MICROECONOMICS

COURSE
BY
Emery Emerimana
MBA-Project Management and Finance
Email: emmanege@yahoo.fr
Tel: 71 578 069/75 658 470
Course Purpose
• The purpose of this course is to introduce
students to the problem of scarcity and provide
them with a framework of analyzing how
individuals and societies confront it. Concepts
such as utility maximization, efficient resource
use, supply and demand, Consumer theory, and
market structures will be explored and applied
to real-life situations.
 Course outcomes
• By the end of the course the learner should be able to:
Understand that economics is about the allocation of scarce resources, that scarcity
forces choice, tradeoffs exist and that every choice has an opportunity cost. Be able
to demonstrate these concepts using a production possibility frontier diagram.
Understand how comparative advantage provides the basis for gains through trade.
List the determinants of the demand and supply for a good in a competitive market
and explain how that demand and supply together determine equilibrium price.
Analyze theoretical and empirical factors affecting behavior of business costs and
revenues.
Apply Economic models to different market environments in which firms operate
with special attention to the effects of antitrust policy, government regulation trade
policy
 Course contents
1. The Economic Problems
- Scarcity, choice and opportunity Cost
- Production Possibility Curve
- Marginal Analysis
- Economic Systems
2. Theories of Supply and Demand
- Theory of demand
- The demand curve
- Theory of supply
- Supply Curve
- Elasticities of Demand and supply
- Market equilibrium
- Price and quantity controls
 Course contents (cont)
Chap 3: Theory of consumer choice
- Total utility and Marginal Utility
- Utility maximization
- Individual and market demand curves
Chap 4: Theory of Production
- Production processes
- Production functions
- Marginal production and diminishing returns
- Choice of optimal factor inputs
 Course contents (cont)
Chap 5: Theory of cost
- Cost –output relations
- Short –run and long-run cost functions
- Cost minimizing input combination and productive efficiency
Chap 6: Firm behavior and Market Structure
- Perfect competition
- Monopoly
- Monopolistic competition
- Oligopoly and strategy behavior
 Course Materials
Michel L. Katz and Harvey S. Rossen (1998), Microeconomics, 3rd Edition, McGraw-
Hill/Irwin, USA

Text Books for Further Reading

1. Walter Nicholson (1989), Microeconomics Theory: Basic Principles and Extensions,

4th edition, Library of Congress Cataloging- in-Publication Data, USA

2. Pappas, James L, Managerial Economics, 6th Edition, Mark Hirschey Chicago Dryden
Press

3. Bradley R. Schiller (2003), The Micro Economics Today, 9th edition, McGraw-Hill
Higher Education, USA.
 CHAPTER 1: The Economic Problem
1.1. Definition of Economics
• Economics is the study of how societies use scarce resources to produce
valuable commodities and distribute them among different people.
• Economists therefore study how people make decisions: how much they work,
what they buy, how much they save, and how they invest their savings.
Economists also study how people interact with one another.
• For instance, they examine how the multitude of buyers and sellers of a good
together determine the price at which the good is sold and the quantity that is
sold.
• Finally, economists analyze forces and trends that affect the economy as a
whole, including the growth in average income, the fraction of the population
that cannot find work, and the rate at which prices are rising.
 1.2. Branches of economics
Economics is the study of how people manage resources. In economics, resources are just
physical things like cash and gold mines. They are also intangible things, such as time, ideas,
technology, job experience, and even personal relationships. The economics is the study of the
choices people make in the presence of scarcity. The study of these choices has been broken
into two main subjects:
 Microeconomics
 Macroeconomics
 Branches of economics
A. Macroeconomics
Macroeconomics is the other major branch of economics which is concerned with the overall
performance of the economy. This part of economics studies the effects, at a country or global
level, of the decisions made by households, firms, and government. Each part of economics has
basic issues or questions that it addresses.
B. Microeconomics
This part of economics studies the choices of individuals and firms. This part also looks into
how government policy plays a role in affecting these individual decisions.
 The economic problem
• Human wants are unlimited but the means of satisfying them is
limited. Even after satisfaction of certain wants, new wants arise and
the means of satisfying them may become quite inadequate.
• The economic problem arises because the individuals’ wants are
virtually unlimited, whilst the resources to satisfy them are scarce.
• Due to scarcity of resources individuals have to make a choice on
which needs/wants to satisfy and which to sacrifice.
• Satisfaction of one thing implies sacrifice of another and hence
opportunity cost i.e. value of best forgone alternative. This choice
relates to the basic economic problems.
 1.2.1. Basic economic problems
• There are three basic economic questions:
1. What is to be produced – which product and how
much?
2. How is to be produced? – the method /means /
technology
3. For whom to produce- the need/ want/ market/
allocation?
 1.2.2 Economic models
Figure 1.1: Circular Flow Model
Revenue Spending
MARKETS FOR
. GOODS AND
SERVICES
Goods and • Firms sell Goods and
Services Sod • Households buy Services bought

FIRMS HOUSEHOLDS
• Produce and sell • Buy and consume
goods and services goods and services
• Hire and use • Own and sell factors
factors of production
of production

