Microeconomics AIDE

MICROECONOMICS
ASIAN INSTITUTE FOR DISTANCE EDUCATION FOUNDATION INC.

Microeconomics
SELF-INSTRUCTIONAL MODULE
for MICRO-ECONOMICS
MODULE 1 - Demand, Supply and Equilibrium

Price
MODULE 2 - Theory of the Household
MODULE 3 - Production and Costs
MODULE 4 - Theory of Markets
MODULE 5 - Factor Prices
Page | 2
Microeconomics
TABLE OF CONTENTS
Module 1 – Demand, Supply and Equilibrium Price
Lesson 1 – Demand ………………………………………………………. 7

Lesson 2 – Supply ………………………………………………………… 26
Lesson 3 – Eqiulibrium …………………………………………………. 34
Lesson 4 – An Application ……………………………………………… 44
Module 2 – Theory of the Household
Lesson 1 – Indifference Curves ……………………………………….. 50

Lesson 2 – The Budget Line …………………………………………… 55
Lesson 3 – Consumer’s Equilibrium ………………………………… 58
Lesson 4 – Price Effect, Income Effect, and Substitution Effect . 62
Consumer’s Equilibrium
Income and Substitution Effects
Demand Functions, Income Effects and Substitution Effects Theory and
Evidence
Module 3 – Production and Costs ………………………………….. 65
Module 4 – Theory of Markets
Lesson 1 – Price and Output Under Perfect Competition ……… 85

Lesson 2 – Price and Output Under Pure Monopoly ……………. 98
Lesson 3 – Price and Output Under Oligopoly …………………… 112
Lesson 4 – Price and Output Under Monopolistic Competition.. 121
Module 5 – Factor Prices
Lesson 1 – Perfect Competition in the Product and Factor

Markets …………………………………………………….. 128
Lesson 2 – Perfect Competition in the Factor Market and
Monopoly in the Product Market ……………………. 137
Lesson 3 – Monopoly …………………………………………………. 144
Page | 3
Microeconomics
MACROECONOMICS
Description of the Subject
The course aims to explain the behavior or individual household and business firms.
Transactions between these two groups of economic factors involve prices of goods in the
goods market and of factors of production in the factor market. The course aims to examine
as well how such prices are determined and why they rise or fail.
Scope of the Subject
The subject consists of the following five modules:
Module 1 – Demand, Supply and Equilibrium Price

Module 2 – Theory of the Household
Module 3 – Production and Costs
Module 4 – Theory of Markets
Module 5 – Factor Price
Page | 4
Microeconomics
MODULE 1
DEMAND, SUPPLY and

EQUILIBRIUM PRICE
Page | 5
Microeconomics
MODULE 1 – DEMAND, SUPPLY AND EQUILIBRIUM

PRICE
Scope of the Module
Module 1 contains the following four lessons:
Lesson 1 – Demand
Lesson 2 – Supply
Lesson 3 – Equilibrium
Lesson 4 – An Application
Overview of the Module
We start with a quick review of the nature of our subject, microeconomics. We proceed
to discuss the concept of demand, list some of the more important factors (or variable, as
economics prefer to call them) influencing it, and concentrating on the important variable,
which is price, explain the law of demand and the meaning, measure, and interpretation of
price elasticity of demand. Turning to the supply side, we examine the similar topics: concept,
determining variable, price elasticity of supply. We finally bring together the demand and
supply sides to explain the determination of the market price of a good and the amount of it
exchanged in the market. We then explain how changes in demand and supply cause the
market. We then explain how changes in demand and supply cause the market price to rise
or fail. We bring the module to a close by considering some application of demand-supply
analysis.
Objectives of the Module
After completing this module, you are expected to:
1. enumerate and explain the variables influencing demand and supply;
2. explain, measure and interpret price elasticities;
3. explain how the interaction of demand and supply determines equilibrium price and
quantity; and
4. explore some application of the analysis.
Page | 6
Microeconomics
Lesson 1 – Demand
Lesson Objectives
Upon completion of this lesson, you should be able to:
1. distinguished macroeconomics and microeconomics;

2. explain the concept of demand;
3. enumerate some of the variable influencing demand for a good;
4. explain and illustrate the law of demand; and
5. explain, measure and interpret price elasticity of demand.
Introduction
Someone has remarked that even a parrot can be taught economics. The parrot needs
to learn only two words – demand and supply. After all, the activities economics as a subject
tries to explain may be broadly thought to fall into the two sides of consumption (or demand)
and production (or supply).
Demand and supply, however, may be studied from the viewpoint either of a large
economic unit like a national or international economy or of a small economic unit individual
households and business firms.
In the former case we are interested in, say, the total market value of goods and services
produced by the Philippine economy or in the total amount of money households spent on
them. We are also interested in the related problems of unemployment and underemployment,
the general level of prices, and external debt. Such study of the behavior of large economic
units may be called macroeconomics (macro means large).
In the latter case we are interested in the behavior of individual households and business
firms. In the market for goods and services, households represent the demand side and
business firms the supply side. In the market for factors of production, the roles are reversed.
Here household supply productive services, especially labor, and firms demand them. In any
case the object of study is the individual household or business firm, or at most a group of
household and firms composing a market. Such study of the behavior of small units, which
is in fact our subject now, is called microeconomics (micro means small).
Concept of Demand
We have just recognized two kinds of market. In microeconomics – the goods market
and the factor market. This lesson, and in fact this module, confines itself to the goods market.
The last module will take care of the factor market.
Page | 7
Microeconomics
We first consider the demand side of the goods market. We have to be clear, however,
about our idea of market demand. Market demand is the total amount of a good which
households in the market are willing and able to buy over a specified period time. Since the
demand side of the market consists of a group of households with separate individual demands,
market demand is the sum of such individual demands.
Demand in the sense we use it in our subject is intended, or planned, demand. It is the
amount buyers intend or plan to buy, regardless of whether the buying does take place. In
many cases buyers actually buy the amount they intend to buy. There is then no confusion
about the meaning of demand. If, however, they intend to buy 100 bars of soap but go home
with only 70 because the store has only 70 bars left in its shelf, their demand, according to our
definition, is still 100, not 70.
Moreover, demand involves not only the willingness to buy, but also the ability to do
so. No matter how strong our desire is for a leisurely tour of Europe, we do not have demand
for the tour if we do not have the money to pay for it.
Lastly, we need to specify the time period over which demand is measured. We need
to specify, for example, whether we are talking about demand per day, per week, or per month.
Is the demand for 10 packs of cigarettes the demand of a heavy smoker? It depends. It
maybe if the demand for the 20 packs is expressed per day. It may not be if the demand is
expressed per decade.
Determinants of Demand
Demand for a good is influenced by many variables. The more important variables
are the price of the good itself, the price of substitute goods, the price of complementary goods,
the incomes of buyers, and their tastes.
If, for example, consumers in a market are observed to drink more coffee, they may do
so because the price of coffee has decreased, or the price of tea (a substitute) has increased, or
the price of coffee creamer (a complement) has decreased, or consumers have just enjoyed an
increase in their incomes, or simply because of effective TV and newspaper advertisements
they have been tempted to drink more coffee.
It is more likely, however, that not one single variable but a number of variables
combine to account for the rise in coffee intake.
A realistic explanation of the rise in demand for coffee should therefore investigate the
combined effect of simultaneous changes in several variable, such as the fall in the price of
coffee accompanied by a favorable change in consumer taste and a marked rise in the price of
substitutes like tea.
Page | 8
Microeconomics
To ease our understanding of such combined effect, we find it necessary to analyze one
variable at a time to determine how that variable acting alone influences demand. Only after
the separate effects have been analyzed will it be possible to predict the effect on demand of a
combination of changes in those variables?
Familiarity with elementary mathematics can greatly simplify our discussion in this
section of the lesson. Using the language of mathematics, what we have discussed so far we
may call the demand function. The word function in mathematics refers to a relation between
two or more variables. A demand function in economics refers to the relation between the
quantity demanded of a good and its determinants.
The notation 𝑦 = 𝑓 (𝑥, 𝑧, 𝑡) is read “y is a function of x, z, and t” and means that y

depends upon x, z, and t. Since y depends on x, y, and t, y is called the dependent variable
and x, z, and t the independent variables.
If 𝑄𝑑 is quantity demanded of a good, P is its price, Ps is the price of substitute goods, Pc is

the price of complementary goods, Y is consumers’ incomes, and T is consumers’ tastes, we may write
our demand function as 𝑄𝑑 = 𝑓 (𝑃, 𝑃𝑠 , 𝑃𝑐 , 𝑌, 𝑇) read “𝑄𝑑 is a function of P, Ps, Pc, Y, and T”. It
means that quantity demanded of a good depends upon its price, the price of substitute, the price of
complements, consumers’ incomes and consumers’ tastes.
Law of Demand
In the previous section we said that it would be systematic for us to isolate the effect of
each independent variable on the quantity demanded of a good before we attempt to explain
the combine effect of a group of independent variables. We devote the rest of this lesson to
the explanation of the relationship between quantity demanded and the price of a good. We
postpone to Lesson 3 the discussion of combined effects of several variables.
If we are to isolate the effect of the price of a good on the quantity demanded of it, we
have to assumer that no change takes place in the prices of substitute and complementary goods
or in consumers’ incomes and tastes. This assumption, which we call the cateris paribus
(Latin phrase for “other things being equal”) assumption, is necessary to ensure that any
observed change in the amount buyers are prepared to buy is caused only by a change in the
price of the good.
We may then write our demand function as 𝑄𝑑 = 𝑓 (𝑃, 𝑃𝑠 , 𝑃𝑐 , 𝑌, 𝑇), with the bar above
Pc, Ps, Y and T indicating that these variables are held constant. Alternatively, we may write
𝑄𝑑 = 𝑓 (𝑃), ceteris paribus to mean the same thing. Even more simply, we may write 𝑄𝑑 =
𝑓 (𝑃) , understood to be expressed under the ceteris paribus assumption.
The relationship between the price of a good and the quantity demanded of it is given
by the law of demand, which says that people buy more of a good when its price falls and less
when its price rises. Module 2 will elaborate on the reasons for this behavior, as well as
possible exceptions to the law. At this stage we may explain the law of demand in terms of
the so-called substitution effect.
Page | 9
Microeconomics
As the price of a good rises, people tend to buy less of it because they turn to substitutes which
now appear relatively cheaper. A rise in the price of coffee will reduce the amount demanded
of it because buyers may switch to tea.
The law of demand may be illustrated in a table or schedule. Table 1 is a hypothetical

demand schedule for coffee.
Table 1 – A Demand Schedule for Coffee
Price Quantity Demanded

(Per Jar) (Jars per day)
C 0 250
E ₱ 5.00 200
F 10.00 150
G 15.00 100
H 20.00 50
I 25.00 0
The demand schedule, which is a tabular presentation of the demand function, shows
that as the price of coffee goes up from ₱10.00 to ₱20.00 per jar, quantity demanded falls from
150 to 50 jars, in accordance with the law of demand. It also shows that buyers will pay at
most ₱25.00 per jar and will get 250 jars if coffee is a free good (its price is zero).
It is more usual, however, to illustrate the law of demand in a diagram. Price is plotted
along the vertical axis and quantity demanded along the horizontal axis, as in Figure 1. To
math students, the independent variable, in this case price, is usually plotted along the
horizontal axis and the dependent variable, in this case, quantity demanded, is plotted along
the vertical axis. Just the same, we preserve the traditional way the demand curve is drawn in
economics textbooks.
Figure 1 A Demand Curve for Coffee
25
P 20
R
15
I
C 10
E 5
0
50 100 150 200 250
Quantity Demanded
Page | 10
Microeconomics
Anyone familiar with high school algebra would easily transfer the pieces of
information from a table to a diagram. It will still be worth our while, however, to refresh
ourselves with the elementary techniques of graphing, considering the superabundance of
diagrams in microeconomics.
Table 1 includes six pairs of price and quantity demanded. These pairs we label C, E,
F, G, H, and I. Pair F, for example, includes quantity demanded of 150 and price of ₱10.00.
Each of these pairs of price and quantity demanded is then located, they are connected by a
line. This line is a demand curve, which we may defined to be a graphical presentation of the
demand function. We note that a demand schedule and a demand curve give us the same
pieces of information. They differ only in the manner they present such pieces of information.
The law of demand is indicated by the downward slope of the demand curve.
Generally, curves either have upward or downward slopes, or inclinations, as illustrated below.
Figure 2 – Slopes of Curves
y x
N
y1 T
ya
y0 M yb U
x x
x0 x1 xa xb
A B
The upward or downward slope of a curve tells us whether as X changes, Y rises or
falls. Consider the movement from M to N in the upward slopping curve in Figure 2A. As
X rises (from X0 to X1), Y also rises (from Y0 to Y1). If we reverse the direction of the change
(N to M instead of M to N) we note that as X falls (X 1 to X0), Y also falls (Y1 to Y0). X and
Y are seen to move in the same direction. We say X and Y are directly related.
In the case of the downward sloping curve in Figure 2B, the movement from T to J
shows a fall in 𝑌 (𝑌𝑎 𝑡𝑜 𝑌𝑏 ) resulting from the rise in 𝑋(𝑋𝑎 𝑡𝑜 𝑋𝑏 ). On the other hand a
movement from J to T shows a rise in 𝑌(𝑌𝑎 𝑡𝑜 𝑌𝑏 ) resulting from a fall in 𝑋(𝑋𝑎 𝑡𝑜 𝑋𝑏 ). X
and Y are seen to move in opposite directions. We say X and Y are inversely related.
So much for X and Y. We now go back to our demand curve in Figure 1 where we
have P and Qd instead of X and Y. As we discussed in the last paragraph, because of the
download slope of the demand curve, price and quantity demanded are inversely related: as
price rise, quantity demanded falls and as price falls, quantity demanded rises.
Page | 11
Microeconomics
For example, as the price rises from ₱10.00 to ₱20.00, quantity demanded falls from 150 to 50
(point F to H). Similarly as price falls from ₱10.00 to ₱5.00 quantity demanded rises from
150 to 200. This inverse relation between price and quantity demanded is, of course, the law
of demand.
Price Elasticity of Demand
The law of demand, as we discussed at length in the previous section, says that as the
process of a good changes quantity demanded changes in the opposite direction.
For some goods the change in quantity demanded is large – a rise in price reduces
quantity demanded by a large amount, a fall in price raises quantity demanded by a large
amount. Demand for these goods is sensitive, or responsive, or to use the more technical
word in economics, elastic with respect to price changes. For some other goods the change
in quantity demanded is small for a given change in price – a rise in price reduces quantity
demanded by a small amount, a fall in price raises quantity demanded by a small amount.
Demand for these other goods is insensitive, or unresponsive, or inelastic with respect to price
changes. We may define price elasticity of demand as the sensitivity of the quantity demanded
of a good to changes in its price.
This distinction between price elastic and price inelastic demand according to the size
of the change in quantity demanded is at best a rough distinction because we still need to judge
whether a given change in quantity demanded is indeed large or small. And what may be
large for one person may be small for another.
For this reason we prefer to use a formula which will give a numerical measure of price
elasticity of demand. Toward the end of this lesson we will interpret such numerical measure.
In the meantime we derive the price elasticity formula.
There are actually two formulas in use – the arc elasticity and the point elasticity
formulas. The arc elasticity formula is in price and the point elasticity formula for small
changes. We are however thrown back to the problem of how large is and how small, small
is.
To solve this problem, we review Figure 1. A rise in price from ₱10.00 to ₱20.00 (F
to H) is considered large enough to require the use of the arc elasticity formula. So is a rise
in price from ₱10.00 to ₱15.00 (F to G). And, for that matter, a ₱0.05 rise in price from
₱10.00 to ₱10.05. If a ₱0.05 rise in price is considered large, how small is a small change in
price? A change in price is considered small (and will therefore require the use of point
elasticity of demand) if it is so small we cannot see it.
Indeed, as the name suggests, point elasticity is measure at a point in the demand curve,
say point E. At such point we imagine a very small, infinitesimally small change in price.
Page | 12
Microeconomics
On the other hand, arc elasticity is measure over an arc, or segment, of the demand curve, say
segment HF in Figure 1. In effect arc elasticity is measured between two points in the demand
curve, point elasticity at only one point.
With this clarification, we now derive the arc and point elasticity formulas. Let us
start with the former. Specifically, let us compute price elasticity of demand between points
H and F in Figure 1.
Price elasticity of demand is equal to the percentage change in quantity demanded

divided by percentage change in price. To solve for the percentage change in a variable, we
divide the change in the variable by its old value. If I weigh 126 pounds this month against
120 pounds last month, my weight increased by 5% (equal to the 6 pounds change in weight
divided by my old weight of 120 pounds).
While it is easy to compute the change in quantity demanded (the numerator in the
percentage change formula), there is nothing in the demand schedule and the corresponding
demand curve to tell us which is the old quantity demanded (the denominator in our percentage
change formula) and which is the new. We are only told that when the price of coffee is
₱20.00 per jar quantity demanded is 150. Apparently the old quantity demanded is either 50
or 150. As a kind of compromise we use the average quantity demanded to represent the old
quantity demanded. The average quantity demanded in our sample problem is 100 (we add
50 and 150 and divide the sum by 2).
We now derive a general are elasticity formula. Every point in the demand curve, we
recall, stands for a pair of quantity demanded and price. Arc elasticity is measured between
two such pairs. Suppose we designate one pair as Q0 and P0 and the other pair as Q1 and P1.
If we use the notation Ed for price elasticity of demand,
𝑄1 − 𝑄0
1⁄2 (𝑄1 + 𝑄0 )
𝐸𝑑 = (𝐸𝑞𝑢𝑎𝑡𝑖𝑜𝑛 1)
𝑃1 − 𝑃0
1⁄2 (𝑃1 + 𝑃0 )
𝑄1 −𝑄0
We note that the formula is actually a fraction with as the numerator and
1⁄2 (𝑄1+ 𝑄0 )
𝑃1 − 𝑃0
as the denominator. The numerator is the percentage change in quantity demanded
1⁄2(50+150)
with Q1 – Q0 as the change in quantity demanded and ½ (Q1 + Q0) as the average quantity we
discussed earlier. The denominator is the percentage change in price with P 1 – P0 as the
change in price and ½ (P1 + P0) as the average price. The minus sign in the formula ensures
that the elasticity measure is not a negative number and will therefore be easier to interpret.
To solve for Ed we plug in the numerical values of P1, P0, Q1, and Q0. Going back to
our problem of computing Ed between points H and F, suppose we let Q1 be 50, P1 be 20, Q0
be 150 and P0 be 10. Price elasticity of demand is therefore:
Page | 13
Microeconomics
50 − 150 −100
1⁄2 (50 + 50) −1
𝐸𝑑 = − = − 100 = − = −(−3⁄2)
20 − 10 10 2
1⁄2 (20 + 10) 15 3
1
= 3⁄2 𝑜𝑟 1 ⁄2
We can have an even faster computation if simply the arc elasticity formula above.
The simplification is
𝑄1 − 𝑄0 𝑃1 + 𝑃0
𝐸𝑑 = 1 (𝐸𝑞𝑢𝑎𝑡𝑖𝑜𝑛 2)
𝑄1 + 𝑄0 𝑃1 − 𝑃0
This shorter formula is derived from the basic formula above by cancelling the fraction
½ appearing in the numerator and the denominator and, recalling our grade school arithmetic,
by inverting the denominator and multiplying it with the numerator.
Using this shorter formula,
As an exercise, show that Ed is 2/3 between G and E, 3/7 between F and E, and 1
between H and E.
Let us now turn to the point elasticity formula. We remember at point classically is
computed at a point in the demand curve where we imagine a very small change in price.
Consider point F (where P is ₱10.00 and Qd is 150) in Figure 1.
The first step is to obtain the point elasticity formula from the basic formula for price elasticity
of demand which we discussed in words and which we now express in symbols below:
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑑
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑑 𝑜𝑙𝑑 𝑄𝑑
𝐸𝑑 = = − (𝐸𝑞𝑢𝑎𝑡𝑖𝑜𝑛 3)
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃
𝑜𝑙𝑑 𝑃
The word change in mathematics and in economics is given by the symbol (read “delta”).
Change in Qd may therefore be written and change in price may be written .
Inasmuch as the point elasticity formula pertains to only one point in the demand curve where
a very small change in price (and hence also in quantity demanded) is imagined, it is not possible to
identify the old and the new P and Qd. The single P and the single Qd are therefore regarded as both
the new and the old P and Qd at the same tune. In short the old P in the formula above is simply P and
the old Qd is simply Qd. The general price elasticity formula may now be written as:
Page | 14
Microeconomics
To apply this formula we should know how to compute the numerical value of the slope of a
straight line. In later modules we will discuss the getting of the slope of curves that are not straight.
(In math, a straight line is classified as a curve).
The numerical value of slope in a curve in Y and X is given by . Generally, the slope is the
ratio of the change in the variable along the horizontal axis to the change in the variable along the
horizontal axis. Returning to Figure 1, we express the slope of the demand curve as since P
appears along the vertical and Qd along the horizontal axes.
Actually the slope can be computed for any two points in the demand curve. How do we get
the slope between F and G? Assume we move from F to G. The change in price is 5 and the change
in quantity demanded is -50. (A negative change is a decrease). The slope is therefore
− 1⁄10(−5⁄−50). Assume we instead move from G to F. Here is -5 and is 50. The slope
1
is still − . The slope between H and E is in fact also −1⁄10 because is 15 (if we move from E
10
to H) and is −150. We can generalize that the slope between two points in a straight line is equal
to the slope between any other two points. Finally we can say that a straight line has only one slope,
After the excursion to elementary mathematics we go back to our point elasticity sample
problem. We rewrite the point elasticity formula:
1 𝑃
𝐸𝑑 = − − (𝐸𝑞𝑢𝑎𝑡𝑖𝑜𝑛 4)
∆𝑃 𝑄𝑑
∆𝑄𝑑
The problem gives us the values of P and 𝑄𝑑 to be 10 and 150 respectively. The value of the
slope has in fact been computed to be −1⁄10. We recall that for a straight line the slope is computed
by taking any two points and measuring the slope between them. The value thus obtained is also the
slope of the straight line as a whole.
Substituting −1⁄10 for , 10 for P and 150 for Qd, we find Ed at point F in Figure 1 to be:
1 10
𝐸𝑑 = − = −(10) (1⁄15) = −(−2⁄3) = 2⁄3
−1⁄10 150
As an exercise, show that Ed is 3/2 at G, 4 at H, and ¼ at E.
Page | 15
Microeconomics
Point elasticity may also be calculate graphically. Take the demand curve below.
P
K
J L
𝑄𝑑
0 N M
𝑁𝑀 𝐽𝑂
𝐸𝑑 = =
𝑂𝑁 𝐾𝐽
Figure 3. Graphical calculation of point elasticity of demand
We give these results without proof. If you are interested in one, you may consult one of the
textbooks recommended for this course.
Along the horizontal axis we measure the distance NM and divide it by the distance ON. Along
the vertical axis we measure the distance JO and divide it by the distance KJ.
Our algebraic solution to our sample problems shows price elasticity of demand at point F in
Figure 1 to be 2/3. We get the same result graphically.
Figure 4. Sample Graphical Calculation of Point Elasticity of Demand
100 10
Along the horizontal axis, 𝐸𝑑 = = 2⁄3. Along the vertical axis, 𝐸𝑑 = = 2⁄3.
150 15
Earlier, you were added to show that E d is 3/2 at G, 4 at H, and ¼ at E. Show the same
results graphically.
Making use of the demand curve in Figure 1, we have illustrated the computation of arc and
point elasticity of demand. We computed arc elasticity of demand between points H and F to be equal
to 3/2. We computed point elasticity of demand at F to be equal to 2/3.
Page | 16
Microeconomics
We now try to make sense of the numerical values we obtained. It will be pointless for us to
have gone through the trouble of performing those computations involving arc and point elasticities
and yet be unable to interpret the numerical values the computations yield.
Before we do so let us enlarge our classification of price elasticities by including the extreme
and intermediate cases. We may now say demand for a good is either perfectly inelastic, relatively
inelastic, unit elastic, relatively elastic, on perfectly elastic.
Moreover, we will establish the relationship between price elasticity of demand and total
expenditure of the buyer (total revenue of the seller). Total expenditure on any good is simply the
price of the good multiplied by the number of units bought. If I buy 10 bottles of soft drinks at ₱8.00
per bottle, I spend ₱80.00
If after using the arc or point elasticity formula we get the numerical value zero, we say demand
over the arc or the point is perfectly inelastic; if the numerical value is greater than zero but less than
one, demand is relatively inelastic; if it is exactly equal to one, demand is unit elastic; greater than one
but less than infinity, relatively elastic; infinity, perfectly elastic.
Since Ed is 3/2 (more than one but less than infinity) between H and F, demand between these
two points relatively elastic. Since Ed is 2/3 (greater than zero but less than one) at F, demand at this
point is relatively inelastic.
We have given the basic price elasticity of demand formula to be the percentage change in
quantity demanded by the percentage change in price. (Strictly, we refer to the absolute value of the
percentage change regardless of its plus or minus sign: a 20% rise or fall in price is measured as a 20%
change in price, no distinction being made between a positive percentage change in the case of a rise
and a negative percentage change in the case of a fall.) As we also noted, E d is actually a fraction with
the percentage change in quantity demanded as the numerator and the percentage change in price as the
denominator.
If a fraction is equal to zero, its numerator must be equal to zero (0/100 is equal to 0). If E d is
equal to zero, its numerator, percentage change in quantity demanded, must be equal to zero: there is
no change in quantity demanded at all as price changes. The quantity demanded is completely inelastic
(or insensitive, or unresponsive) to price change.
The demand schedule below and the demand curve beside it illustrate the perfectly inelastic
case.
Table 2 – A Demand Schedule for Coffee: Perfectly Inelastic Case
Price per Jar Quantity Demanded Total Expenditure

Jars Per Day
P 5.00 100 P 500

10.00 100 1,000
15.00 100 1,500
20.00 100 2,000
25.00 100 2,500
Page | 17
Microeconomics
Figure 5 – A Demand Curve for Coffee: Perfectly Inelastic Case
As we discussed early in this section, if demand for a good is inelastic a rise in price
reduces quantity demanded by a small amount and a fall in price raises quantity demanded by
a small amount. If demand is perfectly inelastic, not only is the change in quantity demanded
small – there is no change at all. Note that the demand curve for a good in perfectly inelastic
demand is a vertical line, showing that quantity demanded is riveted at a certain level, in this
case 100, whether the price rises or falls.
Inasmuch as the quantity demanded does not change as the price rises, total expenditure
must rise. The rise in price from ₱10.00 to ₱15.00 raises total expenditure from ₱1,000.00
to ₱1,500.00 since buyers continue to buy 100 jars per day despite the price rise.
Similarly, the fall in price from ₱25.00 to ₱15.00 reduces total expenditure from
₱2,500.00 to ₱1,500.00 since buyers continue to buy only 100 jars despite the price fall.
If a fraction is between zero and one, its numerator must be less than its denominator.
If 𝐸𝑑 is between zero and one, its numerator, the percentage change in quantity demanded,
must be less, than its denominator, the percentage change in price. Price, for example, rises
(falls) by 80% and quantity demanded falls (rises) by 20%. In the case of perfect inelasticity,
as price rises total expenditure also rises because quantity demanded does not fall. In the case
of relative inelasticity, as price rises total expenditure also rises anyway because although
quantity demanded falls, the percentage fall in quantity demanded is not enough to offset the
percentage rise in price. Similarly, as price falls total expenditure also falls because the
percentage rise in quantity demanded is not enough to make up for the percentage fall in price.
Consider the relatively inelastic segment (𝐸𝑑 = 3⁄7) of the demand curve between F
and E in Figure 1. At E, buyers pay ₱5.00 per jar and buy 200 jars for a total expenditure of
₱1,000. As price rises from ₱5.00 at E to ₱10.00 at F, quantity demanded falls but only
slightly (from 200 at E to 150 at F). Hence, total expenditure rises anyway (from ₱1,000 at
E to ₱1,500 at F).
Page | 18
Microeconomics
From the point of view of the seller, it will pay to increase the price if demand is
relatively inelastic because although buyers reduce the amount that they buy, the reduction in
quantity is not large enough to prevent total revenue (total expenditure to the buyers) from
rising. In the same way, it will not pay him to reduce the price because although he is able to
attract more buyers and induce existing buyers to buy more, the rise in quantity demanded that
results is not large enough to raise his total revenue.
In the unit elastic case where 𝐸𝑑 = 1, the numerator (percentage change in quantity
demanded) is equal to the denominator (percentage change in price). If, for example, price
rises by 60%, quantity demanded falls by 60%. With the percentage change in quantity
demanded just matching the percentage change in price, total expenditure remains the same.
Demand between H and E, where 𝐸𝑑 = 1, is unit elastic. At E the price is ₱5.00,

quantity demanded is 200, and total expenditure is ₱1,000. As price rises to ₱20.00, quantity
demanded falls to 50 and total expenditure remains at ₱1,000.00
In the relatively elastic case where E is between one and infinity the percentage change
in quantity demanded is greater than the percentage change in price: the price goes up by, say,
60% and quantity demanded falls by 90%. Here a rise in price by some amount will reduce
quantity demanded by such a large amount that total expenditure will fall.
This is illustrated by points H and G in Figure 1, where 𝐸𝑑 = 7⁄3 (use the arc elasticity
formula to show this). At G, the price is ₱15.00, quantity demanded is 100, and total
expenditure is ₱1,500. As price rises to ₱20.00, quantity demanded falls to 50, and total
expenditure falls to ₱1,000.
From the point of view of the seller, it will not pay to raise the price of a good, demand
for which is price elastic because this will cause such a great fall in quantity demanded, buyers
being quite sensitive to price changes, that total revenue will fall. In fact it will pay the
revenue-conscious seller to reduce the price as this will cause a rise in quantity demanded,
large enough to raise total revenue as well.
If demand is perfectly elastic, buyers are so sensitive to price changes that a small rise
in price reduces quantity demanded to zero and a small fall in price will raise quantity
demanded to infinity (assuming they have an infinite amount of money to pay for the good).
Here, the percentage change in price, the denominator in the elasticity formula, is zero. The
demand schedule below and the demand curve beside it illustrate the perfectly elastic case.
Page | 19
Microeconomics
Table 3. A Demand Schedule for Coffee: Perfectly Elastic Case
Price Quantity Demanded

