AmboUni

ver
sit
y

Gudermamomezemi
rcampus

School
ofAgr
icul
tur
aleconomi
csandAgr
ibusi
ness

Depar
tmentofagr
icul
tur
aleconomi
cs

Mi
croeconomi
csI(
AgEc211)Chr
.3
Mi
croeconomi
csI

Cour
seDescr
ipt
ions

Thi
scour
sei
ntr
oducesst
udent
stobasi
ceconomi
cconcept
s;scar
cit
y;choi
ceand
oppor
tuni
tycost
;consumert
heor
y;demand;
pref
erence;
uti
l
ity
;fact
orsofpr
oduct
ion;
pr
oduct
ion f
unct
ions;pr
oduct
ion cost
s;pr
ofi
tfunct
ions;concept
s of mar
ket
st
ruct
ures;per
fect
ly compet
it
ive mar
ketst
ruct
ure;monopol
y mar
ketst
ruct
ure;
equi
l
ibr
ium pr
iceandout
putdet
ermi
nat
ionunderper
fectcompet
it
iveandmonopol
y
model
s.

Cour
seObj
ect
ives Theai
m oft
hiscour
sei
stomakest
udent
sacquai
ntedwi
th
def
ini
ti
onandbasi
cconcept
sofEconomi
cs;scar
cit
yandoppor
tuni
tycost
s;t
heor
ies
of demand and suppl
y,consumer
s behav
ior and ut
il
it
y maxi
mizat
ion,pr
ofi
t
maxi
mizat
ionandcostmi
nimi
zat
ion,basi
csofmar
ketst
ruct
uresandequi
l
ibr
ium
pr
iceandout
putdet
ermi
nat
ionunderper
fectcompet
it
iveandmonopol
ymodel
s.
Af
tercompl
etedt
hiscour
se,
student
swi
l
lbeexpect
edt
o:

under
standbasi
cconcept
sofeconomi
cs

under
standscar
cit
yofr
esour
cesandoppor
tuni
tycosti
nmaki
ngchoi
ce

under
standt
heor
yofdemandandsuppl
y,andt
hei
rappl
i
cat
ions

under
standt
het
heor
iesofut
il
it
yandconsumerbehav
iorandt
hei
rappl
i
cat
ions

under
standt
heor
iesofpr
oduct
ion

under
standdi
ff
erentt
ypesofpr
oduct
ionr
elat
ionshi
ps

under
standt
heor
yofcost
sandcostcur
veswi
thpr
oduct
ioncur
ves

expl
ainmar
ketst
ruct
uresandbasi
csofmar
ketst
ruct
ures

1
CHAPTERONE:I
ntr
oduct
iont
oEconomi
cs

Def
ini
ti
onandScopeofEconomi
cs

Thewor
deconomi
cscomesf
rom t
heGr
eekwor
d‘Economi
cous’meani
ng,onewho
managesahousehol
d.Ther
ear
etwof
undament
alf
act
sthatpr
ovi
det
hef
oundat
ion
f
ort
hef
iel
dofeconomi
cs:Humanorsoci
ety
’smat
eri
alwant
sar
eunl
i
mit
edand
Economi
cresour
cesar
escar
ceorl
i
mit
edi
nsuppl
y.

Soci
ety
’s mat
eri
alwant
sref
erst
othe desi
re ofconsumer
s,busi
nesses,and
gov
ernmentt
ogett
hoset
hingst
hathel
pthem r
eal
i
zet
hei
rrespect
ivegoal
s.Not
e
t
hatgoalofconsumer
sist
ogetmaxi
mum sat
isf
act
ion,t
hegoalofbusi
nessesi
sto
pr
oducegoodsandser
vicesandgetpr
ofi
t,andt
hegoaloft
hegov
ernmenti
sto
sat
isf
ythecol
l
ect
ivewant
sofi
tsci
ti
zens.Al
loft
hesewant
sar
enotonl
ynumer
ous
butal
somul
ti
plyt
hrought
ime.

Economi
cresour
cesr
efer
stoany
thi
ngnat
uralormanmadet
hatcanbeusedi
n
pr
oduct
ionofgoodsandser
vices.Byeconomi
cresour
ces,
wer
efert
hev
ari
oust
ypes
ofl
abor
s,mi
ner
als,bui
l
dings,t
rucks,oi
ldeposi
ti
es,communi
cat
ionf
aci
l
iti
es,et
c.,
t
hatcanbeusedi
npr
oduct
ionofgoodsandser
vices.Andal
ltheser
esour
cesar
e
scar
ceorl
i
mit
ed i
n suppl
y.So,on t
heonehand,soci
ety
’smat
eri
alwant
sar
e
unl
i
mit
ed;ont
heot
herhand,economi
cresour
cesar
eli
mit
ed.Thesecont
radi
ctor
y
f
act
slayt
hef
oundat
ionf
ort
hef
iel
dofeconomi
cs.

Def
ini
ti
on:Economi
csi
s,t
hus,def
ined asa soci
alsci
ence,whi
ch st
udi
eshow
soci
eti
esal
l
ocat
escar
cer
esour
cesi
nthepr
oduct
ionanddi
str
ibut
esofgoodsand
ser
vicessoast
oat
tai
nthemaxi
mum f
ulf
il
lmentofsoci
ety’
smat
eri
alwant
s.

Br
anchesofEconomi
cs

2
Gener
all
y,Economi
cscanbedi
vi
dedi
ntot
womai
nbr
anches:
-macr
oeconomi
csand
mi
croeconomi
cs,
wher
e‘macr
o’meansbi
gand‘
micr
o’meanssmal
l
.

A.Mi
croeconomi
cs:i
stheconcer
nedwi
theconomi
cbehav
ior(
act
ion)ofi
ndi
vi
dual
economi
cuni
ts,wel
l
-def
inedgr
oupsofi
ndi
vi
dualeconomi
cuni
ts,andhow mar
ket
s
ofi
ndi
vi
dualcommodi
ti
es f
unct
ion:These i
ndi
vi
dualeconomi
c uni
ts can be
househol
dsor f
ir
ms.I
tst
udi
est
he i
nter
rel
ati
onshi
psbet
ween t
hese uni
tsi
n
det
ermi
ningt
hepat
ter
nofpr
oduct
ionanddi
str
ibut
ionofgoodsandser
vices.I
tis
concer
nedwi
tht
hedeci
sionst
akenbyi
ndi
vi
dualconsumer
sandf
ir
msandwi
tht
he
wayt
hesedeci
si
onscont
ri
but
etot
heset
ti
ngofpr
icesandout
puti
nvar
iouski
ndsof
mar
ket
.Forexampl
e,quest
ionsl
i
kehow doesapar
ti
cul
arper
sonorhousehol
d
maxi
mize sat
isf
act
ion,how does a par
ti
cul
arbusi
ness ent
erpr
ise st
ri
vet
o get
maxi
mum possi
blepr
ofi
tbypr
oduci
ngandsel
l
ingapr
oduct
,.et
car
est
udi
edi
n
mi
croeconomi
cs.

B.Macr
oeconomi
cs:i
sthebr
anchofeconomi
canal
ysi
sthatst
udi
eseconomyas
whol
eandsubaggr
egat
esoft
heeconomy
:Itdoesnotdealwi
thhousehol
d,f
ir
m,or
i
ndust
ry.I
tdeal
swi
thmagni
tudessuchast
het
otalout
putl
eveli
naneconomy
,
nat
ionali
ncomeofacount
ry,t
heov
eral
llev
elofpr
ices,t
otalout
putand t
otal
empl
oymenti
nthe economy
,gener
alpr
ice l
evelofgoods and ser
vices i
nthe
economy
,et
c.Forexampl
e,i
nmi
croeconomi
cswecanst
udywhyt
hepr
iceof‘
tef
f’
i
ncr
easeordecr
easei
nAddi
sAbaba.Butt
hisi
ncr
easeordecr
easei
nthepr
icel
evel
of‘
tef
f’
isnott
heconcer
nofmacr
oeconomi
cs.Macr
oeconomi
csr
atherconcer
ned
wi
thwhet
hert
heav
eragel
evelofpr
icesofgoodsandser
vicesi
ntheeconomyas
whol
eisi
ncr
easi
ngordecr
easi
ng.I
nshor
t,i
nmi
croeconomi
cswest
udyat
reei
na
f
orest
;butmacr
oeconomi
cswest
udyt
hef
orest
,notat
ree.Remembert
hat
,li
ke
macr
oeconomi
cs,mi
croeconomi
csal
sousesaggr
egat
es.Forexampl
e,wet
alkof
t
he t
otalmar
ketdemand f
orwheat
,tot
almar
ketdemand f
ormai
ze…et
c.I
n
mi
croeconomi
cs,weaggr
egat
eov
erhomogenouspr
oduct
,buti
nmacr
oeconomi
cs,
t
heaggr
egat
ioni
satt
heeconomyl
evel
.Inmi
croeconomi
cswecannotaggr
egat
ethe
t
otalmar
ketdemandf
orwheatandmai
zet
oget
her
.Inmacr
oeconomi
cswecan
3
aggr
egat
ethet
otalofsev
eralpr
oduct
sandt
alkaboutt
het
otall
evelofout
put
s
cur
rent
lypr
oducedi
nacount
ryt
hisy
ear
.

Scar
cit
yandchoi
ce:Oppor
tuni
tycost
Scar
cit
y

Whati
sthecr
uci
ali
ngr
edi
entt
hatmakesapr
obl
em aneconomi
cone?Theansweri
s
t
hatt
her
eisonecent
ralpr
obl
em f
acedbyal
lindi
vi
dual
sandal
lsoci
eti
esandf
rom
t
hispr
obl
em al
ltheot
hereconomi
cpr
obl
emsst
em.Thi
scent
raleconomi
cpr
obl
em
i
sthepr
obl
em ofscar
cit
y.Atanyonet
imet
hewor
ldcanonl
ypr
oduceal
i
mit
ed
amountofgoodsandser
vices.Thi
sisbecauset
hewor
ldonl
yhasal
i
mit
edamount
ofr
esour
ces.Ther
easonsf
orscar
cit
yeconomi
cresour
cei
shumanwant
sar
e
v
irt
ual
l
yunl
i
mit
ed,
wher
east
her
esour
cesav
ail
abl
etosat
isf
ythesewant
sar
eli
mit
ed.
Wecant
husdef
inescar
cit
yist
heexcessofhumanwant
sov
erwhatcanact
ual
l
ybe
pr
oduced.Because of scar
cit
y,v
ari
ous choi
ces hav
eto be made bet
ween
al
ter
nat
ives

Economi
csi
sthest
udyofscar
cit
y-t
hest
udyoft
heal
l
ocat
ionofscar
cer
esour
cest
o
sat
isf
yhumanwant
s.Peopl
e’
smat
eri
alwant
s,f
ort
hemostpar
t,ar
eunl
i
mit
ed.
Out
put
,ont
heot
herhand,i
sli
mit
edbyt
hest
ateoft
echnol
ogyandt
hequant
it
yand
qual
i
tyoft
heeconomy
’sr
esour
ces.Thus,t
hepr
oduct
ionofeachgoodandser
vice
i
nvol
vesacost
.Agoodi
susual
l
ydef
inedasaphy
sicali
tem suchasacarora
hambur
ger
,andaser
vicei
ssomet
hingpr
ovi
dedt
oyousuchasi
nsur
anceorahai
rcut
.

Scar
cit
yisa f
undament
alpr
obl
em f
orev
erysoci
ety
.Deci
sionsmustbe made
r
egar
dingwhatt
opr
oduce,how t
opr
oducei
t,andf
orwhom t
opr
oduce.Whatt
o
pr
oducei
nvol
vesdeci
si
onsaboutt
heki
ndsandquant
it
iesofgoodsandser
vicest
o
pr
oduce.Howt
opr
oducer
equi
resdeci
sionsaboutwhatt
echni
quest
ouseandhow
economi
cresour
ces(
orf
act
orsofpr
oduct
ion)ar
etobecombi
nedi
npr
oduci
ng
out
put
.Theeconomi
cresour
cesusedt
opr
oducegoodsandser
vicesi
ncl
ude:l
and:
(
theeconomy
’snat
uralr
esour
ces-
suchasl
and,t
rees,andmi
ner
als.
);l
abor(
The
ment
alandphy
sicalski
l
lsofi
ndi
vi
dual
sinasoci
ety
);capi
tal(
Goods-
suchast
ool
s,
4
machi
nes,andf
act
ori
es-
usedi
npr
oduct
ionort
ofaci
l
itat
epr
oduct
ion)
.Forwhom t
o
pr
oducei
nvol
vesdeci
sionson t
hedi
str
ibut
ion ofout
putamong member
sofa
soci
ety
.

Economi
cshel
pst
osol
vet
het
hreei
mpor
tantquest
ionsofwhatt oduce,how t
opr o
pr
oducei
t,andf
orwhom t
opr
oduce.Thesedeci
sionsi
nvol
veoppor
tuni
tycost
s.An
oppor
tuni
tycosti
swhati
ssacr
if
icedt
oimpl
ementanal
ter
nat
iveact
ion,i
.e.
,whati
s
gi
venupt
opr
oduceorobt
ainapar
ti
cul
argoodorser
vice.

Choi
ceandoppor
tuni
tycost

Choi
cei
nvol
vessacr
if
ice.Themor
efoody
ouchooset
obuy
,thel
essmoneyy
ouwi
l
l
hav
etospendonot
hergoods.Themor
efoodanat
ionpr
oducest
hef
ewerr
esour
ces
wi
l
lther
e be f
orpr
oduci
ng ot
hergoods.I
n ot
herwor
ds,t
he pr
oduct
ion or
consumpt
ionofonet
hingi
nvol
vest
hesacr
if
iceofal
ter
nat
ives.Thi
ssacr
if
iceof
al
ter
nat
ivesi
nthepr
oduct
ion(
orconsumpt
ion)ofagoodi
sknownasi
tsoppor
tuni
ty
cost
.Oppor
tuni
tycosti
sthecostofanyact
ivi
tymeasur
edi
nter
msoft
hebest
al
ter
nat
ivef
orgone.Exampl
e;i
fthewor
ker
sonaf
arm canpr
oduceei
ther1000t
ons
ofwheator2000t
onsofbar
ley
,thent
heoppor
tuni
tycostofpr
oduci
ng1t
onsof
wheati
sthe2t
onsofbar
leyf
orgone.

Economi
csy
stem
Onei
mpor
tantdi
ff
erencebet
weensoci
eti
esi
sint
hedegr
eeofgov
ernmentcont
rolof
t
heeconomy
.Basedont
hiswehav
ethr
eet
ypesofeconomi
csy
stems:Fr
eemar
ket
economy
;commandorpl
annedeconomyandmi
xedeconomy
.Iti
susef
ult
oanal
yze
t
heext
remes,i
nor
dert
oputt
hedi
ff
erentmi
xedeconomi
esoft
her
ealwor
ldi
nto
per
spect
ive.

Fr
eemar
keteconomyi
saneconomywher
eal
leconomi
cdeci
sionsar
etakenby
i
ndi
vi
dualhousehol
ds and f
ir
ms and wi
th no gov
ernmenti
nter
vent
ion atal
l
.
Househol
dsdeci
dehowmuchl
aborandot
herf
act
orst
osuppl
y,andwhatgoodst
o
consume.Fi
rmsdeci
dewhatgoodst
opr
oduceandwhatf
act
orst
oempl
oy.The
5
pat
ter
nofpr
oduct
ionandconsumpt
iont
hatr
esul
tsdependsont
hei
nter
act
ionsofal
l
t
hesei
ndi
vi
dual
demandandsuppl
ydeci
sions.

Command orcent
ral
ly pl
anned economy i
s an economy wher
e al
leconomi
c
deci
si
onsar
etakenbyt
hecent
ral
aut
hor
it
ies/
gov
ernment
.

Mi
xedeconomyi
samar
keteconomywher
ether
eissomegov
ernmenti
nter
vent
ion.
Becauseoft
hepr
obl
emsofbot
hfr
ee-
mar
ketandcommandeconomi
es,al
lreal
-
wor
ldeconomi
esar
eami
xtur
eoft
het
wosy
stems.Gov
ernmenti
nter
vent
ioncanbe
usedt
orect
if
yvar
iousf
ail
i
ngsoft
hemar .Not
ket e,however
,thatgover
nment
sar
e
notper
fectandt
hei
ract
ionsmaybr
ingadver
seaswel
lasbenef
ici
alconsequences.

Lear
ningAct
ivi
ti
es
 Whatdoy ouunderstandabouteconomi cs?
 Whatdoy ouunderstandaboutEconomi cresource?
 Expl
ainthereasonforscarcit
y?
 Dist
ingui
shtherel
ationshipbetweenscarci
ty,choiceandopport
uni
tycost
?
 Dist
ingui
shbetweenaf ree-marketandacommandeconomy .

Summar
y
Economi
csi
sthest
udyofhowsoci
eti
eschooset
ousescar
cer
esour
cest
opr
oduce
valuablecommodi t
iesanddi stributesamongdi f
ferentgroups.Thef ourtypesof
factorofpr oduct ionineconomi csi ncludel and,labor,capit
alandmanager i
alabil
ity.
Thescar ci t
yoft heser esour cescompel sthesoci etytochooset hebestwayofusi ng
l
imi t
edr esour cessoast oachi ev emaxi mum l evelofeconomi cwel f
are.Therear e
threeuniv ersalfundament alchoi cest obemade.Thesear ewhattopr oduce?Howt o
produce and f or whom t o pr oduce? Economi cs is usually divi
ded i nto
microeconomi csandmacr oeconomi cs.Micr oeconomi csdealswiththebehav i
orand
operations of i ndivi
dualcomponent sl i
ke househol ds,firms and i ndustri
es.
Macr oeconomi cs anal yzes t he f unct i
oning oft he economy atnat i
onall evel.
Microeconomi csandmacr oeconomi cscannev erbesepar atedfrom eachot hera
macr oeconomi csr esultist hesum ofmi croeconomi cs.Wel iveinaneconomi c
system i nwhi chmi l
l
ionsofeconomi cdeci sionsar emadedai lybyconsumer s,
producer s,andt hegov ernment .Theseeconomi csystemsar e;Fr
eemar keteconomy ,
Commandorpl annedeconomyandMi xedeconomy .

6
7
CHAPTERTwo:Theor
yofDemandandSuppl
y

Pr
etest
s
 Whati
smeantbydemandandsuppl
y?
 Whati
smeantbyEl
ast
ici
tyofDemand&Suppl
y?

Meani
ngofDemand

I
nourday
-to-
dayl
i
fe,
weuset
hewor
ddemandi
nal
oosesenset
omeant
hedesi
reof
aper
sont
opur
chaseacommodi
tyorser
vice.Buti
neconomi
csi
thasspeci
fi
c
meani
ng.Demandi
mpl
i
esmor
ethanamar
edesi
ret
opur
chaseacommodi
ty.I
t
st
atest
hatt
heconsumermustbewi
l
li
ngandabl
epur
chaset
hecommodi
ty,
whi
chhe
desi
re.Hi
sdesi
reshoul
dbebackedbypur
chasi
ngpower
.Apoorper
soni
swi
l
li
ngt
o
buyacar
;ithasnoabi
l
ityt
opayf
ori
t.Onot
herhand,hi
sdesi
ret
obuyt
hecarmust
bebackedbyt
hepur
chasi
ngpowerconst
it
uti
ngdemand.Demandt
hus,meanst
he
desi
reofcommodi
tyt
heconsumerf
orcommodi
tybackedbyt
hepur
chasi
ngpower
.
Theset
wof
act
orsar
eessent
ial
.Ifconsumeri
swi
l
li
ngt
obuybuti
snotabl
etopay
,
hi
sdesi
rewi
l
lnotbecomedemand.I
fconsumeri
sabi
l
ityt
opaybuti
snotwi
l
li
ngt
o
pay
,hi
s desi
re wi
l
lnotbe cal
l
ed demand.Demand r
efer
stot
he amountt
hat
consumer
sar
ewi
l
li
ngandabl
etopur
chaseataal
ter
nat
ivepr
iceov
eragi
venper
iod
(
e.g.aweek,oramont
h,oray
ear
).Quant
it
ydemandedr
efer
stot
heamountt
hat
consumer
sar
ewi
l
li
ngandabl
etopur
chaseatagi
venpr
iceov
eragi
venper
iod(
e.g.
aweek,
oramont
h,oray
ear
).Theydonotr
efert
owhatpeopl
ewoul
dsi
mpl
yli
ket
o
consume.

LawofDemand
TheLaw ofdemandst
atest
hatt
her
eisani
nver
ser
elat
ionshi
pbet
weenpr
iceofa
commodi
tyandi
tsquant
it
ydemandi
nthemar
ket
s,keepi
ngot
herf
act
orsconst
ant
.It
meanst
hati
tshowsusani
nver
ser
elat
ionshi
pbet
weent
heabov
etwov
ari
abl
es.The
quant
it
yofagooddemandedperper
iodoft
imewi
l
lfal
laspr
icer
isesandwi
l
lri
seas
pr
icef
all
s,ot
hert
hingsbei
ngequal(
cet
eri
spar
ibus)
.Thet
woexpl
anat
ionst
othel
aw

8
ofdemandar
eincomeef
fectandsubst
it
uti
onef
fect
.
Ther
easonsf
orl
awofdemandar
e:
 Peopl
ewi
l
lfeelpoor
er.Theywi
l
lnotbeabl
etoaf
for
dtobuysomuchoft
he
goodwi
tht
hei
rmoney
.Thepur
chasi
ngpoweroft
hei
rincome(
thei
rreal
i
ncome)hasf
all
en.Thi
siscal
l
edt
hei
ncomeef
fectofapr
icer
ise.
 Thegoodwi
l
lnowcostmor
ethanal
ter
nat
iveor‘
subst
it
ute’
goods,
andpeopl
e
wi
l
lswi
tcht
othese.Thi
siscal
l
edt
hesubst
it
uti
onef
fectofapr
icer
ise.
Butt
heabov
elaw oper
atesonl
yundert
heassumpt
iont
hat“
othert
hingsr
emai
n
const
ant
”.Theabov
ephr
asei
mpl
i
est
hatwhenwest
atet
hel
aw ofdemand,we
assumet
hedet
ermi
nant
sofdemandconst
ant
,thesear
e
 Tast
esandpr
efer
encer
emai
nconst
ant
 Thenumberandpr
iceofsubst
it
utegoods
 Thenumberandpr
iceofcompl
ement
arygoods.
 I
ncomeofconsumer
 Di
str
ibut
ionofi
ncome.
 Expect
ati
onsoff
utur
epr
icechanges.
 Adv
ert
isement
 Pastdemand
 Consumerf
utur
epr
iceandi
ncome
Thedemandcur
vesl
opesdownwar
dfr
om l
eftt
ori
ght
.Thedownwar
dsl
opeof
demandcur
ver
efl
ect
sthel
awofdemand.I
nthenextsect
iony
ouwi
l
lel
abor
atet
he
l
awofdemandi
nter
msofcur
ve,
equat
ionsandt
abl
es.

Demandschedul
e

Ademandschedul
eisdef
inedasat
abl
ewhi
chpr
esent
sthequant
it
ydemandedat
eachpr
icel
eveldur
ingaspeci
fi
cti
meper
iod.Assumi
ngt
hatal
lot
herf
act
orsar
e
const
antbyv
ary
ingt
hepr
iceoft
hegoodsi
tsel
f,wegetani
ndi
vi
dualdemand
schedul
efort
hegood(
seeTabl
e2.
1).Tabl
eshowshowmanyki
l
ogr
amsofpot
atoes
permont
h,woul
dbepur
chasedatv
ari
ouspr
ices.Col
umns(
2)and(
3)show t
he
9
demandschedul
esf
ort
woi
ndi
vi
dual
s,Tr
aceyandDar
ren.Col
umn(
4)bycont
rast
,
showst
het
otalmar
ketdemandschedul
e.Thi
sist
het
otaldemandbyal
lconsumer
s.
Toobt
aint
hemar
ketdemandschedul
eforpot
atoes,
wesi
mpl
yaddupt
hequant
it
ies
demandedateachpr
icebyal
lconsumer
s:i
.e.Tr
acey
,Dar
renandev
ery
oneel
sewho
demandspot
atoes.
Tabl
e2.
1Thedemandf
orpot
atoes(
mont
hly
)

Demand schedul
eforan i
ndi
vi
duali
sref
erst
oat
abl
e showi
ng t
he di
ff
erent
quant
it
iesofagoodt
hataper
soni
swi
l
li
ngandabl
etobuyatv
ari
ouspr
icesov
era
gi
venper
iodoft
ime.
Mar
ketdemandschedul
eisdef
inedasat
abl
eshowi
ngt
hedi
ff
erentt
otalquant
it
ies
ofagoodt
hatconsumer
sar
ewi
l
li
ngandabl
etobuyatv
ari
ouspr
icesov
eragi
ven
per
iodoft
ime.