Factors of Production Labor, land and

MARKETS FOR Capital
FACTORS OF
PRODUCTION
Wages, rent, and • Households sell Income
• Firms buy
Profit
 1.2.3. Production possibilities and Opportunity Costs
• The economy is a dynamic system of millions of
households working to produce goods and services.
• Although these millions of households can produce
trillions of dollars in goods, there is a limit.
• Given this limit, if we wish to produce more of one
good, we must be willing to give up some of another
good.
• The production possibilities frontier (PPF) depicts these
limits.
 1.2.3.1. Production Possibilities Frontier
The production possibilities frontier is a graph that shows the various combinations of
output—in this case, cars and computers—that the economy can possibly produce given the
available factors of production and the available production technology that firms use to turn
these factors into output.
Figure 1.2: Production possibilities frontier

Quantity of
Computers
Produced
3,000 C
B

Production possibilities frontier

A

1,000 Quantity of
Cars Produced
 1.2.3.2. Production Efficiency
• An outcome is said to be efficient if the economy is
getting all it can from the scarce resources it has
available.
• Points on (rather than inside) the PPF are
considered efficient. We cannot produce more of
one good without giving up some of the other. We
cannot get more of both. There are no unused
resources. Efficient points will always face a
tradeoff with other goods.
1.2.3.3. Tradeoff along the PPF
•Every point along the PPF involves a
tradeoff.
•We must give up some of one good to
get more of the other good.
•Every tradeoff has a cost which we will
call an opportunity cost.
 1.2.3.4. Opportunity Cost
The opportunity cost of an item is what you give up to get that item. When making any
decision, decision makers should be aware of the opportunity costs that accompany each
possible action.
The opportunity cost of a choice is the highest valued alternative. We can use the PPF to
quantify these opportunity cost.
Opportunity Cost is a Ratio: We can typically think of opportunity cost in the form of a ratio.
Opportunity cost of choosing more A= decrease in good B / increase in good A

The opportunity cost of a unit of any good increases as we have more and more of the good. It
cost more and more to produce an additional unit of a good, especially if we already have a lot
of it.
 Chapter 2: Theories of Supply and
Demand
• 2.1. Demand function
• Because any economic system is the essence a
collection of individuals, it is natural to start out
analysis with an examination of individual
behavior.
 2.1.1. Individual and Market demand
• An individual demand for a commodity is the quantity that an
individual consumer is willing and able to purchase at a particular
price over a given period of time.
• The market demand for a commodity is the sum of quantities
demanded by the l individual consumers in the market at a given
price level during a given time period. The first two panels of figure
2.1 represent the demand curves for two consumers.
• At a price of $10, the individual quantities demanded are 5 and 8
units, respectively. Hence the total market demand at the price of
$10 (as shown in the third panel) is 13 units. Graphically, the market
demand curve is horizontal summation of individual demand curves.
Figure 2.1: The market Demand Curve
 2.1.2. Determinants of Market Demand
Among the most important factors that determine market demand include:

a) Price of the product

Increase in price leads to decrease in demand for goods and vice versa ceteris paribus

b) Consumers’ income
For most goods, an increase in consumer income would cause the demand curve for the
product to shift to the right

c) Prices of other related products

A rise in the price of a good is likely to lead to increase of demand of its substitutes.
For example, an increase in the price of chicken would cause people to purchase less
of it and consume more beef. An increase in the price of a good will cause demand for
its compliment to decrease. (e.g. fuel and motor vehicle).
 Other determinants of demand
d) Consumer Taste and preferences

e) Seasons

f) Government policies

g) Climate

h) Expectations on future prices

i) Changes in population size and composition

h) Advertising
 1.1.3. The Law (theory) of Demand
This law states; “there is an inverse (negative) relationship between the price of a commodity
and the quantity buyers are willing to purchase in a defined time period, ceteris paribus.”The
higher the price of a commodity the lower is the quantity demanded and vice versa. Dx = f
(Px)

a. Demand Schedule

Consider the table which shows the demand of product x at different prices.

Consumers demand schedule for product X

Price per Kg in dollars Quantity demanded per Week.

50 100

40 200

30 300

20 400

10 500
 2.2. Theory of Supply
2.2.1. Individual supply

It is the quantities of goods and services which an individual firm or supplier is willing and
able to offer for sale at given price over a given period of time.

a. Theory or Law of supply

There is a direct (positive) relationship between price and supply of a commodity. As the
price of good increases ceteris paribus, its supply also increases. This is due to profit
maximization since the higher the price the greater the profit margin ceteris paribus.
 2.2.2. Market supply
Refers to summation of all individual supplies in a relevant market

Price

+ =
+ Quantity
supplied.
 Example
Points Price (per Quantity of web services supplied by
hour) Ann Bob Cory = Market

i $50 94 35 19 148 
45 140 
j 40 93 14
h 35 33 130  
g 90 10 114
30 30 0 90
f 25 86 62
e 20 0 39
d 15 78 28
0 20
c 53
 2.2.2. Determinants of supply
a) Price of the commodity
b) Other factors related to supply.
1. Price of factors of production
2. Prices of other related goods
3. State of technology
4. Climatic, weather, seasonal condition.
5. Price expectations
6. Objectives of the firm – Can be sale maximization or profit maximization.
7. Government policy such as tax and subsidy
8. Exogenous factors (natural factors)
9. Transport and communication
 2.3. Market Equilibrium
Market Equilibrium is a situation where quantity demanded and quantity supplied in a market
are equal.