(per jar) (jars per day)
₱ 10.00 50
₱ 10.00 100
₱ 10.00 150
₱ 10.00 200
₱ 10.00 250
Figure 6 – A Demand Curve for Coffee Perfectly Elastic Case
Note that the demand curve is horizontal line, showing price to be constant.
In explaining the relationship between price elasticity of demand and total expenditure
(or revenue), we may think of price and quantity demanded, which are inversely related
according to the law of demand, as forces pulling in opposite directions. Whichever force is
stronger will prevail and will carry with it the direction of total expenditure. If demand is
perfectly inelastic, where buyers are completely insensitive or unresponsive to price changes,
quantity demanded offers no resistance whatsoever to price change. Hence price dictates the
change in total expenditure: as price rises total expenditure also rises: as price falls total
expenditure also falls. If demand is relatively inelastic, where buyers are more or less
insensitive to price changes, quantity demanded offers little resistance to changes in price.
Here, as in the perfectly inelastic case, price dictates what happens to total expenditure,
although the change in total expenditure is not as large as in the perfectly inelastic case where
there is no offsetting change in quantity demanded at all. If demand is unit elastic, the two
forces of price and quantity demanded are equally strong and the contest between them ends
in a draw.
Page | 20
Microeconomics
If demand is relatively elastic, where buyers are more less sensitive to price changes, the
resistance of quantity demanded to price is strong enough for it (quantity demanded) to decide
the direction of the change in total expenditure: a rose in price reduces quantity demanded and
total expenditure, a fall in price raises quantity demanded and total expenditure. Finally, if
demand is perfectly elastic, quantity demanded so overwhelms price that it pushes total
expenditure to its limits: a rise in price reduces quantity demanded and total expenditure to
zero, a fall in price raises quantity demanded and total expenditure (subject only to the
availability of money to finance the purchase) to infinity.
The table should help clarify the relationship among price elasticity of demand, price,
quantity demanded, and total expenditure.
Numerical Terminology Mathematical Price Quantity Total

Measure Condition Demanded Expenditure
Zero Perfectly Change in price produces Up Constant Up

Inelastic no change in quantity Down Constant Down
demanded
Between Relatively Percentage change in Up Down Up

Zero and Inelastic quantity demanded is less Down Up Down
One than percentage change in
price
One Unit Percentage change in Up Down Constant

Elastic quantity demanded is equal Down Up Constant
to percentage change in
price
Between Relatively Percentage change in Up Down Down

one and Elastic quantity demanded is Down Up Up
infinity greater than percentage
change in price
Infinity Perfectly Rise in price reduces Up Down to Zero, Down to Zero

Elastic quantity demanded to zero;
fall in price raises quantity Up to Infinity Up to Infinity
demanded to infinity Down
Price elasticity of demand maybe the most popular elasticity measure, but it certainly
is not the only one. Examples of other elasticity measure are interest elasticity of investment
in macro-economics and income elasticity of demand, cross elasticity of demand, and price
elasticity of supply in microeconomics.
Page | 21
Microeconomics
We note that the elasticity measure involves the relationship between an independent
variable and a dependent variable. It is conventional in economics for the dependent variable
to be made the first word in the name of the elasticity measure and for the independent variable
to be made the last. Thus, investment is the dependent variable and interest rate the
independent variable in the interest elasticity of investment measure.
We may now give the general definition of elasticity to be the sensitivity of the
dependent variable to changes in the independent variable. Starting from the basic elasticity
formula: elasticity is equal to the percentage change in the dependent variable divided by the
percentage change in the independent variable, we can easily develop the appropriate arc and
point elasticity formulas. We simply refer to our arc and point price elasticity of demand
formulas, replacing Q by the relevant dependent variable and P by the relevant independent
variable.
(PERFORM PROGRESS CHECK TEST 1)
Page | 22
Microeconomics
PROGRESS CHECK TEST 1
A. Fill in the blanks Fill in the blank with the correct words/ that will best
complete the sentence.
1. _____________________________ is the study of the behavior of small economic

units such as the individual consumer and individual producer,
2. The law of _____________________________ states that as the price of a good

changes quantity demanded changes in the opposite direction.
3. _________________________ is the sensitivity of the quantity demanded of a good to

change in its price.
4. _________________________ is a Latin phrase which means “other things being

equal”.
5. A ___________________________ is a graphical presentation of the demand function.
B. Enumeration Enumerate the important variables influencing demand for a good,

on the blanks provided,
6. _________________________________
7. _________________________________
8. _________________________________
9. _________________________________
10. _________________________________
Page | 23
Microeconomics
C. Multiple Choice Underline the best answer inside the parenthesis. Given the
demand curve below:
The demand curve shows that as the price of the good rises from ₱4.00 to ₱6.00, the
amount buyers (1.) (are willing but not able; are able but not willing; are willing and able;
are neither willing nor able; have succeeded) to buy (2.) (rises to 60; remains at 90; rises
to 90; false to 90.) This (3.) (inverse; direct) relationship between price and quantity
demanded is indicated by the (4.) (upward; downward) slope of the demand curve.
Between points L and M, the numerical value of price elasticity of demand is (5.) (1/3;
3/7; 1; 1 ¾; 3). Since the numerical value is (6.) (between zero and one; one; between
one and infinity), demand between the two points is (7.) (relatively inelastic; unit elastic;
relatively elastic). The rise in price from ₱2.00 to ₱4.00 (8.) (raises; reduces) total
expenditure from ₱240 to (9.) (₱120; ₱200; ₱300; ₱360; ₱450).
The numerical value of price elasticity of demand at point A is (10.) (3/4; 1; 2; 3; 4).
Along the horizontal axis the numerical value is equal to the distance 120 divided by the
distance (11.) (15; 30; 45; 60; 75). Along the vertical axis the numerical value is equal to
the distance 8 divided by the distance (12.) (1; 2; 3; 4; 5). Since the numerical value is
(13.) (between zero and one; one; between one and infinity), demand at the point is (14.)
(relatively inelastic; unit elastic; relatively elastic). As price rises by a small amount, total
expenditure (15.) (rises; falls; remains the same).
COMPARE YOUR ANSWERS WITH THE ANSWER KEY TO THE PROGRESS CHECK
TEST AND FIND OUT HOW YOU FARED.
Page | 24
Microeconomics
KEY TO PROGRESS CHECK TEST 1
A.
1. microeconomics
2. demand
3. price elasticity of demand
4. ceteris paribus
5. demand curve
B.
6. price of the goods
7. price of substitute goods
8. price of complementary goods
9. consumers’ incomes
10. consumers’ tastes
C.
1. are willing and able
2. falls to 60
3. inverse
4. downward
5. 3/7
6. Between zero and one
7. Relatively inelastic
8. Raises
9. ₱360
10. 4
11. 30
12. 2
13. Between one and infinity
14. Relatively elastic
15. Falls
RATING: No. of correct answers x 4 = _________
My rating is ________________
DID YOU FARE WELL IN THE PROGRESS CHECK TEST? IF YOU DID, YOU MAY
NOW PROCEED TO LESSON 2.
Page | 25
Microeconomics
Lesson 2 – Supply
Lesson Objectives
1. explain the concept of supply;
2. enumerate some of the variable influencing supply of a good;
3. explain and illustrate the supply function; and
4. explain measure and interpret price elasticity of supply.
Introduction
Lesson 1 proved to be rather long. This is so because as we discussed the demand side
of the goods in the market, we introduced ourselves to a number of concepts basic to
microeconomics – ceteris paribus assumption, functions, schedules, curves, elasticities.
Familiarity with the content of the previous lesson should ease our understanding of the
remaining lessons of this subject. The amount of time and energy we spent on Lesson 1 will
then be said to have been worth it.
Concept of Supply
We may define supply to be the total amount of a good firms in the market are willing
and able to sell over a specified period. Like demand, supply in the sense we use it in our
subject is intended, or planned, supply. It is the amount sellers are prepared to sell, not the
amount they actually sell. And as in the case of demand, we need to specify the time period
over which we measure supply.
Determinants of Supply
Supply of a good is influenced by many variables. The more important variables are
the price of the goods itself (P), prices or related goods (𝑃𝑟 ) prices of factors of production
(𝑃𝑟 ), technology (T), features of nature (N), and social and political climate (𝑐 ). We may
then write our supply function as 𝑄 = 𝑓(𝑃, 𝑃𝑟 , 𝑃𝑓 , 𝑇, 𝑁, 𝐶). We postpone to the next lesson
the discussion of the effect on quantity supplied of changes in several of these independent
variables. In this lesson we confined ourselves to the relationship between quantity supplied
and the price of the good itself.
Page | 26
Microeconomics
As in our analysis of demand, to isolate the effect of price on the quantity supplied we assume
no change in the other variables. We may therefore write our narrower supply function as
𝑄𝑠 = 𝑓(𝑃, 𝑃𝑟 , 𝑃𝑓 , 𝑇, 𝑁, 𝐶), 𝑜𝑟 𝑄𝑠 = 𝑓 (𝑃), ceteris paribus, or even more simply 𝑄𝑠 = 𝑓 (𝑃) so
long as we understand that the ceteris paribus assumption holds.
Supply Function
We recall that the equivalent of this section in the previous lesson is entitled law of
demand. It is natural to expect this section to acquire the title law of supply.
While the inverse relationship between the quantity demanded of a good and its price
(the law of demand) holds good in almost all cases, the direct relationship between quantity
supplied and price (what others call the law of supply) holds good only in many (as compared
to almost all) cases. Hence our choice o the safer supply function as the title of this section.
Just the same we discuss the normal supply function showing a direct relationship
between price and quantity supplied.
The supply function, like the demand function, may be presented in a table (supply
schedule) or in a graph (supply curve). A sample supply schedule and its corresponding
supply curve is shown below.
Table 4 – A Supply Schedule for Coffee
Price Quantity Supplied

Per Jar Jars per day
R 0 25
T 5 50
U 10 75
V 15 100
W 20 125
X 25 150
Page | 27
Microeconomics
Figure 7. A Supply Curve for Coffee
Our supply schedule shows that as the price of coffee goes up, quantity supplied also
goes up. This direct relationship is shown by the upward sloping supply curve in Figure 7.
Price Elasticity of Supply
Price elasticity of supply is the sensitivity of the quantity supplied of a good to changes
in its price. If as price rises and quantity supplied rises by a large amount, quantity supplies
is described to be sensitive, or responsive, or elastic to the change in price. If the resulting
change in quantity supplied is small, quantity supplied is inelastic with respect to the change
in price. This, of course, as in price elasticity of demand, is an imprecise distinction.
For a more precise demarcation between elastic and inelastic supply, we use the same
arc and point elasticity formulas we developed earlier. In fact the supply elasticity being
positively sloped. (We computed the slope of a downward sloping demand curve in Figure
1 to be − 1⁄10. In fact the slope of a downward sloping is negative. On the other hand the
slope of an upward sloping curve is positive.)
While the mathematical calculation of point elasticity of supply is identical (except for
the negative sign which is dropped) to that of point elasticity of demand, the graphical
calculation is not. Consider point W in the supply curve in Figure 7 where price is 20 and
quantity supplied is 125.
Mathematically,
Page | 28
Microeconomics
We recall that to get the slope of a straight line we choose any two point along the line,
measure the change in the variable along the vertical axis, and divide it by the change in the
variable along the horizontal axis.
To get the slope of the supply curve in Figure 7, therefore, we choose any two points
along it. Suppose we choose points T and U. Assume that we start at T where price is 5
and quantity supplied is 50. As we move to U, price rises to 10 and quantity supplied rises
to 75. The change in quantity supplied, the variable along the horizontal axis, is 25. The
slope between T and U, as well as for the entire supply curve, is therefore 1⁄5 (= 5⁄25).
In symbols, as well as for the entire supply curve, is therefore 1⁄5 (= 5⁄25) In symbols,
∆𝑃
and . Hence ∆𝑄 = 𝑎𝑚 1⁄5. The changes in price and quantity supplied
are show in Figure 7.
The graphical calculation of point elasticity of supply is derived by interpreting the

point elasticity formula graphically. The formula requires us to measure the slope of the
supply curve, price and quantity supplied.
At W, price is 20. Graphically it is equal to the distance WN. Quantity supplied at

W is 125. Graphically it is equal to KN. The slope, as we have just explained is obtained
by locating two points along the supply curve and measuring and . Suppose we choose
points R and W. is therefore equal to the distance WN, is equal to the distance MN,
and the slope is WN/MN.
Returning to our point elasticity formula and plugging in WN/MN for , WN for
P and KN for Q.
𝑀𝑁 100
The graph shows MN to be 100 and KN to be 125. Hence 𝐸𝑠 = = =
𝐾𝑁 125
4
.
5
This result tallies with that of the mathematical approach.
Mathematically and geometrically show that point elasticity of supply is ½ at T, 2/3 at

U, and ¾ at V.
We note that 𝐸𝑠 at all points along the supply curve (except R where 𝐸𝑠 is so small it
approaches zero) is above zero but less than one. This is expected. MN, the numerator in
the formula, is shorter than KN, the denominator. Hence 𝑀𝑁⁄𝐾𝑁 is less than one. In fact
𝐸𝑠 is between zero and one so long as the straight line supply curve starts from the horizontal
axis.
Page | 29
Microeconomics
𝐴𝐶
If the supply curve starts from the vertical axis as in the diagram below, 𝐸𝑠 = 𝐴 at
point A. This time the AC, is greater than the denominator AB. Hence, 𝐸𝑠 is greater than
one but less than infinity.
Figure 8. Graphical Calculation of Point Elasticity of Supply:

Relatively Elastic Case
We generalize by saying that if the supply curve starts from the horizontal axis as in
Figure 7, supply is relatively inelastic; it if starts from the vertical axis, it is relatively elastic;
if it starts from the origin, it is unit elastic. The perfectly elastic and inelastic cases are no
different from those for the demand curve. The following diagram (Figure 9) shows these
generalizations.
Figure 9. Price Elasticities of Linear Supply Curves
Page | 30
Microeconomics
A. Enumeration On the blank provided, enumerate 5 important variables

influencing supply of a good.
1. _________________________________________
2. _________________________________________
3. _________________________________________
4. _________________________________________
5. _________________________________________
B. Multiple Choice Underline or encircle the best answer inside the parenthesis.
Numbers 1 to 8 pertain to supply curve 𝑆𝑎 , numbers 9 to 13 to supply curve 𝑆𝑏 .
Given the supply curves below,
Supply curve 𝑆𝑎 shows that as the price of the good rises from ₱10.00 to ₱20.00, the
amount sellers (1. intends to sell; actually sell) (2. rises to 200; falls to 200; rises to 300; falls
to 300; remains at 200). This (3. direct; inverse) relationship between the quantity supplies
of a good and its price is indicated by the (4. upward; downward) slope of the supply curve.
At point H the numerical value of price elasticity of supply is (5. ½; 2/3; 1; 1 ½; 10). Since
the numerical value is (6. between zero and one; one; between 1 and infinity), supply at the
point is (7. relatively inelastic; unit elastic; relatively elastic). This means that a rise in price
will increase quantity supplies by a percentage (8. less than; equal to; greater than) the
percentage rise in price.
Page | 31
Microeconomics
Price elasticity of supply at point T in supply curve 𝑆𝑏 is (9. ½; 2/3; 1; 1 ½; 10). Since
the numerical value is (10. Between zero and one; between one and infinity), supply at the
points is (11. Relatively inelastic; unit elastic; relatively elastic). This means that a rise in
price will increase quantity supplied by a percentage (12. Less than; equal to; greater than) the
percentage rise in price.
Supply curve 𝑆𝑦 is (13. Perfectly inelastic; unit elastic; perfectly elastic). Supply curve
𝑆𝑥 is (14. Perfectly inelastic; unit elastic; perfectly elastic). Supply curve 𝑆𝑛 is (15. Perfectly
inelastic; unit elastic; perfectly elastic).
Page | 32
Microeconomics
A. (Any five)
1. Price of the goods

2. Price of related goods
3. Technology
4. Features of nature
5. Social and political climate
6. Taxes or subsidies
B. Multiple choice
1. Intend to sell
2. Rises to 300
3. Direct
4. Upward
5. 2/3
6. Between zero and one
8. Less than
9. 1 ½
10. Between one and infinity
12. Greater than
13. Unit elastic
14. Perfectly elastic
15. Perfectly elastic
Page | 33
Microeconomics
Lesson 3 – Equilibrium
Lesson Objectives:
Upon completion of this lesson you should be able to:
1. Explain the determination of equilibrium price and quantity;
2. Distinguish change in quantity demanded or supplied and change in demand or

supply; and
3. Explain why prices rise or fall.
Determination of Equilibrium Price and Quantity
Lesson 1 was devoted to a discussion of demand. Lesson 2 was devoted to a

discussion of supply. We now bring together in one place the elements of demand and supply
to explain the determination of the equilibrium price of a good and the amount actually bought
and sold.
Specifically, we merge the demand and supply and schedules (Tables 1 and 4) and
sketch the demand and supply curves (Figures 1 and 7) in one diagram. These are shown
below:
Table 5 – Determination of Equilibrium Price and Quantity
Price Quantity Quantity Excess Supply

(per jar) Demanded Supplied (Excess Demand)
0 250 25 (225)
5 200 50 (150)
10 150 75 (75)
15 100 100 0
20 50 125 75
25 0 150 150
Page | 34
Microeconomics
Figure 10. Determination of Equilibrium Price and Quantity
What price will be charged in the market and how many jars of coffee will be bought
and sold? (For computational ease, we assume the quantities are in units. In practice, they
may be in thousand or even millions of jars.)
Let us suppose that the price is ₱20.00 per jar. According to the supply schedule and
curve, sellers are prepared to sell 125 jars per day. On the other hand, buyers find the price
rather high and are prepared to buy, according to the demand schedule and curve, only 50 jars
at this price. The amount actually bought and sold is therefore only 50 leaving 75 unsold jars
in the hands of sellers. Unless they do something about it, sellers will find themselves
unnecessarily adding 75 jars of coffee every day to their stock of unsold goods. In one month
they will have accumulated 2,250 unsold jars of coffee on their shelves or warehouses. To
prevent this from happening, sellers are forced to lower the price that they charge. Hence the
price to be charged in the market will be lower that ₱20.00
Suppose the price is instead ₱5.00 per jar. The demand schedule and curve show that
buyers, quite excited by this low price, are prepared to buy as many as 200jars of coffee per
day. On the other hand sellers are not so happy amount this low price and are prepared to sell
only 50 jars. The amount actually bought and sold is therefore only 50 jars. There is a
shortage or excess demand of 150 jars, representing the difference between the amount buyers
intend to buy and the amount they can actually buy (220 – 50). We may imagine buyers
having to wake up very early in the morning to be among the first to get to the store. Those
who go to the store in the afternoon may even have to go home empty handed. And the more
enterprising buyers may find it profitable to buy as many jars as they can at the prevailing price
of ₱5.00 per jar and sell them at the black market price of ₱20.00 per jar. (Note that the demand
schedule and curve show that when the quantity is 50 buyers are prepared to pay ₱20.00 per
jar).
Page | 35
Microeconomics
Because of these inconveniencies, buyers expect and begin to accept a higher price for coffee.
Sellers, of course, can easily raise the price without losing total revenue. Hence, the price to
be charged in the market will be higher than ₱5.00.
If the price to be charged is lower than ₱20.00 but higher than ₱5.00, just what price
will be charged in the market? It must be at that price at which there is neither excess supply,
and hence no pressure for the price to fall, nor excess demand, and hence no pressure for the
price to fall, nor excess demand, and hence no pressure for the price to rise. Table 5 shows
that there is neither excess supply nor excess demand only at the price of ₱15.00. Figure 10
determines the same price at the intersection between the demand and supply curves. This
price is called the equilibrium price, the price which once attained is likely to be maintained.
The equilibrium quantity is shown to be 100 jars.
Change in Quantity Demanded or Supplied versus Change in Demand or Supply
We have just explained the determination of equilibrium price and quantity. We now
proceed to the explanation of the changes in them.
Before we do so, however, we need to distinguish a change in quantity demanded or

supplied and a change in demand or supply. Let us start with the difference between change
in quantity demanded and change in demand. Consider Figure 11 below.
Figure 11. Change in quantity demanded versus change in demand
Suppose we are initially at A where price is 𝑃𝑜 and quantity demanded is 𝑄𝑎 . The

movement from A either B or G is a change in quantity demanded. The movement from A to
B is a rise in quantity demanded, the movement from A to G is a fall. Note that a change in
quantity demanded is shown by a movement from one point in the demand curve to another
point in the same demand curve.
On the other hand, a change in demand is a shift from one demand curve like. Do to
another demand curve like 𝐷1 or 𝐷2 . The shift from 𝐷0 to 𝐷1 is an increase in demand, the
shift from 𝐷0 to 𝐷2 a decrease.
Page | 36
Microeconomics
Another point of distinction between a change in quantity demanded and a change in

demand is the cause of the change. A change in the price of a good is the only cause of a
change in quantity demanded. This is so because of our ceteris paribus assumption when we
sketch demand curves that freeze the values of variables other than the price of the good at
certain levels, making impossible for them to account for any observed change in quantity
demanded.
The situation is reversed in the case of a change in demand. This time it is the price
of the good which is held constant and all other influences such as the prices of complements
and substitute and consumer’s incomes and tastes may change. If, for example, we are initially
at A and perhaps because of a rise in the price of substitute demand for a good increases, at the
same price 𝑃0 consumers may now be prepared to buy 𝑄𝑐 units at C, higher that 𝑄𝑎 before the
change. Similarly, if demand falls perhaps because of an unfavorable change in consumer’s
tastes, at the same price 𝑃0 consumers may, after a shift to 𝐷2 , choose to buy only 𝑄𝑓 at F. In
both cases there is no change in price at all. In fact, we define a change in demand as an
increase or decrease in the quantity demanded of a good at all possible prices.
The same consideration hold for the distinction between a change in quantity supplied
and a change in supply. A change in quantity supplied is a movement from one point in a
supply curve to another point in the same supply curve. On the other hand, a change in supply
is a shift from one supply curve to another supply curve. A shift to the right is an increase in
supply, a shift to the left a decrease in supply.
A change in the price of the good is the only cause of a change in quantity supplied
because if the ceteris paribus assumption behind the drawing of the supply curve. And in the
case of a change in supply, it is the change in the price of the good which is now being held
constant, all other influences such as the price of related goods, prices of factors of production,
technology, features of nature and social and political climate being allowed to change.
Causes of increases in demand include a rise the price of substitutes, a fall in the price
of complements, a rise in consumers’ incomes, and a favorable change in consumers’ tastes.
If these variables move in the opposite direction, a decrease in demand results.
Causes of increase in supply include a fall in the price of related goods, a fall in the
price of factors of production, technological advances, favorable change in the weather, and a
favorable change in the political and social climate. By related goods in this context we mean
related in production. Supply of coffee, for example, may be affected not only the price of
coffee but also by the price of other agricultural products like rice. If the price of rice rises
sharply farmers may switch from coffee production to rice production. If on the other hand
the price of rice markedly falls, farmers may switch to coffee production instead, thus raising
the supply of coffee.
Page | 37
Microeconomics
Change in the Equilibrium Price and Quantity
Having understood the concept of change in demand and change in supply, we are now
better equipped to provide an explanation of changes in equilibrium price and quantity.
Briefly, equilibrium price and quantity change because of a change in demand, in

supply, or in both.
Let us first consider the effect on equilibrium price and quantity of a change in demand.
Assume that households in the coffee market enjoy increases in their incomes that allow them
to increase the quantity of coffee that they demand by 75 jars per day at all prices. This means
that a price of ₱5.00 per jar, they are now prepared to by 175 jars compared to 100 before the
increases in incomes; at a price of ₱20.00 they are now prepared to buy 125 against 50 before
the change. If quantity demanded is increased by 75 at all prices, the demand curve shifts
from 𝐷0 to 𝐷1 . Study the diagram below.
Figure 12. Effect on Equilibrium Price and Quantity of a Rise in Demand by 75
Equilibrium price cannot continue to be ₱15.00 because at this price while sellers are
still prepared to sell 100 jars buyers are now prepared to buy 175 jars. The increase in incomes
brought about an excess demand of 75 jars at the old equilibrium price. In accordance with
our analysis early in this lesson, there will be pressure in the market for the price to rise. The
price will continue to rise until the excess demand disappears at the higher price of ₱20.00.
At this price quantity is 125 jars. As the arrows in the diagram indicate, a rise in demand
increases both equilibrium price and equilibrium quantity. Note that if supply is perfectly
elastic the rise in demand will raise equilibrium quantity but will not change equilibrium price;
and that is supply is perfectly inelastic a rise in demand will raise equilibrium price but will
not change equilibrium quantity.
Page | 38
Microeconomics
Assume that the change in demand described in the last paragraphs did not happen.
Assume instead that because of a favorable change in the weather supply rises by 150 jars per
day at all prices. This shifts the supply curve as shown below.
Figure 13. Effect on Equilibrium Price and Quantity of a Rise in Supply by 150
Equilibrium price will no longer be ₱15.00 after the shift in supply because while
buyers continue to want to buy 100 jars per day, sellers are now prepared to sell 250 jars.
There is an excess supply of 150 jars which, as we have earlier analyzed, can be disposed of
only by reducing the price until the excess supply disappears. The price at which the excess
supply disappears is ₱5.00, where quantity is 200. As the arrows indicate, a rise in supply
raises equilibrium quantity but reduces equilibrium price. Note that a fall in supply will raise
the price but will reduce equilibrium quantity.
An even more interesting case is a simultaneous change in demand and supply.