Demandcur
ve:
Thedemandschedul
ecanber
epr
esent
edgr
aphi
cal
l
yasademandcur
ve.Demand
cur
vei
sgr
aphshowi
ngt
her
elat
ionshi
pbet
weent
hepr
iceofagoodandt
hequant
it
y
oft
hegooddemandedov
eragi
vent
imeper
iod.Pr
icei
smeasur
edont
hev
ert
ical
axi
s;quant
it
ydemandedi
smeasur
edont
hehor
izont
alaxi
s.Ademandcur
vecanbe
f
orani
ndi
vi
dualconsumerorgr
oupofconsumer
s,ormor
eusual
l
yfort
hewhol
e
mar
ket
.Itsl
opesdownwar
dfr
om l
eftt
ori
ght
:theyhav
enegat
ivesl
ope.Thi
sindi
cat
e
10
t
hel
owert
hepr
iceoft
hepr
oduct
,themor
eist
heper
sonl
i
kel
ytobuy
.

Fi
gur
e2.
1 showst
hemar
ketdemand cur
vef
orpot
atoescor
respondi
ng t
othe
schedul
einTabl
e2.
1.Poi
ntEshowst
hatatapr
iceof100pperki
l
o,100000t
onesof
pot
atoesar
edemandedeachmont
h.Whent
hepr
icef
all
sto80pwemov
edownt
he
cur
vet
opoi
ntD.Thi
sshowst
hatt
hequant
it
ydemandedhasnowr
isent
o200000
t
onspermont
h.Si
mil
arl
y,i
fthepr
icef
all
sto60pwemov
edownt
hecur
veagai
nto
poi
ntC:350000t
onesar
enow demanded.Thef
ivepoi
ntsont
hegr
aph(
A–E)
cor
respondt
othef
igur
esi
ncol
umns(
1)and(
4)ofTabl
e2.
1.

Fi
g2.
1Mar
ketdemandf
orpot
atoes(
mont
h)

Det
ermi
nant
sofDemand
Theext
entoft
hedemandf
oragoodi
sdet
ermi
nedbyt
wof
act
ors.Thesef
act
orsar
e:
1.Pr
icef
act
or
2.Nonpr
ice(
Thecondi
ti
onofdemand)f
act
ors
Pr
icef
act
or(
Thecondi
ti
onsofdemandr
emai
nconst
ant
)
Pr
icei
sthemosti
mpor
tantf
act
ort
hatdet
ermi
neshowmuchofagoodpeopl
ewi
l
l
buy(
demand)
,whi
l
ethecondi
ti
onofdemandi
sremai
nconst
ant
.

Thecondi
ti
onofdemand(
pri
cei
sassumedt
obeconst
antorgi
ven)
Pr
icei
snott
heonl
yfact
ort
hatdet
ermi
neshow muchofagoodpeopl
ewi
l
lbuy
.
Demandi
sal
soaf
fect
edbyt
hef
oll
owi
ng.
 Tast
es:t
hemor
edesi
rabl
epeopl
efi
ndt
hegood,t
hemor
etheywi
l
ldemand.
Tast
esar
eaf
fect
edbyadv
ert
isi
ng,
byf
ashi
on,
byobser
vingot
herconsumer
s,by
consi
der
ati
onsofheal
thandbyt
heexper
iencesf
rom consumi
ngt
hegoodon
pr
evi
ousoccasi
ons.
11
  Thenumberandpr
iceofsubst
it
utegoods(
i.
e.compet
it
ivegoodsorgoods
consi
der
edbyconsumer
stobeal
ter
nat
ivest
oeachot
here.
g.Cof
fee&Tea)
:
t
hehi
ghert
hepr
iceofsubst
it
utegoods,t
hehi
gherwi
l
lbet
hedemandf
ort
his
goodaspeopl
eswi
tchf
rom t
hesubst
it
utes.
 Thenumberandpr
iceofcompl
ement
arygoods.Compl
ement
arygoodsar
e
t
hoset
hatar
econsumedt
oget
her
:car
sandpet
rol
,shoesandpol
i
sh.Thehi
gher
t
hepr
iceofcompl
ement
arygoods,t
hef
eweroft
hem wi
l
lbeboughtandhence
t
hel
esswi
l
lbet
hedemandf
ort
hisgood.
 I
ncome.Aspeopl
e’
sincomesr
ise,t
hei
rdemandf
ormostgoodswi
l
lri
se.Such
goodsar
ecal
l
ed nor
malgoods.Ther
ear
eexcept
ionst
othi
sgener
alr
ule,
howev
er.Aspeopl
egetr
icher
,theyspendl
essoni
nfer
iorgoods,
suchascheap
mar
gar
ine,and swi
tch t
o bet
terqual
i
tygoods.N.
B Nor
malgoods whose
demand i
ncr
eases as consumeri
ncomes i
ncr
ease.I
nfer
iorgoods whose
demanddecr
easesasconsumeri
ncomesi
ncr
ease.
 Di
str
ibut
ionofi
ncome.I
fnat
ionali
ncomewer
eredi
str
ibut
edf
rom t
hepoort
o
t
her
ich,
thedemandf
orl
uxur
ygoodswoul
dri
se.Att
hesamet
ime,
ast
hepoor
gotpoor
ert
heymi
ghthav
etot
urnt
obuy
ingi
nfer
iorgoods,whosedemand
woul
dthusr
iset
oo.
 Expect
ati
onsoff
utur
epr
icechanges.I
fpeopl
ethi
nkt
hatpr
icesar
egoi
ngt
o
r
isei
nthef
utur
e,t
heyar
eli
kel
ytobuymor
enowbef
oret
hepr
icedoesgoup.

Mov
ement
sal
ongandshi
ft
sint
hedemandcur
ve

Ademandcur
vei
sconst
ruct
edont
heassumpt
iont
hat‘
othert
hingsr
emai
nequal
’
(
cet
eri
spar
ibus)
.Inot
herwor
ds,i
tisassumedt
hatnoneoft
hedet
ermi
nant
sof
demand,ot
hert
hanpr
ice,changes.Theef
fectofachangei
npr
icei
sthensi
mpl
y
i
l
lust
rat
edbyamov
emental
ongt
hedemandcur
ve:
forexampl
e,f
rom poi
ntBt
opoi
nt
Di
nFi
gur
e2.
1whent
hepr
iceofpot
atoesr
isesf
rom 40pt
o80pperki
l
o.

Whathappens,t
hen,when oneoft
heseot
herdet
ermi
nant
sdoeschange?The
answeri
sthatwehav
etoconst
ructawhol
enewdemandcur
ve:t
hecur
veshi
ft
s.I
fa
12
changei
noneoft
heot
herdet
ermi
nant
scausesdemandt
ori
se–say
,incomer
ises
–t
hewhol
ecur
vewi
l
lshi
ftt
other
ight
.Thi
sshowst
hatateachpr
icemor
ewi
l
lbe
demandedt
hanbef
ore.Thusi
nFi
gur
e2.
2atapr
iceofP,aquant
it
yofQo was
or
igi
nal
l
ydemanded.Butnow,af
tert
hei
ncr
easei
ndemand,Q1 i
sdemanded.(
Not
e
t
hatD1i
snotnecessar
il
ypar
all
elt
oD0.
)Ifachangei
nadet
ermi
nantot
hert
hanpr
ice
causesdemandt
ofal
l
,thewhol
ecur
vewi
l
lshi
ftt
othel
eft
.

Fi
g2.
2shi
fti
ndemandcur
ve

Todi
sti
ngui
shbet
weenshi
ft
sinandmov
ement
sal
ongdemandcur
ves,i
tisusualt
o
di
sti
ngui
shbet
weenachangei
ndemandandachangei
nthequant
it
ydemanded.A
shi
fti
nthe demand cur
vei
sref
err
ed t
o as a change i
n demand,wher
eas a
mov
emental
ongt
hedemandcur
veasar
esul
tofachangei
npr
icei
sref
err
edt
oasa
changei
nthequant
it
ydemanded.

Demandf
unct
ion
Wecanr
epr
esentt
her
elat
ionshi
pbet
weent
hemar
ketdemandf
oragoodandt
he
det
ermi
nant
sofdemandi
nthef
orm ofanequat
ion.Thi
siscal
l
edademandf
unct
ion.
I
tcanbeexpr
essedei
theri
ngener
alt
ermsorwi
thspeci
fi
cval
uesat
tachedt
othe
det
ermi
nant
s.Si
mpl
edemandf
unct
ions.Demandequat
ionsar
eof
tenusedt
orel
ate
quant
it
ydemanded t
ojustonedet
ermi
nant
.Thusan equat
ion r
elat
ing quant
it
y
demandedt
opr
icecoul
dbei
nthef
orm:
qd =a-
bp (
1)
Forexampl
e,t
heact
ualequat
ionmi
ghtbe:Qd=10,
000-200P.Mor
ecompl
exdemand
13
f
unct
ions.I
nasi
mil
arway
,wecanr
elat
ethequant
it
ydemandedt
otwoormor
e
det
ermi
nant
s.Forexampl
e,ademandf
unct
ioncoul
dbeoft
hef
orm:

qd =a- dPs +ePc

bp +cY- .(
2)
Wher
eQd = quant
it
ydemanded;p=pr
iceoft
hegood;Y=i
ncome;Ps=pr
iceof
subst
it
utegood;
Pc=pr
iceofcompl
ement

Def
ini
ti
onofSuppl
y
Suppl
yref
erst
othev
ari
ousquant
it
iesofapr
oductt
hatsel
l
ers(
producer
s)ar
ewi
l
li
ng
andabl
etopr
ovi
deatv
ari
ouspr
icesi
nagi
venper
iodoft
ime,ci
tr
uspar
ibus.Not
e
t
hatquant
it
ysuppl
i
edandsuppl
yar
etwodi
ff
erentconcept
s.Quant
it
ysuppl
i
edr
efer
s
t
oaspeci
fi
cquant
it
ythatasuppl
i
eri
swi
l
li
ngandabl
etopr
ovi
deataspeci
fi
cpr
ice.
Butsuppl
yref
erst
othewhol
erel
ati
onshi
pbet
weenpossi
blepr
icesofapr
oductand
t
hecor
respondi
ngquant
it
iessuppl
i
ed.

LawofSuppl
y

Law ofsuppl
yst
atest
hat
,ot
hert
hingsr
emai
nunchanged,aspr
iceofapr
oduct
i
ncr
eases quant
it
ysuppl
i
ed oft
he pr
oducti
ncr
eases,and as pr
ice decr
eases,
quant
it
ysuppl
i
edoft
hepr
oductdecr
eases.Fr
om l
awofsuppl
y,weunder
standt
hat
sel
l
ersar
emot
ivat
edt
osel
lmor
eathi
gherpr
icest
hanatl
owerpr
ices.

TheSuppl
yCur
ve,
Schedul
eandFunct
ion

Theamountt
hatpr
oducer
swoul
dli
ket
osuppl
yatv
ari
ouspr
icescanbeshowni
na
suppl
yschedul
e.Tabl
e2.
2showsamont
hlysuppl
yschedul
eforpot
atoes,bot
hfor
ani
ndi
vi
dualf
armer(
far
merX)andf
oral
lfar
mer
stoget
her(
thewhol
emar
ket
).The
suppl
yschedul
ecanber
epr
esent
edgr
aphi
cal
l
yasasuppl
ycur
ve.Asuppl
ycur
ve
maybeani
ndi
vi
dualf
ir
m’ssuppl
ycur
veoramar
ketcur
ve(
i.
e.t
hatoft
hewhol
e
i
ndust
ry)
.Taket
hesamedef
ini
ti
onf
orsuppl
yschedul
eandsuppl
ycur
veaswe
def
inedf
ordemand.
Tabl
e2.
2Indi
vi
dualpr
oducer
’ssuppl
yofpot
atoespermont
hly

14
 Thesuppl
yc:
schedul
e:
Thesuppl
yofpot
atoes(
mont
hly
)

Pr
iceof Far
merX's Tot
alMarket
pot
atoes suppl
y supply
(
penceperkg) (t
onnes) (t
onnes:000s)

a 20 50 100

b 40 70 200

c 60 100 350

d 80 120 530

e 100 130 700

Fr
om t
heabov
etabl
ewenot
icet
hataspr
icer
ises,t
her
espect
ivequant
it
ysuppl
i
ed
r
ises,andaspr
icedecr
eases,t
her
espect
ivequant
it
ysuppl
i
eddecr
eases.Thedi
rect
r
elat
ionshi
pbet
weenpr
iceofapr
oductandquant
it
ysuppl
i
ed,hol
dingot
hert
hings
const
ant
,iscal
l hel
edt awofsuppl
y.

Law ofsuppl
yst
atest
hat
,ot
hert
hingsr
emai
nunchanged,aspr
iceofapr
oduct
i
ncr
eases quant
it
ysuppl
i
ed oft
he pr
oducti
ncr
eases,and as pr
ice decr
eases,
quant
it
ysuppl
i
edoft
hepr
oductdecr
eases.Fr
om l
awofsuppl
y,weunder
standt
hat
sel
l
ersar
emot
ivat
edt
osel
lmor
eathi
gherpr
icest
hanatl
owerpr
ices

Fi
g2.
3Mar
ketsuppl
yofpot
atoes(
mont
hly
)

Fi
gur
e2.
3showst
hemar
ketsuppl
ycur
veofpot
atoes.Aswi
thdemandcur
ves,
pri
ce

15
i
spl
ott
edont
hev
ert
icalaxi
sandquant
it
yont
hehor
izont
alaxi
s.Eachoft
hepoi
nt’
s
a–ecor
respondst
oaf
igur
einTabl
e2.
2.Thus,f
orexampl
e,aspr
icer
isef
rom 60p
perki
l
ogr
am t
o80pperki
l
ogr
am wi
l
lcauseamov
emental
ongt
hesuppl
ycur
vef
rom
poi
ntct
opoi
ntd:t
otalmar
ketsuppl
ywi
l
lri
sef
rom 350000t
onspermont
hto530
000t
onspermont
h.Notal
lsuppl
ycur
veswi
l
lbeupwar
dsl
opi
ng(
posi
ti
vel
ysl
oped)
.
Somet
imest
heywi
l
lbev
ert
icalorhor
izont
alor
\ev
endownwar
dsl
opi
ng.Thi
swi
l
l
dependl
argel
yont
het
imeper
iodov
erwhi
chf
ir
ms’r
esponset
opr
icechangesi
s
consi
der
ed.

Det
ermi
nant
sofSuppl
y

Li
kedemand,suppl
yisnotsi
mpl
ydet
ermi
nedbypr
ice.Theot
herdet
ermi
nant
sof
suppl
y(suppl
yshi
ft
er)ar
easf
oll
ows.
 Thecost
sofpr
oduct
ion(
pri
ceofi
nput
s);t
hehi
ghert
hecost
sofpr
oduct
ion,
t
hel
esspr
ofi
twi
l
lbemadeatanypr
ice.Ascost
sri
se,f
ir
mswi
l
lcutbackon
pr
oduct
ion,pr
obabl
yswi
tchi
ngt
oal
ter
nat
ivepr
oduct
swhosecost
shav
enot
r
aisedsomuch.
 Thepr
ofi
tabi
li
tyofal
ter
nat
ivepr
oduct
s(subst
it
utesi
nsuppl
y);I
fapr
oduct
whi
chi
sasubst
it
utei
nsuppl
ybecomesmor
epr
ofi
tabl
etosuppl
ythanbef
ore,
pr
oducer
sar
eli
kel
ytoswi
tchf
rom t
hef
ir
stgoodt
othi
sal
ter
nat
ive.Suppl
yof
t
hef
ir
stgoodf
all
s.Ot
hergoodsar
eli
kel
ytobecomemor
epr
ofi
tabl
eif
:thei
r
pr
icesr
ise;
thei
rcost
sofpr
oduct
ionf
all
.
 The pr
ofi
tabi
li
ty ofgoods i
njoi
ntsuppl
y;Somet
imes when one good i
s
pr
oduced,
anot
hergoodi
sal
sopr
oducedatt
hesamet
ime.Thesear
esai
dtobe
goodsi
njoi
ntsuppl
y.Anexampl
eist
her
efi
ningofcr
udeoi
ltopr
oducepet
rol
.
Ot
hergr
adef
uel
swi
l
lbepr
oducedaswel
l
,suchasdi
eselandpar
aff
in.I
fmor
e
pet
roli
spr
oduced,duet
oar
isei
ndemandandhencei
tspr
ice,t
hent
hesuppl
y
oft
heseot
herf
uel
swi
l
lri
set
oo.
 Nat
ure,‘
random shocks’andot
herunpr
edi
ctabl
eevent
s;I
nthi
scat
egor
ywe
woul
dincl
udet
heweat
heranddi
seasesaf
fect
ingf
arm out
put
,war
saf
fect
ing
t
hesuppl
yofi
mpor
tedr
aw mat
eri
als,t
hebr
eakdownofmachi
ner
y,i
ndust
ri
al

16
 di
sput
es,
ear
thquakes,
floodsandf
ir
e,et
c.
 Theai
msofpr
oducer
s;Apr
ofi
t-
maxi
mizi
ngf
ir
m wi
l
lsuppl
yadi
ff
erentquant
it
y
f
rom af
ir
mthathasadi
ff
erentai
m,suchasmaxi
mizi
ngsal
es.Formostoft
he
t
imeweshal
lassumet
hatf
ir
msar
epr
ofi
tmaxi
mizes.
 Expect
ati
onsoff
utur
epr
icechanges;I
fpr
icei
sexpect
edt
ori
se,pr
oducer
s
mayt
empor
ari
l
yreducet
heamountt
heysel
l
.Inst
eadt
heyar
eli
kel
ytobui
l
dup
t
hei
rst
ocksandonl
yrel
easet
hem ont
othemar
ketwhent
hepr
icedoesr
ise.At
t
hesamet
imet
heymayi
nst
allnew machi
nesort
akeonmor
elabour
,sot
hat
t
heycanber
eadyt
osuppl
ymor
ewhent
hepr
icehasr
isen.
 Thenumberofsuppl
ier
s;I
fnew f
ir
msent
ert
hemar
ket
,suppl
yisl
i
kel
yto
i
ncr
ease.

Mov
ement
sal
ongandshi
ft
sint
hesuppl
ycur
ve

Thepr
inci
pleher
eist
hesameaswi
thdemandcur
ves.Theef
fectofachangei
npr
ice
i
sil
l
ust
rat
edbyamov
emental
ongt
hesuppl
ycur
ve:f
orexampl
e,f
rom poi
ntdt
o
poi
ntei
nFi
gur
e2.
3whenpr
icer
isesf
rom 80pt
o100p.Quant
it
ysuppl
i
edr
isesf
rom
530000t
o700000t
onspermont
h.I
fanyot
herdet
ermi
nantofsuppl
ychanges,t
he
whol
esuppl
ycur
vewi
l
lshi
ft
.Ar
ight
war
dshi
fti
l
lust
rat
esani
ncr
easei
nsuppl
y.A
l
eft
war
dshi
fti
l
lust
rat
esadecr
easei
nsuppl
y.Thusi
nFi
gur
e2.
4,i
ftheor
igi
nalcur
ve
i
sS0,t
hecur
veS1r
epr
esent
sani
ncr
easei
nsuppl
y(mor
eissuppl
i
edateachpr
ice)
,
wher
east
hecur
veS2r
epr
esent
sadecr
easei
nsuppl
y(l
essi
ssuppl
i
edateachpr
ice)
.

Fi
g2.
4shi
ft
sinsuppl
y
Amov
emental
ongasuppl
ycur
vei
sof
tenr
efer
redt
oasachangei
nthequant
it
y
17
suppl
ied,wher
easashi
fti
nthesuppl
ycur
vei
ssi
mpl
yref
err
edt
oasachangei
n
suppl
y.

Suppl
yFunct
ion

Thesi
mpl
estf
orm ofsuppl
yequat
ionr
elat
essuppl
ytoj
ustonedet
ermi
nant
.Thusa
f
unct
ionr
elat
ingsuppl
ytopr
icewoul
dbeoft
hef
orm:
qs =c+dp…………………………………………………. (
1)
Thusanact
ual
suppl
yequat
ionmi
ghtbesomet
hingl
i
ke:
Qs=500+1000P (
2)
Mor
ecompl
exsuppl
yequat
ionswoul
drel
atesuppl
ytomor
ethanonedet
ermi
nant
.
qs =c+dp-
ea1-
f …….
a2 +gj ………………………. (
3)
Wher
ePi
sthepr
iceoft
hegood,a1 anda2 ar
ethepr
ofi
tabi
l
ity
’soft
woal
ter
nat
ive
goodst
hatcoul
dbesuppl
i
edi
nst
ead,
andj
ist
hepr
ofi
tabi
l
ityofagoodi
njoi
ntsuppl
y.
Expl
ainwhyt
hePandj
ter
mshav
eaposi
ti
vesi
gn,
wher
east
hea1anda2t
ermshav
ea
negat
ivesi
gn.

Mar
ketEqui
li
bri
um

Thi
swi
l
lshowhowt
heact
ualpr
iceofapr
oductandt
heact
ualquant
it
yboughtand
sol
dar
edet
ermi
nedi
naf
reeandcompet
it
ivemar
ket
.Equi
l
ibr
ium i
sthepoi
ntwher
e
conf
li
cti
ngi
nter
est
sar
ebal
anced;onl
yatt
hispoi
nti
stheamountt
hatdemander
s
ar
ewi
l
li
ngt
opur
chaset
hesameast
heamountt
hatsuppl
i
ersar
ewi
l
li
ngt
osuppl
y.I
t
i
sapoi
ntt
hatwi
l
lbeaut
omat
ical
l
yreachedi
naf
reemar
kett
hrought
heoper
ati
onof
t
he pr
ice mechani
sm.The pr
ice wher
e demand equal
s suppl
yis cal
l
ed t
he
equi
l
ibr
ium pr
ice and t
he quant
it
y wher
e demand equal
s suppl
yis cal
l
ed t
he
equi
l
ibr
ium quant
it
y.Letusr
etur
ntot
heexampl
eoft
hemar
ketdemandandmar
ket
suppl
yofpot
atoes,
anduset
hedat
afr
om Tabl
es2.
1and2.
2.Thesef
igur
esar
egi
ven
agai
ninTabl
e2.
3.

Tabl
e2.
3Themar
ketdemandandsuppl
yofpot
atoes(
mont
hly
)

18
Fi
g2.
5thedet
ermi
nat
ionofmar
ketequi
l
ibr
ium (
pot
atoes:
mont
hly
)

Thedet
ermi
nat
ionofequi
l
ibr
ium pr
iceandout
putcanbeshownusi
ngdemandand
suppl
ycur
ves.Equi
l
ibr
ium i
swher
ethet
wocur
vesi
nter
sect
.Fi
gur
e2.
5showst
he
demandandsuppl
ycur
vesofpot
atoescor
respondi
ngt
othedat
ainTabl
e2.
3.
Equi
l
ibr
ium pr
icei
sPe(
60p)andequi
l
ibr
ium quant
it
yisQe(
350000t
ones)
.

Atanypr
iceabov
e60p,t
her
ewoul
dbeasur
plus.Thusat80pt
her
eisasur
plusof
330 000 t
ones(
d-D)
.Mor
eissuppl
i
ed t
hanconsumer
sar
ewi
l
li
ng and abl
eto
pur
chaseatt
hatpr
ice.Thusapr
iceof80pf
ail
stocl
eart
hemar
ket
.Pr
icewi
l
lfal
lto
t
heequi
l
ibr
ium pr
iceof60p.Asi
tdoesso,t
her
ewi
l
lbeamov
emental
ongt
he
demandcur
vef
rom poi
ntDt
opoi
ntC,
andamov
emental
ongt
hesuppl
ycur
vef
rom
poi
ntdt
opoi
ntc.

Atanypr
icebel
ow60p,
ther
ewoul
dbeashor
tage.Thusat40pt
her
eisashor
tageof
300000t
onnes(
B-b)
.Pr
icewi
l
lri
set
o60p.Thi
swi
l
lcauseamov
emental
ongt
he
19
suppl
ycur
vef
rom poi
ntbt
opoi
ntcandal
ongt
hedemandcur
vef
rom poi
ntBt
o
poi
ntC.Poi
ntCci
stheequi
l
ibr
ium:wher
edemandequal
ssuppl
y.I
nfact
,onl
yone
pr
icei
ssust
ainabl
e– t
hepr
icewher
edemand equal
ssuppl
y:namel
y,60p per
ki
l
ogr
am,wher
ebot
hdemandandsuppl
yar
e350000t
ones.Whensuppl
ymat
ches
demandt
hemar
keti
ssai
dtocl
ear
.Ther
eisnoshor
tageandnosur
plus.