Demand curve

Price

Supply curve

Pe Equilibrium point

Qe Quantity

In theory if prices exceed the equilibrium level, there will be excess supply and if price are
below equilibrium there will be excess demand.

At equilibrium; Qd = Qs
2.3.1. Examples of Equilibrium market
• 1. The following equations represent the
demand and supply functions for
commodity X. Find the equilibrium quantity
and price.
• Qs + 10 = 6p
• Qd = -4p + 20
 Examples (cont)
1. The market for pizza has the following demand and supply schedules:

Price Quantity demanded Quantity supplied

$4 135 pizzas 26 Pizzas
5 104 53
6 81 81
7 68 98
8 53 110
9 39 121
Graph the demand and supply curves. What is the equilibrium price and quantity in this market?
Exercises
1. Suppose that the demand functions for tickets for three cinema
operators in the entire market are represented as follows:
• First operator: P = 35 – 0.5QA
• Second operator: P = 50 – 0.25QB
• Third operator: P = 40 – 2.0QC
• The market supply equation is given by Qs = 40 + 3.5P
Where P = price in $; Q = quantity of tickets bought/sold
• Determine the market equilibrium price and quantity of tickets
Exercise 2
• Consumers of a certain product demand 45 units
at the price of $10 per unit and 37 units at the
price of $14 per unit. Producers on the other
hand are willing to supply 30 units at the price of
$ 15 per unit and 60 units at the price of $25 per
unit.
• Determine the equilibrium price and quantity
• Determine the price elasticity of demand if p=10
 2.4. Elasticity of Demand and of Supply
2.4.1. Elasticity of demand

The price elasticity of demand measures the responsiveness of quantity demanded of a

commodity to a change in one of the factors influencing demand. The main measures of
elasticity of demand are:

a) Price elasticity of demand

b) Income elasticity of demand

c) Cross price elasticity of demand

 a. Price elasticity of demand
The price elasticity of demand measures the responsiveness of quantity demanded of a
commodity to a change in its price. It is the percentage change in quantity demanded resulting
%Q
from one percent change in the price of the commodity. E P 
%P

Ep is negative because of the law of demand which states that price and quantity demanded are
inversely related. Thus when the price change is positive, the change in quantity demanded is
negative and vice versa.
 Point Price Elasticity
The point Elasticity of demand or the elasticity at a given point on the demand curve is given
by the following formula.

%Q Q / Q Q P
EP    
%P P / P P Q

Where ∆Q/∆P is the inverse of the slope of the demand curve and it is negative because
quantity and price move in the opposite directions
Figure 2.4 the Point Price Elasticity of
Demand
 Point Price Elasticity
Note that given an estimated equation such as 2.3 above, the value of ∆Q/∆P is given by a1 (the
estimated coefficient of Px). Therefore the formula for point price elasticity of demand can be
rewritten as

P
E P  a1 
Q

Where a1 is the estimated coefficient of P in the linear regression of Q on P and other

explanatory variables
 Arc Price Elasticity of Demand
The arc price elasticity is defined as

Q  P2  P1  / 2 Q2  Q1 P2  P
EP    
P  Q2  Q1  / 2 P2  P1 Q2  Q1

Where the subscripts 1 and 2 refer to the original and to the new values, respectively of price
and quantity or vice versa

Therefore, arc price elasticity for movement from point C to point F

Q2  Q1 P2  P  50  20   1  4 
EP       0.714
P2  P1 Q2  Q1  1  4   50  20 

The same result is obtained for the reverse movement from point F to point C.
 b. The Income elasticity of demand
When other factors are held constant the income elasticity of a good or service is the percentage
change in demand associated with a 1% change in income. As with price elasticity, we have
point and arc income elasticity.

1. Point income elasticity of demand is given by:

%Q Q / Q
EY  
%Y Y / Y

Q Y
 
Y Q

Where ∆Q and ∆Y refer respectively to the change in quantity and the change in income
given
 2. Arc Income Elasticity

Q  Y2  Y1  / 2 Q2  Q1 Y2  Y1
EY  Y   Q2  Q1  / 2  Y2  Y1  Q2  Q1
Where the subscripts 1 and 2 refer to the original and to the new levels of income and quantity,
respectively. Thus arc income elasticity of demand measures the average relative
responsiveness in demand of commodity for a change in income in the range between Y 1 and
Y2
 3. Inferior Goods, Necessities and Luxuries
Income elasticities can be either negative or positive. Negative income elasticity implies that
increases in income are associated with decreases in the quantity demanded of goods and
service. Goods that behave this way are called inferior goods.