Suppose the increases in incomes and the favorable change in the weather happen at the same
time, shifting both demand and supply curves as shown below.
Figure 14. Effect of a Rise in Demand by 75 and a Rise in Supply by 150
Page | 39
Microeconomics
The market is taken from equilibrium point 𝐸0 , the intersection between the old demand
and supply curves, to equilibrium point 𝐸1 , the intersection between the new demand and
supply curves. Price is seen to fall by ₱5.00 (from ₱15.00 at 𝐸0 to ₱10.00 at 𝐸1 ) and quantity
to rise by 125(from 100 at 𝐸0 to 225 at 𝐸1 ).
To understand what happens, we analyze the effects of the increases in incomes and
the favorable change in the weather separately. The increases in incomes alone will take the
market from 𝐸0 to 𝐸𝑡 , where the equilibrium price is ₱20.00. If the increases in incomes are
accompanied by the favorable change in the weather, the equilibrium price cannot continue to
be at ₱20.00, as the increase in supply creates an excess supply of 150 at that price. Price will
then be forced down until the excess supply disappears at 𝐸1 , where equilibrium price is ₱10.00
and equilibrium quantity is 225. The transfer from 𝐸0 to 𝐸1 may be then thought of as
consisting of two steps. 𝐸0 to 𝐸𝑡 and 𝐸𝑡 to 𝐸1 may then be thought of as consisting of two
steps. 𝐸0 to 𝐸𝑡 and 𝐸𝑡 to 𝐸1 . If, of course, we choose to consider first (the effect of a rise in
supply), the market is taken from 𝐸0 to 𝐸𝑣 initially and 𝐸𝑣 to 𝐸1 finally. In any case the market
is taken from 𝐸0 to 𝐸1 . The arrows show that equilibrium quantity to rise and the equilibrium
price to fall.
Even without putting up Figure 14, we can tell whether equilibrium quantity will rise
or fall. Figure 12 shows that the rise in demand alone raises equilibrium quantity. Figure 13
shows that the rise in supply alone raises equilibrium quantity. If both demand and supply
rise at the same time, the change in equilibrium quantity will be larger than the change brought
about by either a rise in demand or a rise in supply taking place separately.
On the other hand, the effect on equilibrium price is uncertain. Figure 12 shows that
a rise in demand alone raises equilibrium price. Figure 13 shows that a rise in supply alone
reduces price. If both demand and supply rise at the same time, it is uncertain whether
equilibrium price will rise or fall. We have two forces pulling in opposite directions.
Obviously the stronger force will prevail. Since in Figure 14 the rise in supply is larger than
the rise in demand, the rise in supply will dictate the direction of the change in equilibrium
price. Hence equilibrium price falls. If the rise in demand is larger, equilibrium price will
rise. If the rise in demand is just as large as the rise in supply, equilibrium price will remain
the same.
The three diagrams below illustrates these points.
Figure 15. Effect on Equilibrium Price and Quantity of a Rise in Demand and Supply
Page | 40
Microeconomics
We can think of more possibilities: a rise in demand and a fall in supply where the rise
in demand is larger than, equal to, or smaller than the fall in supply; a fall in demand and a rise
in supply where the fall in demand is larger than, equal to, smaller than the fall in supply. And
then we have the extreme cases of perfectly elastic and perfectly inelastic demand and supply.
We can play with diagrams to explore these possibilities. We need to be sure, however,
that we know why the market is taken to a particular situation.
Page | 41
Microeconomics
Multiple Choice Encircle the best answer inside the parenthesis.
Given the diagram below:
Assume a rise in supply from 𝑆0 to 𝑆1 resulting from technological advances. The

equilibrium price before the rise in supply cannot continue to be equilibrium price after that
rise in supply because at that price while buyers are prepared to buy (1. 100; 200; 300; 400)
units, sellers are prepared to sell (2. 100; 200; 300; 400) units. The rise in supply in effect
created an excess (3. demand; supply) of (4. 100; 200; 300; 400) units, which can be
eliminated only by (5. raising; reducing) the price. The price will keep on changing until it
reaches (6. ₱20; ₱30; ₱40; ₱50), at which quantity is (7. 100; 200; 300; 400). Quantity
is shown to (8. rise; fall; remain the same). If demand is perfectly elastic, equilibrium price
will (9. rise; fall; remain the same). If demand is perfectly inelastic, equilibrium quantity
will (10. rise; fall; remain the same).
COMPARE YOUR ANSWERS WITH THE ANSWER KEY TO PROGRESS CHECK TEST
AND FIND OUT HOW YOU FARED.
Page | 42
Microeconomics
1. 100
2. 300
3. supply
4. 200
5. reducing
6. ₱40
7. 200
8. rise
9. remain the same
10. remain the same
RATING: No. of Correct Answers x 10 = __________
My rating is ______________
DID YOU FARE WILL IN THE PROGRESS CHECK TESTS? IF YOU DID, YOU MAY
Page | 43
Microeconomics
Lesson 4 – An Application
Lesson Objective:
Upon completion of this lesson, you should be able to appreciate applications of

demand-supply analysis to as many cases as possible.
Demand-supply analysis has a number of applications. Let us consider one of them.
The matter of rent control has long been a subject of intense debate between landlords
and tenants. And for that same span of time, the government has been without a firm policy
on it.
To throw the issue into clearer relief, we make use of our demand and supply curves.
Figure 16
Figure 16 shows demand for and supply of housing units. The price of housing
services is their rental. The demand curve also has its expected upward slope, indicating that
landlords are prepared to construct more housing units as rentals increase to levels that can at
least cover production costs. The intersection between the demand and supply curves
determines the equilibrium rental.
Apparently to help more tenants get housing services more cheaply, the government
imposes rent control, say at 𝑅𝑐 . Our diagram shows that at this rather low rental, tenants in
the market are willing and able to rent 𝑄1 units. However, landlords find the rate so low that
they are willing and able to supply only 𝑄2 units. There is therefore an excess demand for
housing units amounting to 𝑄2 𝑄1 . Without rent control rentals will rise to 𝑅𝑐 . With rent
control, it is not legally possible for rentals to rise beyond 𝑅𝑐 . Hence the shortage of 𝑄2 𝑄1
persists.
Page | 44
Microeconomics
While the government appears to help to keep rentals within the reach of the average tenant, it
creates another problem – the problem of housing shortage. Prospective tenants like newly
married couples are greatly prejudiced. Even old tenants covered by the rent control law may
not be much better off as landlords refuse, for example, to repair leaking roofs.
This problem of housing worsens over time as the population grows fast. In terms of
our diagram this means an increase in demand, say from 𝐷0 to 𝐷1 . The shift from 𝐷0 to 𝐷1
increases the amount of the shortage from 𝑄2 𝑄1 to 𝑄2 𝑄3 .
One way to keep rentals within the reach of many people without creating housing
shortages is for the government to actively participate in the construction of housing units.
Another way is for the government to encourage private housing construction by providing,
for example, tax incentives. Whatever the approach may be, the objective is to increase supply
by an amount large enough to match the rise in demand over time at what the government
believes to be the reasonable rental. In the diagram this means shifting the supply curve from
𝑆0 to 𝑆1 and making it intersect the new demand curve at the rent rate of 𝑅𝑐 .
(PERFORM PROGRESS CHECK TEST 4

AND THEN THE MODULE TEST)
Page | 45
Microeconomics
Multiple Choice Encircle the best answer inside the parenthesis.
Given the demand and supply curves for housing units below:
Equilibrium rental is (1. ₱300; ₱600; ₱1,000; ₱1,200) and equilibrium number of
housing units is (2. 50; 80; 120; 200). If the government imposes rent control at ₱300 per
month, there is an excess (3. demand; supply) of (4. 50; 70; 80; 120) housing units. Without
rent control, rentals will (5. rise; fall).
Overtime as population grows, demand for housing units rises. This means a shift in
the demand curve from 𝐷0 to, say, 𝐷1 . If rent control is not lifted, there is an additional excess
(6. demand; supply) of (7. 50; 70; 80; 120) for a rental excess (8. demand; supply) of (9.
50; 100; 150; 200). If the government wants to maintain rentals at ₱300 without housing
shortages, it has to cause supply of housing units to rise from 𝑆0 to 𝑆1 , which intersects the
new demand curve at the controlled rental of ₱300 a month. The rise in supply increased
quantity supplied by (10. 50; 100; 150; 200) at the controlled rental of ₱300 a month.
COMPARE YOUR ANSWERS WITH THE ANSWER KEY TO PROGRESS CHECK TEST
AND FIND OUT HOW YOU FARED.
Page | 46
Microeconomics
1. ₱1,000
2. 80
3. Demand
4. 70
5. Rise
6. Demand
7. 80
8. Demand
9. 150
10. 150
RATING: No. of Correct Answers x 10 = ______________
My Rating is ______________
NOW PROCEED TO THE MODULE TEST.
Page | 47
Microeconomics
MODULE 2
THEORY OF THE HOUSEHOLD
Page | 48
Microeconomics
MODULE 2 - THEORY OF THE HOUSEHOLD
Scope of the Module
Module 2 contains the following four lessons:
Lesson 1 – Indifference Curves
Lesson 2 – The Budget Line
Lesson 3 – Consumer’s Equilibrium
Lesson 4 – Price Effect, Income Effect and Substitution Effect
Module 1 was devoted to the discussion of demand and supply. In this module we
extend our investigation of the demand side of the market.
As we have just learned, the demand curve shows the amount of a good consumers are
willing and able to but at various prices of the good. These two aspects of willingness to buy
and ability to buy will receive much of our attention in this module. We will also provide an
explanation of the law of demand.
After completing this module, you are expected to be able to:
1. Explain the assumptions of the theory of the household;
2. Explain the nature and characteristics of indifference curves;
3. Construct and interpret the budget line;
4. Explain the determination of consumer equilibrium; and
5. Explain changes in consumer equilibrium resulting from changes in the consumer’s

income and the prices of goods.
Page | 49
Microeconomics
Lesson 1 – Indifference Curves
Lesson Objectives:
1. explain the assumptions of the theory of the household; and
2. explain the nature and characteristics of indifference curves.
Introduction
The theory of the household is also called the theory of utility. Utility, according to
elementary microeconomics, is the satisfying power of a good or service. Some goods gives
much utility, others give little utility.
There are two theories of utility – the cardinal utility theory and the ordinal utility
theory. The words cardinal and ordinal are borrowed from mathematics. Examples of
cardinal numbers 1, 2, 3 and so on.
Cardinal utility theory assumes that utility is measurable. If, for example, I drink a
cup of coffee I am assumed to be able to measure the amount of satisfaction that I experience,
say 100 units (or utils, the unit of measure applied to utility). If on the other hand a bottle of
beer gives me 138 utils, I prefer a bottle of beer to a cup of coffee by 38 utils.
Ordinal utility theory does not require the measurability of utility. After all it is not
easy to measure the satisfaction afforded by goods and services. All that ordinal utility theory
requires is that a consumer is able to rank his preferences. There is no need to state precisely
by how much I prefer to coffee. I only need to say that I prefer beer to coffee. Perhaps I
prefer beer to coffee markedly; perhaps I prefer beer to coffee only slightly. In any case I
need to specify by how much in terms of such measures as utils.
This module will discuss the ordinal utility theory.
Assumptions about the Consumer’s Preferences
We are now about to build a theory of consumer behavior. Before we do so, however,
we have to establish certain assumptions about the consumer’s preferences. Our theory will
hold good only if these assumptions are satisfied.
Page | 50
Microeconomics
The first assumption is that confronted with two combinations of goods (or market
basket), a consumer can decide whether he prefers the first market basket to the second market
basket, whether he prefers the second market to the first, or whether he is indifferent between
them. In short, it is assumed that the consumer has a scale of preferences.
The second assumption is that the consumer’s preferences are transitive. If I prefer
beer to coffee which I prefer to tea, I must prefer beer to tea. Similarly, if I like beer as much
as coffee which I like as much as tea, I must like beer as much as tea. Transitivity is
consistency.
The third assumption, called the assumption of nonsatiety, is that the consumer will
prefer more of a good to less of it. This simply means that the consumer will prefer two cups
of coffee to one cup.
Indifference Curves
Figure 17 shows several combinations or market baskets of coffee and tea. Market
basket M includes 1 cup of coffee and 3 cups of tea. By the assumption of nonsatiety, market
based M must be preferred to market basket F, which also contains 1 cup of coffee but only
one cup of tea. Market basket L contains the same number of cups of tea as market basket M
but the former must be preferred to the latter inasmuch as the former has more cups of coffee.
Between M and L it is uncertain whether M will be preferred to L or L will be preferred to M.
There is a third possibility. To the consumer M and L may be equivalent. In fact M is
equivalent to L, M and L belong to what is known as indifference curve. An indifference
curve is a set of market baskets that are equivalent to the consumer in the sense that they give
him the same level of satisfaction. The curve is an indifference curve because the consumer,
finding the market baskets equivalent, does not care or is indifferent which particular market
basket he gets. In indifference curve number 2, for example, the consumer does not care
whether he gets M or J or L.
Figure 17
Page | 51
Microeconomics
Characteristics of Indifference Curves
Indifference curves have four characteristics.
Indifference curves are negatively sloped. Consider the four indifference curves in
Figure 18. Figure 18A shows a positively sloped indifference curve. By definition of
indifference curves, S and A should be equivalent. By the assumption of nonsatiety, however,
A should be preferred to S. Hence S and A belong to the same indifference curve. The only
way to admit the possibility of a positively sloped curved is to assume that good X is a
nuisance: it gives disutility instead of utility. This is shown by the need for the consumer to
consume more units of Y to maintain the same level of satisfaction after he has consumer
additional units of good X (movement from S to A).
Figure 18B shows an indifference curve with zero slope. Again, K, by the assumption
of nonsatiety should be preferred to Z. We may think of good X as a useless good relative to
good Y. At market Z the consumer consumes some units of Y and none of X. Given extra
units of X (Z to K), the consumer is not better off as Z and K are equivalent by definition of
an indifference curve. Equivalently, if the consumer moves from K to Z, he reduces his
consumption of good X to zero but does not decrease his satisfaction as Z and K are equivalent.
Figure 18C shows an infinitely slope indifference curve. Following the arguments in
the last paragraph, we may consider good Y as a useless good relative to good X.
Nuisance goods (which some economists call bads) and useless goods are extreme and
exceptional cases. The more usual goods are represented by negatively sloped indifference
curves as in Figure 18D. It is possible for market baskets H and I to be equivalent and hence,
belong to the same indifference curve since the consumer may have less of good Y in market
basket I but this may just be compensated by his having more units of X.
Figure 18
Page | 52
Microeconomics
The second characteristic of indifference curves is that higher indifference curves

represent greater levels of satisfaction than lower indifference curves. Thus, market basket
R in indifference curve number 3 in Figure 17 is preferred to market basket L which belongs
to a lower indifference curve. Market basket L is in turn preferred to market basket F which
belongs to an even lower indifference curve. The explanation for his second characteristic is
that market baskets belonging to the higher indifference curve contain more units of both goods
X and Y. Market basket R, for example, contains more units of goods X and Y than J. It
can also be shown that market basket R should be preferred to market basket M. If R is
preferred to J by the nonsatiety assumption, and J is equivalent to M by definition of
indifference curves, R must be preferred to M by the transitivity assumption.
The third characteristic is that two indifference curves cannot intersect. If they do, an
internal inconsistency will be discovered. Consider Figure 19, K and Z are equivalent because
they belong to the same indifference curve. C and Z are also equivalent because they also
belong to the same indifference curve. Hence K and C are equivalent by the transitivity
assumption. But K should be preferred to C and by the nonsatiety assumption because K has
more units of the goods than C has. We are therefore forced to make two contradictory
statements – that K is equivalent to C and that K is preferred to C – which can be resolved only
by saying that two indifference curves cannot intersect.
Figure 19
The fourth characteristic of indifference curves is that they are convex. The first
characteristic, as we have seen, is that indifference curves are negatively sloped. There are
three ways for an indifference curve to be negatively sloped: convex, concave, and linear. The
graphs below show these three ways.
Figure 20
Page | 53
Microeconomics
We now examine the convex indifference curve in Figure 20A. Suppose the consumer
is initially in market basket A consuming 𝑋𝑎 of X and 𝑌𝑎 of Y. If he would like to have an
extra unit of good X (say 𝑋𝑎 to 𝑋𝑏 ) he is prepared to give up 𝑌𝑎 𝑌𝑏 units of good Y. 𝑌𝑎 𝑌𝑏 the
number of units the consumer is willing to give up for an extra unit of good X, is called the
marginal rate of substitution. The consumer is then taken to market basket B which shows
him to have more and X and less of Y than he has at A. For still another unit of X, say 𝑋𝑏 𝑋𝑐 ,
the consumer is willing to give up 𝑌𝑏 𝑌𝑐 of Y. Note that 𝑌𝑏 𝑌𝑐 , the marginal rate of substitution
(MRS) between B and C is smaller than 𝑌𝑎 𝑌𝑏 , the MRS between A and B. And even smaller
MRS equal to 𝑌𝑐 𝑌𝑑 is noted between A and B. As the consumer moves from A to B to C to
D, he acquires more and more of X and less and less of Y. The diminishing MRS (from 𝑌𝑎 𝑌𝑏
to 𝑌𝑏 𝑌𝑐 to 𝑌𝑐 𝑌𝑑 ) means that as the consumer has more and more of good X and less of less of
good X. This is so because as he has more and more of a good, the less important an extra
unit of it becomes to him relative to another good. This is the economic interpretation of the
convexity of indifference curves.
Activity
Read and watch the video available in the following sites:
Indifference Curve Definition (Investopedia.com)
(PROCEED TO NEXT LESSON)
Page | 54
Microeconomics
Lesson 2 – The Budget Line
Lesson Objectives
Upon completion of this lesson, you should be able to sketch and interpret a budget
line.
Lesson 1 discussed the consumer’s willingness to buy goods and services as reflected
in his indifference curves. We now turn to the consumer’s ability to buy as reflected in his
budget line.
Suppose a consumer has a budget of ₱30.00. The price of coffee (good X) is ₱6.00
per cup and the price of tea (good Y) is ₱3.00 per cup. Can he afford to buy market basket A
in Figure 21? Market basket A contains 1 cup of coffee and 4 cups of tea. One cup of coffee
at ₱6.00 per cup will require an expenditure of ₱6.00 and 4 cups of tea at ₱3.00 per cup will
require an expenditure of ₱12.00 for a total expenditure of ₱18.00. This is way below the
consumer’s ₱30.00 budget. He can therefore afford to buy market basket A.
What about market basket K? K includes 2 cups of coffee and 6 cups of tea. Two
cups of coffee at ₱6.00 per cup means an expenditure of ₱12.00 and 6 cups of tea at ₱3.00 per
cup means an expenditure of ₱18.00 for a total expenditure of ₱30.00. He can therefore just
afford to buy market basket K.
Finally, what about market basket L? On coffee the consumer needs to spend ₱12.00
and on tea he needs to spend ₱30.00 for a total expenditure of ₱42.00, which is higher than his
₱30.00 budget. The consumer cannot afford to buy L.
Apparently, to be able to tell whether a consumer can afford to buy a market basket we
multiply the quantity of the first good by its price to get the required expenditure for that good,
multiply as well the quantity of the second good by its price to get the required expenditure for
the second good, compute the total expenditure on the two goods and compare it with the
consumer’s budget.
This is however a tedious process. An easier way is to draw a line which will separate
market baskets falling within the consumer’s budget and those beyond it. This line is the
budget line. A budget line may be defined to be the set of market basket that will exhaust the
consumer’s budget, given the prices of the two goods. If, for example, the consumer’s budget
is ₱100, a budget line will include all combinations of two goods that will make the consumer
spend exactly ₱100.
Page | 55
Microeconomics
The equation of the budget line is 𝑋𝑃𝑥 , 𝑌𝑃𝑦 = 𝐵, where 𝑃𝑥 is the price of good X, 𝑃𝑦 is
the price of good Y, and B is the consumer’s budget. 𝑋𝑃𝑥 is the expenditure on good X. 𝑌𝑃𝑦
is the expenditure on good Y. 𝑌𝑃𝑥 𝑌𝑃𝑦 is therefore the total expenditure on goods X and Y.
The equation in effect requires that for a market basket to lie along a budget line the total
expenditure on it must be equal to the consumer’s budget.
A budget line is a straight line. As such it can be drawn if at least two points along it
are known. The two points which we will find convenient to locate are the horizontal and
vertical intercepts.
At the horizontal intercept the value of Y is zero. If Y is 0, 𝑋(𝑃𝑥 )0(𝑃𝑦 ) = 𝐵, 𝑋𝑃𝑥 =

𝐵
𝐵, 𝑋 = 𝑃 . The horizontal intercept is therefore 𝐵⁄𝑃𝑥 = ₱30⁄₱6 = 5 in our sample problem.
𝑥
At the vertical intercept the value of X is zero. If X is zero, 𝑂(𝑃𝑥 )𝑌𝑃𝑦 = 𝐵,

.
These intercepts are then located in the diagram and connected by a straight line. The
straight line is the budget line.
Figure 21
Note that all market baskets along the budget line require a budget of exactly ₱30.00.
At market basket C the consumer needs to spend ₱6.00 on good X and ₱24.00 on Y for a total
expenditure of ₱30.00. Market basket F requires an expenditure of ₱24.00 on X and ₱6.00 on
Y also for a total of ₱30.00
On the other hand, market baskets below the budget line such as market A will make
the consumer spend less than his budget. As we have earlier computed, at A the consumer
needs to spend only ₱18.00.
Page | 56
Microeconomics
Market baskets above the budget line are market baskets the consumer is unable to buy.
An example is again L which requires a ₱42.00 expenditure against a budget of only ₱30.00.
Finally, we note the slope of the budget line. As we recall from Module 1, to get the
slope of a straight line we choose any two points along the line, compute the change in Y and
divide it by the change in X. In our budget line suppose we again choose our intercepts. The
change in Y is noted to be the vertical intercept itself. The change in X is also the horizontal
intercept. The slope is therefore equal to 𝐵⁄𝑃𝑦 divided by 𝐵⁄𝑃𝑥 . Performing the division we
find the slope to equal to 𝑃𝑥 ⁄𝑃𝑦 .
In our sample problem 𝑃𝑥 is ₱6.00 and 𝑃𝑦 is ₱3.00. Hence the slope is 2.
The slope of a budget line is interpreted as the number of units of good Y the consumer
is forced to give up to be able to buy an extra unit of good X if he is to remain within his
budget. If the slope is 2 as in our sample problem, the consumer must give up 2 units of good
Y for an extra unit of good X if he is to remain within his ₱30.00 budget. If, for example, the
consumer is initially at K and wants to buy an extra unit of good X, he is taken to market basket
O at which he has to spend ₱36.00. This is beyond his budget. If the consumer insists on
having an extra unit of good X he has to give 2 units of good Y. The consumer is now in
market basket I.
Activity
Read the articles from the following sites:
6.1 The Budget Line – Principles of Microeconomics (bbcampus.ca)
Page | 57
Microeconomics
Lesson 3 – Consumer’s Equilibrium
Lesson Objectives
Upon completion of this lesson you should be able to determine and explain the
consumers’ equilibrium.
Lesson Presentation
In Lesson 1 we discussed the consumer’s willingness to buy. In Lesson 2 we discussed

the consumer’s ability to buy.
We now look for the market basket that the consumer is both willing and able to buy
given his indifference curves and budget line.
In figure 22 four indifference curves and a budget line are drawn. Comparing the
market baskets shown, we noted that while the consumer is just too willing to get to the highest
indifference curve at, say, market G, he cannot afford G since G lies above the budget line.
Market basket V belongs to a lower indifference curve but is still beyond the consumer’s
budget anyway.
Market basket I lies along the budget line and is therefore a market basket the consumer
can afford. However, market basket I belongs to a low indifference curve. He can increase
his satisfaction and yet remain within his budget if he travels to K, which belongs to a higher
indifference curve. In fact he can keep on travelling along his budget line until he gets to H.
If he goes beyond H he is returned to a lower indifference curve as in market basket J.
In a diagram, the consumer maximizes his satisfaction or utility subject to his budget
constraint at market H where he buys 𝑋ℎ of X and 𝑋ℎ of Y. Other market baskets the consumer
may be willing but not able to buy as market baskets V and G or may be able but not willing
to buy as market baskets I, K, and J.
Note that consumer equilibrium is established at the market basket where the budget
line is tangent to an indifference curve. Given 𝑃𝑥 , the consumer is willing and able to buy 𝑋ℎ .
This is a pair of values of price and quantity demanded that belongs to a demand curve for X.
Page | 58
Microeconomics
Figure 22
We may express consumer’s equilibrium in another way. Before we can do so,

however, we need to take another excursion to mathematics.
We have so far extensively made use of the techniques of the slope in the case of
straight line such as demand and supply curves in Module 1 and the budget line in the previous
lesson. We now calculate the slope of curves that are not straight. (We remind ourselves
that in mathematics and in economics a straight line is also called a curve. Thus in Module 1
our demand and supply curves are, for simplicity of analysis, drawn as straight lines.)
The first thing to note about nonlinear functions (functions not expressed by straight
lines) is that the slope will vary from point to point of the curve. In indifference curve 2 in
Figure 22, for example, the slope of the curve at point K is different from the slope at H. There
is no such thing, therefore, as the slope of a curve if the function is nonlinear. The slope can
be calculated only at a particular point of the curve.
To calculate the slope of a curve at a point, we sketch a tangent line to the curve at that
point and compute the slope of such tangent line. The slope of that tangent line is the slope
of the curve at that point. Those who are interested in the proof of this technique may
consult a book in mathematical analysis or in mathematical economics.
To get the slope of indifference curve 1 at point I in figure 22, we sketch a tangent
line to point I as shown. The slope of this tangent line, which is also the slope of the
indifference curve at point I, is obtained in the usual way the slope of a straight line and a
tangent line is a straight line —is obtained: choose any two points along the line,
calculate the change in y and divide it by the change in x.
Suppose we choose points I and S in computing the slope of the tangent line at
point I. The change in y is given by the distance IF and the change in x is given by the
distance FS. The slope is therefore IF/FS.
Page | 59
Microeconomics
We may compare the value of this slope of the indifference curve at point I and the
slope of the budget line. The budget line being a straight line, its slope can be determined
by, again, choosing any two points along it, calculating the change in y and dividing it by the
change in x. If we choose points I and R, the change in y is given by IQ and the change in x is
given by QR. The slope of the budget line is therefore IQ/QR.
Comparing IQ/QR, the slope of the budget line, and IF/FS, the slope of the
indifference curve at point I, we find the slope of the indifference curve to be larger than the
slope of the budget line. The diagram shows QR, the denominator of the formula of the
slope of the budget line, to be equal to FS, the denominator of the formula of the slope of
the indifference curve at point I. With the denominators equal, we need to compare only
the numerators to determine which fraction is larger. Obviously, IF, the numerator of the
formula of the slope of the indifference curve at point I, is longer than IQ, the numerator of
the formula of the slope of the budget line. Hence, IF/FS is greater than IQ/QR.
In Lesson 1 of this module we made mention of the marginal rate of substitution (MRS).
We defined it to be the number of units of good y the consumer is willing to give up for an
extra unit of good x. If the MRS is 2, for example, the consumer is willing to give up 2 units
of y for an extra unit of x; for 2 extra units of x, he is willing to give up 6 units of y. The MRS
in fact involves a change in y and a change in x, and is indeed the ratio between the change in
y to a given change in x. In short the MRS is the slope of an indifference curve at a particular
point in that curve. More precisely, the MRS is the absolute value of the slope of the
indifference curve. If the slope of the indifference curve is —3, the MRS is 3; if the slope is
—10, the MRS is 10.
In our discussion of the budget line in the previous lesson, we ignored the sign of its
slope. In fact the budget line, as we can very well see, is also negatively sloped. Hence,
the slope of the budget line is, strictly Px/Py.
To ease the comparison between the slope of the indifference curve at point I and the
slope of the budget line, it will be convenient for us to ignore the negative sign for both
slopes. We may therefore express the slope of the indifference curve as the MRS at point I and
the slope of the budget line as Px/Py.
Recalling our earlier result that IF/FS, the slope of the indifference curve at point I,
is greater than IQ/OR, the slope of the budget line, we may now say that at point I, the MRS is
greater than Px/Py.
If the MRS is the number of units of good y the consumer is willing to give up for an
extra unit of good x and Px/Py is the number of units x of good y a consumer is forced to give
for an extra unit of good x, to say that the MRS is greater than P x/Py is to mean that the
consumer is willing to give up more units of good y than he is forced to for an extra unit of
good x. If, for example, the MRS is 3, the price of good x is P6.00, the price of good y is P3.00
and hence Px/Py is 2, for an extra unit of good x the consumer must give up 2 units of good y
although he is actually prepared to give p 3. He is therefore left with 1 unit of good y ready to
be exchanged for good x.
Page | 60
Microeconomics
The consumer is not in equilibrium at point I because at that point he is prepared

to substitute good y for good x. He will be in equilibrium only if he is no longer prepared
to give up good y for good x, or good x for good y.
If we draw a tangent line at point K in indifference curve 2 in Figure 22, we note

that the slope of the tangent line is still greater than the slope of the budget li ne: the MRS
is still greater than P x/Py. The consumer will continue to substitute good y for good x.
He will keep on doing so until he reaches point H at which he consumes Xh of x

and Yh of y. At this point the line tangent to the indifference curve is the budget line
itself. Since the slope of a curve at a point is equal to the slope of the line tangent to the
curve at that point, the slope of the indifference curve at H is the slope of the budget line,
which happens to be such tangent line. In short, at point H, MRS = P x/Py. The number of
units of good y the consumer is forced to give up for an extra unit of good x is equal to
the number of units of good y he is in fact willing to give up . There is then no
inducement for the consumer to give up good y for good x, or good x for good y.
This latter case, giving up good x for good y, is illustrated at point J. If a

tangent line is drawn at J, its slope, which is the slope of the indifference curve at point J,
is less than the slope of the budget line. The number of units of good y the consumer is
forced to give up for an extra unit of good x is greater than the number of units of goody he
is in fact willing to give up. The consumer cannot be persuaded to substitute good y for
good x. In fact he would rather substitute good x for good y. He will keep on doing so until he
gets to point. H where, as already analyzed, MRS = Px /Py . At point T, on the other hand, MRS <
Px/Py.
Activity
Access the lesson on Consumer Equilibrium from the following sites (also
attached)
318 Economics Eng Lesson14.pdf (nios.ac.in)
Page | 61
Microeconomics
Lesson 4. Price Effect, Income Effect, and Substitution Effect
Lesson Objectives
Upon completion of this lesson you should be able show how changes in income
and prices affect the quantity demanded of a good.
Income Effect
Suppose the consumer's budget increases, his budget line shifts upward.
Arithmetically, the upward shift is expected because B, the numerator in the formula for
the horizontal and vertical intercepts of the budget line, increases. As the numerator of a
fraction increases with the denominator constraint, the value of the fraction rises. We use
B' to designate the new B. If of course the budget falls, the budget line will shift
downward. The new budget line is parallel to the old because the slope of both old and
new budget lines is unchanged at Px/P y.
The old budget line in Figure 23A shows the consumer to be prepared to buy Xr
or X and Yr of Y at market basket R, the old equilibrium point. After a rise in his budget,
his budget line shifts upward and becomes tangent to a higher indifference curve at point
H where the consumer is now prepared to buy larger amounts of both goods. The length
of the arrows shows the increase in the amount the consumer is willing and able to buy.
We in fact expect the consumer to behave this way. Goods, the demand for which rises
with a rise in income are called normal goods.
On the other hand there are goods which are bought only because the consumer's
budget is limited. As his income rises, he turns to other goods and snubs the g oods he
bought when he had little money. These good, demand for which rises with a fall in
income and falls with a rise in income are called inferior goods_ Figure 23B
illustrates the case of the inferior good. The arrows indicate the direction and magnitude
of the change in the amount demanded. The inferior good is good x. Note that y is a
normal good.
Page | 62
Microeconomics
Figure 23
Another effect is the substitution effect. The rise in the price of good X makes good
Y relatively cheaper. The consumer may begin to substitute good Y for the now relatively
dearer good X. In the diagram this is shown as the movement from B to C, where the
consumer is prepared to buy less of good X and more of good Y.
Because of both income and substitution effects, the quantity demanded of good X
falls with a rise in its price. In the case of good Y it is uncertain whether the quantity demanded
of it rises or falls as a result in the rise in the price of good X. The income effect reduces
the quantity demanded of good Y. The substitution effect increases it. The net effect will
depend on which effect — the income or the substitution effect — is stronger. In our example
the substitution effect is stronger as indicated by the length of the arrows. Hence the consumer
winds up wanting to buy more units of good Y.
Just the same our interest is really in the quantity demanded of good X.
Indifference curve analysis confirms the law of demand. If prices is P x , quantity
demanded is Xa; if price is Px, a higher price, the quantity demanded is the smaller amount
Xe. These two pairs of values of price and quantity demanded should form part of a demand
curve for good X. Assuming many other prices of good X and locating new equilibrium points
which give the equilibrium quantity demanded of good X, we will be able to sketch a demand
curve for good X.
This is done in Figure 25. Given Py, B, and Px3, the consumer is in equilibrium at market
basket 3, consuming x3 of good x and y3 of good y. If the price rises to P,a, he is down to
indifference curve C at market basket 2, consuming x2 of good x (we ignore the amount
demanded of good y; we are interested only in the effect of changes in the price of good x
on the amount of it). As the price rises even further to P xi, the consumer is taken to an even
lower indifference curve at market basket 1 at which the amount demanded of good x is x1.
Finally, if the price rises as high as Pxo, the consumer is driven down the lowest indifference
curve shown in the diagram at point 0 where the consumer demands xo of good x.
Page | 63
Microeconomics
It is now possible to construct a demand schedule for good x. The demand

schedule simply related the quantity demanded of good x and its price. The demand schedule
is
Px QX
P x0 X0
Px1 X1
Px2 x2
Px3 x3
Each of these pairs of price and quantity is then located as one point in the demand
curve for good x in Figure 25B. Note that as already explained Pxo > Pxi > Px2 > Px3. The
resulting demand curve has the expected downward slope in obedience to the law of demand.
Figure 25
Read:
1. Summary of Price and Substitution Effect (attached)

2. Demand Functions, Income Effects and Substitution Effects: Theory and
Evidence (attached)
PROCEED TO MODULE TESTS
Page | 64
Microeconomics
MODULE 3
PRODUCTION AND COST
Page | 65
Microeconomics
Production and Costs
Production is the process by which inputs are transformed into “output”.