Mov
ementt
oanewequi
li
bri
um

Theequi
l
ibr
ium pr
icewi
l
lremai
nunchangedonl
ysol
ongast
hedemandandsuppl
y
cur
vesr
emai
nunchanged.I
fei
theroft
hecur
vesshi
ft
s,anew equi
l
ibr
ium wi
l
lbe
f
ormed.Achangei
ndemand;I
foneoft
hedet
ermi
nant
sofdemandchanges(
other
t
hanpr
ice)
,thewhol
edemandcur
vewi
l
lshi
ft
.Thi
swi
l
lleadt
oamov
emental
ongt
he
suppl
ycur
vet
othenewi
nter
sect
ionpoi
nt.

Fi
g2.
6Ef
fectofashi
fti
nthedemandcur
ve

Changei
nSuppl
y

Li
kewi
se,i
foneoft
hedet
ermi
nant
sofsuppl
ychanges(
othert
hanpr
ice)
,thewhol
e
suppl
ycur
vewi
l
lshi
ft
.Thi
swi
l
lleadt
oamov
emental
ongt
hedemandcur
vet
othe
new i
nter
sect
ionpoi
nt.Forex
ampl
e,i
nFi
gur
e2.
7,i
fcost
sofpr
oduct
ionr
ose,t
he
suppl
ycur
vewoul
dshi
ftt
othel
eft
:toS2.Ther
ewoul
dbeashor
tageofg jatt
he
20
ol
dpr
iceofPe1.Pr
icewoul
dri
sef
rom Pe1t
oPe3.Quant
it
ywoul
dfal
lfr
om Qe1t
oQe3.
I
not
herwor
ds,t
her
ewoul
dbeamov
emental
ongt
hedemandcur
vef
rom poi
ntgt
o
poi
ntk,
andal
ongt
henewsuppl
ycur
ve(
S2)f
rom poi
ntj
topoi
ntk.

Fi
g2.
7Ef
fectofashi
fti
nthesuppl
ycur
ve

Tosummar
ies:ashi
fti
nonecur
vel
eadst
oamov
emental
ongt
heot
hercur
vet
othe
new i
nter
sect
ionpoi
nt.Somet
imesanumberofdet
ermi
nant
smi
ghtchange.Thi
s
mi
ghtl
eadt
oashi
fti
nbot
hcur
ves.Whent
hishappens,equi
l
ibr
ium si
mpl
ymov
es
f
rom t
hepoi
ntwher
etheol
dcur
vesi
nter
sect
edt
othepoi
ntwher
ethenew ones
i
nter
sect
.

El
ast
ici
tyofDemandandSuppl
y

Pr
iceel
ast
ici
tyofdemand(
ed)
:
Thel
awofdemandsi
mpl
yst
atest
hatquant
it
ydemandeddecr
eases(
incr
eases)as
pr
iceofgoodsandser
vicesi
ncr
eases(
decr
eases)
.It
,howev
er,say
snot
hingabout
t
hemagni
tudeofchangei
nquant
it
ydemanded.Theext
entofchangei
nquant
it
y
demandedi
sembeddedi
ntheconceptofel
ast
ici
ty.
El
ast
ici
tyi
sameasur
eofr
esponsi
venessofquant
it
ydemandedt
ochangesi
nthe
pr
iceofagood.I
tissi
mpl
ytheper
cent
agechangei
nquant
it
ydemandedf
oraone
per
centchangei
nthepr
iceofagood.
Mat
hemat
ical
l
y,

21
 per
cent
agechangei
nquant
it
ydemanded %ΔQ
εd = =
per
cent
agechangei
npri
ce %ΔP
changeinquanti
tydemanded changeinpri
ceori
ginal
= ÷
ori
ginal
quanti
tydemanded ori
ginal
pri
ce
ΔQ
×100%
Q ΔQ P
= = ×
ΔP ΔP Q
×100%
P
Wher
e,QandPar
eor
igi
nal
quant
it
ydemandedandpr
icer
espect
ivel
y.
When el
ast
ici
tyi
scomput
ed,changesi
n quant
it
yand pr
icesar
e expr
essed as
per
cent
ages.Hence,t
heel
ast
ici
tyv
aluei
suni
tfr
ee,i
.e.
,itdoesn’
tdependonuni
tof
measur
ement
.

Exampl
e:Whenpr
iceofwheatf
all
sfr
om 4bi
rrt
o2bi
rr
,thequant
it
ydemandedr
ose
f
rom 6t
o8qui
ntal
s.Fi
ndel
ast
ici
ty.

Ans: 2
εd =-
3
N.
B.–Pr
iceel
ast
ici
tyofdemandi
snegat
ivebecauseoft
hel
awofdemand.
-Conv
ent
ional
l
y,wei
gnor
ethesi
gnbyt
aki
ngi
nabsol
utet
erms

| |
εd =%ΔQ
%ΔP

Cl
assi
fi
cat
ionofpr
iceel
ast
ici
tyofdemand
Pr
iceel
ast
ici
tyofdemandcanbecl
assi
fi
edi
ntoel
ast
ic,
inel
ast
icanduni
tar
yel
ast
ic.
1.El
ast
icdemand(
%ΔQ >%ΔP)
:demandi
ssai
dtobepr
iceel
ast
ici
fthepr
ice
el
ast
ici
tyofdemandi
sgr
eat
ert
hanuni
ty(
one)
.Thati
s,t
heper
cent
agechange
i
nquant
it
ydemandedexceedst
heper
cent
agechangei
npr
ice.I
not
herwor
ds,
i
fthepr
iceel
ast
ici
tyofagoodi
sgr
eat
ert
hanone,t
hendemandi
ster
medas
pr
iceel
ast
ic,

| |
εd =
%ΔQ
%ΔP
>1→el
ast
icdemand

22
Thi
simpl
i
est
hatchangei
npr
iceofagoodhasgr
eat
eref
fectonquant
it
ydemanded.
Quant
it
yissensi
ti
vet
ochangesi
npr
ice.e.
g.l
uxur
iousgoodshav
eel
ast
icdemand.
Thedemandf
orapr
oductmaybeper
fect
lyel
ast
ic.Thi
smeanst
hatami
nut
echange
i
npr
iceofagoodwi
l
lresul
tinani
nfi
nit
elyl
argechangei
nquant
it
ydemanded.The
demandcur
vef
orsuchgoodsi
shor
izont
ali
mpl
yi
ngt
hatasmal
lchangei
npr
icewi
l
l
l
eadt
oani
nfi
nit
elyl
argechangei
nquant
it
ydemanded.

Asmal
lchangei
npr
icewi
l
lleadt
olar
ger(
inf
ini
te)changesi
nquant
it
ydemanded
2.I
nel
ast
i %ΔQ <%ΔP)
cdemand( :Ift
hepr
iceel
ast
ici
tyofdemandhasbeenzer
o
andone(
zer
oincl
uded)
,thendemandi
ssai
dtobepr
icei
nel
ast
ic.

For
mal
l
y,
ΔQ P
0≤εd <1or0≤ × <1→i
nel
ast
icdemand
ΔP Q
Whendemandi
sinel
ast
ic,achangei
npr
icehasl
i
ttl
eimpactonquant
it
ydemanded.
Thati
s,demandi
sweakl
yresponsi
vet
ochangesi
npr
ice.
Pr
iceel
ast
ici
tyofdemand maybeper
fect
lyi
nel
ast
ic.Undersuchsi
tuat
ion,t
he
demandcur
vewoul
dbev
ert
ical
.Demandi
scompl
etel
ynon-
sensi
ti
vet
ochangesi
n
pr
ice.

Thev
ert
icaldemandcur
vei
ndi
cat
est
hati
fpr
icechanges,t
her
ewi
l
lbenochangei
n
quant
it
ydemanded.Thati
s,nomat
terwhatt
hechangei
npr
ice,
demandr
emai
nst
he
same.
23
Exampl
e:demandf
ori
nsul
i
n
ΔQ P
εd = × ≈0
ΔP Q
3.Uni
tar
il
yel
ast
icdemand(%ΔQ =%ΔP)
:Ift
hepr
iceel
ast
ici
tyofdemandi
s
equal
toone,
thendemandf
oragoodi
ssai
dtobeuni
tar
yel
ast
ic.

For
mal
l
y,
ΔQ P
εd = × =1
ΔP Q
I
not
herwor
ds,t
heper
cent
agechangei
nquant
it
ydemandedequal
stheper
cent
age
changei
npr
ice.
Exampl
e:I
f200% i
ncr
easei
npr
iceofagooddecr
easet
hequant
it
ydemandedby
200%,
demandwi
l
lbeuni
tar
yel
ast
ic.

Summar
y
El
ast
ici
ty Cl
assi
fi
cat
ion I
nter
pret
ati
on
0≤εd <1 I
nel
ast
ic %ΔQ <%ΔP)
(
εd =1 Uni
tar
yel
ast
ic (
%ΔQ =%ΔP)

εd >1 El
ast
ic (
%ΔQ >%ΔP)

Det
ermi
nant
sofPr
iceEl
ast
ici
tyofDemand
Whatdet
ermi
nest
hepr
iceel
ast
ici
tyofdemandf
orapr
oduct
?
a)Av
ail
abi
l
ityofsubst
it
utes:

I
ngener
al,t
hemor
eandbet
tersubst
it
utesexi
stf
orani
tem,t
hemor
eel
ast
ic
i
tsdemandwi
l
lbe.Aper
fect
lyel
ast
icdemandhasmanyper
fectsubst
it
utes.
Ont
hecont
rar
y,aper
fect
lyi
nel
ast
icdemandhasv
irt
ual
l
ynosubst
it
utes.
Exampl
e,demandf
ort
axi
ser
vice(
ofonedr
iver
).
b)Pr
opor
ti
onofi
ncomeconsumer
sspendonacommodi
ty:

24
 I
fconsumer
sspendal
argepr
opor
ti
onoft
hei
rincomeonagi
veni
tem,
t
hent
hati
tem haspr
iceel
ast
icdemand.
e.
g.Foodi
nlar
gef
ami
l
y(wi
thsomanychi
l
dren)
,i-
pod,
etc.
Ont
heot
herhand,
ifconsumer
sspendl
essoft
hei
rincomeonapar
ti
cul
ari
tem,
then
t
hedemandf
ort
hati
tem i
sinel
ast
ic.Exampl
e,Mat
ches,
sal
t,et
c.
c)Adj
ust
mentt
ime

Demand t
ends t
o be mor
e el
ast
ic wi
thl
ongert
ime ov
erl
ong per
iods;
consumer
s wi
l
lhav
e mor
eti
me t
o adj
ustt
hei
rconsumpt
ion pat
ter
ns i
n
r
esponset
opr
icechanges,
that
,is,
findsubst
it
utes.
Exampl
e,Aper
manenti
ncr
easei
npr
iceofgasol
i
nel
eadst
odev
elopmentof
subst
it
utes(
sol
ar,t
her
mal
,et
c.)ener
gysour
ces.Buti
nshor
terper
iod,i
tis
di
ff
icul
ttodev
elopsubst
it
utes.
d)Gener
alVsSpeci
fi
ed

The mor
e nar
rowl
y def
ined t
he pr
oduct
,the gr
eat
ert
he numberof
subst
it
utesandt
hehi
ghert
heel
ast
ici
tyofdemand.Exampl
e,PepsiVssof
t
dr
inks,
Chev
rol
etsVsaut
omobi
l
e,t
axi
Vst
ranspor
tser
vice,
etc.

Cal
cul
ati
ngPr
iceEl
ast
ici
tyofDemand
Pr
iceel
ast
ici
tyofdemandcanbemeasur
edatapoi
ntorbet
weent
wopoi
nts.
a)Poi
ntel
ast
ici
ty:i
sel
ast
ici
tymeasur
edatasi
ngl
epoi
ntorf
orar
bit
rar
il
y
smal
lchanges.

Dist
anceofthepoi
ntfr
om Qaxi
s
poi
ntel
ast
ici
tyofdemand =
Di
stanceoft
hepointf
rom t
hePaxis

wi
thbot
hdi
stancesmeasur
edal
ongt
hedemandcur
ve.
Exampl
e
P
A

E C
=

25
=
O F B Q
 Butt
het
ri
angl
es and ar
esi
mil
ar

Thi
sisappl
i
cabl
eify
ouhav
ethedemandf
unct
ionf
orsome

goodX oratl
eastt
hedemandcur
vef
orsomegi
venl
evelofpr
iceand

quant
it
y,i
.e.

b)Ar
cel
ast
ici
ty:I
tisanel
ast
ici
tymeasur
edbet
weent
wopoi
ntsona
demandcur
ve.

El
ast
ici
tyi
sdef
inedas:

| |
εd =ΔQP
ΔPQ
Thequant
it
iesΔQandΔP ar
eeasyt
odef
ine( Q1 andΔP =P2-
asΔQ =Q2- P1)
.But
t
hequest
ionar
isesast
owhatv
aluesofQandPweuse.Ar
ewesupposedt
otake
t
hebegi
nni
ngorf
inal
val
uesorsomeav
erage?
Themostconv
eni
entwayi
stouset
heav
erageoft
hei
nit
ial
andf
inal
val
ues.

Exampl
e1:
Lett
hei
nit
ial
poi
ntbe( P1)andf
Q1, inal
poi
nt( P2)
Q2, ,then
26
 (P +P2)/2 Q2-
Q1 P1 +P2
εd =ΔQ. 1 = .
ΔP(Q1 +Q2)
/2 P2-
P1 Q1 +Q2

Thi
sist
hef
ormul
atof
indar
cel
ast
ici
tyofdemandbet
ween2poi
nts.
Geomet
ri
cal
l
y:
P

P2 A
P1 B

Q2 Q1 Q

N.
B.Ast
hegapbet
weenpoi
ntA andBappr
oacheszer
o,ar
cel
ast
ici
tybecomes
cl
osert
opoi
ntel
ast
ici
ty.
Exampl
e2:Supposet
hatt
hepr
iceofaqui
ntalofwheatr
isesf
rom 200Bi
rrt
o300
Bi
rrandasar
esul
tthequant
it
yofwheatdemandeddecl
i
nedf
rom 100t
o90qui
ntal
s.
Gi
ven:
(Q1,
P1)=(
100,
200)and(
Q2,
P2)=(
90,
300)

Ar
c

Pr
iceEl
ast
ici
tyofDemandandSl
ope
The sl
ope oft
he l
i
neardemand cur
vei
s const
antf
rom poi
ntt
o poi
nt,wi
th

.Howev
er,si
nce i
snotconst
ant
,thedemandel
ast
ici
tywi
l
lbe

di
ff
erentatdi
ff
erentpoi
ntsont
henon-
li
neardemandcur
ve.
Exampl
e:Thequant
it
ydemandedi
srel
atedt
opr
icebyt
hef
oll
owi
ngequat
ion:
Foral
la,
b>0

27
Pr
iceEl
ast
ici
tyofDemandal
ongt
heDemandCur
ve
Pr
iceel
ast
ici
tyofdemandv
ari
escont
inuousl
yal
ongal
i
neardemandcur
ve.I
twi
l
lbe
hi
gherathi
gherpr
ice(
lowerout
put
),equal
tooneatt
hemi
d-poi
ntofademandcur
ve
andi
twi
l
lbel
oweratl
owerpr
ice(
higherout
put
)lev
els.
E
Graphi
cal
ly:
N.B El
ast
icit
yist her
ati
o ofthe
di
stancefrom poi
ntFtoQc (
poi
nt M
on the demand curve) t
ot he
di
stancebetweenEandt hepoi
nt
onthecur
v e.
F

Pr
iceEl
ast
ici
tyofDemandandTot
alRev
enueandExpendi
tur
e
Tot
alexpendi
tur
e(TE)
:ist
he pr
oductoft
he amountofgoods and ser
vices
pur
chasedandt
hei
rpr
icedur
ingagi
vent
imeper
iod.i
.e.
Tot
alr
evenue(
TR)
:ist
heamountsol
dmul
ti
pli
edbyt
hepr
iceov
eragi
vent
imeper
iod.
i
.e.
,

Not
e:Expendi
tur
ebybuy
ersr
epr
esent
srev
enuef
orsel
l
ers.
Exampl
e:
Pr
ice Quant
it
y TE=TR Change i
n
TR(
=MR)
A 12 1 12
28
B 10 2 20 8
C 8 3 24 4
D 6 4 24 0
E 4 5 20 -
4

Ot
herEl
ast
ici
tyConcept
s
El
ast
ici
tycanbedef
inedwi
thr
espectt
oanyt
wor
elat
edv
ari
abl
es.Ther
ear
etwo
mor
eimpor
tantel
ast
ici
ti
esofdemand,namel
y,i
ncomeel
ast
ici
tyofdemandand
cr
oss-
pri
ceel
ast
ici
tyofdemand.
a)I
ncomeel
ast
ici
tyofdemand( )
:Itmeasur
est
hesensi
ti
vi
tyofconsumer

pur
chasesf
oragi
venper
cent
agechangei
nincome,cet
eri
spar
ibus.I
tcanbe
def
inedas:

,
wher
eY=i
ncomeandQ=quant
it
ydemanded.

measur
est
heper
cent
agechangei
nthenumberofuni
tsofa good

demanded,
wheni
ncomechangesbyoneper
cent
,cet
eri
spar
ibus.
Exampl
e: =2.
3impl
i
esa1%i
ncr
easei
nincomel
eadst
oa2.
3%i
ncr
easei
n

quant
it
ydemanded,
cet
eri
spar
ibus.
Whencomput
ing ,wedon’
ttakei
tinabsol
utet
erm si
ncei
tssi
gni
sof

i
nter
est
.Incomeel
ast
ici
tyofdemandcoul
dbeposi
ti
veornegat
ive.
i
. Posi
ti
vei
ncome el
ast
ici
ty:Posi
ti
vei
ncome el
ast
ici
tyi
ndi
cat
es t
hat
i
ncr
easesi
nincomear
eassoci
atedwi
thi
ncr
easei
nthequant
it
yof
goodspur
chased.Thosegoodswi
th >0ar
enor
mal
/super
iorgoods.

Nor
malgoodsar
eal
sof
urt
hercl
assi
fi
edi
ntonecessi
ti
esandl
uxur
ies.Agood
i
ssai
dtobenecessi
tyi
fit
sincomeel
ast
ici
tyi
sposi
ti
veandl
esst
hanone,
i.
e.
0< <1

e.
g.t ori
hedemandf njer
a

29
 Thi
smeanst
hatt
hequant
it
ydemandedf
orapr
oducti
ncr
easeswheni
ncome
i
ncr
eases,
butl
esst
hanpr
opor
ti
onat
ely
.Peopl
ewi
l
lspendasi
mil
arf
ract
ionof
t
hei
raddi
ti
onal
incomeonsuchgoods.
I
fincomeel
ast
ici
tyofdemandexceedsone,
thegoodi
scal
l
edl
uxur
ygood,
i.
e.
i
f >1,
thent
hismeanspeopl
ewi
l
lspendal
argerf
ract
ionoft
hei
rincomeon

l
uxur
yit
ems.
i
i
. Negat
ivei
ncomeel
ast
ici
ty:A negat
ivei
ncomeel
ast
ici
tyofdemand
i
ndi
cat
esani
nver
ser
elat
ionshi
pbet
weeni
ncomeandt
heamountof
t
hegoodpur
chased.Goodst
hathav
enegat
ivei
ncomeel
ast
ici
tyof
demandar
ecal
l
edi
nfer
iorgoods.

b)Cr
oss-
Pri
ceEl
ast
ici
tyofDemand( )
:

I
tisusedt
omeasur
ethesensi
ti
vi
tyofconsumerpur
chaseofonegoodt
o
changesi
nthepr
iceofanot
hergood.
Exampl
e:Theel
ast
ici
t orgoodYwi
yofdemandf thr
espectt
othepr
icesof
goodXmeasur
est
her
esponsi
v orYt
enessofdemandf oachange
i
nthepr
iceofXandi
sdef
inedas:

Exampl
e:Acr
oss-
pri
ceel
ast
ici
tyof =-
1.4meanst
hata1% i
ncr
easei
n

t
hepr
iceofgoodX l
eadst
oa1.
4% r
educt
ioni
nthedemandf
or
goodY.
Agai
nthesi
gnoft
heel
ast
ici
tyi
simpor
tant
.A posi
ti
vecr
oss-
pri
ceel
ast
ici
tyof
demandmeanst
hatani
ncr
easei
nPXl
eadst
oani
ncr
easei
nthedemandofgoodY
(
ordecr
easei
nquant
iydemandedofgoodX)
t ,cet
eri
spar
ibus.Hence,
thet
wogoods
ar
esubst
it
utes.
A negat
ivecr
oss-
pri
ceel
ast
ici
tyofdemand,ont
heot
herhand,i
mpl
i
est
hatan
i
ncr
easei
nPX causesar
educt
ioni
nquant
iydemandedofgoodY.Hence,t
t het
wo
goodsar
ecompl
ement
s.(
e.g.t
eaandsugar
,shoeandsocks,
etc.
)

30
Not
e:Twogoods(
XandY)hav
etwocr
oss-
pri
ceel
ast
ici
ti
es;
i
) -el
ast
ici
tyofdemandf
orYwi
thr
espectt
oPX

i
i
) -el
ast
ici
tyofdemandf
orXwi
thr
espectt
oPY

Theset
woel
ast
ici
ti
esneednotbeequal
.Ifcr
oss-
pri
ceel
ast
ici
ti
esar
ezer
o( =

=0)
,thent
het
wogoodsar
eindependent
/unr
elat
ed.

Pr
iceEl
ast
ici
tyofSuppl
y( )

Thel
aw ofsuppl
ysi
mpl
ytel
l
sust
hataspr
icei
ncr
easesordecr
eases,t
hequant
it
y
suppl
i
edwi
l
lincr
easeordecr
ease,r
espect
ivel
y.Butt
hel
awdoesn’
ttel
lusany
thi
ng
abouthow muchdoesquant
it
ysuppl
i
edi
ncr
easeordecr
easeaspr
icei
ncr
easeor
decr
easebyagi
venamount
.Suppl
yel
ast
ici
tyt
ell
susaboutt
hemagni
tudeofchange
i
nquant
it
ysuppl
i
edaspr
icechanges.
Def
ini
ti
on:Thepr
iceel
ast
ici
tyofsuppl
yisanumberusedt
omeasur
ethesensi
ti
vi
ty
ofchangei
nquant
it
ysuppl
i
edt
oagi
venper
cent
agechangei
nthepr
iceofagood.
Al
ter
nat
ivel
y,i
tcan be def
ined as t
he per
cent
age change i
n quant
it
ysuppl
i
ed
r
esul
ti
ngf
rom a1%changei
npr
ice,
cet
eri
spar
ibus.Thati
s:

i
sal
way
sposi
ti
ve noneedf
orabsol
utev
aluesi
gn.

Cl
assi
fi
cat
ionofPr
iceEl
ast
ici
tyofSuppl
y:i
tcanbecl
assi
fi
edi
ntoel
ast
ic,
inel
ast
icor
uni
tar
yel
ast
ic.
i
) El
ast
icsuppl
y:I
f i
sgr
eat
ert
hanone,t
hensuppl
yofani
tem i
ssai
dtobe

el
ast
ic(
i.
e., >1)
.Suppl
yofani
tem maybeper
fect
lyel
ast
ic.Theshapeof

el
ast
icsuppl
ycur
vei
shor
izont
al. → i
.e.asmal
lchangei
npr
icewi
l
llead
P
31

Q
 t
oani
nfi
nit
echangeofquant
it
ysuppl
i
edbyf
ir
ms.

i
i
) I
nel
ast
icsuppl
y:I
fthepr
iceel
ast
ici
tyofsuppl
yisequalorgr
eat
ert
hanzer
o
butl
esst
hanone,
thensuppl
yissai
dtobepr
icei
nel
ast
ic(
i.
e.,
0≤ <1)
.

Pr
iceel
ast
ici
tyofsuppl
ymaybeper
fect
lyi
nel
ast
ic,i
.e. =0,whi
chi
scompl
etel
y

unr
esponsi
vet
opr
i P
cechange.

Q
i
i
i) Uni
tar
yEl
ast
ici
tyofSuppl
y:I
fthepr
iceel
ast
ici
tyofsuppl
yisequalt
oone( =

1)
,thensuppl
yissai
dtobeuni
tar
yel
ast
ic.