Normal goods and services have positive income elasticities. Examples of normal goods
include food, clothing, housing, education and recreation. For the first three (necessities) Ey is
positive but low (i.e. 0<Ey≤1). That is demand is relatively unaffected by changes in income.
As individuals become wealthier, expenditures on luxuries goods represent a larger share of
their income
 c. Cross-Price elasticity of demand
Cross elasticity of demand is the percentage change in quantity demanded of one good caused
by 1 percent change in the price of some other good. Point cross- price elasticity of demand is
given by:

%Q X Q X / Q X Q X P0
EX 0    
%P0 P0 / P0 P0 Q X

Where ∆Qx and ∆P0 refer, respectively to the change in the quantity of commodity X and the
change in the price of other commodity, Po.
 Substitutes and Compliments
If the value of Exo is positive (i.e. Exo> 0), commodity X and Y are substitutes because an
increase in Po lead to an increase in Qx as X is substituted for O in consumption. Example of
substitute commodities includes coffee and tea, beef and chicken.

When Exo is negative (i.e. Exo< 0), commodity X and O are complimentary because an increase
in Po leads to a reduction in Qo and Qx. Example of complimentary commodities includes cars
and fuel.

Finally if Exo is close to zero and Y are independent commodities. This may be the case with
books and beer, pencils and potatoes, and so on.
 2.4.2. Elasticity of Supply
The price elasticity of supply measures the responsiveness of quantity supplied of a
commodity to a change in one of the factors influencing demand.

1. Point Price Elasticity

The point Elasticity of supply is the elasticity at a given point on the supply curve. It is given
by the following formula.

%Q Q / Q Q P
EP    
%P P / P P Q

Therefore the formula for point price elasticity of supply can be rewritten as

dQ P
EP  
dP Q
 2. Arc Price Elasticity of Supply
Arc elasticity of supply is elasticity between two points on supply curve.

Arc price elasticity is defined as

Q  P2  P1  / 2 Q2  Q1 P2  P
EP    
P  Q2  Q1  / 2 P2  P1 Q2  Q1

Where the subscripts 1 and 2 refer to the original and to the new values, respectively of price
and quantity or vice versa
 EXERCISES
Suppose that the demand functions for tickets for three cinema operators in the entire market
are represented as follows:

First operator: P = 35 – 0.5QA

Second operator: P = 50 – 0.25QB

Third operator: P = 40 – 2.0QC

The market supply equation is given by Qs = 40 + 3.5P

Where P = price in $; Q = quantity of tickets bought/sold

a) Determine the market equilibrium price and quantity of tickets

b) Determine the (market) point price elasticity of demand for tickets at P = $28
 Exercise 2
The following table gives the demand schedules for two related goods.

Commodity X Commodity Y

Price Quantity demanded Price Quantity demanded

150 2000 140 1900

150 1700 160 1650

From the information, calculate the cross elasticity of demand for commodity X given the
price of commodity Y. With a valid reason, identify the nature of the two goods
 Exercise 3

In a certain region the price of butter increased from $ 200 to $ 250 per kilogram. As a result
the quantity demanded of margarine increased from 1500 to 1600 kilograms. Compute the
arc cross price elasticity of demand and interpret it.
 2.3. Impact of Government policy on demand and
supply

a) Impact of taxation on equilibrium price and quantity.

Refer to example (1) Qd = 240 – 2P and Qs = -40 +3P.

The government imposes a tax of $ 5 per unit. Find the new equilibrium price and quantity after
the tax.
 Solution of the example
Tax only affects the supply function hence:

Qs = -40 + 3P

Make price subject of formula,

P = Qs/3 + 40/3

Taxed Price will be: Pt = (Qs/3 + 40/3) + 5

3Pt = Qs + 55

Qs = 3Pt – 55

Since Qs = Qd, then

3Pt – 55 = 240 – 2P

3Pt +2p = 240 + 55

5Pt = 295

Pt = 59 and Quantity after tax is 240 – 2(59)

Q = 122.

Equilibrium quantity= 122; Equilibrium price= $ 59

 b) Distribution of tax between seller (producer) and buyer
(consumer)

Tax payable by buyer: This is taxed equilibrium price minus initial equilibrium price
(Pt – P)

Tax payable by seller: This is total tax minus tax paid by buyer (T - Tb).

Illustration

Refer to above question. Find how the seller and Buyer share the tax.
 Solution
Tax payable by consumer,

Pt –P = 59 – 56 = $ 3

Tax Payable by seller, Tax-Tax Paid by buyer

= 5- 3 =$2
 c) Impact of subsidy on equilibrium price
and quantity.
Refer to question (2) Qd = 240 – 2P and Qs = -40 +3P.

The government imposes a subsidy of $ 3 per unit. Find the new equilibrium price and
quantity
 SOLUTION
Subsidy reduces price by affecting the supply function

If Qs = -40 +3P

Make P subject of formula.