Production is carried out by producers or firms. A firm acquires different inputs like
labour, machines, land, raw materials etc. It uses these inputs to produce output. This
output can be consumed by consumers or used by other firms for further production. For
example, a tailor uses a sewing machine, cloth, thread and his owned labour to “produce”
shirts. A farmer uses his land, labour, a tractor, seed, fertilize, water etc. to produce
wheat. A car manufacturer uses land for a factory, machinery, labour, and various other
inputs (steel, aluminum, rubber, etc.) to produce cars. A rickshaw puller uses a rickshaw
and his own labour to “produce” rickshaw rides. A domestic helper uses her labour to
produce “cleaning services”. We make certain simplifying assumptions to start with.
Production is instantaneous: in our very simple model of production no time elapses
between the combination of the inputs and the production of the output. We also tend to
use the terms production and supply synonymously and often interchangeably.
In order to acquire inputs a firm has to pay for them. This is called the cost of
production. Once output has been produced, the firm sell it in the market and earns
revenue. The difference between the revenue and cost is called the firm’s profit. We
assume that the objective of a firm is to earn the maximum profit that it can.
1. Production Function
The production function of a firm is a relationship between inputs used and output
produced by the firm. For various quantities of inputs used, it gives the maximum
quantity of output that can be produced.
Consider the farmer we mentioned above. For simplicity, we assume that the
farmer uses only two inputs to produce wheat: land and labour. A production function
tells us the maximum amount of wheat he can produce for a given amount of land that he
uses, and a given number of hours of labour that he performs. Suppose hat he uses 2
hours of labour/ day and 1 hectare of land to produce a maximum of 2 tones of wheat.
Then, a function that describes this relation is called a production function.
One possible example of the form this could take is: q = K x L.
Where, q is the amount of wheat produced, K is the area of land in hectares, L is

the number of hours of work done in a day.
Describing a production function in this manner tells us the exact relation between
inputs and output. If either K or L increase, q will increase. For any L and any K, there
will be only one q. Since by definition we are taking the maximum output for any level
of inputs, a production function deals only with the efficient use of inputs. Efficiency
implies that it is not possible to get any more output from the same level of inputs.
Page | 66
Microeconomics
A production function is defined for a given technology. It is the technological

knowledge that determines the maximum levels of output that can be produced using
combinations of inputs. If the technology improves, the maximum levels of output
obtainable for different input combinations increase. We then have a new production
function.
The inputs that a firm uses in the production process are called factors of
production. In order to produce output, a firm may require any number of different
inputs. However, for the time being, here we consider a firm that produces output using
only two factors of production – labour and capital. Our production function, therefore,
tells us the maximum quantity of output (q) that can be produced by using different
combinations of these two factors of productions – Labour (L) and Capital (K).
We may write the production function as q = f (L, K) where, L is labour and K is

capital and q is the maximum output that can be produced.
Table 3.1: Production Function
Factor Capital
0 1 2 3 4 5 6
0 0 0 0 0 0 0 0
1 0 1 3 7 10 12 13
2 0 3 10 18 24 29 33
3 0 7 18 30 40 46 50
Labour 4 0 10 24 40 50 56 57
5 0 12 29 46 56 58 59
6 0 13 33 50 57 59 60
A numerical example of production function is given in Table 3.1. The left

column shows the amount of labour and the top row shows the amount of capital. As we
move to the right along any row, capital increases and as we move down along any
column, labour increases. For different values of the two factors, the table shows the
corresponding output levels. For example, with 1 unit of labour and 1 unit of capital,
the firm can produce at most 1 unit of output; with 2 units of labour and 2 units of capital,
it can produce at most 18 units of output and so on.
In our example, both the inputs are necessary for the production. If any of the
inputs becomes zero, there will be no production. With both inputs positive, output will
be positive. As we increase the amount of any input, output increases.
Page | 67
Microeconomics
Isoquant
Isoquant is an alternative way of representing the production function.

Consider a production function with two inputs labour and capital. An isoquant is
the set of all possible combinations of the two
inputs that yield the same maximum possible
level of output. Each isoquant represents a
particular level output and is labelled with that
amount of output.
Let us return to table 3.1, notice that the

output of 10 units can be produced in 3 ways
(4L, 1K), (2L, 2K), (1L, 4K). All these
combination of L, K lie on the same isoquant,
which represents the level of output 10. Can you identify the sets of inputs that will
lie on the isoquant q = 50?
The diagram here generalizes this concept. We place L on the X axis and
K on the Y axis. We have three isoquants for the three output levels, namely q =
q1, q = q2 and q = q3. Two input combinations (L1, K2) and (L2, K1) give us the
same level of output q1. If we fix capital at K1 and increase labour to L3, output
inceases and we reach a higher isoquant, q = q2. When marginal products are
positive, with greater amount of one input, the same level of output can be produced
only using lesser amount of the other. Therefore, isoquants are negatively sloped.
2. The Short Run and the Long Run
Before we begin with any further analysis, it is important to discuss two concepts
– the short run and the long run.
In the short run, at least one of the factor – labour or capital – cannot be varied,
and therefore, remains fixed. In order to vary the output level, the firm can vary only the
other factor. The factor that remains fixed is called the fixed factor whereas the other
factor which the firm can vary is called the variable factor.
Consider the example represented through Table 3.1. Suppose, in the short run,
capital remains fixed at 4 units. Then the corresponding column shows the different
levels of output that the firm may produce using different quantities of labour in the short
run.
In the long run, all factors of production can be varied. A firm in order to produce
different levels of output in the long run may vary both the inputs simultaneously. So,
in the long run, there is no fixed factor.
Page | 68
Microeconomics
For any particular production process, long run generally refers to a longer time
period than the short run. For different production processes, the long run periods may
be different. It is not advisable to define short run and long run in terms of say, days,
months or years. We define a period as long run or short run simply by looking at whether
all the inputs can be varied or not.
3. Total Product, Average Product and Marginal Product
Total Product
Suppose we vary a single input and keep all other inputs constant. Then for
different levels of the input, we get different levels of output. This relationship between
the variable input and output, keeping all other inputs constant, is often referred to as
Total Product (TP) of the variable input.
Let us again look at Table 3.1. Suppose capital is fixed at 4 units. Now in the
Table 1, we look at the column where capital takes the value of 4. As we m ove down
along the column, we get the output values for different values of labour. This is the
total product of labour schedule with K 2 = 4. This is also sometimes called total return
to or total physical product of the variable input. This is shown again in the second
column of table 2.
One we have defined total product, it will be useful to define the concepts of
average product (AP) and marginal product (MP). They are useful in order to describe
the contribution of the variable input to the production process.
Average Product
Average product is defined as the output per unit of variable input. We calculate
it as
𝑇𝑃𝐿
𝐴𝑃𝐿 =
𝐿
The last column of table 3.2 gives us a numerical example of average product of
labour (with capital fixed at 4) for the production function described in table 3.1. Values
in this column ae obtained by dividing TP (column 2) by L (column 1).
Page | 69
Microeconomics
Marginal Product
Marginal product of an input is defined as the change in output per unit of change
in the input when all other inputs are held constant. When capital is held constant, the
marginal product of labour is
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑜𝑢𝑡𝑝𝑢𝑡
𝑀𝑃𝐿 = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑝𝑢𝑡
∆𝑇𝑃𝐿
= ∆𝐿
where ∆ represents the change of the variable.
The third column of table 3.2 gives us a numerical example of Marginal Product
of labour (with capital fixed at 4) for the production function described in table 3.1.
Values in this column are obtained by dividing change in TP by change in L. For
example, when L changes from 1 to 2, TP changes from 10 to 24.
𝑀𝑃𝐿 = (𝑇𝑃 𝑎𝑡 ∶ 𝑢𝑛𝑖𝑡𝑠) − (𝑇𝑃 𝑎𝑡 𝐿 − 1 𝑢𝑛𝑖𝑡)
Here, Change in TP = 24 – 10 = 14
Change in L = 1
Marginal product of the 2 nd unit of labour = 14/1 = 14
Since inputs cannot take negative values, marginal product is undefined at zero
level of input employment. For any level of an input, the sum of marginal products of
every preceding unit of that input gives the total product. So total product is the sum of
marginal products.
Table 3.2: Total Product, Marginal product and Average product
Labour TP MPL APL

0 0 - -
1 10 10 10
2 24 14 12
3 40 16 13.33
4 50 10 12.5
5 56 6 11.2
6 57 1 9.5
Page | 70
Microeconomics
Average product of an input of any level of employment is the average of all

marginal products up to that level. Average and marginal products are often referred to
as average and marginal returns, respectively, to the variable input.
4. The Law of Diminishing Marginal Product and The Law of Variable

Proportions
If we plot the data in table 3.2 on graph paper, placing labour on the X-axis and
output on the Y-axis, we get the curves shown in the diagram below. Let us examine
what is happening to TP. Notice that TP increases as labour input increases. But the
rate at which it increases is not constant. An increase in labour from 1 to 2 increases TP
by 10 units. An increase in labour from 2 to 3 increases TP by 12. The rate at which TP
increases, as explained above, is shown by the MP. Notice that the MP first increases
(up to 3 units of labour) and then begins to fall. This tendency of the MP to first increase
and then fall is called the law of variable proportions or the law of diminishing
marginal product. Law of variable proportions say
that the marginal product of a factor input initially
rises with its employment level. But after reaching a
certain level of employment, it starts falling.
Why does this happen? In order to understand

this, we first define the concept of factor proportions.
Factor proportions represent the ratio in which the
two inputs are combined to product output.
As we hold one factor fixed and keep increasing the other, the factor proportions
change. Initially, as we increase the amount of the variable input, the factor proportions
become more and more suitable for the production and marginal product increases. But
after a certain level of employment, the production process becomes too crowded with
the variable input.
Suppose table 3.2 describes the output of a farmer who has 4 hectares of land, and
can choose how much labour he wants to use. If he uses only 1 worker, he has too much
land for the worker to cultivate alone. As he increases the number of workers, the amount
of labour per unit land increases, and each worker adds proportionally more and more to
the total output. Marginal product increases in this phase. When the fourth worker is
hired, the land begins to get “crowded”. Each worker now has insufficient land to work
efficiently. So the output added by each additional worker is now proportionally less.
The marginal product begins to fall.
We can use these observations to describe the general shapes of the TP, MP and
AP curves as below.
Page | 71
Microeconomics
5. Shapes of Total Product, Marginal Product and Average Product Curves
An increase in the amount of one of the inputs

keeping all other inputs constant results in an
increase in output. Table 3.2 shows how the total
product changes as the amount of labour increases.
The total product curve in the input-output plane is
a positively sloped curve. Figure 3.1 shows the
shape of the total product curve for a typical firm.
We measure units of labour along the

horizontal axis and output along the vertical axis.
With L units of labour, the firm can at most produce
q 1 units of output.
According to the law of variable proportions, the marginal product of an input

initially rises and then after a certain level of employment, it starts falling. The MP curve
therefore, looks like an inverse U-shaped curve as in Figure 3.2
Let us now see what the AP curve looks like. For the first unit of the variable
input, one can easily check that the MP and the AP are same. Now as we increase the
amount of input, the MP rises. AP being the average of marginal products, also rises, but
rises less than MP. Then, after a point, the MP starts falling. However, as long as the
value of MP remains higher than the value of the AP, the AP continues to rise. Once MP
has fallen sufficiently, its value becomes less than the AP and the AP also starts falling.
So AP curve is also inverse U-shaped.
As long as the AP increases, it must be the case

that MP is greater than AP. Otherwise, AP cannot rise.
Similarly, when AP falls, MP has to be less than AP. It
follows that MP curve cuts AP curve from above at its
maximum.
Figure 3.2 shows the shapes of AP and MP curves

for a typical firm. The AP of factor 1 is maximum at L.
To the left of L, AP is rising and MP is greater than AP.
To the right of L, AP is falling and MP is less than AP.
6. Returns to Scale
The law of variable proportions arises because factor proportions change as long
as one factor is held constant and the other is increased. What if both factors can change?
Remember that this can happen only in the long run. One special case in the l ong run
occurs when both factors are increases by the same proportion, or factors are scaled up.
Page | 72
Microeconomics
When a proportional increase in all inputs results in an increase in output by the

same proportion, the production function is said to be display Constant ret urns to scale
(CRS).
When a proportional increase in all inputs results in an increase in output by the

same proportion, the production function is said to display Increasing Returns to Scale
(IRS).
Decreasing Returns to Scale (DRS) holds when a proportional increase in all input
results in an increase in output by a smaller proportion.
For example, suppose in a production process, all inputs get doubted. As a result,
if the output gets doubled, the production function exhibits CRS. If output is less t han
doubled, then DRS holds, and if it is more than doubled then IRS holds.
Consider a production function
𝑞 = 𝑓 (𝑥1 , 𝑥2 )
Where the firm produces q amount of output using 𝑥1 amount of factor 1

and 𝑥2 amount of factor 2. Now suppose the firm decides to increase the
employment level of both the factors 𝑡 (𝑡 > 1) times. Mathematically, we
can say that the production function exhibits constant returns to scale
if we have,
𝑓 (𝑡𝑥1 , 𝑡𝑥2 ) = 𝑡. 𝑓 (𝑥1 , 𝑥2 )
i.e. the new output level 𝑓 (𝑡𝑥1 , 𝑡𝑥2 ) is exactly t times the previous output
level 𝑓(𝑥1 , 𝑥2 ).
Similarly, the production function exhibits increasing returns to scale if,
𝑓 (𝑡𝑥1 , 𝑡𝑥2 ) > 𝑡𝑓(𝑥1 , 𝑥2 ).
It exhibits decreasing returns to scale if,
𝑓 (𝑡𝑥1 , 𝑡𝑥2 ) < 𝑡𝑓(𝑥1 , 𝑥2 ).
7. Costs
In order to produce output, the firm needs to employ inputs. But a given level of
output, typically, can be produced in many ways. There can be more than one input
combinations with which a firm can produce a desired level of output.
Page | 73
Microeconomics
In table 3.1, we can see that 50 units of output can be produced by three different input
combinations (L = 6, K = 3), (L = 4, K = 4) and (L = 3, K = 6). The question is which
input combination will the firm choose? With the input prices given, it will choose that
combination of inputs which is least expensive. So, for every level of output, the firm
chooses the least cost input combination. Thus the cost function describes the least cost
of producing each level of output given prices of factors of production and technology.
Cobb-Douglas Production Function
𝛽
Consider a production function 𝑞 = 𝑥1𝛼 𝑥2 where 𝛼 and 𝛽 are constants. The firm
produces 𝑞 amount of output using 𝑥1 amount of factor 1 and 𝑥2 amount of factor 2. This
is called a Cobb-Douglas production function. Suppose with 𝑥1 = 𝑥̅1 and 𝑥2 = 𝑥̅2 , we
have 𝑞0 units of output, i.e.
𝑞0 = 𝑥̅1 𝑎 𝑥̅2 𝛽
If we increase both the inputs 𝑡 (𝑡 > 1) times, we get the new output
𝑞1 = (𝑡𝑥̅1 )𝛼 (𝑡𝑥̅2 )𝛽
= 𝑡 𝛼+ 𝛽 𝑥̅1 𝛼 𝑥̅2 𝛽
When 𝛼 + 𝛽 = 1, we have 𝑞1 = 𝑡𝑞0 . That is, the output increases t times. So the
production function exhibits CRS. Similarly, when 𝛼 + 𝛽 > 1, the production function
exhibits IRS. When 𝛼 + 𝛽 < 1 the production function exhibits DRS.
7.1 Short Run Costs
We have previously discussed the short run and the long run. In the short run,
some of the factors of production cannot be varied, and therefore, remain fixed. The
cost that a firm incurs to employ these fixed inputs is called the total fixed cost (TFC).
Whatever amount of output the firm produces, this cost remains the fixed for the firm.
To produce any required level of output, the firm, in the short run, can adjust only variable
inputs. Accordingly, the cost that a firm incurs to employ these variable inputs is called
the total variable cost (TVC). Adding the fixed and the variable costs, we get the total
cost (TC) of a firm
𝑇𝐶 = 𝑇𝑉𝐶 + 𝑇𝐹𝐶
In order to increase the production of output, the firm must employ more of the
variable inputs. As a result, total variable cost and total cost will increase. Therefore, as
output increases, total variable cost and total cost increase.
Page | 74
Microeconomics
In Table 3.3, we have an example of cost function of atypical firm. The first
column shows different levels of output. For all levels of output, the total fixed cost is
Rs 20. Total variable cost increases as output increases. With output zero, TVC is zero.
For 1 unit of output, TVC is Rs 10; for 2 units of output, TVC is Rs 18 and so on. In the
fourth column, we obtain the total cost (TC) as the sum of the corresponding values in
second column (TFC) and third column (TVC). At zero level of output, TC is just the
fixed cost, and hence, equal to Rs 20. For 1 unit of output, total cost is RS 30; for 2 units
of output, the TC is Rs 38 and so on.
The short run average cost (SAC) incurred by the firm is defined as the total cost
per unit of output. We calculate it as
𝑇𝐶
𝑆𝐴𝐶 = 𝑞
In Table 3.3, we get the SAC – column by dividing the values of the fourth column
by the corresponding values of the first column. At zero output, SAC is undefined. For
the first unit, SAC is Rs 30; for 2 units of output, SAC is Rs 19 and so on.
Similarly, the average variable cost (AVC) is defined as the total variable cost
per unit of output. We calculate it as
𝑇𝑉𝐶
𝐴𝑉𝐶 = 𝑞
Also, average fixed cost (AFC) is

𝑇𝐹𝐶
𝐴𝐹𝐶 = 𝑞
Clearly,
𝑆𝐴𝐶 = 𝐴𝑉𝐶 + 𝐴𝐹𝐶
In Table 3.3, we get the AFC column by dividing the values of the second column
by the corresponding values of the first column. Similarly, we get the AVC column by
dividing the values of the third column by the corresponding values of the first column.
At zero level of output, both AFC and AVC are undefined. For the first unit of output,
AFC is Rs 20 and AVC is Rs 10. Adding them, we get the SAC equal to Rs 30.
The short run marginal cost (SMC) is defined as the change in total cost per unit
of change in output
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 ∆𝑇𝐶
𝑆𝑀𝐶 = =
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑜𝑢𝑡𝑝𝑢𝑡 ∆𝑞
Where ∆ represents the change in the value of the variable.
Page | 75
Microeconomics
The last column in Table 3.3 gives a numerical example for the calculation of
SMC. Values in this column are obtained by dividing the change in TC by the change in
output, at each level of output.
Thus at q = 5.
Change in TC = (TC at q = 5) - (TC at q=4)
= (53) – (49)
=4
Change in q = 1
SMC = 4/1 = 4
Table 3.3: Various Concepts of Costs
Output TFC TVC TC AFC AVC SAC SMC

(units) (q) (Rs) (Rs) (Rs) (Rs) (Rs) (Rs) (Rs)
0 20 0 20 - - - -
1 20 10 30 20 10 30 10
2 20 18 38 10 9 19 8
3 20 24 44 6.67 8 14.67 6
4 20 29 49 5 7.25 12.25 5
5 20 33 53 4 6.6 10.6 4
6 20 39 59 3.33 6.5 9.83 6
7 20 47 67 2.86 6.7 9.57 8
8 20 60 80 2.5 7.5 10 13
9 20 75 95 2.22 8.33 10.55 15
10 20 95 115 2 9.5 11.5 20
Just like the case of marginal product, marginal cost also is undefined at zero level
output. It is important to note here that in the short run, fixed cost cannot be changed.
When we change the level of output, whatever change occurs to total cost is entirely due
to the change in total variable cost. So in the short run, marginal cost is the increase in
TVC due to increase in production of one extra unit of output . For any level of output,
the sum of marginal costs up to that level gives us the total variable cost at that level.
Page | 76
Microeconomics
One may wish to check this from the example represented through Table 3.3. Average
variable cost at some level of output is therefore, the average of all marginal costs up to
that level. In Table 3.3, we see that when the output
is zero, SMC is undefined. For the first unit of output,
SMC is Rs 10; for the second unit, the SMC is Rs 8
and so on.
Shapes of the Short Run Cost Curves
Now let us see what these short run cost curves

look like. You could plot the data from in Table 3.3
by placing output on the x-axis and cost on the y-axis.
Previously, we have discussed that in order to

increase the production of output the firm needs to
employ more of the variable inputs. This results in an
increase in total variable cost, and hence, an increase in
total cost. Therefore, as output increases, total variable
cost and total cost increase. Total fixed cost, however,
is independent of the amount of output produced and
remains constant for all levels of production.
Figure 3.3 illustrates the shapes of total fixed cost,

total variable cost and total cost curves for a typical firm.
We place output on the x-axis and cost on the y-axis.
TFC is a constant which takes the value c 1 and does not
change with the change in output. It is, therefore, a
horizontal straight line cutting the cost axis at the point c 1. At q 1, TVC is c 2 and TC is
c 3.
AFC is the ratio of TFC to q. TFC is a constant. Therefore, as q increases, AFC

decreases. When output is very close to zero. AFC is arbitrarily large, and as output
moves towards infinity. AFC moves towards zero. AFC is arbitrarily large, and as
output moves towards infinity, AFC moves towards zero. AFC curve is, in fact, a
rectangular hyperbola. If we multiply any value q of output with its corresponding AFC,
we always get a constant, namely TFC.
Figure 3.4 shows the shape of average fixed cost curve for a typical firm. We
measure output along the horizontal axis and AFC along the vertical axis. At q1 level of
output, we get the corresponding average fixed cost at F. The TFC can be calculated as
𝑇𝐹𝐶 = 𝐴𝐹𝐶 𝑥 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦

= 𝑂𝐹 𝑥 𝑂𝑞1
= 𝑡ℎ𝑒 𝑎𝑟𝑒𝑎 𝑜𝑓 𝑡ℎ𝑒 𝑟𝑒𝑐𝑡𝑎𝑛𝑔𝑙𝑒 𝑂𝐹𝐶𝑞1
Page | 77
Microeconomics
We can also calculate AFC from TFC curve. In Figure 3.5, the horizontal straight
line cutting the vertical axis at F is the TFC curve. At q 0 level of output, total fixed cost
is equal to OF. At q0 , the corresponding point on the TFC curve is A. Let the angle
∠𝐴𝑂𝑞0 be 𝜃. The AFC at 𝑞0 is
𝑇𝐹𝐶
𝐴𝐹𝐶 =
𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
𝐴𝑞0
= = tan 𝜃
𝑂𝑞0
Let us now look at the SMC curve. Marginal cost is

the additional cost that a firm incurs to produce one extra
unit of output. According to the law of variable
proportions, initially, the marginal product of a factor
increases as employment increases, and then after a
certain point, it decreases. This means initially to
produce every extra unit of output, the requirement of the factor becomes less and less,
and then after a certain point, it becomes greater and greater. As a result, with the factor
price given, initially the SMC falls, and then after a certain point, it rises. SMC curve
is, therefore, U-shaped.
At zero level of output, SMC is undefined. The TVC at a particular level of output
is given by the area under the SMC curve up to that level.
Now, what does the AVC curve look like? For the
first unit of output, it is easy to check that SMC and AVC
are the same. So both SMC and AVC curves starts from
the same point. Then, as output increases, SMC falls.
AVC being the average of marginal costs, also falls, but
falls less than SMC. Then, after a point, SMC starts rising.
AVC, however, continues to fall as long as the value of
SMC remains less than the prevailing value of AVC. Once
the SMC has risen sufficiently, its value becomes greater
than the value of AVC. The AVC then starts rising. The AVC curve is theref ore U-
shaped.
As long as AVC is falling, SMC must be less than the AVC. As AVC rises, SMC
must be greater than the AVC. So the SMC curve cuts the AVC curve from below at the
minimum point of AVC.
Page | 78
Microeconomics
In Figure 3.7, we measure output along the horizontal axis and

TVC along the vertical axis. At 𝑞0 level output, OV is the
total variable cost. Let the angle ∠𝐸𝑂𝑞0 be equal to 𝜃. Then,
at 𝑞0 , the AVC can be calculated as
𝑇𝑉𝐶
𝐴𝑉𝐶 = 𝑜𝑢𝑡𝑝𝑢𝑡
𝐸𝑞0
= = tan 𝜃
𝑂𝑞0
In Figure 3.6 we measure output along the horizontal axis and AVC along the
vertical axis. At 𝑞0 level output, AVC is equals to OV. The total variable cost at 𝑞0 is
TVC = AVC x quantity
= AV x 𝑂𝑞0
= the area of the rectangle OV 𝐵𝑞0
Let us now look at SAC. SAC is the sum of AVC and AFC. Initially, both AVC
and AFC decrease as output increases. Therefore, SAC initially falls. After a certain
level of output production. AVC starts rising, but AFC continuous to fall. Initially
the fall in AFC is greater than the rise in AVC and SAC is still falling. Bu t, after a
certain level of production, rise in AVC becomes larger than the fall in AFC. From
this point onwards, SAC is rising. SAC curve is therefore U -shaped.
It lies above the AVC curve with the vertical difference being equal to the
value of AFC. The minimum point of SAC curve lies to the right of the minimum
point of AVC curve.
Similar to the case of AVC and SMC, as long as SAC is falling, SMC is less than
the SAC. When SAC is rising, SMC is greater than the SAC. SMC curve cuts the SAC
curve from below at the minimum point of SAC.
Figure 3.8 shows the shapes of short run marginal cost, average variable cost
and short run average cost curves for a typical firm. AVC reaches its minimum at 𝑞1
units of output. To the left of 𝑞1 , AVC is falling and SMC is less than AVC. To the
right of 𝑞1 , AVC is rising and SMC is greater than AVC. SMC curve cuts the AVC curve
at “P” which is the minimum point of AVC curve. The minimum point of SAC curve
is “S” which corresponds to the output 𝑞2 .
Page | 79
Microeconomics
It is the intersection point between SMC and SAC curves.