Det
ermi
nant
sofEl
ast
ici
tyofSuppl
y:
i
. Ti
me
i
i
. Av
ail
abi
l
ityoff
act
orsofpr
oduct
ion(
resour
ces)
i
i
i. Possi
bil
i
tyofswi
tchi
ngpr
oduct
iont
oot
herpr
oduct
s

Lear
ningact
ivi
ti
es
 Whatar
ethedet
ermi
nant
sofdemandandsuppl
y?
 Di
ff
erent
iat
ebet
weenl
awofdemandandsuppl
y?
 Whatdoest
hel
awofdemandandsuppl
yst
ates?
 Enumer
atet
hedemandshi
ft
er?
 Expl
ainf
act
orst
hatcausemov
ement
sal
ongandshi
ft
sint
hedemandcur
ve?
 Li
standdi
scussdet
ermi
nant
sofsuppl
yot
hert
hanownpr
ice?
 Whatar
ethedet
ermi
nant
sofpr
iceel
ast
ici
tyofdemand?
 Di
scusst
her
elat
ionshi
pbet
weenpr
iceel
ast
ici
tyofdemand&Tot
alr
evenue&
expendi
tur
e?
 Di
scussot
herel
ast
ici
tyconcept
s?

32
Summar
y
Economi
stsuset
hemodelofsuppl
yanddemandt
oanal
yzecompet
it
ivemar
ket
s.I
n
acompet
it
ivemar
ket
,ther
ear
emanybuy
ersandsel
l
ers,eachofwhom hasl
i
ttl
eor
noi
nfl
uenceont
hemar
ketpr
ice.Accor
dingt
othel
awofdemand,ast
hepr
iceofa
goodf
all
sthequant
it
ydemandedr
ises,ot
hert
hingsr
emai
nconst
ant
.Ther
efor
e,t
he
demandcur
vesl
opesdownwar
d.I
naddi
ti
ont
opr
ice,ot
herdet
ermi
nant
soft
he
quant
it
y demanded i
ncl
ude i
ncome,t
ast
es,expect
ati
ons,and t
he pr
ices of
subst
it
utesandcompl
ement
s.I
foneoft
heseot
her
sdet
ermi
nant
schanges,t
he
demandcur
veshi
ft
s.

Thesuppl
ycur
veshowshowt
hequant
it
yofagoodsuppl
i
eddependsont
hepr
ice.
Accor
dingt
othel
aw ofsuppl
y,ast
hepr
iceofagoodr
ises,t
hequant
it
ysuppl
i
ed
r
ises.Ther
efor
e,t
he suppl
y cur
ve sl
opes upwar
d.I
n addi
ti
on t
o pr
ice,ot
her
det
ermi
nant
s of t
he quant
it
y suppl
i
ed i
ncl
ude i
nput pr
ices,t
echnol
ogy
,and
expect
ati
ons.I
foneoft
heseot
her
sdet
ermi
nant
schanges,t
hesuppl
ycur
veshi
ft
s.
Thei
nter
sect
ionoft
hesuppl
yanddemandcur
vesdet
ermi
nest
hemar
ketequi
l
ibr
ium.
Att
heequi
l
ibr
ium pr
ice,t
hequant
it
ydemandedequal
sthequant
it
ysuppl
i
ed.To
anal
yzehowanyev
enti
nfl
uencesamar
ket
,weuset
hesuppl
y-
and-
demanddi
agr
am
t
oexami
nehow t
heev
entaf
fect
stheequi
l
ibr
ium pr
iceandquant
it
y.Todot
hiswe
f
oll
owt
hreest
eps.Fi
rst
,wedeci
dewhet
hert
heev
entshi
ft
sthesuppl
ycur
veort
he
demandcur
ve(
orbot
h).Second,
wedeci
dewhi
chdi
rect
iont
hecur
veshi
ft
s.Thi
rd,
we
compar
ethenewequi
l
ibr
ium wi
tht
heol
dequi
l
ibr
ium.

Thel
astconcepti
sonel
ast
ici
tyofdemandandsuppl
y.Thel
aw ofdemandsi
mpl
y
st
atest
hatquant
it
ydemandeddecr
eases(
incr
eases)aspr
iceofgoodsandser
vices
i
ncr
eases(
decr
eases)
.It
,howev
er,say
snot
hingaboutt
hemagni
tudeofchangei
n
quant
it
ydemanded.Theext
entofchangei
nquant
it
ydemandedi
sembeddedi
nthe
conceptofel
ast
ici
ty.Pr
ice el
ast
ici
tyofdemand can be cl
assi
fi
ed i
nto el
ast
ic,
i
nel
ast
icanduni
tar
yel
ast
ic.

33
Thel
aw ofsuppl
yal
sosi
mpl
ytel
l
sust
hataspr
icei
ncr
easesordecr
eases,t
he
quant
it
ysuppl
i
edwi
l
lincr
easeordecr
ease,r
espect
ivel
y.Butt
hel
aw doesn’
ttel
lus
any
thi
ngabouthow muchdoesquant
it
ysuppl
i
edi
ncr
easeordecr
easeaspr
ice
i
ncr
ease ordecr
ease by a gi
ven amount
.Suppl
y el
ast
ici
tyt
ell
s us aboutt
he
magni
tudeofchangei
nquant
it
ysuppl
i
edaspr
icechanges.Ti
me,av
ail
abi
l
ityof
f
act
ors & possi
bil
i
ty ofswi
tchi
ng pr
oduct
ion t
o ot
herpr
oduct
s ar
ethe maj
or
det
ermi
nant
sofsuppl
y.

Chapt
erThr
ee:Theor
yofUt
il
it
yandPr
efer
ences
Pr
etest
s
 Whatdoy
oumeanbyut
il
it
y?
 Howut
il
it
ycanbemeasur
ed?

ConsumerPr
efer
encesandChoi
ces

I
nthi
ssect
iony
ouwi
l
lseehow consumer
sal
l
ocat
ethei
rli
mit
edi
ncomeamong
di
ff
erentnumberofgoodsandser
vicesMor
eov
er,y
ouwi
l
llear
nhow consumer
’s
al
l
ocat
iondeci
sionsdet
ermi
nequant
it
ydemandofgoodsandser
vices.

ConsumerPr
efer
ence
Gi
venanyt
woconsumpt
ionbundl
es(
groupsofgoods)av
ail
abl
eforpur
chase,
howa
consumercompar
est
hegoods?Doeshepr
eferonegoodt
oanot
her
,ordoeshe
i
ndi
ff
erentbet
ween t
he t
wo gr
oups.Gi
ven any t
wo consumpt
ion bundl
es,t
he
consumercanei
therdeci
det
hatoneofconsumpt
ionbundl
esi
sst
ri
ctl
ybet
tert
han
t
heot
her
,ordeci
det
hathei
sindi
ff
erentbet
weent
het
wobundl
es.

St
ri
ctpr
efer
ence
Gi
venanyt
woconsumpt
ionbundl
es(
X1,
X2)and(
Y1,
Y2)
,i
f(X1,
X2)
>(Y1,
Y2)ori
fhe
chooses(
X1,
X2)when(
Y1,
Y2)i
sav
ail
abl
etheconsumerdef
ini
tel
ywant
stheX-
bundl
ethanY.

Weakpr
efer
ence

34
Gi
venanyt
woconsumpt
ionbundl
es(
X1,
X2)and(
Y1,
Y2)
,i
ftheconsumeri
sindi
ff
erent
bet
weent
het
wocommodi
tybundl
esori
f(X1,
X2) (
Y1,
Y2)
,theconsumerwoul
dbe
equal
l
ysat
isf
iedi
fheconsumes(
X1,
X2)or(
Y1,
Y2)
.

Compl
eteness
Foranyt
wocommodi
tybundl
esXandY,
aconsumerwi
l
lpr
eferXt
oY,
YtoXorwi
l
l
bei
ndi
ff
erentbet
weent
het
wo.
Tr
ansi
ti
vi
ty
I
tmeanst
hati
faconsumerpr
efer
sbasketAt
obasketBandt
obasketC,t
hent
he
consumeral
sopr
efer
sAt
oC.

Mor
eisbet
tert
hanl
ess
Consumer
sal
way
spr
efermor
eofanygoodt
olessandt
heyar
enev
ersat
isf
iedor
sat
iat
ed.Howev
er,badgoodsar
enotdesi
rabl
eandconsumer
swi
l
lal
way
spr
efer
l
essoft
hem.

Theor
yofUt
il
it
y

Economi
stsuset
het
erm ut
il
it
ytodescr
ibet
hesat
isf
act
ionorenj
oymentder
ived
f
rom t
heconsumpt
ionofagoodorser
vice.

Def
ini
ti
on
Ut
il
it
yist
hel
evelofsat
isf
act
iont
hati
sobt
ainedbyconsumi
ngacommodi
tyor
under
taki
nganact
ivi
ty.I
ndef
ini
ngst
ri
ctpr
efer
ence,wesai
dthatgi
venanyt
wo
consumpt
ionbundl
es(
X1,
X2)and(
Y1,
Y2)
,t
heconsumerdef
ini
tel
ywant
stheXbundl
e
t
hant
heYbundl
eif(
X1,
X2)>(
Y1,
Y2)
.Thi
smeans,t
heconsumerpr
efer
redbundl
e
(
X1,
X2)t
obundl
e(Y1,
Y2)i
fandonl
yift
heut
il
it
y(X1,
X2)i
slar
gert
hant
heut
il
it
yof
(
Y1,
Y2)
.

Theconceptofut
il
it
yischar
act
eri
zedwi
tht
hef
oll
owi
ngpr
oper
ti
es:
 ‘
Uti
l
ity
’and ‘
Usef
ulness”ar
e notsy
nony
mous.Forexampl
e,pai
nti
ngs by

35
 Pi
cassomaybeusel
essf
unct
ional
l
ybutof
fergr
eatut
il
it
ytoar
tlov
ers.
 Ut
il
it
yissubj
ect
ive.Theut
il
it
yofapr
oductwi
l
lvar
yfr
om per
sont
oper
son.
Thatmeans,t
heut
il
it
ythatt
woi
ndi
vi
dual
sder
ivef
rom consumi
ngt
hesame
l
evelofapr
oductmaynotbet
hesame.Forexampl
e,no-
smoker
sdonot
der
iveanyut
il
it
yfr
om ci
gar
ett
es.
 Theut
il
it
yofapr
oductcanbedi
ff
erentatdi
ff
erentpl
acesandt
ime.
 AConsumerconsi
der
sthef
oll
owi
ngpoi
ntst
ogetmaxi
mum ut
il
it
yorl
evelof
sat
isf
act
ion:
 Howmuchsat
isf
act
ionheget
sfr
om buy
ingandt
henconsumi
nganext
rauni
t
ofagoodorser
vice.
 Thepr
icehepay
stogett
hegood.
 Thesat
isf
act
ionheget
sfr
om consumi
ngal
ter
nat
ivepr
oduct
s.
 Thepr
icesofal
ter
nat
ivegoodsandser
vices.

Appr
oachest
omeasur
eUt
il
it
y

Ther
ear
etwomaj
orappr
oachesofmeasur
ingut
il
it
y.Thesear
eCar
dinalandor
dinal
appr
oaches.Thi
ssect
ioni
sdi
vi
dedi
ntot
wosect
ions.I
nSect
iononet
heCar
dinal
ut
il
it
yappr
oachwi
l
lbedi
scussedwhi
l
einSect
iont
wot
heconceptofor
dinalUt
il
it
y
wi
l
lbeaddr
essed.

TheCar
dinal
Uti
li
tyt
heor
y

Ut
il
it
ymaxi
mizat
iont
heor
iesar
eimpor
tantt
odealwi
thconsumerbehav
ior
.Thus,i
n
t
hissect
ion,
youwi
l
llear
naboutt
heCar
dinalUt
il
it
ytheor
y.Neocl
assi
caleconomi
sts
ar
guedt
hatut
il
it
yismeasur
abl
eli
kewei
ght
,hei
ght
,temper
atur
eandt
heysuggest
ed
auni
tofmeasur
ementofsat
isf
act
ioncal
l
edut
il
s.Aut
ili
sacar
dinalnumberl
i
ke
1,
2,
3et
csi
mpl
yat
tachedt
out
il
it
y.Hence,
uti
l
itycanbequant
it
ati
vel
ymeasur
ed.

Assumpt
ionsofCar
dinalUt
il
it
ytheor
y

1)Rat
ional
it
yofConsumer
s.Themai
nobj
ect
iveoft
heconsumeri
stomaxi
mize
hi
s/hersat
isf
act
iongi
venhi
s/herl
i
mit
edbudgetori
ncome.Thus,i
nor
dert
o
36
 maxi
mizehi
s/hersat
isf
act
ion,
theconsumerhast
ober
ati
onal
.
2)Ut
il
it
yis car
dinal
ly Measur
abl
e.Accor
ding t
othi
s appr
oach,t
he ut
il
it
y or
sat
isf
act
ionofeachcommodi
tyi
smeasur
abl
e.Moneyi
sthemostconv
eni
ent
measur
ementofut
il
it
y.I
not
herwor
ds,t
hemonet
aryuni
tthatt
heconsumeri
s
pr
epar
edt
opayf
oranot
heruni
tofcommodi
tymeasur
esut
il
it
yorsat
isf
act
ion.
3)Const
antMar
ginalUt
il
it
yofMoney
.Accor
ding t
o assumpt
ion numbert
wo,
moneyi
sthemostconv
eni
entmeasur
ementofut
il
it
y.Howev
er,i
fthemar
ginal
ut
il
it
yofmoneychangeswi
tht
hel
evelofi
ncome(
weal
th)oft
heconsumer
,then
moneycannotbeconsi
der
edasameasur
ementofut
il
it
y.
4)Li
mit
edMoneyI
ncome.Theconsumerhasl
i
mit
edmoneyi
ncomet
ospendont
he
goodsandser
viceshe/
shechoosest
oconsume.
5)Di
mini
shi
ng Mar
ginalUt
il
it
y(DMU)
.The ut
il
it
yder
ived f
rom each f
rom each
successi
veuni
tsofacommodi
tydi
mini
shes.I
not
herwor
ds,t
hemar
ginalut
il
it
y
ofacommodi
tydi
mini
shesast
heconsumeracqui
resl
argerquant
it
iesofi
t.
6)Thet
otalut
il
it
yofabasketofgoodsdependsont
hequant
it
iesoft
hei
ndi
vi
dual
commodi
ti
es.
7)I
fther
ear
encommodi
ti
esi
nthebundl
ewi
thquant
it
ies, t
het
otal

ut
il
it
yisgi
venby
:TU=f( )

Tot
alandMar
ginalUt
il
it
y

Tot
alUt
il
it
y(TU)
:Itr
efer
stot
het
otalamountofsat
isf
act
ionaconsumerget
sfr
om
consumi
ngorpossessi
ngsomespeci
fi
cquant
it
iesofacommodi
tyatapar
ti
cul
ar
t
ime.Ast
heconsumerconsumesmor
eofagoodpert
imeper
iod,
his/
hert
otalut
il
it
y
i
ncr
eases.Howev
er,t
her
eisasat
urat
ionpoi
ntf
ort
hatcommodi
tyi
nwhi
cht
he
consumerwi
l
lnotbecapabl
eofenj
oyi
nganygr
eat
ersat
isf
act
ionf
rom i
t.

Mar
ginalUt
il
it
y(MU)
:Itr
efer
stot
headdi
ti
onalut
il
it
yobt
ainedf
rom consumi
ngan
addi
ti
onaluni
tofacommodi
ty.I
not
herwor
ds,mar
ginalut
il
it
yist
hechangei
ntot
al

37
ut
il
it
yresul
ti
ngf
rom t
heconsumpt
ionofoneormor
euni
tofapr
oductperuni
tof
t
ime.Gr
aphi
cal
l
y,i
tist
hesl
opeoft
otal
uti
l
ity
.

Mat
hemat
ical
l
y,t
hef
ormul
aformar
ginal
uti
l
ityi
s:

Wher
e:TUi
sthechangei
nTot
alUt
il
it
y,andQi
schangei
ntheamountofpr
oduct
consumed.

Lawofdi
mini
shi
ngmar
ginalUt
il
it
y(LDMU)

I
stheut
il
it
yyougetf
rom consumpt
ionoft
hef
ir
stor
angei
sthesameast
hesecond
or
ange?Theut
il
it
ythataconsumerget
sbyconsumi
ngacommodi
tyf
ort
hef
ir
stt
ime
i
snott
hesameast
heconsumpt
ionoft
hegoodf
ort
hesecond,
thi
rd,
four
th,
etc.The
Law ofDi
mini
shi
ng Mar
ginalUt
il
it
ySt
atest
hatast
hequant
it
yconsumed ofa
commodi
tyi
ncr
easesperuni
toft
ime,t
heut
il
it
yder
ivedf
rom eachsuccessi
veuni
t
decr
eases,consumpt
ionofal
lot
hercommodi
ti
esr
emai
ningconst
ant
.TheLDMUi
s
bestexpl
ainedbyt
heMUcur
vet
hati
sder
ivedf
rom t
her
elat
ionshi
pbet
weent
heTU
andt
otal
quant
it
yconsumed.
Tabl
e2.
1Hy
pot
het
ical
tabl
eshowi
ngTUandMUofconsumi
ngOr
anges(
X)
Uni
ts of
0 1st 2nd r
d
4th 5th 6th
Quant
it
y(x) 3 uni
t
Uni
t Uni
t uni
t Uni
t Uni
t Uni
t
consumed
TUX 0ut
il 10ut
il
s 16ut
il
s 20ut
il
s 22ut
il
s 22ut
il
s 20ut
il
s
MUX 0 10 6 4 2 0 -
2

Equi
li
bri
um ofaconsumer

A consumert
hatmaxi
mizes ut
il
it
yreaches hi
s/herequi
l
ibr
ium posi
ti
on when
al
l
ocat
ionofhi
s/herexpendi
tur
eissucht
hatt
hel
astbi
rrspentoneachcommodi
ty
y
iel
dst
hesameut
il
it
y.Forexampl
e,i
ftheconsumerconsumesabundl
eofn
commodi
ti
esi
.ex1,
x2,
…,xn,he/
shewoul
dbei
nequi
l
ibr
ium orut
il
it
yismaxi
mizedi
f
andonl
yif
:
38
 Wher
e:MUm –mar
ginal
uti
l
ityofmoney

Di
agr
ammat
ical
l
y,

A
C
PX

B
MUX

Fi
gur
e2.
2mar
ginalut
il
it
yofaconsumer

Not
ethat
:atanypoi
ntabov
epoi
ntC l
i
kepoi
ntA wher
eMUX>Px,i
tpay
sthe
consumert
oconsumemor
e.Atanypoi
ntbel
owpoi
ntCl
i
kepoi
ntBwher
eMUX<Px
t
heconsumerconsumesl
essofX.Howev
er,
atpoi
ntCwher
eMUx=Pxt
heconsumer
i
satequi
l
ibr
ium.

Tabl
e2.
2Ut
il
it
yschedul
eforasi
ngl
ecommodi
ty
Quant
it
y of TU MU MU per MUofmoney
Or
ange Bi
rr
(pr
ice=2bi
rr
)
0 0 - - 1
1 6 6 3 1
2 10 4 2 1
3 12 2 1 1
4 13 1 0.
5 1
5 13 0 0 1
6 11 -
2 -
1 1

Forconsumpt
ionl
evell
owert
hant
hreequant
it
iesofor
anges,si
ncet
hemar
ginal

39
ut
il
it
yofor
angei
shi
ghert
hant
hepr
ice,t
heconsumercani
ncr
easehi
s/herut
il
it
yby
consumi
ngmor
equant
it
iesofor
anges.Ont
heot
herhand,
forquant
it
ieshi
ghert
han
t
hree,si
ncet
hemar
ginalut
il
it
yofor
angei
slowert
hant
hepr
ice,t
heconsumercan
i
ncr
easehi
s/herut
il
it
ybyr
educi
ngi
tsconsumpt
ionofor
anges.Mat
hemat
ical
l
y,t
he
equi
l
ibr
ium condi
ti
onofaconsumert
hatconsumesasi
ngl
egoodXoccur
swhent
he
mar
ginal
uti
l
ityofXi
sequal
toi
tsmar
ketpr
ice.

Li
mit
ati
onoft
heCar
dinal
istappr
oach

TheCar
dinal
i
stappr
oachi
nvol
vest
hef
oll
owi
ngt
hreeweaknesses:
1)Theassumpt
ionofcar
dinal
uti
l
ityi
sdoubt
ful
becauseut
il
it
ymaynotbequant
if
ied.
2)Ut
il
it
ycannotbemeasur
edabsol
utel
y(obj
ect
ivel
y).Thesat
isf
act
ionobt
ained
f
rom di
ff
erentcommodi
ti
escannotbemeasur
edobj
ect
ivel
y.
3)Theassumpt
ionofconst
antMU ofmoneyi
sunr
eal
i
sti
cbecauseasi
ncome
i
ncr
eases,
themar
ginal
uti
l
ityofmoneychanges.

TheOr
dinalUt
il
it
yTheor
y

I
ntheor
dinalut
il
it
yappr
oach,ut
il
it
ycannotbemeasur
edabsol
utel
ybutdi
ff
erent
consumpt
ionbundl
esar
erankedaccor
dingt
opr
efer
ences.Theconcepti
sbasedon
t
hef
actt
hati
tmaynotbepossi
blef
orconsumer
stoexpr
esst
heut
il
it
yofv
ari
ous
commodi
ti
est
heyconsumei
nabsol
utet
erms,l
i
ke,1ut
il
,2ut
il
,or3ut
il
,buti
tis
al
way
spossi
blef
ort
heconsumer
sto expr
esst
heut
il
it
yinr
elat
ivet
erms.I
tis
pr
act
ical
l
ypossi
blef
ort
heconsumer
stor
ankcommodi
ti
esi
ntheor
deroft
hei
r

pr
efer
enceas andsoon.

Assumpt
ionsofOr
dinalUt
il
it
ytheor
y
Li
ket
hepr
evi
ousappr
oach,
thi
sappr
oachi
sbasedont
hef
oll
owi
ngassumpt
ions:
1)TheConsumer
sar
erat
ional
-t
heyai
m atmaxi
mizi
ngt
hei
rsat
isf
act
ionorut
il
it
y
gi
vent
hei
rincomeandmar
ketpr
ices.
2)Ut
il
it
yis or
dinal
,i.
e.ut
il
it
yis not absol
utel
y(car
dinal
l
y) measur
abl
e.

40
 Consumer
sar
erequi
redonl
ytoor
derorr
ankt
hei
rpr
efer
encef
orv
ari
ous
bundl
esofcommodi
ti
es.
3)Di
mini
shi
ng Mar
ginalRat
e ofSubst
it
uti
on (
MRS)
:The mar
ginalr
ate of
subst
it
uti
oni
sther
ateatwhi
chaconsumeri
swi
l
li
ng t
o subst
it
uteone
commodi
ty(
x)f
oranot
hercommodi
ty(
y)so t
hathi
stot
alsat
isf
act
ion
r
emai
nst
hesame.Whenaconsumercont
inuest
osubst
it
uteXf
orYt
her
ate
goesdecr
easi
ngandi
tist
hesl
opeoft
heI
ndi
ff
erencecur
ve.
4)Thet
otal
uti
l
ityoft
heconsumerdependsont
hequant
it
iesoft
hecommodi
ti
es

consumed, i
.e.
,U=f( )
5)Pr
efer
encesar
etr
ansi
ti
veorconsi
stent
:Iti
str
ansi
ti
vei
nthesensest
hati
fthe
consumerpr
efer
smar
ketbasketXt
omar
ketbasketY,
andpr
efer
sYt
oZ,
and
t
hent
heconsumeral
sopr
efer
sXt
oZ.Whenwesai
dconsi
stenti
tmeanst
hat
I
fmar
ketbasketXi
sgr
eat
ert
hanmar
ketbasketY(
X>Y)t
henYnotgr
eat
er
t
hanX(
Ynot>Y)
.
Theor
dinalut
il
it
yappr
oachi
sexpr
essedorexpl
ainedwi
tht
hehel
pofi
ndi
ff
erence
cur
ves.Ani
ndi
ff
erencecur
vei
saconceptusedt
orepr
esentanor
dinalmeasur
eof
t
het
ast
esandpr
efer
encesoft
heconsumerandt
oshow how he/
shemaxi
mizes
ut
il
it
yinspendi
ngi
ncome.Si
ncei
tusesI
Cst
ost
udyt
heconsumer
’sbehav
ior
,the
or
dinal
uti
l
ityt
heor
yisal
soknownast
heI
ndi
ff
erenceCur
veAnal
ysi
s.

I
ndi
ff
erenceSet
,Cur
veandMap

I
ndi
ff
erenceSet
/Schedul
e:I
tisacombi
nat
ionofgoodsf
orwhi
cht
heconsumeri
s
i
ndi
ff
erent
,pr
efer
ri
ngnoneofanyot
her
s.I
tshowst
hev
ari
ouscombi
nat
ionsof
goodsf
rom whi
cht
heconsumerder
ivest
hesamel
evel
ofut
il
it
y.

