of pollution on human health and biological diversity, and many
other examples are increasingly at the centre of policy debates. This
section of BVFD covers the assignment of property rights as a method of
dealing with externalities, postponing the use of taxes and subsidies to
achieve similar ends until the next chapter, although if you want to look at
Figure 14.7 and the accompanying text that would fit in with the current
analysis. It is important to realise that, just as the optimal size of the
neighbour’s tree is not zero in the example illustrated in Figure 13.7, the
fact that industrial production generates pollution as a side effect does not
mean that the socially optimal level of pollution is zero; what is required
is that the marginal cost of pollution is equal to the marginal benefit (if it
seems strange to you that pollution can have benefits, consider the effect
on the costs of production of requiring firms to reduce pollution levels).
► BVFD: read Maths box 13.1.
This maths box provides a mathematical explanation of Coase theorem,

which states that an efficient use of resources can be achieved through
the allocation of property rights, and that this is not affected by whether
the party causing the externality or the party suffering from it is given
the property rights. In the story in this Maths box, the right to pollute
is given to Firm A. Since Firm A can sell this right to Firm B, the cost
and revenue functions of Firm B become relevant to Firm A’s production
decisions. For this reason, Firm A will decide on a level of polluting where
the marginal private cost is equal to the marginal social cost – the efficient
level of pollution in this scenario. As the textbook suggests, try to work
out the case where B is given ownership of the right to pollute. Please
work through the maths box to absorb the basic ideas behind the Coase
theorem (and also understand the reasons why it may be difficult to apply
in practice).
► BVFD: read section 13.6 and activity 13.1.
The analysis of greenhouse gas emissions is an application of the principles

discussed in section 13.5 – namely a situation where marginal social
costs dramatically exceed marginal private costs. Having determined the
optimal level of emissions in the aggregate, the key economic principle in
terms of achieving this target efficiently is the equalisation of the marginal
143
cost of emissions reduction between businesses/factories. That is the aim

of the market-based programmes such as cap-and-trade, as they use the
trading of credits between firms to allow firms with a lower marginal cost
of reducing emissions to reduce more and firms with a higher marginal
cost of reducing emissions to reduce less. This section also introduces
the important topic of social discounting and its central role formulating
climate change policy. Discount rates have to do with adjusting future
or past values so that values from different time periods can be properly
compared. The choice of the appropriate social discount rate is complex,
and probably involves some value judgements. Complex as these issues are
(and they would be studied in more depth in a specialist course on public
economics, environmental economics or cost-benefit analysis), they are
vital in determining today’s policies.
Risk, uncertainty, missing markets and asymmetric information

► BVFD: read sections 13.7 and 13.8.
These two sections again introduce issues that are rigorously analysed in
more advanced courses (risk, uncertainty, missing markets and asymmetric
information tend to be topics dealt with in intermediate microeconomic
courses). However, you should follow the general principles outlined
here. Missing markets are a further reason for market failure. Externalities
occur in cases where there are missing markets, for example for noise or
pollution. Section 13.7 discusses other missing markets, namely time and
risk. That is not to say there are no markets at all which relate to time or
risk, but rather there are many aspects of time and risk that cannot be
traded in markets. The scope of futures contracts is very limited. Also,
although there are many things people can buy insurance for, there are
also many things which cannot be insured against. This is partly due to
moral hazard – for example, you cannot insure your house against poor
maintenance or general wear and tear, as insurance companies would not
be able to monitor which parties are taking a reasonable amount of care of
their homes and for this reason, once insurance is taken out, the incentive
to care for the home is reduced.
Section 13.8 discusses other aspects of market failure in relation to
information. Gathering information is costly and incomplete information
may lead to inefficient private choices. Certification provides information
more efficiently, as the benefit is reaped by the whole society but the cost
is borne by a single agency. Certification is generally provided by public or
non-profit organisations rather than businesses because the profit motive
may distort incentives to reveal the truth. This was one of the key causes
behind the recent global financial crisis, when ratings agencies, being paid
by banks and financial institutions, rated ‘junk’ products as if they were
extremely sound and reliable financial instruments.
The imposition of standards requires value judgements. Costs and benefits
must be calculated and weighed up against each other, but there is often
a subjective element to these calculations (e.g. the value of human life, or
the optimal level of risk-aversion). An economic approach is useful in this
case since it helps make decisions about subjective factors transparent and
as such, can make the calculations as objective as possible.
144
Overview
This block provides an introduction to welfare economics, which involves
normative judgements as to how well the economy is working. Two
key concepts are equity (horizontal and vertical equity) and efficiency
(productive and allocative efficiency, as well as Pareto efficiency). The
textbook shows that perfect competition, under strict assumptions, is
Pareto efficient, since under perfect competition MC = MB = P. Much of
economic policy making concerns a conflict between equity and efficiency.
For example, redistributive taxes improve vertical equity but are not
allocative efficient. Perfectly competitive markets are rare in practice
and, in reality, there are many distortions which lead to market failure.
Distortions occur whenever free market equilibrium does not equate
marginal social cost and marginal social benefit. Key sources of distortions
are taxes, imperfect competition, externalities, and missing markets. The
first best solution to a distortion is to remove it and restore efficiency,
however, if distortions cannot be removed or if policy makers would rather
leave them in place than lose the benefits to equity that arise through these
distortions, the second-best solution is to spread distortions widely over
many markets rather than concentrating the distortion in a single market,
looking for ways in which distortions can be offsetting rather reinforcing.
A major cause of market failure is externalities – there are both production
or consumption externalities and these can be either positive or negative.
An externality occurs when there is a divergence of private and social
costs and benefits due to the absence of a market for the externality itself.
Inefficiencies can also occur due to information problems, such as moral
hazard, adverse selection and incomplete information. Regulations provide
information and express society’s value judgements about intangibles.