To the left of 𝑞2 , SAC is falling and SMC is less than
SAC. To the right of 𝑞2 , SAC is rising and SMC is
greater than SAC.
7.2 Long Run Costs
In the long run, all inputs are variable. There are no fixed costs. The total cost
and the total variable cost therefore, coincide in the long run. Long run average cost
(LRAC) is defined as cost per unit of output, i.e.
𝑇𝐶
𝐿𝑅𝐴𝐶 = 𝑞
Long run marginal cost (LRMC) is the change in total cost per unit of change in
output. When output changes in discrete units, then, if we increase production from 𝑞1 −
1 to 𝑞1 units of output, the marginal cost of producing 𝑞1 th unit will be measured as
𝐿𝑅𝑀𝐶 = (𝑇𝐶 𝑎𝑡 𝑞1 𝑢𝑛𝑖𝑡𝑠) − (𝑇𝐶 𝑎𝑡 𝑞1 − 1 𝑢𝑛𝑖𝑡𝑠)
Just like the short run, in the long run, the sum of all marginal costs up to some
output level gives us the total cost at that level.
Shapes of the Long Run Cost Curves
We have previously discussed the returns to scales. Now let us see their
implications for the shape of LRAC.
IRS implies that if we increase all the inputs by a certain proportion, output
increases by more than that proportion. In other words, to increase output by a certain
proportion, inputs need to be increased by less than that proportion . With the input
prices given, cost also increases by a lesser proportion. For example, suppose we want
to double the output. To do that, inputs need to be increased, but less than double. The
cost that the firm incurs to hire those inputs therefore also need to be increased y less
than double. What is happening to the average cost here? It must be the case that as long
as IRS operates, average cost falls as the firm increases output.
Page | 80
Microeconomics
DRS implies that if we want to increase the output by a certain proportion, inputs
need to be increased by more than that proportion. As a result, cost also increases by
more than that proportion. So, as long as DRS operates, the average cost must be rising
as the firm increases output.
CRS implies a proportional increase in inputs resulting in a proportional increase

in output. So the average cost remains constant as long as CRS operates.
It is argued that in a typical firm IRS is observed at the initial level of production.
This is then followed by the CRS and then by the DRS. Accordingly, the LRAC curve
is a U-shaped curve. Its downward sloping part corresponds to IRS and upward rising
part corresponds to DRS. At the minimum point of the LRAC curve, CRS is observed.
Let us check how the LRMC curve looks like. For

the first unit of output, both LRMC and LRAC are the
same. Then, as output increases, LRAC initially falls,
and then, after a certain point, it rises. As long as
average cost is falling, marginal cost must be less than
the average cost. When the average cost is rising,
marginal cost must be greater than the average cost.
LRMC curve is therefore a U-shaped curve. It cuts the
LRAC curve from below at the minimum point of the
LRAC. Figure 3.9 shows the shapes of the long run
average cost curves for a typical firm.
LRAC reaches its minimum at 𝑞1 . To the left of 𝑞1 , LRAC is falling and LRMC
is less than the LRAC curve. To the right of 𝑞1 , LRAC is rising and LRMC is higher
than LRAC.
Summary
• For the different combinations of inputs, the production shows the maximum
quantity of output that can be produced.
• In the short run, some inputs cannot be varied. In the long run, all inputs can be
varied.
• Total product is the relationship between a variable input and output when all
other inputs are held constant.
• For any level of employment of an input, the sum of marginal products of every
unit of that input up to that level gives the total product of that input at that
employment level.
Page | 81
Microeconomics
• Both the marginal product and the average product curves are inverse U-shaped.
The marginal product curve cuts the average product curve from above at the
maximum point of average product curve.
• In order to produce output, the firm chooses least cost input combinations.
• Total cost is the sum of total variable cost and the total fixed cost.
• Average cost is the sum of average variable cost and average fixed cost.
• Average fixed cost curve is downward sloping.
• Short run marginal cost, average variable cost and short run average cost curves
are U-shaped.
• SMC curve cuts the AVC curve from below at the minimum point of AVC.
• SMC curve cuts the SAC curve from below at the minimum point of SAC.
• In the short run, for any level of output, sum of marginal costs up to that level
gives us the total variable cost. The area under the SMC curve up to any level of
output gives us the total variable cost up to that level.
• Both LRAC and LRMC curves are U-shaped.
• LRMC curve cuts the LRAC curve from below at the minimum point of LRAC.
Page | 82
MODULE 4
THEORY OF MARKETS
Microeconomics
MODULE 4 - THEORY OF MARKETS
Scope of the Module
Module IV is composed of the following lessons:
Lesson 1 Price and Output Under Perfect Competition

Lesson 2. Price and Output Under Pure Monopoly
Lesson 3. Price and Output Under Oligopoly
Lesson 4. Price and Output Under Monopolistic Competition
This module brings together the analytical tools we learned in the previous modules
particularly in the theories of demand, production, and cost. These analytical tools are used to
examine the pricing and output mechanism under different market conditions. In the determination
of its equilibrium price and equilibrium quantity, the firm's primary consideration is to maximize
profits, which in turn determines its continued existence in the market. However, profit
maximization may not always be the advisable position that the firm has to take. Under certain
conditions, the firm may be better off by taking a defensive position in order to minimize its losses
and continue its operations. There are also circumstances that minimizing losses may require the
firm to shut down. We shall also discuss the short-run and long-run equilibrium in the various
markets. There are four market classifications, namely: (1) perfect competition, (2) pure monopoly,
(3) oligopoly, and (4) monopolistic competition. While the mechanism to determine equilibrium
price and equilibrium output is the same, that is MC=MR, they do not yield the same equilibrium
price and equilibrium output. Furthermore, the welfare effects of these markets differ from one
another.
After studying this module, you are expected to be able to:
1. analyze the pricing and output mechanism in the four markets; discuss the
welfare effects of the different market classifications.
2. compare the short-run and long-run equilibrium in each market; and interpret
the conditions for profit maximization, break even, loss minimization, and shut
down.
Page | 84
Microeconomics
Lesson 1. Price and Output Under Perfect Competition
Lesson Objectives
At the end of this lesson, you are expected to be able to:
1. discuss the factors that determine the level of output for competitive firms in the
short run;
2. explain the factors that determine the demand curve for a competitive firm and
industry;
3. analyze why most supply curves are upward sloping; and
4. explain how profits are computed in the long-run and how long-run
equilibrium is attained.
Characteristics
The perfectly competitive markets are primarily characterized by the following:
1. Product homogeneity among sellers;

2. Many small buyers and sellers of the product;
3. Absence of artificial restraints on demand, supply, and product price;
4. Free mobility of goods and resources; and
5. Perfect knowledge of present and future prices and cost.
Demand Facing a Perfectly Competitive Firm
One of the characteristics of a perfectly competitive market is that all firms produce
a homogeneous product. Therefore, it does not matter where the consumers buy the product
because it is exactly the same. Wag-Wag rice bought from a rice seller in Nepa-Q-Mart
market is exactly the same as the Wag- wag rice bought from a rice seller in Divisoria market.
Another major characteristic of a perfectly competitive market is the existence of many

small buyers and sellers. Continuing our example of Wag-wag rice, there are many small sellers
of Wag-wag rice such that no single seller or group of sellers can control the price of Wag-wag rice.
If one Wag-wag rice seller increases his price, consumers will simply buy from other
sellers since there are plenty of them. On the other hand, if a Wag-wag seller seeks to increase
his total revenue by lowering his price, he will incur an opportunity loss because consumers buy
anyway at the prevailing market price. At the same time the seller cannot accommodate the
increase in demand for his rice should he lower his prices. The existence of many small buyers
prevents the manipulation of prices by a single buyer or group of buyers. In Metro Manila,
there are more than a million households, all of them are buyers of rice. If there were one
single-buyer — a monophony - then this buyer can influence the market price.
Page | 85
Microeconomics
Figure 4.1 below shows the relationship between the demand and supply
equilibrium in a perfectly competitive market and the demand curve facing a perfectly
competitive firm.
Figure 4.1. Derivation of Demand for a Perfectly Competitive Firm
Panel A, shows the demand and supply equilibrium in the market. Equilibrium price
is OP. and quantity demanded and supplied is 0Q 0. The marginal revenue for every firm
in the industry is OP.. The demand curve for any firm in this perfectly competitive industry
is shown in Panel B. Each producer knows that changes in the firm volume of output will have
no perceptible effect upon market price. A change in the rate of sales per period of time will
change the firm's revenue, but it will not affect market price. Notice that the demand curve is
perfectly elastic and this is due to the fact that the product of a perfectly competitive firm has
substitutes — the products of all other firms of the industry. The perfectly elastic demand
curve also indicates that a perfectly competitive output produced and sold.
Short-Run Equilibrium
The short run is a time period in which the firm can vary its output but does not have
the time to change its plant size. From the industry point of view, the number of firms is fixed.
Time is so short that no new firms can enter, neither can existing firms leave. Each firm is so
small relative to the market in which it sells, to be able to affect the market price of the product.
Hence, the problem facing the firm is that of determining what output to produce and sell. For
the market as a whole, the market price and market output must be determined.
Figure 4.2 shows the short run profit maximization using total curves. The upper panel
shows the short run total cost curve and the total revenue curve. We have discussed the
characteristics of the short run total cost curve in the preceding module. The total revenue
curve, as you can see, is a linear curve. This is explained by the fact that in a perfectly
competitive market, the price is set by the market. Hence, the only way the firms can increase
revenue is to increase the number of outputs produced and sold.
Page | 86
Microeconomics
Figure 4.2. Short Run Profit Maximization
Since
TR = P x Q price being constant, increasing TR is achieved by increasing quantity. Profit is
maximized at output Q4 or at the point where the slope of the TC curve (point D) is equal
to the slope of the TR curve, TR being greater than TC when a line is drawn tangent to point
D, it will be parallel to the TR curve. At this point the gap between TC and TR is at its widest,
hence, profits is at its highest as shown at the lower panel in Figure 4.2.
Notice that at point A, the slope of the TC curve is equal to the TR curve. However,
since TC is greater than TR at this point then it is not the profit maximizing point rather it is
the point where the loss is largest. Points B and E are break-even points where TC is just equal
TR. Point C is tangent to the broken line OL and we know that at this point the average cost is
at its lowest. This means that a firm in perfect competition does necessarily maximize profits
by producing at the quantity where the average cost per unit is at its lowest.
Profit maximization can also be analyzed in terms of per-unit cost and revenue curves.
The basic analysis is the same above but the diagrammatic treatment is in a different form.
Specifically, we shall now apply our knowledge in short run per unit cost curves.
Page | 87
Microeconomics
As mentioned earlier the demand curve of a perfectly competitive firm is perfectly

elastic and this curve is equal to the price, average revenue and marginal revenue:
𝐷 = 𝑃 = 𝐴𝑅 = 𝑀𝑅
Average revenue is equal to total revenue over quantity

𝑇𝑅
𝐴𝑅 = since TR = P x Q
𝑄
then
𝑃𝑥𝑄
𝐴𝑅 = therefore AR = P
𝑄
Marginal revenue is equal to the change in total revenue over the change in
quantity.
since price is constant in a perfectly competitive firm,
then therefore MR = P.
Figure 4.3 Short Run Profit Maximization Per Unit Curves
Profits are maximum at the output level at which marginal cost equals marginal
revenue. This can be seen at point D in Figure 4.3 at output Qo. Total profits is the rectangular
area p c d e. Outputs less than Qo means that marginal cost is lesser than marginal revenue.
Hence, the production of additional outputs will result to an increase in total receipts more than
an increase in total costs. Beyond output Qo marginal cost is greater than marginal revenue
which means that larger outputs will increase total costs more than they increase total receipts.
Page | 88
Microeconomics
Figure 4.4 Short Run, Break-even, Loss Minimization and Shut-down
It is not always the case that firms make profits. There are cases where per unit cost
rises due to sudden increase in materials cost or the market price has gone down due to a slack
in demand. In Figure 4.4 above, at output Qi, S R M C = S R A C = P1. At this point marginal
cost is equal marginal revenue and at the same time the price per unit is just equal average cost
per unit. Thus, the firm is at the break-even point, that is, total cost is just equal total revenue.
At output Q2, price (P2) is equal marginal cost but is lesser than the average cost. The
firm is therefore losing because the price per unit is not able to recoup the average cost per
unit. In this case, total revenue is less than total cost. Should the firm continue its operations?
As long as the price is higher than A V C per unit the firm can continue production in
anticipation for better prices. Remember that AC = AFC + AV C. If P < AC but P >
AVC, then the firm can still pay it's A V C and part of it's A F C. The firm at this point is
minimizing losses.
At output Q3, the price (P3) is equal to marginal cost and average variable cost. At
this point, the price per unit is just equal to the A V C per unit of output. In other words, the
price is not sufficient to cover average fixed cost or total variable cost is equal total revenue.
Thus, whether the firm produces or not, its losses would equal total fixed cost. It would then
be better for the firm to close down. Definitely, there is no question that any price below
AVC the firm would incur larger losses. That is total revenue aside from not being able to
cover total fixed cost, will not be sufficient to cover total variable cost.
As a summary, there are four points discussed. In all these points the short run
equilibrium condition is that MC = MR in order to determine the level of output.
The four points are:
1. Profit maximizing: MR = MC > AC

2. Break-even : MR = MC = AC
3. Loss minimizing : MR = MC < AC > AVC
Page | 89
Microeconomics
4. Shut-down MR = MC < AVC < AC
Short Run Supply Curve
The Short Run Supply Curve of a firm in perfect competition is precisely its marginal
cost curve for all rates of output equal to or greater than the rate of output associated with
minimum average variable cost. It is assumed that the unit prices of variable inputs are fixed
and no individual firm acting alone can change a factor's unit cost of the other firm.
Figure 4.5. Supply curve and Marginal Curve in the Short Run Perfect Competition
In Figure 4.5 Panel A shows that if market price is at P1, the corresponding
equilibrium rate of output is q. On Panel B, it can be seen that the points P1 and Qi is
associated with the point Si which represents the quantity supplied at price P1.
Long-Run Equilibrium
In the long run, all factors of production and all costs are variable. It means that a
farm will remain in business in the long run only if its total revenue equals total
cost. In other words, there must be no incentive for new firms to enter the industry or for
existing firms to leave. It is a state wherein there are no lure of economic profits to induce
the entry of new firms, neither are there pain of losses to induce the present firms to leave.
Page | 90
Microeconomics
Figure 4.6 below shows the long run equilibrium where LRAC = LRMC = SRAC
= SRMC = P. Notice that the plant size is appropriate and takes advantage of the
economies of scale.
Economic Profits
Economic profits are a pure surplus or an excess of total receipts over all costs of
production incurred by the firm. The costs include the opportunity costs, implicit costs and
explicit costs. The concept of economic profits as economists see it, is diffe rent
from that of accountants. An accountant determines profits as follows:
Gross Income
Less: All Expenses (including interest payments,
Equal: Net Income amortization and depreciation) Or "Profits"
For economists, payments to capital owners in the form of dividends from corporation
"profits" are also costs of production just like those incurred for labor or raw materials.
Such that:
Net Income or "profits" Less: Average Dividends

equal Economic Profits
The economic profits usually go to the owners of the firm in form of higher returns or
are plowed back to the firm to expand or improve it. Thus, when the perfectly competitive
industry has economic profits, it attracts new firms and in the process competes away pure
profits in the long run. This means that the increase in the number of firms shifts the supply
curve to the right thereby decreasing prices hence reducing profits. Or the increase in the
number of firms increases the demand for raw materials, which in turn raises prices.
Page | 91
Microeconomics
This means that the cost of production increases, thereby reducing profits. The "normal" profit
in the perfectly competitive industry simply means that individual firms are earning just
enough to make their opportunity costs equal zero. Thus, if the average return on investments
is 10 per cent in the whole economy and the entrepreneur is earning 10 per cent then his
opportunity cost on the average is zero.
Constant Cost Industries
What happens when economic profits exist? Adjustments will take place which will
result in a long run equilibrium, i.e., elimination of economic profits. In a constant cost
industry, the entry of new firms does not increase market demands for resources sufficiently
to cause their prices to increase. This can be explained with the use of Figure 4.7 below:
Figure 4.7. Long Run Equilibrium Adjustment in a Constant Cost Industry
Panel A shows that the long run equilibrium of the firm while Panel B shows the long
run equilibrium in the market. At the initial equilibrium price Pi, the firm produces output qi,
and the total output of market is at Q1. When demand rises from D1 to D2, equilibrium price
rises to P2 in the short run. At P2, economic profits exist, the firms already in the industry will
increase their output to q2 which results to a corresponding increase in industry output to Q 2.
With the existing economic profits more firms will enter the industry.
As a result, the supply curve of industry shifts to the right as total output is increased.
Prices therefore go down to their initial level at P1 and the individual firm will produce at its
initial output level q 1. However, since more firms are now involved total market output
will be at Q1. The only reason why the equilibrium price went back to its initial level is due
to the fact that the rise in the demand for resources did not increase factor prices thus, the
cost curves of the firms were not affect or remained stable. The long run supply curve is
horizontal or perfectly elastic in this case. This can be derived by connecting the two
equilibrium points in panel B, that is, D1S 1 and D2S2. Notice that the shift of demand from DI
to D2 is fully compensated by the shift of supply from S1 to S2.
Page | 92
Microeconomics
Increasing Cost Industries
The increasing cost industries is characterized by a rise in factor prices as more

firms enter the industry to pursue economic profits. As seen in Figure 4.8, equilibrium
price rises from P1 to P2 as market demand increases from D1 to D2.
The short run adjustment is the increase of the firm's output from ql to q 2 which
increases total market output for Q 1 to Q2. Economic profits will attract more firms to
enter the industry. The rise in the demand for resources increases factor prices forcing the
cost curves of the firm to shift upward to the left. As more firms are engaged in
production, the market supply curve shifts to S2 with market equilibrium output at Q3.
Equilibrium price will fall from P2 to P3. Note that the final long run equilibrium price,
P3, is higher than the previous one, P1. The final equilibrium output of each firm is at q 3
which is lesser than its initial equilibrium at q i because of the use of the rise in factor
prices. Since there are more firms in the industry than there was before the aggregate
output actually increases. The long run supply curve in this kind of industry is
upward sloping since the increase in supply is not sufficient to compensate the increase
in demand.
Figure 4.8. Long Run Equilibrium in an Increasing Cost Industry
Page | 93
Microeconomics
Decreasing Cost Industries
Decreasing cost cases are rather rare: In this case, factor prices fall as more firms enter
a perfectly competitive industry in the long run. In Figure 4.9 as prices go up from P1 to P2
due to an increase in demand from D1 to D2, economic profits are created. Due to this, more
firms enter the industry. As more firms enter, resource cost goes down due to the external
economies of increasing production. That is, the industry producing the resources are able to attain
economies of scale because of the increase in the demand for their products. The cost of
production therefore goes down shifting the cost curves downward to the right. With more
firms now in the industry supply will shift from S1 to S2 resulting to a decline in price from
P2 to P3.
The final long run equilibrium price P3 is lesser than the initial equilibrium price, P1.
Furthermore, the firm's long run equilibrium output increases from ql to q3, while that of the
market will increase from Qi to Q3. The long run supply curve is downward sloping.
Figure 4.9. Long Run Equilibrium Adjustments in a Decreasing Cost Industry
In all the three cases of long run equilibrium changes, the final equilibrium is reached
when LRMC = LRAC = SMRC = SRAC = P. Probably, increasing cost industries are
the most prevalent of the three cases analyzed. Decreasing costs are most unlikely to occur.
Industries of constant cost and of decreasing cost are likely to become industries of increasing
cost as they become older and more established.
Page | 94
Microeconomics
Welfare Effects of Pure Competition
Compared to other market structures, it is only in perfect competition where

consumer welfare is maximized.
First, pure competition leads to that organization of productive capacity at which prices
of products are equal to their per unit costs-marginal and average. There are no profits or
losses. Productive capacity and resources are so allocated that is valued equally by
consumers in all its alternative uses, and no reallocation can increase welfare. This means that
the marginal rate of substitution is just equal to the price ratio of two products X and Y or
MRS xY = PX/PY.
Second, each firm operates at peak efficiency, producing its product output at the lowest
cost per unit. It is only in perfect competition wherein firms seek to build the optimum size
plant and produce at the optimum rate of output in the long run.
Third, resources are not divested into sales promotion efforts since no firm can influence
the market, the price being determined and the product being homogeneous. No unnecessary
expenses are incurred which will just increase the cost of production.
Page | 95
Microeconomics
True or False Write the word TRUE if the statement is true and FALSE if the statement is
not on the blank provided before each number.
__________ 1. There are many sellers in this market some of which are large.
__________ 2. The demand curve in this type of market is perfectly elastic.
__________ 3. A firm may not earn profits in the short run in this type of market.
__________ 4. The MC curve and supply curve are synonymous in this market.
__________ 5. If MC > MR, it pays to increase production.
__________ 6. In a constant cost industry, the increase in the demand for factor inputs
results to a rise in factor prices.
__________ 7. In the long run equilibrium P = SRAC = LRAC.
__________ 8. If MC < MR, it means that an additional output adds more to total revenue
than to total cost.
__________ 9. The increase in demand for factor inputs in a decreasing cost industry
causes a decline in factor prices.
__________10. A seller in this market can sell more by reducing his prices.
COMPARE YOUR ANSWERS WITH THE ANSWER KEY TO THE PROGRESS

CHECK TEST AND FIND OUT HOW YOU FARED.
Page | 96
Microeconomics
1. FALSE
2. TRUE
3. FALSE
4. TRUE
5. FALSE
6. FALSE
7. TRUE
8. TRUE
9. TRUE
10. FALSE
RATING: No. of correct answers x 10 = _____________
My rating is _______________
Page | 97
Microeconomics
Lesson 2. Price Output Under Pure Monopoly
Lesson Objectives:
After studying this lesson, you are expected to be able to:
1. analyze how equilibrium price and output are determined for a monopoly in the
short run and long run;
2. explain why a monopolist has no supply curve;
3. determine the social cost of monopoly;
4. analyze the conditions under which a monopolist would charge different prices
for the same commodity; and
5. explain the principles of monopoly regulation
Pure Monopoly Defined
A pure monopoly exists when there is only one firm in a market producing a
commodity for which there are no close substitutes. There are no direct competitors or
rivals in the popular or technical sense. However, the policies of a monopolist may be
constrained by the indirect competition of all commodities for the consumer’s peso and by
reasonable adequate substitute goods.
Examples of Monopolistic firms are Meralco, Philippine Long Distance Telephone

Company and Philippine Air Lines (for domestic passenger flights).
Demand and Marginal Revenue Pure Monopoly
In a pure monopoly, the firm is the industry and faces a negatively sloped industry
demand curve for the commodity. As a result, if the monopolist wants to sell more of the
commodity he must lower its price. Thus for a monopolist, MR < P and his MR curve lies
below his demand curve. Figure 4.10 shows the relationship between the total revenue,
demand curve and marginal revenue.
Page | 98
Microeconomics
Figure 4.10 Total Revenue, Marginal Revenue and Demand
We mentioned earlier, a monopolist can sell more by lowering its prices but it
doesn’t follow that his total revenue increases. In figures 4.10 above, as price goes down
from P1 to P2, the quantity demanded increases from Q 1 to Q2 and total revenue rises from
point A to point B. When price is further lowered from P 2 to P3, the quantity demanded
increases from Q2 to Q3. This is because the marginal revenue is positive although
declining. However, total revenue does not increase but falls from point B to point C.
Beyond X2, marginal revenue is negative, thus any additional output does not contribute
additional revenue because the increase in quantity demanded is not sufficient to cover the
fall in price.
The relationship between marginal revenue and price at any quantity can be
expressed as:
1
𝑀𝑅 = 𝑃 (1 − 𝐸)
Where E is the absolute value of demand elasticity at this quantity. From this equation, it
is apparent that when marginal revenue is negative, demand is inelastic (E < 1) and total
revenue declining. When marginal revenue is positive, demand is elastic (E > 1) and total
revenue is increasing. Finally, when marginal revenue is zero, demand has unitary elasticity
(E = 1) and total revenue is at its maximum.
Short Run Equilibrium
The short run equilibrium output of the monopolist is the output at which either total
profits are maximized or total losses minimized. Using the total curves in Figure 4.11, it
can be seen that the total revenue curve differs from that of a firm in perfect competition.
A monopolist’s total revenue rises and after reaching a point falls.
Page | 99
Microeconomics
Figure 4.11. Short Run Profit Maximization Total Curves
At outputs Q1 and Q3, TR = TC, hence total profit is zero and the firm is breaking
even. At output Q2, the gap between TR and TC is at its widest and total profit is at its
maximum. It is also at Q 2 where the slope of the TR curve is equal to the slope of the TC
curve. Note that TR reaches its maximum at Q 3 but at this output level total profit is lesser
compared to its peak at output Q 2. This means that a monopolist does not maximize profit
by producing at the output level where total revenue is at its highest.
Short run equilibrium can also be analyzed using per unit curves. As in perfect
competition, short run equilibrium level of output of a monopolist can be determined at the
point where MC = MR. Short run profit maximization is shown in Figure 4.12. Profits
are maximum at output Q at which SRMC = SR R. The price per unit that the monopolist
can get for that output is P. Average cost is C and profits are equal to CP multiplied by Q.
At smaller outputs MR is greater than MC; thus; thus, larger outputs up to Q add more to
total receipts than to total costs and increase profits. At larger outputs MR is less than MC,
hence, increases beyond Q add more to total cost than to total receipts and cause profits to
decrease.
Page | 100
Microeconomics
Figure 4.12. Short Run Profit Maximization Per Unit Curves
Short run loss minimization occurs when the average cost per unit of output is higher
than the price. The firm may continue its operation as long as average variable cost per
unit is higher than the price per unit. This can be observed in Figure 4.13 below.
Figure 4.13 Short Run Loss Minimization Per Unit Curves
In the above graph, notice that C is higher than the price P. On the other hand, the
average variable cost V is lower than P. The monopolist in this case can still pay the total
variable cost and part of the total fixed cost.
A monopolist is forced to close down if the average variable cost is equal to a higher
than the price per unit. Figure 4.14 shows that V and C now higher than P. Since the
average variable cost is higher than the price, the monopolist can reduce its losses by simply
shutting down the plant. (The analysis is similar to that of a competitive firm).
Page | 101
Microeconomics
Figure 4.14 Shut Down Point Per Unit Curves
Long Run Equilibrium
In the long run, a monopolist will remain in business only if he can make a profit (or
at least break even) by producing the best of output with the most appropriate scale of plant.
To do this, he must be able to forestall the entry of new firms or else he will not be a
monopolist for long. Blocking the entry of new firms into his field can be done in several
ways: 1) controlling the sources of raw materials necessary for the production of his
product; 2) by holding certain patents that prevent other firms from duplicating his products;
or 3) by acquiring exclusive franchises granted by the governmental unit concerned.
Since entry into the industry is blocked, the monopolist adjusts his long run output
by means of size of plant adjustments. There are three possibilities each of which are
appropriate given the existing relations. These are: 1) a plant of less than optimum size; 2)
an optimum size plant; and 3) a larger than optimum size of plant.
Less than Optimum Size of Plant
If the size of the market of the monopolist is so limited, his marginal revenue curve
cuts his long run average cost curve to the left of its minimum point. Given this situation,
the monopolist will build a less than optimum size of plant and operate is less than the
optimum sale of output since his market is not large enough for him to expand the plant
sufficiently to taka advantage of the economies of scale. In Figure 4.15 below, it can be
seen that long run profits are maximum at the output at which LRMC = MR. The output is
Q and price is P. The monopolist should build the size of plant that will produce output Q
at the least possible average cost, so that the short run average cost curve SRAC should be
tangent to LRAC at output X.
Page | 102
Microeconomics
If SRAC is tangent to LRAC at output X, LRMC = MR, hence, a monopolistic firm in long
run equilibrium is necessarily in short run equilibrium too.
Figure 4.15 Long Run Profit Maximization Less Than Optimum Plant Sizes
Optimum Size of Plant
If the monopolist’s market is large enough for him to take advantage of economies
if scale, then he will build an optimum size of plant to produce the output at the least possible
cost per unit. This is the point where LRMC = LRAC = SRAC = MR. This can be seen in
Figure 4.16 below where Q is the equilibrium output, P the price and C the average cost per
unit.
Figure 4.16 Long Run Profit Maximization: Optimum Size of Plant
Price
LRMC
P
SRMC
SRAC
C LRAC
0 MR
Q D
Quantity
Page | 103
Microeconomics
Greater than Optimum Size of Plant
In this case, the monopolist’s market is large enough for his marginal revenue to cut
his LRAC curve to the right of its minimum point. This is seen in Figure 4.16-A. The
proper plant to build is SRAC which is tangent to LRAC at output Q, the long run profit
maximizing output. At this output, LRMC = SRMC = MR; therefore, the monopolist is in
equilibrium both in the short run and long run.
Figure 4.16 B. Long Run Profit Maximization: Optimum Size of Plant
This figure shows the case in which the market size is just large enough to permit
the monopolist to build the optimal plant and use it as full capacity.
This should be clear that which of the shows situations will emerge in any particular
case depends on the size of the market (give the technology of the monopolist). There is
no certainty that in the long run, the monopolist will reach the optimal scale, as is the case
in pure competitive market. In monopoly there are no market forces similar to those in pure
competition which lead the firms to operate at optimum plant size and utilize it at its full
capacity in the long run.
Page | 104
Microeconomics
Figure 4.17 No Supply Curve in Monopoly
No Supply Curve in Monopoly
This differs from a competitive industry, where there is a one to one correspondence
between price (P) and quantity supplied (Q). For a monopoly, the price depends on the
shape of the demand curve, as shown in the figure. A mathematical function is defined as
a one-to-one correspondence between each point in the range (x) and the domain (y). A
supply curve, then, requires a single price (P) for each quantity (Q). This graph shows that
there is more than one price associated with each quantity. At quantity Q0 for demand
curve D1, the monopolist maximizes profits by setting MR 1 = MC, which results in P1.
However, for demand curve D 2, the monopolist would set MR2 = MC, and charge a lower
price, P2. Since there is more than price associated with a single quantity (Q 0), there is no
one-to-one correspondence between price and quantity supplied, and no supply curve for a
monopolist.
Special Cost Monopoly
Measuring the social cost of monopoly can best be illustrated by using the concept
of consumer surplus. Consumer’s surplus is defined as the area below a demand curve and
above the market price. It is frequently used to measure the welfare gain or loss due to a
decrease or increase in market price.
Page | 105
Microeconomics
At price P1 in Figure 4.18, the quantity demanded is Q 1 and consumer surplus is the triangle
P1AE. As price goes up to P2, consumer surplus shrinks to triangle P 2AD. Finally at
price P4, consumer surplus is area of the triangle P 4AB. This means that the higher the
price the lesser is the consumer surplus.
Figure 4.18 Consumer Surplus
Now let me use the concept of consumer’s surplus to indicate the loss from
monopoly. Assume that OD in Figure 4.19 represents the demand for a particular
commodity. The industry is at first a competitive constant cost industry. Long run industry
is at P1 where P1 = MC = AC. Prior to monopolization of the industry, total consumer
surplus is shown as P 1DB. After a monopoly is formed, price rises to P 2 and consumer
surplus is now P2DA. The P1P2AB.
Figure 4.19 Welfare Loss from Monopoly
Page | 106
Microeconomics
Price Discrimination
A monopolist can increase his total revenue and profits for a given level of output
by practicing price discrimination. There are two conditions necessary for such a price
discrimination to occur: 1) he must be able to keep his market apart; and 2) the elasticities
of demand at each price level must differ among market.
Figure 4.20 Profit Maximization Price Discrimination
Two separate markets are seen in Figure 4.20, each with different elasticities as
shown by the slopes of their demand curves. Market A is more inelastic since its demand
curve is steep. While market B is more elastic as shown by its flatter demand curve. To
determine the profit maximizing the price and quantity for each market ∑MR for both
markets should equal MC. The total output of the monopolist is determined in the last
diagram in Figure 4.20 where ∑MR = MC. From this equilibrium we draw the liner to
determine the price in each market and the distribution of quantity for each market. In
market A, Price is set at P 1 with quantity Q1 sold while at market B, price is set at P2 with
quantity Q2 sold.
Regulation of Monopoly
Because of the unwanted effects of monopoly on the society, governments may

regulate it to offset some of its adverse effects. There are two possible regulatory devices:
1) price control and 2) taxation. Taxation can be of two types: a) lump sum tax and b)
specific tax.
By setting a maximum price at the level where SRMC curve cuts the demand curve,
the government can induce the monopolist to increase his output to the level the industry
would have had produced if organized along perfectly competitive lines.
Page | 107
Microeconomics
This also reduces monopolist’s profits Figure 4.21 shows a monopolist “normal”
profit maximizing price P 1 and quantity Q1 which is determined by the condition MC = MR.
If the government limits price to P 2 such that P2 = MC = D, the monopolist will be forced
to produce at output Q 2 resulting to the reduction of its profits which is P 2C2 multiplied by
Q2 .
Figure 4.21 Regulation of Monopoly by Price Control
By imposing a lump sum tax, such as a license fee or a profit tax, the government
can reduce or even eliminate the monopolist profits without affecting either commodity
price or output. The monopolists can not shift the tax burden to the consumer, since the
lump sum tax is constant regardless of the level of output; it becomes part of fixed cost
shifting the average cost curve higher but has no effect on marginal cost curves. Thus, the
shifting of the average cost curve from SAC1 to SAC2 in Figure 4.22 results in the
elimination of the monopolists profit with price constant at P 1 and quantity constant at Q 1.
Figure 4.44 Regulation of Monopoly by Lump Sum Tax
Page | 108
Microeconomics
The government can also reduce the monopolist profit by imposing a per unit tax on
him. However, in this case the monopolist will be able to shift part of the burden of the per
unit tax in the form of higher price and a smaller output of the commodity. Since per unit
tax increases with the increase in output it becomes part of the variable cost and thus shifting
both marginal cost and average cost curves upwards as shown in Figure 4.22. As a result,
price goes up from P1 to P2 and quantity is reduced from Q1 to Q2.
Figure 4.23 Regulation of Monopoly by Specific Tax
Welfare Effects on Monopoly
1. Output restriction both in the long run and short run. This is because monopolist
produces at the quantity where P > MC and P > MR. It is for this reason why
consumer surplus welfare is reduced.
2. The monopolistic form ordinarily will not use resources at their peak potential
efficiency. The size of plant and the output that maximize the monopolistic
long run politics are not necessarily optimal.
3. Monopolist engages in wasteful promotional sales activities to enlarge his

market.
PERFORM PROGRESS CHECK TEST 2
Page | 109
Microeconomics
True or False Write the word TRUE if the statement is true and FALSE if the
statement is not on the blanks provided before each number.
__________ 1. The monopolist always produces at the point where the elasticity of the
demand curve is greater than one.
__________ 2. Since the monopolist controls the price of the product it always makes
profits.
__________ 3. In the long run equilibrium the monopolist will never build an optimum
size plant.
__________ 4. The best way to control monopoly is to improve a specific or per unit tax.
__________ 5. Monopoly in the market reduces consumer welfare.
__________ 6. A monopolist will always maximize profits at the point where total
revenue is at its maximum.
__________ 7. To maintain its monopoly power, the monopolist has to have control to
strategic raw materials.
__________ 8. Since they are the only market for a particular product, a monopolist need
not advertise.
__________ 9. A monopolist has to sell at the same price in two different markets, even if
their demand elasticities differ.
__________10. If a monopolist is subject to a perfectly competitive market, it will be

force to reduce its price and increase its output.