I
ndi
ff
erenceCur
ves:ani
ndi
ff
erencecur
veshowst
hev
ari
ouscombi
nat
ionsoft
wo
goodst
hatpr
ovi
det
heconsumert
hesamel
evelofut
il
it
yorsat
isf
act
ion.I
tist
he
l
ocusofpoi
nts(
par
ti
cul
arcombi
nat
ionsorbundl
esofgood)
,whi
chy
iel
dthesame
ut
il
it
y(l
evel
ofsat
isf
act
ion)t
otheconsumer
,sot
hatt
heconsumeri
sindi
ff
erentast
o
t
hepar
ti
cul
arcombi
nat
ionhe/
sheconsumes.
41
I
ndi
ff
erenceMap:Todescr
ibeaper
son’
spr
efer
encesf
oral
lcombi
nat
ionspot
ato
andmeat
,wecangr
aphasetofi
ndi
ff
erencecur
vescal
l
edani
ndi
ff
erencemap.I
n
ot
herwor
dsi
tist
heent
ir
esetofi
ndi
ff
erencecur
vesi
sknownasani
ndi
ff
erencemap,
whi
chr
efl
ect
stheent
ir
esetoft
ast
esandpr
efer
encesoft
heconsumer
.Ahi
gher
i
ndi
ff
erencecur
ver
efer
stoahi
gherl
evelofsat
isf
act
ionandal
oweri
ndi
ff
erence
cur
veshowsl
essersat
isf
act
ion.

Pr
oper
ti
esofI
ndi
ff
erenceCur
ves:

1)I
ndi
ff
erencecur
veshav
enegat
ivesl
ope(
downwar
d sl
opi
ng t
other
ight
).
I
ndi
ff
erencecur
vesar
enegat
ivel
ysl
opedbecauset
heconsumpt
ionl
evelof
onecommodi
tycanbei
ncr
easedonl
ybyr
educi
ngt
heconsumpt
ionl
evelof
t
heot
hercommodi
ty.Thatmeans,
ift
hequant
it
yofonecommodi
tyi
ncr
eases
wi
tht
hequant
it
yoft
heot
herr
emai
ning const
ant
,thet
otalut
il
it
yoft
he
consumeri
ncr
eases.Ont
heot
herhand,i
fthequant
it
yofonecommodi
ty
decr
easeswi
tht
hequant
it
yoft
heot
herr
emai
ningconst
ant
,thet
otalut
il
it
yof
t
heconsumerr
educes.Hence,i
nor
dert
okeept
heut
il
it
yoft
heconsumer
const
ant
,ast
hequant
it
yofonecommodi
tyi
sincr
eased,t
hequant
it
yoft
he
ot
hermustbedecr
eased.
2)I
ndi
ff
erencecur
vesdonoti
nter
secteachot
her
.Int
ersect
ionbet
weent
wo
i
ndi
ff
erencecur
vesi
sinconsi
stentwi
tht
her
efl
ect
ionofi
ndi
ff
erencecur
ves.I
f
t
heydi
d,t
hepoi
ntoft
hei
rint
ersect
ionwoul
dmeant
wodi
ff
erentl
evel
sof
sat
isf
act
ion,
whi
chi
simpossi
ble.
3)Ahi
gherI
ndi
ff
erencecur
vei
sal
way
spr
efer
redt
oal
owerone.Thef
urt
her
awayf
rom t
heor
igi
nani
ndi
ff
erentcur
vel
i
es,t
hehi
ghert
hel
evelofut
il
it
yit
denot
es:basket
sofgoodsonahi
gheri
ndi
ff
erencecur
vear
epr
efer
redbyt
he
r
ati
onalconsumer
,becauset
heycont
ainmor
eoft
het
wocommodi
ti
est
han
t
hel
owerones.
4)I
ndi
ff
erencecur
vesar
econv
ext
otheor
igi
n.Thi
simpl
i
est
hatt
hesl
opeofan
i
ndi
ff
erencecur
vedecr
eases(
inabsol
utet
erms)aswemov
eal
ongt
hecur
ve
f
rom t
he l
eftdownwar
ds t
othe r
ight
.Thi
s assumpt
ion i
mpl
i
es t
hatt
he

42
 commodi
ti
escansubst
it
uteoneanot
heratanypoi
ntonani
ndi
ff
erencecur
ve,
butar
enotper
fectsubst
it
utes.

Banana B

Banan
E
D I
C2
C
A
I
C1

X
Or
ange Or
ange

Fi
g. 5posi
2. ti
vel
ysl
opedandi
nter
sect
edi
ndi
ff
erencecur
ves

Aswedi
scussedear
li
er,I
ndi
ff
erencecur
vescannoti
nter
secteachot
her
.Ift
heydi
d,
t
heconsumerwoul
dbei
ndi
ff
erentbet
weenCandE,
(Ri
ghtpaneloff
igur
e2.
6)si
nce
bot
har
eoni
ndi
ff
erencecur
veone(
IC1)
.Si
mil
arl
y,t
heconsumerwoul
dbei
ndi
ff
erent
bet
weenpoi
ntsD andE,si
ncet
heyar
eont
hesamei
ndi
ff
erencecur
ve,I
C2.
By
t
ransi
ti
vi
ty,t
heconsumermustal
sobei
ndi
ff
erentbet
weenC andD.Howev
er,a
r
ati
onalconsumerwoul
dpr
eferDt
oCbecausehe/
shecanhav
emor
eOr
angeat
poi
ntD(
mor
eOr
angebyanamountofX)
.

TheMar
ginalr
ateofsubst
it
uti
on(
MRS)
Def
ini
ti
on:Mar
ginalr
ateofsubst
it
uti
onofXf
orYi
sdef
inedast
henumberofuni
ts
ofcommodi
tyYt
hatmustbegi
venupi
nexchangef
oranext
rauni
tofcommodi
tyof
Xsot
hatt
heconsumermai
ntai
nst
hesamel
evel
ofsat
isf
act
ion.

I
tist
henegat
iveoft
hesl
opeofani
ndi
ff
erencecur
veatanypoi
ntofanyt
wo
commodi
ti
essuchasXandY,andi
sgi
venbyt
hesl
opeoft
het
angentatt
hatpoi
nt:
i
.e.
,Sl
opeofi
ndi
ff
erencecur
ve

43
I
not
herwor
ds,MRSr
efer
stot
heamountofonecommodi
tyt
hatani
ndi
vi
duali
s
wi
l
li
ngt
ogi
veupt
ogetanaddi
ti
onaluni
tofanot
hergoodwhi
l
emai
ntai
ningt
he
same l
evelofsat
isf
act
ion orr
emai
ning on t
he same i
ndi
ff
erence cur
ve.The
di
mini
shi
ngsl
opeoft
hei
ndi
ff
erencecur
vemeanst
hewi
l
li
ngnesst
osubst
it
uteXf
or
Ydi
mini
shesasonemov
edownt
hecur
ve.
Not
ethat( )measur
est
hedownwar
dver
ti
cal
dist
ance(
theamountofyt
hat

t
hei
ndi
vi
duali
swi
l
li
ngt
ogi
veup)peruni
tofhor
izont
aldi
stance(
i.
e.peraddi
ti
onal

uni
tofxr
equi
red)t
oremai
nont
hesamei
ndi
ff
erencecur
ve.Thati
s,

becauseoft
her
educt
ioni
nY,
MRSi
snegat
ive.
Howev
er,
wemul
ti
plybynegat
iveoneandexpr
ess asaposi
ti
vev
alue.

Ther
ati
onal
ebehi
ndt
heconv
exi
ty,t
hati
s,di
mini
shi
ngMRS,i
sthataconsumer
’s
subj
ect
ivewi
l
li
ngnesst
osubst
it
uteAf
orB(
orBf
orA)wi
l
ldependont
heamount
sof
BandAhe/
shepossesses.
Tabl
e2.
5levelofconsumpt
ionofgoodXandY
Bundl
e(Combi
nat
ion) A B C D
Or
ange(
X) 1 2 4 7
Banana(
Y) 10 6 3 1

Dearl
ear
ner
,int
heabov
ecaset
heconsumeri
swi
l
li
ngt
ofor
go4uni
tsofBananat
o
obt
ain1mor
euni
tofOr
ange.I
ftheconsumermov
esf
rom poi
ntBt
opoi
ntC,hei
s
wi
l
li
ngt
ogi
veuponl
y2uni
tsofBanana(
Y)t
oobt
ain1uni
tofOr
ange(
X),
sot
heMRS
i
s2(
ΔY/
ΔX=4/
2).Hav
ingst
il
llessofBananaandmor
eofOr
angeatpoi
ntD,t
he
consumeri
swi
l
li
ngt
ogi
veuponl
y1uni
tofBananasoast
oobt
ain3uni
tsofOr
ange.
I
nthi
scase,t
heMRSf
all
sto⅓.I
ngener
al,ast
heamountofYi
ncr
eases,t
he
mar
ginalut
il
it
yofaddi
ti
onaluni
tsofYdecr
eases.Si
mil
arl
y,ast
hequant
it
yofX
decr
eases,
itsmar
ginalut
il
it
yincr
eases.I
naddi
ti
on,
theMRSdecr
easesasonemov
e
44
downwar
dst
other
ight
.

Mar
ginalUt
il
it
yandMar
ginalr
ateofSubst
it
uti
on

The i
srel
atedt
otheMUxandt
heMUyi
s:

TheBudgetLi
neort
hePr
icel
ine

Thebudgetl
inei
sal
i
neorgr
aphi
ndi
cat
ingdi
ff
erentcombi
nat
ionsoft
wogoodst
hat
aconsumercanbuywi
thagi
veni
ncomeatagi
venpr
ices.I
not
herwor
ds,
thebudget
l
i
neshowst
hemar
ketbaskett
hatt
heconsumercanpur
chase,
giv
ent
heconsumer
’s
i
ncomeandpr
evai
l
ingmar
ketpr
ices.

Assumpt
ionsf
ort
heuseoft
hebudgetl
ine
I
nor
dert
odr
aw t
hebudget l
i
nef
aci
ngt
heconsumer
,weconsi
dert
hef
oll
owi
ng
assumpt
ions:
1)t
her
ear
eonl
ytwogoods,
XandY,
boughti
nquant
it
iesXandY;
2)eachconsumeri
sconf
ront
edwi
thmar
ketdet
ermi
nedpr
ices,
PxandPy
,ofgood
XandgoodY r
espect
ivl
ey;and
3)t
heconsumerhasaknownandf
ixedmoneyi
ncome(
M).
Byassumi
ngt
hatt
heconsumerspendsal
lhi
s/heri
ncomeont
wogoods(
XandY)
,
wecanexpr
esst
hebudgetconst
rai
ntas:
Wher
e,PX=pr
iceofgoodX,
PY=pr
iceofgoodY;
X=quant
it
yof
goodX;
Y=quant
it
yofgoodY;
M=consumer
’smoneyi
ncome
Thi
smeanst
hatt
heamountofmoneyspentonXpl
ust
heamountspentonYequal
s
t
heconsumer
’smoneyi
ncome.

Supposef
orexampl
eahousehol
dwi
th30Bi
rrperdayt
ospendonbanana(
X)at5
Bi
rreachandOr
ange(
Y)at2Bi
rreach.Thati
s, .Ther
efor
e,
ourbudgetl
i
neequat
ionwi
l
lbe:

Tabl
e2.
6Al
ter
nat
ivepur
chasepossi
bil
it
iesoft
het
wogoods
45
Consumpt
ion
A B C D E F
Al
ter
nat
ives
Kgsofbanana(
X) 0 1 2 3 4 6
KgsofOr
ange(
Y) 15 12.
5 10 7.
5 5 0
Tot
alExpendi
tur
e 30 30 30 30 30 30

Atal
ter
nat
ive A,t
he consumeri
s usi
ng al
lofhi
s/heri
ncome f
orgood Y.
Mat
hemat
ical
l
yiti
sthey
-i
nter
cept(
0,15)
.Andatal
ter
nat
iveF,t
heconsumeri
s
spendi
ngal
lhi
sincomef
orgoodX.mat
hemat
ical
l
y;i
tist
hex-
int
ercept(
6,0)
.We
maypr
esentt
hei
ncomeconst
rai
ntgr
aphi
cal
l
ybyt
hebudgetl
i
newhoseequat
ioni
s
der
ivedf
rom t
hebudgetequat
ion.

Byr
ear
rangi
ngt
heabov
eequat
ionwecander
ivet
hegener
alequat
ionofabudget
l
i
ne,

=Ver
ti
cal
Int
ercept(
Y-i
nter
cept
),whenX=0.

=sl
opeoft
hebudgetl
i
ne(
ther
ati
ooft
hepr
icesoft
het
wogoods)

Thehor
izont
ali
nter
cept(
i.
e.,t
hemaxi
mum amountofXt
hei
ndi
vi
dualcanconsume
orpur
chasegi
venhi
sincome)i
sgi
venby
:

M/
PY

46
M/
PX
Fi
g.2.
7.Der
ivat
ionoft
heBudgetLi
ne

Ther
efor
e,t
hebudgetl
i
nei
sthel
ocusofcombi
nat
ionsorbundl
eofgoodst
hatcan
bepur
chasedi
ftheent
ir
emoneyi
ncomei
sspent
.

Opt
imum oft
heConsumer
Ar
ati
onalconsumerseekst
omaxi
mizehi
sut
il
it
yorsat
isf
act
ionbyspendi
nghi
sor
heri
ncome.I
tmaxi
mizes t
he ut
il
it
y by t
ryi
ng t
o at
tai
nthe hi
ghestpossi
ble
i
ndi
ff
erencecur
ve,gi
vent
hebudgetl
i
ne.Thi
soccur
swher
eani
ndi
ff
erencecur
vei
s
t
angentt
othebudgetl
i
nesot
hatt
hesl
opeoft
hei
ndi
ff
erencecur
ve( )i
s

equalt
othe sl
ope oft
he budgetl
i
ne Thus,t
he condi
ti
on f
orut
il
it
y
maxi
mizat
ion,consumeropt
imi
zat
ion,orconsumerequi
l
ibr
ium occur
swher
ethe
consumerspendsal
lincome(
i.
e.he/
shei
sont
hebudgetl
i
ne)andt
hesl
opeoft
he
i
ndi
ff
erence cur
ve equal
stot
he sl
ope oft
he budgetl
i
ne .The
pr
efer
encesoft
heconsumer(
whathe/
shewi
shes)ar
eindi
cat
edbyt
hei
ndi
ff
erence
cur
veand t
hebudgetl
i
nespeci
fi
est
hedi
ff
erentcombi
nat
ionsofX and Y t
he
consumercanpur
chasewi
tht
hel
i
mit
edi
ncome.Ther
efor
e,t
heconsumert
ri
est
o
obt
aint
hehi
ghestpossi
blesat
isf
act
ionwi
thi
nhi
sbudgetl
i
ne.

Howev
er,t
heconsumercannotpur
chaseanybundl
ely
ingabov
eandt
other
ightof
t
hebudgetl
i
ne.BecauseI
ndi
ff
erencecur
vesabov
ether
egi
onoft
hebudgetl
i
near
e
bey
ondt
her
eachoft
heconsumerandar
eir
rel
evantf
orequi
l
ibr
ium consi
der
ati
on.
Thequest
iont
henar
isesast
owhi
chcombi
nat
ionsofXandYt
her
ati
onalconsumer
wi
l
lpur
chase.Gr
aphi
cal
l
y,t
heconsumeropt
imum orequi
l
ibr
ium i
sdepi
cted as
f
oll
ows:

47
Fi
gur
e2.
14Consumerequi
li
bri
um

Atpoi
nt‘
A’ont
hebudgetl
i
ne,t
heconsumerget
sIC1 l
evelofsat
isf
act
ion.When
he/
shemov
esdownt
opoi
nt‘
B’byr
eal
l
ocat
inghi
stot
ali
ncomei
nfav
orofXhe/
she
der
ivesgr
eat
erl
evel
ofsat
isf
act
iont
hati
sindi
cat
edbyI
C2.Thus,
poi
nt‘
B’i
spr
efer
red
t
opoi
nt‘
A’.Mov
ingf
urt
herdownt
opoi
nt‘
E’
,theconsumerobt
ainst
hegr
eat
estl
evel
ofsat
isf
act
ion(
IC3)r
elat
ivet
oot
heri
ndi
ff
erencecur
ves.

Ther
efor
e,poi
nt‘
E’(
whi
chr
epr
esent
scombi
nat
ionXandY)i
sthemostpr
efer
red
posi
ti
onbyt
heconsumersi
ncehe/
sheat
tai
nst
hehi
ghestl
evelofsat
isf
act
ionwi
thi
n
hi
s/herr
each and poi
nt’
E’i
sknown ast
hepoi
ntofconsumerequi
l
ibr
ium (
or
consumeropt
imum)
.Thi
sequi
l
ibr
ium occur
satt
hepoi
ntoft
angencybet
weent
he
hi
ghestpossi
blei
ndi
ff
erencecur
veandt
hebudgetl
i
ne.Putdi
ff
erent
ly,
equi
l
ibr
ium i
s
est
abl
i
shedatt
hepoi
ntwher
ethesl
opeoft
hebudgetl
i
nei
sequal
tot
hesl
opeoft
he
i
ndi
ff
erencecur
ve.Mat
hemat
ical
l
y,consumeropt
imum (
equi
l
ibr
ium)i
sat
tai
nedat
t
hepoi
ntwher
e:

Lear
ningact
ivi
ti
es
 Di
sti
ngui
shbet
weenmar
ginal
rat
eofsubst
it
uti
onandmar
ginal
uti
l
ity
?
 Expl
ainwhywest
udyt
het
heor
yofconsumerbehav
ior
?
 Whatdoesi
tmeanbymar
ginal
uti
l
ityofacommodi
tyi
sdi
mini
shi
ng?
 Expl
aint
hedi
ff
erencebet
weenequi
l
ibr
ium condi
ti
onsoft
heconsumerunder
48
 car
dinal
uti
l
ityappr
oachandor
dinal
uti
l
ity(
indi
ff
erencecur
ve)appr
oach
 Supposet
het
otalut
il
it
yfunct
ionofaconsumeri
sgi
v X)=2X2.Whati
enasTU( s
t
hemar
ginal
uti
l
ityofX?

Summar
y
Consumer
sgi
vent
hei
rincomeandpr
icesoft
hecommodi
ti
es,t
heyspendt
hei
r
i
ncomesoast
oat
tai
nthehi
ghestpossi
blesat
isf
act
ionorut
il
it
yfr
om commodi
ti
es.
Ut
il
it
yist
hust
he sat
isf
act
ion obt
ained f
rom t
he consumpt
ion ofa good.The
maxi
mizat
ionofut
il
it
yisr
efer
redt
oast
heaxi
om ofut
il
it
ymaxi
mizat
ion.Toat
tai
n
t
hisut
il
it
ymaxi
mizat
ionobj
ect
ive,t
heconsumermustbeabl
etocompar
etheut
il
it
y
oft
hev
ari
ousbasket
sofgoods,whi
cht
heycanbuywi
tht
hei
rincome.I
nor
dert
o
expl
aint
hecompar
isonoft
hesecommodi
ti
eswehav
etwoappr
oaches.Thesear
e:
car
dinalappr
oach and t
he Or
dinalappr
oach.Car
dinal
i
stbel
i
eved t
hatcar
dinal
number
scoul
dbeusedt
oex
presst
heut
il
it
yder
ivedf
rom t
heconsumpt
ionofa
commodi
tywhi
l
eor
dinal
i
stsbel
i
evedt
hatut
il
it
yisnotmeasur
eabl
e,buti
sanor
dinal
magni
tude.Themai
nor
dinalt
heor
iesar
ethei
ndi
ff
erececur
vesappr
oachandt
he
r
eveal
ed pr
efer
ences hy
pot
hesi
s.These appr
oaches ar
e al
so known as t
he
i
ndi
ff
erencecur
vet
heor
ies.

49
CHAPTERFour
:Theor
iesofPr
oduct
ion

Pr
e-t
est
 Whati
spr
oduct
ion?
 Whati
spr
oduct
ioncost
?

Meani
ngofpr
oduct
ionandpr
oduct
ionf
unct
ion

Thet
erm pr
oduct
ionr
efer
stot
hecr
eat
ionoft
hosegoodsandser
viceswhi
chhav
e
changev
alue.I
tisconcer
nedwi
tht
hecr
eat
ionofeconomi
cut
il
it
ies.Theseeconomi
c
ut
il
it
iesar
eoft
hreef
orms;f
orm,t
imeandpl
aceut
il
it
y.Pr
oduct
ioni
sanact
ivi
ty
whet
herphy
sicalorment
alwhi
chi
sdi
rect
edt
osat
isf
act
ionofot
herpeopl
eswant
s
t
hroughexchange.

Essent
ial
sofpr
oduct
ions
 Nopr
oduct
ioni
spossi
blewi
thoutsomeact
ivi
ty,
phy
sical
orment
al
 Theact
ivi
tymustbedi
rect
edt
othesat
isf
act
ionofot
her
speopl
e’
swant
s.Thus,
if
af
armerpr
oduceswheatf
orsel
f-
consumpt
ion,t
hisact
ivi
tywi
l
lnotber
egar
ded
asoneofpr
oduct
ion.
 Ot
herpeopl
e’
swant
smustbesat
isf
iedt
hrought
hepr
ocessofexchange.I
fa
t
eachert
eachesst
udent
swi
thoutanyr
emuner
ati
on i
n exchange,hi
sser
vice
cannotbet
reat
edaspr
oduct
ion.

I
n gener
alsense,economi
sts hav
e char
act
eri
zed t
he pr
oduct
ion pr
ocess as a
combi
nat
ion of f
our f
act
ors: l
and, l
abour
, capi
tal and or
gani
zat
ion or
ent
repr
eneur
shi
ps. Landpl
aysr
olei
nagr
icul
tur
esect
or,whi
l
eot
herf
act
orshav
e
pr
omi
nencei
nindust
ri
alsect
or.Theent
repr
eneurwhol
ooksaf
tert
heor
gani
zat
ional
aspect
sofpr
oduct
ioni
sthedeci
sionmakerwhot
hrought
hecombi
nat
ionoft
he
f
act
orspr
oducest
heout
put
.Whi
l
eent
repr
eneur
shi
pisani
mpor
tantf
eat
uref
ort
he
dev
elopmentofanycount
ry’
seconomy
,ent
repr
eneuri
sof
tenconsi
der
edasan
i
nnov
ator
.

Fact
orsofpr
oduct
ion

50
Pr
oduct
ioncanal
sobedef
inedasapr
ocessbywhi
chr
esour
cesar
etr
ansf
ormed
i
ntof
inalgoodsandser
vices.Anygoodorser
vicet
hatcomesoutofpr
oduct
ion
pr
ocessi
sknownasout
put
.Pr
oduct
ionr
equi
resi
nput
sli
kel
abor
,land,capi
taland
ent
repr
eneurabi
l
ity
.Thesear
ethepr
oduct
ionr
esour
cesort
heeconomi
cresour
ces
usedt
opr
oducegoodsandser
viceswhi
chi
ncl
ude:
1.Land.Theeconomy
’snat
ural
resour
cessuchasl
and,
trees,
andmi
ner
als.
2. Labor
.Thement
alandphy
sical
ski
l
lsofi
ndi
vi
dual
sinasoci
ety
.
3.Capi
tal
.Goods-
suchast
ool
s,machi
nes,andf
act
ori
es-
usedi
npr
oduct
ionort
o
f
aci
l
itat
epr
oduct
ion.
4.Management
/ent
repr
eneur
shi
p/-
itconsi
stsspeci
alt
ypesofhumant
alentt
hat
hel
pst
oor
gani
zeandmanageot
herf
act
orsofpr
oduct
ionf
act
orsl
i
kel
and,l
abor
andcapi
tal
.

Def
ini
ti
onofPr
oduct
ionf
unct
ion

Pr
oduct
ionf
unct
ioni
sasy
stemat
icwayofshowi
ngt
her
elat
ionbet
weendi
ff
erent
amount
sofar
esour
ceori
nputt
hatcanbeusedt
opr
oduceapr
oductandt
he
cor
respondi
ngout
put
.Thepr
oduct
ionf
unct
ioncanbeexpr
essedi
nmanyway
s:
wr
it
tenf
orm,
tabul
ar,
andgr
aphi
cal
.