Pt = (Qs/3 + 40/3) - 3

3Pt = Qs + 31

Qs = 3P – 31Qs = 3P – 31
 SOLUTION (cont)
And since Qs = Qd at Equilibrium, then

3P – 31 = 240 – 2P

271 = 5P

P = 54.2 and Q = 240 – 2(54.2)

Q = 131.6.

Equilibrium quantity= 131.6; Equilibrium Price= $ 54.2

 d) Distribution of Subsidy between buyers and Sellers
Illustration: Refer to above example,

SOLUTION

Subsidy to buyers:

Initial Equilibrium Price less equilibrium price with subsidy

P – Ps = 56 – 54.2, =$ 1.80

Subsidy to sellers

Total Subsidy minus subsidy to sellers

S – Sb

3 – 1.80 = $ 1.20
 Exercises
1. Consumers of a certain product demand 45 units at the
price of $10 per unit and 37 units at the price of $14 per unit.
Producers on the other hand are willing to supply 30 units at
the price of $ 15 per unit and 60 units at the price of $25 per
unit.
a. Determine the product’s equilibrium price and quantity
b. Determine the new equilibrium price and quantity if the
government imposes a $6 tax per unit of the product
c. show the distribution of it between producers and
consumers
 Exercise 2
Two new firms in a textile industry, Kenez and Lorenz in the same region
advertised for the same post with similar qualifications. Kenez advertised
for 300 vacancies at $ 100 per month and received 400 applications.
Lorenz advertised for 260 vacancies at $ 120 per month and received 460
applications. To encourage employment the government granted the firms
a subsidy of $ 20 for each employee hired per month.
a) Formulate the demand and supply functions for labor for this post.
b) Find the equilibrium salary and number of employees without the
subsidy
c) Find the equilibrium salary and number of employees after the subsidy
d) Find the distribution of the subsidy between the firm and the employee
 Chapter 3: Theory of Consumer Choice
1.1.Total Utility and Marginal Utility

Total utility and marginal utility are related, but different, ideas. Total utility is the total amount
of satisfaction or pleasure a person derives from consuming some specific quantity-for example,
10 units-of a good or service.

Marginal utility is the extra satisfaction a consumer realizes from an additional unit of that
product-for example, from the eleventh unity. Alternatively, marginal utility is the change in
total utility that results from the consumption of 1 more unit of a product.
 Utility-maximizing rule

Of all the different combinations of goods and services a consumer can obtain within his or her
budget, which specific combination will yield the maximum utility or satisfaction? To maximize
satisfaction, the consumer should allocate his or her money income so that the last dollar spent on
each product yields the same amount of extra (marginal) utility.

In our utility-maximizing rule merely requires that these ratios be equal. Algebraically;

MUof Pr oductA MUof Pr oductB


Pr iceOfA Pr iceOfB
 Indifference curve Analysis of consumer
theory
Indifference curve is a locus of all the possible combinations of two goods which yield the same
level of utility to a consumer.

Good Y

15
A

B
10

C
5 Ux

0
4
Good X
All combinations along the curve give the same or equal marginal utilities.

A = B = C because they are equally satisfying.

 3.2. MRS (Marginal Rate of substitution)
This is the amount of good y given up in order to obtain more of good x. This rate reduces down
the indifference curve because the rate of substitution declines hence consistent with the law of
Diminishing Marginal Rate of Substitution.

The budget line

It shows the various combinations of 2 commodities that can be bought with the same income. Eg

An increase in a consumer’s income can lead to an increase in the quantity consumed of a

commodity (normal good) or a decrease (giffen good).

A change in the price of a commodity has 2 effects:

(i) The substitution effect: if the price rises ceteris paribus, the consumer will try to shift
to a substitute

(ii) The income effect: the rise of a price reduces the real income of a consumer thus
reducing the quantity consumed of the commodity.
 The individual’s Budget Constraint for two goods
First, using a graphic approach, we illustrate utility maximization for the two good cases. We
began with an analysis of the budget constraint.

1) Budget constraint

Assume that the individual has I dollars to allocate between good X and good Y. if P X is the
price of good X and P Y the price of good Y, then the individual is constraint by

P X X+ P Y Y  I (3.1)
 The equilibrium in consumption: Optimal combination
To derive consumer’s equilibrium under ordinal approach, we superimpose the indifference
curve on the budget line.

Good y
a.

y E

Good x

x
At E the consumer can purchase the maximum units which will give him the maximum utility.
MRSxy = Px / Py
 Optimal combination(cont)
The objective of a consumer is to maximize his utility so that:

The consumer maximizes his/her utility at the point of intersection of the indifference curve and
the budget line.
 Optimal combination by Langrage Method
Using the Lagrangian multiplier method,

The first-order conditions are:

…………………………….(1)

…………………………….(2)

……………………..(3)

Solving the 3 equations simultaneously yields the following condition for utility maximization:

This gives information about the consumers income and prices of goods x and y.
 Example

The utility function for a consumer is . If the price per unit of is $ 10 and $ 5
per unit of , determine amount of and that the consumer should buy so as to maximize
his utility given that the consumer has a $ 300 budget.
 Solution