Page | 110
Microeconomics
1. True
2. False
3. False
4. False
5. True
6. False
7. True
8. False
9. False
10. True
RATING: No. of correct answers x 10 = ____________
My rating is ___________
Page | 111
Microeconomics
Lesson 3. Price and Output Under Oligopoly
Lesson Objectives:
1. discuss why we have no general theory where there is an oligopolistic market;
2. analyze how pricing and output is determined in various types of oligopolistic

structure;
3. explain why collusion among firms takes place and why it does not in some
cases; and
4. analyze the effects of oligopolistic structure on the operation of the economy.
Oligopoly Defined
Oligopoly is market organization in which there are few sellers of a commodity. So,
the action of each seller will affect other sellers. As a result, no general theory can be
established and specific assumptions to be made about the reactions of other firms to the
actions of the firm under study. Since what one firm is able to do in the market is
conditioned by the ways in which other firms react to the market activities of the one, the
extent of this oligopolistic uncertainty is highly variable from case to case. As such, the
position and shape of the demand curve it faces may be highly conjectural. Because of this,
all we have are many different models, most of which are more or less unsatisfactory.
Oligopolistic industries abound in the Philippines. Some of these are: soft drink
industry, the appliance industry, car battery manufacturers industry, flour milling industry,
tire manufacturing industry and others. These industries produce the same product (soft
drinks) but differentiated (coke, Tru-Orange, 7-Up, etc.)
Collusion
Oligopolistic market structure invites collusion among the firms in an industry, but
at the same time collusion arrangements are difficult to maintain. There are three
advantages of collusion, these are: 1) they can increase their profits if they can decrease the
amount of competition among themselves and act monopolistically; 2) it can decrease
oligopolistic uncertainty and prevent any one firm from taking detrimental actions against
the others; 3) it facilitates blocking of newcomers from that industry. There are two types
of collusion: a) perfect and b) imperfect.
Page | 112
Microeconomics
Perfect collusion consists primarily of cartel arrangements wherein there is formal

organization of the producers within a given industry. There are two kinds of cartel
arrangements: a) centralized cartel; and b) market sharing cartel. In centralized cartel, the
cartel has almost complete control over the member firms. While the market sharing cartel
is somewhat a looser form of organization where member firms agree on market shares with
or without an understanding regarding prices.
Imperfect collusions are made up mostly of tacit informal arrangements under which
the firms of an industry seek to establish prices and outputs. There are two kinds of
imperfect collusion arrangements: 1) price leadership of a low cost firm; and 2) price
leadership of a dominant firm.
Perfect Collusion
In a centralized cartel, profits are maximum where the industry output and price are
such that industry marginal revenue equals industry marginal cost. For any given output
level, the central agency should minimize industry costs. This goal can be accomplished
by allocating quotas to the member firms in such a way that the marginal cost of each firm
when producing its quota is equal to the marginal cost of every other firm when each is
producing its respective quota.
In Figure 4.24, the industry marginal revenue r is derived when ∑MC of all firms in
the industry is equal to the industry MR. Once the equilibrium ∑MC = MR, the industry
price Pd and output Qd can be determined. The individual output levels of each firms A &
B depend upon their efficiency levels, that is the position of their cost curves. Note that
Firm A which is inefficient as seen by its higher cost curves has lesser quota Q a than Firm
B which is efficient as seen by its cost curves and hence producing more at Q b.
Figure 4.24 The Centralized Cartel
Page | 113
Microeconomics
To simplify the analysis in a market sharing cartel, let us assumer that there are only
two firms in the industry. The two firms produce homogeneous products, have equals costs
and agree to share the market half and half. In Figure 4.25, D D is the industry demand
curve and d d is the demand curve of one firm which is exactly the same with the other. As
mentioned, SRMC and SRAC are the same in both firms. The industry price is P and
industry output is QQb. Both firms will set their price at P. One firm will produce QQ a
quantity and the other firm will produce Q aQb quantity where QQa = QaQb.
Figure 4.25 The Market Sharing Cartel
Imperfect Collusion
In the absence of a formal cartel arrangement, price leadership by one firm in the
industry is frequently the means of colluding. We shall suppose that there are two firms in
the industry, that a tacit market sharing arrangement has been established with each firm
assigned half the market, that the product us undifferentiated and that one firm has lower
cost than the other. DD is the demand for the industry in Figure 4.26 while dd is the
demand curve for the firm. Firm 1 has the cost curves SRMC, and SRAC, and Firm 2 has
the cost curves SRMC2 and SRAC2. Since the cost curves of Firm 2 is lower, it can set its
prices at P2 which is lower than Firms 1’s P 1 and can produce more at quantity Q2. Since
the low cost firm can afford to sell at a lower price than the higher cost firm can, Firm 1
will have no recourse other than to sell at the price set by Firm 2 or else he would not be
able to sell its product.
Page | 114
Microeconomics
Figure 4.26 Price Leadership of a Low Cost Firm
Many oligopolistic industries are made up of one or more large firms, together with
a number of small firms. We shall simplify matters by assuming that there is a single
dominant firm. In Figure 4.27, DD is the industry demand curve, dd the demand curve of
the dominant firm, MRd the MR of the dominant firm. The dominant firm sets its price at
P where MCd = MRd and producers at Qd. Each small firm will consider the price set by
the dominant firm as fixed (as in a competitive market). ∑MC s is the summation of all the
supply curves of all small firms to determine their profit maximizing output at Q s. The
total output of the industry is at Q d.
Figure 4.27 Price Leadership of a Dominant Firm
Price Wars and Price Rigidity
Unlike the collusive arrangements discussed above, there may exist an oligopolistic
industry characterized by independent action on the part of individual firms. An analytical
device frequently used to explain this type of oligopolistic market is the “Kinked” demand
curve.
Page | 115
Microeconomics
The following assumptions are set: 1) The industry is a mature one, either with or without
product differentiation. A price or cluster of prices fairly satisfactory to all has been
established; 2) If one firm lowers the price of other firms will follow or undercut it in order
to retain their shares of the market; 3) If one firm increases the price, other firms will not
follow. In Figure 4.28, the demand curve facing the oligopolist has a “Kinked” at the
prevailing output Q. Note that the demand curve is much more elastic above the kink than
below because the assumption that other oligopolists will not match price increases but will
match price cuts. The kink at point D on the demand curve causes the AB discontinuity in
the marginal revenue curve. The oligopolist’s marginal cost curve can rise or fall anywhere
with the discontinuous portion of his MR curve without changing his prevailing level of
price.
Figure 4.28 The Kinked Demand Curve
The Long Run Equilibrium
The discussion made above are short run analysis. In the long run, the size of plant
that the individual firm should build depends on its anticipated rate of output. But there is
no reason for expecting that the firm would tend to construct an optimum size plant whether
under collusion, perfect or imperfect, or independent section. This entirely depends on the
size of the market and the perceptions of the individual firms on how the market develops
in the future. If one firm believes that the market is large or growing, it might expand its
plant. Another firm may anticipate the expansion of other firms and anticipates prices to
go down and hence, may not decide to expand.
When entry into the industry is comparatively easy, it may not remain oligopolistic
in the long run. Furthermore, easy entry tends to break down collusion arrangements. In
Figure 4.29, the entry of more firms in the long run, shifts the ∑MC curve to the right.
Page | 116
Microeconomics
As it does, prices go down from P 1 to P3 as quantity produced increases from Q 1 to Q3.

Entering firms that remain outside the collusive group will encroach more on the profits of
that group or will cause the group to incur losses and force its eventual dissolution.
Figure 4.29 Long Run Cartel Equilibrium and the Effects of Entry
Barriers Entry
For the oligopoly to be maintained in the long run, there has to be barriers to prevent
new firms from entry to the industry. These barriers may either be natural or artificial.
There are two kinds of natural barriers. The first one is the smallness of the product market
in relation to the optimum size of plant for a firm in the industry. The second one consists
of the difficulty of putting together a large and complex plant and of obtaining funds to
build it. Artificial barriers may be in the following forms: 1) government supported barriers
such as patents, licenses, franchises, etc.; 2) control of strategic source of raw materials
necessary for producing the product; 3) price policies of the established firms in an industry;
(reducing prices to undersell new entrants); and 4) product differentiation by building up
the name of a “superior” brand to make other firm’s brand “inferior” therefore, unsaleable.
Nonprice Competition
Although oligopolists may be reluctant to encroach upon each other’s market shares
by lowering the product price, they appear to have little hesitancy in using other means to
accomplish the same results. One of these is advertising. The primary purpose of
advertising is to shift the demand faced by the seller to the right and to make it less elastic.
Page | 117
Microeconomics
Thus, the seller can sell a larger volume at the same or higher price without the
danger of touching off a price war. But advertising has also its limits and up to a certain
extent may add more to marginal cost rather than marginal revenue.
Another type of non-price competition is the variations in the quality and design of
particular products. The purpose of variations is to establish consumer preference for his
product, that is, to shift his demand curve to the right (or to enlarge his share of the total
market and to make his demand curve elastic). Quality variation may also be used to extend
the market vertically, meaning different qualities to appeal to different classes or groups of
buyers.
Welfare Effects of Oligopoly
Compared with perfectly competitive market structures, Oligopolistic market

structures have adverse effects on consumer welfare. These are:
a. Output restriction. An oligopolistic firm usually faces a downward sloping

demand curve. As a result P > MR and P > MC just like in monopoly. This as
we know reduces consumer surplus and thus their welfare.
b. Efficiency of the firm. The size of plant built by an oligopolistic firm is not
necessarily the optimum size. This is because the firms output depends upon its
quota, its market share, or its anticipations with regard to its marginal revenue
and its long run marginal costs.
c. Sales promotion waste. Most f the firm which we see in TV commercials or

newspaper ads are oligopolists. As a result, cost of production goes up and
becomes higher than the value of consumer satisfaction. In other words
consumers pay more than what they ought to pay.
d. Range of products. Oligopolists produce a wide range of products which may

cater to the consumers individual tastes or preferences. In this regard, oligopoly
apparently works in favor of enhancing consumer welfare.
Page | 118
Microeconomics
Enumeration/Fill in the blanks
1-3. Advantages of Collusion
1.
2.
3.
4. _______________________ consists primarily of cartel arrangements wherein

there is a formal organization within a given industry.
5. _________________________ are made up mostly of facit informal

arrangements under which the firms of an industry seek to establish prices and
outputs.
6. __________________________ is a condition where the industry maximizes

profits by allocating quotas to the member firm in such a way that the marginal
cost of each firm when producing its quota is equal to the marginal cost of
every other firm where each is producing its respective quota.
7. _________________________ is a market where firms produce a homogenous

products, have equal costs and degrees to show the market half and half.
8. _______________________ is a market where other firms follow the price set

by the most efficient firm.
9. ________________________ is a market where small firms act as if it were in

perfect competition after the price has been set by the firm with the largest
market.
10. This market is characterized by rigid prices and price wars and its demand
curve which is _________________________.

Page | 119
Microeconomics
1. They can increase their profits if they can decrease the amount of
competition among themselves and act monopolistically.
2. It can decrease oligopolistic uncertainty and prevent any one firm from
taking detrimental actions against others.
3. In facilitates blocking of newcomers from that industry.
4. Perfect collusion
5. Imperfect collusion
6. Centralized cartel
7. Market Sharing cartel
8. Price leadership of a least cost firm
9. Price leadership of a dominant firm
10. Kinked
RATING: No. of correct answers x 10 = _____________
My rating is ______________
Page | 120
Microeconomics
Lesson 4. Price and Output Under Monopolistic Competition
Lesson Objectives
1. analyze how pricing and output is determined in a monopolistically competitive

market structure;
2. explain why entry is not normally blocked; and
3. examine the effects of monopolistic competition on the welfare of the society.
Characteristics of Monopolistic Competition
1. The number of sellers is large enough so that the actions of any one have no
perceptible effect upon other sellers.
2. There is product differentiation which leads some consumers to prefer products

of particular sellers over those of others.
3. Examine the effects of monopolistic competition on the welfare of the society.
4. Because of No. 2 above, the demand curve faced by an individual seller has
some downward slope enabling the seller to exercise a small degree of control
over his product price.
5. Different sellers will receive somewhat different prices, depending on

consumer’s judgments with regards to the comparative qualities of the
differentiated products.
An example of a monopolistic competition is the restaurant industry. There are

thousands of restaurants in Metro Manila but consumers may choose a particular restaurant
over another. Another is the garments industry which produce essentially the same product-
garments. There are more than 20,000 firms in this industry, yet no one will produce exactly
the same class or kind of pants or dress.
Page | 121
Microeconomics
The Short Run Equilibrium
Just like a firm in other market situations, the firm does not have time to change its
plant size. Therefore, there is insufficient time for new firms to enter the industry. Profit
maximization with respect to output and price is governed by the same principles that is at
the point where MC = MR. In Figure 4.30, the firm’s demand curve, D is slightly downward
sloping with the MR curve below it. P is the equilibrium price, Q is the equilibrium
quantity and C is the cost. Profits per unit is PC and total profits are CP multiplied by Q.
Figure 4.30 Short Run Profit Maximization
Short run equilibrium does not imply that all firms charge identical prices since the
firms of the industry do not produce homogeneous outputs.
The Long Run Equilibrium
There are two possibilities in the long run depending whether entry is blocked or
open. Entry is not usually blocked. In most cases, a legislative enactment may ban the
entry of new firms to the industry. An example would be a law declaring an industry as an
“overcrowded industry”. In this case, the long run adjustments are the point where P >
SRAC = LRAC and LRMC = MR. In other words, the firm will experience pure profits or
economic profits in the long run. This can be seen in Figure 4.31, where the profit
maximizing price P and quantity Q is attained by more than an optimum size plant. Note
that SRAC is tangent to LRAC in upper right side not on LRAC’s lowest point. This
existence of pure profits is due to the limitation of firms engaging in the industry.
Page | 122
Microeconomics
Figure 4.31 Long Run Profit Maximization Entry Blocked
Under normal circumstances, entry into or exist from a monopolistically competitive

industry is easy. It is rare for the government to influence and set-up barrier except in
extraordinary circumstances. The entry of new firms into the industry will affect the cost
of production for existing firms. Ordinarily, this situation could lead to an increasing cost
industry as in perfect competition resulting to the upward shift of the cost curves. Long
run equilibrium is attained where LRMC = MR and P = SRAC = LRAC. In Figure 4.32, it
can be seen that the long run adjustment leads to a building of a less than optimum size
plant.
The SRAC is tangent to the upper left side of the LRAC curve before it reaches its
minimum point. Since price is equal to average cost both in the long and short run there is
no economic profit, hence, the industry does not attract new firms neither does it discourage
the present forms from leaving. The less than optimum size plant is cause by the fact that
there are too many firms in the industry such that the market for each firm does not warrant
an optimum size plant.
Figure 4.32 Long Run Maximization Entry Open
PERFORM PROGRESS CHECK TEST 4 AND THEN THE MODULE TEST
Page | 123
Microeconomics
Enumeration/Fill in the Blanks
1-4 Characteristics of Monopolistic Competition
1.
2.
3.
4.
5. The Marginal Revenue Curve is _________________________ the demand

curve in a monopolistically competitive firm.
6. Because of number 5, the firm equilibrium price is __________________

marginal cost.
7. In the long run when ___________________________, the firm will enjoy

economic profits.
8. The firms will have zero economic profits in the long run when
____________________________.
9. When a law is passed declaring an industry _____________________, no new

firms may be allowed to entry.
10. Output in monopolistic competition is _________________________ because

the demand is slightly downward sloping.

Page | 124
Microeconomics
1. The number of sellers is large enough so that the actions of any one has no
perceptible effect upon other sellers.
2. There is no product differentiation which leads some consumers to prefer products

of particular sellers over those of others.
3. Because of no. 2 above, the demand curve faced by an individual sellers has some
downward slope enabling the seller to exercise a small degree of control over his
product price.
4. Different sellers will receive somewhat different prices, depending in consumers’

judgments with regards to the comparative qualities of the different products.
5. Lesser than
6. Higher or greater than
7. Entry is blocked
8. Entry is open
9. As an “overcrowded” industry
10. Restricted
RATING: No. of correct answers x 10 = _______________
My rating is _____________________
NOW PROCEED TO MODULE TEST.
Page | 125
Microeconomics
MODULE 5
FACTOR PRICES
Page | 126
Microeconomics
MODULE 5 – FACTOR PRICES
Scope of the Module
Module 5 contains the following three lessons:
Lesson 1 – Perfect Competition in the Product and Factor Markets
Lesson 2 – Perfect Competition in the Factor Market and Monopoly in the Product
Market
Lesson 3 – Monopsony
The module analyzes and explain how the prices of the factors of production are
determined in various market conditions both in the product and factor markets. The tools
that you have learned in the previous lessons will be helpful in the analysis. Some of the
useful concepts are the law of supply and demand, marginal product, marginal revenue and the
theory of the firm.
At the end of this module, you are expected to be able to:
1. discuss the influence of market structure both in the product and factor markets
in determining factor price;
2. explain how factor prices influence the maximization of profit at the firm level;
and
3. analyze the effect of factor pricing on the employment level of factors or

resources.
Page | 127
Microeconomics
Lesson 1: Perfect Competition in the Product and Factor Markets
Lesson Objectives
At the end of this lesson, you will understand how a firm, which is a perfect
competitor in both the product and factor markets, determines resources prices. More
specifically you are expected to be able to:
1. explain how factor prices affect profit maximization;
2. discuss how to derive the demand curve of the firm for one or more variables;
3. analyze the market demand curve for a resource; and
4. discuss the mechanism in pricing and level of employment of a factor.
Assumptions
In the analysis of factor prices when there is perfect competition in the product and
factor markets, the following assumptions hold.
1. No one firm takes enough of any given resources to be able to influence its prices.
2. No one resource supplier can place enough of a given resource on the market to
be able to influence its price.
3. Variable resources are mobile as among different employments.
4. Market prices of variable resources are flexible.
Profit Maximization and Least Cost Factor Combinations
In order for a firm to maximize its total profits, it must produce its best level of
output with the best, and therefore, least cost-combination. This double condition is
satisfied when:
𝑀𝑃𝑏 1 1
𝑀𝑃𝑎 = = = 𝑃𝑥
𝑃𝑎 𝑃𝑏 𝑀𝐶𝑥
where MP = marginal product, P = price, MC = marginal cost; and A and B, factors of

production and X is the final commodity.
Page | 128
Microeconomics
Recall that in the theory of production, the least-cost combination condition is
𝑀𝑃𝑎 𝑀𝑃𝑏
=
𝑃𝑎 𝑃𝑏
This means that to secure a given output at least possible cost, the marginal product
of a peso’s worth of one resource must be equal to the marginal product of a peso’s worth
of every other resource used.
On the other hand, profit maximization in a perfectly competitive market is P = MC.

1
Remember, that in this type of market P = MR. The condition 1 = 𝑀𝐶 𝑃 is the reciprocal
𝑟 𝑥
of MC = P.
𝑀𝑃𝑎 𝑀𝑃𝑏 1 1
Supposing we have a condition where = = >
𝑃𝑎 𝑃𝑏 𝑀𝐶𝑥 𝑃𝑥
The Demand Curve of the Firm for One Variable Factor
A profit maximizing firm will employ a factor of production only as long as it adds
more to the total revenue than it adds to the total cost. If factor A is the only variable factor
for the firm, the value of the extra output generated by the additional unit of factor A hired
(i.e., the VMPa) is equal to the extra output of the additional unit of factor A hired (i.e., the
MPa) times the price at which the output is sold (i.e., P r). Thus, the value of marginal
product of factor A is VMP a = MPa x Px. As more units of factor A are hired, the MP of A
goes down as the result of the law of diminishing marginal returns, and thus the VMPa
eventually decline. The declining portion of the VMPa schedule is the firm’s demand
schedule for factor A.
Figure 5.1 Value of Marginal Product, Resource Price and

Profit Maximization
(1) (2) (3) (4) (5) (6)
Quantity of A Quantity of X MPa Px VMPa Resource
P (MPa x Pr) Price (Pa)
P
4 10 5
5 18 8 5 P 40 20
6 25 7 5 35 20
7 31 6 5 30 20
8 36 5 5 25 20
9 40 4 5 20 20
10 43 3 5 15 20
Page | 129
Microeconomics
As the quantity of the variable A increases (column 1), the quantity of X product
(column 2) also increases and at the same time, the marginal product of A declines (column
3) as a result of diminishing returns. Since we are assuming perfect competition in both
the product and factor markets, the price of the product (column 4) is constant
notwithstanding the increase in the level of output and the price of variable factor A (column
6) also is constant inspite of the increase usage (and therefore demand) of factor A. The
value of marginal product (column 5) which is derived by multiplying MPa with P, shows a
declining trend due to the diminishing marginal returns of factor A. This simply means
that as the firm increases the employment of factor A, the value of the extra output generated
by the additional unit of factor A declines. The firm can employ variable factor A until it
reaches the point where VMP a = Pa or MPa x Px= Pa which is also the point where Qa 9 in
column 1. Note that if Qa = 5, VMPa is P40 and given the factor price at P20, the firm earns
a net profit at P20.
Figure 5.1 Firm’s Demand for Factor A
Figure 5.1 above shows the firm’s demand schedule for factor A which actually is
the VMPa curve. The higher the price of factor A (at Pa 1), the lesser quantity of factor A
is employed (at Qa 1). The lower the price of factor A (at Pa 2), the more is the quantity of
factor A employed (at Qa 2). If at Pa2, the firm hires Qa 1 of factor A, the firms total costs
will increase by Qa 1B, but its total revenue will increase by Qa 1C or a net profit of BC.
Clearly, it is to the advantage of the firm to increase employment of factor A to Qa 2 to
capture additional profits of CBD. If the price of factor A is at Pa 1 but employs Qa2 of
factor A the firm will incur loss of CBD since additional revenue is only Qa 2D while total
cost is higher at Qa 1C. In this case, the film has to reduce the employment of factor A to
Qa1 to eliminate losses.
The Demand Curve of the firm for One of Several Variable Factors
When factor A is only one of several variable factors, the VMP a curve no longer
represents the firm’s demand curve for the factor A. The reason for this is that, given the
price of the other variable factors, a change in the price of factor A will bring about changes
in the quantity used of these other variable factors. These changes, in turn, cause the entire
VMPa curve of the firm to shift. The quantities of factor A demanded by the firm at
different prices of factor A will be given by points on different VMP curves.
Page | 130
Microeconomics
Figure 5.2 The Firm’s Demand for One of Several Variable Resources
For example, when the price of factor A falls from Pa 1 to Pa2, a firm would normally
increase the employment of factor A from Qa 1 to Qa. However, if factor A is only one of
several variable resources, the number of factor A employed will actually be Qa 2 instead of
Qa1. The demand curve for factor A will then be dd which connects points L and M. This
is due to what we call the “internal effects” of the price change of factor A. The fall in the
price of factor A will encourage the firm to employ more A. To do so, the firm has to
substitute some of its variable resources for A. On the other hand, the resources
complementary to factor A will be increased to allow the firm to use more factor A than
was possible before the price decrease.
The Market Demand Curve for A Factor
We cannot get the market demand curve for factor A by simply summing
horizontally the individual firm’s demand curves for factor A. This is due to what we call
the “external effect” on the firm resulting from the reduction in the price of factor A. When
the price of factor A falls, all firms producing commodity X will increase their producti on
and hence increase the supply of commodity X in the market. This would mean that the
price of commodity X will fall. The fall in the price of commodity X will discourage the
producers to increase their production of X. This would therefore reduce the demand for
factor A.
Page | 131
Microeconomics
Figure 5.3 – The Market Demand Curve for a Resource
In Figure 5.3, the price of factor A falls from P a1 to Pat, the firm will initially increase
the employment of A from Q a1 to Qa2. However, as the price of commodity X falls, the
demand curve for factor A will shift from d 1 to d2, thus, reducing the quantity of factor A
employed from Qa1 to Q. The market demand curve for resource A for the whole industry
is shown by the curve Da which passes through points Q and R.
The Market Supply Curve for A Factor
Just as in the case of a final commodity, the equilibrium price of a factor of

production and the quantity of it employed are determined at the intersection of the market
demand curve and the market supply curve of the factor.
Under conditions of perfect competition the equilibrium price of resource A is at P a

in Figure 5.4 below. A single firm will employ QA of resource A and the market as a whole
will employ QA of resource A. At a price higher than Pa, sellers of resource A will want
to sell more than buyers and will want to employ at that price. Thus, at price P a1, there will
be an over supply of resource A resulting to some unemployment. The owners of
unemployed units will undercut each other to gain full employment. As a result, the market
price of resource A will be driven down to P a. If price is at P a2 (lower than Pa), there will
be a shortage of Resource A. Thus, resource buyers will bid against each other for the
available supply driving the price up the equilibrium level.
Page | 132
Microeconomics
Figure 5.4 – Employment and Firm Level of Employment of a Resource
Rent and Quasi-Rent
Rent is the payment for hiring a factor of production whose supply is completely
fixed. The payment is usually over and above the minimum amount needed to bring forth
its supply. Rent is a long-run concept and is not confined to land, nor does it have anything
to do with leasing things or hiring them. The factor owner can receive rent from la nd, or
from capital under certain conditions, or from labor under certain conditions. What is
certain is that the supply curve of these factors are less than perfectly elastic.
Figure 5.5 – Supply and Rent
In Figure 5.5 above, S is the long-run supply curve for managers in an industry, with
the demand D, OP is the salary of managers. Some of them would work for less if the
demand were smaller. The shaded area is the rent part of manager’s incomes, that is, the
excess of what they get over what they would take if they had to. For example, if the
present salary of a manager is ₱10,000 a month, but is willing to accept ₱5,000 a month,
Page | 133
Microeconomics
then the rent is the difference between what he is actually receiving (₱10,000) and he is
willing to receive to remain in the job (₱5,000). Thus, ₱10,000 - ₱5,000 = rent.
In essence, the idea of rent cannot be competed away.
Quasi-rents are the incomes of the owners of capital or fixed factors in the short run.
Fixed factors or capital are paid, whatever is left from the firms total revenue after the firm
has paid its variable factors. Thus, fixed factors are not paid according to the VMP
schedule. Since all factors are variable in the long run, quasi-rent disappears in the long
run.
Page | 134
Microeconomics
True or False
_________ 1. In a perfectly competitive factor market, one of the many resource

suppliers can control the price of the particular resource.
_________ 2. A firm which is employing the least-cost combination of factors is

necessarily maximizing profits.
_________ 3. When a factor price of a certain resource goes down, the value of marginal
product of the resource goes up.
_________ 4. The concept of rent is limited to fixed assets like apartment and land.
_________ 5. When the firm is in profit maximizing condition, it necessary follows that it
is employing the least-cost factors combination.
_________ 6. If the firm is in profit maximizing condition, it necessary follows that it is

employing the least-cost factors combination.
_________ 7. The market demand for a factor can be derived simply by summing
horizontally the individual firm’s demand for the factor.
_________ 8. The supply curve of a factor to an individual firm is infinitely elastic in a

perfectly competitive factor market.
_________ 9. Quasi-rents are incomes of the owners of capital or fixed factors in the
long-run.
_________10. If = = < , it means that the firm is producing more than it
𝑃𝑎 𝑃𝑏 𝑀𝐶𝑥 𝑃𝑥
ought to, to attain maximum profits.