Pr
oduct
ionf
unct
ioni
spur
elyt
echni
calr
elat
ion,whi
chconnect
sfact
ori
nput
sand
out
put
s.Pr
oduct
ionf
unct
ionsf
oranycommodi
tyt
hatmaybepr
oducedperuni
tof
t
imef
oreachsetofal
ter
nat
ivei
nput
s,whent
hebestofpr
oduct
iont
echni
quesar
e
used.I
tdescr
ibest
hel
aw ofpr
opor
ti
ont
hati
sthet
ransf
ormat
ionoff
act
ori
nput
s
i
ntoout
put
sdur
inganypar
ti
cul
art
imeper
iod.Pr
oduct
ionf
unct
ionsar
epr
esentei
ther
i
ntechnol
ogyoff
ir
m ori
ndust
ryoroft
heeconomyaswhol
e.I
tshowshow,andt
o
whatext
ent
sout
putchangeswi
thv
ari
ati
onsi
ninput
sdur
ingaspeci
fi
edper
iodof
t
ime.Pr
oduct
ionf
unct
ionexpr
essest
hef
unct
ional
rel
ati
onshi
pbet
weenquant
it
iesof
i
nput
sandout
put
s,t
hiscanal
sobeexpr
essedi
nmat
hemat
icalequat
ionf
ormi
n
whi
chout
puti
sthedependentv
ari
abl
eandi
nput
sar
ethei
ndependentv
ari
abl
es.

ThePr
oduct
ionf
unct
ioni
sal
way
sspeci
fi
edf
oraper
iodoft
ime.I
tist
hef
low of
51
i
nput
sresul
ti
ngi
naf
lowofout
putdur
ingspeci
fi
edper
iod.Ev
erymanuf
act
uri
ngf
ir
m
hasi
tsownpr
oduct
ionf
unct
ion,whi
chi
sdet
ermi
ned byt
hest
ateoft
echni
cal
knowl
edge,andmanager
ialabi
l
ityoft
hatf
ir
m.I
mpr
ovementoft
echni
calknowl
edge
manager
ialabi
l
ityoft
hef
ir
m wi
l
lbr
ingaboutanewpr
oduct
ionf
unct
ioni
nthepl
ace
oft
heexi
sti
ngone.Thenew pr
oduct
ionf
unct
ionei
thergi
vesmor
eout
putwi
tht
he
samequant
it
yofor
igi
nali
nput
sori
tmayusesmal
l
erquant
it
iesofi
nput
sfort
he
sameor
igi
nal
out
put
s.

Assumpt
ionsofpr
oduct
ionf
unct
ion
a)I
tisal
way
srel
atedt
oaspeci
fi
edper
iodoft
ime
b)Techni
cal
knowl
edgei
sassumedt
obeconst
ant
c)Thef
ir
minquest
ionwi
l
luset
hebestandt
hemostef
fi
cientt
echni
queav
ail
abl
e
d)Thef
act
orsofpr
oduct
ionar
edi
vi
sibl
eint
oinv
ari
abl
euni
ts

Shor
trunt
heor
yofpr
oduct
ion(
Fact
or-pr
oductr
elat
ionshi
p)

I
nshor
t-
run,i
tispossi
blet
oincr
easet
hequant
it
yofonei
nputwhi
l
ekeepi
ngt
he
quant
it
yofot
heri
nput
sconst
anti
nor
dert
ohav
emor
eout
put
.Thi
saspectof
pr
oduct
ionf
unct
ioni
sknownast
hel
aw ofv
ari
abl
epr
oduct
ion.Thel
aw i
sal
so
knownasPr
oduct
ionf
unct
ionwi
thonev
ari
abl
einput
.Accor
dingt
othi
slaw,i
nthe
pr
oduct
ionf
unct
ionofaf
ir
m,al
linput
sar
efi
xedexceptone.Thi
sonei
nputi
scal
l
ed
t
hev
ari
abl
einput
.Int
hel
ong-
run,
iti
spossi
blef
oraf
ir
mtochangeal
li
nput
sinor
der
t
oexpandi
tsbusi
ness.Thi
sknownas“
Ret
urnst
oscal
e”

Thecostofpr
oduci
nganyl
evelofout
putwi
l
ldependont
heamountofi
nput
s(or
‘
fact
orsofpr
oduct
ion’
)usedandt
hepr
icet
hef
ir
m mustpayf
ort
hem.Letusf
ir
st
f
ocusont
hequant
it
yoff
act
orsused.I
faf
ir
m want
stoi
ncr
easepr
oduct
ion,i
twi
l
l
t
aket
imet
oacqui
reagr
eat
erquant
it
yofcer
tai
ninput
s.Forexampl
e,amanuf
act
urer
canusemor
eel
ect
ri
ci
tybyt
urni
ngonswi
tches,buti
tmi
ghtt
akeal
ongt
imet
o
obt
ainandi
nst
all
mor
emachi
nes,
andl
ongerst
il
ltobui
l
dasecondort
hir
dfact
ory
.

Thedi
sti
nct
ionwear
emaki
ngher
eisbet
weenf
ixedf
act
orsandv
ari
abl
efact
ors.A

52
f
ixedf
act
ori
sani
nputt
hatcannotbei
ncr
easedwi
thi
nagi
vent
imeper
iod(
e.g.
bui
l
dings)
.Av
ari
abl
efact
ori
sonet
hatcanbei
ncr
easedwi
thi
nagi
vent
imeper
iod.
Thedi
sti
nct
ionbet
weenf
ixedandv
ari
abl
efact
orsal
l
owsust
odi
sti
ngui
shbet
ween
t
heshor
trunandt
hel
ongr
un.Theshor
truni
sat
imeper
ioddur
ingwhi
chatl
east
onef
act
orofpr
oduct
ioni
sfi
xed.I
ntheshor
trun,t
hen,out
putcanbei
ncr
easedonl
y
byusi
ngmor
evar
iabl
efact
ors.Thel
ongr
uni
sat
imeper
iodl
ongenoughf
oral
l
i
nput
stobev
ari
ed.Gi
venl
ongenough,af
ir
m canbui
l
dasecondf
act
oryandi
nst
all
newmachi
nes.

Thel
awofdi
mini
shi
ngr
etur
ns

Pr
oduct
ioni
ntheshor
truni
ssubj
ectt
odi
mini
shi
ngr
etur
ns.Thel
awofdi
mini
shi
ng
r
etur
nsi
soneoft
hemostf
amousofal
l‘l
aws’ofeconomi
cs.Toi
l
lust
rat
ehowt
his
l
awunder
li
esshor
t-
runpr
oduct
ionl
etust
aket
hesi
mpl
estpossi
blecasewher
ether
e
ar
ejustt
wof
act
ors:onef
ixedandonev
ari
abl
e.Taket
hecaseofaf
arm.Assumet
he
f
ixedf
act
ori
slandandt
hev
ari
abl
efact
ori
slabour
.Si
ncet
hel
andi
sfi
xedi
nsuppl
y,
out
putperper
iodoft
imecanbei
ncr
easedonl
ybyi
ncr
easi
ngt
heamountofwor
ker
s
empl
oyed.Buti
magi
newhatwoul
dhappenasmor
eandmor
ewor
ker
scr
owdont
oa
f
ixedar
eaofl
and.Thel
andcannotgoony
iel
dingmor
eandmor
eout
puti
ndef
ini
tel
y.
Af
terapoi
ntt
headdi
ti
onst
oout
putf
rom eachext
rawor
kerwi
l
lbegi
ntodi
mini
sh.
Wecannow st
atet
hel
aw ofdi
mini
shi
ng(
mar
ginal
)ret
urnsaswheni
ncr
easi
ng
amount
sofav
ari
abl
efact
orar
eusedwi
thagi
venamountofaf
ixedf
act
or,
ther
ewi
l
l
comeapoi
ntwheneachext
rauni
toft
hev
ari
abl
efact
orwi
l
lpr
oducel
essext
ra
out
putt
hant
hepr
evi
ousuni
t.

Letusnow seehow t
hel
aw ofdi
mini
shi
ngr
etur
nsaf
fect
stot
alout
putort
otal
phy
sicalpr
oduct(
TPP)(
TPPi
sthet
otalout
putofapr
oductperper
iodoft
imet
hati
s
obt
ainedf
rom agi
venamountofi
nput
s).Ther
elat
ionshi
pbet
weeni
nput
sandout
put
i
sshowni
napr
oduct
ionf
unct
ion(
Themat
hemat
icalr
elat
ionshi
pbet
weent
heout
put
ofagoodandt
hei
nput
susedt
opr
oducei
t.I
tshowshowout
putwi
l
lbeaf
fect
edby
changesi
nthequant
it
yofoneormor
eoft
hei
nput
s).I
nthesi
mpl
ecaseoft
hef
arm

53
wi
thonl
ytwof
act
ors–namel
y,af
ixedsuppl
yofl
and(
Ln)andav
ari
abl
esuppl
yof
f
arm wor
ker
s(Lb)–t
hepr
oduct
ionf
unct
ionwoul
dbe:
TPP=f(
Ln,
Lb)
.

Thi
sst
atest
hatt
otalphy
sicalpr
oduct(
i.
e.t
heout
putoft
hef
arm)ov
eragi
venper
iod
oft
imei
saf
unct
ionof(
i.
e.dependson)t
hequant
it
yofl
andandl
abourempl
oyed.
We coul
d expr
ess t
he pr
eci
se r
elat
ionshi
p usi
ng an equat
ion.Al
ter
nat
ivel
y,t
he
pr
oduct
ionf
unct
ioncoul
dbeexpr
essedi
nthef
orm ofat
abl
eoragr
aph.Tabl
e3.
1
andFi
gur
e3.
1showahy
pot
het
icalpr
oduct
ionf
unct
ionf
oraf
arm pr
oduci
ngwheat
.
Thef
ir
stt
wocol
umnsofTabl
e3.
1andt
het
opdi
agr
am i
nFi
gur
e3.
1showhowt
otal
wheatout
putpery
earv
ari
esasext
rawor
ker
sar
eempl
oyedonaf
ixedamountof
l
and.
Tabl
e3.
1Wheatpr
oduct
ionpery
earf
rom apar
ti
cul
arf
arm

Fi
g3.
1Wheatpr
oduct
ionpery
ear(
tones)

54
Wi
thnobodywor
kingont
hel
and,out
putwi
l
lbezer
o(poi
nta)
.Ast
hef
ir
stf
arm
wor
ker
s ar
etaken on,wheatout
puti
nit
ial
l
yri
ses mor
e and mor
erapi
dly
.The
assumpt
ionbehi
ndt
hisi
sthatwi
thonl
yoneort
wowor
ker
sef
fi
ciencyi
slow,si
nce
t
hewor
ker
sar
espr
ead t
oo t
hinl
y.Wi
thmor
ewor
ker
s,howev
er,t
heycanwor
k
t
oget
her–each,
per
haps,
doi
ngsomespeci
ali
stj
ob–andt
hust
heycanuset
hel
and
mor
e ef
fi
cient
ly.I
n Tabl
e 3.
1,out
putr
ises mor
e and mor
erapi
dly up t
othe
empl
oymentoft
het
hir
dwor
ker(
poi
ntb)
.InFi
gur
e3.
1theTPPcur
veget
sst
eeperup
t
opoi
ntb.Af
terpoi
ntb,howev
er,di
mini
shi
ngmar
ginalr
etur
nsseti
n:out
putr
ises
l
essandl
essr
api
dly
,andt
heTPP cur
vecor
respondi
ngl
ybecomesl
essst
eepl
y
sl
oped.Whenpoi
ntdi
sreached,wheatout
puti
satamaxi
mum:t
hel
andi
syi
eldi
ng
asmuchasi
tcan.Anymor
ewor
ker
sempl
oyedaf
tert
hatar
eli
kel
ytogeti
neach
ot
her
’sway
.Thusbey
ondpoi
ntd,
out
puti
sli
kel
ytof
allagai
n:ei
ghtwor
ker
spr
oduce
l
esst
hansev
enwor
ker
s.

Av
erage and mar
ginalpr
oduct
;In addi
ti
on t
otot
alphy
sicalpr
oduct
,two ot
her
i
mpor
tantconcept
sar
eil
l
ust
rat
edbyapr
oduct
ionf
unct
ion:namel
y,av
eragephy
sical
pr
oduct(
APP)andmar
ginal
phy
sical
product(
MPP)
.

Av
eragephy
sicalpr
oduct
:Thi
sisout
put(
TPP)peruni
toft
hev
ari
abl
efact
or(
Qv)
.In
t
hecaseoft
hef
arm,i
tist
heout
putofwheatperwor
ker
.APP=TPP/
Qv Thusi
n
Tabl
e3.
1theav
eragephy
sicalpr
oductofl
aborwhenf
ourwor
ker
sar
eempl
oyedi
s
36/
4=9t
onspery
ear
.

Mar
ginalphy
sicalpr
oduct
:Thi
sist
heext
raout
put(
ΔTPP)pr
oducedbyempl
oyi
ng
onemor
euni
toft
hev
ari
abl
efact
or.Thusi
nTabl
e3.
1themar
ginalphy
sicalpr
oduct
oft
hef
our
thwor
keri
s12t
ones.Ther
easoni
sthatbyempl
oyi
ngt
hef
our
thwor
ker
,
wheatout
puthasr
isenf
rom 24t
onst
o36t
ones:ar
iseof12t
ones.I
nsy
mbol
s,
mar
ginalphy
sicalpr
oducti
sgi
venby
:MPP=ΔTPP/
ΔQv;Thusi
nourexampl
e:MPP
=12/
1=12.
Not
ethati
nTabl
e3.
1thef
igur
esf
orMPPar
eent
eredi
nthespacesbet
weent
he
ot
herf
igur
es.Ther
easoni
sthatMPP canbeseenast
hedi
ff
erencei
nout
put

55
bet
weenonel
evelofi
nputandanot
her
.Thusi
nthet
abl
ethedi
ff
erencei
nout
put
bet
weenf
iveandsi
xwor
ker
sis2t
ones.Thef
igur
esf
orAPPandMPPar
epl
ott
edi
n
t
hel
owerdi
agr
am ofFi
gur
e3.
1.Wecandr
aw anumberofconcl
usi
onsf
rom t
hese
di
agr
ams:
 TheMPPbet
weent
wopoi
ntsi
sequalt
othesl
opeoft
heTPPcur
vebet
ween
t
hoset
wopoi
nts.Forexampl
e,whent
henumberofwor
ker
sincr
easesf
rom 1t
o
2(
ΔLb=1)
,TPPr
isesf
rom 3t
o10t
ones(
ΔTPP=7)
.MPPi
sthus7:t
hesl
ope
oft
hel
i
nebet
weenpoi
nt’
sgandh.
 MPPr
isesatf
ir
st:
thesl
opeoft
heTPPcur
veget
sst
eeper
.
 MPPr
eachesamaxi
mum atpoi
ntb.Att
hatpoi
ntt
hesl
opeoft
heTPPcur
vei
s
ati
tsst
eepest
.
 Af
terpoi
ntb,
dimi
nishi
ngr
etur
nsseti
n.MPPf
all
s.TPPbecomesl
essst
eep.
 APPr
isesatf
ir
st.I
tcont
inuesr
isi
ngasl
ongast
headdi
ti
ont
oout
putf
rom t
he
l
astwor
ker(
MPP)i
sgr
eat
ert
hant
heav
erageout
put(
APP)
:theMPPpul
l
sthe
APPup.Thi
scont
inuesbey
ondpoi
ntb.Ev
ent
houghMPPi
snow f
all
i
ng,t
he
APPgoesonr
isi
ngasl
ongast
heMPPi
sst
il
labov
etheAPP.ThusAPPgoeson
r
isi
ngt
opoi
ntc.
 Bey
ondpoi
ntc,MPPi
sbel
ow APP.New wor
ker
saddl
esst
oout
putt
hant
he
av
erage.Thi
spul
l
stheav
eragedown:
APPf
all
s.
 Atanypoi
ntont
heTPcur
ve,
APi
sgi
venbyt
hesl
opeoft
her
ayf
rom t
heor
igi
n
t
othatpoi
nt.
 When t
he r
ayf
rom t
he or
igi
nist
angentt
othe TP cur
ve,AP r
eachesi
ts
maxi
mum.
 Asl
ongasMPPi
sgr
eat
ert
hanzer
o,TPPwi
l
lgoonr
isi
ng:newwor
ker
saddt
o
t
otal
out
put
.
 Atpoi
ntd,
TPPi
satamaxi
mum (
it
ssl
opei
szer
o).Anaddi
ti
onal
wor
kerwi
l
ladd
not
hingt
oout
put
:MPPi
szer
o.
 Bey
ondpoi
ntd,
TPPf
all
s.MPPi
snegat
ive.

56
St
ageofpr
oduct
ioni
ntheshor
t-
runpr
oduct
ionf
unct
ion

St
age-
I(i
ncr
easi
ngr
etur
ntof
act
or)
;Thi
sther
egi
onupt
othehi
ghestpoi
ntont
he
MPcur
ve(
poi
ntb)wher
eifaddi
ti
onaluni
tsofl
aborar
eempl
oyed,
TPi
ncr
easeatan
i
ncr
easi
ngr
ate(
MP)
.
St
age-
II(
dimi
nishi
ngr
etur
ntof
act
or(
labor
));Thi
sther
egi
onf
rom t
hehi
ghestpoi
nt
ont
heMPcur
veupt
othezer
oMP,wher
eifaddi
ti
onaluni
tsl
aborar
eempl
oyedTP
st
il
li
ncr
easebuti
tincr
easeatadi
mini
shi
ngr
ate.
St
age-
II
I(negat
iver
etur
ntof
act
or(
labor
));t
hisi
sther
egi
onwher
eMPi
snegat
ive
andt
hismakest
het
otal
productf
all
i
ng.

Longr
unPr
oduct
ion:Pr
oduct
ionwi
tht
wov
ari
abl
einput
s
wehav
ecompl
etedouranal
ysi
soft
heshor
t-
runpr
oduct
ionf
unct
ioni
nwhi
cht
he
f
ir
m usesonev
ari
abl
einput(
labor
)andonef
ixedi
nput(
capi
tal
).Nowwet
urnt
othe
l
ongr
unanal
ysi
sofpr
oduct
ion.Remembert
hatl
ongr
uni
saper
iodoft
ime(
planni
ng
hor
izon)whi
chi
ssuf
fi
ci
entf
ort
hef
ir
mtochanget
hequant
it
yofal
linput
s.Fort
he
sakeofsi
mpl
i
cit
y,assumet
hatt
hef
ir
m usest
woi
nput
s(l
aborandcapi
tal
)andbot
h
ar
evar
iabl
e.

Thef
ir
m cannow pr
oducei
tsout
puti
nav
ari
etyofway
sbycombi
ningdi
ff
erent
amount
sofl
aborandcapi
tal
.Wi
thbot
hfact
orsv
ari
abl
e,af
ir
m canusual
l
ypr
oducea
gi
venl
evelofout
putbyusi
ngagr
eatdealofl
aborandv
eryl
i
ttl
ecapi
taloragr
eat
dealofcapi
talandv
eryl
i
ttl
elaborormoder
ateamountofbot
h.I
nthi
ssect
ion,we
wi
l
lseehow af
ir
m canchooseamongcombi
nat
ionsofl
aborandcapi
talt
hat
gener
atet
hesameout
put
.Todoso,
wemaket
heuseofi
soquant
.Soi
tisnecessar
y
t
ofi
rstseewhati
smeantbyi
soquant
sandt
hei
rpr
oper
ti
es.Dearl
ear
ner
,whati
san
i
soquant
?

I
soquant
s
Ani
soquanti
sacur
vet
hatshowsal
lpossi
bleef
fi
cientcombi
nat
ionsofi
nput
sthat
cany
iel
dequall
evelofout
put
.Ifbot
hlaborandcapi
talar
evar
iabl
einput
s,t
he
57
pr
oduct
ionf
unct
ionwi
l
lhav
ethef
oll
owi
ngf
orm.
Q=f(
L,K)
Gi
vent
hispr
oduct
ionf
unct
ion,t
heequat
ionofani
soquant
,wher
eout
puti
shel
d
const
antatqi
s
q=f(
L,K)
Thus,
isoquant
sshowt
hef
lexi
bil
i
tyt
hatf
ir
mshav
ewhenmaki
ngpr
oduct
iondeci
sion:
t
heycanusual
l
yobt
ainapar
ti
cul
arout
put(
q)bysubst
it
uti
ngonei
nputf
ort
heot
her
.

I
soquantmaps:whenanumberofi
soquant
sar
ecombi
nedi
nasi
ngl
egr
aph,
wecal
l
t
he gr
aph an i
soquantmap.An i
soquantmap i
s anot
herwayofdescr
ibi
ng a
pr
oduct
ionf
unct
ion.Eachi
soquantr
epr
esent
sadi
ff
erentl
evel
ofout
putandt
hel
evel
ofoutput
sincr
easesaswemov
eupandt
other
ight
.Thef
oll
owi
ngf
igur
eshows
i
soquant
sandi
soquantmap.

Capi
tal

q3 58
2 q2
1 q1
1
Labor
1 3 6

Fi
g3.
2Isoquantandi
soquantmap.I
soquant
sshowt
hef
actt
hatl
ongr
unpr
oduct
ion
pr
ocessi
sver
yfl
exi
ble.Af
ir
m canpr
oduceq1l
evelofout
putbyusi
ngei
ther3capi
tal
and1l
aboror2capi
taland3l
aboror1capi
taland6l
abororanyot
hercombi
nat
ion
ofl
aborandl
aboront
hecur
ve.Thesetofi
soquantcur
vesq1q2&q3ar
ecal
l
ed
i
soquantmap.

Pr
oper
ti
esofi
soquant
s
I
soquant
shav
emostoft
hesamepr
oper
ti
esasi
ndi
ff
erencecur
ves.Thebi
ggest
di
ff
erencebet
weent
hem i
sthatout
puti
sconst
antal
ongani
soquantwher
eas
i
ndi
ff
erencecur
veshol
dut
il
it
yconst
ant
.Mostoft
hepr
oper
ti
esofi
soquant
s,r
esul
ts
f
rom t
hewor
d‘ef
fi
cient
’ini
tsdef
ini
ti
on.
1.I
soquant
ssl
opedownwar
d.
2.Thef
urt
herani
soquantl
aysawayf
rom t
heor
igi
n,t
hegr
eat
ert
hel
evelofout
put
i
tdenot
es.
3.I
soquant
sdonotcr
osseachot
her
.
4.I
soquant
smustbet
hin.

Thesl
opeofani
soquant
:mar
ginalr
ateoft
echni
calsubst
it
uti
on(
MRTS)

Thesl
opeofani
soquant(
-K/
L)i
ndi
cat
eshow t
hequant
it
yofonei
nputcanbe
t
radedof
fagai
nstt
hequant
it
yoft
heot
her
,whi
l
eoutputi
shel
dconst
ant
.The
absol
utev
alueoft
he sl
opeofani
soquanti
scal
l
edmar
ginalr
ateoft
echni
cal
59
subst
it
uti
on(
MRTS)
.TheMRTSshowst
heamountbywhi
cht
hequant
it
yofonei
nput
canber
educedwhenoneext
rauni
tofanot
heri
nputi
sused,sot
hatout
putr
emai
ns
const
ant
.MRTSofl
aborf
orcapi
tal
,denot
edasMRTSL,K showst
heamountbywhi
ch
t
hei
nputofcapi
talcanber
educedwhenoneext
rauni
tofl
abori
sused,sot
hat
out
putr
emai
nsconst
ant
.
Thi
sisanal
oguest
othemar
ginal
rat
eofsubst
it
uti
on(
MRS)i
nconsumert
heor
y.
MRTSL,K decr
easesast
hef
ir
m cont
inuest
osubst
it
utel
aborf
orcapi
tal(
orasmor
e
ofl
abori
sused)
.Inf
ig.
2.9t
oincr
easet
heamountofl
aborf
rom 1t
o2,t
hef
ir
m
r
educes4uni
tsofcapi
tal(
K=4)
,toi
ncr
easel
aborf
rom 2t
o3,
thef
ir
mreduce2uni
t
ofcapi
tal(
K=2)
,andsoon.Hence,t
hef
ir
mreducesl
owerandl
owernumberof
capi
tal
fort
hesuccessi
veoneuni
tofl
abor
.Dearl
ear
ner
,whydoest
hishappen?

Ther
easoni
sthatwhent
henumberofcapi
tali
slar
geandt
hatofl
abori
slow,t
he
pr
oduct
ivi
tyofcapi
tali
srel
ati
vel
ylowerandt
hatofl
abori
shi
gher(
duet
othel
owof
di
mini
shi
ngmar
ginalr
etur
ns)
.Thus,att
hispoi
ntr
elat
ivel
ylar
geamountofcapi
tali
s
r
equi
redt
orepl
aceoneuni
tofl
abor(
oroneuni
tofl
aborcanr
epl
acer
elat
ivel
ylar
ge
amountofcapi
tal
).As t
he empl
oymentofl
abori
ncr
eases and t
hatofcapi
tal
decr
eases(
aswemov
edownwar
dal
ongt
hei
soquant
),qui
tet
her
ever
sewi
l
lhappen.
Thati
s,pr
oduct
ivi
tyofcapi
tali
ncr
easesandt
hatofl
abordecr
eases.Hence,t
he
amountofcapi
talt
hatneedst
ober
educedi
ncr
easewhenoneext
ral
abori
sused
decr
eases.Thef
actt
hatt
hesl
opeofani
soquanti
sdecr
easi
ngmakesani
soquant
conv
ext
otheor
igi
n.
MRTSL,
K(t
hesl
opeofi
soquant
)canal
sobegi
venbyt
her
ati
oofmar
ginal
product
s
off
act
ors.Thati
s,

Lett
hepr
oduct
ionf
unct
ioni
sgi
venas:

q=f(
L,K) Wher
eq-i sout
put
L-i
sunitofl
aboremployed
K6
-i
st
0 heamountofcapit
alempl
oyed.
 