The augmented objective function is:

The first-order conditions are:

 Solution (cont)
For maximum utility,

So that,

it follows that , substituting this into equation (iii) we get

and and the maximum utility is )

Note: The second-order condition for utility maximization is:

 Exercise1

Utility = u(X, Y) = X .Y  X 0.5 .Y 0.5

Assume that hamburgers cost $1 each (P Y =1.00) and soft drinks cost $0.25 ( PX  .25 ) and this
person has $2.00 to Spend (I=2.00). Now the budget constraint is 1.00Y+.25X=2.00
 Exercise 2
Joana has a utility function expressed as: U =12Q13Q2 5

In which Q1 and Q2 represents amounts of two composite commodities Q1 and Q2 whose prices
per unit are $ 6 and $ 12 respectively. She has $ 1200 to spend on the two commodities.

i) Using Lagrange method, formulate the augmented objective function and

find the first-order conditions for utility maximization.
ii) Find the optimal/equilibrium values of Q1 and Q2

iii) Find the maximum utility attainable.

iv) Find the second order condition and interpret it.
 Chapter 4: Theory of Production
• Managers are faced with production decisions
regarding the optimal combination of inputs such as
labor and capital for production of a desired quantity
of output.
• The objective is to combine resources of the firm in
the most efficient manner by finding the lowest cost
combination of inputs to produce the organization’s
output.
 Factors of Production
• A production function is a tool of analysis used to explain the technological relationship
between inputs and outputs in physical rather than in monetary terms.
• Assuming for simplicity that a firm produces only one type of output with two inputs,
labor (L) and capital (K), the production function may be algebraically expressed as, Q = f
(K, L) (4.1)
• The production function (4.1) implies that quantity of the commodity produced depends
on the quantity of capital and labor L, employed.
• Given that in the short run capital is fixed, the firm can only increase its output by
increasing labor only. The short run production function can be expressed as
• Q = f (L) (4.2)
• In the long run, however the firm can employ more of both capital and labor accordingly,
the long-term production function takes the form
• Q = f (K, L) (4.3)
 4.2. Production Elasticity
Elasticity of production is the percentage change in output Q resulting from a given percentage
change in the amount of the variable input x employed in the production process. It indicates the
responsiveness of output to changes in the given input:

Q
%Q Q / Q X Q X MPx
Ex      
%X X / X Q X Q APx
X

Since MPx  Q and APx  Q

X X
 4.3. Determining the optimal use of the variable input
With one of the inputs (y) fixed in short run, the producer must determine the optimal quantity of
the variable input (x) to employ in the production process.

Marginal Revenue Product (MRPX)

It is change in total revenue per unit change in the variable input. It is the amount that an additional
unit of the variable input adds to the total revenue:

TR
MRPx  ……………………………………………………………………. [4.4]
X

Where ∆TR = change in total revenue

∆x = change in variable unit

MRPX is equal to the marginal product of x (MP X) times the marginal revenue (MRQ) resulting
from the increase in output obtained

MRPX = MPX. MRQ

NOTE: In a perfectly competitive market, MR is equal to the selling price, MR = P

 Marginal Factor Cost and Optimal Input Level
It is change in total cost per unit change in the variable input It is the amount that an additional
unit of the variable input adds to total cost:

TC
MFC x  …………………………………………………………….. [4.5]
X

Where ∆TC = Change in cost

∆x = change in variable input

Optimal Input Level

Optimal input level occurs at the point where the marginal benefits equal to the marginal costs.
For the short run production decision, the optimal level of the variable input occurs where

MRPX = MFCX
 Marginal Revenue Product and Marginal Factor Cost
Example: An ore-mining company uses capital (K) as fixed
input and labor (L) as variable input. It sells its ore at $ 10
per ton in a perfectly competitive market. The company
employs workers at $ 50 per period of time. The labor
market is perfectly competitive. Its total product of labor
varied as follows with different levels of labor as shown in
the table below. Compute its MPL, TR, MR, MRPL and MFCL
and hence find its optimal input level.
 Example(cont)
Marginal Marginal
Marginal Total
Labor Total Product Revenue Revenue Marginal
Product of Revenue
input L of Labor TR Product Factor
Labor TR = P. Q MRQ=
Q = (TPL) MRPL Cost
(1) (2)
MPL ($) Q =MPL* MRQ MFCL
(3) (4) (5) (6)

0 0

1 6

2 16

3 29

4 44

5 55

6 60

7 62

8 62
 Average product – APL&APK
AP is output per unit input. It is derived by dividing the total product by the quantity of input used.

TP
APL 
L

TP
APK 
K
 Marginal Product- MPL&MPK
MP is the change in output per unit change in input in production. MPL is the incremental change
in output associated with a 1- unit change in workers. MPK is the incremental change in output
associated with a 1- unit change in capital.