Page | 135
Microeconomics
1. False
2. False
3. False
4. False
5. True
6. True
7. False
8. True
9. False
10. True
RATING: No. of correct answers x 10 = __________

My rating is _____________
Page | 136
Microeconomics
Lesson 2. Perfect Competition in the Factor Market and

Monopoly in the Product Market
Lesson Objectives:
After studying this lesson, you will be able to understand how a firm which is
perfectly competitive in the factor market, but a monopoly in the product market works.
Specifically, you are expected to be able to:
1. explain how the firm maximizes profit and combine factors;
2. explain how the demand curve of the firm for one variable or more is derived;
3. discuss why the value of marginal product is different from marginal revenue
product; and
4. enumerate the factors that affect the market curve for factors and its pricing.
Introduction
Unlike in our last lesson (Lesson 1) where the firm its resources from a perfectly
competitive factor market and sells its products in a perfectly competitive product market,
our present lesson deals with a situation where a firm buys its resources from a perfectly
competitive factor market, but sells its products in a monopolistic market. An example
would be the Philippine Long Distance Telephone, a monopoly in telephone services in
Metro Manila. This company competes with other thousand of companies for its clerical
labor resources. Definitely, all kinds and types of companies would need at least one clerk
to do administrative work. Thus, we can say that the factor market for clerical labor
resource is competitive. Clearly, a monopolistic in the product market does not necessarily
control the various resources it needs to produce a given product or service.
Profit Maximization and Least-Cost Factor Combinations
The firm, which is the monopolistic (or an imperfectly competitive) seller of

commodity X, but a perfectly competitive buyer of factors A and B will maximize its total
𝑀𝑃 𝑀𝑃 1 1
profits when 𝑃 𝑎 = 𝑃 𝑏 = 𝑀𝐶 = 𝑀𝑅 . Again we have condition which are:
𝑎 𝑏 𝑥 𝑥
𝑀𝑃𝑎 𝑀𝑃𝑏
1. least-cost combination condition = and
𝑃𝑎 𝑃𝑏
Page | 137
Microeconomics
1 1
2. profit maximization condition 𝑀𝐶𝑥 = 𝑀𝑅𝑥 or using its reciprocal = .
𝑀𝐶𝑥 𝑀𝑅𝑥
These principles of imperfect competition, more monopoly, oligopoly and
monopolistic competition are applicable as long as pure competition prevails in
the buying of resources. The only difference is that in perfectly competitive
seller’s market 𝑀𝑅 = 𝑃, and 𝑀𝐶 = 𝑀𝑅 can be translated to 𝑀𝐶 = 𝑃. However,
the seller’s market in pure monopoly, oligopoly and monopolistic competition,
the statement competition, pure monopoly, oligopoly and monopolistic 𝑀𝐶 = 𝑃
is not applicable since in these type of markets 𝑃 > 𝑀𝐶.
When a monopolistic (or an imperfectly competitive) seller encounters conditions

such that:
𝑀𝑃𝑃𝑎 𝑀𝑃𝑃𝑏 1 1
= = >
𝑃𝑎 𝑃𝑏 𝑀𝐶𝑥 𝑀𝑅𝑥
The monopolist has the correct least-cost combinations of variable resources, but is
not maximizing his profits. To maximize profits, he must increase his output until such
point where the marginal revenue from his product sales and marginal cost of his product
output are equal. The monopolist can increase output by increasing the quantities of
resources A and B. The MP of both A and B will therefore decrease, causing the marginal
cost of the product to rise. The larger output and sales of the monopolist cause marginal
revenue from the product to fall. The quantities of A and B, together with the firm’s output,
will be increased until the marginal cost and the marginal revenue are equal.
The Demand Curve of the Firm for One Variable Factor
When factor for the monopolistic seller of commodity X, the firm’s demand curve
for factor A is not given by its 𝑉𝑀𝑃𝑎 curve, but its 𝑀𝑅𝑃𝑎 curve, where 𝑀𝑅𝑃𝑎 is defined as
the marginal revenue product of factor A and measures the change in the monopolist’s total
revenue in selling the output of commodity X that results from the employment of one
∆𝑇𝑅
additional unit of factor A. Mathematically, 𝑀𝑅𝑃𝑎 = ∆𝑞 𝑥 𝑜𝑟 𝑀𝑅𝑃𝑎 = 𝑀𝑃𝑎 𝑥 𝑀𝑅𝑥 .
𝑎
Table 5.2 shows the changes in the firm’s total receipts and the causes of those
changes. Column 1 shows the quantity of resource A used while column 2 shows the total
quantity of X produced as more of resources A are used. Column 3 measures the increments
of product X for every additional unit of resource A. Column 4 shows the declining price
of product X which is necessary to enable the monopolist to sell more. Recall that in a
perfect competitive market the product price is constant regardless of the quantity of
products to be sold in the market. Column 6 is the marginal revenue product of resource A
and shows the additions of the firm’s total receipts made by one unit increments in the
quantity of resource A. It can be directly computed from column 5.
Page | 138
Microeconomics
The decrease in 𝑀𝑅𝑃𝑎 is caused by two reasons. First the increase in the level of
employment of resource A will cause the MP of A to decline because of the law of
diminishing returns and second, marginal revenue for the monopolist ordinarily will decline
as he sells larger quantities of the product.
Table 5.2
QUANTITY QUANTITY MARGINAL PRICE OF TOTAL MARGINAL PRICE OF

OF A OF X PRODUCT X REVENUE REVENUE A
OF A OF X PRODUCT
OF X
3 10 12 120 25
4 15 5 11 165 45 25
5 19 4 10 190 25 25
6 22 3 9 198 8 25
7 24 2 8 192 (-6) 25
8 25 1 7 175 (-7) 25
Figure 5.6 – The Marginal Revenue Product For A Resource
In Figure 5.6 above, the monopolist’s demand curve for resource A is represented by the
curve 𝑀𝑅𝑃𝑎 . The additions made to total receipts by a one-unit increment are equal to the
additions made to total cost by the increment. This is at the point where 𝑀𝑅𝑃𝑎 =
𝑃𝑎 𝑜𝑟 𝑀𝑃𝑎 𝑥 𝑀𝑅𝑎 = 𝑃𝑎 . Thus, at the price 𝑃𝑎 in Figure 5.6, the monopolist will hire 𝑄𝑎 of
resource A. Referring back to Table 5.2, this is the point where quantity of resource A
employed is 5 where 𝑀𝑅𝑃𝑎 = 𝑃𝑎 = ₱25.00.
If only 4 units of A are employed, 𝑀𝑅𝑃𝑎 > 𝑃𝑎 𝑜𝑟 ₱45.00 > ₱25.00. In this case,
the monopolist will gain by increasing its output by use of more resources since the additions
to total receipts is greater than the cost of additional input. On the other hand, when quantity
of resource A used is 6 units, 𝑀𝑅𝑃𝑎 > 𝑃𝑎 𝑜𝑟 ₱8.00 > ₱25.00. In this case, the increment
to the total receipts due to the sixth unit of resource A is lesser (₱8) compared to the cost of
Page | 139
Microeconomics
that sixth unit of resource A (₱25). Thus, the monopolist is better off by reducing its output
level of reducing the usage of A from 6 units to 5 units.
Difference Between VMP and MRP
VMP is mathematically stated as 𝑀𝑃𝑎 𝑥 𝑃𝑥 = 𝑃𝑎 and is applicable to firms

engaged in perfect competition in both the product and factor markets MRP is
mathematically stated as 𝑀𝑃𝑎 𝑥 𝑀𝑅 = 𝑃𝑎 and is applicable to a firm which is monopoly in
the product market but a perfectly competitive buyer in the factor market.
With a monopoly (or imperfect competition) in the product market, 𝑀𝑅𝑥 < 𝑃𝑥 and
so 𝑀𝑅𝑃𝑎 = 𝑀𝑃𝑎 𝑥 𝑀𝑅𝑥 < 𝑀𝑃𝑎 𝑥 𝑃𝑥 = 𝑉𝑀𝑃𝑎 . Since 𝑉𝑀𝑃𝑎 > 𝑀𝑅𝑃𝑎 , the excess of
𝑉𝑀𝑃𝑎 over 𝑀𝑅𝑃𝑎 when the firm is in equilibrium is referred to as monopolistic exploitation.
Table 5.3 is taken from Table 5.2 and also shows the value of VMP.
Table 5.3
Quantity of A Marginal Price of X Total Revenue 𝑀𝑅𝑃𝑎 𝑉𝑀𝑃𝑎

Product of A of X 𝐴 𝑇𝑅 (𝑀𝑃𝑎 𝑥 𝑃𝑂)
𝐴 𝐶𝑙𝑎
(𝑀𝑃𝑎 𝑥 𝑀𝑅)
4 5 11 165 45 55
5 4 10 190 25 40
6 3 9 198 8 27
7 2 8 192 (-6) 16
8 1 7 175 (-7) 7
Thus, a monopolist will pay ₱45.00 each if 4 units of A are employed but a perfect
competitor will pay higher at ₱45.00 each. If 6 units of resource A are employed, the
monopolist will pay only ₱8.00 for each resource but a perfect competitor will pay higher
at ₱27.00. Exploitation under monopoly occurs because the monopolist, faced by the
market rice of the resource, stops short of the employment level at which VMP of the
resource equals resource price. Nevertheless, the price paid a resource must be equal to
what it can earn in alternative employment. Exploitation does not mean that the monopolist
pays units of the resource less than do competitive firms hiring units of the same resource.
The Demand Curve of the Firm for One of Several Variable Factors
When Factor A is only one of several factors, then the 𝑀𝑅𝑃𝑎 curve no longer
represents the firms demand for factor A. We can derive a new demand curve by
considering the internal effect on the firm the results from the changes in factor price of A.
This internal effect is similar to the one discussed for a firm in perfect competition.
Page | 140
Microeconomics
Figure 5.7 – The Firm’s Demand Curve for a Resource
In Figure 5.7 above, at the initial factor price 𝑃𝑎1, the quantity of factor A employed
is a 𝑄𝑎1. As the price of factor A goes down to 𝑃𝑎2, it will encourage the monopolist to
expand the employment of A toward 𝑄𝑎1. However, as the employment of A increases, the
marginal product curves and marginal revenue product curves of complementary resources
will be shifted to the right, causing larger quantities of these resources to be used at their
given prices. The corresponding curves of substitute resources will be shifted to the left by
the greater utilization of A, and smaller quantities of substitute resources will be given at
their given prices by the monopolist. The combination of these two effects will shift the
MRP curve to the right at 𝑀𝑅𝑃𝑎2 and the quantity employed will be 𝑄𝑎2. The firm’s
demand curve for factor A will therefore consist of points tracing out a curve such as dd.
The Market Demand Curve and Factor Pricing
If all the firms demanding factor A are monopolists in their respective commodity
markets, then the market demand curve for factor A is obtained simply by the straight
forward horizontal summation of each monopolist’s demand curve for factor A. In other
words, there would be no external or industry effects resulting from a decrease in the price
of factor A, since each monopolist is the sole supplier of product for his industry.
On the other hand, if the firms demanding factor A are monopolistic competitors or
oligopolists, the market demand curve for factor A is no longer the horizontal summation
of individual firm demand curves for it. There would be external or industry effects
resulting from a decrease in the price of factor A. This is similar to what has been discussed
in the previous lesson wherein the decrease in the price of factor A results in an increase in
the output in the industry as a whole. This results in a decline in the product price which
actually discourages individual firms in the industry to limit the expansion of their output
thereby limiting the increase usage of factor A than what was expected.
Page | 141
Microeconomics
PRFORM PROGRESS CHECK TEST 2

True or False Write the word True if the statement is correct and False if it is not.
__________ 1. The Philippine Long Distance Telephone (PLDT) company can dictate the
prices of its factors.
__________ 2. A monopoly (who compete in the factor market) can maximize its profits
𝑀𝑃 𝑀𝑃 1 1
if the following conditions occur 𝑃 𝑎 = 𝑃 𝑏 = 𝑀𝐶 = 𝑃
𝑎 𝑏 𝑥 𝑥
__________ 3. The price of the commodity produced by a monopolist, who competes in

the factor market, is always higher than its marginal cost.
__________ 4. The marginal revenue product is equal to the marginal product of factor A
multiplied by the price of the commodity X.
__________ 5. When 𝑀𝑅𝑃𝑎 > 𝑃𝑎 , the monopolist can increase his profits by reducing the
employment of factor A.
__________ 6. A monopolist, who competes in the factor market, exploits the factors it
employs by paying less than it should.
__________ 7. An electrical engineer employed by Meralco usually receives a lower

salary than the one employed by a garments factory.
__________ 8. When the price of one of the several variable factor goes down, the MRP
curve of that factor will shift to the left.
__________ 9. If all the firms demanding a certain factor are monopolists in their
respective commodity markets, the market demand curve for that factor is
obtained by simply the straight forward summation of each monopolist’s
demand curve.
__________10. The hiring of more factor A, will result to the decline of the 𝑀𝑅𝑃𝑎 since it
will cause the price of factor A to rise.

Page | 142
Microeconomics
1. False
2. False
3. True
4. False
5. False
6. True
7. False
8. False
9. True
10. False
RATING: No. of correct answers x 10 = ____________

My Rating is ____________
DID YOU FARE WELL IN THE PROGRESS CHECK TEST? IF YOU DID, YOU
MAY NOW PROCEED TO LESSON 3.
Page | 143
Microeconomics
Lesson 3 – Monopoly
Lesson Objectives:
1. analyze the factor supply curve and marginal factor cost of monopsonist;
2. explain how a monopsonist price and employ one or several variable factors;
3. know the conditions giving use to monopsony; and
4. appreciate the measures to counteract monopsony.
Introduction
Monopsony is a resource market situation in which there is a single buyer if a

particular resource. This situation is the polar extreme of the situation of pure competition
among resource buyers. For example, the Semirara Coal Mining Company (SCMC) is the
only buyer of labor resources in Semirara Island. Residents in the island (and its native
labor force) have no alternative employment opportunities except with SCMC. Of course
they can go fishing and engage in farming but the returns from these types of employment
is marginal and seasonal. Another example would be a holder of a Ph.D. in nuclear
engineering who can sell his services only to the Philippine Atomic Energy Commission
(PAEC) if he prefers to work in Metro Manila, PAEC in this case is a monopsony with
regards to that specific resource – a Ph.D. holder in nuclear engineering.
Two additional factor market situations can be distinguished. The first is oligopoly,
in which there are few buyers of a particular resource that may or may not be differentiated.
One buyer takes a large enough proportion of the total supply of the factor or resource to
influence the market price of the resource. The other situation is one of monopsonistic
competition. Here, there are many buyers of a particular kind of resource, but there is
differentiation within the resource category that causes specific buyers to prefer the resource
of one seller to that of another. Our analysis on monopsony may be applicable to oligopsony
and monopsonistic competition.
Factor Supply Curve and Marginal Factor Cost
As the only buyer of a resource, the monopsonist faces that positively sloped market
supply curve for the factor or resource. This means that if he wants more of the resource,
he must pay a higher price not only for the additional units, but for all units of the resource
Page | 144
Microeconomics
that he purchases. Recall that under perfect competition, the firm can get as many units of
the resource per unit of time as it desires at the going market price.
Hence, in perfect competition, the resource supply curve is horizontal or perfectly elastic
even though the market curve may be upward sloping to the right or less than perfectly
elastic.
Marginal Factor Cost (MFC) is defined as the change in the firm’s total cost resulting
from a one-unit change in the purchase of the factor per unit of time. Mathematically this
is expressed as 𝑀𝐹𝐶𝑎 = 𝑇𝐶𝑎 . MFC is higher than to enable the monopsonist to hire more
factors. 𝑄𝑎 Inevitably, the MFC curve faced by a monopsonist lies above the factor supply
curve that he faces.
Table 5.4 – The Computation of Marginal Factor Cost

QUANTITY OF FACTOR PRICE OF A TOTAL FACTOR MARGINAL FACTOR
FACTOR A COST OF A COST OF A
1 2 2 4
2 4 8 6
3 6 18 10
4 8 32 14
5 10 50 18
6 12 72 22
Figure 5.8 _ Marginal Factor Cost Curve and Factor Supply Curve
Columns 1 and 2 of Table 5.4 present a typical factor supply schedule which is
plotted by the curve S, in Figure 5.8. Column 3 shows the total cost of factor A to the firm
for different quantities purchased. Column 4 shows the MFC of factor A which is plotted
by the curve 𝑀𝐹𝐶𝑎 in Figure 5.8. Clearly it can be seen that under perfect competition a
firm will pay ₱4.00 each if it employs 2 units of factor A whereas a monopsonist has to pay
₱6.00 each for the same quantity of resource. Accordingly, the 𝑀𝐹𝐶𝑎 curve has to be above
the factor supply curve as shown in Figure 5.8.
The marginal factor cost curve bears the same relationship to the supply curve that
a marginal cost curve bears to an average cost curve. In fact, the market supply curve of
factor A is the average cost curve of factor A alone, and the marginal factor cost curve is
Page | 145
Microeconomics
the marginal cost curve of factor A alone. Obviously then, if the supply (average cost)
curve of A is rising, the marginal factor cost (marginal cost) curve must be above it.
Pricing and Employment for One Variable Factor
In order to maximize his total profits, the monopsonist will employ as many factor
A provided that 𝑀𝑅𝑃𝑎 > 𝑀𝐹𝐶𝑎 and stops having A when 𝑀𝑅𝑃𝑎 = 𝑀𝐹𝐶𝑎 . This is of course
assuming that factor A is the only variable factor. Alternatively, the monopsonist maximize
his profits when he employs the quantity of factor at which 𝑀𝑃𝑎 𝑥 𝑀𝑅𝑥 = 𝑀𝐹𝐶𝑎 .
Figure 5.9 – Marginal Revenue Product, Marginal Factor Cost and

Profit Maximization for a Monopsonist
In Figure 5.9 above, 𝑀𝑅𝑃𝑎 = 𝑀𝐹𝐶𝑎 at point C, thus, the monopsonist will hire 𝑄𝑎
of factor A. However, instead of paying at B, the monopsonist pays the amount 𝑃𝑎 only.
In other words, there is monopsonistic exploitation of factor A as shown by the area 𝑃𝑎 𝐶𝐷.
The same area represents monopsony profits as a result of exploitation Observe that at 𝑄𝑎
in Figure 5.9 𝑀𝑅𝑃𝑎 > 𝑃𝑎 which means that the monopsonist is able to add to its total
revenue than to the cost of the additional quantity of factor A used. Should the monopsonist
employ that quantity of factor A at which 𝑀𝑅𝑃𝑎 > 𝑃𝑎 as what competitive buyer would
have done, he would make less profits. He, therefore, maximizes his profits by restricting
the quantity of resource used and pays it a price per unit which is lower than its MRP.
Pricing and Employment of Several Variable Factors
The least-cost factor combination to produce any level of output for a monopsonist
using two or more variable factors is that combination at which the marginal product per
peso’s worth of a factor is equal to the marginal product per peso’s worth of every other
variable factor. That is:
𝑀𝑃𝑎 𝑀𝑃𝑏 𝑀𝑃𝑏

= ……….=
𝑀𝐹𝐶𝑎 𝑀𝐹𝐶𝑏 𝑀𝐹𝐶𝑏
Page | 146
Microeconomics
The reciprocal of either of the fractions, i.e., 𝑀𝐹𝐶𝑎 , represents the marginal cost of the
product at whatever output the firm is producing. A unit of factor A used results in an
increment 𝑀𝐹𝐶𝑎 to total costs and an amount 𝑀𝑃𝑎 to total product.
In order for the monopsonist to maximize his total profits, he must not only use the
best or Least-cost factor combination, but he must also use the correct amount of each
variable factor to produce his best level of output for a certain commodity/ Thus, the
monopsonist must follow the following necessary conditions for profit maximization.
= = =
𝑀𝐹𝐶𝑎 𝑀𝐹𝐶𝑏 𝑀𝐶𝑥 𝑀𝑅𝑥
1 1
Thus, the least-cost combination is not enough. If MC > MR or its reciprocal 𝑀𝐶 > 𝑀𝑅.
The firm’s level of output is not enough to maximize its profits. The monopsonistic firm
has to increase its output which of course can be done by hiring more factors A and B (in
the right combination). More factors used means that marginal cost rises until such point
where it equalizes with marginal revenue. Once that point is reached then the monopsonist
have to stop the expansion of its production to maximize revenue. Individually, factor A
should be hired up to the point at which: 𝑀𝑃𝑎 𝑥 𝑀𝑅𝑥 = 𝑀𝐹𝐶𝑎 , or 𝑀𝑃𝑎 = 1. Likewise,
factor B should be used up to the point at 𝑀𝐹𝐶𝑎 𝑀𝑅𝑥 used up to the point at which:
𝑀𝑃𝑏 1
𝑀𝑃𝑏 𝑥 𝑀𝑃𝑥 = 𝑀𝐹𝐶𝑏 or = .
𝑀𝐹𝐶𝑏 𝑀𝑅𝑥
From the two equations, we can state: = = =
𝑀𝐹𝐶𝑎 𝑀𝐹𝐶𝑏 𝑀𝐶𝑥 𝑀𝑅𝑥
It can be obtained that the conditions for profit maximization is applicable to all classifications of
both product seller’s markets and factor buyer’s markets under conditions of perfect competition,
we simply replace MFCx with the price of factor A and replace MR with the price of product X.
Conditions Giving Rise to Monopsony
There are two basic reasons why a monopsony exists. First, when the resource is specialized
to a particular user. In this case, the marginal revenue product is highest for th e particular use it
was intended for, compared to any alternative employment in which it can be conceivably used. For
example, PLDT training telephone technicians for their company. These technicians are experts in
the different parts of the telephone and how it works. It is precisely because of this specific kind of
expertise that they may find it hard to find employment elsewhere (and at the same rate) since there
is only one telephone company in Metro Manila and other parts of the Philippines.
Another example, which is a common practice in the Philippines, is when garments

manufacturer (for export) subcontracts part of his contracted output to small firms. These small
firms can not sell their output to any other firm, because of the existing arrangements. The garments
firm in this case acts as a monopsonist. In the field of entertainment, we know that film companies,
like Regal Films and Viva Films have contracts with their stars. During the period of the contract,
the actor or actress cannot appear in any other film companies making Viva and Regal the sole buyer
for their services.
Page | 147
Microeconomics
The second condition from which monopsony may stem is the immobility of certain
resources. By immobility, we are not referring to inanimate objects like a building or land but also
refers to people. The concept of mobility in this case, is that of tran sferring resources from where
it is less productive to where it is more productive, and not simply a physical movement from one
place to another.
The immobility of labor resource for example, may be due to the worker’s emotional ties to
the community together with the fear of the unknown. Another would be ignorance of existing –
alternative employment opportunities; lack of funds to allow the worker to seek alternative jobs and
move to other fields of work. Workers who have been staying long with a firm and have
accumulated pension rights may be reluctant to leave. For an archipelagic country, like the
Philippines, the geographic location of the worker may hinder his mobility.
Measures to Counteract Monopsony
Two alternatives are available to prevent or minimize monopsony. The first alternative is
to set a minimum price for a specific factor or resource. The second one is to design and implement
programs aimed to increase the mobility of resources which will reduce the monopsonistic power
of particular resource users.
The government or organized groups of resource suppliers can set the minimum resource
prices. This can be analyzed by looking at Figure 5.10 below.
Figure 5.10 – Control of Monopsony by Minimum Resource Prices
At the point where 𝑀𝑅𝑃𝑎 = 𝑀𝐹𝐶, the monopsonist will employ 𝑄𝑎 of factor A but instead
of paying at B, it pays only 𝑃𝑎 . Once the minimum price is set at 𝑃𝑎1 , CDE, 𝑀𝑅𝑃𝑎 curve will
intersect the new MFC curve at point C. Thus, the minimum price has two effects: 1) it raises the
price of the resource or factor (but still lower than what the monopsonist should pay, i.e., point B),
and 2) it increases the employment of the resource. Any price between B and 𝑃𝑎1 will also
counteract exploitation but will result to unemployment of the resource. This is due to the fact, that
resource sellers will want to put more on the market than buyers are willing to buy.
Page | 148
Microeconomics
While it is quite conceptually easy to determine minimum pricing, it is in reality difficult to

pinpoint the exact price level. The best the government can do is pass minimum wage laws
applicable to all industries. At the firm level, unions can set minimum wage levels through the
collective bargaining agreements.
Several programs may be implemented to increase the mobility of resources. First, the
government must set up an efficient institution to collect and disseminate information regarding
alternative employment practices. Meralco Foundation, a private organization, is doing a similar
service, but is limited only to specific technical jobs.
Second, the educational system should be structured such that horizontal and vertical
mobility of resources are encouraged and promoted. For example, educational opportunities can be
used to enable the younger generation to attain higher paying and higher position. Older employees
can be retained to attain upward movement through higher skill classifications. Workers in low
paying jobs can be retained into areas with high paying jobs. Third, the government must subsidize
the transportation workers to enable them to move into alternative employment areas. The subsidy
may take the form of government loans or outright grants to assist the worker to relocate.

AND THEN THE MODULE TEST
Page | 149
Microeconomics
True or False Write the word True if the statement is correct and False if it is not.
___________ 1. A monopsonist in the factor market is necessarily a monopolist in the

product market.
___________ 2. A monopsonist earns profits by not hiring enough factors.
___________ 3. The factor or resource hired by a monopsonist usually receives less than
the same factor hired by a perfect competitor.
___________ 4. Job specialization is one cause of monopsony.
___________ 5. When 𝑀𝑅𝑃𝑎 is greater than 𝑀𝐹𝐶𝑎1 the monopsonist will hire less of factor A.
____________ 6. One solution to reduce monopsony is through the educational system.

1 1
____________ 7. If > , the monopsonist should reduce is level of output to maximize
𝑀𝐶 𝑀𝑅
profits.
____________ 8. Through collective bargaining agreements, the unions, can actually raise their
salaries over what the monopsonist is paying them.
____________ 9. Immobility of resources refer to the physical movement of resources only.
____________10. A Doctor of Business Administration degree holder is subject to less or no

monopsonistic exploitation compared to a holder of a Ph.D. (Nuclear Physics)
degree.
Page | 150
Microeconomics
1. false
2. true
3. false
4. true
5. false
6. true
7. false
8. true
9. false
10. true
RATING: No. of correct answers x 10 = _________

My Rating is __________
NOW PROCEED TO THE MODULE TEST.
Page | 151
Consumer's Equilibrium MODULE - 6
Consumer's Behaviour
14
Notes
CONSUMER'S EQUILIBRIUM
We buy many goods and services to satisfy our wants. Using up of goods and
services to satisfy wants is called consumption and the economic agent who buys
goods and services is called a consumer. When a consumer buys any good or
service, his/her main objective is to get maximum satisfaction from the quantity of
the commodities purchased by spending his/her income at the given market price.
How does a consumer maximize his/her satisfaction from spending his/her income
on various goods and services is the subject matter of this chapter.
OBJECTIVES
After completing this lesson, you will be able to:
z understand the meaning of consumer’s equilibrium;
z understand the meaning of utility, marginal utility and total utility;
z understand the relationship between total utility and marginal utility;
z explain the law of diminishing marginal utility;
z explain consumer’s equilibrium, based on utility analysis;
z understand the meaning of indifference curve, indifference map, budget line,
budget set and marginal rate of substitution; and
z derive consumer’s equilibrium using indifference curve and budget line.
14.1 MEANING OF CONSUMER’S EQUILIBRIUM

Equilibrium means a state of rest from where there is no tendency to change. A
consumer is said to be in equilibrium when he/she does not intend to change his/
her level of consumption i.e., when he/she derives maximum satisfaction. Thus,
consumer’s equilibrium refers to a situation where the consumer has achieved
ECONOMICS 27
MODULE - 6 Consumer's Equilibrium
maximum possible satisfaction from the quantity of the commodities
purchased given his/her income and prices of the commodities in the market.
As the resources are scarce in relation to unlimited wants, a consumer has to follow
some principles or laws in order to attain the highest level of satisfaction.
There are two main approaches to study consumer’s equilibrium. They are as
follows:
Notes
1. Cardinal utility approach (or Marshall’s utility analysis)
2. Ordinal utility approach (or indifference curve analysis)
14.2 CARDINAL UTILITY APPROACH

The theory of consumers behaviour by using utility approach was first given by the
noted economist Alfred Marshall.
Before discussing how a consumer attains equilibrium , we need to understand the

concept of utility, marginal utility and total utility.
(i) Utility
Utility is defined as the power of a commodity to satisfy a human want. Utility
of a commodity is the total amount of psychological satisfaction that a person gets
from consumption of a good or service, e.g. a thirsty person derives satisfaction
from drinking a glass of water. So a glass of water has got utility for the thirsty
person. Utility differs from person to person. Utility is subjective and cannot be
measured quantitatively. Yet for the sake of convenience it is measured in ‘utils’.
Marshall suggested that the measurement of utility should also be done in
monetary terms by converting ‘util’ into money by using the following formula
Utility in Money = Utility in Util/Utility of a rupee. Utility of rupee can be assumed
to be any number such as 1, 2, 3 ... . Let utility of a rupee is assumed to be 2 utils.
10
Then 10 utils = = ` 5.
2
(ii) Marginal Utility (MU)

Marginal utility is the addition to the total utility derived from the consumption
of an additional unit of a commodity. It can also be defined as the utility from
the last unit of a commodity consumed. Let us explain the concept of marginal
utility with the help of an example. Suppose, a consumer gets total utility of 10 utils
from consumption of one orange and 18 utils from two oranges. He gets 8 utils
from consumption of second orange. So, marginal utility of second orange is 8
utils. If total utility derived from three oranges is 24 utils then marginal utility of
28 ECONOMICS
three oranges is 6 utils (i.e. 24-18 utils). In this case third orange is the last orange.
Thus marginal utility of 3 oranges is 6 utils. Marginal utility can be calculated by
the following formula:
MUn = TUn – TUn–1
ǻTU
or MU = Notes
ǻX
Where MUn = Marginal utility of nth unit of the commodity
TUn = Total utility of n units
TUn–1 = Total utility of n–1 units
Xn = Quantity of nth unit of good X
Xn–1 = Quantity or (n–1)th unit of good X
“n” takes the values 1, 2, 3, ... .
(iii) Total utility
Total utility is the total satisfaction obtained from the consumption of all
possible units of a commodity. For example, if the first orange gives you a
satisfaction of 10 utils, second one gives you 8 utils and third one gives you 6 utils,
then total utility from three oranges = 10 + 8 + 6 = 24 utils. Total utility can be
obtained by summing up marginal utilities from consumption of different units of
a commodity. Thus, total utility can be calculated as:
TUn = MU1 + MUZ + MU3 + ........ MUn
or TUn = 6MU
where, TUn = Total utility from n units of a given commodity