Ther
efor
e,t
hesl
opeofani
soquantcanbegi
venast
her
ati
oofmar
ginalpr
oduct
sof
i
nput
s.

Thel
ongr
unl
awofpr
oduct
ion:Thel
awofr
etur
nst
oscal
e
Thel
awsofpr
oduct
iondescr
ibet
het
echni
cal
l
ypossi
bleway
sofi
ncr
easi
ngt
hel
evel
ofpr
oduct
ion.
Out
putmayi
ncr
easei
nvar
iousway
s.I
nthel
ongr
unout
putcanbei
ncr
easedby
changi
ngal
lfact
orsofpr
oduct
ion.Thi
slongr
unanal
ysi
sofpr
oduct
ioni edLaw
scal
l
ofr
etur
nst
oscal
e.
I
ntheshor
trunout
putmaybei
ncr
easedbyusi
ngmor
eoft
hev
ari
abl
efact
or,whi
l
e
capi
tal(
andpossi
blyot
herf
act
orsaswel
l
)ar
ekeptconst
ant
.Theexpansi
onof
out
putwi
th one f
act
or(
atl
east
)const
anti
sdescr
i he l
bed byt aw ofvar
iabl
e
pr
opor
ti
onort
hel
awof(
event
ual
ly)di
mini
shi
ngr
etur
nsoft
hevar
iabl
efact
or.

VE:Th
CHAPTERFI eor
yofCost

Conceptofcost
s
Costandr
evenuear
ethet
woi
mpor
tantf
act
orst
hatpr
ofi
tmaxi
mizi
ngf
ir
m needst
o
moni
torcont
inuousl
y.I
tist
hel
evelofcostr
elat
ivet
orev
enuet
hatdet
ermi
nest
he
f
ir
m’sov
eral
lpr
ofi
tabi
l
ity
.Inor
dert
omaxi
mizepr
ofi
ts,af
ir
mtr
iest
oincr
easei
ts
r
evenueandl
oweri
tscost
s.Whi
l
ethemar
ketf
act
orsdet
ermi
net
hel
evelofr
evenue
t
ogr
eatext
ent
,thecostcanbebr
oughtdownei
therbypr
oduci
ngt
heopt
imum l
evel
ofout
putusi
ngl
eastcostcombi
nat
ionofi
nput
s,ori
ncr
easi
ngf
act
orpr
oduct
ivi
ti
es,
orbyi
mpr
ovi
ngt
heor
gani
zat
ionalef
fi
ciency
.Thef
ir
m out
putl
eveli
sdet
ermi
nedby
cost
.Pr
oductpr
icear
edet
ermi
nedbyt
hei
nter
act
ionoft
hemar
ketf
orcesofdemand
61
andsuppl
yinper
fectmar
ket
.Thebasi
cfact
orunder
lyi
ngt
heabi
l
ityandwi
l
li
ngness
off
ir
mst
osuppl
yapr
oducti
nthemar
keti
sthecostofpr
oduct
ion.Thus,costof
pr
oduct
ionpr
ovi
dest
hef
loort
opr
ici
ng.I
tist
hecostt
hatf
ormst
hebasi
sforany
manager
ialdeci
si
onsl
i
kewhi
chpr
icet
oquot
a,whet
hert
oacceptapar
ti
cul
aror
der
ornot
,whet
hert
oabandonoraddapr
oductt
otheexi
sti
ngpr
oductl
i
ne,whet
heror
nott
oincr
easet
hev
olumeofout
put
,whet
hert
ousei
dlecapaci
tyorr
entoutf
aci
l
ity
,
whet
hert
omakeorbuyapr
oduct
…et
c.Howev
er,
iti
sessent
ialt
ounder
li
neher
ethat
al
lcost
sar
enotr
elev
antf
orev
erydeci
sionunderconsi
der
ati
on.

Ty
pesofcost
s

Ther
ear
emanyt
ypesofcost
sthataf
ir
m mayconsi
derr
elev
antf
ordeci
sionmaki
ng
underv
ary
ingsi
tuat
ion.Themanneri
nwhi
chcostar
ecl
assi
fi
edordef
inedi
slar
gel
y
dependentont
hepur
posef
orwhi
cht
hecostdat
aar
ebei
ngout
li
ned.

A.Expl
ici
tandi
mpl
ici
tcost
s
Expl
ici
tcosti
sref
erst
otheex
penseswhi
char
eincur
redbyaf
ir
minbuy
inggoods
andser
vicesdi
rect
ly.Ex
ampl
es:Monet
aryexpensesi
ncur
redbyapr
oducert
ohi
re
wor
ker
s,pur
chaseofr
awmat
eri
als,
power
….et
c.ar
eexpl
i
citcost
.
I
mpl
ici
tcosti
stheexpenseswhi
char
eimput
edorsel
fowned.Expensef
orsel
f-
empl
oyedr
esour
ces,sal
aryoft
heowneroft
hef
ir
m,r
entonownbui
l
ding…et
car
e
cal
l
edi
mpl
ici
tcost
s.

B.MoneycostandRealcost

Moneycost
s:af
ir
m usual
l
yincur
smoneyexpensesf
orpr
oduci
ngacommodi
ty.I
t
mayspendmoneyonwages,sal
ari
es,r
aw mat
eri
als,pl
ant
,equi
pment
…et
c.These
ar
ecal
l
edmoneyexpenses.
Realcost
s:Realcost
sar
ethosewher
ethememberofsoci
etymakesacr
if
icesi
n
t
hei
ref
for
tst
opr
oduceacommodi
ty.Thesesacr
if
icesandef
for
tsar
erealcostof
62
pr
oduct
ion.Wor
ker
sfor
ego l
eisur
e,capi
tal
i
sts sav
e and i
nvest
,land l
ordf
or
pr
oduct
ion.Theseki
ndsofsacr
if
icesandef
fect
soft
hemember
soft
hesoci
etyar
e
cal
l
edcostofpr
oduct
ion.

C.Fi
xedandv
ari
abl
ecost
s

Fi
xedcosti
sdef
inedasacostofpr
oduct
iont
hatdoesnotv
arywi
tht
hel
evelof
out
put
.Fi
xedcost
sar
eassoci
atedwi
tht
hev
eryexi
stenceofaf
ir
m’spl
antand
t
her
efor
emustbepai
dev
eni
fthef
ir
m’sofr
ateout
puti
szer
o.Suchcost
sasi
nter
est
ar
ebor
rowedcapi
tal
,rent
alpay
ment
s,apor
ti
onofdepr
ecat
ionchar
gesofequi
pment
andbui
l
dings’
,sal
aryoft
opmanagement
,keyper
sonalar
egener
all
yfi
xedcost
s.On
t
heot
herhand,
Var
iabl
ecosti
sacostofpr
oduct
iont
hatv
ari
esdi
rect
lywi
tht
hel
evel
ofout
put
.Theyi
ncl
udepay
mentf
orr
aw mat
eri
als,char
geonf
uelandel
ect
ri
cit
y,
wageandsal
aryoft
empor
aryst
aff
,depr
eci
ati
onchar
geassoci
atedwi
thwearand
t
earofasset
s,andsal
escommi
ssi
ons…et
c.

Cost
sandI
nput
s
Af
ir
m’scost
sofpr
oduct
ionwi
l
ldependont
hef
act
orsofpr
oduct
ioni
tuses.The
mor
efact
orsi
tuses,t
hegr
eat
erwi
l
lit
scost
sbe.I
ntheshor
trun,somef
act
orsar
e
f
ixedi
nsuppl
y.Thei
rtot
alcost
s,t
her
efor
e,ar
efi
xed,i
nthesenset
hatt
heydonot
v
arywi
thout
put
.Rentonl
andi
saf
ixedcost
.Iti
sthesamewhet
hert
hef
ir
m
pr
oducesal
otoral
i
ttl
e.Thet
otalcostofusi
ngv
ari
abl
efact
ors,howev
er,doesv
ary
wi
thout
put
.Thecostofr
awmat
eri
alsi
sav
ari
abl
ecost
.Themor
ethati
spr
oduced,
t
hemor
erawmat
eri
alsar
eusedandt
her
efor
ethehi
gheri
sthei
rtot
alcost
.

Shor
t-
runcostAnal
ysi
s

Theshor
truni
sat
imeper
ioddur
ingwhi
chatl
eastonef
act
orofpr
oduct
ioni
sfi
xed.
I
ntheshor
trun,t
hen,out
putcanbei
ncr
easedonl
ybyusi
ngmor
evar
iabl
efact
ors.
Thel
ongr
uni
sat
imeper
iodl
ongenoughf
oral
linput
stobev
ari
ed.Gi
venl
ong
enough,
afi
rm canbui
l
dasecondf
act
oryandi
nst
all
newmachi
nes.
Tot
alcost(
TC)

63
Thet
otalcost(
TC)ofpr
oduct
ioni
sthesum oft
het
otalv
ari
abl
ecost
s(TVC)andt
he
t
otalf
ixedcost
s(TFC)ofpr
oduct
ion:TC=TVC+TFC.Consi
derTabl
e5.
2andFi
gur
e
5.
2.Theyshowt
het
otalcost
sforf
ir
m Xofpr
oduci
ngdi
ff
erentl
evel
sofout
put(
Q).
Letusexami
neeachoft
het
hreecostcur
vesi
ntur
n.

Fi
g3.
2Tot
alcost
sforf
ir
mX

Tot
alf
ixedcost(
TFC)

 TFCi
sacostofpr
oduct
iont
hatdoesnotv
arywi
tht
hel
evel
ofout
put
 I
nourex
ampl
e,t
otalf
ixedcosti
sassumedt
obe£12.Si
ncet
hisdoesnotv
ary
wi
thout
put
,iti
sshownbyahor
izont
alst
rai
ghtl
i
ne.

Tot
alv
ari
abl
ecost(
TVC)

Wi
thazer
oout
put
,nov
ari
abl
efact
orswi
l
lbeused.ThusTVC=0.TheTVCcur
ve,
t
her
efor
e,st
art
sfr
om t
heor
igi
n.Theshapeoft
heTVCcur
vef
oll
owsf
rom t
hel
awof
di
mini
shi
ngr
etur
ns.I
nit
ial
l
y,bef
oredi
mini
shi
ngr
etur
nsseti
n,TVCr
isesl
essandl
ess
r
api
dlyasmor
evar
iabl
efact
orsar
eadded.Taket
hecaseofaf
act
orywi
thaf
ixed
suppl
yofmachi
ner
y:i
nit
ial
l
yasmor
ewor
ker
sar
etakenont
hewor
ker
scando
i
ncr
easi
ngl
yspeci
ali
stt
asksandmakeaf
ull
eruseoft
hecapi
talequi
pment
.Thi
s
cor
respondst
othepor
ti
onoft
heTPPcur
vet
hatr
isesmor
erapi
dly(
upt
opoi
ntbi
n
Fi
gur
e3.
1).

64
Asout
puti
sincr
easedbey
ondpoi
ntm i
nFi
gur
e3.
2,di
mini
shi
ngr
etur
nsseti
n.Si
nce
ext
rawor
ker
s(t
heext
rav
ari
abl
efact
ors)ar
epr
oduci
ngl
essandl
essext
raout
put
,
t
heext
rauni
tsofout
putt
heydopr
oducewi
l
lcostmor
eandmor
eint
ermsofwage
cost
s.ThusTVC r
isesmor
eandmor
erapi
dly
.TheTVC cur
veget
sst
eeper
.Thi
s
cor
respondst
othepor
ti
onoft
heTPPcur
vet
hatr
isesl
essr
api
dly(
bet
weenpoi
nt’
sb
anddi
nFi
gur
e3.
1).

Av
erageandmar
ginalcost
s

Av
eragecost(
AC)i
scostperuni
tofpr
oduct
ion:
AC =TC/
Q.Thusi
fitcostaf
ir
m £2000t
opr
oduce100uni
tsofapr
oduct
,the
av
eragecostwoul
dbe£20f
oreachuni
t(£2000/
100)
.Li
ket
otalcost
,av
eragecost
canbedi
vi
dedi
ntot
het
wocomponent
s,f
ixedandv
ari
abl
e.I
not
herwor
ds,av
erage
costequal
sav
eragef
ixedcost(
AFC=TFC/
Q)pl
usav
eragev
ari
abl
ecost(
AVC=
TVC/
Q):
AC=AFC+AVC
Mar
ginalcost(
MC)i
stheext
racostofpr
oduci
ngonemor
euni
t:t
hati
s,t
her
isei
n
t
otal
costperoneuni
tri
sei
nout
put
:MC=ΔTC/ΔQ.
Forexampl
e,assumet
hataf
ir
miscur
rent
lypr
oduci
ng1000000boxesofmat
chesa
mont
h.I
tnow i
ncr
easesout
putby1000boxes(
anot
herbat
ch)
:ΔQ =1000.Asa
r
esul
t,i
tst
otalcost
sri
seby£30:ΔTC=£30.Whati
sthecostofpr
oduci
ngonemor
e
boxofmat
ches?
.Iti
s:ΔTC/
ΔQ =£30/
1000=3p(
1£=100pence)(
Not
ethatal
l
mar
ginalcost
sar
evar
iabl
e,si
nce,bydef
ini
ti
on,t
her
ecanbenoext
raf
ixedcost
sas
out
putr
ises.
)Gi
vent
heTFC,TVCandTCf
oreachout
put
,iti
spossi
blet
oder
ivet
he
AFC,AVC,ACandMCf
oreachout
putusi
ngt
heabov
edef
ini
ti
ons.Whatwi
l
lbet
he
shapesoft
heMC,AFC,AVCandACcur
ves?Thesef
oll
ow f
rom t
henat
ureoft
he
MPPandAPPcur
vest
hatwel
ookedati
nsect
ion3.
1abov
e.Youmayr
ecal
lthatt
he
t
ypi
cal
shapesoft
heAPPandMPPcur
vesar
eli
ket
hosei
l
lust
rat
edi
nFi
gur
e3.
3.

65
Fi
g3.
3Av
erageandmar
ginal
phy
sical
product

Theshapeoft
heMC cur
vef
oll
owsdi
rect
lyf
rom t
hel
aw ofdi
mini
shi
ngr
etur
ns.
I
nit
ial
l
y,i
nFi
gur
e3.
4,asmor
eoft
hev
ari
abl
efact
ori
sused,
ext
rauni
tsofout
putcost
l
esst
hanpr
evi
ousuni
ts.MCf
all
s.Thi
scor
respondst
other
isi
ngpor
ti
onoft
heMPP
cur
vei
nFi
gur
e3.
3andt
hepor
ti
onoft
heTVCcur
vei
nFi
gur
e3.
2tot
hel
eftofpoi
ntm.
bey
ondacer
tai
nlev
elofout
put
,di
mini
shi
ngr
etur
nsseti
n.Thi
sisshownaspoi
ntxi
n
Fi
gur
e3.
4andcor
respondst
opoi
ntbi
nFi
gur
e3.
3(andpoi
ntm i
nFi
gur
e3.
2).
Ther
eaf
terMCr
isesasMPPf
all
s.Addi
ti
onaluni
tsofout
putcostmor
eandmor
eto
pr
oduce,
sincet
heyr
equi
reev
eri
ncr
easi
ngamount
soft
hev
ari
abl
efact
or.

Av
eragef
ixedcost(
AFC)

AFCf
all
scont
inuousl
yasout
putr
ises,
sincet
otalf
ixedcost
sar
ebei
ngspr
eadov
era
gr
eat
erandgr
eat
erout
put
.

Av
eragev
ari
abl
ecost(
AVC)

Theshapeoft
heAVCcur
vedependsont
heshapeoft
heAPPcur
ve.Ast
heav
erage
pr
oductofwor
ker
sri
ses(
upt
opoi
ntci
nFi
gur
e3.
3),
theav
eragel
abourcostperuni
t
ofout
put(
theAVC)f
all
s:asf
araspoi
ntyi
nFi
gur
e3.
4.Ther
eaf
ter
,asAPPf
all
s,AVC
mustr
ise.

66
Fi
g3.
4Av
erageandmar
ginal
cost
s
Av
erage(
tot
al)cost(
AC)

ACi
ssi
mpl
ythev
ert
icalsum oft
heAFCandAVCcur
ves.Not
ethatasAFCget
sless,
t
hegapbet
weenAVCandACnar
rows.

TheRel
ati
onshi
pbet
weenAv
erageCostandMar
ginalCost

Asl
ongasnewuni
tsofout
putcostl
esst
hant
heav
erage,
thei
rpr
oduct
ionmustpul
l
t
heav
eragecostdown.Thati
s,i
fMCi
slesst
hanAC,
ACmustbef
all
i
ng.Li
kewi
se,
if
new uni
tscostmor
ethant
heav
erage,t
hei
rpr
oduct
ionmustdr
ivet
heav
erageup.
Thati
s,i
fMCi
sgr
eat
ert
hanAC,ACmustber
isi
ng.Ther
efor
e,t
heMCcr
ossest
he
ACati
tsmi
nimum poi
nt(
poi
ntzi
nFi
gur
e3.
4).Si
nceal
lmar
ginalcost
sar
evar
iabl
e,
t
hesamer
elat
ionshi
phol
dsbet
weenMCandAVC.

Lear
ningAct
ivi
ty

67
1.Di
sti
ngui
shbet
weenf
ixedandv
ari
abl
efact
orsofpr
oduct
ion.
2.Descr
ibeanddef
inet
hel
aw ofdi
mini
shi
ngr
etur
nsandgi
veexampl
esf
rom t
he
r
eal
wor
ld.
3.Show how out
putv
ari
eswi
thi
nput
sint
heshor
trunanddescr
ibeashor
t-
run
pr
oduct
ionf
unct
ion.
4.Const
ructt
otal
,av
erageandmar
ginalphy
sicalpr
oductcur
vesandexpl
aint
hei
r
shapes.
5.Whati
spr
oduct
ionf
unct
ion?
6.Expl
aint
heanal
yti
calt
oolusedt
oexpl
aint
her
elat
ionshi
pbet
weeni
nput
sand
out
putbot
hinshor
trun&l
ongr
un.

Summar
y
Land,l
abor
,capi
taland ent
repr
eneur
ialabi
l
ityar
ethemai
nty
pesoff
act
orsof
pr
oduct
ion.Theyar
eknownasi
nput
s.I
ntheshor
t-
runi
nput
sar
edi
vi
dedi
ntof
ixed
i
nput
sandv
ari
abl
einput
s.Af
ixedf
act
ori
sani
nputt
hatcannotbei
ncr
easedwi
thi
na
gi
vent
imeper
iod.Av
ari
abl
efact
ori
sonet
hatcanbei
ncr
easedwi
thi
nagi
vent
ime
per
iod.Thedi
sti
nct
ionbet
weenf
ixedandv
ari
abl
efact
orsal
l
owsust
odi
sti
ngui
sh
bet
weent
heshor
trunandt
hel
ongr
un.Theshor
truni
sat
imeper
ioddur
ingwhi
ch
atl
eastonef
act
orofpr
oduct
ioni
sfi
xed.Pr
oduct
ionf
unct
iondescr
ibest
het
echni
cal
r
elat
ionshi
pbet
weeni
nput
sandout
put
sinphy
sicalt
erms.Tot
alpr
oduct(
TP)i
sthe
Quant
it
yofout
putpr
oducedbyal
lthef
act
orsempl
oyeddur
ingaf
ixedt
imeper
iod.
Av
eragepr
oduct(
AP)i
sequalt
otot
alpr
oduct(
TP)di
vi
dedbyt
heamountofv
ari
abl
e
i
nput
s.

Mar
ginalpr
oduct(
MP)equal
schangei
ntot
alpr
oduct(
TP)di
vi
dedbychangei
nthe
v
ari
abl
einput
s.WhenAPofv
ari
abl
einput
sisi
ncr
easi
ngt
heMPofv
ari
abl
einputi
s
gr
eat
ert
hanAP;att
hehi
ghestl
evelofAPcur
veMPandAPar
eequalwhenAPi
s
decr
easi
ng,
theMPi
slesst
hant
heAP.

68
Ther
ear
ethr
eest
agesofpr
oduct
ionst
ageIext
endsf
rom t
heor
igi
nupt
othehi
ghest
poi
ntofont
heAPcur
ves.St
ageI
Irangesf
rom t
hehi
ghestpoi
ntonAPcur
vet
othe
zer
oMPandLast
ly,st
ageI
IIbegi
nswher
ethempcur
vet
ouchest
hehor
izont
alaxi
s
f
rom abov
eandext
endst
othel
i
ghtwher
eMPi
snegat
ive.Hestf
rom t
heor
igi
nupt
o
t
hehi
ghestpoi
ntonMPcur
ve,i
fthev
ari
abl
einputi
ncr
easet
her
ewi
l
lbei
ncr
easi
ng
r
etur
n.Fr
om t
hehi
ghestpoi
ntonMPcur
veupt
ozer
oMPt
other
ight
,thesewi
l
lbe
di
mini
shi
ngt
othev
ari
abl
einput
.Att
hezer
oMPt
otalpr
oductr
eachesi
tshi
ghest
l
evel
.Thus,
rat
ional
producer
soper
atei
nst
ageI
I.

Costofpr
oduct
ionmeanst
hesum ofal
lpay
ment
smadet
othesuppl
i
ersofi
nput
s.
Themoneypay
ment
swhi
chapr
oducermakeswheni
tbuy
sinput
sfr
om ot
her
sar
e
knownasexpl
i
citcost
.Somet
imest
hef
ir
m usesi
tsowni
nput
srat
hert
hanbuy
ing
t
hem.Thesecost
sar
ecal
l
edi
mpl
i
citcost
s.Economi
ccost
sar
ethesum ofexpl
i
cit
and i
mpl
i
citcost
s.A f
ir
m’scost
sofpr
oduct
ion wi
l
ldepend on t
he f
act
orsof
pr
oduct
ioni
tuses.Themor
efact
orsi
tuses,
thegr
eat
erwi
l
lit
scost
sbe.I
ntheshor
t
r
un,somef
act
orsar
efi
xedi
nsuppl
y.Thei
rtot
alcost
s,t
her
efor
e,ar
efi
xed,i
nthe
senset
hatt
heydonotv
arywi
thout
put
.Iti
sthesamewhet
hert
hef
ir
m pr
oducesa
l
otoral
i
ttl
e.Thet
otal
costofusi
ngv
ari
abl
efact
ors,
howev
er,
doesv
arywi
thout
put
.

Tot
alcost(
TC)i
sthesum oft
het
otalv
ari
abl
ecost
s(TVC)andt
het
otalf
ixedcost
s
(
TFC)ofpr
oduct
ion:TC =TVC + TFC. Av
eragecost(
AC)i
scostperuni
tof
pr
oduct
ion:AC=TC/
Q.Mar
ginalcost(
MC)i
stheext
racostofpr
oduci
ngonemor
e
uni
t:t
hati
s,t
her
isei
ntot
alcostperoneuni
tri
sei
nout
put
:MC=ΔTC/ΔQ.Av
erage
r
evenuei
stheamountt
hef
ir
m ear
nsperuni
tsol
d.Thus:AR =TR/
Q.Mar
ginal
r
evenuei
stheext
rat
otalr
evenuegai
nedbysel
l
ingonemor
euni
t(pert
imeper
iod)
.
Theshor
t-
runout
putr
elat
ionshi
prev
eal
sther
elat
ionshi
pbet
weent
hev
ari
abl
einput
andout
put
.

.CHAPTERSI
X:Theor
iesofmar
ketst
ruct
ures

Pr
etest
s
 Def
inet
hewor
dmar
ket
69
  Whatki
ndofmar
ketst
ruct
uresdoy
ouknow?

Per
fect
lycompet
it
ivemar
ket
:Meani
nganddef
ini
ti
ons

Per
fectcompet
it
ioni
sanext
remesi
tuat
ionwher
ecompet
it
ionr
eachesi
tsmaxi
mum
possi
bledegr
ee.Themodelofper
fectcompet
it
ionhowev
ercannotber
eal
i
sti
cal
l
y
expect
edt
oexi
sti
ntot
ali
tyi
nev
ery
dayl
i
fe.I
tishi
ghl
ytheor
eti
cal
,butt
hemodel
pr
ovi
desausef
ult
oolofeconomi
canal
ysi
s.Per
fectcompet
it
ioni
sat
heor
eti
cal
mar
ketst
ruct
ure.I
tispr
imar
il
yusedasabenchmar
kagai
nstwhi
chot
hermar
ket
st
ruct
uresar
ecompar
ed.Thei
ndust
ryt
hatbestr
efl
ect
sper
fectcompet
it
ioni
nreal
l
i
fei
stheagr
icul
tur
ali
ndust
ry.