TP TP
MPL  MPK 
L K

Q Q2  Q1
MPL  
L L2  L1

Q Q2  Q1
MPK  
K K 2  K1

MP can also be obtained by differentiating total product with respect to input

TP TP
MPL  MPK 
L K
 Total, Average and Marginal Product of Labor Schedules
Number of Capital Number of Workers Total Product TP TP
(K) (L) APL  MPL 
L L
1 0 0

1 1 5

1 2 16

1 3 36

1 4 68

1 5 95

1 6 114

1 7 119

1 8 120

1 9 117

1 10 100
  
4.8 Optimal combination of factors of production

Equilibrium is achieved at the point where the isocost line is tangent (touches) to the isoquant. At
this point the slopes of isocost line and isoquant are equal.
MPL PL W
 
MPK PK R

Where PL is the price of labor (wage rate – W) and Pk is the price of capital (rent-R)
 Illustration
The production function for a firm is expressed as follows:
½ 2/3
Q = 24K L
A unit of capital (k) and labor (l) costs $15 and $12 respectively.
a) Find the units of capital and labor that the firm should hire to maximize its production
without spending more than $1200.
Find the maximum output
 Solution
½ 2/3
Max Q = 24K L
Subject to 1200 = 15K + 12L
15K + 12L – 1200 = 0
½ 2/3
L = 24K L + λ (15K + 12L – 1200)
½ 2/3
L= 24K L + 15K λ + 12L λ – 1200 λ
Lk = 12K-1/2L2/3 + 15 λ = 0 --------- (i)
1/2 -1/3
LL = 16K L + 12 λ = 0 -------- (ii)
L λ = 15K + 12L – 1200 =0 -------- (iii)
 Solution (cont): Solve for K, L and ƛ
Output maximizing condition,
MPK/MPL = PK/PL
MPK = ∂Q/∂K = 12K-1/2L2/3
MPL = ∂Q/∂L= 16K1/2L-1/3
PL= 12 and PK = 15
12K-1/2L2/3 = 15
16K1/2L-1/3 12
= K-1L = 5/3
L = 5/3K
And 15K + 12L – 1200 =0
15K + 12(5/3K) – 1200 = 0
15K + 20K = 1200
35K = 1200
K = 34.3 and L = 57.2 Units.
 Maximum output
Q = 24K ½ L 2/3
½ 2/3
24(34.3) (57.2)
= 24(5.83) (14.85) = 2077.8

2nd order condition,

2 2
2P1P2L12 – (P1 L22 + P2 A11)
Hence 2PLPKLLK – (P2LLKK + P2K LLL)
-1/2 -1/3 2/3 2/3 -1/3 2/3
2(12)(15)(8K L ) – [122-(-6K L ) + 152(-16K /3L-1 )] > 0
It’s a maxim
 PRACTICE EXERCISE
1. The production function of a firm is given as

Q = 60K1/2 L2/3 – 2 + 1
5L3 7K5
Determine APL, APK, MPL and MPK

2. The demand and average cost functions for a certain firm are given as:
Q = 600 - 5 P
ATC = 12Q +12 - 128
Q
Determine
i) price elasticity of demand at P= 10
ii) marginal revenue and marginal cost functions
iii) profit function
iv) Profit maximizing output for the firm.
 Exercise 3
The production function of certain firm is given as

Q = 24 K1/2 L ¾

A unit of capital and labor costs $ 12 and $ 24 respectively. The firm would like to maximize
output subject to it spending $ 4800. Determine the number of units of capital and labor it should
hire.
 Chapter 5: Cost and Profit Maximization
A firm’s primary objective is to maximize profits which are represented as the positive difference
between total revenue and total costs. The firms cost functions are derived from the optimal input
combinations and show the minimum cost of producing various levels of output.

CONCEPTS

The total cost C can be a function of many factors such as output (Q), technology (T), and price
(P):

C = f(Q, T,P)

For simplicity purposes, costs are assumed to be a function of output, C = f(Q), ceteris paribus.
 TOTAL AND PER UNIT COST FUNCTIONS
In the short run the firm incurs costs on fixed factors and variable factors of production

Total Fixed Costs (TFC)

Are total costs on all fixed factors. These include interest payments on borrowed capital, rental
expenditures on leased plant and equipment, property taxes, costs of managerial and administrative
staff.

Total Variable Costs (TVC)

On the other hand, are total obligations of the firm for all the variable inputs that the firm uses.
These include payments for raw materials, most labor cost, etc.

Total Costs (TC)

Equals totals fixed costs (TFC) plus total variable costs (TVC). That is,

TC = TFC +TVC
 Average and Marginal Cost
From the total fixed, total variable and total cost functions we can derive the corresponding per
unit (average fixed, average variable, average total and marginal) cost functions of the firm.

TFC
Average Fixed Cost (AFC) =
Q

TVC
Average Variable Cost (AVC) =
Q

TC TFC TVC
Average Total Cost (ATC) =  
Q Q Q

ATC = AFC + AVC

TC TC TC 2  TC1

Marginal Cost (MC) =  , MC 
Q Q Q2  Q1
 Example
Given the following table, develop the columns of the total fixed cost (TFC), total variable cost
(TVC), average variable cost (AVC), average total cost (ATC), and Marginal cost (MC)

Quantity of Output (Q) Total Cost (TC)

0 60

1 80

2 90

3 105

4 140

5 195
 Profit maximizing behavior of firms
Firms seek to maximize profits under normal circumstances.