MU1, MU2, MU3, MUn = Marginal utilities from 1st, 2nd 3rd and nth unit of the
commodity
14.3 RELATIONSHIP BETWEEN TOTAL UTILITY AND

MARGINAL UTILITY
The relationship between total utility and marginal utility is explained with the help
of following table 14.1 and Fig. 14.1.
ECONOMICS 29
Table 14.1
Units of Oranges Marginal Utility Total Utility
Consumed (Utils) (Utils)
0 – 0 º
»
1 10 10 » TU increases at diminishing
Notes »
2 8 18 » rate (MU is
»
3 6 24 » positive)
»
4 2 26 ¼
5 0 26 @ TU is maximum when MU is
zero
6 –2 24 @ TU falls when MU is
negative
30
C
25 TU
(TU and MU)
20
Utility
15
10 A
5
B
0
1 2 3 4 5 6
MU
No of units of oranges
Fig. 14.1
1. MU is the rate of change of TU. It means that Total Utility increases as long
as marginal utility is positive. In the table 14.1 marginal utility is declining
between the range AB but is positive. So total utility is increasing at decreasing
rate.
2. Total Utility is maximum when marginal utility is zero. At point B, MU = 0, and
the corresponding point on TU is C where TU is maximum.
3. Total utility starts declining when marginal utility becomes negative (i.e., less
than zero)
30 ECONOMICS
14.4 LAW OF DIMINISHING MARGINAL UTILITY
It is a matter of common observation that as we get more and more units of a
commodity, the intensity of our desire for that commodity tends to diminish. The
law of diminishing marginal utility also explains the same thing. It states that ‘as
more and more units of a commodity are consumed, marginal utility derived
from each successive unit goes on diminishing.’
Notes
The law can be explained with the help of an example. Suppose, a thirsty man
drinks water. The first glass of water he drinks will give him maximum satisfaction
(utility), say, 20 utils. Second glass of water will also fetch him utility but not as
much as the first one because a part of his thirst is satisfied by drinking the first glass
of water. Suppose he gets 10 utils from the second glass. It is just possible that he
may get zero utility from the third glass because his thirst has now been satisfied.
There will be negative utility from the fourth glass of water. Any rational consumer
will not consume additional glass of water when it gives disutility or negative
utility.
14.4.1 Assumption of Law of Diminishing Marginal Utility
The law of diminishing marginal utility operates under certain specific conditions.
These are called assumptions of the law. Some important assumptions of the law
are:.
1. It is assumed that utility can be measured and a consumer can express his
satisfaction in quantitative terms like 1, 2, 3 etc. We have already said that unit
of measurement of utility is ‘util’. So utility is cardinal.
2. Quality of the commodity should not undergo any change. Take the above
example of glass of water. From the quality point of view a consumer who
drinks a glass of cold water must continue with the same. He or she cannot
change its quality from cold to normal as normal water give different
satisfaction.
3. Consumption should not proceed at intervals. It should be a continuous
process. Continuing with the above example, second glass of water, if
consumed two hours after the first glass of water was consumed, may give
more, less or equal satisfaction.
4. Consumer should be a rational person. This means that he/she prefers more
quantity to less quantity of a good.
5. Time period of consumption should not be too long. Consumer’s tastes,
habits, income etc. may change if the time gap is more.
6. The price of the substitute and complementary goods should not change. If
these prices change, it may be difficult to predict about the utility derived from
the commodity in question.
ECONOMICS 31
14.4.2 Exceptions to the Law of Diminishing Marginal Utility
Some of the important exceptions to the law are following:
(i) A miser is not a good subject for this law. His desire for more wealth may in
fact increase with every successive increase in the accumulation of wealth.
(ii) A collector of rare articles like stamps, coins, paintings etc. may escape this
law.
Notes
(iii) The law may not apply when it comes to a melody recital or a beautiful scenic
view.
These are in fact the only real exceptions of the law and these too do not prove
real hurdles to the application of the law. It is easy to visualize that a miser or
stamp collector or a musician may find their marginal utilities increasing
instead of decreasing as postulated by the law. But this tendency shall not last
for long having reached a particular stage; the law must come into operation.
INTEXT QUESTIONS 14.1

1. What is meant by consumer’s equilibrium?
2. Define the following:
(i) Utility (ii) Marginal Utility (iii) Total Utility
3. State the law of diminishing marginal utility.
4. What will be the total utility when marginal utility is zero?
14.5 CONSUMER’S EQUILIBRIUM IN CASE OF A

SINGLE COMMODITY
Consumer’s equilibrium in case of a single commodity can be explained on the
basis of the law of diminishing marginal utility. How does a consumer decide as to
how much to buy of a good? It will depend upon two factors.
(a) The price she pays for each unit which is given and
(b) The utility she gets
At the time of purchasing a unit of a commodity, a consumer compares the price
of the given commodity with its utility. The consumer will be at equilibrium when
marginal utility (in terms of money) equals the price paid for the commodity say
‘X’ i.e. MUx = PX. (Note that marginal utility in terms of money is obtained by
dividing marginal utility in utils by marginal utility of one rupee).
If MUX > Px, the consumer goes on buying the commodity because she is paying
less for each additional amount of satisfaction. As she buys more, MU falls due to
operation of law of diminishing marginal utility. When MU becomes equal to price,
consumer gets maximum satisfaction and now she is at equilibrium. When MUX
32 ECONOMICS
< Px, the consumer will have to reduce consumption of the commodity to raise his
total satisfaction till MU becomes equal to price. This is because she is paying more
than the additional amount of satisfaction that she is getting.
Consumer’s equilibrium (in case of single commodity) can be explained with the
help of table 14.2. Suppose, the consumer wants to buy a good which is priced at
`.10 per unit. Further, suppose, MU obtained from each successive unit is
determined. Assumed that 1 util = Re. 1. Notes
Table 14.2: Consumer’s Equilibrium (in case of a single commodity)
Consumption `)
Price (` MUX MUX(` `) Difference Remarks
(Units of X) (PX) (Utils) (1 Util = Re. 1)
1 10 20 20/1 = 20 10 MUx> Px,

consumer will
2 10 16 16/1 = 16 6 increase the

consumption
3 10 10 10/1 = 10 0 MUx = Px,

consumer’s
equilibrium
4 10 4 4/1 = 4 –6 MUx < Px,

consumer will
5 10 0 0/1 = 0 –10 decrease the

consumption
6 10 –2 –2/1 = –2 –12
It is clear from the table 14.2 that the consumer will be at equilibrium when he buys
3 units of the commodity X. He will increase consumption beyond 2 units as MUx
> Px. He will not consume 4 units or more of the commodity X as MUx < Px.
14.6 CONSUMER’S EQUILIBRIUM IN CASE OF TWO

OR MORE COMMODITIES
The law of diminishing marginal utility applies in case of one commodity only. But
in real life a consumer normally consumes more than one commodity. In such a
situation, law of equi-marginal utility helps in optimum allocation of his income.
Law of equi-marginal utility is based on law of diminishing marginal utility.
According to the law of equi-marginal utility a consumer will be in equilibrium
when the ratio of marginal utility of a commodity to its price equals the ratio of
marginal utility of other commodity to its price.
Let a consumer buys two goods X and Y. Then at equilibrium
ECONOMICS 33
MUx/Px = MUY/PY = MU of last rupee spent on each good, or simply MU of Money.
MU X MU Y MU Z
PX = PY PZ = MUMoney – MUMoney
Similarly if there are three goods X, Y, Z then the condition of equilibrium will be
simply MU Money.
Notes
Thus, to be in equilibrium
1. Marginal utility of the last rupee of expenditure on each good is the same.
2. Marginal utility of a good falls as more of it is consumed.
To explain the consumer’s equilibrium in case of two goods let us take an example.
Suppose a consumer has ` 24 with him to spend on two goods X and Y. Further,
suppose price of each unit of X is ` 2 and that of Y is ` 3 and his marginal utility
schedule is given in table 14.3.
Table 14.3: Consumer’s Equilibrium (in case of two goods)
Units MUX MUX/Px MUY MUY/PY
(A Rupee worth) (A Rupee worth)
of MU of MU
1 20 20/2 = 10 24 24/3 = 8
2 18 18/2=9 21 21/3=7
3 16 16/2 = 8 18 18/3=6
4 14 14/2 = 7 15 15/3 = 5
5 12 12/2 = 6 12 12/3 = 4
6 10 10/2=5 9 9/3=3
For obtaining maximum satisfaction from spending his income of ` 24, the
consumer will buy 6 units of X by spending ` 12 (` 12 = 2 × 6) and 4 units of Y
by spending ` 12 (` 12 = 2 × 6). This combination of goods brings him maximum
satisfaction (or state of equilibrium) because a rupee worth of MU in case of good
X is 5 (MUx/Px = 10/2) and in case of good Y is also 5
(MUY/PY = 15/3)
(= MU of last rupee spent on each good)
It should be noted that, consumer’s maximum satisfaction is subject to-budget
constraints i.e. the amount of money to be spent by the consumer (` 24 in this
example)
34 ECONOMICS
What happens when the consumer is not in equilibrium?
Suppose, MUx/Px is greater than MUy/Py. This means that MU from last rupee
spent on X is greater than the MU of the last rupee spent on Y. This induces the
consumer to transfer his expenditure from Y to X. As a consequence, MUx falls
and MU rises. The act of transfer of expenditure continues until MUx/Px becomes
equal to MUy/Py.
Notes
14.7 LIMITATION OF UTILITY ANALYSIS
In the utility analysis, it is assumed that utility is cardinally measurable, i.e., it can
be expressed in quantitative term. However, utility is a feeling of mind and there
cannot be a standard measure of what a person feels. So, utility cannot be
expressed in figures.

1. State the necessary condition for consumer’s equilibrium in case of a single
good.
2. What are necessary conditions for consumer’s equilibrium in case of two
goods?
14.8 ORDINAL UTILITY APPROACH (INDIFFERENCE

CURVE ANALYSIS)
You have already studied the utility approach which was based on the assumption
that utility is measurable numerically (like 1 util, 2 utils, 3 utils). This is called
cardinal utility approach. Prof. J.R. Hicks criticized the utility approach as
unrealistic because satisfaction (utility) is a subjective phenomenon and so it can
never be measured precisely. He, therefore, presented an alternative technique
known as indifference curve approach (also called ordinal utility approach). It is
based on the assumption that every consumer has a scale of preference in the form
of assigning ranks (like 1st 2nd, 3rd rank) to different combinations of two goods
called bundle and can tell which bundle he likes most.
Before we proceed to discuss the consumer’s equilibrium through indifference
curve approach, let us understand some useful concepts related to indifference
curve analysis.
(i) Meaning of Indifference Curve
When a consumer consumes various goods and services, then there are some
combinations (bundles) which give him same satisfaction. The graphical
representation of such combinations is termed as indifference curve.
ECONOMICS 35
An indifference curve is a curve that shows all those combinations (bundles) of two
goods which give equal satisfaction to the consumer.
Table 14.4 shows an indifference schedule showing all the combinations of good
X and good Y giving ‘equal satisfaction to the consumer.
Table 14.4: Indifference Schedule
Notes Combinations Good X Good Y Marginal Rate of Substitution
(Units) (Units) ' Y/'
(' ' X)
A 1 8 –
B 2 4 4Y: 1X
C 3 2 2Y: 1X
D 4 1 1Y : 1X
Combinations A, B, C and D of good X and Y viz. (1X + 8Y), (2X + 4Y), (3X +
2Y) and (4X + 1Y) give the consumer equal satisfaction. In other words, consumer
is indifferent between these combinations of good X and good Y. When these
combinations are represented graphically, we get an indifference curve as shown
in Fig. 14.2.
Good Y
8 A
7
6
5
4 B
3
2 C
D
1
IC
0 1 2 3 4 Good X
Fig. 14.2
(ii) Monotonic Preferences

Consumer’s preferences are called monotonic if and only if between two bundles,
consumer prefers the bundle which has more of at least one of the good and no less
of other good as compared to other bundles. For example, between the bundles
36 ECONOMICS
(2X + 2Y), (1X + 2Y), (2X + 1Y) and (1X + 1Y), the consumer will prefer only
bundle (2X + 2Y) to all the three bundles, if his preferences are monotonic.
(iii) Indifference Map
An indifference map is a collection of indifference curves that represent
different levels of satisfaction. Higher indifference curves represent higher level
of satisfaction because higher indifference curves represent more quantities of Notes
both the goods or same quantity of one good and more quantity of other good.
Good Y
IC3
IC2
IC1
0 Good X
Fig. 14.3 Indifference Map
An indifference map containing three indifference curves IC1, IC2 and IC3, is
drawn in Fig. 14.3. All the bundles on IC2 give more satisfaction to the consumer
in comparison to IC1. Similarly, the bundles on IC3 give more satisfaction to the
consumer in comparison to IC1 and IC2. This is a result of monotonic preferences.
(iv) Budget Line

A budget line graphically represents all possible combinations of two goods which
a consumer can buy with his entire income at the prevailing market prices.
Anywhere on the budget line consumer is spending his entire income either on
single or both the goods. Suppose, the consumer wants to buy good X and good
Y; price of each unit of X is P and that of Y is P2; Then
Accordingly the expenditure on X will be equal to P1X and the same on Y will be
equal to P2Y.
Total expenditure on good X and Y will be P1X + P2Y. Let the money required to
buy these goods is denoted as M. So we can write that
P1X + P2Y = M
ECONOMICS 37
This is called the equation for budget line.
This is shown in Fig. 14.4
Quantity of good Y
p
Notes 1x
3 Bu + p
dg 2 y
et = M
lin
2 e
O X
1 2 3 B
Quantity of Good X
Fig. 14.4
In the Fig. 14.4, AB is the budget line. Point A is located by dividing the entire
income over quantity of good Y only. Similarly point B is located by dividing the
entire income over quantity of good X only. At any point on the line AB other than,
A and B, the consumer can buy certain combination of X and Y by using her
income.
A budget line changes when either the prices of the goods or income of the
consumer or both changes. A budget line is negatively sloped because to buy more
units of a good, consumer must buy less units of other good as consumer’s income
is fixed.
Slope of budget line = Quantity of other good sacrificed/ Quantity of good
obtained = 'Y/'X
Suppose, price of good X is `.2 and that of good Y is Re.1. So, he has to sacrifice
2 units of good Y to obtain one unit of good X. In this example,
Slope of budget line = 'Y/'X
= 2/1
2/1 is nothing but the price ratio between good X and good Y. So the price ratio
indicates the slope of budget line. Thus,
Slope of budget line = Px/Py. This is also called market rate of exchange (MRE)
because the two goods can be exchanged at this rate, given their prices in the
market.
38 ECONOMICS
(v) Budget Set
Budget set is the set of all possible combinations of two goods which a
consumer can afford, given his income and market prices of the two goods.
So, a budget set includes all the bundles of two goods which consumer can afford
even if her entire income is not spent.
(vi) Marginal rate of substitution (MRS) Notes

Marginal rate of substitution refers to the rate at which consumer is willing
to give up amount of other good to obtain one extra unit of the good in
question without affecting total satisfaction. So, the rate of substitution of one
commodity for another is called marginal rate of substitution. It is expressed as
MRSxy of good X for good Y. Symbolically, MRSxy = Loss of good Y/ Gain of
good X = 'Y/ 'X
MRSxy can be explained with the help of Fig. 14.5.
Y1 A
Good Y
DY
Y2 B
C
DX
IC
X
X1 X2 Good X
Fig. 14.5
MRSXY = 'Y/'X = AC/CB

AC/CB is the slope off indifference curve, i.e. slope of indifference curve =
MRSXY. As the consumer gets more and more units of good X, marginal utility of
good X goes on falling with every increase in units of good X. Simultaneously, the
consumer is left with lesser units of good Y. So, marginal utility of Y rises.
Therefore, he is willing to give up lesser quantity of good Y for obtaining additional
units of good X. Hence MRS diminishes along an indifference curve when we
move from upwards to downward.
14.9 PROPERTIES OF INDIFFERENCE CURVES

(i) Indifference Curves are always convex to the origin
Indifference curves are always convex to the origin because of diminishing
marginal rate of substitution. As the consumer consumes more and more of one
ECONOMICS 39
good, his marginal utility of this good keeps on declining and he is willing to give
up less of other good. Therefore, indifference curves are convex to the origin.
(ii) Indifference Curves slope downwards
It implies that as a consumer consumes more of one good, he must consume less
quantity of the other good so that the total utility remains the same.
Notes (iii) Higher Indifference Curves represent Higher level of satisfaction
Consider Fig. 14.6
A B
Y1
Good Y
IC2
IC1
O X
X 1 X2 Good X
Fig. 14.6
Bundle A on indifference curve IC1, contains OY1 quantity of good Y and OX,
quantity of good X. Bundle B on indifference curve IC2 has same quantity i.e. OYl
of good Y but more quantity i.e. OX2 of good X. Since, the consumer’s preferences
are monotonic, he will prefer bundle B to bundle A. It means, higher indifference
curves represent higher level of satisfaction.
(iv) Indifference Curves can never Intersect
To analyze this, let us consider Fig. 14.7
Y
C A
Good Y
IC2
IC1
O X
Good X
Fig. 14.7
40 ECONOMICS
We have two indifference curves that intersect at point B. The consumer is
indifferent between bundles A and B as they lie on the same indifference curve IC1.
Similarly, the consumer is indifferent between bundles C and B as they lie on the
same indifference curve IC2. This implies that bundles A and C give the consumer
the same level of satisfaction. However, this is not possible as higher indifference
curve represents higher level of satisfaction.
Notes
14.10 ASSUMPTIONS OF INDIFFERENCE CURVES
Indifference curve analysis is based upon the following assumptions:
(i) It is assumed that the consumer has fixed amount of money whole of which
is to be spent on two goods, given the market prices of goods.
(ii) It is assumed that the consumer has not reached the point of satiety. He always
prefers more of both the commodities.
(iii) Consumer can rank his preferences on the basis of the satisfaction from each
bundle of goods.
(iv) It is assumed that marginal rate of substitution is diminishing.
(v) Consumer is a rational person i.e. he always aims to maximize his satisfaction.
14.11 CONSUMER’S EQUILIBRIUM BY INDIFFERENCE

CURVE ANALYSIS
As stated earlier, consumer’s equilibrium refers to a situation when he gets
maximum satisfaction and he feels no need to change his position, subject to his
income and market prices of two goods.
Condition of Consumer’s Equilibrium

According to indifference curve approach, a consumer will be at equilibrium when:
(i) Budget line is tangent to the indifference curve.

i.e. slope of budget line = slope of indifference curve
Or, MRSXY = Px/PY
Suppose, two goods consumed are X and Y. Further suppose the consumer wants
to increase consumption of good X in place of good Y. MRS is the rate/at which
consumer is willing to sacrifice amount of Y to get one more unit of X. Market rate
of exchange (MRE) is the rate at which consumer has to sacrifice amount of Y to
get one more unit of X.
ECONOMICS 41
When MRS>MRE, it implies that in order to obtain one unit of X, the consumer
is willing to sacrifice more units of Y than the market allows. This will lead to
increase in consumption of X but decrease in consumption of Y. MRS starts falling.
He continues to consume more of X till MRS becomes equal to MRE.
When MRS<MRE, it implies that inorder to get one more unit of X, the consumer
is willing to sacrifice less units of Y than the market requires. He will reduce the
Notes
consumption of X and increase consumption of Y. MRS Starts rising. He continues
reducing consumption of X till MRS becomes equal to MRE.
To study consumer’s equilibrium, let us study the Fig. 14.8
A
G
C
Good Y
Y1 E
IC3
D IC2
IC1
O X
X1 B Good X
Fig. 14.8
Given the indifference map and the budget line, the consumer is at equilibrium at
point E. The consumer obtains maximum satisfaction when, he consumes bundle
E containing OXl quantity of good X and OY1 quantity of good Y. At E point
budget line is tangent to the indifference curve IC2, i.e. MRS = MRE= Px/PY Note
that the consumer can buy bundles C and D because they also lie on his budget line
but these bundles lie on lower indifference curve which represents lower level of
satisfaction. He will like to consume bundle G lying on indifference curve IC3
which represents highest level of satisfaction but it is beyond his budget. So the
consumer's equilibrium bundle is X1, Y1 at point E where the budget line is tangent
to indifference curve.
42 ECONOMICS

1. What is an indifference curve?
2. Define marginal rate of substitution.
3. What do you mean by monotonic preferences? Give example.
Notes
4. State the conditions of consumer’s equilibrium in indifference curve approach.
WHAT YOU HAVE LEARNT

z Consumer’s equilibrium refers to a situation when he/she spends his/her
money income on purchase of a commodity/bundle in such a way that yields
him/her maximum satisfaction and he/she feels no urge to change.
z Utility is the power of a commodity to satisfy a want.
z Marginal utility is the addition to the total utility derived from the consumption
of an additional unit of a commodity, say good X.
'TU
MUX =
'X
z Total utility (TU) is the total satisfaction obtained from the consumption of all
possible units of a commodity.
TUn = MU1 + MU2 + MU3 + ...... MUn
z (i) TU increases when MU is positive
(ii) TU is maximum when MU is zero
(iii) TU falls when MU is negative
z Law of diminishing marginal utility states that ‘as more and more units of a
commodity are consumed, marginal utility derived from each successive unit
goes on diminishing.’
z In case of a single commodity a consumer will be at equilibrium when marginal
utility (in terms of money) equals the price paid for the commodity.
i.e., MUX = PX, where X is the commodity.
z In case of two goods, a consumer will be in equilibrium when (i) the ratio of
MU of a good to its price equals the ratio of MU of another good to its price,
i.e. MUX/PX = MUY/PY = MU of last rupee spent on each good. This is called
law of equimarginal utility.
z An indifference curve is a curve that shows all those combinations of two
goods which give equal satisfaction to the consumer
ECONOMICS 43
z An indifference map is a collection of indifference curves that represent
different levels of satisfaction.-
z A budget line graphically represents all possible combinations of two goods
which a consumer can buy with his entire income at the prevailing market
prices.
z Budget set is the set of all possible combinations of two goods which a
Notes consumer can afford, given his income and market prices of the two goods.
z Marginal rate of substitution refers to the rate at which consumer is willing to
give up amount of other good to obtain one extra unit of the good in question
without affecting total satisfaction.
z Consumer’s preferences are called monotonic if and only if between two
bundles, consumer prefers the bundle which has more of at least one of the
good and no less of the other good as compared to the other bundles.
z Properties of indifference curves are:
(i) Indifference curves are always convex to the origin;
(ii) Indifference curves always slope downwards;
(iii) Indifference curves never intersect;
(iv) Higher Indifference curves represent higher level of satisfaction.
z According to indifference curve approach a consumer will be in equilibrium
when,
(i) Budget line is tangent to the indifference curve
or MRS = PX/PY
or MRS = MIRE
TERMINAL EXERCISE
1. What is meant by consumer’s equilibrium? Explain the condition of consumer’s
equilibrium in case of a single commodity using utility approach.
2. Explain the condition determining how many units of a good the consumer will
buy at a given price.
3. Explain the relationship between total utility and marginal utility.
4. Explain the law of diminishing marginal utility with the help of a schedule.
5. A consumer buys two goods X and Y. Explain the conditions of his equilibrium
using utility approach.
44 ECONOMICS
6. A consumer buys two goods X and Y. Explain the conditions of his equilibrium
using indifference curve approach.
7. Explain the properties of indifference curves.
ANSWERS TO INTEXT QUESTIONS

Notes
14.1
1. Read section 14.1
2. (i) Read section 14.2(i)
(ii) Read section 14.2(ii)
(iii) Read section 14.2(iii)
3. Read section 14.3 (Maximum)
14.2
14.3
1. Read section 14.8(i)
2. Read section 14.8(vi)
3. Read section 14.8(ii)
ECONOMICS 45
Income and Substitution Effects — A Summary
What are Income and Substitution Effects?
When the price of q1, p1, changes there are two effects on the consumer. First, the price of q1 relative to the
other products (q2, q3, . . . qn) has changed. Second, due to the change in p1, the consumer's real income
changes. When we compute the change in the optimal consumption as a result of the price change, we do not
usually separate these two effects. Sometimes we might want to separate the effects.
The Substitution Effect is the effect due only to the relative price change, controlling for the change in real
income. In order to compute it we ask what is the bundle that would make the consumer just as happy as
before the price change, but if they had to make their choice faced with the new prices. To find this point we
consider a budget line characterized by the new prices but with a level of income such that it is tangent to the
initial indifference curve. In the diagram on the next page, the initial consumer equilibrium is at point A
where the initial budget line is tangent to the higher indifference curve. Consumption at this point is 11 units
of good 1 and 8 units of good 2. After an increase in the price of good 1, the consumer moves to point E,
where the new budget line is tangent to the lower indifference curve. Consumption of good 1 has fallen to 4
units while consumption of good 2 has increased to 10 units. The substitution effect is the movement from
point A to point G. This point is characterized by two things. (1) It is on the same indifference curve as the
original consumption bundle; AND (2) it is the point where a budget line that is parallel to the new budget
line is just tangent to initial indifference curve. This "intermediate" budget line is attempting to hold real
income fixed so we can isolate the substitution effect. The point G reflects the consumer's choice if faced
with the new prices (the budget line has the slope reflecting the new prices) and the compensated income
(i.e., an income level that holds real income fixed). The substitution effect is the difference between the
original consumption and the new "intermediate" consumption. In this case consumption of good 1 falls
from 11 to 6.84 while consumption of good 2 increases to 14.27.
When p1 goes up the Substitution Effect will always be non-positive (i.e., negative or zero).
The Income Effect is the effect due to the change in real income. For example, when the price goes up the
consumer is not able to buy as many bundles that she could purchase before. This means that in real terms
she has become worse off. The effect is measured as the difference between the “intermediate"
consumption” at G and the final consumption of q1 and q2 at E.
Unlike the Substitution Effect, the Income Effect can be both positive and negative depending on whether
the product is a normal or inferior good. By the way we constructed them, the Substitution Effect plus the
Income Effect equals the total effect of the price change.
Alternative Way of Analyzing a Price Change

One can also analyze the income and substitution effects by first considering the income change necessary to
move the consumer to the new utility level at the initial prices. This constitutes the income effect. The
movement along the new indifference curve from the intermediate point to the new equilibrium as the slope
of the price line changes is then the substitution effect. See if you can identify the “intermediate” point on
the lower indifference curve by shifting the budget line (Hint: q1 and q2 both fall.).
Substitution and Income Effects
Increase in the price of good 1
20
q1
18 Initial Budget Line
16
14
12 A
10
8 G
6
E
4
2
Subsequent Budget Line
0
0 2 4 6 8 10 12 14 16 18 20
q2

Microeconomics AIDE

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Microeconomics AIDE

Uploaded by

Copyright:

Available Formats

MICROECONOMICS

ASIAN INSTITUTE FOR DISTANCE EDUCATION FOUNDATION INC.

MODULE 1 - Demand, Supply and Equilibrium

MODULE 2 - Theory of the Household

MODULE 3 - Production and Costs

MODULE 4 - Theory of Markets

MODULE 5 - Factor Prices

Lesson 1 – Demand ………………………………………………………. 7

Module 2 – Theory of the Household

Lesson 1 – Indifference Curves ……………………………………….. 50

Module 3 – Production and Costs ………………………………….. 65

Module 4 – Theory of Markets

Lesson 1 – Price and Output Under Perfect Competition ……… 85

Module 5 – Factor Prices

Lesson 1 – Perfect Competition in the Product and Factor

Description of the Subject

Scope of the Subject

The subject consists of the following five modules:

Module 1 – Demand, Supply and Equilibrium Price

DEMAND, SUPPLY and

MODULE 1 – DEMAND, SUPPLY AND EQUILIBRIUM

Scope of the Module

Module 1 contains the following four lessons:

Overview of the Module

Objectives of the Module

After completing this module, you are expected to:

1. enumerate and explain the variables influencing demand and supply;

2. explain, measure and interpret price elasticities;

4. explore some application of the analysis.

Upon completion of this lesson, you should be able to:

1. distinguished macroeconomics and microeconomics;

The notation 𝑦 = 𝑓 (𝑥, 𝑧, 𝑡) is read “y is a function of x, z, and t” and means that y

If 𝑄𝑑 is quantity demanded of a good, P is its price, Ps is the price of substitute goods, Pc is

The law of demand may be illustrated in a table or schedule. Table 1 is a hypothetical

Table 1 – A Demand Schedule for Coffee

Price Quantity Demanded

Figure 1 A Demand Curve for Coffee

Figure 2 – Slopes of Curves

Price Elasticity of Demand

Price elasticity of demand is equal to the percentage change in quantity demanded

Using this shorter formula,

As an exercise, show that Ed is 3/2 at G, 4 at H, and ¼ at E.

Figure 4. Sample Graphical Calculation of Point Elasticity of Demand

Table 2 – A Demand Schedule for Coffee: Perfectly Inelastic Case

Price per Jar Quantity Demanded Total Expenditure

P 5.00 100 P 500

Figure 5 – A Demand Curve for Coffee: Perfectly Inelastic Case

Demand between H and E, where 𝐸𝑑 = 1, is unit elastic. At E the price is ₱5.00,

Table 3. A Demand Schedule for Coffee: Perfectly Elastic Case

Price Quantity Demanded

Figure 6 – A Demand Curve for Coffee Perfectly Elastic Case

Numerical Terminology Mathematical Price Quantity Total

Zero Perfectly Change in price produces Up Constant Up

Between Relatively Percentage change in Up Down Up

One Unit Percentage change in Up Down Constant

Between Relatively Percentage change in Up Down Down

Infinity Perfectly Rise in price reduces Up Down to Zero, Down to Zero

(PERFORM PROGRESS CHECK TEST 1)

PROGRESS CHECK TEST 1

1. _____________________________ is the study of the behavior of small economic

2. The law of _____________________________ states that as the price of a good

3. _________________________ is the sensitivity of the quantity demanded of a good to

4. _________________________ is a Latin phrase which means “other things being