I
ntheshor
tter
m,per
fect
ly-
compet
it
ivemar
ket
sar
enotpr
oduct
ivel
yef
fi
cientas
out
putwi
l
lnotoccurwher
emar
ginalcosti
sequalt
oav
eragecost
,butal
l
ocat
ivel
y
ef
fi
cient
,asout
putwi
l
lal
way
soccurwher
emar
ginalcosti
sequalt
omar
ginal
r
evenue,
andt
her
efor
ewher
emar
ginalcostequal
sav
erager
evenue.I
nthel
ongt
erm,
such mar
ket
s ar
e bot
h al
l
ocat
ivel
y and pr
oduct
ivel
y ef
fi
cient
.Under per
fect
compet
it
ion,any pr
ofi
t-
maxi
mizi
ng pr
oducer f
aces a mar
ket pr
ice equalt
o
i
tsmar
ginalcost
.Thi
simpl
i
est
hataf
act
or'
spr
iceequal
sthef
act
or'
smar
ginal
r
evenue pr
oduct
.Thi
s al
l
ows f
order
ivat
ion oft
hesuppl
y cur
veon whi
ch t
he
neocl
assi
cal
appr
oachi
sbased.

Char
act
eri
sti
csofper
fect
lycompet
it
ivemar
ket

Thi
simpl
i
est
henumberofbuy
ersandsel
l
ersi
ssol
arget
hatt
heshar
eofeachbuy
er
(
whateachbuy
erpur
chases)i
ntot
aldemandandt
heshar
eofeachsel
l
er(
whateach
sel
l
erof
fer
sforsal
e)i
ntot
alsuppl
yissosmal
lthatnosi
ngl
ebuy
ercanaf
fectt
he
mar
ketpr
icebychangi
nghi
sdemand,
notasi
ngl
esel
l
erbychangi
nghi
ssuppl
y.Thi
s
i
sli
kel
ytobet
ruei
nmanyagr
icul
tur
alpr
oduct
s.
I
dent
icalpr
oduct
s
Al
lthepr
oduct
sof
fer
edbyt
hei
ndi
vi
dualsuppl
i
ersmustbeexact
lyt
hesamesot
hat
buy
erswi
l
lbecompl
etel
yindi
ff
erentasf
rom whi
chsel
l
ert
obuy
.
Per
fectknowl
edge

70
Thi
smeansal
lpar
ti
ci
pant
s(buy
ersandsel
l
ers)hav
eknowl
edgeaboutpr
ices,
qual
i
ty,
out
put
slev
elsandal
lot
hermar
ketcondi
ti
ons.Thus,noconsumerwoul
dpaymor
e
t
hant
hemar
ketpr
iceandnosuppl
i
erwoul
dbewi
l
li
ngt
osel
lforl
esst
hant
hemar
ket
pr
ice.
Fr
eedom ent
ryandexi
t
Ther
eisnogov
ernmenti
nter
fer
encei
nthef
orm ofpr
icecont
rol
,andnor
est
ri
cti
on
whi
chwoul
dpr
eventf
ir
msent
eri
ngi
ntot
hei
ndust
ryorl
eav
ingi
t.Undercondi
ti
onsof
per
fectcompet
it
ion,
thei
nter
act
ionoft
hemar
ketsuppl
yanddemanddet
ermi
nest
he
mar
ketpr
icef
ort
hei
ndust
ry,andeachf
ir
mint
hei
ndust
ryt
aket
hepr
iceasgi
ven.
Thef
ir
m underper
fectcompet
it
ioni
spower
lesst
oexer
tanyi
nfl
uenceont
hepr
ice
andi
sknownasa‘
pri
cet
aker
’.Buy
ersar
eal
sopr
icet
aker
.

Pur
emonopol
y:Meani
nganddef
ini
ti
ons
Amonopol
yexi
stswhenaspeci
fi
cper
sonorent
erpr
isei
stheonl
ysuppl
i
erofa
par
ti
cul
arcommodi
ty.(
Thi
scont
rast
swi
thamonopsonywhi
chr
elat
est
oasi
ngl
e
ent
it
y'
scont
rolofamar
kett
opur
chaseagoodorser
vice,andwi
thol
i
gopol
ywhi
ch
consi
stsofaf
ewent
it
iesdomi
nat
ingani
ndust
ry)
.Monopol
i
esar
ethuschar
act
eri
zed
bya l
ackofeconomi
ccompet
it
iont
o pr
oducet
hegoodorser
viceand a l
ackof
v
iabl
esubst
it
utegoods.Thev
erb"
monopol
i
ze"r
efer
stot
hepr
ocessbywhi
cha
companygai
nst
heabi
l
ityt
orai
sepr
icesorexcl
udecompet
it
ors.I
neconomi
cs,a
monopol
yisasi
ngl
esel
l
er.I
nlaw,
amonopol
yisbusi
nessent
it
ythathassi
gni
fi
cant
mar
ketpower
,thati
s,t
hepower
,tochar
gehi
ghpr
ices.Al
thoughmonopol
i
esmaybe
bi
gbusi
nesses,
sizei
snotachar
act
eri
sti
cofamonopol
y.Asmal
lbusi
nessmayst
il
l
hav
ethepowert
orai
sepr
icesi
nasmal
li
ndust
ry(
ormar
ket
).

Amonopol
yisdi
sti
ngui
shedf
rom amonopsony
,inwhi
cht
her
eisonl
yonebuy
erofa
pr
oductorser
vice;amonopol
ymayal
sohav
emonopsonycont
rolofasect
orofa
mar
ket
.Li
kewi
se,a monopol
yshoul
d be di
sti
ngui
shed f
rom acar
tel
(af
orm of
ol
i
gopol
y),i
nwhi
chsev
eralpr
ovi
der
sactt
oget
hert
ocoor
dinat
eser
vices,pr
icesor
sal
eofgoods.Monopol
i
es,monopsoni
esandol
i
gopol
i
esar
eal
lsi
tuat
ionssucht
hat
oneoraf
ew oft
heent
it
ieshav
emar
ketpowerandt
her
efor
eint
eractwi
tht
hei
r
71
cust
omer
s(monopol
y),suppl
i
ers(
monopsony
)andt
heot
hercompani
es(
oli
gopol
y)
i
nagamet
heor
eti
cmanner–meani
ngt
hatexpect
ati
onsaboutt
hei
rbehav
ioraf
fect
s
ot
herpl
ayer
s'choi
ceofst
rat
egyandv
icev
ersa.Thi
sist
obecont
rast
edwi
tht
he
modelofper
fectcompet
it
ioni
nwhi
chcompani
esar
e"pr
icet
aker
s"anddonothav
e
mar
ketpower
.

Whennotcoer
cedl
egal
l
ytodoot
her
wise,monopol
i
est
ypi
cal
l
ymaxi
mizet
hei
rpr
ofi
t
bypr
oduci
ngf
ewergoodsandsel
l
ingt
hem athi
gherpr
icest
hanwoul
dbet
hecase
f
orper
fectcompet
it
ion.Somet
imes gov
ernment
s deci
de l
egal
l
ythata gi
ven
companyi
samonopol
ythatdoesn'
tser
vet
hebesti
nter
est
soft
hemar
ketand/
or
consumer
s.

Char
act
eri
sti
csofmonopol
ymar
ket
s

Apur
emonopol
yconcer
nst
heexi
stenceofasi
ngl
esel
l
erofagoodf
orwhi
cht
her
e
i
snocl
osesubst
it
ute.
 Ther
eisonl
yonesel
l
ersot
hatt
her
eisnodi
sti
nct
ionbet
weenf
ir
m and
i
ndust
ry.
 Thepr
oducti
suni
queandt
her
eisnocl
osesubst
it
ute.
 Themonopol
i
stcanexer
cisecont
rolov
ert
hepr
ice.Themonopol
yfi
rmi
s,
t
her
efor
e,apr
icemaker
.
 Theexi
stenceofbar
ri
erst
oent
ryi
ntot
hemar
ket
.Noot
herf
ir
m cansuppl
y
t
hepr
oductbecauseofl
egal
,geogr
aphi
cal
ort
echnol
ogi
cal
rest
ri
cti
ons.
 Ther
emayormaynotbeadv
ert
isement
.

Sour
cesofmonopol
ymar
ket

Thef
oll
owi
ngar
ethemai
nsour
cesofmonopol
y:
Legalr
est
ri
cti
ons:i
nsomecases,t
hegov
ernmentcr
eat
esmonopol
i
esbyl
aw.I
t
meanst
hatt
hegov
ernmentmayest
abl
i
short
akeov
erani
ndust
ryandt
henpr
event
s
compet
it
ion.I
tisi
l
legalt
ocompet
ewi
thi
t.TheEt
hiopi
anPostser
vicei
sanexampl
e
ofgov
ernmentmonopol
y.

72
Nat
uralf
act
orendowment
s:whenonecompanyorcount
ryi
sthesol
eordomi
nant
ownerofsomeki
ndofnat
uralr
esour
ce,
ithasanef
fect
ivecont
rolov
ert
hesuppl
yof
t
her
esour
ceandov
ert
hesuppl
yofanymanuf
act
uredpr
oduct
sder
ivedf
rom t
hat
r
esour
ce.

Hi
gh ent
rycost
s:i
n some i
ndust
ri
es t
he r
elat
ivel
yhi
gh set
-up cost
s cr
eat
ea
f
ormi
dabl
ebar
ri
ert
oent
ry.I
nsuchcases,t
heexi
sti
ngmonopol
yfi
rm,pr
oduci
nga
l
argequant
it
yout
put
,benef
it
sfr
om economi
esofscal
e.

Pat
ent
:Gov
ernment
s encour
age i
nvent
ion ori
nnov
ati
on by gr
ant
ing excl
usi
ve
pr
oduct
ionr
ight
sforaper
iodoft
imef
ort
hosewhodi
scov
ernew pr
oduct
sornew
met
hodsofpr
oduct
ion.Asl
ongast
hepat
enti
sinef
fectt
hef
ir
m hasapr
otect
ed
posi
ti
onandi
samonopol
y.

Ef
fi
ciency:Ef
fect
ive managementmi
nimi
zes wast
e and l
eads t
o ef
fi
ciency i
n
pr
oduct
ion.Thi
senabl
est
hef
ir
mtodr
iver
ival
soutofbusi
nessbyunder
cut
ti
ngpr
ice.

Agr
eement
sbet
weenpr
oducer
s:I
naddi
ti
ont
oasol
esuppl
i
ermonopol
y,i
tisal
so
possi
blet
ofi
ndanumberoff
ir
msact
ingt
oget
hert
ocr
eat
emonopol
ypower
.Such
agr
eementi
sil
l
egali
n some count
ri
es.An exampl
e ofi
nter
nat
ionalmonopol
y
t
hroughcol
l
usi
oni
sOr
gani
zat
ionofPet
rol
eum Expor
ti
ngCount
ri
es(
OPEC)
.

Monopol
ist
iccompet
it
ion:Meani
ngsanddef
ini
ti
ons

Ther
ealwor
ldi
snei
therper
fect
lycompet
it
ivenorper
fect
lymonopol
i
sti
c.Thet
ypeof
compet
it
ionf
oundi
nther
ealwor
ldl
i
esbet
weent
het
woext
remes.Thi
sfor
m of
compet
it
ioni
sknownas‘
i
mper
fectcompet
it
ion’
.Monopol
i
sti
ccompet
it
ioni
sone
f
orm ofi
mper
fectcompet
it
ion.I
tis a mar
ketst
ruct
urei
n whi
ch manysel
l
ers
compet
etosel
ladi
ff
erent
iat
edpr
oduct
.Ast
henamesuggest
s,i
tcombi
nessome
aspect
sofbot
hper
fectcompet
it
ionandmonopol
y.

Monopol
i
sti
ccompet
it
ioni
sat
ypeofi
mper
fectcompet
it
ionsucht
hatcompet
ing
pr
oducer
ssel
lpr
oduct
sthatar
edi
ff
erent
iat
edf
rom oneanot
herasgoodbutnot
73
per
fectsubst
it
utes(
such asf
rom br
andi
ng,qual
i
ty,orl
ocat
ion)
.In monopol
i
sti
c
compet
it
ion,af
ir
mtakest
hepr
iceschar
gedbyi
tsr
ival
sasgi
venandi
gnor
est
he
i
mpactofi
tsownpr
icesont
hepr
icesofot
herf
ir
ms.

I
n a monopol
i
sti
cal
l
y compet
it
ive mar
ket
,fi
rms can behav
eli
kemonopol
i
esi
n
t
heshor
trun,i
ncl
udi
ngbyusi
ngmar
ketpowert
ogener
atepr
ofi
t.I
nthel
ongr
un,
howev
er,ot
herf
ir
msent
ert
hemar
ketandt
hebenef
it
sofdi
ff
erent
iat
iondecr
ease
wi
thcompet
it
ion;t
hemar
ketbecomesmor
eli
keaper
fect
lycompet
it
iveonewher
e
f
ir
ms cannot gai
n economi
c pr
ofi
t.I
n pr
act
ice, howev
er,i
f consumer
r
ati
onal
i
ty/
innov
ati
veness i
s l
ow and heur
ist
ics ar
e pr
efer
red,
monopol
i
sti
c
compet
it
ioncan f
alli
ntonat
uralmonopol
y,ev
en i
nthe compl
ete absence of
gov
ernmenti
nter
vent
ion.

I
nthe pr
esence of coer
civ
e gov
ernment
,monopol
i
sti
c compet
it
ion wi
l
lfal
l
i
ntogov
ernment
-gr
ant
edmonopol
y.Unl
i
keper
fectcompet
it
ion,t
hef
ir
m mai
ntai
ns
spar
e capaci
ty.Model
s ofmonopol
i
sti
c compet
it
ion ar
e of
ten used t
o model
i
ndust
ri
es.

Char
act
eri
sti
csofmonopol
ist
iccompet
it
ion

Manysel
l
ersandbuy
ers:t
hemar
ketconsi
stsofl
argenumberofpr
oducer
sand
cust
omer
s.Butt
henumbermaynotbeasl
argeast
hati
nper
fectcompet
it
ion.
Pr
oductdi
ff
erent
iat
ion:Pr
oductdi
ff
erent
iat
ioni
sthepr
oduct
ionofdi
ff
erentv
ari
eti
es
orbr
andsoft
hesamepr
oducti
nthei
ndust
rywhi
chconsumer
sbuyaccor
dingt
o
t
hei
rpr
efer
ences.Eachsuppl
i
er’
spr
oducthasuni
quequal
i
tiest
hatcausesome
buy
erast
opr
eferi
ttopr
oduct
sofcompet
ingf
ir
ms.Thedi
ff
erencecanbei
nqual
i
ty,
st
yle,col
or,dur
abi
l
ity
,br
andnameet
c.Thepr
oduct
soft
hemanysel
l
ersar
ecl
ose
subst
it
utesf
oreachot
her
,butt
hei
ndi
vi
dualsel
l
erhasanel
ementofmonopol
i
sti
c
cont
rol
overi
tsownpr
oduct
.
Fr
eeent
ryandexi
t:i
nthemonopol
i
sti
cal
l
ycompet
it
ivemar
ket
s,i
tiseasyt
osetup
newf
ir
ms,
andf
ir
msest
abl
i
shedi
nthei
ndust
ryf
indi
teasyt
oexi
t.Nocol
l
usi
on:i
tis
di
ff
icul
tfort
hef
ir
mst
oacti
nconcer
tbecauset
heyar
emanyandt
heymaynot

74
r
ecogni
zet
hei
rint
erdependence.Thi
smeanst
hef
ir
msdonotcooper
atet
ofi
xpr
ices
soast
oincr
easet
hei
rgr
ouppr
ofi
ts.

Because pr
oduct
s ar
e di
ff
erent
iat
ed, t
he monopol
i
sti
cal
l
y compet
it
ive f
ir
m
det
ermi
nespr
icel
i
ket
hemonopol
i
st.Pr
icecut
sincr
easequant
it
ydemandedby
capt
uri
ngpar
toft
hecompet
it
or’
smar
ket
.Unl
i
keaper
fect
lycompet
it
ivef
ir
m,a
monopol
i
sti
ccompet
it
ivef
ir
m canr
aisei
tspr
iceandnotl
ossal
lofi
tssal
es.I
na
monopol
i
sti
ccompet
it
ion,someconsumer
swi
l
lremai
nloy
alt
othef
ir
m’spr
oduct
andcont
inuet
opur
chasei
tev
ent
hought
hepr
icehasgoneupandt
her
ear
ecl
ose
subst
it
utes.

Ty
picalmonopol
ist
iccompet
it
ors
Al
thoughi
tisdi
ff
icul
ttoi
dent
if
yindust
ri
est
hatf
itpr
eci
sel
yourdescr
ipt
ionof
monopol
i
sti
ccompet
it
ion,t
hef
oll
owi
ngoneappr
oxi
mat
eit
:bar
ber
shops,gr
ocer
y
st
ores,l
aundr
ies,cl
i
nics,r
etai
lst
ores,beaut
yshops,t
ext
il
emanuf
act
ures,f
urni
tur
e
pr
oducer
s

Ol
igopol
ymar
ketst
ruct
ure:
Meani
ngsanddef
ini
ti
ons
Theot
hert
ypeofmar
keti
mper
fect
ioni
sol
i
gopol
y.Ol
i
gopol
yist
hef
orm ofmar
ket
or
gani
zat
ioni
nwhi
cht
her
ear
efew sel
l
ersofahomogeneousordi
ff
erent
iat
ed
pr
oduct
.Iti
samar
ketst
ruct
urechar
act
eri
zedbyasmal
lnumberoff
ir
msandagr
eat
dealofi
nter
dependenceamongt
hem.Unl
i
kemonopol
i
sti
ccompet
it
ion,ol
i
gopol
y
cont
ainsf
ew f
ir
mst
hateachol
i
gopol
i
stf
ormul
atesi
tspol
i
cieswi
thaney
etot
hei
r
ef
fectonr
ival
s.

So anychangesi
nthef
ir
m’spr
iceorout
puti
nfl
uencet
hesal
eand pr
ofi
tsof
compet
it
ors.Mor
eov
er,eachf
ir
m mustr
ecogni
zest
hatchangesi
nit
sownpol
i
cies
ar
eli
kel
ytoel
i
citchangesi
nthepol
i
ciescompet
it
oroft
his,aswel
l
.Becauseof
i
nter
dependenceol
i
gopol
i
stsf
aceasi
tuat
ionwher
etheopt
imaldeci
sionofonef
ir
m
dependsonwhatot
herf
ir
msdeci
det
odo,andwher
etheopt
imaldeci
sionofone
f
ir
m dependsonwhatot
herf
ir
msdeci
det
odo,andwher
ether
eisoppor
tuni
ty,f
or
bot
hconf
li
ctandcooper
ati
on.
75
Ol
i
gopol
i
sti
ccompet
it
ioncangi
ver
iset
oawi
der
angeofdi
ff
erentout
comes.I
n
somesi
tuat
ions,t
hef
ir
msmayempl
oyr
est
ri
cti
vet
radepr
act
ices(
col
l
usi
on,mar
ket
shar
ing et
c.)t
orai
sepr
icesand r
est
ri
ctpr
oduct
ion i
n much t
hesamewayas
amonopol
y.Wher
ether
eisaf
ormalagr
eementf
orsuchcol
l
usi
on,t
hisi
sknownas
acar
tel
.Apr
imar
yexampl
eofsuchacar
teli
sOPECwhi
chhasapr
ofoundi
nfl
uence
ont
hei
nter
nat
ional
pri
ceofoi
l
.

Char
act
eri
sti
csofol
igopol
y

Bar
ri
erst
oent
ryt
heser
efert
ocondi
ti
onst
hathi
ndert
heent
ryofnewf
ir
msi
ntot
he
i
ndust
ry.Thesebar
ri
ersmaybei
nthef
orm ofowner
shi
pofr
esour
ces,l
argercapi
tal
r
equi
rement
s,cont
rolofpat
ent
sbyexi
sti
ngf
ir
ms.Few sel
l
ers‘
few sel
l
ers’donot
necessar
il
ymeant
henumberofsel
l
ersi
sver
ysmal
l
.Thenumberoff
ir
msmaybe
l
arge butf
ew f
ir
msaccountf
ort
he maj
orpor
ti
on oft
he i
ndust
ry’
spr
oduct
ive
capaci
ty.Thati
s,ot
her
sar
einsi
gni
fi
cantasf
arast
hei
rmar
ketshar
eisconcer
ned.
Recogni
zedmut
uali
nter
dependenceeachf
ir
mrecogni
zest
hati
tspr
ofi
tsar
eheav
il
y
dependentont
heact
ionsoft
heot
herf
ir
msi
nthei
ndust
ry.

Ty
pesofpr
oduct
sunderol
i
gopol
ypr
oduct
sar
eei
theri
dent
icalordi
ff
erent
iat
ed.
Ther
eisnoot
hermar
ketst
ruct
uret
hati
smor
edi
ff
icul
ttoanal
yzet
hanol
i
gopol
y.The
di
ff
icul
ty ar
ises f
rom t
he i
nter
dependence nat
ure of ol
i
gopol
i
sti
c deci
sions.
Ol
i
gopol
i
stshav
eacommoni
nter
esti
nset
ti
ngpr
icessot
hatmonopol
ypr
ofi
tsar
e
made,
andani
ndi
vi
duali
nter
esti
nanat
tempt
ingt
ogett
hemaxi
mum possi
blepr
ofi
t.
Thesei
nter
est
sar
econt
radi
ctor
yin nat
ure,and hencet
heeconomi
ctheor
yof
ol
i
gopol
yconcer
ningpr
ici
ngandout
putdeci
sionshasnoty
etbeenst
andar
dized.

Thesour
cesofol
igopol
y

Economi
esofscal
e:scal
eeconomi
esmayt
akei
tunpr
ofi
tabl
eformor
ethanaf
ew
f
ir
mst
ocoexi
sti
nthemar
ket
Pat
ent
soraccess:t
oat
echnol
ogymayexcl
udepot
ent
ial
compet
it
ors
Hugecapi
tali
nvest
ment
sandspeci
ali
zedi
nput
s:ar
eusual
l
yrequi
redt
oent
eran
ol
i
gopol
i
es’
indust
ryandt
hisactasnat
ural
bar
ri
ert
oent
ry.
76
Est
abl
ishedf
ir
ms:mi
ghthav
eal
oyalf
oll
owi
ngofcust
omer
sbasedonpr
oduct
qual
i
tyandser
vicet
hatnewf
ir
msmayf
indv
erydi
ff
icul
ttomat
ch.
The need t
o spend moneyf
orname r
ecogni
ti
on and mar
ketr
eput
ati
on may
di
scour
ageent
ry

Ol
igopol
ist
icI
ndust
ri
es

Al
thoughi
tiscommont
oanal
yzemonopol
i
sti
ccompet
it
ionandol
i
gopol
ysepar
atel
y,
i
tisnotal
way
seasyt
odr
awv
eryshar
pdi
sti
nct
ionsbet
weent
het
wot
ypesofmar
ket
st
ruct
ure.Fr
om t
hepoi
ntofv
iewoft
henumberofpr
oducer
sandt
heeaseofent
ry,
somei
ndust
ri
esmi
ghtbecl
assi
fi
edasmonopol
i
sti
cal
l
ycompet
it
ive.Ont
heot
her
hand,f
rom t
hepoi
ntofv
iew ofr
ecogni
zedmut
uali
nter
dependencei
tmi
ghtbe
r
easonabl
etocl
assi
fyt
hesamei
ndust
ri
esasol
i
gopol
i
sti
c,t
hati
s,t
heycannotbeso
easi
l
ycl
assi
fi
ed.Howev
er,goodsl
i
keoi
l
,st
eel
,ti
res,sy
nthet
icf
iber
s,soap,and
el
ect
ri
cbul
bsar
eusual
l
ypr
oducedundercondi
ti
onsofol
i
gopol
y.

Lear
ningAct
ivi
ty
1)Whatdoy
ouunder
standbyt
heconceptofper
fectcompet
it
ion?
2)Whatar
ethef
eat
uresofper
fectcompet
it
ivemar
ketst
ruct
ure
3)Whati
sthebasi
sforbei
ngmonopol
yornoti
nthemar
ket
4)Howdol
egal
rest
ri
cti
onscr
eat
emonopol
yint
hemar
ket

Summar
y

77
78
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79
80