Profits (π) = TR – TC

Conditions for profit maximization: Requires that the firms marginal revenue (MR) equal its
Marginal cost (MC).

MR = MC

By differentiating the equation (Π = TR – TC) with respect to output gives the profit maximizing
condition / equation.

The necessary condition MR = MC also means that dπ /Dq

 Examples
EXAMPLE 1

TR = 20Q – Q2

TC = 50 + 4Q

a. Find the level of output, Q that maximizes profit (II)

b. Find the maximum profit
 Examples (cont)
EXAMPLE 2:

TR  45Q  0.5Q 2

TC  Q  8Q  57Q  2
3 2

a. Find Q that maximizes profit (∏).

Find the maximum profit

 Breakeven Analysis
• Cost-Volume (sales)-Profit analysis is one of the most powerful tools that
managers have at their command. It helps them understand the
interrelationship between cost, sales, and profit in an organization.
• The difference between total revenues and total variables costs is called
contribution margin. It is called contribution margin because it is a
contribution toward fixed costs and profit
• The contribution income statement emphases the behaviour of costs and
therefore is extremely helpful to a manager in judging the impact on
profits of changes in selling price, cost, or volume
• The contribution margin as a percentage of the total sales is referred to as
the contribution margin ratio. This ratio is computed as follows:
CM
CM ratio=
Sales
 Breakeven point Analysis(cont)
• The concept of a break-even point is based on the analysis of variable costs ,
which fluctuate with the level of activity, and in fixed costs independent of
the level of activity.
• The breakeven point is the sales or level of activity that the company must
achieve to cover all of its expenses (variable and fixed) and for which it
generates no profit or loss.
• The breakeven point (BEP) is that quantity of output sold at which total
revenue equals total costs that is there is no profit or loss. The breakeven
point tells managers how much output they must sell to avoid a loss.
Breakeven number of units = Fixed costs/Contribution per unit
Breakeven revenues = Fixed costs/ Contribution margin ratio or %.
Contribution margin per unit x Breakeven number of units = Fixed costs
 Graphically analysis of Breakeven point
Graphically, it can be calculated as:

Revenue/Cost Total revenue

100,000 Break even point in revenue Profit area Variable costs

80,000

60,000

40,000 Loss area Fixed costs

20,000 Break even point in units

10 20 30 40 50 60

Units sold
 Example
Voltar Company manufactures and sells a telephone answering machine. The company’s
contribution format income statement for the most recent year is given below:
Total Per Unit Percent of sales
Sales (20,000 units) .................................. $1,200,000 $60 100%
less variable expenses .....................................900,000 45 ?
Contribution margin...................................... 300,000 15 ?
Less fixed expenses ........................................240,000
Net operating income $ 60,000

Management is anxious to improve the company’s profit performance and has asked for any
analysis of a number of items.
Required:
1. Compute the Company’s CM ratio and variable expense ratio
2. Compute the company’s break-even point in both units and sales dollars.
 PRACTISE EXERCISE
1. Owen intends to start a car wash business in Bujumbura. He has identified an open

ground for which he is being charged a daily rental fee of Fbu 40,000 and Fbu 1,000 per
car. He will be charging Fbu 5,000 for every car regardless of the model. Assuming q cars
are washed daily including Sundays:

i) Formulate Owen’s daily revenue, cost and profit functions

ii) Find his break even point

iii)Calculate his average daily revenue, cost and profit if 140 cars are
washed in a week.
2. The following table shows how total cost (TC) relates to total output (Q).
Q 0 10 20 30 40 50 60 70 80

TC 90 160 200 270 370 540 810 1210 1770

i) Find the value of total fixed cost (TFC)

Develop columns for total variable costs (TVC), average total cost (AC), and marginal cost (MC)
from the above data
 Exercise 3
Krampouz manufactures and sells pancake machines for professionals according to the following
appendices:
Appendix1: data of exercise "N"
Elements Items Amount
Number of models sold 16 000 units
Unit price excluding taxes 79 €
Variable expenses proportional to the turnover:
- materials and supplies consumed 467 800 €
- workforce 202 000 €
- distribution cost 8 % of the sales
Fixed charges 341 400 €
Appendix 2: data of exercise "N+1"
Elements
Increase in quantities sold: 10%.
Decrease of selling price: 5%.
3% decrease in unit prices of materials and supplies consumed.
Other unit costs remain the same.
Fixed costs are estimated at 307,000€.
a. Calculate the breakeven point in value, the security index and the breakeven point in days for the
exercise N
b. Carry out an identical study for the forecasts of the "N + 1" exercise.
c. Calculate the number of models that the company should sell to achieve an overall result of
220,000€ under the same operating conditions as in the year N + 1
Chapter 6: Firm behavior and Market
Structure

Research Paper and

Group Presentation