1. Suppose that Bill, Jill and Al constitute the entire market for
consumers of national defence. Each individual has an identical
demand curve for national defence, which can be expressed as P
= 50 – Q. Suppose that the marginal cost for national defence can
be expressed as MC = £30. What is the optimal quantity of national
defence?
a. 150 units
b. 60 units
c. 40 units
d. 20 units.
Draw a diagram showing the analysis.
145
2. The equations below describe a negative production externality:

Demand: DD = £80 – 0.6*Q
Marginal private cost: MPC = £20
Marginal social cost: MSC = £20 + 0.2*Q
The social cost of this externality is equal to
a. 750
b. 3,000
c. 2,250
d. 250.
3. Two goods, x and y, are complements. What will be the effect on the
prices of x and y of a substantial increase in the supply of x?
a. The price of x rises and the price of y rises.
b. The price of x falls and the price of y falls.
c. The price of x rises and the price of y falls.
d. The price of x falls and the price of y rises.

1. This question concerns a two good economy (food and clothing)
where there are two agents (Bill and Ernie) who can trade with each
other.
a. Bill has an initial endowment consisting of 10 units of food and
10 units of clothing. Ernie has an initial endowment of 10 units of
food and 20 units of clothing. Draw an Edgeworth box for these
consumers.
b. Bill regards food and clothing as perfect one-for-one substitutes,
while Ernie regards them as perfect complements but in a ratio of
3 units of clothing for 2 units of food.
i. On your diagram, indicate the area which represents the set of
allocations that are Pareto-preferred or Pareto superior to the
original endowment given above.
ii. Find the Pareto-optimal allocation.
iii. What price ratio would allow this Pareto-optimal trade to take
place?
146

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Block 4: Consumer choice

Block 4: Consumer choice

Synopsis of this block

Consumer choice and demand decisions

Diminishing marginal rate of substitution Lines never cross

The slope of the indifference curve is the marginal rate of

Movement Change in clothing Change in food Marginal rate of substitution

What is the interpretation of the slope of the budget constraint? It

► BVFD: read Maths 5.1.

Utility maximisation and choice

Figure 4.3: Consumer choice and the decision rule.

We can describe the consumer’s optimal decision using equations as

► BVFD: read section 5.2.

► BVFD: read section 5.3 and cases 5.1 and 5.2.

A fall in the price of meals An increase in the price of films

Income and price changes

• For inferior goods, the income and substitution effects work in

Normal goods, price of X rises Inferior good, price of X rises

Normal goods, price of X falls Inferior good, price of X falls

Deriving demand: ‘The individual demand curve’

(Price per sandwich = p1)

(Price per sandwich = p2)

(Price per sandwich = p4)

Demand curves and consumer surplus

To do this, we can put some numbers on a given utility maximising point

Demand curve for x

Figure 4.6: Willingness to pay and consumer surplus.

Deriving demand: ‘The market demand curve’

Figure 4.7: Deriving the market demand curve.

Complements and substitutes

The section on complements and substitutes (section 5.5) introduces the

• Figure 5.20, RHS – perfect complements – indifference curves are

Cash transfers versus transfers in kind

► BVFD: read Appendix part 3 and Maths A5.1.

The section of the appendix entitled ‘ordinal utility and indifference

Reminder of your learning outcomes

Sample examination questions

Block 5: The Firm I

Synopsis of this block

Introduction to the firm

► BVFD: read section 6.4.

The firm’s supply decision

The production function

We begin with production. The hill-shaped structure depicted below is

Q, measured vertically, and inputs, K and L on the horizontal plane.

Figure 5.1: The production set.

► BVFD: read section 7.2.

► BVFD: read case 7.1 and Maths 7.1.

Quantity of Total Product Average Product Marginal Product

Isoquants and isocost lines

Output = 10 Output = 20 Output = 24

What is the slope of the isocost lines?

Input price changes and input sustainability

Figure 5.2: The shape of isoquants and opportunities for substitution.

Profit = Total revenue – Total cost

Figure 5.3: Total cost.

Figure 5.4: Demand curve.

Figure 5.6: Total cost, total revenue and profit.

Output Price Total Total Marginal Marginal Profit

Reminder of learning outcomes

Sample examination questions

Long response question

2. a. Fill in the blanks in the table below

Explain the difference between economists and accountants

Perfectly compeve Pure monopoly